Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

The SEC Madoff Investigation Report

Ever since the Markopolos documents became public, we have known
that the SEC bungled its investigation of Madoff very badly (see my
blog posts here
and here). So
when the SEC asked its Office of Investigations to investigate the
SEC’s failure, there was only one question to answer – was
it incompetence or was it something worse? We now have a 450 page
report
(with only minor portions redacted) describing how the SEC
dealt with various complaints against the SEC.

In my first blog post last year, I wrote that:

I could not get away from the feeling that the SEC bungled this
investigation very badly. But I also suspect that regulators are much
more geared towards dealing with complaints from whistleblowers or
other complaints with a “smoking gun” proof rather than
some forensic economics that most regulators probably do not
understand. Perhaps also the fact that a complaint comes from a rival
automatically devalues its credibility in the eyes of many
regulators.

I believe that in financial regulation, both these attitudes are
completely mistaken. Forensic economics is usually more valuable than
“smoking guns” and complaints by rivals and other
interested parties are the best leads that a regulator can
get.

By and large, the investigation report tells the same story. But I
think the report pushes the incompetence story a bit too much to the
point where it almost reads like a whitewash job. I counted the term
“inexperienced” or “lack of experience” being
used 25 times in the report and that count excludes several other
similar phrases. When an investigator is a good attorney, the report
complains that the person had no trading experience; when the person
had trading experience, it complains about his lack of investigative
experience.

I am a firm believer in Hanlon’s Razor: “Never
attribute to malice what can be adequately explained by
stupidity,” but the report’s furious attempt to document
incompetence makes one wonder whether it is trying to cover up
something worse than incompetence.

At several points in the last few years, the SEC staff appear to
have been tantalizingly close to uncovering the fraud. They knew that
Madoff was lying to them repeatedly, but their seniors seemed to be
unwilling to let them go where the facts seemed to point them. On all
occasions, the staff seem to have been intimidated by Madoff’s
standing in the industry and within the SEC itself. Repeatedly, the
senior staff in the SEC seemed to turn any complaint about Madoff into
one on front running even when the complaint was not about front
running or explicitly stated that front running was unlikely. Of
course, front running was the one crime that Madoff was not guilty
of!

The report gives a completely clean chit to the SEC where it really
matters:

The OIG did not find that the failure of the SEC to uncover
Madoff’s Ponzi scheme was related to the misconduct of a
particular individual or individuals, and found no inappropriate
influence from senior-level officials. We also did not find that any
improper professional, social or financial relationship on the part of
any former or current SEC employee impacted the examinations or
investigations.

Rather, there were systematic breakdowns in the manner in which the
SEC conducted its examinations and investigations …

While Sandeep
Parekh
states that he is “impressed that such a self
critical report was put up on the main page of the SEC’s
website,” the SEC OIG report appears to me to be a report of
self exoneration.

My adherence to Hanlon’s Razor remains unchanged, but this
adherence is in spite of the OIG report and not because of it.

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