Monday, December 15, 2008

Madoff Fraud Exposes Regulatory Weakness

How do you perpetrate a $50 billion ponzi scheme?  The details are still hazy, but a few clues that something was amiss at Bernie Madoff's investment fund were enough to keep at least one shrewd advisor from steering clients into the massive fraud.  An advisory firm named Aksia, attempted to replicate the "split-strike conversion" strategy, using a quant analyst who failed to reproduce the returns indicated by Madoff's fund.  Furthermore, since all of the firm's assets were custodied with Madoff Securities, rather than a third-party clearing firm, Aksia investigated the auditor Friehling & Horowitz.  F & H only had three employees, one of which was a 78 year-old living in Florida, one secretary and one active 47 year-old accountant.  The office was in Rockland County, NY and was only 13ft x 18ft large.  Given the scope of Madoff's investment operation, the auditing firm appeared small.  Why other advisory firms and fund of funds firms didn't perform the same due diligence remains a mystery.  After all, what purpose do all of those extra fees on top of fees serve if not to fund extensive due diligence?  It is remarkable how many wealthy and sophisticated investors forked over money to Mr. Madoff given the lack of transparency.  Furthermore, it is even more incredible that some very wealthy investors were so enamored with Mr. Madoff that they handed their entire net worth over to one fund.  The Wall Street Journal has several interesting articles covering many of the issues raised by the Madoff debacle.  The victims of the fraud included many well known wealthy investors and Jewish charities.  Furthermore, an entire enclave in Palm Beach where Mr. Madoff recruited investors has been decimated by losses, with four ultra-luxury condos hitting the market this weekend in one resort, and investors calling the local high-end pawn shop on a Saturday (when it is ordinarily closed) to get loans. 
Where exactly was the SEC?  Asleep at the switch again.  According to the Wall Street Journal, the SEC investigated the firm several times over the years and came up empty-handed.  The agency's enforcement division even investigated a whistle-blower's concerns in 2007, but closed the probe without bringing a case.  Additionally, Mr. Madoff registered his firm as an investment advisor in September 2006 and was not examined within the first year, as is the  requirement for new investment advisors.  The SEC did not sue until December 11, 2008 when Mr. Madoff's sons turned their father in after his confession.  Clearly, there is something very wrong with the regulatory structure of the US securities industry if it cannot unearth a scheme this large without a confession from the guilty party.  The fact that this monumental scam went undetected for so long is mind-boggling and will be a tremendous blow to the hedge fund industry.  Make no mistake, if investors were scrambling to get their money out of hedge funds before the Madoff fraud was unveiled, redemption requests will only increase significantly on the heels of this news.  Analysts who have been calling for the industry to shrink by 30-40%, will have to revise their estimates much higher.  Try 70%.  That's if they can get around the "gates."    

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