Take it from an ex-regulator

Throughout the course of this week you will no doubt hear more and more about Bernard "Bernie" Madoff and his investment fraud. If you haven't heard about Mr. Madoff and what he was able to do for the past 40 years take a quick second to read the following article entitled "Another View: The Madoff Scheme" as published in the New York Times "Deal Book" by Stephen David. Now that you know what's happened, while the world struggles to cope with the fallout of this situation I'd like to share some unique insights with you.

In a past life I was an auditor for the National Futures Association ("NFA") and learned first hand the techniques and procedures related to regulatory and financial auditing. In my tenure at NFA I was privileged to have been a part of more than 100 financial audits throughout the United States. Through my experiences I was able to see first hand what fraud looked like, what compliance looked like, and learned how to deal with everything in between. My experience at NFA was one that I will always cherish as it enabled me to gain a great deal of insight into how financial operations are organized and what they "should" look like when they are run as efficiently as possible.

To give you a bit of a background before I continue; NFA is a private regulatory agency which over-sees the enforcement of commodity, futures, options on futures, and foreign exchange ("Forex") law on behalf of a Federal Agency called the Commodity Futures Trading Commission ("CFTC"). The CFTC and NFA are responsible for being the watch dogs of the commodities and derivatives industries through the use of varying market surveillance techniques and routine in-office examinations of federally registered commodities brokerage firms. Their securities counter parts or direct equivalents (for all practical purposes) are the Securities Exchange Commission ("SEC"), and the Financial Industry Regulatory Authority ("FINRA") which was previously known as the NASD.

Understanding the relationship between these regulatory bodies is paramount to what I want to share. Most importantly it's important to understand the similarity between the CFTC/NFA and the SEC/FINRA, as the SEC is currently under a great deal of scrutiny over how the Madoff scandal was allowed to continue for nearly 40 years. People are asking how a Ponzi scheme could have been run for so long, with so much money, and not have been questioned or collapsed sooner.

In my experience at NFA I can assure that everyone I worked with was trained on many, many industry situations and practices. I can also tell you that within the first few weeks of my training I was taught about Ponzi schemes among other known financial frauds. NFA taught on this issue so that in the unlikely event that my fellow auditors or I saw activity which appeared to be fraudulent we'd be more readily able to recognize it and do something to try and stop it. More specifically, to ensure we understood things, we were given reproduced documents from previous regulatory experiences and were asked to review them for irregularities. Through this process we learned very quickly what "normal" looked like and NFA did the best it could to prepare us for what might lie ahead during our auditing careers.

Getting back to the point, I can distinctly remember in our training that we were taught about Ponzi scheme's such as the one that Bernie Madoff has admitted to orchestrating. We were taught that a scheme such as his was one of the oldest financial frauds ever created to illegitimately gain money from investors. In addition at this time we were also told that Ponzi schemes were becoming increasingly less prevalent as the public became wiser and society became more technologically advanced. Most importantly though is the fact that this type of scheme WAS explained to us.

Back then, we learned of some basic things to look for if we suspected a Ponzi scheme which included:

1. An abnormally long string of consistent positive returns that significantly beat long term industry averages.
2. An overall lack of clarity existed about: how returns were generated, where firm assets when received from clients were ultimately deposited, and if fuzzy explanations about what trading strategies or partners were utilized by the firm were provided.
   
3. The ratio of client withdrawals to client deposits is highly abnormal based on typical withdrawals and deposit schedules of similar operations.
   
4. Based on the size of the firm and the overall sophistication level of its client base the company's certified auditor (accounting firm responsible for the organizations annual certified financial statements) was to be equally sized and sophisticated to handle such an examination.
5. Lastly, and the most obvious, review the internal investigation system at NFA and review the complaints that had been received to see if anyone had alleged things just didn't seem right.

and one I didn't consider until reading the articles about Madoff: a use of paper statements with no client access to electronic trading records; A red flag in 2008 which compliments the ideal of a decrease in these schemes with the advance of technology as stated above.

Based on my experience, every auditor after completing training at NFA (at least while I was there) knew about Ponzi style fraud even if they had never seen one in real life. Therefore I am comfortable in saying that SEC investigators must have also had training on this particular type of fraud. I mean really, how could they not have since it is one of the most basic scams in the entire financial industry?

Now looking at the Madoff situation (which was under SEC jurisdiction) we know the following:

1. Madoff had only 5 months with losses from 1996 through last Thursday. On a yearly basis he returned roughly 11% consistently and averaged a 2% gain each month. To date this year the stock market is down 34% and many, many people have lost nearly everything. At the very least this should have come out prior to December and not after Madoff's own admission of guilt.
   
2. Madoff was incredibly secretive about how, where, when, and what he traded. Many market players have stated that based on the size of Madoff's fund they should have been able to "feel" his trades in the market but couldn't. Additionally one investor was quoted as saying: "Madoff's performance just doesn't make sense. The numbers can't be straight." While yet another sophisticated Madoff investor actually went through trade confirms in order to reverse-engineer the strategy and said, "it doesn't add up."
3. At this point we know that Madoff claims to have lost at least $50 billion in client funds, that would signal that the deposit to withdrawal ratio of the fund was totally out of line with industry norms; even for funds with regularly positive returns.
4. Madoff's auditing firm was Friehling and Horowitz, an alleged 3 person accounting firm whose last certified financial statement was 4 pages long. Keep in mind as of October Madoff reported to the SEC he had $17 Billion under management, yet his financial statement was 4 pages long...
   
5. Complaints about Madoff were filed with the SEC as early as 1992 and continued to come in over the years; The most recent I've read about coming in late 2007. Also in 1992 the SEC investigated Madhoff's involvement with another unscrupulous accounting firm and according to bloomberg resovled the issue by saying "Investors’ money was all accounted for"
6. Madoff still issued paper statements and clients had no access to electronic trading records, unheard of for a financial organization this sophisticated or complex during 2008.
   

How on earth could the SEC not have seen this coming? It makes you wonder if they didn't "want" to see it coming doesn't it?

You just can't make this stuff up...



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