"In today's regulatory environment, it's virtually impossible to violate rules ... and this is something the public really doesn't understand ... but it's impossible for you to go - for a violation to go undetected. Certainly not for a considerable amount of time."
-Bernard L. Madoff, just over a year before turning himself in for perpetrating what may prove to be the largest financial fraud in history.

    After the revelation of a massive fraud scheme, a former government investigator has accused government law enforcement officials of repeatedly turning a blind eye to Wall Street crime and, in doing so, allowing the foundational trust of the global financial system to crumble.

    The Securities and Exchange Commission (SEC), the oversight body which was set up to enforce laws regulating finance in order to prevent a repeat of the stock market crash of 1929, has admitted to falling down on the job, missing the long-running scheme allegedly perpetrated by Bernard L. Madoff - potentially the largest scandal ever to rock Wall Street.

    Madoff, a 70-year-old Wall Street icon, turned himself into authorities after allegedly scamming investors out of up to $50 billion, using what appears to be a decades long "Ponzi" scheme, where money from new investors is used to pay off previous investors. The scheme collapsed because new victims could not be found and investors started to ask for their money back. Madoff could not return their funds because the money was gone and there were no real assets to sell. The details of exactly where the estimated $50 billion went are still unclear, but victims ranging from wealthy individuals to charities to foreign banks have all stepped forward to admit losses totaling approximately $20 billion to date.

    On Tuesday, SEC chairman Christopher Cox admitted that the agency had failed to thoroughly investigate multiple "credible and specific allegations regarding Mr. Madoff's financial wrongdoing," adding "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."

    The Madoff affair is the latest in a string of missteps made by the regulatory body.

    Gary Aguirre on the SEC

    After a successful career as a trial lawyer, Gary Aguirre turned his attention to public service, trading in a lucrative practice to become a government lawyer tasked with investigating financial crimes.

    In the course of an investigation into possible insider-trading by hedge fund Pequot Capital Management, Aguirre pushed to subpoena Wall Street star John Mack, now the chief executive of finance giant Morgan Stanley. The investigation was halted by Aguirre's supervisor and the SEC allowed the case to die.

    A subsequent report by the internal SEC watchdog found that Aguire's supervisors acted improperly in firing Aguirre and shutting down his investigation. While the report recommended punishment against four officials in the chain of command, Cox declined to hold them accountable.

    Aguirre continues to closely follow the activities of officials in Washington, DC, and executives on Wall Street. I spoke with Aguirre about the significance of the Madoff fraud and the failure of SEC to stop it.

    Matt Renner: Why was Madoff able to hide his activity from oversight?

    Gary Aguirre Madoff was an investment adviser, which means the SEC had regulatory authority over him. He engaged in a classic kind of fraud called a 'Ponzi' Scheme, which means that he gave phony profits to some investors which he took from the pockets of other investors. That kind of fraud is difficult to detect until investors can't get their money back. Then it comes to light. In this case, we know that there were repeated complaints to the SEC over a period of nine years. The SEC was told Madoff was operating a Ponzi scheme. So, it is stunning that the SEC failed to investigate those allegations and uncover the fraud. It's a new low for the SEC.

    MR: What oversight powers does the SEC hold over this type of financial activity?

    GA: An investment adviser is a regulated entity. The SEC can obtain a stay order, can bring the whole business to a halt, they can go in and look at records without a subpoena, they can conduct an audit. SEC has considerable regulatory authority to examine the ongoing business activities and do whatever is necessary to protect the public.

    MR: Why do you think the SEC didn't use these regulatory powers in this case?

    AG: We can't really prejudge it at this point. There is a lot of talk in the media that there were personal links between SEC staff and Madoff. One has been identified; I'm not sure he was the only one involved. But stepping beyond personal connections, in general, I believe that the SEC has been reluctant to apply the securities laws to the big players, to Wall Street's elite. They have often gotten a pass. The SEC is focused on the small players.

    In the investigation that I conducted, which is now the subject of a Senate report, there was suspicious trading activity involving both a hedge fund involving an $18 million profit. They also detected a $150,000 profit by a low-level employee of General Electric (GE) and a Taiwanese kung fu instructor. SEC passed on the hedge fund case where the trading indicated millions in profit and SEC focused on the GE employee and the kung fu instructor. The SEC and the US attorney rigorously prosecuted the low-level GE employee, but both passed on any investigation of the major hedge fund.

    This is not a rarity; it is more the practice. The exception is when they look at an elite player on Wall Street. Not only is it an exception, if you try to pursue a big player as I did; it can be career-shortening experience. At the SEC, it is a culture of deference. That culture is intolerant of investigations into the Wall Street elite. Keep in mind that the SEC was created to keep an eye on Wall Street, so it has completely lost sight of its mission and that is why we have a situation like the one with Madoff.

    MR: What is it about the culture at SEC that steers them away from looking at the big Wall Street players?

    AG: All the agencies have to some extent or another a revolving door [where government employees rotate out to the private sector and earn more money]. But at the SEC, what you rotate into is an enormous salary leap. SEC managers may make $200,000. That same person may make $2 million as a starting salary on the outside and can move up from there. Now, when he leaves, I'm not sure he's worth $2 million as a lawyer, but he takes his Rolodex with him and that Rolodex is gold. The system maintains itself, because those that stay know their turn will come if they play the game. They see a director or associate director move onto a $2 million job with a Wall Street law firm. Then, the departed employee calls back to his former colleagues and says, "you know I really don't think there is much of a case against so-and-so, I'd like for you to take a look at it." And the case goes away; the system goes on in perpetuity.

    MR: Did you see the revolving door in action in your case?

    (On January 31, 2005, prior to the phone call mentioned below, an email beginning with the word "Yowza!" was sent from Jan Lower, an attorney at the Debevoise and Plimpton law firm, to Aguirre's supervisor Paul Burger. The email described in detail the potential earnings that a former SEC official could receive at the Debevoise and Plimpton law firm - $2 million a year.)

    AG:Senior officials at the SEC got a call from Debevoise lawyer asking about a case I was handling. It was clear she wanted the investigation of John Mack to go away so he could become Morgan Stanley's new CEO. And it did go away. SEC associate director Paul Berger derailed the investigation and when I questioned that decision, fired me. Within a few days of firing me, he made an inquiry through one of his colleagues to the Debevoise law firm to see if they were interested in hiring him. After the case against Mack was dead, Berger took a job with Debevoise and that is where he's working now. I'll let you draw your own inferences.

    What you have when you leave the SEC is contacts with the SEC, you have the Rolodex and the ability to call back to people you used to work with. I don't want to single out Burger, I think that is really the culture there. A culture of 'don't rock the boat,' the industry does not want 'boy scouts,' and if you can be effective with the SEC through your contacts, that is a very valuable asset you can bring to the table.

    (An August 2007 report, page 83, by the Senate Finance and Judiciary committees backs up Aguirre's charges against Burger. The report also found that Berger failed to disclose the date of his initial contact with the Debevoise firm to Senate investigators.)

    MR: Do you have faith that SEC chairman Christopher Cox will listen to the SEC inspector general?

    AG: Cox will be leaving in a couple of weeks. Mary Shapiro will likely be coming in. It may be easier for IG to do a no-holds-barred report on what has happened in the Madoff case. There is an expectation that the SEC will face rigorous scrutiny by the new administration because the SEC's failures were a primary cause of the deepening financial crisis. Many expect the new chairman will focus on what can be done to clean up the SEC. As part of that, Kotz's investigation of the Madoff affair would be helpful.

    Counter to that, is the fact that Kotz issued two reports in September. They called for discipline for all the SEC supervisors involved in my discharge, and similar discipline for the head of the Miami office on the Bear Stearns investigation. In those cases, nothing happened. Worse yet, Cox appointed someone to trash the Kotz reports and indirectly Kotz himself. So, Kotz may be a little gun-shy at this point.

    MR: Experts have said that it is impossible to get away with this level of fraud for such a long time. Madoff himself said this in 2007. Do you have faith in the current securities law enforcement agencies?

    AG: I think we've had a collapse of the markets caused by three different factors. The three factors all point to the failure of regulatory entities to carry out their missions. One area is the liquidity and capitalization of the major banks, which SEC was supposed to keep an eye on. We've had one bank fail after another. When you look at the scope of those failures, and the magnitude of those failures, you have to ask yourself, how could anybody miss the red flags that these banks were in deep trouble.

    The second factor is market manipulation and insider trading. It has been a colossal failure by the SEC. Its failure to investigate the big players gave them a sense they were invulnerable. So, the just got bolder.

    The SEC seemed to be doing its best job on investment fraud, but some of the fraud that has surfaced before Madoff raised some questions about the SEC. Madoff is on a new scale. It is a ten on the Richter scale. There were some preshocks that should have been picked up. It was the SEC's strong suit and they missed it. There has been a regulatory failure in this area; by the SEC, FBI, Department of Justice and local US attorneys' offices.

    The SEC has a budget of around $1 billion. It's not enough to police the financial industry, but it is enough to show that you can do things efficiently and competently. Occasionally, you can bring a case against somebody who has a significant effect on the markets and detect the fraud, conduct the surgery rather than the autopsy.

    MR: Do you think there are other Madoffs out there?

    AG: We have to look back in history. Yes, I do. I believe there are other Madoffs out there. I don't think that the banks are finished collapsing and imploding, and I think we will also see more evidence of market abuse and insider trading. The way it works is when markets are going up, none of this comes to light. But when you have the markets begin to go into free fall and people begin losing money, it becomes hard to conceal the fraud. That's what happened in Madoff's case. In 1929, when the market crashed and the Senate Banking Committee surveyed the rubble, they discovered all kinds of fraud by Wall Street elite.

    I'm not sure that all of the dirt has come to light at this point. I think one reason for that is because [Treasury Secretary Henry] Paulson, a representative of Wall Street, has been pumping money into the system. We're transferring trillions of dollars from taxpayer's pockets to Wall Street to try to stem the downward cycle that we are in and perhaps to some extent we have. But that may help conceal the extent of the fraud. It is when the veneer is completely stripped away; that's when you discover the fraud. To the extent that we are pouring trillions into the capital markets, we may delay, postpone or even prevent the full extent of the fraud from surfacing. But I think it is out there and I don't think the downward cycle has ended yet. As long as it continues, we'll discover more.