SEC Didn't Act on Madoff Tips

Regulators now suspect that he may have run a second investment advisory business that was never registered with regulators, according to people familiar with the investigation.

The SEC does not have the resources to examine investment advisers on a regular schedule. Instead, the agency prioritizes examinations of companies based on their risk profile, which is basically a process of judging books by their covers. People familiar with the process said the SEC tends to focus on high-risk investment strategies, such as trading in derivatives.

Lori A. Richards, director of the SEC's Office of Compliance Inspections and Examinations, said that only 10 percent of the 11,300 investment advisers registered with the SEC are examined on a regular basis -- those with high-risk characteristics. They are examined every three years. Others might be examined randomly or where there is cause, Richards said.

From 1998 to 2002, the SEC aimed to examine every adviser at least once every five years and to examine newly registered advisers during their first year, but a 50 percent increase in the number of advisers since 2002 ended that practice, Richards said.

Richards declined to comment on Madoff's firm.

Some experts said that the SEC's criteria made sense and that the fraud Madoff allegedly constructed was successful in part because it avoided the appearance of risk. It avoided the scrutiny of investors and regulators by claiming to engage in vanilla trading and reporting steady but unspectacular returns.

"I think the SEC is going to have a PR issue to deal with, but I'm not sure you'd find that the SEC staff did anything wrong," said Barry Barbash, a partner at Willkie Farr & Gallagher and a director of the SEC's Division of Investment Management during the Clinton administration. "They've had to make judgments, and they decided to look at derivatives, short sales, insider trading, all the things that Madoff never had."

Others said that the SEC should have flagged Madoff for examination no later than the moment he registered as an investment adviser, in 2006, because of the history of complaints against his firm and because of its unusual characteristics. These included Madoff's history of smooth earnings -- above 10 percent a year, every year -- and his company's reliance on a small auditing firm that had no other large Wall Street clients.

Aksia, a New York-based consulting firm that advises institutional investors about hedge funds, found that Madoff's auditor worked out of a 13-foot-by-18-foot office in Rockland County, N.Y., with only three employees. The employees of the firm, which had only Madoff as a client, included a 78-year-old living in Florida and a secretary, Aksia said it discovered. The auditor, Friehling and Horowitz, did not respond to a request for comment.

"If it's true that the SEC had begun receiving warnings in 1999, then even if they did nothing before then, surely when he registered with them in 2006, he should have gone to the top of their list," said Barbara Roper of the Consumer Federation of America.

Madoff avoided scrutiny despite the dogged bell-ringing of a Boston accountant, employed by another investment firm, who repeatedly accused Madoff of breaking the law in a series of letters to the SEC that began in 1999. The accountant, Harry Markopolos, said he sent his most recent letter in April.

A former SEC enforcement official said the letters should have raised red flags for regulators.

"It is not common to get complaints about somebody who's running a large amount of money that it's a Ponzi scheme," said the former official, speaking on condition of anonymity.

He said that investigating a Ponzi scheme is not difficult: The agency can simply demand proof that the investment adviser holds the amount of money he claims to hold. And he added that regulators also should have noticed that Madoff was audited by a tiny company with no reputation. He said there are only a few accounting firms with the sophistication to audit an investment adviser that, at the time of registration with the SEC, reported $17 billion on assets.

Regulators should have noticed instantly, he said, that Madoff's auditor was not on the list.

Staff researcher Meg Smith contributed to this story.