Psychopaths thrive amid confusion, inexperience and denial

Bernie Madoff swindled an estimated $50 billion from investors in his hedge fund, and in March 2009, pleaded guilty to securities fraud. He was sentenced to 150 years in jail. But if the Securities and Exchange Commission (SEC), which is charged with regulating the securities business, had been doing its job, Madoff could have been stopped years earlier.

In a scathing report issued last week, the SEC’s inspector general, H. David Kotz, summarized six substantial complaints that the agency received about Madoff dating back as far as 1992. The SEC conducted two investigations and three examinations into the complaints, and never identified Madoff’s Ponzi scheme.

The good news is that Kotz found no evidence of blatant wrongdoing in the SEC—no one was paid off to whitewash the investigations. The bad news is that the inspector general found plenty of evidence of screw-ups.

Several different teams of examiners looked into the complaints, yet Madoff was able to dazzle, confuse and intimidate them so that they never found out what he was really doing. Then, after the examinations were closed, Madoff gave himself the SEC seal of approval. In his report, Kotz wrote:

Madoff proactively informed potential investors that the SEC had examined his operations. When potential investors expressed hesitation about investing with Madoff, he cited the prior SEC examinations to establish credibility and allay suspicions or investor doubts that may have arisen while due diligence was being conducted. Thus, the fact the SEC had conducted examinations and investigations and did not detect the fraud, lent credibility to Madoff’s operations and had the effect of encouraging additional individuals and entities to invest with him.

Bureaucratic ineptitude

So how did this happen? Essentially, Madoff used the inherent nature of governmental agencies to his advantage.

We probably all have stories of bureaucratic ineptitude. All organizations have issues with politics, turf wars, not-my-job, lack of direction, miscommunication, falling-through-the-cracks, brown nosing, not-pulling-your-weight, etc., etc. In my opinion and experience, these issues are worse in governmental organizations, where connections outrank skill and it’s impossible to get rid of underperformers.

Psychopaths exploit these conditions to the max. They are experts at using upheaval and confusion to their advantage. But in Bernie Madoff’s case, it seems that what he used the most was ignorance.

In his report, Kotz repeatedly says that the people assigned to investigate Madoff were “inexperienced.” How inexperienced were they?

2004 investigation

In an investigation initiated in 2004, touched off by the discovery of an e-mail that provided a step-by-step analysis of why Madoff must have been engaging in fraud, one of the junior examiners was five years out of college, and the SEC was his first job. Another examiner had worked on only four cases before being assigned to the Madoff case.

So it looks like the SEC sent a few 20-somethings to deal with Bernie Madoff. The psychopath distracted them with his stories of the securities business and intimidated them by dropping names of his high-up connections. When they actually persisted in asking for documents, Madoff became angry. “His veins were popping out of his neck,” one of the investigators said.

When the young examiners reported their difficulties to superiors, they got no support. In fact, the “were actively discouraged from forcing the issue,” Kotz wrote.

Why did they receive no backup? My guess is that higher-ranking bureaucrats at the SEC knew Bernie Madoff, either personally or by reputation, and did not want to go up against a man who was former chairman of the NASDAQ stock exchange and a legend in the securities business.

The investigators repeatedly caught Madoff in lies and inconsistencies. But instead of seeking independent verification, they accepted Madoff’s explanations as plausible.

2005 investigation

In 2005, a former investment manager turned whistleblower, Harry Markopolos, submitted his third complaint about Madoff to the SEC. The title: The world’s largest hedge fund is a fraud.

An SEC regional Enforcement department took the case. Here’s how the complaint was handled, according to Kotz:

It was assigned to a team with little to no experience conducting Ponzi scheme investigations. The majority of the investigatory work was conducted by a staff attorney who recently graduated from law school and only joined the SEC 19 months before she was given the Madoff investigation. She had never previously been the lead staff attorney on any investigation, and had been involved in very few investigations overall. The Madoff assignment was also her first real exposure to broker-dealer issues.

The Enforcement staff, which I assume means our young attorney, discounted the Markopolos report and questioned his motives. Furthermore, they (she) believed Madoff did not fit the “profile” of a Ponzi scheme operator because he was a reputable member of society.

The Enforcement staff did not understand options trading. They did not understand Madoff’s purported trading strategy. They were told that they were not sufficiently prepared to take Madoff’s testimony. They went forward with the scheduled testimony anyway.

Here’s a final note about the Enforcement staff investigation that Katz included in his report:

Shortly after the Madoff Enforcement investigation was effectively concluded, the staff attorney on the investigation received the highest performance rating available at the SEC, in part, for her “ability to understand and analyze the complex issues of the Madoff investigation.”

Systemic failures

The report of H. David Kotz, Investigation of failure of the SEC to uncover Bernard Madoff’s Ponzi scheme, is fairly readable, even for those of us who don’t understand the securities business. What was released last week was the 22-page executive summary. The full report, which will apparently come out soon, is over 400 pages.

The summary is an eye-opening look at the systemic failures of an important agency that was supposed protect the interests of American investors. It shows, in brutal detail, how many opportunities to bust Madoff were missed, and why. If you don’t want to read the 22 pages, an article in the New York Times, Report details how Madoff’s web ensnared SEC, provides a good summary.

Misconceptions

The issue of Madoff not fitting the profile goes, I believe, to the heart of the problem: People cannot conceive of the fact that evil can masquerade as reputable.

Of course, there was a time when many of us lived under the same misconceptions: The trappings of respectability reflect actual respectability. People in positions of responsibility play by the rules. There’s good inside everyone.

It’s only after our own run-ins with psychopaths that we’ve learned differently.

The bottom line is this: Society doesn’t understand that some people are evil, no matter how good they look. Many government agencies, along with other organizations, are structurally incapable of coping with covert evil. This creates an environment of confusion, inexperience and denial that enables psychopaths to flourish.