Could SEC Have Stopped Madoff Scam In 1992?

In the unfolding tale of Bernard Madoff's alleged $50 billion Ponzi scheme, feeder firms have grabbed much of the focus.

They get their name because they marketed the funds that held the assets ultimately managed by Madoff. Lawsuits are filling the courthouses as burned investors attempt to recoup at least some of their losses from the firms. Last week New York Law School sued Ascot Partners, run by GMAC Financial Services Chairman Ezra Merkin, for losing $3 million of its money to Madoff. Other Ascot investors, including Mort Zuckerman, are expected to follow. Ascot reportedly steered $1.8 billion of client money to Madoff.

Fairfield Greenwich Group and Tremont Capital have taken the brunt of the scrutiny. Tremont had $3.3 billion invested with Madoff through various funds. Fairfield, a hedge fund run by Walter Noel, is the target of a lawsuit by investors, who claim it failed to protect their assets while collecting millions of dollars in fees. The suit says the firm failed to conduct "even a minimum level" of due diligence, breached fiduciary duty and was negligent and unjustly enriched.

But ironically, the Securities and Exchange Commission might have unearthed Madoff's massive scheme in 1992 through its scrutiny of a feeder fund back then.

In late 1992, the agency filed suit against a Florida investment firm, Avellino & Bienes, accusing it of selling $440 million of unregistered securities to 3,200 investors. Avellino & Bienes funneled the investments to a single manager and promised clients a curiously steady 13.5% to 20% annual return, the SEC said at the time, but the scrutiny didn't go any deeper. The Avellino firm was shut down in 1993, and the money was tracked down and returned to investors.

Turns out, Madoff was the sole manager who took in the Avellino & Bienes money. In a December 1992 interview with TheWall Street Journal, Madoff himself explained he didn't know the funds had been raised illegally and added that his performance tracked the 10-year performance of the Standard & Poor's 500, hardly notable.

The relationship between Frank Avellino, Michael Bienes and Madoff had grown so lucrative that, according to the Journal article, Avellino and Bienes abandoned their accounting business in 1984 to focus on investments full time, a fact that also got them in trouble with the SEC, which accused them of running an unregistered investment company.

According to the SEC complaint against Avellino & Bienes, their infractions dated back to 1962. Madoff founded his firm, Bernard Madoff Investment Securities, in 1960. In another interesting coincidence, their lawyer, Ira Lee Sorkin, is currently representing Madoff.

In the Journal's 1992 interview with Madoff, there is a description of his investment strategy that seems all too eerie today, in light of the charges against him. In the 1970s, investors were put into convertible arbitrage positions in large-cap stocks, with promised investment returns of 18% to 20%. In 1982, the investment strategy changed to include greater use of stock index futures. Madoff claimed he was in stock market index puts (a type of option contract) on the day the market crashed in 1987.

Now regulators say Madoff kept several sets of books and probably cooked the numbers he gave investors to maintain the allusion of consistent returns. He may not have invested much at all, despite having a vague strategy involving buying blue chip stocks and hedging them in the options markets. A $7 billion tsunami of redemptions this year is probably what drove his scheme to the brink. Ponzi schemes, in which early investors are paid using money from new investors, only work when fresh money is coming in.

Last week, SEC Chairman Christopher Cox acknowledged that the agency missed several warning signs. "I am gravely concerned by the apparent multiple failures over at least a decade to thoroughly investigate these allegations or at any point to seek formal authority to pursue them."