No One Would Listen: A True Financial Thriller

by Harry Markopolos

  One more time. Putting in all the work that would be required didn’t concern me, but the possibility—no, the probability—that the SEC would ignore us once again was really holding me back. The thought of gearing all the way up only to be shot all the way down was just too depressing for me.

  It was in June that we got the very first hint that Madoff was in trouble. Frank was having lunch with a Benchmark Plus client, an Italian who ran an F3, a fund of funds of hedge funds. An F-cubed meant that investors were paying three levels of fees, but a lot of them believed it gave them increased stability. At some point during this lunch, Frank asked the same question that by now he’d asked five hundred times: “What do you know about Bernie?”

  This time he got a very different answer. “Oh, Bernie,” the client said, waving his hands in disgust. “They’re saying in Europe that he’s been looking to take loans from banks.” He mentioned one bank that had actually refused to give him a credit line.

  “That’s strange,” Frank responded. “Why would he need money? He’s got $30 billion from his clients. What does he need the banks for?”

  The Italian had more news. “The banks have pulled him from their approved list.” He explained that two major international banks, the Royal Bank of Canada and Société Générale, were no longer lending money to their clients to invest with Madoff. “So he’s out looking for money.”

  “I don’t get it,” Frank said, getting it. “I thought he was closed. Supposedly he isn’t taking any new money.”

  “I don’t know,” the Italian said, clearly knowing. “But he’s getting aggressive. He needs money.” The Italian also mentioned that Bernie’s returns had decreased. When we had first looked at Broyhill’s numbers (discussed in Chapter 2), he was producing 19 percent net returns, but those had dropped steadily over the years.

  “Who knows?”

  Frank knew. And when he sent me an e-mail relating this conversation, I knew. Bernie was in trouble. He was having difficulty raising new money to feed the beast. The worldwide economy was slowing down, and he was beginning to feel it. I knew it was only a matter of time now before he collapsed completely. To me, that meant that like any cornered animal he was more dangerous than ever. He would do anything necessary to survive. So it made sense for me to do whatever I could to bring him down as quickly as possible—even if it meant going back to the SEC.

  Finally, and reluctantly, I told Ed to set up a meeting with Garrity. It was scheduled for late October 2005. In preparation I began working on the submission that would accompany my presentation. I remembered that in August 2001 the Bush administration had successfully avoided paying any attention to an intelligence briefing entitled “Bin Laden Determined to Strike in U.S.” I hoped that the government had learned at least some lesson from that failure, so to make sure anyone reading my submission would know exactly what it contained, I titled it subtly “The World’s Largest Hedge Fund Is a Fraud.”

  “The World’s Largest Hedge Fund Is a Fraud.” That was a pretty brash statement. I hoped it would make someone at the SEC besides Ed Manion pay attention.

  For my protection, my name appeared nowhere in the report. So I had to establish my credentials. “I am the original source for the information presented herein . . .” my submission began. After outlining the way I gathered the information, I outlined my qualifications: “I am a derivatives expert and have traded or assisted in the trading of several billion $US in option strategies for hedge funds and institutional clients. I have experience managing split-strike conversion products both using index options and using individual stock options, both with and without index puts. Very few people in the world have the mathematical background needed to manage these types of products but I am one of them....”

  And then I explained my fears. “As a result of this case, several careers on Wall Street and in Europe will be ruined. Therefore, I have not signed or put my name on this report. I request that my name not be released to anyone outside this SEC region without my express written permission. The fewer people who know who wrote this report the better. I am worried about the personal safety of myself and my family....”

  And then over the next 15 pages, plus several attachments, I made my case. I described Madoff as “effectively the world’s largest hedge fund” but admitted no one knew how much money he was managing. I estimated it as somewhere between $20 billion to $50 billion, adding that “we don’t even know the size of the hedge fund industry so none of this should be surprising.” Then, I described 30 red flags, any one of which should have raised suspicion, but taken together they made it clear Madoff was a fraud. While I had no doubt it was a Ponzi scheme, Frank and Mike still were not entirely convinced he wasn’t front-running, so I did mention both possibilities, although I pointed out, “If BM was front-running, a highly profitable activity, then he wouldn’t need to borrow funds from investors at 12 percent implied interest. Therefore it is far more likely that BM is a Ponzi scheme.... The elaborateness of BM’s fund-raising, his need for secrecy, his high 12 percent average cost of funds, and reliance on a derivatives investment scheme that few investors (or regulators) would be capable of comprehending lead to a weight of the evidence conclusion that this is a Ponzi scheme.”

  I went through a lot of mathematical data, trying to simplify it wherever possible, but understanding did require at least a basic comprehension of the way the market functions. Red Flag #5, for example, read as follows: “Assuming BM bought 3 month out-of-the-money OEX put options that are 3% out-of-the-money, and that he paid 3% for them, then the market would have to drop 6% in order for his investors to recoup their cost on the puts. More importantly, the individual stock call options sold against each stock holding would not earn enough of a return to offset losses in the stocks during periods of significant market decline. Yet BM had only ONE MONTHLY LOSS OF 6 BASIS POINTS during 1997’s Asian Currency Crises, the 1998 Russian and LTCM Crises and the market blood bath of 2000-2002. According to Fairfield Sentry Limited’s return data (attachment 1) BM posted a -0.06% loss in August 2002. These return numbers are too good to be true! And, in my experience, whenever a hedge fund has posted returns that are too good to be true they’ve turned out not to be true.”

  I finished this report with a series of predictions about what would happen if Madoff was a Ponzi scheme. “Congress will be up in arms,” I wrote, “and there will be Senate and House hearings....”

  And then I outlined the financial version of A Christmas Carol, pointing out to them the good things that might happen for the SEC if it took action: “The SEC will gain political strength in Washington from this episode but only if the SEC is proactive and launches an immediate, full-scale investigation into all of the Red Flags surrounding Madoff Investment Securities, L.L.C.,” but also warning what could happen if it didn’t: “Otherwise it is almost certain that NYAG Eliot Spitzer will launch his investigation first and once again beat the SEC to the punch, causing the SEC further public embarrassment.”

  Boston SEC Branch Chief Mike Garrity didn’t understand the numbers, but unlike so many of the other people I’d met at that agency, he knew it and was willing to admit it. Most important, he wanted to learn. That was surprising. I met with Garrity and several other people in an SEC office on October 25. Garrity was a former journalist and an attorney, so he knew how to ask questions and the legal consequences of the answers. He’d read my report, he said, and thought it was very credible. He had hours’ worth of questions to ask. There was a whiteboard in the front of the meeting room, and when there was something he didn’t understand he had me outline it on the board until he got it. I spent hours drawing charts and diagrams and guiding him through the mathematics. A lot of it was high school algebra and trigonometry, basic math. I worked from an x-axis and y-axis, explaining complex calculations in simple layman’s terms. When we know the market goes both up and down, it wasn’t that difficult for him to look at a performance line rising at a 45-degree angle and understand that something w
as very wrong. He wouldn’t let me sit down until he was confident he understood the point I was making. He asked endless questions: What are the stocks doing? What should the stocks be doing? What can’t they be doing? What are the options doing? How are they affecting the portfolio’s returns? At one point he and I discussed the possibility that I was totally wrong. “You’ve got two fraud theories,” he asked. “What if his returns are real? Is there any possible explanation for that?”

  Actually there was one conceivable explanation, I said, and unfortunately I’d left it out of my submission. “The only way these returns are real is that Bernie Madoff is an alien from outer space who has perfect foreknowledge of what the capital markets are about to do.”

  Mike Garrity considered that in the spirit in which I’d proposed it. If I was right, he suggested, and Madoff is an alien, it would destabilize the U.S. financial industry. “Investors don’t want to have to trade against aliens,” he pointed out.

  “No, that wouldn’t be fair,” I agreed, laughing, pleased with the knowledge that Garrity was deeply suspicious about Madoff’s reported returns.

  By the time we finished that meeting, Garrity not only understood the math, he understood the threat that Madoff posed to the world economy. He explained that he would immediately begin an investigation and would respond to me as quickly as possible. I left that meeting more excited than I had ever thought possible. I thought Garrity was smart, tenacious, and talented. And he got it. He called me less than a week later. “Harry, I’ve investigated,” he said. “I’ve found some serious irregularities that are very disturbing. I’m not at liberty to share them with you, but I think it’s so serious that I need to put you in touch with our New York regional office.

  “If this was taking place in our jurisdiction I’d have teams in there tomorrow tearing the place apart. Unfortunately, it’s not. It’s in New York, and I have to tell you we don’t have a great relationship with that office.”

  He promised me he would do as much as he could before passing it along to New York. He gave me the names of the two people he would be contacting. The only thing that I asked for in return was that my identity be protected. I said, “I want only two people in New York to know who I am, the branch chief and the investigation’s team leader. Just forward the submission to them and tell them it came from the Boston whistleblower. I’ll call one of them and identify myself as the Boston whistleblower and reveal my identity to them. But really, I want only those two people to know my name.” I assumed that based on Garrity’s recommendation New York would finally send in investigators, and I wanted the people on the ground to be able to ask me questions. If possible, I would have liked to prep the team before they went in to make sure they asked the right questions and demanded the right documents. Garrity gave me his word he would do the best he could to make that happen.

  As I learned later, the regional administrator of the Boston office, Walter Ricciardi, wanted to keep this case for himself. He knew what it was; he knew it was potentially a career maker. He wrestled with the decision to turn it over to New York. He felt it was the strongest case he’d seen in his entire career. But as he told the SEC’s inspector general, he had spent his career preaching cooperation between the different regions, and it was up to him to take a leadership role in making that happen. He knew that if he turned over to New York a case that would generate headlines and promotions, everyone would know how serious he was about regional cooperation. I knew that if Boston had kept the case they would have investigated thoroughly and I would have been right there to advise them.

  The last thing any of us expected was that the New York office would take the evidence and basically bury it. In retrospect, I don’t know why I was surprised. Expecting the New York office to respond any differently than it had in the past was sort of like handing the Three Stooges a rubber mallet and expecting them not to hit each other over the head with it.

  Ironically, two days after my initial presentation, Ricciardi was appointed a deputy director of the SEC’s Division of Enforcement in Washington. In that position, his job was to “assist in planning and directing the Commission’s investigations and other enforcement efforts.” He was the right guy in the perfect position. I’m not certain I ever told Neil or Frank that we finally had Bernie, but that’s what I was thinking. His empire was tottering financially and I was confident the SEC was about to launch an investigation. There was no way he could remain standing after this barrage.

  Ah, that was just me being an optimist again.

  The two names Garrity gave me were New York Branch Chief Meaghan Cheung and Assistant Director Doria Bachenheimer. I had never heard either name before. Meaghan Cheung was the New York equivalent of Mike Garrity, but as it turned out that was in title only. As Garrity had suggested, in early November I called Meaghan Cheung and identified myself as the Boston whistleblower. I guess I expected some kind of reaction from her, even something as obvious as “I read your report and I have a couple of questions.”

  Instead, the most she would acknowledge was that she had read the report. She didn’t ask me a single question about it. Not one. The strongest impression that I got from her was that I was bothering her. There was no excitement, no enthusiasm, no recognition that I had just put in her hands the biggest case she would ever have in her career. I had to draw every sentence out of her. When I asked her if she had any questions about my report or if there was anything in it she didn’t understand, she acted as if I were insulting her intelligence. I remember asking her, “Well, do you understand derivatives?”

  She responded, as if answering my question, “I did the Adelphia case.”

  When I pointed out that the Adelphia case was basically a $3 billion accounting fraud case, a case in which executives cooked the books to loot the company for their personal use, and that this was many times bigger and substantially more complicated, she seemed offended. I told her that a derivatives fraud required a much higher level of financial sophistication than an accounting fraud. It wasn’t necessary for her to understand derivatives, she said, telling me that the SEC’s Office of Economic Analysis in Washington, D.C., was staffed with PhD’s who were capable of understanding derivatives.

  When this conversation began I was hoping we would have a collaborative relationship; instead it was turning confrontational. I explained to her that the formulas used by PhD’s in academia were completely different from those used in the industry. I wasn’t trying to be insulting; I was just trying to explain to her that the math was different and the way it was used in practice was very different than in academic institutions. I spent the previous decade of my career taking these financial instruments apart backward and forward. I’d done it so often I could do it in my sleep. Those people working in her Office of Economic Analysis just wouldn’t have that experience.

  The point I was trying to make was that I could help her; the point she was trying to make was that she didn’t want my help. That was the way our relationship progressed. Over the next few months I would call her or e-mail her from time to time. She would always take my call, but she never initiated a conversation or followed up a discussion. She seemed totally disinterested in speaking with me. No matter what questions I asked, she remained noncommittal. “What’s the status of the investigation?”

  “I can’t tell you.”

  “Has it gone to a formal investigation yet?”—meaning that the SEC has decided to issue subpoenas to get the information it needs.

  “No.”

  “Can you tell me anything about what’s going on?”

  “No.”

  “Is there anything you need from me?”

  “If we do, we’ll call you.”

  I tried everything I could think of to convince her to investigate Madoff. I told her that I had a list of 47 respected professionals in the industry who would speak with her if she called and every one of them could confirm everything I said. Among the people on that list were Citibank’s head of global equity de
rivatives research, Leon Gross; Bud Haslet, who was the chief option strategist at Miller Tabak Securities; and Mike Ocrant. As far as I know, she never called anyone.

  Poor Ed Manion. He was the really good guy through all of this. At least once a week I’d call him and let all my frustration out on him. “Your agency sucks!” I told him. “Your people are beyond incompetent. I don’t think they’re capable of catching a cold in the winter. I can’t even believe some of these people get dressed by themselves in the morning. I mean, most of your staff barely respond to heat and light.

  “Believe me, Ed, this Meaghan Cheung is no Mike Garrity. I’m handing her the biggest case of her life and she treats me like I’m bothering her. There’s no way she’s the slightest bit interested in this case. I’m telling you, the next question she asks’ll be the first one. What kind of agency are you people running?”