Madoff warnings fell on deaf ears

There’s a scene in Woody Allen’s “Hannah and Her Sisters” in which Max von Sydow grumbles about a Holocaust documentary he’s just watched.

“More gruesome film clips and more puzzled intellectuals declaring their mystification over the systematic murder of millions,” he says. “The reason they can never answer the question ‘How could it possibly happen?’ is that it’s the wrong question. Given what people are, the question is, ‘Why doesn’t it happen more often?’ ”

The same thought occurred to me as moral outrage built last week over Bernard L. Madoff and his alleged Ponzi scheme that bilked clients out of as much as $50 billion -- possibly the biggest financial fraud in U.S. history.

What’s shocking isn’t the epic scope of the alleged swindle, although Madoff does get bonus points for chutzpah. What’s most striking is that for years federal regulators ignored repeated warnings that Madoff may have been hoodwinking his clients.

“We have been asleep at the switch,” President-elect Barack Obama told reporters Thursday. “I think the American people right now are feeling frustrated that there is not a lot of adult supervision out there.”

Another frustration: In light of Madoff’s alleged shenanigans, how can anyone know if their own money’s safe?

“There are probably a lot of scammers out there,” acknowledged Arthur Levitt, who chaired the Securities and Exchange Commission from 1993 to 2001. “The nature of this fraud was so far-reaching, and so outrageous, that obviously there are flaws in the system that must be corrected.”

That’s putting it mildly. I’ll get to some of my proposals in a moment. First, a little recap:

Madoff, 70, a former chairman of the Nasdaq Stock Market and a senior advisor to the SEC, established a name for himself as a savvy money manager capable of delivering double-digit returns for clients, even when the stock market was taking a nose dive.

By January 2008, he had $17 billion in assets under management, according to a regulatory filing. All he required of clients was that they not ask too many questions about how he worked his financial alchemy.

And in the best tradition of greed getting the better of people’s judgment, most clients were more than happy to acquiesce.

Some observers, however, saw in Madoff’s consistently stellar returns a sign that something had to be hinky. The SEC admits it received warnings about Madoff for years -- and for years the agency did little more than tell whistle-blowers not to worry their pretty heads.

In an extraordinary statement, SEC Chairman Christopher Cox admitted last week that regulators had received “credible and specific allegations” about Madoff as early as 1999, but these allegations “were never recommended to the commission for action.”

“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,” he said.

I shared Cox’s concern with Lynn Turner, who worked as chief accountant for the SEC from 1998 to 2001. He pointed out that the agency has only about 430 inspectors to keep tabs on roughly 16,000 mutual funds and more than 11,000 investment advisors.

“It’s just impossible that those inspectors can get the job done,” he said.

Turner also noted that limited resources prevent the SEC from hiring top-flight financial investigators. “They basically have to hire new kids out of college,” he said.

“This set of circumstances makes you wonder what kind of regulator we really have and whether we really have cops on the beat,” Turner said.

One reason Madoff got away with what he’s alleged to have done is that he knew the system so well. He knew where all the blind spots are in regulators’ field of vision.

He also served as both investment advisor and broker-dealer for his clients -- an especially troublesome setup. Typically, an investor will get advice from one guy but have his or her securities traded by someone else.

By wearing both hats, Madoff was able to have clients send checks directly to him and was able to use the money however he wanted. This allowed him to allegedly shuffle cash among clients rather than make genuine investments.

So is it time to junk the SEC? Levitt said no.

“The agency has got to be salvaged,” he said. “We have to look at systemic problems at the SEC and examine ways that we can make it better.”

Down the road, we may also want to consider merging the SEC with some of its regulatory kin. Considering the complexity of many transactions, it no longer makes sense to have the SEC overseeing one corner of the playground and the Commodity Futures Trading Commission another.

It’s also time to stop thinking that white-collar crime is somehow “nicer” than more run-of-the-mill felonies.

“Why do we treat white-collar crime different from murder?” asked Ken Winans, president of Winans International, a Bay Area money management firm. “What Madoff did is financial murder. How many people has he destroyed? How many pensions has he destroyed? He’s ruined people’s lives.”

I’m thinking that if a few Wall Street types ended up doing hard time at some of the rougher federal penitentiaries, rather than penal country clubs where most of them seem to go, this would send a pretty clear message to other white-collar scofflaws.

Somehow, I imagine this would be a whole lot more effective than hiring an army of new financial inspectors, and probably cheaper too.

In Madoff’s case, he’s been charged with a single count of securities fraud and faces up to 20 years in prison and a fine of $5 million if convicted. That’s fine as far as it goes.

But a night or two in the box would be better.

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David Lazarus’ column runs Wednesdays and Sundays. Send your tips or feedback to david.lazarus@latimes.com.