1. Letter, 2. Government Response (Madoff Investigations), 3. Data: Canada

U.S. Treasury Market: Government Response:

Participants in SEC Investigations of Bernard Madoff

This page is not about front-running and other dealer misconduct in the U.S. Treasury bond market, the subject of the rest of this site. Instead it looks at how John A. McCarthy and Eric J. Swanson, two of the Securities and Exchange Commission officials who heard my description of the Treasury market in June 2004, responded to allegations against Bernard Madoff. The Commission’s August 31, 2009, report, “Investigation of Failure of the SEC to Uncover Bernard Madoff’s Ponzi Scheme,” provides a detailed look at more than a decade of investigations of Madoff’s firm. McCarthy was an Office of Compliance Inspections and Examinations (OCIE) supervisor on four such exams. He was the associate director, with Swanson reporting to him as an assistant director, for all but the first. McCarthy supervised as many as 25 SEC employees; Swanson as many as 18.

Examinations of Madoff Market-Making Operation

McCarthy was a supervisor on a 1997-1998 inspection that found that Bernard L. Madoff Investment Securities (BMIS) had violated the SEC’s order handling rules, generating a deficiency letter.

McCarthy and Swanson (after he joined McCarthy’s group) helped direct an exam, begun in 1999, that concluded that Madoff’s firm was not complying with the SEC’s limit order display rule. McCarthy signed a referral to Enforcement, which opened a Matter Under Inquiry but chose not to pursue the case against BMIS.

McCarthy and Swanson were the two senior supervisors for a 2003 examination of order handling in the Nasdaq 100 ETF (ticker symbol QQQ, since changed to QQQQ), though McCarthy told SEC investigators that he had “just a very vague recollection” of the exam and that “my role would have simply said, ‘Sure, go ahead and do that,’ ” and Swanson testified that he “likely wouldn’t have been involved in the day to day review of any files.” The OCIE staff attorney who completed the exam wrote Swanson that “there is a best execution problem with MADF” and recommended that a deficiency letter be sent, but one never was. The staff attorney later testified that “there was no training” when he joined OCIE and that there were “a lot of projects at the time that would just kind of die off.” McCarthy disagreed with the latter criticism, though the SEC’s report concluded that “This apparent weakness in the examination process would reappear during the 2004 OCIE Cause Examination [of Madoff’s hedge fund business] and seemed to demonstrate a systemic flaw in the OCIE examination process.”

Examination of Madoff Hedge Fund Business

The May 7, 2001, Barron’s included “Don’t Ask, Don’t Tell,” a skeptical look at Madoff’s hedge fund business’s consistently high returns, lack of fees, and secrecy. OCIE’s director, Lori A. Richards, sent the article to McCarthy (whose group was awaiting Enforcement’s decision on Madoff’s market-making operation’s display rule violations) with a note: “John, she [the author] is very good. This is a great exam for us! Lori.” The SEC’s report states that “McCarthy did not open an examination of Madoff in response to the article, and testified that he may not have read the article at the time Richards provided it to him.” (Asked by investigators about the article, Richards testified that she had “no recollection of this document.”)

In May 2003, while McCarthy’s Market Oversight Group was looking at Madoff’s QQQ order handling, a hedge fund manager e-mailed his concerns about Madoff’s fund business to Mavis Kelly of OCIE’s Investment Management Group. Most fundamentally, information from the CBOE and large brokers suggested Madoff could not be trading enough options to implement his strategy on the billions of dollars he was managing. The manager also included a May 2001 article, “Madoff Tops Charts; Skeptics Ask How” (which was inspired by information from Harry Markopolos and in turn inspired “Don’t Ask, Don’t Tell”), as well as some performance data and marketing literature for the Madoff feeder funds.

Kelly forwarded the fund manager’s e-mail to McCarthy’s group (since Madoff’s firm was registered as a broker-dealer, not as an investment adviser), where it apparently was ignored until after Richards sent McCarthy another tip about Madoff—this one alleging front-running—on December 10, 2003. McCarthy then requested another copy of “Don’t Ask, Don’t Tell.” On December 16 McCarthy’s group drafted a Planning Memorandum for a cause exam of BMIS, targeted, at McCarthy’s decision, solely at front-running. McCarthy told SEC investigators “It was not a mistake for me to focus on that, on front-running, because that’s where my area, my team’s area of expertise led,” though he also acknowledged that “front-running exams are relatively—you know, there’s—I don’t recall ever being involved in that many of them, so whether there’s a standard step probably is overstated.” On December 18 McCarthy sent Richards an e-mail, signed “Eric [Swanson],” about the hedge fund manager’s tip, without mentioning its documentation or when it had been received. The same day, Richards and McCarthy telephoned Madoff to discuss the upcoming exam.

Although the Planning Memorandum called for obtaining trade data from the NASD and a request was drafted for Swanson’s signature, it was never sent so the exam relied entirely on data provided by Madoff (the SEC’s investigation found this was “not unusual for OCIE,” even for fraud exams). The central allegation of the hedge fund manager (and the subtext of “Madoff Tops Charts; Skeptics Ask How” and “Don’t Ask, Don’t Tell”)—that Madoff’s returns were fictional—could therefore not be evaluated (nor could front-running, the exam’s stated target). Asked about the fund manager’s complaint, McCarthy told investigators “I don’t ever recall seeing that, no,” and Swanson testified “I’ve never seen this document,” despite their December 18 e-mail to Richards and a January 29, 2004, conference call between Market Oversight’s Mark Donohue (and perhaps others—McCarthy took notes on the call) and the fund manager. About “Madoff Tops Charts,” McCarthy said “I don’t recall seeing this article” and Swanson said “I have not [ever seen the article before].” More generally, McCarthy “wasn’t familiar with the hedge fund business” and Swanson “didn’t know anything, very little anyway, about hedge funds and mutual funds and how they operated.

Market Oversight’s examiners soon questioned whether Madoff was acting as an unregistered investment adviser and found many puzzling inconsistencies in even his fabricated trade data. However, on April 6, 2004, Alex J. Sadowski, who according to the staff attorney was part of the “primary inner circle” around McCarthy [he arranged my June 2004 call and meeting with the SEC], e-mailed one of the examiners to “get the mutual fund work completed first”: only one and a half more days of work would be done on the exam. After work had stopped, Kelly asked Swanson “What ever happened with this?” and was told “The examination is ongoing—we are in the process of reviewing trading on the MM [market-making] desk and comparing it against the trades in the hedge funds.” He conceded to investigators that he “very likely gave Mavis [Kelly] a response that would please her a little bit, to let her know that, you know, it was still being looked at and—might have overstated my case a little bit.”

In August 2004 Swanson asked Shana D. Madoff, Bernard’s niece and BMIS’s compliance counsel, for her thoughts on a presentation he was preparing for an NASD-Wharton seminar. In October 2004 Shana e-mailed him “Eric, you are so great and no matter what you and John [McCarthy] will always be my A-team players. You were my first round draft picks!!” On March 16, 2005, McCarthy and Swanson shared a cab with her from the St. Louis Hyatt to a securities conference. (In a three-year period Swanson took part in at least 17 Securities Industry Association breakfasts, which Shana helped arrange as a member of the SIA’s Compliance and Legal Division Executive Committee.) That afternoon Swanson e-mailed Donohue “What is the status of the madoff hedge fund thingy?” and Donohue replied “Deady. We never found any real problems. Does it need to be revised?”

The month McCarthy’s group suspended its exam, the SEC’s Northeast Regional Office (NERO, located in New York) saw internal e-mail from Renaissance Technologies asking some of the same questions in the hedge fund manager’s complaint. Because Market Oversight had not entered its exam in the SEC’s tracking system, NERO started its own exam without the benefit of their tips or exam results. On May 26, 2005, NERO examiners learned of the OCIE exam from Bernard Madoff himself. During an ensuing conference call between New York and Washington, a NERO examiner recalled one of McCarthy, Swanson, or Donohue saying “He’s a very powerful person, Bernie, and you know, just remember that.” On June 9 OCIE sent NERO two boxes of exam documents, already bound for storage; the hedge fund manager’s complaint was the last item on a list of their contents. McCarthy’s group never issued a closing report for its exam.

On February 28, 2006, Swanson and McCarthy learned from NERO that “our Enforcement people got an anonymous complaint [Markopolos’s third, from October 2005] alleging Madoff is either frontrunning or is the biggest Ponzi scheme ever.” McCarthy didn’t “recall having a reaction” to this news. He did, however, remember why he asked Swanson the following day to “put the squeeze on Shana”: to see if she could get him on a panel at the SIA Compliance and Legal Division Seminar, to be held March 19-22 at the Westin Diplomat Resort & Spa in Hollywood, Florida. McCarthy also testified that around the same time Director of Enforcement Stephen Cutler “wanted us to look into possible—possibility of insider trading in CDSs [credit default swaps].” On May 12, 2006, a NERO Enforcement Staff Attorney working on Markopolos’s complaint wrote that one of her supervisors would “talk to Joseph Cella, the head of Market Surveillance in DC [and the senior Enforcement official to hear my description of the Treasury market], to find out what he knows/has heard of Madoff’s trading” [it is unclear if this conversation took place].

John McCarthy received the SEC’s Chairman’s Award of Excellence in 1998 as well as the Commission’s Capital Markets Award in 2000 and 2004. When he left the SEC in November 2006 to become general counsel for Getco LLC, Richards said that “his expertise in trading and markets has been enormously valuable to the SEC.” Eric Swanson and Shana Madoff became romantically involved in March 2006, were engaged in December 2006, and married in September 2007. Swanson left the Commission in September 2006 to become chief counsel and vice president for regulatory strategy at Ameriprise. In January 2008 he became general counsel of BATS Exchange.

Alex Sadowski left the SEC to become Getco’s assistant general counsel under McCarthy. He told investigators in 2009 that “it is difficult if they [new SEC employees] are really not up to par to get rid of them.” He also explained that “there is a mentality sometimes … we have this checklist, right, so we need to go by this checklist and if everything happens on this checklist, it is okay … The analogy that we use is that a typical SEC examiner walks into a room where there are a bunch of dead bodies lying around and they notice that the clocks are 10 minutes fast.” 1. Letter, 2. Government Response (Madoff Investigations), 3. Data: Canada

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