How a pyramid scheme takes shape
Regulators' response to warnings questioned
About nine years ago, Frank Casey went to New York to check out the competition and came away unimpressed with Bernard Madoff.
Casey was vice president of marketing for Rampart Investment Management in Boston, one of the country's top firms specializing in investing in options. Madoff, at the time, was earning a reputation on Wall Street as a can't-miss money manager who used options strategies to produce double-digit returns without blemish.
But from what Casey saw in 1999, Madoff's system did not make sense.
"Either he wasn't doing what he said he was doing, or maybe he was using the clients' money to help his own positions," Casey recalled in an interview yesterday.
When he reported back to colleagues at Rampart, one in particular grew determined to unravel Madoff's mysterious investment strategy - portfolio manager Harry Markopolos. And when he couldn't, Markopolos undertook a crusade against Madoff that started with asking officials at the Boston office of the Securities and Exchange Commission to investigate him.
Now an executive recruiter, Markopolos declined to be interviewed. But what regulators did - and did not do - in response to Markopolos's entreaties is a now a burning question for the agency, after Madoff's arrest last week on charges of running a Ponzi scheme that lost up to $50 billion, perhaps the largest in history.
The SEC and other authorities say Madoff confessed to running a Ponzi scheme - paying one set of clients with money from another - cheating dozens of investors, including some of the most prominent families in Massachusetts, out of millions. The charges came after Madoff allegedly confessed to employees of his own firm.
Madoff's attorney didn't return messages yesterday.
The SEC did conduct two inquiries of Madoff, in 2005 and 2007. The agency did not find any major problems at either time. The SEC said it won't discuss whether either review was prompted by Markopolos.
At a conference yesterday, SEC enforcement director Linda Thomsen declined to comment specifically on the Madoff situation but said "we are sort of vigorous in pursuing those who violate the federal securities laws."
The SEC has been criticized repeatedly over the years for missing or being late to investigate potential fraud and other cases that have led to substantial investor losses, and some industry specialists believe the Madoff case will result in a major reexamination of the agency.
"Congress will predictably give them little mercy," said John Coffee, a professor of securities law at Columbia University.
Casey said he first began to hear about Madoff's strategies in the late 1990s and went to visit a New York money manager who invested clients' money with him. He said he was unable to see how Madoff's returns matched broader patterns in stock markets.
For instance, Madoff seemed to make money even when the markets fell, a fact that didn't square with the way he was using put and call options to hedge against market moves, Casey said.
"Madoff's return streams didn't correlate," he said.
Markopolos and another colleague, Neil Chelo, a former Rampart portfolio manager, also tried to unravel Madoff's strategy, but they, too, could not figure how it could work, Chelo said.
David Henry, an independent investment adviser and friend of Markopolos, said Markopolos wrote at least one memo outlining why Madoff's strategy seemed amiss, which he shared.
Michael Ocrant, a former financial journalist, said one memo that Markopolos sent the SEC listed more than 28 warning signs the SEC should look in Madoff's business, and he remembers reading the words "Ponzi scheme" in it.
"Pretty much everything that's come to be, he laid out in exact detail," Ocrant said.
At the time Madoff wasn't very forthcoming. "It's a proprietary strategy. I can't go into it in great detail," he told Barron's magazine in 2001.
The same year, he told Ocrant, "I'm not interested in educating the world on our strategy, and I won't get into the nuances of how we manage risk."
Both Henry and Casey recall Markopolos alerting SEC officials of his suspicions and giving them memos, starting with the Boston office around 2000, and later, according to Casey, contacting officials at the SEC's New York offices.
Henry said yesterday that when he first heard of Madoff's arrest, he called Markopolos to compare notes.
Markopolos, Henry said, remarked, "It's about time!"
Ross Kerber can be reached at kerber@globe.com. 