No One Would Listen: A True Financial Thriller

by Harry Markopolos

  Gaytri Kachroo became my lawyer. She began negotiating with different firms, trying to find lawyers who would agree to those conditions. And eventually we found firms in several states. Those market-timing cases were Gaytri’s introduction to the SEC, and she got a good dose of its incompetence early in our relationship. When the SEC dropped all of my cases, I was livid. I was furious. I tend to be restrained; I like to be in emotional control, but this time my frustration was too much to hold inside. “These guys are good for nothing!” I screamed into the phone. “They’re never gonna get it. I can’t believe I keep giving them chances and they never get it!”

  Because I had told Gaytri absolutely nothing about Madoff, she probably thought I was overreacting. But as she listened to me yelling about the SEC’s incompetence, about their stupidity, about their refusal to do their job, as she listened to me letting all my anger and frustration come out, she finally realized that I’d had previous encounters with that agency. And she began wondering about that.

  Chapter 7

  More Red Flags Than the Soviet Union

  In August 2007 Frank Casey sent me an e-mail about a new financial product he’d found on the Internet site NakedShorts: “Investment dealers are excited to announce the newest structured finance product—Constant Obligation Leveraged Originated Structured Oscillating Money Bridged Asset Guarantees, or Colostomy Bags. Designed to accommodate the most sophisticated investment strategies, Colostomy Bags contain the equity tranches of Structured High Interest Taxable derivatives, or Shit, and are leveraged an infinite amount of times through the innovative use of derivatives.”

  I probably smiled sadly as I read it, knowing that it was no less real than Madoff, and that if it actually existed and somebody could make money from it, they would sell it. I wrote back, “That’s an awesome-sounding product! Who do I call to get an allocation? I want to take down a small piece first, say $100 million, then pitch them to the French HFOF’s as a higher return, slightly higher volume product than Madoff.”

  When Neil was sitting across the desk from me at Rampart and things got a little hairy, he would remind me that his mother, who never invested in anything more risky than a certificate of deposit, had tried to talk him out of going into the financial industry. “My Dad was in favor of it, telling me Wall Street people are smart. They make a lot of money. Get in the trenches and do a good job. But my Mom thought investment people were scam artists, and wanted me to become something respectable: ‘Be a doctor or a lawyer.”’

  Then he would add, “And we aren’t even Jewish!” We’d laugh and manage to somehow get through the current crisis. But as the years went by, it occurred to me that maybe she knew what she was talking about. After spending so many years trying to convince government officials, reporters, and fund managers that Madoff was a fraud and being rejected or ignored by every one of them, it’s human nature to at least wonder if maybe everybody else was right and I was wrong. But the truth is that I never doubted myself. There is a single irrefutable fact that I relied on: Numbers can’t lie. That’s the basis of my career. First examine the numbers, then investigate how those numbers were generated.

  The question I’ve struggled with, which all of us on the team have struggled with, is why did so many people permit this fraud to continue for so long? The industry knew, there’s no question about that. After Madoff collapsed, I was told so many stories about people who knew he was a fraud and warned others. For example, I’ve been told about an e-mail a manager at one of the largest investment houses sent to a Madoff client in 2005, warning him that “everybody here knows Madoff is a fraud” and urging him to get his funds out.

  Another very smart guy Neil and I knew ran a fixed income arbitrage strategy for one of the major feeder funds that was heavily invested in Madoff. This manager joined the firm long after it had made its initial investments in Bernie, and I believe he eventually became a partner. This person is very outspoken, but he knows what he’s talking about. He speaks numbers. For example, when Rampart was marketing the product I’d created, he’d looked at it and figured out almost immediately that “This is a trade; it’s not a strategy.”

  I explained to him that I was delivering a product that fulfilled certain demands, but he just crushed it. Neil and I wondered how somebody that smart could have gotten involved with this fund. He looked at my numbers and knew what I was doing, so he must have known what Madoff was doing.

  Finally, Neil told him right to his face that Madoff was a fraud. When the man started to defend his fund’s investments, Neil challenged him: “Check the trade tickets. There are no trades.”

  We have good reason to believe that he did exactly that, and that he discovered that the volume never happened at the prices Madoff quoted at the time Madoff said they did. It wouldn’t have been hard for him to do that; in fact, had the SEC investigators done it they would have discovered that the trades didn’t exist and Madoff would not have been able to explain it. But this manager quietly left this hedge fund and opened his own fund with a unique strategy he had developed. He was immediately successful and, as part of Neil’s job recruiting managers for Benchmark Plus, Neil visited him in his new East Coast office. “I spoke to him for a few hours,” Neil told me. “His desk was covered with papers and I saw the logo from [his former employer] on his desk and I was trying to read them without being caught as he explained his strategy to me. I couldn’t do it, though.

  “Finally I just asked him straight out, ‘You were at [the fund] for a long time. I just gotta ask you, what did you really think about Madoff?’”

  “And?” I asked.

  “He hesitated, like he was trying to find the right way of answering. I can’t really explain it, Harry, but you should have seen how uncomfortable he was with this question. His whole body sort of sat up and I could hear the strain in his voice. ‘Basically,’ he said, ‘I did my own thing while I was there. The Madoff thing was [he named another partner]; he took care of all that.’ I pressed him, and the closest he got to admitting anything was telling me that there was enough going on where he thought it was a good time to exit. He said, ‘I was running my own strategy anyway, so it seemed like the right thing to do.”’

  Neil and I both believed very strongly that he knew. He was much too smart to believe in either the tooth fairy or Bernie Madoff. But his attitude was very typical of the attitude on Wall Street. Those people who knew something was wrong and had not invested with him went along with the unspoken industry code: If it’s not my business and it doesn’t affect my business, I’m not going to get involved. And those people who were invested with him and knew something was wrong kept silent because his returns were too good. Bernie Madoff could not possibly have gotten away with it for so long without the silence of so many people. Madoff wasn’t an aberration; he was a creation of the profit-at-all-costs culture of Wall Street. And maybe the scariest thing about Bernie Madoff?

  He isn’t the only one. Like unvanquished monsters, there are more of them out there in the dark.

  When we had discovered Madoff in 1999, Frank, Neil, and I had been working at Rampart. In the eight years since then, each of our lives had changed drastically. Neil had moved to Tacoma and had become the director of research—meaning he hired hedge fund managers—for Benchmark Plus; Frank had survived a catastrophe at sea and was living in New Jersey, working for a marketing firm dedicated to raising pension assets for hedge funds and funds of funds called Parkway Capital; I had started my own business, and Faith and I now had three little children. About the only thing that hadn’t changed was our pursuit of Madoff. Month and month, year after year, we continued compiling a growing mountain of damning evidence that nobody seemed to care about.

  In 1999 Madoff had easily been the largest hedge fund in the world, and he had continued to grow bigger and bigger. It was no longer possible to estimate accurately how large he had become; we guessed $35 billion to $40 billion, but certainly it could have been substantially more. After he collapsed, in
vestigators found evidence that he was taking money from well over 339 funds of funds in over 40 countries, and estimates of the total amounts investors thought they had invested with Madoff as of their November 2008 monthly statements were as high as $65 billion.

  And no matter how many red flags we discovered, there were always more. Early in 2007, Neil was speaking to a third party marketer (someone who sells for various hedge funds), who started telling him about an incredible fund he had discovered. As soon as he said “phenomenal returns” and “split-strike conversion,” Neil knew who he was talking about.

  “Are you talking about Bernie Madoff?” It was the Fairfield Greenwich Sentry Fund. Neil laughed. He liked this guy, and told him that he had heard—not that he had spent almost eight years investigating Madoff—that there was something wrong with Madoff, that he might be a fraud.

  “I’ve heard that, too,” this man responded, “but there’s nothing to it.” Madoff had been around forever. He couldn’t be a fraud, the marketer explained to Neil. How could he have pulled off a fraud for 20 years? And besides, the SEC had investigated him and didn’t find any problems.

  Neil had become a pretty good investigator. So rather than simply dismissing the concept, he asked if it was possible to see Madoff’s audits. At that point we didn’t realize how much Bernie needed every million dollars he could get his hands on, so this investment adviser was delighted to provide to Neil copies of Madoff’s audited financial statements from 2004 to 2006. As he wrote to Neil in two e-mails, “I have attached the last three audits for the Fairfield Sentry Fund, which is the domestic Madoff strategy....

  “The year-end audits show only the snapshot of what the fund is holding on December 31 of that year.... Madoff is always in T-bills at year-end, so that is all you see.... He has closed out his trades and put the money into Treasuries for year-end, which is typical for him.

  “I know it is odd. I am still working on getting the actual trade examples for you, and again, I am happy to put you in touch with someone at the Sentry Fund to walk you through how the trade works and the process.”

  As soon as Neil got them he forwarded them to me. And after even a brief examination we were amazed.

  Each of those three statements was done by a different accounting firm. In 2004 Madoff had used a regional firm based in Stamford, Connecticut. In 2005 he had used PricewaterhouseCoopers in Rotterdam, the Netherlands; and a year later he had used PricewaterhouseCoopers in Toronto. Obviously he was auditor shopping. It meant he didn’t want to have an ongoing relationship with an auditor because the auditor knew too much from the previous year’s audit. Using PricewaterhouseCoopers in different countries was pretty clever. Many people looking at these statements would see the PricewaterhouseCoopers name and assume it was PricewaterhouseCoopers U.S., a respected firm. And they’d see that name at least two years in a row, probably more. What many people don’t realize is that PricewaterhouseCoopers is actually a different corporation in different countries. The corporations have the same brand name, but basically they’re franchises. They operate independently under the same name. Very few people know the accounting system or the standards for licensing an accountant in those countries. While it’s the same brand, it may not be the same quality as in the United States. That’s an obvious red flag.

  And at least I have to wonder if anyone at these auditing firms ever questioned why a large American hedge fund had picked them out, above all the thousands of qualified accounting firms in the United States, to conduct its year-end audit.

  Even more surprising was what we found when we examined these audits. Supposedly Madoff had gone to all cash at the end of each of these three audited years, and was holding Treasury bills. While Madoff had boasted he was invested in the market only six to eight times a year, the fact that he had nothing to audit at the end of the year—no stocks, no options—was much too convenient, and especially because he was in T-bills. In more than two decades of looking at audits, none of us had ever seen this before. It made the audit useless because there was nothing for the auditors to inspect.

  The bigger problem was that he claimed to be holding T-bills worth roughly $160 million at those year-ends and had no trading positions. The obvious question that should have been asked was: What happened to the rest of those billions? But the auditors had no way of knowing what wasn’t there. If Madoff claimed all his money was in T-bills, there was nothing else for them to look at. I wrote to Neil that “the audits that show only T-bills worth $160 million or so on a $1.47 billion portfolio have me wondering where did the missing $1.31 billion go? There’s more holes in the Madoff portfolio than all the golf courses in Florida. Why is he in T-bills at year-end? Name a broker that he trades thru?”

  If the auditors had only bothered to conduct a simple examination, they, too, would have discovered that this was a fraud. Instead it appears that they just assumed that one of the most powerful men on Wall Street could be trusted to actually own the $160 million in T-bills he claimed. It would have been simple to check. When you buy a T-bill, there has to be a counterparty selling it to you. There are a limited number of places from which you can buy them. Madoff could have bought them from the Federal Reserve Bank of New York directly or from a primary dealer. He even could have bought them in a secondary market, although most people don’t do that. What the accountants could have done was ask him, “Say, Bernie, who’d you buy these things from?” Bernie would have told them something, and then they could have gone to that party and asked, “Did you sell Bernie Madoff a hundred sixty million dollars’ worth of T-bills? Mind if I take a look at the trade confirmations?”

  My guess is that the party’s answer would have been “No,” because I doubt that those T-bills ever existed, except on Bernie’s fantasy audits. This raises the question: What good are Big Four accounting firm audits if these accounting firms aren’t checking for fraud? Why pay for an audit if the auditors are not also trained as fraud examiners? What good is a clean audit opinion on a crooked company, anyway? Enron, WorldCom, Global Crossing, Adelphia, HealthSouth, and all the other corporate felons all had clean audit opinions from the most respected accounting firms. Believe me, a lot of the hedge funds of funds had clean audit opinions, and these audits didn’t detect that Madoff was a fraud.

  There is one other noninnocent explanation for why Fairfield Greenwich Sentry Fund had three different auditors in three different countries for three consecutive year-ends. Accountants have something called accountant-client privilege, and some states recognize it but usually in a much more limited sense than attorney-client privilege. Shockingly, especially in a profession like accounting where you would at least hope that they held fast to some sort of code of conduct, you’d think that once external auditors discovered accounting fraud they’d immediately go to law enforcement and report it. But you’d be wrong. Instead what most accounting firms do in these situations is “make a noisy withdrawal” by resigning the account but telling nobody why they resigned and, in effect, firing their client. Board members, law enforcement, and investors are supposed to be able to immediately know that whenever accountants resign, the reasons for it are serious and should be delved into. This may or may not be the case with Fairfield Greenwich Sentry’s use of three different auditors, but if it was the case, that says all you need to know about accounting firms and professional ethics. One would hope that this profession would require its members to report criminal activity upon discovery.

  Lots of large banks, particularly European banks, ended up in bed with Bernie Madoff—which should give all investors pause when trusting any financial institution with their hard-earned money. In finance, 90 percent of the skullduggery takes place beneath the surface.

  One thing that galls me about the hedge fund of fund business is how many of these charlatans claimed to be using large, prestigious banks as their custodians to keep control of the securities in investors’ accounts. Yet, somehow, Madoff and these HFOFs were able to subvert even this commonsense
safeguard. Investors may have wired their money to prestigious Custody Bank A but unbeknownst to them, this bank then wired the money straight to Bernie Madoff who, acting as sub-custodian, “self-custodied” the assets himself and then stole every dime. Obviously these large custody banks “rented” their “good names” to these HFOF charlatans but unfortunately investors didn’t realize they were being hoodwinked.

  Third party plan administrators who are charged with record keeping and performance accounting were also fooled by Bernie Madoff—or were they? HFOFs like to brag about their use of these so-called third party plan administrators as an additional investor safeguard, but do they really offer investors an impervious shield against fraud? Definitely not! If a third party plan administrator does come across fraud, he’ll likely just resign the account and remain silent.

  The other thing you should know about these third party plan administrators is that they are supposed to be providing independent valuations of the securities held in your account, but all too often they don’t have a clue how to value complex securities. Instead, the hedge fund manager ends up telling the plan administrator how to value the securities. In other words, these plan administrators aren’t nearly as independent as they would have you believe.

  Personally, I wouldn’t want any third party plan administrator hired on my behalf unless they had a policy of mandatory fraud reporting to the authorities as soon as they spotted something amiss. Otherwise, I don’t see how a Big Four accounting firm, custody bank, or third party plan administrator offers me any value whatsoever. My view is that if you hold yourself up as a professional you have to uphold a sense of ethical duty to your clients.