Financial analyst and fraud tipster Harry Markopolos testified before the House Financial Services Committee today about the Bernie Madoff Ponzi scandal. For almost nine years, Markopolos conducted his own investigation and pleaded with the SEC to investigate what would become the largest Ponzi scheme yet recorded. His testimony questions fundamental competency within the SEC and suggests that SEC attorneys failed for the same reason many Madoff investors got duped: ignorance about the investments plus embarrassment at not understanding.
Markopolos' prepared testimony reads like a voluminous field report from a financial analyst turned vigilante investigator. Ignored by SEC regulators, Markopolos, a derivatives trading expert, is forced out of civic duty to conduct an investigation with his own team. Says Markopolos, “[m]y army special operations background trained me to build intelligence networks, collect reports from field operatives, devise lists of additional questions to fill in the blanks, analyze the data, and send draft reports for review and error correction before submission to the SEC.” Theatrics (and that he reportedly was a competitor of Madoff) aside, Markopolos appears to have been largely right.
For years, Markopolos believed that based on the types of investments Madoff was supposedly offering, the returns reported simply could not be real. As the Guardian reports, five minutes with Madoff's offering materials were enough for Markopolos to suspect fraud. And in four hours he broke down the mathematical models to show that Madoff's returns could not come from the investments he purportedly sold.
He tried to explain this to the SEC though detailed reports, phone calls, meetings and emails in 2000, 2001, 2005, 2006, 2007 and in 2008. The upshot? As Markopolos estimates in his testimony, "SEC securities lawyers if only through their investigative ineptitude and financial illiteracy colluded to maintain large frauds such as the one to which Madoff later confessed." He is particularly hard on former SEC New York Branch Chief Meaghan Cheung, whose office failed to investigate Madoff. Markopolos claims she never understood the concepts in his reports, and was too arrogant to ask any questions.
Which brings us back to the first shady Madoff investment to catch Markopolos' eye: a "split-strike conversion" strategy Madoff was offering in or around 1999. Way back then, Markopolos saw a reason that Madoff chose "split-strike conversion" to cover what was truly a Ponzi investment scheme. "He knew most wouldn't understand it and would be embarrassed to admit their ignorance so he would have [fewer] questions to answer." A nice hook for a Ponzi schemer: ignorance plus embarrassment.
Markopolos, the House Finance Committee and the public rightfully demand an SEC that understands the mechanics of the field which it regulates. However, investors can also see a lesson in the Madoff case about the importance of understanding any investment, and of asking questions about what you don't understand. More questions of Madoff earlier could have meant fewer billions stolen.