The Wizard of Lies: Bernie Madoff and the Death of Trust (25 page)

“What are you looking for?”

On April 20, 2005, Bernie Madoff confronted the two SEC examiners who had been occupying a glass-walled office on the nineteenth floor for three weeks. He was no longer the charming host who had entertained them recently with tales about the old days on Wall Street. He was an angry, streetwise bouncer who was itching to kick them out. “Tell me what you’re looking for,” he insisted.

The SEC staffers, William David Ostrow and Peter Lamore, were surprised at this outburst of temper—but not as surprised as they had been when Madoff, the chairman of the firm, insisted on being their only contact in the office. They’d both been around long enough to know how odd that was, especially at a firm this size. They should have been dealing with someone lower in the food chain.

But Madoff was handling this examination personally; he always dealt with regulatory examiners personally. He had too much to hide, and there were only a few people he trusted to help him do that. Frank DiPascali on the seventeenth floor had been busy ever since the call came in about this exam. DiPascali had been checking the fake paper and computer records they had created to obscure the Ponzi scheme. The elaborate records backed up Madoff’s lies and supported his cover story: that he was just a hired hand who executed hedge fund trades for less than a nickel a pop.

It had worked with the SEC before.

On December 18, 2003, Madoff was walking through the Lipstick Building lobby when his cell phone rang. He recognized the caller as Lori Richards, a high-level SEC staffer in Washington. It was Richards who had flagged the
Barron’s
magazine article about Madoff in 2001 as “a great exam for us.” Nothing had been done back then, but in 2003 someone on her staff got a detailed tip from a hedge fund manager questioning Madoff’s returns, and she was following up.

“Bernie, it’s Lori,” she said.

“Hi, Lori.”

“I need you to help me out. Can you tell me about your hedge funds?”

Madoff stood still. “I don’t have a hedge fund,” he answered.

“I didn’t think so,” she replied.

Madoff quickly added, “I execute trades for hedge funds.”

The distinction he made seemed to satisfy the SEC official, although she indicated that there would be a follow-up examination. When her staff came up with more questions, Madoff easily deflected them. The inquiry then just rolled to a halt without even a final report closing the file. The records from that exam were piled into a pair of boxes and forgotten.

Although Madoff was ready for the visit from Ostrow and Lamore in 2005, this exam had been particularly annoying. Lamore was okay, a smart kid, but Madoff thought Ostrow was obnoxious. He had gritted his teeth as Ostrow paged through e-mail records, expense account records, telephone bills—an aimless fishing expedition, as far as he could see. He’d kept his temper when Lamore asked for yet another computer run, in a different format this time.

So far, the examiners hadn’t asked about the hedge funds—or about custody accounts, or trading records, or third-party confirmations for all the options and blue chips that Madoff was supposedly buying and selling. What on earth
were
they looking for, if not for that?

Ostrow and Lamore tried to calm Madoff. It was just a routine examination of the brokerage firm’s books and records, they said, the kind of thing that happens all the time.

This was not entirely true; the examination was not routine. It was a belated response to a set of e-mails that an alert SEC staffer had found in the files of a prominent hedge fund firm during a truly routine examination nearly a year earlier. The fund manager, Renaissance Technologies, had an indirect stake in Madoff through its Meritor hedge fund. The Renaissance e-mails, written in late 2003, expressed the same mystification about Madoff’s performance and practices as the
Barron’s
and Ocrant articles had in the spring of 2001.

In one of the e-mails, a senior executive shared his doubts with his investment committee. “First of all, we spoke to an ex-Madoff trader,” the executive said. “He said Madoff is pretty tight-lipped and therefore he didn’t know much about it, but he didn’t really know how they made money.” Then, a respected hedge fund consultant “told us in confidence that he believes Madoff will have a serious problem within a year. We are going to be speaking to [the consultant] in 11 days to see if we can get more specifics.”

But this executive already had pretty much made up his mind. “The point is that as we don’t know why he does what he does we have no idea if there are conflicts in his business that could come to some regulator’s attention.” It just didn’t make sense to risk a scandal for the relatively modest return they expected. “The risk-reward on this bet is not in our favor,” he concluded, adding, “please keep this confidential.”

The SEC examiner showed the intriguing e-mails to his supervisor, who took them seriously and asked him to learn more from the hedge fund. But when the SEC staffer returned, the Renaissance executive was dismissive. The author of the e-mail had been at a conference “where there was some chatter about Madoff,” the executive said, but it was all unsubstantiated, as far as he knew. True, the hedge fund had cut its stake in the Madoff deal, but that was simply because of mediocre returns.

It was an odd explanation. The doubts expressed in the extensive e-mail chain were cogent, well researched, and unequivocal. As early as 2003, these men had stopped trusting Madoff’s game and started cashing in their chips. And they knew other smart people on Wall Street who had done the same. They surely could have helped the young SEC examiner who was trying to figure out what Madoff was doing.

But apparently the people at Renaissance—like those at Credit Suisse and Rogerscasey, who had quietly blacklisted Madoff by early 2004—didn’t want to get involved. A top Renaissance executive, Nat Simons, later explained that he felt that all the information Renaissance had was readily available to the SEC. “Despite the fact that we are kind of smart people, we were just looking at matters of public record…. It’s not like we needed a Ph.D. in mathematics,” Simons said.

Besides, he said, the information they relied on wasn’t that hard to get. Indeed, although Simons didn’t know it, the SEC had already gotten this information without any help from elite players such as Renaissance. Although it dismissed Harry Markopolos’s accusations in 2000 and 2001, it received similar warnings in May 2003, the very tip that prompted Lori Richards to call Madoff on his cell phone that December and ask about his hedge fund business.

The tip came in to the SEC’s Washington office as a result of a 2002 survey of the hedge fund industry by the SEC’s Investment Management Office. At that time, the agency encouraged executives to report any suspicious activity—and on May 20, 2003, a hedge fund managing director actually did. He told the SEC, in confidence, that his firm had considered investing in two different Madoff feeder funds but backed off both times. There were all kinds of red flags, he said, but the most worrisome was the fact that nobody he talked with in the options trading community confirmed doing any business with Madoff. Of course, that community of traders was supposed to keep customer information confidential, but it still seemed strange not to confirm even a general business relationship with someone who should have been one of their biggest customers.

The tip was sent along to the SEC office that handled brokerage firms, where it sat unexamined for months. When it was finally dusted off, the inquiry that followed did not focus on the mysterious lack of options trading—but it still came agonizingly close to uncovering Madoff’s fraud. Someone on the exam team had the idea of getting two years’ worth of Madoff trading records from the industry regulators at the NASD—which would immediately have shown that he was not trading billions of dollars’ worth of blue-chip stocks and options.

But the request was never sent, for reasons no one involved could later recall.

An official study would later conclude that the staffers decided it was easier to request the trading records from Madoff himself, not from the NASD—and with Frank DiPascali’s help, Madoff came up with fake records, of course. Questions were left hanging, but in early 2004 the shorthanded SEC staff members were told to shift their attention to a wide-ranging investigation of the mutual funds industry, which seemed more important because mutual funds were mainstream America’s primary investment vehicle.

No one logged the tip from Harry Markopolos in 2001, or the nearly identical one from the hedge fund manager in 2003, into the agency’s internal data base of investigative information. So there were no records of those earlier, unexamined warnings when the e-mails from Renaissance Technologies were found in 2004.

At least the Renaissance e-mails were taken seriously at the SEC—albeit at a glacial pace. In fact, they were the reason William David Ostrow and Peter Lamore were sitting in an office in the Lipstick Building in April 2005 watching Bernie Madoff lose his temper.

Almost shouting, Madoff repeated his original question: “What are you looking for?”

Lamore shot back, “Well, what do you want us to look for? What do you think we’re looking for?”

Madoff answered immediately: “Front-running—aren’t you looking for front-running?”

Front-running was a form of insider trading. Any trader who could see his firm’s incoming orders could anticipate which ones were big or numerous enough to move a stock’s price up or down. By inserting his own trades in front of those large, market-changing orders, he could profit on his insider’s knowledge.

For the SEC, and for many skeptics on Wall Street, front-running would always be the default explanation for the chronic doubts about Bernie Madoff. His firm’s trading desk handled hundreds of thousands of transactions a day from the nation’s biggest mutual fund companies, online brokers, and Wall Street trading desks. It seemed perfectly plausible that Madoff could step into that order flow, trading for his private clients ahead of market-moving orders to lock in foolproof profits. The SEC did not seem to realize that the split-second computerized trading networks Madoff had helped to create had made the illicit practice much harder to carry off. And since front-running was a crime that Madoff’s sons and brother were absolutely certain he was not committing, at least not on their trading desk, the regulators’ fixation was actually reassuring to those who thought they knew Bernie best.

To the SEC staffer supervising Ostrow and Lamore in this 2005 exam, however, front-running was the major focus of this exercise. He had instructed them to investigate “the possibility that Madoff is using his vast amounts of customer order flow to benefit the $6 billion in hedge fund money that we believe he manages.”

In the SEC’s defense, some of Madoff’s own sophisticated investors also seemed to think that Madoff’s access to his firm’s order flow was somehow behind the profits he produced for them, although they would later vehemently deny this allegation when it was made against them in private lawsuits. Some experts quoted in Michael Ocrant’s examination of Madoff in 2001 also put forward this theory. Years later, one Italian money manager said
market intelligence
was the code word that popped up in the investment conference chatter in Europe and, occasionally, in some hedge fund prospectuses.

Another possibility whispered about in the hedge fund community was that Madoff was secretly allocating his firm’s most profitable stock and options trades to his hedge fund clients, an illegal practice known as “cherry-picking.” Considering the volume of trading he conducted for his giant wholesale customers, perhaps he was boosting his hedge fund clients’ profits—or smoothing out their volatility—by creaming off the best of the day’s trades for them and filling his wholesale orders with second-best, good-enough prices.

In either case, the assumption was clear and simple: Madoff was benefiting his investment advisory clients by cheating his firm’s big institutional trading customers. But as long as the hedge funds were the beneficiaries of this somewhat technical violation of the rules, why should they worry? At worst, the regulators would catch Madoff and shut down the game. At best, his hedge fund clients would keep getting those slightly soiled profits for years.

For almost another month, Ostrow and Lamore scoured unhelpful records and gathered more details about Madoff’s trading operation. Their supervisor even went so far as to request trading information for the month of March from Barclays, one of the banks whose name showed up on transactions in London, on the theory that Madoff might have been trading for his hedge funds through the bank there. On May 16, 2005, the supervisor received a curious response from Barclays: the bank said that Madoff’s firm had recently opened an account but that “no relevant transaction activity” had taken place during March. The supervisor did not share the response with Lamore or Ostrow, apparently thinking it was unhelpful.

A week later, on May 25, the two examiners and their supervisor met to interview Madoff and confront the issue head-on. Did Madoff manage money for hedge funds?

Initially Madoff stuck to his basic hired-hand story: “We do a few trades on behalf of brokerage firms and institutions, which include a number of hedge funds.” How many? Maybe four.

Ostrow flipped a copy of the four-year-old article by Michael Ocrant onto the table in front of Madoff and then leaned back. “So tell me about this article.”

Madoff glanced at it. “What about it? Lori Richards has a whole file I sent her with this information. They have it.” He explained that a team from the SEC’s Washington office had come to see him back in 2003 looking at the same issue.

The news was a shock to the men from the New York office, although Madoff thought their surprise was an act. He had assumed they knew about the earlier exam and, in fact, were following up on it.

Recovering, Ostrow said something about the SEC being a large organization where things could slip between the cracks. He drew Madoff’s attention back to the article on the table. He and Lamore had already found more than four funds that claimed to pursue his strategy.