Ostrow reported Madoff’s strange denial to Nee, who asked for a list of the feeder funds that supposedly funneled money to Madoff for investment.
Although Ostrow said he often found Madoff to be charming, within a week, relations were deteriorating. Madoff thought Ostrow was “obnoxious,” a “total asshole,” a “blowhard,” and “an idiot,” he later said. Ostrow kept asking for reams of computer data and was “doing things that made no sense,” Madoff thought. Lamore reported that during a meeting on April 20, “it was disconcerting how angry he [Madoff] became. I mean, his veins were popping out of his neck . . . and he just repeatedly said, ‘What are you looking for?’ And his voice got increasingly loud and the veins were popping out.” (Madoff confirmed that “I almost came to blows with him.”) Lamore turned Madoff’s question around, asking Madoff what he thought they should be looking for. “Front running,” Madoff replied. “Aren’t you looking for front running?” (Front running is the illegal practice of trading ahead of pending customer orders, knowing how those orders are likely to affect market prices. It is a form of insider trading.)
“Just to make you aware of the current situation,” Ostrow e-mailed Nee that day, “Bernard Madoff is getting increasingly agitated regarding our examination. He keeps insisting on knowing exactly what we are looking for. He repeatedly mentions front running as something we should be looking for. He thinks our request for order and execution data is outrageous.”
Of course, the fact that Madoff himself was urging them to examine front running was probably a sure sign that they wouldn’t find anything.
A week later, in a meeting with both Bernie and Peter Madoff, the examiners returned to the basic question of whether Madoff managed money for anyone outside the firm. “Never,” Madoff flatly replied. Peter said nothing to contradict him. Questioned about the issue of his options trading, Madoff said he no longer traded options. If correct, this meant he couldn’t possibly be executing any split-strike conversion strategy, which depended entirely on options trading. The examiners were baffled.
A week later, Lamore reported that in examining some of Madoff’s trading records he’d come across some large transactions involving Barclays, the large London-based bank, and asked Madoff about them. Madoff had gone off to consult with his staff, and reported back that Barclays simply “clears for the brokers in London.” (Clearing is a back-office activity that arranges for payment and delivery of shares once orders are executed.) Lamore asked Madoff if the London office managed any money for outsiders, and Madoff again insisted that neither London nor any other Madoff office did any investment management for outside investors. “We are not that kind of firm,” he insisted. As for the London activities, “It is my money,” Madoff asserted, invested solely for his personal account.
Lamore doubted this. In response, Nee sent Barclays a letter asking for all trading by or on behalf of Madoff or any of the feeder funds by Barclays. Lamore responded by e-mail: “I’m ready to call his bluff on his refusal to admit the money-management side of the business, so your document request is perfect timing.”
Nee responded, “If you think the timing is right, question him about it whenever you want.”
Lamore assumed that Barclays would disclose the trading on behalf of Madoff’s feeder funds, and said he wanted to wait until they heard back before confronting Madoff. “Also, I think it would be a good idea to be ready to speak with the funds as soon as possible after he denies involvement with them. I suggest we shoot for . . . May 24, 2005, to confront him as well as be ready to speak to the funds.”
Barclays responded on May 16. Although Madoff had an account at the bank, “no relevant transaction activity occurred . . . there were no other customer relationships identified at Barclays Capital Inc.” Far from what they expected, Barclays said Madoff did no trading whatsoever, either for his own account or for anyone else.
The SEC examiners didn’t know what to make of it. The Barclays letter noted that Madoff had an account with Barclays’ UK affiliate, and Nee assumed Madoff must be trading there or through a foreign broker dealer. But he never asked Barclays UK for any trading records. The prospect of approaching European banks for information seems to have flummoxed the SEC examiners, even though the SEC has a division devoted to dealing with foreign financial institutions and governments. And no one tried to reconcile Barclays’ disclosure that there was no trading activity with the large transactions Lamore had spotted in the records.
B
y late May, Lamore and Ostrow had been on the Madoff premises for nearly two months. They spent the entire time in a conference room, and neither ever ventured onto the seventeenth floor, which is where Madoff indicated that routine back-office tasks were conducted. Madoff continued to regale them with stories about the evolution of Wall Street, which Lamore found simultaneously “captivating” and “distracting,” and impressed Lamore with his “incredible background of knowledge.” Madoff dropped names of SEC officials he knew and mentioned that he was on the “short list” to be the next SEC chairman. Two weeks before the chairman’s appointment on June 2 Madoff shared with them the confidential information that Christopher Cox would be selected.
At the same time, Madoff was clearly growing impatient with their presence. On May 24, Lamore spoke to Madoff and e-mailed Ostrow, “He wants an idea of when we are going to finish the exam. He is getting more aggressive about trying to find out. I told him that we would speak to him tomorrow and based upon our questions and requests he should have a better idea. . . . Again, be ready for his badgering about us leaving.”
The next morning, Lamore reported on what turned out to be a two-hour meeting with Madoff. Madoff had again taken off on long-winded explanations of the firm’s automated trading program. “Once he started he couldn’t stop,” Lamore lamented. “He started to trash the SEC exam program for not having a full understanding of time slicing, automated market-making trading, spending time reviewing e-mails . . . I defended the program by explaining our mission. Anyway, I look forward to speaking to him regarding the hedge fund issue which he has opportunistically failed to mention to us.”
The examiners’ planned showdown with Madoff took place on the afternoon of May 25. Ostrow leaned back in his chair with his hands behind his head. His manner and appearance reminded Madoff of the disheveled fictional TV detective Lieutenant Columbo.
“So, tell me about this article,” Ostrow said. He showed Madoff the
MAR/ Hedge
report.
Madoff glanced at it. “So, what about it?”
Ostrow pointed out that both it and the
Barron’s
article flatly contradicted Madoff’s repeated claim that he didn’t advise any hedge funds or manage their money. With the articles on the table in front of him, Madoff abruptly reversed himself. “We do execute trades on behalf of brokerage firms and institutions which include a number of hedge funds,” he now acknowledged. “They use a model–algorithm–that we developed.” At first he said there were just four hedge funds using the model, and named Fairfield Sentry, Thema, Tremont, and Kingate Global. But then he said there were actually fifteen clients, including two corporate accounts, but all of them were foreign. (Firms don’t need to register with the SEC as investment advisers if they have fifteen or fewer clients or if they are foreign.)
Lamore and Ostrow asked Madoff how the model worked. Madoff said he developed it eight years earlier (in 1996) and that he was the only person allowed to execute trades using it. He said he used a computer server separate from the firm’s market-making activities. He called the strategy incorporated in the model a split-strike conversion strategy, but described something quite different: a “basket” of about fifty stocks used to replicate the S&P 100, but said it was a “long only” position with no options trading or selling short. He said the model had stopped using options about a year before. Instead, Madoff timed the market, trying to buy at bottoms and sell at peaks, moving in and out of the market based on “momentum signals” and–remarkably–his “gut feel” about where the market was headed. As the examiners wrote in the subsequent report of the interview, Madoff was “adamant” that he “uses his gut feel to enter and exit the market.”
Madoff also volunteered that he did all his trading through European brokerage firms in the early morning before the market opened in New York. Clients using this strategy had committed about “six to seven billion” to the strategy and his firm earned four cents a share as a trading commission, but otherwise received no management or advisory fees. He added that the high volume of the trading meant the model sometimes took several days to implement the strategy, whereas it used to be possible to do it in a single day. On the other hand, he also said the high speed at which the model could execute the strategy was a “competitive advantage,” which seemed contradictory.
Lamore and Ostrow were flabbergasted that all this information was only now being volunteered, after Madoff had repeatedly and flatly denied that he had any outside clients. Why hadn’t he disclosed any of this earlier in their exam? And Lamore was puzzled: Why would it take Madoff several days to execute his equities trading? He of all people should have known that automated trading made it possible to trade almost any volume in seconds, especially highly liquid S&P 100 stocks.
Madoff said that since he received a commission of four cents a share, and no management or incentive fee, he didn’t consider himself an investment adviser or his customers as “clients,” within the meaning of the examiners’ questions. At this juncture, before they could really absorb this highly technical and dubious distinction, Madoff effectively pulled the rug out from under them.
He said he had already disclosed all of this trading to the SEC about a year and a half earlier, when the SEC’s Office of Compliance Inspections and Examinations (OCIE), a separate Washington-based operation whose primary mission is to detect fraud, examined him. “Lori Richards has a whole file I sent her with this info,” Madoff said. “They have it.” (Richards was a compliance official with the OCIE.)
Ostrow and Lamore were embarrassed that this was the first they had heard if it. “Well, it’s a big organization. We don’t talk to each other,” Ostrow responded. Madoff sensed he had them at a disadvantage and adopted a “condescending” tone, as Lamore later put it, “sort of the tone he took like when I didn’t understand algorithmic trading.” Ostrow and Lamore were reduced to asking whom Madoff had dealt with besides Richards so they could follow up. He mentioned John McCarthy and said he’d provide copies of his correspondence with his SEC contacts.
A
ny material false statement made to an SEC examiner is a felony, just as it is when being interviewed by the FBI. Despite the fact that Madoff had changed his story, in effect admitting that his earlier statements to Ostrow and Lamore had been false, neither the examiners nor their superiors appear to have given any serious thought to immediately referring the Madoff case to the U.S. Attorney’s office for further investigation. Nee, their supervisor, later said that Ostrow and Lamore “felt they were lied to by Mr. Madoff on numerous occasions.” But he didn’t consider pursuing any false statement partly because, like perjury cases, they’re hard to prove. “Oh, it was suspicious,” Nee later acknowledged. “But, you know, it’s hard to get inside someone’s head about why they’re saying what they’re saying. But yes, it was suspicious.”
Nee seems not to have focused on the fact that very few people lie simply for the sake of lying, especially when they’re under oath or participating in an official inquiry, as Madoff was. If he was lying, as both Ostrow and Lamore believed, what was he covering up? Surely not front running, which he was urging them to investigate, knowing they would find nothing. Despite the bombshells that Madoff had lobbed–that he was managing and trading six to seven billion dollars for hedge fund clients, after denying having any such clients; and that he was “timing the market” based on his “gut feel”–Ostrow and Lamore as well as their superiors were diverted by the embarrassing disclosure that, as one put it, “the left hand didn’t know what the right hand was doing” at the SEC.
Nee sent an e-mail to McCarthy at the OCIE the day after the Madoff interview. “Our major focus has been 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 [i.e., front running]. In initial inquiries about managing outside money and supplying ‘black box’ models (algorithms, etc.) to outside accounts he either denied it or was evasive.” He asked McCarthy if the OCIE had any information.
In a conference call five days later, McCarthy and other OCIE officials confirmed that they had indeed investigated Madoff, and although it was still an open investigation, “for all intents and purposes it was finished.” They hadn’t reached any conclusions or issued a final report, which Lamore thought was strange. It also struck him that the Washington officials kept stressing how important Madoff was. Ostrow noted that “I don’t know who said it, someone from OCIE basically, ‘He’s a very powerful person, Bernie, and you know, just remember that.’ But basically just, ‘He is a very well-connected, powerful person.’” But the OCIE officials said they’d turn over all their work papers from the investigation.
Ostrow and Lamore turned back to the startling admissions from Madoff, asking for more documents and trading records for the hedge fund accounts. Ostrow ran a search for the term “Madoff ” on a Bloomberg terminal and uncovered an intriguing reference to what appeared to be another Madoff feeder firm, Auriga International. According to the Bloomberg description, Auriga was “an open-end investment company incorporated in the British Virgin Islands. The fund’s objective is to purchase shares in Auriga International Ltd., which itself invests on a leveraged basis into discretionary accounts with B. Madoff Securities, a New York broker dealer which employs an option trading strategy described as ‘split-strike conversion.’ ”