Someone with even a rudimentary knowledge of the securities business should have known that a broker-dealer cannot commingle customer assets with those of the firm. SEC Rule 15c3-3 requires broker-dealers to segregate customer assets. Yet Suh seems to have attributed no significance to Madoff’s response. Indeed, although she was in the process of drafting document requests to the clearing and custodial banks Madoff had identified, she and Cheung decided to hold off sending the requests until they had a chance to question Madoff directly.
But Suh did speak to Susan Tibbs, the director of market regulation at the Financial Industry Regulatory Authority (FINRA), which monitors over-the-counter options trading. Tibbs had examined FINRA’s records for S&P 100 index option trading on one day when Lamore had indicated heavy volume on Madoff’s part. But Tibbs reported there were no S&P 100 index options traded that day over-the-counter. Unless Madoff had failed to report the trades–or they were fictitious, either of which would have been illegal–the only possibility would have been that they were traded through Madoff’s London operation, which didn’t have to report trades to FINRA.
Three days later, on Friday, May 19, 2006, Madoff arrived at the SEC’s New York office. Like DiPascali, Madoff came alone, unaccompanied by a lawyer. He was wearing a white shirt and a dark gray suit and conveyed the confidence and poise of someone who had reached the pinnacle of Wall Street. An hour before he arrived, Suh had called Bachenheimer to ask “how to confront him with the fact that he lied.”
Madoff sat on one side of a conference table, across from Cheung, Suh, and Bachenheimer, all enforcement attorneys, as well as Stephen Johnson, another SEC investigator. Lamore was also at the table. It was the first time Madoff had been required to leave his home turf in midtown, and to testify under oath. He swore to tell the truth and stated his name, Bernard L. Madoff. Suh led the questioning, reminding Madoff that he had a right to be represented by a lawyer and that failure to tell the truth was a crime.
As he had before with Lamore and Ostrow, Madoff recounted at length his humble origins, his rise on Wall Street, the history of trading commissions and how the firm came to “execute” trades for hedge funds. He rarely missed an opportunity to digress on an irrelevant topic, such as the intrusion of television screens onto trading floors. While he described various “models” he relied on for making trading decisions, he stressed that “It’s not autopilot . . . I can listen to a conversation with my traders on how they feel. I can look and see how nervous my trading room is at a particular time or CNBC for example is a very important tool today. It’s something I used to laugh at. I used to ridicule everybody for looking at that, my traders looking at it. We put the screens into the trading room. We had them all over the trading room, you know, television screens. In those days, CNBC just had a bunch of people that were promoting stock like this idiot [Jim] Cramer, whatever his name is. I can’t stand that guy. There were all these guys, Dan Dorfman, I’m showing my age, but whenever he said anything, people would race in and buy the stock, so we had our television screens.”
“Let’s get back to the point,” Suh said. “If you could, please explain what makes you the trader?”
“Forty-some-odd years of experience,” Madoff answered. “To me that’s the best answer I can give you. . . . You have to understand, I’m not saying trust me. I’m saying I’ve been in the business for forty-six years. I have a relationship with the regulators and the firms in general in the Street, and I have never, ever–I know the rules and regulations better than most people because I drafted most of them. The bad news is if I violated them, I can’t say I didn’t know, I was ignorant. I know what the rules are. I go to great pains to stay within those. There’s plenty of ways you can make money in the business doing the right thing. You don’t have to look to do the wrong thing. We document our traders all the time, and that’s why in forty-six years, we’ve never had any sort of regulatory issue with our firm–”
Suh interrupted. “So I guess the answer to the question–the question was what makes you a good trader, and you said experience. Is that pretty much–”
“It’s experience and using what tools are available to me which are perfectly open, legal tools to use,” Madoff continued. “The advantage I have and the reason I don’t need to be represented by lawyers is I’m not doing anything wrong.”
Cheung stepped in, pressing him on the question of why he charged clients only a modest trading commission. “I think the obvious question is why are you leaving the money on the table? I mean you’re making returns for somebody else to make 20 percent of, and you’re getting $.04 a share. I could see, if I were your sons, asking why you were doing that.”
In a rambling answer Madoff expressed his misgivings about the hedge fund business generally (“the bloom is off the rose in that area”), and said specifically that he didn’t like the need to raise capital and meet with investors (“I’m not much of a marketing person or a sales person, quite frankly.”) He continued, “My sons don’t like this business either, that end of the business, and part of it is I guess they feel that I don’t like it. It’s not that I don’t like it. I certainly like the money. . . . There are lots of businesses that we didn’t go into over the years, and most of them were mistakes not going into them. We certainly had opportunities along the road to do that.”
Madoff seemed eager to discuss the split-strike conversion strategy and proprietary model that was uniquely his creation. He likened it to cooking using a blender: “So I’m saying that you’re cooking a meal. You put in carrots and oranges and a whole bunch of stuff. You put it into a blender. If you let it run for two minutes, it’s going to have one consistency. If you let it run for three seconds, it’s going to be a different consistency and so on and so forth. Depending on what you’re looking for, everybody is looking for different things, so people design their systems to say I don’t care about this stuff, I care about that. Again, I don’t attach too much importance to the information that flows out of that stuff. It’s available to anybody. It’s not unique data. It is a–people are always trying to ask me what makes a good trade or why you can trade better than other people and so on. It’s the same thing. We are proprietary traders and market makers. Some guys have more guts than others. Some of them are just stupid. They don’t get frightened when they should be getting frightened. Some people feel the market. Some people just understand how to analyze the numbers that they’re looking at. Everybody is different.” But Madoff, clearly, was one of those people who could “feel” the market.
Early in the interview Suh tried to clarify the issue that had come up with Tibbs, the FINRA official, about whether Madoff traded his options contracts through his London office, thereby avoiding having to report the trades to FINRA. Suh asked what role the London office played in the trading.
“None whatsoever,” Madoff answered.
Lamore was surprised. After all, Madoff had told him that all the trades were handled in London and cleared through Barclays. “Are they involved with the equities at all?” he asked.
“They’re the liaison on the selling side, but not on the trading side, no,” Madoff replied, whatever that meant.
“And how are the equity trades cleared?”
“The equity trades are all cleared through us because they’re U.S. securities.”
Suh continued, “Now going to the options trades, how are those trades executed?”
Madoff launched into an explanation. “The options trades, orders are placed based upon the conditions. We put out an order to buy thirteen thousand contracts with–basically what we do is we go ahead, once we buy the basket shares, we determine what the price of that, we’re looking to hedge it. Basically there are a dozen derivatives dealers that participate in the process, and what we basically do is I’ll call up and say I’m interested in buying–very typically what I say is, I’m looking to buy this put at this price and size. Come back to me. I’ll put that out with all of these dealers. That’s the way it’s typically done, and then they come back.” He continued at length in this vein, reminding Lamore why he had always been such an exasperating witness.
Madoff seized on a question about electronic orders for his options contracts to deliver a long and irrelevant soliloquy about block trading: “Typically the way it works is you call up a block–somebody wants to trade a hundred thousand shares of stock, so they’ll call around a couple of block desks and say, listen, I’m a buyer of IBM in size at this point . . .”
Suh and her colleagues struggled to keep Madoff on point, but to a remarkable degree he was able to avoid answering directly and instead lecture them on the basics of the securities business. Still, they persisted.
“You mentioned that there was a group of dealers to whom you put out this indication of interest each time. Generally, with how many of them do you end up trading in each execution?” Suh asked.
“Within the basket, we’re probably interacting with forty, close to fifty.”
“That’s for equities and options?”
“Equities. Options is a dozen.”
“A dozen. Do all of them end up trading usually?”
“Pretty much . . . yes . . .”
“What is the rationale for going to the over-the-counter market rather than the exchange?”
“Everybody goes to the over-the-counter market on options. That’s the way the market is. The over-the-counter market is just really the institutional–that’s the marketplace. I mean, you can trade on the floor. You could. Then you’d be trading during the U.S. hours, which you don’t want to do and you don’t want to–there’s really not the liquidity in the option market. It’s improving, but it’s not where you would want to go. . . .”
The assertion that “everybody” uses the over-the-counter market was preposterous on its face. The Chicago Board Options Exchange alone trades millions of equity options contracts a day. But Suh moved directly to a critical matter: “Who are the counterparties to the options contracts?”
“They’re basically European banks,” Madoff replied.
“Why foreign dealers rather than U.S.?”
“Because I’m dealing with their time zone, and that’s where my contacts are with. Most of them happen to be the big derivatives dealers anyhow.”
But major U.S. banks also trade in Europe during European business hours, and an over-the-counter trade can be done anytime, even if it is handled in the United States.
“With the options trades, is there any documentation generated?”
“Yes, there’s an affirmation that’s generated electronically, and there’s a master option agreement that’s attached to that that’s also electronic.”
This was startling, since Madoff had earlier told Suh there was no documentation of the options trading. “And the electronic affirmation stores data for each trade with each particular dealer?” Suh asked.
“Correct.”
“So if you wanted to find out with whom you bought these contracts on a particular day, that’s where you would go.”
“Right.”
After taking a break for lunch, Suh asked Madoff why he didn’t just run a hedge fund, charging the usual annual fee and performance fee, instead of leaving that to his feeder funds. Remarkably, Madoff said his results weren’t high enough to justify opening a hedge fund, even though they were, in fact, quite high by any measure, and his answer begged the question of why a fund-of-funds would want to invest its clients’ money with him.
“You mentioned the returns, that they’re not high enough to justify setting up a hedge fund,” Suh continued. “They also are remarkably consistent. They have low volatility, and there are fairly few periods when they’re down. I’m sure you’re aware of people wondering, how can this happen? What’s your answer to that?”
This promoted another long response, filled with digressions. “Well, let me just say that I pay no attention to what other people say or try to figure out,” Madoff began, “because I’ve been in this business a long period of time, and I’ve learned that everybody is always busy trying to figure out what everybody else is doing and how they do it, and the only people that do that are the people that don’t know what they’re doing, quite frankly, so a lot of us in the trading community sit around at times and laugh about these types of questions, and how anybody does anything. If somebody understood the strategy, when somebody says it has low volatility, how come, you’d say because that’s what the strategy is, to have low volatility.”
At this juncture Madoff seized the opportunity to attack Erin Arvedlund, the author of the
Barron’s
article critical of him. “I’ll give you an example. There’s stupidity out there. There was an article written years ago about this strategy. I remember the lady that wrote it who was fired from
Barron’s
or wherever it was. [In fact, she was not fired.] She did a number of stupid articles. The issues that were . . . about being low volatility, she got it from some other article, and she totally misquoted, but the point is they compared it to a fund called Gateway.” And then he launched into a long analysis of Gateway’s returns. When he finally returned to the subject of his own unusually consistent returns, he concluded, “It is absolutely not surprising, the performance and the strategy is what you would expect it to be if you understood the parameters of the strategy, and that’s all I can tell you, but any academic that looked at it would tell you that.”