Of the reams of exhibits from SEC Inspector General David Kotz’s investigation of the agency’s failure to uncover Bernard Madoff’s Ponzi scheme, one getting a lot of attention is Exhibit 104 (pdf, 730 kb), notes from Kotz’s June 17, 2009 interview with Madoff. In the italicized excerpts that follow, Madoff sounds as perplexed as everyone else that he wasn’t found out sooner.

Madoff stated that “Everything the SEC did prior to 2006 was a waste of time…”

Regarding two SEC Office of Compliance Inspections and Examinations (OCIE) investigators who questioned him in 2006:

Madoff stated that “they never even looked at my stock records” or did a “box count.” He said he was “astonished” that they didn’t ask for DTC (Depository Trust Company) records, and stated that only a regulator could get those records from DTC, and the SEC would “have to go to DTC.” He added that DTC does not have separate accounts for each customer, but rather, provides a global report, but stated that if they went to DTC, they would’ve seen his market-making position, and that it “would’ve been easy for them to see” the Ponzi scheme. Madoff stated that the SEC could’ve gone to counterparties, and if they had, they “would’ve seen it,” adding, “they didn’t do any of that.” He stated that “it’s the only thing to do,” and clarified, “If you’re looking at a Ponzi scheme, it’s the first thing you do.”

Regarding an investigation by SEC’s Division of Enforcement:

Madoff said it was “amazing to me” that he didn’t get caught during the Enforcement investigation, because they specifically asked him, “Are these securities at DTC?” They further pressed, “What is your account number.” He replied, “646.” Madoff stated that it was “obvious they thought that something was amiss.” He went on to say that when they asked for the DTC account number, “I thought it was the end game, over. Monday morning they’ll call DTC and this will be over… and it never happened.”

He stated that in 2006, it was clear they asked about front-running because there were sweeps of the industry at that time for front-running. But in trying to discover a Ponzi scheme, he stated, “It’s very easy if you want. You must do a third party check. It’s absolutely a must.” He went on to add that “It’s Accounting 101 to look at DTC, do a box count” if you are looking for a Ponzi scheme.

Regarding a more rigorous exam conducted in 1992, when he was trading legitimately:

He said the SEC saw that the trades were real in 1992. When asked if the SEC did in later exams what they did in ‘92, would they have uncovered the Ponzi scheme? Madoff answered, “Absolutely.” He added, “There is no way they can avoid being criticized for not doing that in 2006.”

Regarding new SEC Chairman Mary Schapiro:

Madoff stated that Mary Shapiro (sic) was a “dear friend,” and that she “probably thinks I wish I never knew this guy.”

That June interview must have informed some of the recommendations included in Kotz’s September 29 memorandum (pdf, 5.0mb) reviewing the OCIE examinations.

Recommendation 27:
For significant issues such as whether trades have been executed and who has custody of assets, in the absence of third party (counterparties, custodians, etc.) documentation, the Office of Compliance Inspections and Examinations (“OCIE”) examiners should not simply rely on representations of BD (broker-dealer) or IA (investment adviser) personnel but should contact third parties directly. OCIE should provide guidance or training that clarifies for examiners circumstances that require such contact with third parties.

Recommendation 28:
The Office of Compliance Inspections and Examinations examination staff should be required to verify a test sample of trading or balance data with counterparties and other independent third parties such as Financial Industry Regulatory Authority, Depository Trust Company, or National Securities Clearing Corporation whenever there are specific allegations of fraud involved in an examination.

The Securities and Exchange Commission lacks adequate procedures to meet its responsibilities under the Freedom of Information Act, and fared poorly when its FOIA performance in 2008 was measured against that of other federal agencies, according to a September 25 report (pdf, 3.6mb) from the office of SEC Inspector General David Kotz. The review found “inadequate or incorrect procedures for determining whether potentially responsive documents exist and how exemptions (from disclosure) are applied, which have the effect of creating a presumption in favor of withholding, rather than disclosure, as required by the FOIA.”

Reviewing data from 2008, the report said SEC’s rate of responsiveness, as measured by full or partial grants of information in response to FOIA requests, was “significantly lower” compared to other federal agencies. The data revealed “that the SEC made ‘full grants’ and ‘partial grants’ 10.5 and 2.9 percent of the time, respectively. In contrast, ‘All Federal Agencies’ reported making ‘full grants’ and ‘partial grants’ of information 41.8 and 18.7 percent of the time, respectively.” The data also indicated that “the SEC reported ‘No Information Found’ 56 percent of the time, in comparison to ‘All Federal Agencies’ reporting 13 percent in the same category.”

In addition, the report said the SEC was not in compliance with a 2005 Executive Order (EO 13392, pdf 99kb) or the 2007 OPEN Government Act (pdf, 49kb) because its chief FOIA officer “did not have sufficient authority or accountability to address FOIA deficiencies.” The role of chief FOIA officer had been filled on a temporary basis and “did not have a position description within the personnel structure, personnel classification system, or in the Code of Federal Regulations (CFR),” the report concluded. “Furthermore, the Chief FOIA Officer has not been required to submit reports about FOIA operations to senior Commission management. Thus, the authority of the role appeared to rest in the Chief FOIA Officer’s personal influence within the Commission. Without clear authority and accountability or without senior management’s recognition, a Chief FOIA Officer may not be effective.”

The report noted that during the course of the inspector general’s review, the SEC created a new position description for a “full-time senior officer level position” and took applications in July, though the position had yet to be filled at the time the report was released. “The position description, if observed, will now meet the specifications of the OPEN Government Act,” the report said.

Kotz’s office was in the news only a month ago for its blistering report on the SEC’s failure to connect the dots in its investigations of Bernard Madoff.

The Securities and Exchange Commission had more than enough information to lead them to an effective investigation of Bernard Madoff’s operation of a Ponzi scheme, but the agency fumbled several chances over a span of more than 16 years to uncover the evidence, according to the executive summary (pdf, 9.5mb) of SEC Inspector General David Kotz’s investigative report.

The investigation found no evidence that personal or financial ties to Madoff influenced the agency’s scrutiny of Madoff’s business.

“The OIG investigation did find, however, that the SEC received more than ample information in the form of detailed and substantive complaints over the years to warrant a thorough and comprehensive examination and/or investigation of Bernard Madoff and BMIS for operating a Ponzi scheme, and that despite three examinations and two investigations being conducted, a thorough and competent investigation or examination was never performed. The OIG found that between June 1992 and December 2008 when Madoff confessed, the SEC received six substantive complaints that raised significant red flags concerning Madoff’s hedge fund operations and should have led to questions about whether Madoff was actually engaged in trading. Finally, the SEC was also aware of two articles regarding Madoff’s investment operations that appeared in reputable publications in 2001 and questioned Madoff’s unusually consistent returns.”

According to the report, an SEC manager thought one of the complaints, received in 2003, “laid out issues that were ‘indicia of a Ponzi scheme,’” and another complaint a year later led some SEC examiners to “some suspicion as to whether Madoff is trading at all.” In 2005, the SEC received a complaint entitled “The World’s Largest Hedge Fund is a Fraud” which detailed “approximately 30 red flags indicating that Madoff was operating a Ponzi scheme.”

“The complaints all contained specific information and could not have been fully and adequately resolved without thoroughly examining and investigating Madoff for operating a Ponzi scheme,” the report said. “The journal articles should have reinforced the concerns about how Madoff could have been achieving his returns.”

The report said examiners focused investigations too narrowly, failed to follow up on even the most “seemingly implausible” and inconsistent answers Madoff gave to their questions, and never launched a third-party investigation to verify Madoff’s trading, a step the report cited as “the most critical step in examining or investigating a potential Ponzi scheme.”

The report described two “remarkably similar” investigations of two separate complaints conducted in 2004 and 2005. “Astoundingly, both examinations were open at the same time in different offices without either knowing the other one was conducting an identical examination,” the report said. “In fact, it was Madoff himself who informed one of the examination teams that the other examination team had already received the information they were seeking from him.”

SEC Chairman Mary Schapiro released a statement which said the Madoff scandal was “a failure that we continue to regret” and listed a number of “post-Madoff reforms” the agency has undertaken “to reduce the chances that such frauds will occur or be undetected in the future.” The SEC will release the full 450-page report “in the coming days,” Schapiro said.

UPDATE: The full report (pdf, 3.6mb) is now available on the SEC website. On September 10, the Senate Committee on Banking, Housing, and Urban Affairs held a hearing on the SEC’s mishandling of the Madoff case.

In a July 30 report (pdf, 8.6mb) sent to the House Oversight and Government Reform Committee highlighting a study of executive compensation in the banking industry, New York State Attorney General Andrew Cuomo said his investigation found that there is “no clear rhyme or reason to the way banks compensate and reward their employees.” Under economic conditions establishing “a virtual laboratory in which to test the hypothesis that compensation in the financial industry was performance-based,” the data indicated that “compensation for bank employees has become unmoored from the banks’ financial performance,” the report said.

Citigroup and Merrill Lynch paid out $9 billion in bonuses in 2008 despite combined losses of $54 billion and TARP bailouts totaling $55 billion, according to the report. At three other firms – Goldman Sachs, Morgan Stanley, and J.P. Morgan Chase – combined bonuses of nearly $18 billion were nearly double the combined earnings of $9.6 billion, even while the three firms took in a combined $45 billion in TARP funds.

“At many banks … compensation and benefits steadily increased during the bull market years between 2003 and 2006. However, when the sub-prime crisis emerged in 2007, followed by the current recession, compensation and benefits stayed at bull-market levels even though bank performance plummeted,” the report said.

In a letter to Cuomo, House Oversight and Government Reform Committee Chairman Edolphus Towns invited Cuomo to appear at a hearing after the August recess “to review executive pay regulations for the Troubled Asset Relief Program recipients and the work of Ken Feinberg,” who was named by the Obama administration in June to the post of Special Master for TARP Executive Compensation.

On July 31, the House passed HR 3269, the Corporate and Financial Institution Compensation Fairness Act of 2009, by a vote of 237-185. The Congressional Budget Office released its summary of the bill (pdf, 23kb) a day earlier. The bill “would require all companies whose stock is traded on public exchanges to allow shareholders to approve, in nonbinding votes, the compensation received by executives and certain compensation agreements between executives and an acquiring entity,” CBO’s summary said. It would also require disclosure to federal regulators of “the structure of any employee compensation agreements that include performance incentives.”

Separately, on August 3, Bank of America settled a Securities and Exchange Commission complaint alleging that the company misled investors about having agreed to up to $5.8 billion in bonuses for Merrill Lynch employees while negotiating its year-end acquisition of Merrill. Cuomo’s report had asserted that at Merrill Lynch, “the compensation structures in the boom years did not account for long-term risk, and huge paydays continued while the firm faced extinction.”