I also included examples of the many strange explanations I’d heard from experienced people in the industry when I’d asked them how Madoff generated such consistent returns: I had been told he was using the information he gets by paying for order flow to earn profits for his hedge fund, that he was actually borrowing the investors’ money to use in his broker-dealer operation and paying them 15.5 percent interest for the use of that money, that he was personally subsidizing the down months to maintain low volatility of returns, and that he had perfect market timing.
And I concluded by pointing out that he did not allow outside performance audits, which no legitimate firm would have any reason to deny.
I was confident that this submission, which I would explain in detail at the meeting and answer any questions it brought up, certainly would arouse the suspicion of the SEC. Given this road map, almost any competent investigative team would easily be able to figure out exactly what Madoff was doing.
I didn’t have any idea how long the process would take. Several months, I guessed.
Well, obviously that was a number I got very wrong.
Chapter 3
Falling Down the Rabbit Hole
If possible, Ed Manion was more determined to expose Bernie Madoff’s scheme than I was. After reading my submission, he believed firmly that it was strong enough to convince the Securities and Exchange Commission (SEC) to open an investigation. And bringing down Bernie was going to be a coup for his agency. He had arranged for the two of us to meet with Jim Adelman, a senior enforcement attorney at the agency, whom he respected. Jim’s a pretty sharp guy, Ed had told me. He’ll get it.
I don’t get nervous very often, but truthfully, I was nervous. This was the first time I’d been in the SEC building, and going forward officially with this accusation represented a big step for me. If Rampart found out about this meeting, it would have caused me some serious difficulty. I suspect I would have been asked to drop the investigation, and if I had persisted it might have cost me my job. However, I knew it was the right thing for me to do. My expectation was that the SEC would find that my allegations were credible and would very quickly assign an examination team or an enforcement team to determine if Madoff was simply a financial fraud or a Ponzi scheme. I didn’t think they would ignore me; I was handing them the largest case in their history. I was giving them the headlines any government agency craves. This was a tremendous opportunity for them to demonstrate to the nation that the SEC was a bulldog when it came to protecting our financial markets.
In May 2000, Ed and I were waiting in a small conference room when Jim came in and immediately began apologizing. “I’m not going to be attending this meeting, because I’ve given my notice to the SEC,” he explained. “I’m going into private practice, but I just wanted to thank you for coming in today.” Then he was gone.
Minutes later Grant Ward, an attorney who was the SEC’s New England regional director of enforcement, walked into the room. After introductions I began my formal presentation. As I explained this massive fraud to Ward, it very quickly became clear he didn’t understand a single word I said after hello. It wasn’t entirely his fault; he never should have been put in that position. He was a securities lawyer who knew little about the financial industry. In preparing my submission I’d specifically left out all the calculus, all the linear algebra. I’d made it as bare-bones as possible so the SEC staff could understand it. But even that wasn’t basic enough. I will give Ward credit; he tried to look interested as I explained the numbers. But truthfully, if blank looks were dollar bills I would have walked out of that room a rich man. He was coldly polite, but he didn’t ask a single probing question. I never knew if that represented a lack of interest, a lack of comprehension, or simply a desire to go to lunch.
Ed was devastated. He knew how badly it had gone. It seemed clear that his faith in his agency had been shaken. He’d done his job; he’d brought in evidence of a fraud and handed it over to the division charged with investigating it. As we waited for the elevator I asked him, “You think he got it?”
Ed shook his head. “Not one single word of it.”
At that moment I still didn’t have the slightest idea how truly incompetent the SEC was. On Wall Street the real fear about the SEC was not that it would uncover hidden crimes, but rather that it would bury you beneath an avalanche of paperwork. That’s what it was best at. SEC audits consisted primarily of confirming that a checklist of documents existed, not necessarily that these documents were accurate, not even that they reflected real trades—just that you had the proper papers in your files. Firms hated these audits because they were distracting and time-consuming and rarely resulted in anything more than a deficiency notice or even a small fine for some minor compliance issue.
Nobody I knew had a lot respect for the exam teams. Most of these teams consisted of bright young accountants whose primary objective was to learn the industry at the taxpayer’s expense, then take that knowledge into the private sector where they could earn a substantial salary. Occasionally there would be a lawyer on the team, but at that level these lawyers wouldn’t understand derivatives. In fact, after Madoff was arrested, his secretary revealed that the few times SEC investigators had come to the firm most of them had asked for employment applications. That was typical. If during an exam investigators found a problem, they would report it and issue a deficiency notice or fine, but most of these people weren’t looking to derail their careers by bringing big, complicated cases that would take years to resolve against the most powerful people in the industry.
My error was in believing that the SEC actually was capable of protecting investors. The problem was that I knew a few dedicated men like Ed Manion and Joe Mick, and I made the assumption that there were lots of others just like them. And that was a big mistake. As I was to learn over the next few years, the SEC had been created to monitor the stock market and it really had never evolved with the industry. Its investigators had neither the experience nor the training to understand something fairly complicated like fixed income, for example, an array of investments that yields a specific return on a regular basis but is much more complex than it initially appears. Municipal bonds, for example, is an area in which there is well-known and widespread corruption. And if the SEC couldn’t do the math for fixed income, it certainly could not do it for complicated derivatives or structured products. Structured products are combinations of underlying assets, like stocks and bonds, combined with various types of derivatives. They are incredibly complex. The SEC certainly doesn’t understand them; in fact, a lot of people on Wall Street don’t really understand them, so what chance does an individual investor have? All you really need to know about structured products is this—it’s the 99 percent of structured products that give the good 1 percent a really bad name.
What should have been obvious to me was that there is a tremendous mismatch in skills between the SEC regulators and the people they are supposed to be regulating. The quants who create these financial products understand differential equations and nonnormal statistics; they program in languages the SEC doesn’t speak; they run statistical packages the SEC doesn’t even know exist. The quants are busy data mining with supercomputers while the SEC is still panning by hand. I suspect SEC attorneys like Grant Ward are probably well-intentioned. I’m sure they want to do a good job, but they never should have been put in their positions. Sending lawyers to oversee capital markets professionals is like sending chickens to chase foxes; it just doesn’t work, because there’s an unbridgeable skills gap between the two. It would be akin to asking me to argue a case in front of the Supreme Court.
The only chance the SEC had to even the playing field was the extensive use of whistleblowers. The agency needed people on the inside to expose corruption, but it offered no incentives to encourage those people to come forward. This isn’t true only in the SEC; it’s pervasive throughout government agencies and private industry. People who come forward to expose corruption risk their jo
bs, their personal relationships, and even their lives. Rather than being celebrated for their honesty and integrity, too often they end up alone and embittered. The sad truth is that in too many cases whistleblowers have gotten badly screwed. In the past few years I’ve come to know several of them well, and this includes people who have received large rewards for exposing frauds that robbed the government of hundreds of millions of dollars, and the truth is that many of them are sorry they ever got involved. The money they eventually received wasn’t worth what they had to go through simply to do the right thing. The SEC whistleblower program was extremely limited in scope—it didn’t apply to Ponzi schemes, for example—as well as in the protections it offered.
Like all whistleblowers, I had taken a risk preparing this submission and showing up at the SEC offices. And then to be so easily dismissed by a powerful senior enforcement executive who had absolutely no understanding of the industry he was supposed to be monitoring was really discouraging.
As Ed and I rode down in the elevator we looked for something positive that had come out of that meeting—we rode all the way down to the bottom floor but we couldn’t find any positive outcome.
I never received a response of any kind from the Boston office of the SEC after that meeting. Not even a “Thank you, and can we validate your parking lot ticket?” Ed really encouraged me to keep going; he kept pushing me. Being smart enough to understand the tremendous damage that Madoff could inflict on the industry, as well as on the SEC, he remained deeply concerned about it. He told me he was going to keep pressing for answers inside the agency, but urged me to continue tracking Madoff and gathering as much additional evidence as possible. At that point I don’t believe I had even told Ed about Frank and Neil. I really wanted to keep them out of it for their own safety.
I believe Ed would have tried to move up the SEC food chain, but as he explained to me, he had run into a jurisdictional problem. The SEC’s New England region extended south only as far as Greenwich, Connecticut. Even if Ward had wanted to, he would not have been permitted to send an investigative team into New York City. Once you crossed into New York State, you had to deal with the New York regional office. And, Ed admitted, the two offices were extremely competitive; there was not a lot of respect in either office for the other one. Although he was going to forward my submission to New York, he pointed out that the chances of the New York office warmly embracing a case handed to them by the Boston office were somewhat limited. “I really don’t have a choice,” he told me. “I’ve got to forward this to New York for action.”
Obviously I was disappointed. I had expected that we would hand over this case to the SEC and watch happily from the sidelines as they closed down Madoff. Then I could get back to my real life, which by then included my new wife, Faith. Faith is an amazing woman. She is Chinese; her parents were senior diplomats in the Chinese Foreign Ministry, and for several years they represented the Communist Chinese government in New York. Faith came to the United States as an exchange student and ended up living with a Jewish family who helped her get a scholarship to Wellesley College. When I met her she was working as an analyst at Fidelity.
We got engaged the old-fashioned way. She gave me a deadline and told me if we weren’t engaged by that date I was history. Her dream was a two-carat engagement ring and I wanted to fulfill that dream. I found out one carat was $3,000, so I naively assumed that two carats would be $6,000. That assumption was wrong. The price didn’t double; it increased geometrically to about $20,000. Maybe Bernie had billions, but I certainly didn’t.
I tried to negotiate with her, suggesting, “Maybe we shouldn’t do the same old diamond ring thing. Jewelers rip you off. Diamond rings are like new cars—they lose half their value the moment you take them out of the showroom. I think we should get cubic zirconia because diamonds have flaws in them, but cubic zirconias are flawless, just like you.”
She didn’t buy that one for a second. So I tried to reason logically with her. “I’ll tell you what. I have a buddy, Paul, who works at a trading desk down in Westchester, and he thinks the only silicon worth investing in is a set of breast implants. When he got married, instead of giving his wife a diamond ring he gave her a $6,000 set of breast implants.” I paused for effect, and added hopefully, “I’m willing to do the same for you. That way it’s something we both can enjoy.”
We settled for a carat and a half.
After we were married I convinced her to become an American citizen. Truly one of the most memorable days of my life was watching Faith become a citizen. She was part of a large group taking the oath of allegiance together. I cried, literally. When you’re watching this ceremony, when you’re listening to a cacophony of accents reciting the pledge of allegiance, it is absolutely impossible not to think about this country and the American values. I’m not going to claim I thought about Bernie Madoff at that moment, but I did think of my Greek family who came here to earn an honest living and taught their children the difference between right and wrong.
I have been asked many times why I continued to pursue Bernie Madoff when no one except the members of my team showed any interest and, if I was right and this was a Ponzi scheme, there was no chance of receiving a bounty. The answer is because what he was doing was wrong and he needed to be stopped. I didn’t put any human face on it. I didn’t do it for any potential reward or to save corporate investments. At that time I didn’t even know about affinity schemes. I did it because my parents had taught me the difference between right and wrong.
That was the reason that even after Ward showed no interest in my submission it never even occurred to me to drop our investigation. Frank, Neil, and I never even discussed that possibility. We were intellectually and emotionally engaged in the pursuit of a master criminal, disguised in plain sight as a highly respected member of the community. In some ways it was like playing a real-life game of Clue: Bernie’s in the parlor with $5 billion!
We were living with the constant feeling that we were just about there, that if we could get just a little more evidence the SEC would be forced to listen to us. And when that happened, it would be bye-bye Bernie.
For Frank, of course, there actually was the potential of a pot of gold at the end of this particular rainbow. Frank continued to believe that Bernie was front-running. If Madoff’s fund was closed down, Access alone had at least $300 million to invest, and Frank was confident that I could create a legitimate product whose returns mimicked Bernie closely enough to grab a chunk of that business—and perhaps a lot more.
What our investigation lacked up to that point was any inside information. We had Bernie Madoff’s numbers, but we knew nothing about him or the way he operated. He existed only through his reports and charts and beautiful returns. I had seen photographs of his brother, Peter, and his two sons, but I had no idea what he looked like. The word most often used to describe him was distinguished, which on Wall Street generally means rich and powerful. Later, as our investigation intensified, I would try to find a disgruntled employee or a former employee who was willing to talk about the company. I’ve done several investigations since this first one and I’ve always been able to recruit one or two insiders who would talk to me. But in this case we were never able to find anyone like that. If there were unhappy employees who knew anything about Madoff and his hedge fund operation, we never found them. He kept his employees. He paid them very well and apparently provided great benefits. And those few people who had left for other opportunities either had no inside information or felt they had been treated fairly.
But in the winter of 2001 we got very lucky, and added an investigative journalist to our team. Frank Casey had been invited by the hedge fund industry magazine MARHedge to speak to potential investors at a conference in Barcelona, Spain. MARHedge had been founded in 1994 to provide information for the rapidly growing hedge fund industry. It was the first monthly magazine aimed specifically at fund managers and investors, and had become a must-read for everybody in that industr
y. MARHedge conferences brought together the heavy hitters from both the United States and Europe, so this was an important sales opportunity for Frank. He had been invited to speak to fund managers on the potential value of structured financial notes to hedge funds. He was trying to convince managers to let Rampart run a portfolio of those notes for their funds.
As Frank and his wife climbed into the backseat of a cab that would take them from the Barcelona airport to the hotel, a somewhat harried younger man asked, “Do you mind if I share the cab? I’m also on my way to the conference.”
No One Would Listen: A True Financial Thriller Page 9