No One Would Listen: A True Financial Thriller (12 page)

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Ed Manion had become a trusted friend and role model. We’d met two or three years earlier; I had been serving as vice president of the Boston Security Analysts Society, and he was the cochairman of the ethics committee. I even knew his lovely wife, Mary Ann, from the society social functions we had both attended. Ethics is a big deal for a Chartered Financial Analyst. I knew Ed cared about the ethics of our industry certainly as much as I did. In fact, he offered a course in ethics for our 4,000 members. Like me, Ed is a CFA—but he had about 25 years’ experience in the industry. He really knew the numbers; he had been a portfolio manager at Fidelity sitting next to Peter Lynch, who was famous in the industry for turning the $18 million Magellan Fund into a $14
billion
fund in 13 years. So I had no doubt he would get it instantly—and he would believe me.

There is no prescribed way to tell someone you’ve discovered one of the largest frauds in history. “Ed, I’ve got something really serious I need to talk to you about,” I began. “I discovered this huge scheme; I’m not sure if this guy is front-running or if it’s a Ponzi scheme, but whatever it is, it’s bigger than anything you can imagine—unbelievably huge. He’s running the largest hedge fund in the world, although no one knows about it because it’s run so secretly, and the whole operation is some kind of fraud.”

In his typically understated manner, Ed replied, “That sounds rather serious, Harry. When can you bring it in?”

I knew I had to prepare a detailed report, laying out my strongest case in a way even an SEC lawyer could understand. “I might need a few more weeks to prepare,” I said.

“Just let me know when you’re ready and I’ll schedule a meeting.”

There. It was done.

I spent quite a few nights over the next few weeks preparing this first written submission, which would reinforce the points I intended to make during my oral presentation. I put a lot of effort into it, knowing I was about to attack one of the most powerful men on Wall Street. It was pretty obvious that a portfolio manager at a midsize Boston firm shouldn’t pick a fight with someone like that unless he had some powerful weapons. This was my weapon. In the end it was only eight pages long, including the Broyhill All-Weather Fund “Manager B” exhibit. It didn’t seem like much, considering I was trying to take down a giant, but it was what I had. My expectation was that my detailed explanation of Madoff’s operation, accompanied by this presentation, would put the SEC on his trail. It would have to initiate its own investigation, and I was totally confident the SEC would reach the same inescapable conclusion we had. After listening to what I had to say and reading this material, I figured they would have to be complete fools not to realize I was handing them the case of a lifetime.

Who knew?

The report began, “In 25 minutes or less, I will prove one of three scenarios regarding Madoff’s hedge fund operation: (1) They are incredibly talented and/or lucky and I’m an idiot for wasting your time; (2) the returns are real, but they are coming from some process other than the one being advertised, in which case an investigation is in order; or (3) the entire case is nothing more than a Ponzi scheme.”

As I explained, “My firm’s marketing department has asked our investment department to duplicate Madoff’s ‘split-strike conversion’ strategy in hopes of duplicating their return stream. We know from bitter experience that this is impossible.... I would like to prove Madoff’s a fraud so I don’t have to listen to any more nonsense about split-strike conversions being a risk-free absolute return strategy.” I added, “If there is a reward for uncovering fraud, I certainly deserve to be compensated. There is no way the SEC would uncover this on their own.” I did add that my firm did not know I was making this submission and I did not want anyone to know I was doing it, a reasonable request for a whistleblower to make, and that I had not traded on the information I was presenting.

I assumed this would be the only submission I would have to make to the SEC. I included six red flags, as I described them, taken directly from the Broyhill material, that individually would raise serious questions about the legitimacy of the hedge fund, but taken together made it clear that the whole operation was a fraud. The first red flag explained that if Madoff was using a split-strike strategy, his reported returns could not come from the performance of the market. Second, there were not enough options in existence to provide the hedging he claimed as part of the strategy. Third, the performance chart rising at roughly a 45-degree angle doesn’t exist in finance. Fourth, his reported returns couldn’t come from the market performance or options hedging, but there was no indication of where they did come from. Fifth, Rampart’s returns from products similar to Madoff’s had been substantially less than those claimed by Madoff. As I wrote, “In down months, our ... program experienced losses ... whereas Madoff reports only 3 losing months out of 87, a claim I believe impossible to obtain using option income strategies. In August 1998, in the midst of the Russian default and the Long Term Capital Management twin crises, the S&P dropped 14.58 percent, yet Madoff earned 0.30 percent. In January 2000, the S&P 500 dropped 5.09 percent, yet Madoff earned 2.72 percent. Our current test portfolios do not support this....” And the sixth red flag specifically noted that while the market had 26 down months in the 87-month period presented, Madoff had only 3, and “the methods given for the return generation are not possible or even plausible. Obviously there are not enough options in existence to delta hedge Madoff’s long stock position....”

I also included examples of the many strange explanations I’d heard from experienced people in the industry when I’d asked them how Madoff generated such consistent returns: I had been told he was using the information he gets by paying for order flow to earn profits for his hedge fund, that he was actually borrowing the investors’ money to use in his broker-dealer operation and paying them 15.5 percent interest for the use of that money, that he was personally subsidizing the down months to maintain low volatility of returns, and that he had perfect market timing.

And I concluded by pointing out that he did not allow outside performance audits, which no legitimate firm would have any reason to deny.

I was confident that this submission, which I would explain in detail at the meeting and answer any questions it brought up, certainly would arouse the suspicion of the SEC. Given this road map, almost any competent investigative team would easily be able to figure out exactly what Madoff was doing.

I didn’t have any idea how long the process would take. Several months, I guessed.

Well, obviously that was a number I got very wrong.

Chapter 3

Falling Down the Rabbit Hole

If possible, Ed Manion was more determined to expose Bernie Madoff’s scheme than I was. After reading my submission, he believed firmly that it was strong enough to convince the Securities and Exchange Commission (SEC) to open an investigation. And bringing down Bernie was going to be a coup for his agency. He had arranged for the two of us to meet with Jim Adelman, a senior enforcement attorney at the agency, whom he respected. Jim’s a pretty sharp guy, Ed had told me. He’ll get it.

I don’t get nervous very often, but truthfully, I was nervous. This was the first time I’d been in the SEC building, and going forward officially with this accusation represented a big step for me. If Rampart found out about this meeting, it would have caused me some serious difficulty. I suspect I would have been asked to drop the investigation, and if I had persisted it might have cost me my job. However, I knew it was the right thing for me to do. My expectation was that the SEC would find that my allegations were credible and would very quickly assign an examination team or an enforcement team to determine if Madoff was simply a financial fraud or a Ponzi scheme. I didn’t think they would ignore me; I was handing them the largest case in their history. I was giving them the headlines any government agency craves. This was a tremendous opportunity for them to demonstrate to the nation that the SEC was a bulldog when it came to protecting our financial markets.

In May 2000, Ed and I were waiting in a small conference room when Jim came in and immediately began apologizing. “I’m not going to be attending this meeting, because I’ve given my notice to the SEC,” he explained. “I’m going into private practice, but I just wanted to thank you for coming in today.” Then he was gone.

Minutes later Grant Ward, an attorney who was the SEC’s New England regional director of enforcement, walked into the room. After introductions I began my formal presentation. As I explained this massive fraud to Ward, it very quickly became clear he didn’t understand a single word I said after hello. It wasn’t entirely his fault; he never should have been put in that position. He was a securities lawyer who knew little about the financial industry. In preparing my submission I’d specifically left out all the calculus, all the linear algebra. I’d made it as bare-bones as possible so the SEC staff could understand it. But even that wasn’t basic enough. I will give Ward credit; he tried to look interested as I explained the numbers. But truthfully, if blank looks were dollar bills I would have walked out of that room a rich man. He was coldly polite, but he didn’t ask a single probing question. I never knew if that represented a lack of interest, a lack of comprehension, or simply a desire to go to lunch.

Ed was devastated. He knew how badly it had gone. It seemed clear that his faith in his agency had been shaken. He’d done his job; he’d brought in evidence of a fraud and handed it over to the division charged with investigating it. As we waited for the elevator I asked him, “You think he got it?”

Ed shook his head. “Not one single word of it.”

At that moment I still didn’t have the slightest idea how truly incompetent the SEC was. On Wall Street the real fear about the SEC was not that it would uncover hidden crimes, but rather that it would bury you beneath an avalanche of paperwork. That’s what it was best at. SEC audits consisted primarily of confirming that a checklist of documents existed, not necessarily that these documents were accurate, not even that they reflected real trades—just that you had the proper papers in your files. Firms hated these audits because they were distracting and time-consuming and rarely resulted in anything more than a deficiency notice or even a small fine for some minor compliance issue.

Nobody I knew had a lot respect for the exam teams. Most of these teams consisted of bright young accountants whose primary objective was to learn the industry at the taxpayer’s expense, then take that knowledge into the private sector where they could earn a substantial salary. Occasionally there would be a lawyer on the team, but at that level these lawyers wouldn’t understand derivatives. In fact, after Madoff was arrested, his secretary revealed that the few times SEC investigators had come to the firm most of them had asked for employment applications. That was typical. If during an exam investigators found a problem, they would report it and issue a deficiency notice or fine, but most of these people weren’t looking to derail their careers by bringing big, complicated cases that would take years to resolve against the most powerful people in the industry.

My error was in believing that the SEC actually was capable of protecting investors. The problem was that I knew a few dedicated men like Ed Manion and Joe Mick, and I made the assumption that there were lots of others just like them. And that was a big mistake. As I was to learn over the next few years, the SEC had been created to monitor the stock market and it really had never evolved with the industry. Its investigators had neither the experience nor the training to understand something fairly complicated like fixed income, for example, an array of investments that yields a specific return on a regular basis but is much more complex than it initially appears. Municipal bonds, for example, is an area in which there is well-known and widespread corruption. And if the SEC couldn’t do the math for fixed income, it certainly could not do it for complicated derivatives or structured products. Structured products are combinations of underlying assets, like stocks and bonds, combined with various types of derivatives. They are incredibly complex. The SEC certainly doesn’t understand them; in fact, a lot of people on Wall Street don’t really understand them, so what chance does an individual investor have? All you really need to know about structured products is this—it’s the 99 percent of structured products that give the good 1 percent a really bad name.

What should have been obvious to me was that there is a tremendous mismatch in skills between the SEC regulators and the people they are supposed to be regulating. The quants who create these financial products understand differential equations and nonnormal statistics; they program in languages the SEC doesn’t speak; they run statistical packages the SEC doesn’t even know exist. The quants are busy data mining with supercomputers while the SEC is still panning by hand. I suspect SEC attorneys like Grant Ward are probably well-intentioned. I’m sure they want to do a good job, but they never should have been put in their positions. Sending lawyers to oversee capital markets professionals is like sending chickens to chase foxes; it just doesn’t work, because there’s an unbridgeable skills gap between the two. It would be akin to asking me to argue a case in front of the Supreme Court.

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