Why I’m scratching my head over the JP Morgan settlement for not reporting the Madoff fraud

I’m still trying to sort out the $2.7B settlement.

My initial hesitation when reading several pages of the deferred prosecution agreement and other news yesterday moved to full head scratching last night when I read the Wall Street Journal’s editorial, Another Madoff Swindle – The same government that ignored the fraud gets a cut of the recovery.  I’ve since read most of the DPA.

The editorial takes exception to the feds getting a $350M cut of the settlement, as if a reward is deserved. Put another way, that is a 17% commission { $350M / ( $1,700M + $350M ) } on the recovery.

Why does the editorial board use the words “extract”, “swindle” (twice!), and “money-grab”? Here’s a few reasons:

Starting at least as early as 1992, the Securities and Exchange Commission began ignoring the red flags around Bernie Madoff. That year two accountants were charged with marketing Madoff investments with bogus promises of sky-high returns, but apparently it never occurred to regulators that the problem might lie with Madoff.

Beginning around 2000 and for years afterward, trader Harry Markopolos implored the SEC to act. The SEC did look into Madoff’s operations at least four times between 1999 and 2007. But regulators cited only minor violations and allowed him to continue stealing from victims until the fraud collapsed in 2008.

Consider also this comment from another WSJ article – J.P. Morgan’s Splitting Headache, which focused on the issue of splitting the chairman and CEO roles at Morgan:

Many supporters argue J.P. Morgan has been scapegoated by the government and that, as a regulated entity, it can’t fight back. The Securities and Exchange Commission, for example, hasn’t been penalized for failing to sniff out Mr. Madoff’s fraud.

Another article at the WSJ, J.P. Morgan’s Madoff Settlement Leaves Many Mysteries, explains that the deferred prosecution agreement outlines a multi-billion dollar volume of ‘round trip’ checks which appear to have been an effort to earn interest on the float.  The bank holding the accounts at the other end of the round trips did file a suspicious activity report for those transactions. Failing to also report those transactions is one of the key things that got JPM in trouble. Although JPM didn’t report them, the feds actually did knew about those suspicious transactions from the other bank. The article says the SEC had multiple reports of oddities in the Madoff enterprise but apparently did not pursue those red flags.

Several specific comments from the article:

The bank eventually ordered that the client repay the money it had lost from the “float” on the rapid-fire movement of checks, but didn’t close either his account or Mr. Madoff’s, and it never alerted the government to the questionable transactions, the documents said.

The other mystery hinted at in the government’s charges on Tuesday is why the extraordinary volume of check transactions didn’t produce any government investigation or actions.

According to the filings, while J.P. Morgan failed to report the suspicious activity to authorities in 1994, the second bank did so, according to the filing. The bank investigated in 1996, decided to terminate its relationship with Mr. Madoff and reported this to J.P. Morgan. The second bank also filed a suspicious activity report with the government, saying Mr. Madoff and the client were engaging in transactions “for which there was no apparent business purpose.”

The government charges also don’t answer the question of whether the government ever did an investigation of Mr. Madoff’s firm as a result of the bank’s suspicious activity report or what it might have found. Previously, a report by the Securities and Exchange Commission’s inspector general identified numerous instances when officials there were alerted to suspicions about Mr. Madoff’s firm and failed to uncover the fraud. The bank’s alert may have been another instance where investigators failed to pursue a red flag and stop what became the largest ever Ponzi scheme.

Exhibit C of the DPA is the Statement of Facts. Multiple instances are described of various JPM staff having reservations about the Madoff investment strategy, but none of those comments made it to the anti-money laundering department.  The implication is several (many?) of those suspicions should have generated a SAR. 

The JPM staff in England filed a report with their regulators at one point, but that info did not get property routed through the US side to the appropriate staff to generate an SAR. 

A number of those unfiled SARs would have had a comment on the order of “gee, they are making tons of money and I don’t understand how.” That woulda’ set off major alarms with regulators – bankers not having a complete understanding of investment trading. Wow.

To put one SAR in perspective, this WSJ report says:

There were roughly 1.6 million … [suspicious activity reports] filed in 2012, the most recent year for which federal data are available. J.P. Morgan alone typically files 150,000 to 200,000 such reports each year.

Another WSJ report says the total number of SARs files increased from 280,000 in 2002 to about 1,500,000 in 2011.

The conclusion of the WSJ’s editorial:

Rather than using the Madoff crimes as an excuse for another federal money-grab, prosecuting U.S. Attorney Preet Bharara should be suing SEC officials for dereliction of duty, if not accessory to fraud.

So here’s why I’m scratching my head – JPM is in trouble for not reporting transactions that were already reported by another bank, whose SAR did not generate any followup by the regulators while the SEC knew of multiple red flags from other sources. They didn’t file other SARs which would have had the incredibly earth-shattering comment that the bankers didn’t understand in detail how Madoff was making so much money.  I can’t quite make the connection to why JPM should hand over a couple billion dollars for not doing their part to report transactions which had already been reported or generating an SAR declaring they don’t quite comprehend a customer’s investment strategy.

Here is my description of the apparent theory why JPM has liability:  If they had added just one more red flag to the already large collection of red flags held by the feds, that one report (out of hundreds of thousands of SARs filed annually) would have made the volume of warning signs large enough to finally prompt an investigation which would have obviously detected the fraud and obviously ended it much earlier. Therefore, those one or three or five missing SARs are the proximate cause for the fraud to continue. Thus the duration of the fraud is obviously JPM’s fault.

What say you? Is my perspective or reasoning off track?

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