Tangled Webs (68 page)
Authors: James B. Stewart
Tags: #History, #United States, #General, #Law, #Ethics & Professional Responsibility
Oddly, Madoff had never mentioned Auriga. Ostrow and Lamore decided they’d test Madoff’s candor, and see if he produced anything related to Auriga after they asked for documents for all his hedge fund and feeder fund clients. He didn’t. Ostrow e-mailed Lamore, who was on the Madoff premises, saying that “if Bernie stops in” he should ask him about Auriga. Lamore did, and Madoff seemed mystified. He said he’d never heard of the firm, although he added it “could be an investor through one of the feeder funds.” “That’s weird,” Ostrow responded, “because Bloomberg reports Auriga has discretionary accounts with B. Madoff.” But then he explained the discrepancy away: “Maybe it was a few years ago or it could be a feeder fund.” No one contacted Auriga.
Madoff’s claim that he timed the market successfully using his “gut feel” also attracted renewed scrutiny. Market timing is the investment equivalent of alchemy: no one has ever figured out how to do it consistently. Indeed, efficient market theorists maintain that the movement of stock prices is a random walk that can never be predicted with any consistency. And yet the Renaissance e-mails had noted Madoff’s high returns and amazing consistency, with an extraordinary ability to exit the market entirely in down quarters.
Lamore, Ostrow, and their supervisors were all skeptical. In another encounter with Madoff, Lamore pressed him on what he meant by his “gut feel.” Madoff cited his “observations of his trading floor in New York, what his European contacts were telling him, and what he reads in industry papers and publications.” Lamore later said that “I thought his gut feel was, you know, strange, suspicious. . . . I kept trying to press him. I thought there was something else. I thought he was getting some sort of insight into the overall broad market that other people weren’t getting. So I repeatedly sort of pressed him on that. I asked Bernie repeatedly over and over again, and at some point, I mean, I’m not sure what else to do.”
Madoff’s production of requested documents was sporadic and often incomplete, but he did turn over monthly statements for two of the feeder funds–Kingate Global and Kingate Euro–as well as a list of brokers who executed trades based on the model. The statements showed no transactions at all over the requested time period. “It seems clear as mud to me,” Lamore wrote Ostrow.
Both Lamore and Ostrow were feeling some pressure–both from Madoff himself and from their superiors–to wrap up the site examination, which was now entering its third month. Despite the many unanswered questions, the investigation had now jelled, at least in Nee’s mind, into an investigation of front running. Lamore e-mailed Nee on June 2 that, after reviewing the Kingate records provided by Madoff, he didn’t see any signs of front running:
I don’t believe the retail customer order flow information from Madoff’s market-making business has anything to do with his hedge fund model. Essentially, he got long the S&P 100 for the hedge funds January 20 through January 24, 2005, and sold the S&P 100 (flattened out) March 10 through March 15, 2005. There was no activity in April 2005. Granted, his purchase & subsequent sale timing was excellent (buy low & sell high), but he held the basket for approximately six weeks. Therefore, I don’t believe that he is using any short-term signals that would come from his retail order flow. I suspect that he is extremely well connected to European order flow information through his brokers (and possibly the investors in his fund) and is timing the market based on that information rather than his retail order flow information.
Ostrow and Lamore were still trying to find out who executed Madoff’s hedge fund trades, and what was going on in his London office, which apparently oversaw the trading. They’d also discovered that Madoff’s vaunted market-making operation was losing millions of dollars a year, and all the firm’s profits were apparently coming from the hedge fund business, which Madoff had concealed until just a few weeks before. At the very least, Ostrow thought Madoff should be required to register as an investment adviser.
Nee disagreed. He later said an “examination cannot go on forever . . . we really didn’t have the luxury to look at any conceivable area which might have a securities violation.” On June 7 he sent an e-mail urging Ostrow to “keep your eyes on the prize,” which was front running.
Two days later, the OCIE delivered all its work papers from the Madoff case–nine categories of documents and records. By now, the air was rapidly draining from the investigation. Lamore thought he “may have glanced” at the files. Ostrow said he didn’t recall reading any of them and noted that he and Lamore had “already returned from the field.” Nor did Nee or any of their supervisors examine the files.
If they had, they would have seen a complaint about Madoff dated May 2003 from a highly regarded manager of a fund-of-funds, who asked to remain anonymous. He had considered an investment with a Madoff feeder fund, and actually met with Madoff to discuss his strategy. Madoff had described the split-strike conversion, and told the hedge fund manager he traded the OEX options on the Chicago Board of Options Exchange (CBOE). “Well, I found something exceptionally odd about that,” the manager had reported. He asked Madoff, “How are you doing that? Because I don’t think there’s enough volume on the Chicago Board of Options Exchange for you to get that sort of coverage for the amount that you’re managing.”
Afterward, the manager called the CBOE to check on volume, and “the problem is, the volume was never there for Madoff. So that was problem no. 1 for me. Problem no. 2 was, I called up buddies of mine around the street and I asked them all if they were trading with Madoff. And nobody was. Nobody was doing these OEX options. And, in fact, the funny part about it was they all said, yeah, I hear that he’s doing all these trades but, you know, we don’t see it anywhere. . . . And so, for me, the biggest issue was the fact that I couldn’t reconcile a big part of that strategy. And the information that [Madoff] told me on the surface seemed to be false.”
Another complaint received by the OCIE had alleged that Madoff was front running, and despite the hedge fund manager’s questioning whether any trades actually existed, the OCIE team had decided to focus exclusively on the issue of front running, a decision made by McCarthy because “that was the area of expertise for my crew.” Also in the files was a letter from Madoff himself stating, “Neither Madoff Securities, nor any person or entity affiliated with Madoff Securities, manages or advises hedge funds” and “we have no interest in becoming a manager or adviser to hedge funds.” The split-strike conversion strategy was simply something the firm executed on behalf of institutional clients; it was their strategy, not Madoff’s. Ostrow and Lamore now knew, by Madoff’s own admission, that all of this was false.
Madoff had produced numerous records, including various client statements with trade data, showing numerous options trades, which undercut his claim that he’d stopped trading options a year before. Like Ostrow and Lamore, the OCIE staff had numerous unanswered questions. They suspected Madoff was in fact creating and executing his split-strike conversion strategy for hedge fund clients and was lying or misleading them. They expanded the investigation from front running to whether Madoff should have to register as an investment adviser. But then the OCIE’s priorities had shifted to issues involving mutual funds. The team was reassigned while the Madoff investigation remained open but dormant. There were no conclusions or final report.
One SEC staff member bumped into Shana Madoff at an industry conference in St. Louis in March 2005, just weeks before Ostrow and Lamore had begun their visit to Madoff’s offices. He’d sent an e-mail to another member of the Madoff team at OCIE. “What is the status of the Madoff hedge fund thingy?”
The reply: “Deady. We never found any real problems.”
O
strow was eager to continue the investigation, and was planning visits to Fairfield Sentry and other Madoff feeder funds. He was especially eager to see how the split-strike conversion strategy could be executed without Madoff trading options. Madoff’s latest explanation had been that the hedge fund clients themselves put on a hedge by trading options. But the glossy brochures they prepared for clients made no mention of this. Did they really trade the options, and if so, how did this fit into the strategy? He and Lamore had never discovered whom the mysterious European brokers were who supposedly executed Madoff’s trades, nor did they know the identity of any of his counterparties when he traded option contracts. Indeed, they’d never spoken to anyone except Madoff himself, who they thought was lying, and a handful of people at his firm who had no involvement with the hedge fund operation. In fact, none of the issues raised by the Renaissance e-mails–which had set the investigation in motion–had been resolved.
strow was eager to continue the investigation, and was planning visits to Fairfield Sentry and other Madoff feeder funds. He was especially eager to see how the split-strike conversion strategy could be executed without Madoff trading options. Madoff’s latest explanation had been that the hedge fund clients themselves put on a hedge by trading options. But the glossy brochures they prepared for clients made no mention of this. Did they really trade the options, and if so, how did this fit into the strategy? He and Lamore had never discovered whom the mysterious European brokers were who supposedly executed Madoff’s trades, nor did they know the identity of any of his counterparties when he traded option contracts. Indeed, they’d never spoken to anyone except Madoff himself, who they thought was lying, and a handful of people at his firm who had no involvement with the hedge fund operation. In fact, none of the issues raised by the Renaissance e-mails–which had set the investigation in motion–had been resolved.
On June 16 Nee met with Ostrow and Lamore and directed them not to visit or contact any of Madoff’s feeder funds. Ostrow recalled that Nee warned them that Fairfield “is a $7 billion customer and if you go and raise red flags there and they go ahead and pull all of their money from Bernie and we’re wrong, then we’ll be sued personally or the SEC itself.” (Nee denied that fear of lawsuits was a factor, but acknowledged, “We’d have to be very careful about going to a hedge fund client.”) Nee told them it was time to end the examination and move on to their next assignment. As he explained, “There’s no hard and fast rule about field work, but field work cannot go on indefinitely because people have a hunch or they’re following things.”
Ostrow and Lamore completed their report on Madoff on September 8, 2005. It cited three minor technical violations they’d discovered in Madoff’s market-making operation.
Ostrow was demoralized by the experience. “It’s frustrating when you’re out there for three months, lied to every day, and you try relaying that, and you try to get it across that, how can this be? . . . We asked him specifically, ‘Do you manage money?’ Like, we asked it eight different ways and six different languages, and you know, got the same ‘no.’ . . . We still knew and felt it was highly suspicious and just odd, and the whole story, there were inconsistencies that were unsettling.”
I
n October 2005, the SEC’s David Bergers e-mailed colleague Michael Garrity that an “informant” was coming in. “We’ll tell him he has an hour but he’ll go over,” Bergers predicted. Bergers and Garrity worked in the SEC’s Boston regional office, Bergers in enforcement and Garrity as the branch chief for investment advisers and investment companies. Garrity, in his late forties, had worked as a journalist in Connecticut, New Jersey, and Philadelphia before going to law school, and had been with the SEC since 2001. Bergers told him his informant’s name was Harry Markopolos. Garrity had never heard of him, but Bergers said he was someone “connected to the industry” who was worth listening to.
n October 2005, the SEC’s David Bergers e-mailed colleague Michael Garrity that an “informant” was coming in. “We’ll tell him he has an hour but he’ll go over,” Bergers predicted. Bergers and Garrity worked in the SEC’s Boston regional office, Bergers in enforcement and Garrity as the branch chief for investment advisers and investment companies. Garrity, in his late forties, had worked as a journalist in Connecticut, New Jersey, and Philadelphia before going to law school, and had been with the SEC since 2001. Bergers told him his informant’s name was Harry Markopolos. Garrity had never heard of him, but Bergers said he was someone “connected to the industry” who was worth listening to.
Later that month, the Boston officials met Markopolos in a satellite office of the SEC on Boston’s Tremont Street. Markopolos was fifty-one years old, with tousled dark hair and a slender build, analytical and talkative, at least about the kinds of arcane financial transactions that fascinated him. His wife had a similar bent and worked in compliance for an investment firm. Markopolos had worked for several years as an options trader and then chief investment officer at a Boston financial firm, Rampart Investment Management. He’d recently left there, and was now an independent forensic accountant, often hired by lawyers and financial firms to ferret out evidence of fraud. Madoff had come to his attention years before when fellow options traders challenged him to match Madoff’s reported returns. Markopolos repeatedly tried, and failed, to replicate Madoff’s results using a split-strike conversion strategy, something Markopolos was very familiar with as an options trader. The strategy could smooth out returns, softening market downturns, but it still put a cap on gains in bull markets and generated losses in bear markets. Markopolos couldn’t get anywhere near Madoff’s returns or his consistency. If not quite an obsession, the quest became an ongoing preoccupation, something that intrigued and mystified Markopolos.
The more he’d learned about Madoff, the more convinced Markopolos had become that he was a fraud. He thought the Madoff operation had all the signs of a Ponzi scheme–a fraudulent investment operation that pays investors from their own money and that of subsequent investors, and not from any actual investment profits. It was named for a charming early twentieth-century swindler, Charles Ponzi, who promised investors a 50 percent profit within forty-five days. Markopolos had first approached the SEC’s Boston office in 2000. He’d met with Ed Manion, a young accountant, and a more senior administrator, Grant Ward. When the meeting was over, Ward seemed uninterested and dismissive. Manion told Markopolos, “He didn’t understand a damn thing we said.” Although Ward told Manion he’d refer the complaint to the New York office, he apparently never did. (Ward left the SEC soon after and later said he didn’t even recall meeting Markopolos. But Manion had stayed in touch and kept encouraging Markopolos to keep tabs on Madoff.)
Now, five years later, Markopolos had heard that Madoff was trying to borrow money at high interest rates in Europe. As they grow, requiring ever-larger amounts of new capital to meet redemptions, all Ponzi schemes eventually implode, and Markopolos thought this meant that Madoff’s operation might be close to running out of cash. He didn’t really want to get involved–indeed, he feared for his and his family’s safety–but the collapse of a multibillion-dollar hedge fund might trigger a financial crisis. He’d felt obliged to act, and had drafted a detailed, twenty-page analysis. At the meeting with Bergers and Garrity, he handed out copies of his report, and the headline was certainly an attention-getter: “The World’s Largest Hedge Fund Is a Fraud.” Given his previous failure to trigger the SEC’s interest, he wanted to make it provocative. Garrity quickly scanned the opening paragraphs:
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