“I am the original source for the information presented herein,” the submission began. Noting that he wasn’t an insider or a whistle-blower, the author said:
My observations were collected firsthand by listening to fund-of-funds investors talk about their investments in a hedge fund run by Madoff Investment Securities LLC, an SEC registered firm. I have also spoken to the heads of various Wall Street equity derivative trading desks and every single one of the senior managers I spoke with told me that Bernie Madoff was a fraud. Of course, no one wants to take undue career risk by sticking their head up and saying the emperor isn’t wearing any clothes.
I am a derivatives expert and have traded or assisted in the trading of several billion $US in options strategies for hedge funds and institutional clients. I have experience managing split-strike conversion products both using index options and using individual stock options, both with and without index puts. Very few people in the world have the mathematical background needed to manage these types of products but I am one of them. I have outlined a detailed set of red flags that make me very suspicious that Bernie Madoff’s returns aren’t real and, if they are real, then they are certainly generated by front running.
Due to the sensitive nature of the case I detail below, its dissemination within the SEC must be limited to those with a need to know. The firm involved is located in the New York region.
As a result of this case, several careers on Wall Street and in Europe will be ruined. Therefore, I have not signed my name on this report. I request that my name not be released to anyone outside this SEC region without my express written permission. The fewer people who know who wrote this report the better. I am worried about the personal safety of myself and my family. Under no circumstances is this report or its contents to be shared with any other regulatory body without my express permission.
Markopolos walked the SEC officers through some of his key findings, sometimes going to a whiteboard to illustrate points or do some simple calculations. Garrity didn’t know much about options or trading strategies, and had never heard of a split-strike conversion, but Markopolos found him curious and open-minded.
Markopolos had organized his report around twenty-six key “red flags” he’d identified. He said it was possible, though unlikely, that Madoff was achieving his results by front running the order flow in his market-making business. The more likely scenario was that he was running a giant Ponzi scheme. Markopolos estimated that Madoff had anywhere from $20 to $50 billion in assets, making it the world’s largest hedge fund. He noted that Madoff didn’t identify his operation as a hedge fund, “although it acts and trades like one.” Although Markopolos had no direct contact with Madoff, he did have the advantage of Fairfield Sentry’s account statements over fourteen and a half years and had spoken to numerous Madoff investors, both in the United States and in Europe.
Just about everything Markopolos had found out about Madoff’s fund was suspicious. Unlike virtually all other hedge funds, the only fee Madoff charged investors was a four-cents-per-share trading commission. Meanwhile, the feeder funds that gave him their money (and did nothing else to generate returns) charged the typical 1 or 2 percent of assets and 20 percent of any gains. Why would Madoff charge so little, leaving all the spoils for the feeder funds? (This was the same issue that had puzzled the Renaissance officials.) Markopolos had never heard of another fund with such a fee arrangement. Why would he leave the fees to others “unless he was a Ponzi scheme?” Markopolos asked.
Like the Renaissance executives, Markopolos was baffled by Madoff’s claimed reliance on a split-strike conversion strategy. Markopolos offered a detailed explanation of it to the SEC officials, since Garrity wasn’t familiar with it. He stressed that “there are not enough index option put contracts in existence to hedge the way Madoff says he is hedging,” that it was “mathematically impossible” for Madoff to earn such consistent returns, with only seven “extremely small” losses in fourteen and a half years, and that other funds pursuing a split-strike conversion strategy didn’t have anywhere near the consistency or level of Madoff’s returns.
Markopolos said that a London-based fund-of-funds he spoke to was considering a Madoff investment, and asked to conduct a performance audit of Madoff’s returns. Madoff refused, saying only his accountant could audit the results in order to preserve the secrecy of Madoff’s model. “The number of hedge funds that have relied on fake audits has got to number in the dozens,” Markopolos pointed out. Markopolos was also troubled that apparently only Madoff family members were privy to the investment strategy, asking, “Name one other prominent multibillion-dollar hedge fund that doesn’t have outside, non-family professionals involved in the investment process. You can’t, because there aren’t any.”
Markopolos also provided performance data from Fairfield Sentry from 1990 to 2005, the
Barron’s
article, and a list of French and Swiss money managers and private banks with investments in Madoff’s hedge fund. (He added that there were undoubtedly dozens more.) “The only way these returns are real is if Bernie Madoff is an alien from outer space who has perfect foreknowledge of what the capital markets are about to do,” Markopolos said.
“Investors don’t want to have to trade against aliens,” Garrity quipped.
Garrity and the other officials were impressed by Markopolos’s analysis, even though some of it was repetitive and Markopolos himself was long-winded and “sometimes he starts out in the middle of things,” as Garrity put it. Garrity also interrupted with numerous questions. Markopolos was also a “bounty hunter,” someone hoping to be paid for a tip that uncovers an insider trading fraud, so he had a motive to expose Madoff (the law prohibiting insider trading allows for bounties to be paid for successful tips, but doesn’t apply to Ponzi schemes). And he had no direct evidence, only information from feeder funds about Madoff’s tactics and results.
Still, Garrity thought Markopolos was credible and he was intrigued by the suggestion that the Madoff operation might be a huge Ponzi scheme. As he came to understand the split-strike conversion strategy, he agreed with Markopolos that it couldn’t generate the results attributed to Madoff. Walter Ricciardi, the Boston office’s chief administrator, was a former general counsel for PricewaterhouseCoopers, and he was especially concerned by the lack of an independent auditor.
Garrity was eager to pursue the investigation. He’d never gotten such a detailed tip with such potentially far-reaching ramifications. “It was intriguing . . . fundamentally interesting,” he said. “It’s the kind of thing I get excited about.” He didn’t think it would be all that difficult to investigate. If Madoff were running a hedge fund of the magnitude Markopolos had suggested, there would be evidence of the massive trading necessary to carry out Madoff’s strategy. He’d simply go to the DTC (the Depository Trust Company, which clears and settles trading in securities), the CBOE, and other options exchanges, or, if Madoff traded options over-the-counter, to his trading counterparties, to verify the timing and prices of the trades. “If this was taking place in our jurisdiction I’d have teams in there tomorrow tearing the place apart,” Garrity told Markopolos.
But Ricciardi felt the case should be referred to New York, since Madoff was based in New York and much of the investigation would have to be conducted there. Offering such a potentially high-profile case to New York might also be seen as a goodwill gesture that would help ease the rivalry that often sprang up between the two offices. But Ricciardi noted in an e-mail, “Let’s try to make sure that NERO [the Northeast Regional Office in New York] recognizes the potential urgency of the situation. By the way, auditors are required to be independent. You cannot have an independent audit performed by a relative.”
TWELVE
“Some People Feel the Market”
I
n New York, Markopolos’s report was assigned to Meaghan Cheung, a branch chief in the enforcement division, and Simona Suh, a staff attorney. “Here’s a new case for Simona,” Doria Bachenheimer, a lawyer and the enforcement staff’s assistant director, wrote to Cheung. “Do you want to come by and we’ll call John Dugan to see what he can tell us?” Dugan was the head of enforcement in Boston.
Both Cheung and Suh had graduated from Fordham Law School in New York City, Cheung in 1999 and Suh in 2001. Cheung had never heard of Madoff, even though he was a cofounder of NASDAQ and a prominent industry executive whose niece, Shana, often organized and participated in conferences dealing with SEC compliance.
Suh had worked at the SEC for only nineteen months, but was considered one of the agency’s best young lawyers. After Fordham, she’d landed prestigious judicial clerkships and worked at Cravath, Swaine & Moore, one of the country’s most prominent firms, as a junior associate on the Enron case. Suh did some Internet research on Markopolos, which she forwarded to Cheung. There wasn’t much available, but she included a quote from Markopolos: “I can teach you how to spot fraud and what to do about it, so you aren’t in the hot seat.”
“I have some qualms about a self-identified independent fraud analyst, but who knows,” Cheung responded, betraying an almost immediate skepticism of Markopolos.
In early November, at Garrity’s suggestion, Markopolos called Cheung to say he was the informant on the Madoff case, and offered to help.
Cheung acknowledged she’d read his report, but then fell silent. Her tone was cool.
Markopolos asked if she had any questions. She didn’t answer.
“Well, do you understand derivatives?” Markopolos persisted.
“I did the Adelphia case,” she replied, sounding offended.
Markopolos pointed out that Adelphia was an accounting fraud, not a Ponzi scheme based on an alleged options trading strategy. Adelphia had nothing in common with Madoff.
Cheung said she didn’t need to understand derivatives because the SEC had a staff of PhDs who did.
Markopolos started arguing that academic PhDs didn’t necessarily understand the world of options trading. Cheung didn’t respond. Markopolos felt this was going nowhere, that he “had to draw every sentence out of her,” and “she acted as if I were insulting her intelligence.”
“Is there anything you need from me?” he concluded.
“If we do, we’ll call you.”
Markopolos was furious. He called Manion, his longtime SEC contact in Boston. “Your agency sucks,” he told him. “Your people are beyond incompetent.”
Given the traditional rivalry between Boston and New York, Manion surmised that New York probably thought Boston had dumped a dead-end case on them, and was treating it accordingly.
Nor did the
Barron’s
and
MAR/Hedge
articles make much of an impression on Cheung, even though they echoed much of what Markopolos was saying. She noted that they dated from 2001, and for all she knew, Markopolos had just gotten his information from them and “rewrote it,” as she later said. A problem for both Cheung and Suh was that Markopolos wasn’t a true whistle-blower who could make a case for them. He didn’t work for Madoff, nor was he a Madoff investor. He had no direct, firsthand knowledge of fraud. It was all inference, albeit based on detailed information he’d obtained from some of Madoff’s customers.
Since Madoff had been investigated only months before by the New York office, Cheung and Suh’s boss sent an e-mail to John Nee saying, “We’re going to look into this.” Nee forwarded it to Lamore with a two word comment: “Oh no!”
“Ironically, I thought of Madoff as I went to sleep last night,” Lamore responded. “I would be more than happy to sit down with anyone . . . I don’t think we missed anything.”
The fact that the enforcement division was looking into Madoff so soon after the regional office had concluded an examination with only minor technical violations seemed to put Nee and Lamore on the defensive. For a renewed investigation of Madoff would inevitably be an investigation of them.
A week later Cheung sent a copy of Markopolos’s report, “The World’s Largest Hedge Fund Is a Fraud,” to Lamore, who forwarded it to Nee and Ostrow. “These are basically the same allegations we have heard before,” Lamore commented (although no one previously had stated directly that Madoff was running a Ponzi scheme). And even though Markopolos would earn a bounty only if insider trading was involved, and not if Madoff was running a Ponzi scheme, Lamore added, “The author’s motives are to make money by uncovering the alleged fraud. I think he is on a fishing expedition and doesn’t have the detailed understanding of Madoff’s operations that we do which refutes most of his allegations. Any thoughts?”
Nee agreed that a “Ponzi scheme or directly trading on order flow doesn’t [seem] likely from what we’ve seen.”
“I must admit I was a bit spooked when you forwarded me the string of e-mails from the Boston and New York SEC offices (Ponzi scheme getting ready to crash), but after having just read the ‘informant’s’ analysis I feel much better he is incorrect,” Lamore replied.
Given that Markopolos was alleging a Ponzi scheme as the most likely explanation–something Lamore and Ostrow never seem to have seriously considered, let alone investigated–and was casting doubt on the level and consistency of Madoff’s returns–and Lamore and Ostrow, by their own admission, had never figured out how Madoff achieved his returns–it’s hard to know on what grounds Markopolos’s analysis made Lamore feel better. Still, despite his skepticism, to his credit Lamore e-mailed Cheung that “to refute all his allegations, we may need to request some documentation from one or more of the funds-of-funds.”