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Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation

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Sun, 06 Sep 2009

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.

Posted at 16:22 on Sun, 06 Sep 2009     View/Post Comments (0)     permanent link