Love, Madoff And The SEC

How far did Bernard Madoff's alleged Ponzi scheme reach? One indication is that a fair number of Investor Team members know people who were involved. Michael Ervolini of Cabot Research is friends with an 80-year-old woman who went, he says, from a comfortable life to having to eke by on Social Security. Stephen Roseman of Thesis Capital says some of his investors lost Madoff money.

It stands out as one of the more astonishing aspects of the entire Madoff debacle that the Securities and Exchange Commission will now have to, in the words of outgoing Chairman Christopher Cox, investigate "all staff contact and relationships with the Madoff family and firm, and their impact, if any, on decisions by staff regarding the firm."

One obvious relationship Cox seems to be referring to is between Eric Swanson, a former assistant director at the Securities and Exchange Commission's Office of Compliance, Inspections and Examination, and Shana Madoff, a former compliance officer at Bernard L. Madoff Investment Securities, who is Madoff's niece.



Roseman, founder of Thesis Capital, notes that it's commonplace for casual relationships to arise between examiners and people at the firms they examine, even sometimes leading to job offers. "It's not uncommon for people in that role to get to become quite familiar with one another," he says.




This issue is that if we like someone we are far more likely to feed them softball questions in order to back up the decision about them we've already made. Conversely, if we don't like someone, we'll play hardball with them. What we should do, Ervolini says, is the opposite. Play tough with people you like and toss some softballs to those you are not as comfortable around.

Peter Gschweng, chief compliance officer at Firstrade Securities, agreed that the potential is there for investigators and those they investigate to get chummy. He's seen it first hand, as he had conducted exams for the National Association of Securities Dealers between 1990 and 1994. In fact, Gschweng admits, he had a brief "more than friends" relationship with a chief operating officer at one of the firms he'd examined, after the exam was finished. "If it can happen to me, it can happen to thousands of examiners out there for the Financial Industry Regulatory Authority," he says.

Still, Gschweng doubts that even if he were so inclined Swanson could have buried any incriminating evidence he'd uncovered about Madoff's firm. "One guy can't make a decision--unless he's in a senior position--to not follow through with an investigation or to sweep something under the rug," he says. "It would have to be collusion of many people to give Madoff a break."

Bob Mewshaw, chief investment officer of the small investment advisory firm Van Sant & Mewshaw, paints a much different picture of the examinations he's experienced. "They prove and ask questions, and we answer them," he says. There's no animosity, he says, but also no friendliness.

Jonathan Kord Lagemann, a longstanding securities attorney and Investor Team member, says that, in his experience, SEC investigators traveled in groups of three--"like nuns"--in order to escape even the suggestion of having personal relationships with a firm. "You would never be alone" with an SEC attorney, he says.

An SEC spokesman declined to comment on whether it is still commission policy to have their inspectors travel like nuns. The experiences of our Investor Team suggest that quaint old notion was long ago put to bed.

Next Page: What Shana Madoff Means

What Shana Madoff Means

Roseman: I don't know anybody involved, or anybody related to the firm, although unfortunately, a couple of my investors were involved. My wife is a former Manhattan district attorney, and we were talking about this, and agreed it's not as unseemly or unusual as it otherwise appears. When you are a Securities and Exchange Commission examiner, you go through your matter of course; the examiners camp out in the office for weeks to months. It's not unusual for CFOs to get to know the investigators very well. That's how [Shana Madoff and Eric Swanson] met, and they started dating. They met during that audit. When I got to Current Capital in 2003, they were being audited by the SEC. [The SEC randomly selects firms.] The audit started a week after I started. They took an empty office. And the two or three of them that were working there were asking for documents, making sure you're doing everything according to Hoyle. Making sure you're doing everything well.

They were literally there for months, and it got to the point where our whole financial team was going to lunch with them together. Because they were working together all day. So it's not as crazy as it seems. Parenthetically, I live in Westchester, and one of the dads of one of my son's schoolmates is in fact a Citibank compliance attorney. He was previously with the SEC, and after an investigation, he was offered a job by Citigroup. As titillating as it seems--and we all want to make something of it, and there might be something there--as a practical matter, it's not that uncommon for people in that role to become quite familiar with each other. In this case, it's romantically; in other cases, it's job offers. Because that's how you get to know people.

Lowlicht: I had that experience also, having been through those audits. My point, if [you're] sitting in that office starting to notice you're romantically involved--and this is not a question if they were romantically involved beforehand--the point I am making is that it's almost impossible to be unbiased in that situation, if you get the point where you feel you're having that attraction. It's almost like your doctor; if you start to become romantic, they have to say, 'stop seeing me or see another doctor.' And I don't know that that's [what happened]. My point was, I read a quote by Bernie's attorney today. And his lawyer says that Bernie is a longstanding leader in the financial services industry, and he's cooperating with the government into this unfortunate set of events. The amount of B.S. around that ... The guy's an upstanding citizen of the financial industry? No, he isnt. He put on that guise and he's misled everyone.

Ervolini: That's right.

Lowlicht: He's not an upstanding citizen in the financial services community. He's not an upstanding citizen in the Jewish community, which I happen to be Jewish and I will say that outright. And he had a responsibility to the financial services community and the Jewish community to represent himself in a good light. It not only affects the financial community, it affects the Jewish community.

Roseman: I would say, for the purposes of editorializing this discussion, I would agree this is a travesty for the Jewish community. But I don't think we should make this about religion.

Ervolini: It's become apparent from the analysis done [that] the SEC's backed up on its offsite activity over the past eight years. That lack of in your face activity has certainly sent a message to the market place. That's part of it, they haven't been as rigorous as they could have been.


Now the perfect parallel for this discussion is something I'm more familiar with, which is hiring and interviewing. It's a well-known fact that we as managers often make up our minds in the first 30 seconds of the interview; we spend the rest of the time asking questions to support our opinions. So if we find ourselves across the table from someone who's nice, energetic and pleasant to look at, we soon say "this is a winner," and then we throw them softball questions--all unconsciously. Likewise, if a person is frumpled, a little confused and sweaty in the palm, then something in our minds clicks, and we say, "I don't know if this person is for us," and we start throwing them hardball questions.


Likewise for people investing 

Lowlicht: That's what I was going to say. It goes deeper than that.

Ervolini: Oh yeah. On the investing side, it's positive affirmation; we want to be associated with these other winners. Everyone investing with Bernie is a winner, and I want to be a winner too. And whatever Bernie says will be consistent with out belief that Bernie is a winner and we're a winner. When people are on the rise, we tend to not ask them tough questions--just like the interview process. And we're looking at the names now in the paper. There are really smart, together folks who did zero investigation into Bernie. If his name was Mike Ervolini, they would have had a more formal process.

Lowlicht: The funny thing about that, Mike, is that I find that a guy who throws out these returns that I was looking at for years and not understanding how these returns are made, and I won't make any investments for my clients if somebody goes, "yeah, we have a system, we have a black box." But you look at it and say, "what is the black box?" And there is no substance for those returns. I'm a believer if it's too good to be true  it's not true. And there are people in our business who want to hear that "too good to be true" scenario.


So how do you change your conceptual thinking, where you're talking about a guy who's not even telling you how he's making these returns? To just throw all caution to the wind, and go, "here is my life savings." I just don't understand that. And I think that goes back to your behavioral issue, which is everyone wants to be part of a winner. Everybody assumed this as factual without any due diligence at all.

Roseman: To be fair, from a retail investor standpoint, for people who you're hearing stories of who had the majority or all of their net worth with him, it's easy to [be a] Monday morning quarterback. But to be fair, it's also easy to understand that if you had been invested with him for 20 years, and you're in your 60s to 80s--which seems to be the common thread, older people--it's easy to see how if you're paying for your weddings and kids Bar Mitzvahs, what do you do? You sell your losing investments. And the one that's been doing really well you're more loath to sell. You would have to make a conscience decision to rebalance.

Lowlicht: That's the whole premise behind investing. That's where everybody's gotten lost. Everyone wanted to own oil at $140. Everyone wanted to own real estate in 2004 and 2005. Everyone wanted to own dot-coms in 2000. So, in essence, what you would have been doing is liquidating all your losers and going into the top every single time.

So yes, I understand what you're saying. But the reality is, when you hire a professional to sit down, which is what I do, I have a harder time raising assets than a Bernie Madoff. Because when a client sits down with me, they get the reality. The reality is, yes, oil is at $140 [and] you own too much of it. I don't want to sell real estate exposure that's down 60% to buy oil exposure that's at $150. I want to keep you allocated based on our time frame and our risk tolerance. And have that asset allocation strategy rebalanced.

That's my job. I understand what you're saying from the individual investor. But that game to me was over 10 years ago, and the problem our community is having is, rather than treating it like a profession where you provide advice as a consultant, like an attorney or an accountant, what we do is sell return. I don't do that. But that is the catch-22 in the business, and it has harmed the individual investors through every single bubble.

Roseman: I'm not saying the people are right. I am saying let's not judge them too harshly, because I can easily see how that happens. Bear in mind that statistic you should be familiar with: People spend more time planning their annual vacation than [they do on] their finances. From a behavioral standpoint, it's also very hard. If you've known somebody five to 20 years, I understand how people just kind of give it a pass--"I'm not going to redeem, I know him." You wouldnt even think twice that it could be an issue.

Most people go in--and its even more near and dear to everybody's lives than their finances--when is the last time anyone did a check on the background of their doctor, as to how many disciplinary issues they've had, or to check how many patients they lost? The reality is people dont do that. If I recommend you to my cardiologist, and if you're being intellectually honest about it it's not even going to cross your mind whether he's lost a patient or not. Nobody does that. I was mortified [when] my wife--when [our] son [was] delivered three and a half years ago--she heard about the misapplication of the epidural and how it can cause a lifetime of chronic headaches. She asked the doctor for his statistics, which I had never heard anybody do. Kudos to my wife. Nobody ever asks the doctor for a track record, for a hit record, as to how successful you've been in treating patients.

It's very easy to understand how, behaviorally, what happened with the Madoff scandal has unfolded as it has. You have someone people are very comfortable with. And they're not comfortable after [just] a meeting or two, they're comfortable after 20 [years] of him supporting their charities, him showing up at their funerals, their weddings and their Bar Mitzvahs. You wouldnt even think twice to second guess it.

Ervolini: On that point, a friend of mine, whose mother was in her 80s, her husband died. When the husband was getting close to the end, he said to his wife, "I want you to be conservative with the money. Give it all to Bernie." And their entire wealth now is gone. And this woman went from comfortable to Social Security. And that's because the purpose of a professional is to disabuse you of your bad thinking. We all have these prejudices about finances and such. And the professional's job is to say no. If Bernie is doing better for you, you can't keep giving him all your money. Because even if his name was Ned Johnson from Fidelity, you still dont want him to have all your money. There's just something imprudent about that. You have to diversify. The better somebody does, the more you like him. That's when you have to ask tough questions.

Lowlicht: Like, "How are you doing better? What is your process for doing better in a market that's getting hammered? How are you consistently getting returns when  the only way to make money in the past six months is to be short?" So you have to say, "How are you making these returns?" One thing you have to separate is it was one investment style--so you're not diversifying, no matter how much you trust him. You need different styles. If you're a real estate mogul, you don't buy real estate all on the same street. Giving all your money to one manager, it's still [the] same style, even if it's a legitimate business. If the style doesn't work and there's a glitch in the system, you can get hurt. So let's spread this risk around.

Another point that Mike made, from a behavioral standpoint, it's my job to take the emotion out of system. I dont invest my own money. I have somebody else at my firm handle my money and I handle their money. I can't invest my own money. My money's an emotional decision making process. When a client sits down, it's a fiduciary responsibility; it gets treated entirely differently. And thats what I get paid to do.

Ervolini: Early in my career, I was an investment fiduciary for pension funds, and I fought for nickels for this client. I dont even look at my own stuff from month to month. I just have a whole different attitude for my client. And not that it's good or bad, but it's different. And, like Mark, its probably safer to let someone else mange it for me.