The Madoff scandal, market regulatory failure and the business education of lawyers.

• Author: Rhee, Robert J.

1. INTRODUCTION II. THE REALITY OF COMPLEXITY III. MADOFF'S FRAUD AND THE SEC'S FAILURE IV. BUSINESS LITERACY AS THE OBJECT LESSON V. A PRAGMATIC PROPOSAL (MAYBE) VI. CONCLUSION I. INTRODUCTION

   The financial crisis of 2008 ushered in a "new" new era of financial folly. This historic chapter in American business and economic history has exposed failures of many institutions of society, from Main Street to Wall Street to K Street. For years to come, many commentators, like investigators of a plane crash, will comb through every minute detail of this catastrophe. This Article contributes in a small way to that process. It suggests that a deficiency in legal education is a contributing cause of the regulatory failure. The most scandalous malfeasance of this new era, the Madoff Ponzi scheme, provides a well-documented, important case study on how a deficit in competence and training of lawyer regulators contributed to market regulatory failure. This Article answers a question underlying these considerations: What can legal education do to better train business lawyers and regulators for a market that is becoming more complex? The answer, it suggests, is a simple one: teach a little more business and a little less law.

2. THE REALITY OF COMPLEXITY

   It is obvious that our world is becoming more complex. The financial crisis conveys innumerable lessons for lawyers, bankers, regulators, and society at large. Perhaps the biggest lesson is a realization of just how complex our financial system and economic organization are. (1) In the past several decades, the financial markets have seen geometric growth in complexity. The junk bond market matured in the 1980s, the derivatives market saw explosive growth in the 1990s, and the new century witnessed the evolution of ever more exotic derivatives and financial instruments that directly connected Main Street to Wall Street. We no longer live in the simple days of stocks and bonds, nor Graham and Dodd's fundamental analysis of them. (2) Only recently did Alan Greenspan, the former chairman of the Federal Reserve, applaud the complexity injected by derivatives markets and hedge funds as a stabilizing force in the financial system. (3) Since then, his assessment has proven to be quite wrong, but there is no denying that the growth of technology and knowledge increases the level of complexity in an ordered system.

   The intellectual germ of this complexity originated not from the clubrooms of Lower Manhattan, but from the classrooms of university economics departments and business schools and the corridors of government. Intellectual breakthroughs provided the architecture of the modern financial market. (4) Some of the most prominent innovations have been applied on Wall Street. These include portfolio theory, which taught us to distinguish between unique and market risks and the benefits of diversification. (5) Asset pricing theory taught us how to value risky streams of cashflow and to quantify the cost of capital. (6) Option pricing theory taught us how to value legally simple yet financially complex contractual bets on the direction of future price movements. (7) The government facilitated the invention of securitization as a way to expand the credit market in residential mortgages. (8) The connection between Wall Street and academia has always been close. The capital market is supported by an intellectual superstructure. Also, it is obvious that the financial crisis has elevated the connection between Wall Street and government to a level at which the two are joint adventurers in an ongoing financial enterprise, and perhaps will be for years to come. (9)

   If the crisis was a failure of regulation, and if regulators are lawyers, then it follows that lawyers in a complex world must have an awareness and basic knowledge of the nature of this complexity. Explicitly, it is difficult to see how a lawyer regulator, from the most senior to the most junior rank and file, can purport to regulate complex financial instruments and markets without having a detailed understanding of these matters beyond legal definitions, qualitative intuitions, and half-guesses. Much of that understanding can be gained from work experience and natural curiosity, but knowledge acquisition is easier with a foundation based on education and training. The suggestion is not that lawyer regulators should have advanced degrees in the technical fields they regulate, but that they should have a level of knowledge and the capability to analyze the technical details of the transactions in question, or at least be aware enough to know what they do not know and to ask the relevant questions. A basic literacy in essential concepts is required.

3. MADOFF'S FRAUD AND THE SEC'S FAILURE

   Among the many leitmotifs of the financial crisis is the failure of lawyers as regulators and gatekeepers. This is not a new theme, as Enron collapsed only a few years ago. (10) The Madoff Ponzi scheme personifies this "new" new era of economic catastrophe. The scandal is not really connected to the financial crisis of 2008, which was triggered by the domino effect of a collapsing housing market, solvency concerns of large financial institutions, illiquidity and distortions in the credit market, and subsequent severe global recession, except that the scandal and the financial crisis cultivated in a medium of recklessness and malfeasance across the entire financial industry and the inability or unwillingness of government to regulate bad behavior. Given the magnitude of the broader financial market crisis, the scandal is a tempest in a teapot. Madoff's fraud pales in comparison to the misdeeds that took place in Wall Street firms. Yet, the case merits academic commentary because regulatory failure is the commonality. Importantly, the scandal provides the best documented episode and case study of how lawyers and the SEC, a principal financial market regulatory agency operated mostly by lawyers, failed to understand the market they regulate and the nonlegal complexities surrounding their work. (11) The implication of this failure goes beyond a terrible fraud.

   The basic facts are well known to most informed readers. Madoff ran the world's largest Ponzi scheme. The mathematics of a Ponzi scheme ensures that it ultimately collapses on the weight of the fraud. Madoff's scheme collapsed upon the steady flow of redemptions following the financial crisis. But the tragedy is that the SEC, on multiple occasions, involving multiple credible complainants, and spanning sixteen years, had opportunities to investigate and uncover Madoff's fraud. (12) The most publicized and documented opportunity was presented by Harry Markopolos. Markopolos was a financial analyst who, since 2000, had tried to get the SEC to investigate Madoff. (13) In a 19-page memorandum dated November 7, 2005, Markopolos provided the SEC a detailed financial analysis, strong evidence that Madoff was running a Ponzi scheme. (14) On January 24, 2006, the SEC opened an investigation in response to Markopolos's memo, and on November 21, 2007, it closed the investigation on the ground that "[t]he staff found no evidence of fraud." (15) On December 11, 2008, Madoff was arrested, and on March 12, 2009, he pled guilty to various felonies. (16) Although Markopolos submitted his complaint only a few years before Madoff's public fall, Ponzi schemes typically grow in size as more victims are needed to fund the fraud until the fraud collapses on its own weight, and thus we can infer that the scandal embroiled many victims in the past few years. If the SEC had acted then, perhaps billions of dollars of investment by innocent victims could have been saved.

   Subsequently, the inspector general of the SEC published a 477-page report documenting its internal investigation of the agency failure (hereinafter "the SEC Report"). This report discloses that the SEC engaged in at least five major investigations of Madoff dating to 1992, and the agency failed to uncover his fraud though numerous staff members had many substantial opportunities to do So. (17) I focus in this Article on the last major opportunity to catch Madoff-Markopolos's 2005 complaint (18)--because his memo is the best single documented analysis of the fraud, and it provided the SEC a detailed roadmap for proving the fraud.

   I had heard references to Markopolos's memo through various media reports. Curiosity led me to obtain a copy of the memo. Reading it was a surprising revelation: I found it difficult to conceive that the most important market regulatory agency and its highly qualified attorneys could have missed seeing a fraud that was spelled out in painstaking detail. There are two plausible, yet uncomfortable, explanations: either the SEC was influenced by Madoff's social and professional stature, a form of structural corruption in the agency, (19) or its attorneys who read the memo were too ignorant to understand its import. With respect to Markopolos's interactions with the agency, both he and the SEC agree that the most probable answer is a deficit in competency. (20)

   The Markopolos memo raises 29 "red flags." (21) Some of these are based on gossip, hearsay, innuendo and rhetoric--the type of soft information that can easily be dismissed by a lawyer with natural skepticism toward such evidence. (22) Although they should have provided vital information to the SEC staff, we do not address this soft information. (23) We focus instead on some of the harder evidence. The Markopolos memo is chock full of data, numbers, and financial reasoning, and it can seem intimidating. But beneath the apparent complexities are some simple, disturbing facts that anyone with some degree of financial training and knowledge should have appreciated. (24) The lawyer regulators at the SEC failed to understand this information, and their failure was complete and catastrophic. (25)

   By using the hedge funds as an intermediary, Madoff allowed the fund...