The Madoff debacle  

Bernard Madoff’s alleged Ponzi scheme is reported to have cost clients $50bn. His business was run through Bernard L Madoff Investment Securities (‘Madoff’), based in New York. For years it appeared that Madoff was consistently making large returns from a sophisticated investment strategy involving purchases of equities hedged by out-of-the-money put-and-call index options. It now seems that those returns were fictitious and that payments to investors were being financed from the proceeds of new investments.  

Not a hedge fund story  

Initially the press reported this as a hedge fund story, no doubt because of Madoff’s purported complex investment strategy. But it seems that Madoff did not establish a hedge fund as an investment vehicle. Instead, it simply managed clients’ investment portfolios on a segregated, client-by-client basis. Indeed, Madoff seemed particularly keen to minimise the number of legal entities involved. It not only managed the accounts as discretionary investment manager, it also executed the trades itself as broker and acted as the custodian of clients’ cash and investments.  

Ironically, it would have been much harder to maintain a fraud if Madoff had operated a hedge fund. Although hedge funds are typically established in less heavily regulated jurisdictions, they generally use an independent administrator, third party brokers and a custodian (often a prime broker) that is not itself the investment manager

The need for frequent reconciliations between the various confirmations, statements, reports and records of these entities makes concealment of fraud much more difficult.  

Madoff and the regulatory system in the US

Inevitably, questions are being asked about whether the Madoff debacle has shown up deficiencies in the US regulatory system. The US system clearly distinguishes between broker dealers on the one hand and investment advisers (including discretionary investment managers) on the other hand. Madoff operated both types of businesses, which it carried out on separate floors of the same building. Initially it was registered only as a broker dealer. It claimed that its discretionary investment management activity did not require it to register as an investment adviser because it was remunerated only by trading commissions, rather than by a percentage of assets under management or profits.  

Following various allegations of potential fraud, a Securities and Exchange Commission (SEC) enforcement investigation was launched in 2006. Although this failed to find any evidence of fraud, Madoff was found to be in breach of the investment adviser registration requirement. Madoff then registered as an investment adviser (in addition to its broker dealer registration) in September 2006. Madoff’s investment advisory business therefore became subject to the SEC’s regular inspection regime for investment advisers in 2006. But no inspection had in fact been carried out before the firm's collapse.

Does any of this suggest that changes are needed to the US regulatory system? Clearly the SEC’s failure to detect fraud in its 2006 investigation suggests that there may be lessons to be learned about how such investigations should be conducted. But it is difficult to tell at this stage how far the SEC was at fault in this respect. If Madoff had been required to register as an investment adviser much sooner, there would have been a greater chance of detecting problems earlier. However, it is much more difficult to detect fraud when one or a few individuals are able to maintain control over books and records without any independent examination of whether the transactions in those books and records are real. It also appears that SEC investigators lacked the financial sophistication to understand that Madoff’s financial results were highly suspect – even though a number of commercial banks and brokerage houses harboured suspicions about this business activity and therefore refused to deal with Madoff.  

One of the most interesting aspects of this case is that the concentration of investment functions in one place is not prohibited under the US regulatory system. There is nothing to prevent an investment adviser from acting as custodian, broker and administrator. This is the case even for ordinary retail and unsophisticated investors. By contrast, regulators have long recognised the importance of segregation of functions within a firm to prevent, for example, the same individual from performing both trading and settlement functions. The fact that no such requirements apply at the level of the firm itself allows opportunities for fraud if the firm is institutionally corrupt.  

Could it happen here?  

The simple answer is ‘yes’. Importantly, the UK system is the same as the US’s in allowing investment management, execution and custody to be performed by the same entity firm, even for retail clients. The more flexible Financial Services Authority (FSA) system based on ‘risk-based’ regulation may have led the FSA to keep a closer eye on the firm’s operations, but that would of course have depended on the FSA having identified the firm as being higher risk in the first place. The job of assessing a firm’s risk profile is a difficult one, which seems deceptively easy only with hindsight. In the light of the Madoff experience it seems likely that the concentration of investment functions in a single firm will rank more highly as a risk factor with the FSA.