No One Would Listen: A True Financial Thriller (11 page)
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Authors: Harry Markopolos
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What Frank was suggesting was that Madoff used the hedge fund investments over which he had complete discretion to produce profits from his broker-dealer. There were two ways we figured Bernie could have front-run his order flow. If a limit order came in to buy one million shares of IBM at a price of $100 or lower, Madoff could have put in his own order to buy the same number of shares at $100.01. He could then buy a million shares at $100.01 knowing that he had a firm order to buy those same shares at $100, so the most he could lose was a penny per share, or $10,000. However, if IBM went up, he could make unlimited profits. Of course, if a client came in and said, “Buy me one million shares of IBM at the market,” then Madoff could have a field day. For market orders all he had to do was buy one million shares of IBM first, which would drive the price of IBM up, and then sell the shares at a guaranteed profit to his trusting client.
Frank knew that as a broker-dealer Madoff printed his own trade tickets. Madoff could print phony tickets and use the cash as his capital base. That way he wouldn’t have to raise a lot of attention by continually going to the banks for short-term loans. And he needed the cash to build his broker-dealer. By 1999 most of the independent market makers had been sold to large firms, giving them tremendous cash resources. Madoff was pretty much the last of the large independent market makers. And while there were a lot of people wondering why he refused to sell his operation—he probably could have gotten more than a $100 million and he owned it by himself—he wouldn’t sell, so Frank argued that he needed large amounts of cash to continue to pay for the order flow he had to have if he was front-running. If he couldn’t get those large orders, he’d lose the inside information he needed to generate profits. As Frank argued, “If you’re going to try to take down big positions, if you want to be the guy everybody calls first when they’re trying to trade a big block of stock and they don’t want to move a market, you have to have a lot of capital.”
Neil was ambivalent, but when pressed he leaned toward front-running. For a long time Neil just couldn’t get beyond Madoff’s reputation. He was a respected public figure who had served on major securities industry boards; he had tremendous credentials. And theoretically he was making so much money from his brokerage there was no need for him to cheat like this. Bernie Madoff was a very wealthy man; if he needed more money, he could easily have raised more than he could possibly spend in his lifetime by selling his broker-dealership and retiring. Neil got caught up in the logic of it. It made no sense. Why would Bernie Madoff risk everything in his life to steal money he didn’t need?
We spent a considerable amount of time wondering about it. This was our mystery, and it served as a welcome diversion from the normal work of the day. One theory that seemed to make sense was that Madoff’s broker-dealership had been devastated by a technical shift in stock price reporting from fractions to decimals, which had made him desperate for cash. At that time we had no way of knowing precisely how long Madoff’s fraud had been in existence. We could trace it back to the beginning of his involvement with Broyhill and Access, which was only a few years earlier. That made us suspect it might have something to do with a fundamental change in the way the market quoted stock prices. Until 1997 the smallest fraction in a stock quote was 1/8, which was 12.5 cents. That meant any change in the value of a stock was a multiple of 12.5 cents. A broker-dealer could easily earn 12.5 cents per share. So if Madoff paid two cents a share to buy the right to market a block, he could still earn more than a dime a share. In 1997, that spread was narrowed to 6.25 cents, substantially cutting profits for the market makers. In 2000, technology allowed the market to begin quoting stock prices in decimals rather than fractions. The good old days of 12.5 cent bid/ask spreads were history. The exchanges began quoting stocks with a five-cent spread; in some instances the spread was only a penny. As Frank pointed out, Madoff’s profits were down 92 percent. So we knew that Madoff’s broker-dealership was no longer a cash cow for him; it was actually possible that it was losing money, and this sudden and substantial loss of income could have been his motive.
What continued to frustrate me was the insistence of Rampart’s management that I create a competitive product. Frustrate me? They were a pain in the ass. How come you can’t do it, Harry? Just give us something to sell, Harry. C’mon, Harry, what are we paying you for?
There is no one in the world who can tell you how many different financial products there are. There are literally thousands of really bright people who sit in offices around the world coming up with esoteric ways for people to get around government regulations, income taxes, estate taxes, and other barriers to the creation and preservation of wealth. Mutual funds, for example, were an innovative product in the mid-1920s. One day they didn’t exist, and decades later they were worth trillions of dollars. When creating a new product there are very few rules that have to be followed. Frank Casey explains it this way: “I can do anything I want. I could tell a client that I aligned Venus with Mars and when they were in the seventh heaven I bought stock and every time that happened I bought and I won. And that client might investigate to make sure Venus and Mars actually were aligned and in the seventh heaven when I bought and that I made money! And then that client would willingly invest in my product.”
So creating a financial product wasn’t the problem; the problem was creating a product that could compete with a Ponzi scheme. In the spring of 2000, less than six months after we had first encountered Bernie Madoff, my anger at being forced into that position became the trigger that made me decide it was time to go to the SEC.
I went to the SEC primarily for my own self-interest. After Madoff imploded, people who knew nothing about me would write that I went to the SEC to try to collect a reward, that I did it for personal monetary gain. It is literally impossible to be any more inaccurate than that. I wanted to rid myself of the pressure of having to develop a product that couldn’t be created. Bernie Madoff was my competition, and I couldn’t compete with him because I had to generate my returns through real trading, while he was creating his returns on a computer. He was playing on my field, in my space, and I knew he was a dirty player. I decided it was time to go to the referee and get him thrown out of the game. The SEC was the referee.
The United States Securities and Exchange Commission was instituted during the Great Depression by President Franklin Delano Roosevelt to restore public trust in the financial markets. Congress established the SEC in 1934 primarily to make sure that the kind of financial abuses that had contributed to the stock market crash of 1929 could never happen again. The SEC, which is supposedly an independent and nonpolitical agency, was created to regulate the entire securities industry. The goal was to level the playing field, to ensure that anyone who wanted to buy or sell securities had access to the same information as everyone else, that they had all the information they needed to make intelligent decisions. As the SEC explains on its web site, its current mission is to “protect investors, [and] maintain fair, orderly, and efficient markets.” The efficient markets hypothesis, which Neil even now continues to believe in, theorizes—very basically—that as long as all market information is simultaneously and freely available to everyone, no one can have an edge. And that is completely dependent on the ability of the SEC to do its job. Through the years, though, the SEC had gained a completely undeserved reputation as the agency that effectively policed the financial markets, allowing people to believe that their interests were being protected. That SEC seal of approval was misleading and actually very dangerous.
Actually, the SEC has a lot less power than most people assume. While it can take civil action against corporations or individuals in district courts for crimes such as insider trading, accounting fraud, and the failure to divulge information, it has extremely limited investigative authority. The most SEC investigators can do is refer suspected criminal activities to state or federal prosecutors. What most people outside Wall Street don’t know is that the SEC doesn’t even regulate the over-the-counter markets. The biggest opponent of protecting those OTC markets was Alan Greenspan, who served as chairman of the Federal Reserve for almost two decades and foolishly believed that the markets were self-regulating.
But because the SEC also had the power to revoke licenses and prevent companies or individuals from participating in the market, I figured the least it would be able to do would be to prove publicly that I was right—that Madoff was a fraud—and shut down his hedge fund, eliminating the pressure on me to create a product that mirrored his returns. While I thought he probably deserved to go to jail, I didn’t spend much time considering the consequences to him or, in fact, to his investors.
I had very little confidence in the ability of the SEC to investigate Madoff on its own. My experience had proved to me that it was generally a nonfunctional agency, but I figured if I handed him to the SEC with all the evidence it needed carefully laid out, even that organization would be able to take action against him. I didn’t think it would be able to resist. It would be an easy case for the agency and would result in a lot of good publicity. The SEC would also be doing precisely what it was originally created to do—protecting investors.
There also was that remote possibility that we could earn a very large reward. Section 21A(e) of the 1934 Act had instituted a bounty program to help the government catch people who violated the insider trading laws. People who provided information that led to the successful civil prosecution of insider trading could theoretically receive as much as 30 percent of the amount actually recovered by the government from a civil penalty. This bounty program was limited to civil cases of insider trading; it didn’t cover criminal acts of any kind or any other type of financial crime. If Madoff was a Ponzi scheme, for example, it would not be covered by this program. And even if he was front-running, it would be the decision of the SEC whether that fit under the insider trading regulations. The SEC had the sole legal discretion to determine who would get paid and the amount, and there was no legal recourse. By 2000, when I first went to the SEC, the program had paid just one whistleblower the sum of $3,500. So clearly the chances of us actually receiving a reward for turning in Madoff were only slightly better than me pitching the first game of the World Series for the Red Sox.
I told Neil and Frank what I was going to do, and I explained I would keep their names out of my report. If there were repercussions I would take the hit for the team. If, for example, Rampart’s management found out what we were doing, they would not be thrilled. I didn’t think they would fire me, but they certainly would put me on notice that the investigation had to end.
Neil was totally supportive, Frank less so. Our relationship at that time was office-friendly but somewhat tense. We still had very different objectives. He wondered if it might not be somewhat premature. “I’ve got nothing to bring to the SEC. What are you going to tell them?” he asked. “Everything’s sort of hypothetical at this point, isn’t it?”
Not to me. The numbers were real.
I had established good relationships with two men I respected in the SEC’s Boston office, Ed Manion and Joe Mick. Because the SEC considers anything derivatives related to be high-risk and because Rampart managed equity derivatives portfolios, our firm was examined by the SEC every three years—like clockwork. An SEC audit is mostly a paper chase, more to make sure records are up-to-date than any kind of real investigation. In fact, the teams that came in never had any derivatives expertise, so they depended on me to teach them what they should be looking for while they were auditing our books. Because the SEC had no derivatives experts on their staff, on occasion Ed Manion would call on me to answer derivatives questions pertaining to issues the SEC examination teams were encountering in the field. I never knew who the SEC was examining, but I know the Boston SEC office appreciated the fact that I was always willing to help out.
I’d met Joe Mick during our first audit. Joe is a lawyer and pretty senior in that office. I’d kept in touch with him on a professional basis; I trusted him completely, so when people e-mailed me illegal inside information or stock tips I would forward those e-mails directly to him.
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