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Court Documents Show How SEC Failed to Nab Madoff in 2006

(AP Photo/Louis Lanzano)

Court documents released this week in the prosecution of Bernard Madoff, who pleaded guilty on Thursday to running a Ponzi scheme, shed new light on the failure of government regulators to nab him during an investigation three years ago.

On May 19, 2006, when the Securities and Exchange Commission questioned Madoff under oath, he falsely described how he would buy and sell stock and options contracts in Europe on behalf of his clients. In reality, as he wrote in a letter that was part of his guilty plea, those statements knowingly "misrepresented" what was going on and he "had not executed trades on behalf of my investment advisory clients."

The SEC came close. It asked Madoff: "Is there any documentation generated?" And: "So if you wanted to find out with whom you bought these contracts on a particular day, that's where you would go."

Eventually, the SEC recommended closing the investigation, according to the Wall Street Journal, "because those violations were not so serious as to warrant an enforcement action."

It probably didn't hurt that his niece Shana Madoff (a former compliance officer at Madoff Investment Securities) married Eric Swanson, a former assistant director at the SEC's Office of Compliance, Inspections and Examination. Another bit of trivia: President Obama's SEC Chairman Mary Schapiro was running the Financial Industry Regulatory Authority when it investigated Madoff -- and also failed to stop him.

Earlier this month, 60 Minutes featured an interview with Harry Markopolos, the man who figured out Madoff's scheme before anyone else, and repeatedly tried to get the SEC interested. "It took me five minutes to know that it was a fraud," Markopolos said. "It took me another almost four hours of mathematical modeling to prove that it was a fraud."

Another example of regulatory failure is the case of Darrel Dochow, the official in the Treasury Department's Office of Thrift Supervision who impeded an investigation into the Charles Keating's failed Lincoln Savings and Loan (which failed) and then allowed backdating transactions on the part of IndyMac Bank (which also failed).

A portion of the court documents filed by federal prosecutors this week, which includes an excerpt from the SEC examination of Madoff, is below.


Specification One
(Page 55, Lines 20-25)

Q: Let's just get back to some of the basics that we
discussed before. You mentioned earlier that the
basket in the institutional trading business may be
hedged with options. Does that in fact happen?

A: Yes.

Specification Two
(Page 57, Lines 15-20)

Q: Let's focus on the actual execution portion of it.
Let's go back to the equities. You mentioned that you
used this AHOE system, and you mention[ed] that it
exposes a sliced order to the European market. Is it
correct then that the equities are traded in Europe?

A: Yes.

Specification Three
(Page 63, Lines 11-23)

Q: Now 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?

A: Within the basket, we're probably interacting with 40,
close to 50.

Q: That's for equities and options.

A: Equities. Options is a dozen.

Q: A dozen. Do all of them end up trading usually?
Pretty much. They all trade on a - yes. It's usually
that they all participate during the trading. They
have an interest in these stocks. These stocks are the
marketplace.

Specification Four
(Page 65, Lines 16-18)

Q: Who are the counterparties to the options contracts?

A: They're basically European banks.

Specification Five
(Page 66, Line 19 - Page 67, Line 20)

Q: So how does the time frame for the options trading
relate to the time frame for the equities trading?

Q: First we're putting the equity basket on, and then
we're putting the options on after the eauity basket is
complete, so the options are being done basically in
the morning typically between 8:00 and 9:00 a.m.

...

Q: With the options trades, is there any documentation
generated? For example, for some derivatives, there is
an after agreement and you have a confirmation, a 2-page document.
Is there something like that for the
options trades?

A: 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.

Q: And the electronic affirmation stores data for each
trade with each particular dealer.

A: Correct.

Q: So if you wanted to find out with whom you bought these
contracts on a particular day, that's where you would
go.

A: Right.

Specification Six
(Page 85, Lines 2-3)

Q: Who has the custody of the assets?

A: We do.

Specification Seven
(Page 116, Line 17 - Page 117, Line 2)

Q: I wanted to go back to the question that [an SEC
attorney] asked you about other persons, persons other
than the institutional customers that we discussed so
far and proprietary situations. The trading for these
persons, is it also pursuant to the same strategy [as]
in the institutional trading business?

A: Yes.

Q: What is approximately the total amount of assets traded
for these persons?

A: My guess would be something, a few hundred million
dollars.