Bernie Madoff’s name was back in the news recently with the announcement that a settlement was reached between the New York Mets owner Fred Wilpon and the Trustee of Madoff’s victims for $162 Million. The one question that has still not been answered to people’s satisfaction is how did the SEC probe miss the fraud that Madoff was perpetrating for so long?
We may never know what really went on at SEC in how they viewed Madoff, but one can better understand the dynamics that probably played out between Madoff and the SEC investigators from reading Scott Snook’s book titled “Friendly Fire.” This book is about an incident in Iraq that took place in the 90s when NATO was enforcing UN's no-fly zone in Norther Iraq to protect the Kurds. In the incident two F-15 pilots shoot down two American helicopters, killing 16 soldiers.
The book offers explanation of this tragic incident from multiple lenses, including, individual, group dynamics and organizational, but the group dynamics is quite relevant to Madoff and SEC since it sheds light on how decision-making can get impaired when there is an informal power structure that develops.
The picture we get about the probe that SEC conducted about Madoff's hedge fund is that it was not that thorough or aggressive. The part in Snook’s book where he looks at the group dynamics among the AWACS crew in the friendly fire incident offers explanation on how the SEC investigators might have viewed Madoff and the whole investigation.
This group dynamics is so common that we see it every where, but very common in sales, on Wall Street and in athletics (most recently, with Penn State Football), where the imbalance of power results in catastrophic decision-making failures.
According to Snook’s book, the AWACS crew officially outrank the F-15 Pilots; however, there is an informal ranking system that has developed in the Air Force over the years where the F-15 Pilots outrank the AWACS crew. This becomes apparent when the AWACS crew do not challenge the F-15 pilot's visual sighting of two Iraqi helicopters and show deference to them since the F-15 Pilots are considered the "Top Guns."
During the patrol, the AWACS crew, instead of challenging the F-15 lead pilot when he misidentified the Iraqi helicopters, the AWACS crew were blown away with the pilot's knowledge of the Iraqi helicopters when he corrected himself from spotting two "Hip" helicopters to two "Hind" helicopters. Obviously, the F-15 pilot was confused, but the AWACS crew did not pick it up or ask for further confirmation from the pilot and/or the wingman.
To bring this back to Madoff, someone in the SEC probably told, most likely, low level SEC investigators to snoop around Madoff's hedge fund to see if there was any wrongdoings going on. We will never really know what level of importance was given to this investigation at the highest level, or was it assigned as just another routine “sniff” test. If the SEC was just going through the motion, then the investigators probably were not focused on looking for any irregularities.
Though SEC had more power, there was an informal power structure that had developed where Madoff was the "King" of Wall Street. The SEC investigators were probably in awe of Madoff based on the reputation he had built over the years on Wall Street.
The investigators probably saw what they wanted to see, which was nothing. Even if they had any suspicion, they were not going to go deep looking for anything irregular, in case nothing turned up and risk getting good jobs on Wall Street after leaving SEC. This is often a big motivating factor when there is an imbalance in power. Madoff could hurt them where it really hurts.
It is too easy to say that SEC didn't find anything. I don't think they ever wanted to find anything. They just went through the motion of meeting ("I mean investigating") Madoff.
The main point of this is that these types of decision-making failures are common because of the culture and the informal hierarchical structure that gets developed over the years. You probably see it around you at home, work, and organization. We don't get to the bottom of why no one saw it unless it results in deaths, scandal or a major fraud.