Bernie Madoff, one of the greatest financial fraudsters of all time, died earlier this month. That his was possibly the largest Ponzi scheme ever created a sense of history unfolding in front of our eyes as it was exposed in 2008. That his fraud was exposed at the height of the greatest economic crisis since 1929 gave the financial crisis a name and a face that the legions of bankers, politicians, Treasury and Fed officials could not. That this was a fraud hidden in plain sight for years, probably decades, that had duped so many cemented the popular impression that nobody had their hands on the wheel of the financial economy; it was a runaway train that spelled doom for its willing and unwilling passengers alike.
My interest in the Madoff fraud has always had little to do with the fraud itself or the context of the times, and more to do with the failure of regulators to detect and investigate Madoff’s activities. The regulatory lapses would be comical if their effects weren’t so tragic.
Through the eyes of regulatory practice, the Madoff fraud is a story of what regulators did not do. The SEC received a half-dozen detailed allegations about Madoff’s business over a 16 year span, allegations that the SEC either dismissed without investigation, or investigated in a half-hearted fashion. In light of what was ultimately learned, the latter are egregious lapses in regulatory conduct. SEC officials accepted implausible statements from Madoff as fact. They failed to perform the most rudimentary of independent research. To wit: a single call to the DTCC would have revealed Madoff hadn’t executed a trade in years.
From a regulatory perspective, the primary conclusions have been (a) shame on the SEC and (b) that regulators are not looking for fraud while it is happening, only describing it in detail once it has been exposed.
Yet there are deeper, personal, questions to reflect on.
The most popular - and the most useless - of these questions is whether or not you would have been a willing investor. The “would you have invested” question is useless in no small part because it implies that the victims are complicit in the perpetuation of the fraud by their own blind faith borne entirely of greed. And it is true that for decades, Madoff’s returns were outrageous and inexplicable by all standards, yet he persisted year after year after year, attracting new investors in his ever-growing Ponzi scheme. But if invited, coerced, hounded, and even shamed by people in your trust network, would you have put money in? Of course you would have. Very few individual investors have the sophistication and skepticism, let alone the cuts and bruises and calluses, of an institutional investor. Add the marketing that Madoff employed - personal relationships, exclusivity, secrecy, and the twisted implication that because the SEC had investigated his firm no less than six times and found nothing it was quite clearly legitimate - and the individual with capital to invest didn’t have much of a chance. As the 19th century sage PT Barnum pointed out, the coefficient of suckers to birth rates has always been nearly 1.0. Very few have special immunity.
The better questions have to do with how you would have behaved as a regulator. The popular posture toward the SEC is one of disappointment, that they failed the very investors they are paid to protect, that the institution itself is corrupted by regulatory capture. Yet had you been a SEC investigator, would you have recognized the impossibility of Madoff’s returns when presented with little more than other people’s theories? Would you have been diligent with inquiries after the boss told you to drop it? Would you even have been just a little bit more hygienically thorough?
Answer those questions in the context of business-as-usual at any regulatory agency. How understaffed is the SEC? How many plausible allegations of fraud is the SEC presented with each month? And the allegations they receive, are they truly the product of independent researchers seeking to right wrongs, or are they motivated by some nefarious intent such as professional jealousy? How does the SEC balance the quantity versus the quality of investigations they undertake? How routine do these investigations become to the investigators themselves? What makes any of us think we would not ourselves be burdened by these - and many, many more - factors in the disposition of our jobs as investigators? This line of questioning is not intended to suggest the SEC was not derelict in its duties, but to point out how difficult the job is.
If the regulatory failures surrounding Madoff are examples of bad governance, what does good look like? I have written elsewhere that we can take cues from the positive behaviors and actions of the activist investor playbook. But if the regulatory lapses in the Madoff case tell us anything, it is that a playbook is one thing, a persona is another. Dr. John Kay summed this up best when he described the person best suited to do this kind of job:
You require both an abrasive personality and considerable intellectual curiosity to do the job.
It is easy to criticize the regulators in hindsight from the comfort of one’s armchair. It is another to possess the personality traits, the discipline to know when to bring them to bear, and the energy to sustain them, in every situation every day in which we find ourselves.
