Ethics Within the SEC During the Madoff Years

On 10 December 2008, the largest “Ponzi-scheme” started to unfold when Bernard L. Madoff reportedly admitted to “one or more employees of BMIS” that he was conducting a Ponzi-scheme and his liabilities estimated around $50 billion (SEC vs. Bernard L. Madoff, 2008). The next day the Securities and Exchange Commission (SEC) filed a complaint against Madoff and Bernard L. Madoff Investment Securities LLC (BMIS) to (a) halt ongoing fraudulent offerings of securities and investment advisory fraud by Madoff and BMIS, (b)expedite relief needed to halt the fraud and prevent the Defendants from unfairly distributing the remaining assets in an unfair and inequitable manner to employees, friend and relatives, at the expense of other customers, and (c) seek emergency relief, including temporary restraining orders and preliminary injunctions, and an order to impose asset freezes; appointing a receiver over BMIS; allowing expedited discovery and preventing the destruction of documents, and requiring the defendants to provide verified accountings (SEC vs. Bernard L. Madoff, 2008).

Prior to his Ponzi-scheme, Madoff’s managed funds were ranked highly in NASDAQ stocks, order flow in the New York Stock Exchange, and in other specialized securities (Ocrant, 2001). Erin Arvedlund, a Barron’s reporter, published an article on May 7, 2001, this article attempts to explain how Madoff delivers above average returns, 10% to 15%, using a secretive split-strike strategy (Arvedlund, 2001). Within the Barron’s article, Erin Arvedlund states, “What’s more, these private accounts have produced compound average annual returns of 15% for more than a decade. Remarkably, some of the larger, billion-dollar Madoff-run funds have never had a down year.”

Madoff Investment Securities reportedly had $6-7 billion in assets that were funneled through him by three feeder funds (Ocrant, 2001). These feeder funds brought in new customers and established a steady stream of cash flow to allow the Ponzi-scheme to carry on for years. Madoff’s knowledge of the markets, regulatory gray area in the securities industry, and the lack of internal ethics within the SEC helped Madoff continue his operation for sixteen years.

The Regulatory Gray Zone

As Madoff conducted his Ponzi-scheme, where were the watchdogs that are supposed to protect investors from these types of fraudulent activities, and why didn’t they catch him? The SEC has the authority to investigate entities such as BMIS as well as Bernard Madoff himself. According to the SEC’s website,

“The SEC oversees the key participants in the securities world, including securities exchanges, securities brokers and dealers, investment advisors, and mutual funds. Here the SEC is concerned primarily with promoting the disclosure of important market-related information, maintaining fair dealing, and protecting against fraud (SEC, 2010).”

However, Madoff was not a registered broker-dealer or a registered investment advisor. The Investment Advisers Act of 1940 and its amendment in 1996, under section 203 titled Registration of Investment Advisers, describes exceptions to those who do not have to register with the SEC. For example, subsection (3) states any investment adviser who during the course of the preceding twelve months has had fewer than fifteen clients and who neither holds himself out generally to the public as an investment adviser nor acts as an investment adviser to any investment company registered under title I of this Act (SEC, 2009).

The exceptions within the Investment Advisers Act and other similar exceptions help formulate a “gray area” that allows people like Madoff to fly under the radar. Staying under this “radar” would mean finding the loopholes in each regulatory agency’s rules and it seems Bernard Madoff was just the man for the job.

Madoff was a prominent member in the securities industry throughout his career. The National Association of Securities Dealers (NASD) knew Madoff as their vice chairman for a period of time, a member of NASD board of governors, and as chairman of its New York region. The NASDAQ Stock Market knew Madoff as a member of the board of governors and executive committee while serving as chairman of its trading committee (SEC, 2008).

Because of his affiliation with each agency that works with the securities industry Madoff was in the position to fully comprehend the ins-and-out of the system and if anyone could find a loophole, it was Madoff. Madoff would use his “Industry Stature” to intimidate examiners and investigators during the 16 years that the SEC complaints started coming in. For example, one examiner from the SEC’s Northeast Regional Office (NERO) characterized Madoff as “a wonderful storyteller” and “very captivating speaker” and noted that he had “an incredible background of knowledge in the industry (Kotz, 2009).” Another NERO examiner, from the same report, recalls that Madoff would become angry during examinations and then Madoff’s “veins were popping out of his neck” and he was repeatedly saying, “What are you looking for? . . . . Front running. Aren’t you looking for front running, “and “his voice level got increasingly loud.”

Madoff may have known the security industry better than the SEC’s teams that investigated him, but did this give the SEC a reason not to catch Madoff’s Ponzi-scheme? Even though Madoff hid his activities behind the gray areas of the security industry, evidence points to other reasons for the SEC’s failure to catch Madoff.

SEC’s failure to catch Madoff

After Bernard Madoff confessed to his multi-billion dollar Ponzi-scheme an investigation conducted by the Office of Inspector General (OIG); the OIG findings are detailed in a report titled, “Investigation of Failure of the SEC to Uncover Bernard Madoff’s Ponzi Scheme.” Lead by Inspector General H. David Kotz, the investigation details that the SEC received eight separate complaints between June 1992 and December 2008. Three of the complaints were from the same source and the first two versions were dismissed entirely (Kotz, 2009). The report also makes known that the SEC was fully aware of the two articles regarding Madoff’s questionable returns. If the SEC had received complaints and knew about the two articles then why didn’t the SEC catch Madoff?

During the sixteen year time span that the SEC received complaints concerning Madoff and BMIS, the SEC conducted three examinations and two investigations into his advisory business based on the complaints that Madoff was possibly misrepresenting his trading and could be operating a Ponzi-scheme. The OIG report states that the most critical step in examining or investigating a potential Ponzi-scheme is to verify the subject’s trading through an independent third party,” and “Yet, at no time did the SEC ever verify Madoff’s trading through an independent third-party, and in fact, never actually conducted a Ponzi scheme examination or investigation of Madoff (Kotz, 2009).”

The first opportunity that the SEC had to catch Madoff’s Ponzi-scheme was in 1992, sixteen years before Madoff confessed. A complaint lead the investigation team to door steps of Avellino & Bienes, an unregistered investment firm providing its customers with 100% safe investments. Although, the focus of this examination was to discover if Avellino & Bienes was operating as an unregistered investment firm, the SEC’s lead examiner states that, “Madoff’s reputation as a broker-dealer may have influenced the inexperienced team not to inquire into Madoff’s operations (Kotz, 2009).” Madoff would rinse and repeat this strategy within all investigations and examinations that were conducted.

The SEC’s blunders into all investigations concerning Madoff and his associates could be considered gross neglect. The interworking of the SEC seems to be missing something that would help them perform their duties better. Maybe that specific piece of the puzzle is ethical values.

Ethics within the SEC

The SEC made many mistakes during the Madoff investigations. Were these mistakes related to internal ethical decisions on the part of the SEC? One way to find out if the SEC’s mistakes were due to internal ethical decisions is to look into the decision history during the Madoff investigations.

Over the years the SEC has established a number of ethics changes in its rulemaking. One ethical change was the SEC’s Final Rule for implementing section 406 and 407 of the Sarbanes-Oxley Act of 2002 (Haynes and Boone, LLP, 2003). Also, a Final Rule, titled Investment Adviser Codes of Ethics, adds new amendments to the Investment Advisers Act of 1940, and requires registered advisers to adopt codes of ethics (SEC, 2004). As we can see the SEC is aware of the need for companies to implement a code of ethics.

The SEC faced many ethical situations during the Madoff investigations; the ethical situations that were prevalent within the SEC, during the time of the investigations, seemed to affect the core decisions that were being made within the SEC. As stated earlier the SEC’s main goal is maintaining fair dealing, and protecting against fraud, with this in mind unethical decisions would entail any decision that fails to align with that mission statement. The OIG report contains a number of decisions, made by the SEC, that failed to align with their mission statement, to name a few: (a) failure on behalf of the SEC to perform due diligence when conducting investigations; (b) the SEC failed to prevent conflict of interests; (c) the lack of internal controls and standardization for conducting investigations; (d) absence of “Tone-at-the-Top;” and (e) the SEC’s lack of formal training for investigators (Kotz, 2009).

The future of the SEC will rest in the ability to perform better investigation and examinations. David Kotz outlines several recommendations, for the SEC, that will improve investigations in the future. Among the recommendations are better training to investigators, better internal controls, and mandating better control over how to handle tips, and arranging more qualified investigation teams (Kotz, Testimony Before the U.S. Senate Committee on Banking,Housing and Urban Affairs, 2009).


Bernard Madoff may have been a great manipulator and master of the security industry, the fact still remains, the SEC should have caught on to the Ponzi-scheme years before he confessed. The SEC had more than enough complaints, from reputable sources that pointed out many red flags. A total of three examinations and two investigations failed to catch Madoff’s Ponzi-scheme. The SEC displayed unethical decisions throughout all inquiries conducted within Madoff’s businesses. Now that the SEC has the hindsight into what when wrong, it’s up to the SEC to fix their internal issue.

In the end, the lives of the people that invested with Madoff and his feeder funds were forever changed. Pointing the finger at this point in time may give some relief to those who seek justice but does nothing to change the outcome to what has already taken place. We, as society, must push to become a more proactive nation that seeks due diligence and higher ethical values for everyone. Forcing companies to setup ethics policies and perform due diligence will not stop people from unethical behavior or making poor decisions. I believe we must find away to instill not just the letter of the law into society but the spirit in which the law was created. My moving beyond compliance, I believe, society will suffer far less instances of fraud by eliminating gray areas that laws fail to address.


Arvedlund, E. (2001, May 7). Don't Ask, Don't Tell: Bernie Madoff is so secretive, he even asks his investors to keep mum'. Barron .

Haynes and Boone, LLP. (2003, January 24). SEC Adopts Code of Ethics Disclosure Rules. Retrieved April 18, 2010, from

Kotz, H. D. (2009). Investigation of Failure of the SEC to Uncover Bernard Madoff's Ponzi Scheme. Office of Inspector General (SEC).

Kotz, H. D. (2009, September 10). Testimony Before the U.S. Senate Committee on Banking,Housing and Urban Affairs. Retrieved April 20, 2010, from

Ocrant, M. (2001, May). Madoff tops charts; skeptics ask how. MAR/Hedge No. 89 , pp. 1-5.

SEC. (2004, July 4). Investment Adviser Codes of Ethics. Retrieved April 18, 2010, from

SEC. (2009, October 13). INVESTMENT ADVISERS ACT OF 1940 [AS AMENDED THROUGH P.L. 111-72].

SEC. (2008, December 11). SEC Charges Bernard L. Madoff for Multi-Billion Dollar Ponzi Scheme. Retrieved April 19, 2010, from

SEC vs. Bernard L. Madoff, 08 CIV 10791 (U. S District Court Southern District of New York December 11, 2008).

SEC. (2010, January 20). What We Do. Retrieved April 19, 2010, from

By: Joseph Dustin