Review of the Commission’s 

Processes for Selecting 

Investment Advisers and 

Investment Companies for 

Examination

PUBLIC REDACTED VERSION November 19, 2009 

Report No. 470 

Review of the Commission’s Process for 

Selecting Investment Advisers and 

Investment Companies for Examinations 

Executive Summary 

Background. On August 31, 2009, the OIG issued a comprehensive, 450-plus 

page investigative report entitled, Investigation of Failure of the SEC to Uncover 

Bernard Madoff’s Ponzi Scheme, Report No. 509. The investigation found that 

the SEC received more than ample information in the form of detailed and 

substantive complaints over a period of many years to warrant a thorough and 

comprehensive examination and/or investigation of Bernard Madoff (Madoff) and 

Bernard Madoff Investment Securities, LLC (BMIS) for operating a Ponzi 

scheme. However, despite three examinations and two investigations of Madoff 

and BMIS, a thorough and competent investigation or examination was never 

performed, and the SEC never identified the Ponzi scheme that Madoff operated. 

The first Enforcement investigation and first examination were conducted in 1992 

after the SEC received information that led it to suspect that Avellino & Bienes, a 

firm for which Madoff was managing money, was selling unregistered securities 

and conducting a Ponzi scheme. The SEC’s investigation focused on Avellino & 

Bienes and did not investigate the possibility that Madoff was the one who was in 

fact operating the Ponzi scheme. 

In 2004 and 2005, the SEC’s examination unit, Office of Compliance Inspections 

and Examinations (OCIE), conducted two parallel cause examinations of BMIS. 

These examinations were conducted by OCIE’s broker-dealer examination unit, 

rather than its investment adviser unit, notwithstanding that many of the issues in 

the complaints that precipitated the examinations related to BMIS’s investment 

adviser operations. During the 2004 examination, the examiners raised the issue 

of whether BMIS was acting as an unregistered investment adviser. A member 

of the examination team drafted a memorandum about whether BMIS met the 

definition of investment adviser, but the memorandum was never finalized, and 

the team did not pursue or resolve the issue of BMIS’s investment adviser status. 

Similarly, in the 2005 examination, examiners began researching the issue of 

whether Madoff should be registered as an investment adviser due to his 

investment discretion over certain hedge fund accounts, but the investment 

adviser registration issue was not pursued or resolved. 

Enforcement formally opened an investigation of BMIS in January 2006, based 

upon a detailed complaint that Harry Markopolos (Markopolos), an independent 

fraud investigator, provided to Enforcement in 2005. Although Markopolos’ 

complaint focused on why Madoff’s returns could not be legitimate, the 

ii 
Enforcement team investigating Markopolos’ complaint decided to open the 

matter to investigate (1) whether BMIS, a registered broker-dealer, provided 

investment advisory services to large hedge funds in violation of the registration 

requirements of the Investment Advisers Act of 1940, and (2) whether BMIS 

engaged in any fraudulent activities in connection with these services. 

During its investigation, the staff learned from an OCIE examiner that in the 2005 

examination of BMIS by OCIE’s broker-dealer examination staff, Madoff failed to 

disclose to the staff both the nature of the trading conducted in the hedge fund 

accounts and also the number of such accounts at BMIS. 

When closing its investigation in 2007, the Enforcement staff stated that they 

found “that BMIS acted as an [unregistered] investment adviser to certain hedge 

funds, institutions, and high net worth individuals in violation of the registration 

requirements of the Advisers Act.” The Enforcement staff also found that 

Madoff’s largest hedge fund client, Fairfield Greenwich Group (FGG), “did not 

adequately disclose to its investors [BMIS’s] advisory role and merely described 

[BMIS] as an executing broker to FGG’s accounts.” 

As a result of this investigation and discussions with SEC staff, BMIS registered 

with the Commission as an investment adviser. BMIS filed Part 1 of its Form 

ADV with the Commission on August 25, 2006, and its registration as an 

investment adviser became effective on September 12, 2006. Further, FGG 

revised its disclosures to investors to reflect BMIS’s advisory role. The 

Enforcement staff stated that BMIS’s investment adviser registration was a “good 

result” because it would expose Madoff and his firm to “extra regulatory scrutiny.” 

They further noted that BMIS’s agreement to register as an investment adviser 

was “a positive development for law enforcement” because, inter alia, BMIS 

would “be subject to continued on-site inspections.” 

However, we found that until Madoff confessed to operating a Ponzi scheme in 

December 2008, OCIE never initiated an examination of BMIS even after BMIS 

was forced to finally register in August 2006. We conducted this review to 

determine OCIE’s rationale for not performing an examination of BMIS’s 

investment advisory business soon after the firm registered as an investment 

adviser in 2006 and to make recommendations to improve OCIE’s process for 

selecting investment advisers and investment companies for examination. 

Results. We found that OCIE assigns each registered investment adviser a 

“low,” “medium,” or “high” risk rating, which is initially based on each adviser’s 

response to certain questions in Part 1 of the Uniform Application for Investment 

Adviser Registration (Form ADV). When BMIS registered as an investment 

adviser in 2006, BMIS was classified as “medium risk,” based on its answers to 

the questions provided on its Form ADV Part 1. BMIS filed two subsequent Form 

ADVs in 2007 and 2008. Each of the three Form ADVs received by the 

Commission resulted in BMIS being assigned a “medium risk” designation in 

iii 
2006, 2007, and 2008. We found that only firms categorized as “high risk” trigger 

routine OCIE examinations within three years of receiving the “high risk” rating. 

To ascertain the Form ADV rating, OCIE uses an algorithm to calculate a 

numeric score for each firm based on certain affiliations, business activities, 

compensation arrangements, and other disclosure items that could pose conflicts 

of interest. Although the risk algorithm allows OCIE to determine an investment 

adviser’s relative risk profile, in the absence of an examination risk rating, it is 

potentially limited because it does not measure the effectiveness of the 

investment adviser’s compliance controls, which are designed to mitigate 

conflicts of interest or other risks that could harm investors. 

OCIE may also develop a risk rating for an investment adviser based upon 

information obtained through an examination. The examination rating is 

weighted more heavily than the Form ADV rating since it is based upon more 

complete information. However, because OCIE’s investment adviser unit never 

conducted a formal examination of BMIS’s investment advisory business, 

notwithstanding the fact that OCIE’s broker-dealer unit and Enforcement 

analyzed numerous aspects of BMIS’s advisory business during their 

examinations and investigations, OCIE never developed a risk rating of BMIS 

based on an OCIE examination. 

Therefore, OCIE’s rating of BMIS was “medium” – the same as BMIS’s Form 

ADV rating. We found this problematic because BMIS was examined and 

investigated by OCIE and Enforcement repeatedly, found to be operating as an 

(unregistered) investment adviser, and OCIE and Enforcement found that Madoff 

lied about BMIS’s advisory role. We found that BMIS’s registration as an 

investment adviser was prompted by an Enforcement investigation, which should 

have automatically led to BMIS receiving an initially higher risk rating than it 

would have received had its registration not been a condition of Enforcement 

closing its investigation. Moreover, findings from OCIE’s prior cause 

examinations of BMIS and from Enforcement’s investigations involving BMIS 

should have prompted OCIE to question BMIS’s “medium” Form ADV rating. 

Enforcement stated that BMIS’s investment adviser registration was a “good 

result” because it would expose Madoff and his firm to “extra regulatory scrutiny.” 

However, there is no indication that anyone on the Enforcement staff ever 

suggested that OCIE’s investment adviser examination staff conduct a cause 

examination of BMIS. We found this fact to be troubling because the 

Enforcement investigation (which included the assistance of an OCIE brokerdealer examiner) revealed that Madoff did not fully disclose either the nature of 

the trading BMIS conducted in hedge fund accounts or the number of such 

accounts at BMIS, that BMIS commingled billions of dollars of equities among its 

investment advisory accounts and with its broker-dealer proprietary account, and 

that the investor disclosures of BMIS’s largest hedge fund client did not 

adequately describe BMIS’s advisory role. As some of the problems identified in 

iv 
this investigation related to BMIS’s investment advisory operations, we found that 

both Enforcement and OCIE’s broker-dealer examination staff should have 

immediately notified OCIE’s investment adviser examination unit. We further 

concluded that at that point, OCIE should have immediately scheduled a cause 

examination. 

We found that Enforcement’s and OCIE’s broker-dealer examination unit’s 

failures to communicate with OCIE’s investment adviser unit led to OCIE’s failure 

to conduct an examination of BMIS’s advisory business. An OCIE Branch Chief 

testified that BMIS might have been subject to a “cause exam” immediately after 

it registered had the investment adviser examination staff been informed that 

Madoff had made misrepresentations to Enforcement and OCIE broker-dealer 

examination staff. 

We also found that OCIE’s risk rating process did not adequately weigh an 

investment adviser’s level of assets under management and the number of 

clients that receive investment advisory services. We believe that advisers with 

more assets under management and more clients who receive advisory services 

should receive progressively higher risk scores. 

As part of our review, we conducted an analysis of BMIS’s 2006, 2007, and 2008 

filings and found that had BMIS provided accurate information on its Form ADVs, 

it may have been classified as a “high risk” adviser and therefore subject to a 

routine OCIE examination within three years of receiving a “high risk” rating. 

We found numerous lies and misrepresentations in Part 1 of BMIS’s Form ADV 

that OCIE should have been aware of because of the examinations it conducted 

of BMIS. We found that Madoff, on behalf of BMIS, lied about the number of 

firms he solicited, the number of clients to whom he provided services, the types 

of clients he had, the amount of BMIS’s assets, whether he had discretionary 

authority to determine the broker or dealer to be used for a purchase or sale of 

securities for a client’s account, whether had compensation any firms for client 

referrals and whether any firms had custody of his advisory clients’ securities. In 

fact, nearly every substantive answer he gave on Part 1 of his Form ADV was a 

lie, and in nearly every case, OCIE’s previous examinations of Madoff had 

revealed that Madoff’s answers were false. Moreover, had OCIE utilized the 

information the SEC gathered from the examinations and investigations of BMIS 

in assigning risk weighting to BMIS’s answers and thus, graded it on accurate 

information, BMIS’s score would have been significantly higher. In that scenario, 

BMIS should have been subject to the three-year cycle for a firm rated as “high” 

risk. 

Our review also found that Form ADV has not been substantively updated since 

2000, when it was first required to be filed electronically with the Commission. 

We believe that OCIE could identify additional risk factors if registrants were 

required to include in Form ADV detailed information about the hedge funds they 

v 
advise, including the hedge funds’ performance and auditor. Further, Form ADV 

should require a hedge fund’s auditor to file its opinion with the Commission. 

Further, we found that until 2000, investment advisers were required to file Parts 

1 and II of Form ADV with the Commission in hard copy. Part II of ADV was 

required to be filed with the SEC until 2000 when the Commission adopted new 

rules under the Advisers Act requiring that registered advisers make filings with 

the Commission electronically through an electronic filing system known as the 

Investment Adviser Registration Depository (IARD) system. At that time, the 

Commission exempted advisers from submitting Part II to the Commission 

because the IARD was not ready to accept those filings. The exemption was 

intended to be temporary, but nine years later, investment advisers are still not 

required to file Part II of their Form ADV electronically or even file a paper copy 

with the Commission, absent a specific request from the Commission. Instead, 

advisers need only retain a copy of Part II of their Form ADV in their files. 

Currently, Part II is deemed to be “filed” with the SEC when advisers update the 

form and place a copy in their files. 

We found that considering Form ADV Part II “filed” with the Commission when an 

adviser places it in his filing cabinet is an inadequate procedure and concluded 

that Part II of Form ADV should be electronically filed with the Commission. This 

document provides pertinent disclosures about an investment adviser’s advisory 

services, fees, types of clients, types of investments on which the adviser offers 

advice, an adviser’s other business activities, affiliates, conditions for managing 

accounts, and compensation information, among other things. 

Finally, our review found that OCIE internal documentation identified a risk that 

hedge fund custodian statements could be fictitious and the assets may not be 

verifiable. Another risk stated that since investment advisers are not required to 

file Part II of Form ADV with the Commission, the SEC does not receive 

important information regarding potential conflicts of interest involving investment 

advisers. While these issues have been identified, we found that they have not 

been resolved. 

Summary of Recommendations. Our report presents 11 specific and concrete 

recommendations designed to improve OCIE’s process for selecting investment 

advisers and investment companies for examination. 

We recommend that OCIE implement a procedure requiring, as part its process 

for creating a risk rating for an investment adviser, that OCIE staff perform a 

search of Commission databases containing information about past 

examinations, investigations, and filings related to the investment adviser. 

We recommend that OCIE change the risk rating of an investment adviser based 

on pertinent information garnered from all Divisions and Offices of the 

Commission, including information from OCIE examinations and Enforcement 

vi 
investigations, regardless of whether the information was learned during an 

examination conducted to look specifically at a firm’s investment advisory 

business. 

Further, Enforcement and OCIE should establish and adhere to a joint protocol 

providing for the sharing of all pertinent information (e.g., securities laws 

violations, disciplinary history, tips, complaints and referrals) identified during the 

course of an investigation or examination or otherwise. 

We recommend that OCIE establish a procedure to thoroughly evaluate negative 

information that it receives about an investment adviser and use this information 

to determine when it is appropriate to conduct a cause examination of an 

investment adviser, and when it becomes aware of negative information 

pertaining to an investment adviser, it examine the investment adviser’s Form 

ADV filings and document and investigate discrepancies existing between the 

adviser’s Form ADV and information that OCIE previously learned about the 

registrant. 

We further recommend that OCIE establish a procedure to thoroughly evaluate 

an investment adviser’s Form ADV when OCIE becomes aware of issues or 

problems with an investment adviser. 

We also recommend that OCIE re-evaluate the point scores that it assigns to 

advisers based on their reported assets under management and their reported 

number of clients to which they provide investment advisory services and assign 

progressively higher risk weightings to firms accordingly. 

Further, we recommend that a Commission rulemaking be instituted that would 

require additional information to be reported as part of Form ADV and that the 

proposed rule providing for Amendments to Form ADV be finalized. We also 

recommend that OCIE develop and adhere to policies and procedures for 

conducting third party verifications, such that OCIE verifies the existence of 

assets, custodian statements, and other relevant criteria. 

We believe that implementation of the recommendations contained in this report 

will significantly improve OCIE’s operations and its process for selecting 

investment advisers and investment companies for examination. 

vii 
TABLE OF CONTENTS 

Executive Summary ................................................................................................ ii 

Table of Contents ..................................................................................................viii 

Background and Objectives ................................................................................10 

Findings and Recommendations........................................................................20 

Finding 1: OCIE’s Risk Rating Process Did Not Provide for a Routine 

Examination of BMIS Because BMIS Was Classified As a Medium Risk 

Firm ...............................................................................................................20 

Recommendation 1.....................................................................25 

Recommendation 2.....................................................................25 

Finding 2: OCIE Should Have Immediately Scheduled a Cause 

Examination of BMIS when BMIS Registered as an Investment Adviser ......25 

Recommendation 3.....................................................................28 

Recommendation 4.....................................................................28 

Recommendation 5.....................................................................29 

Finding 3: BMIS Made Misrepresentations on its Form ADV Filings, and 

OCIE Should Have Been Aware of These Misrepresentations......................29 

Recommendation 6.....................................................................38 

Recommendation 7.....................................................................38 

Recommendation 8.....................................................................38 

Finding 4: Form ADV Should Require Additional Information..........................39 

Recommendation 9.....................................................................40 

Finding 5: Part II of Form ADV Should Be Filed with the Commission ............41 

Recommendation 10...................................................................42 

Finding 6: OCIE Identified Certain Risks But These Risks Have Not Been 

Addressed .....................................................................................................43 

Recommendation 11...................................................................44 

viii 
ix 

Appendices

Appendix I: Acronyms. ....................................................................................45 

Appendix II: Scope and Methodology..............................................................46 

Appendix III: Criteria........................................................................................48 

Appendix IV: List of Recommendations ..........................................................49 

Appendix V: Management Comments.............................................................52 

Appendix VI: OIG Response to Management Comments ...............................56 

Tables

Table 1: Investment Adviser Registrants and SEC Investment Adviser 

and Investment Company Examination Staff..............................................14 

Table 2: Suggested Investment Adviser Risk Ratings According to Form 

ADV and OCIE Examinations .....................................................................23 
Background and Objectives 

Background 

On December 11, 2008, the Securities and Exchange Commission (SEC) 

charged Bernard L. Madoff (Madoff) with securities fraud for a multi-billion dollar 

Ponzi scheme that he perpetrated on thousands of investors, including advisory 

clients of his firm. The complaint charged Madoff with violations of the anti-fraud 

provisions of the Securities Act of 1933, the Securities Exchange Act of 1934 and 

the Investment Advisers Act of 1940. On the same date, the U.S. Attorney’s 

Office in the Southern District of New York indicted Madoff for criminal offenses. 

On March 12, 2009, Madoff pled guilty to all charges, and on June 29, 2009, a 

federal District Judge sentenced Madoff to serve 150 years in prison, which was 

the maximum sentence allowed. 

By mid-December 2008, the SEC learned that credible and specific allegations 

regarding Madoff’s financial wrongdoing were repeatedly brought to the attention 

of SEC staff, but were never recommended to the Commission for action. As a 

result, on the late evening of December 16, 2008, former SEC Chairman 

Christopher Cox contacted the SEC Office of Inspector General (OIG) and asked 

the OIG to undertake an investigation into allegations made to the SEC regarding 

Madoff, going back to at least 1999, and the reasons why these allegations were 

found to be not credible. Former Chairman Cox also asked that the OIG 

investigate the SEC’s internal policies that govern when allegations of fraudulent 

activity should be brought to the Commission’s attention. In addition, Cox 

requested that the OIG investigation include all staff contact and relationships 

with the Madoff family and firm, and any impact such relationships had on staff 

decisions regarding the firm. 

On August 31, 2009, the OIG issued a comprehensive, 450-plus page 

investigative report, Investigation of Failure of the SEC to Uncover Bernard 

Madoff’s Ponzi Scheme, Report No. 509. The investigation found that the SEC 

received more than ample information in the form of detailed and substantive 

complaints over a period of many years to warrant a thorough and 

comprehensive examination and/or investigation of Bernard Madoff and Bernard 

Madoff Investment Securities, LLC (BMIS) for operating a Ponzi scheme. 

However, despite three examinations and two investigations of Madoff and BMIS, 

a thorough and competent investigation or examination was never performed, 

and the SEC never identified the Ponzi scheme that Madoff operated. 

Review of Commission’s Process For Selecting IA & Inv Co. for Exams November 19, 2009

Report No. 470 

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Review of Commission’s Process For Selecting IA & Inv Co. for Exams November 19, 2009

Report No. 470 

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r 

ust 

 

Previously Issued OIG Audit Reports. On September 29, 2009, the OIG issued 

Program Improvements Needed Within the SEC’s Division of Enforcement, 

Report No. 467. The review identified issues that prevented the Division of 

Enforcement (Enforcement) from accomplishing its mission to enforce the 

securities laws and protect investors and identified needed programmatic 

improvements. The report found that Enforcement staff lacked adequate 

guidance on how to appropriately analyze complaints. As a result, Enforcement 

did not conduct a thorough review of complaints brought to its attention prior to 

Madoff’s confession. 

On September 29, 2009, the OIG also issued Review and Analysis of OCIE 

Examinations of Bernard L. Madoff Investment Securities, LLC, Report No. 468. 

The report found that OCIE examiners made critical mistakes in nearly every 

aspect of their examinations of Madoff and BMIS and missed significant 

opportunities to uncover Madoff’s Ponzi scheme. The report concluded that OCIE 

examiners did not properly plan or conduct their examinations of BMISf, and 

because of these failures, were unable to discover Madoff’s fraud. 

SEC’s Oversight of Investment Advisers. The SEC regulates investment 

advisers, primarily under the Investment Advisers Act of 1940 (the Advisers 

Act).1

 One of the central elements of this regulatory program is that a person o

firm meeting the definition of “investment adviser” under the Advisers Act m

register with the Commission, unless exempt or prohibited from registration. 

Generally, advisers that have $25 million or more of assets under management 

or that provide advice to a registered investment company are required to 

register with the Commission. Smaller advisers may register under state law with 

state securities authorities. 

A person or firm is required to register with the Commission if he or it is: 

• An “investment adviser” under Section 202(a)(11) of the Advisers Act; 

• Not excepted from the definition of investment adviser by Section 

202(a)(11)(A) through (E) of the Advisers Act; 

• Not exempt from Commission registration under Section 203(b) of the 

Advisers Act; and 

• Not prohibited from Commission registration by Section 203A of the 

Advisers Act. 

1

 Investment Advisers Act of 1940, 15 U.S.C. 80b-1 et seq. 
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An investment adviser is generally described as any person or firm that (1) for 

compensation; (2) is engaged in the business of; (3) providing advice, making 

recommendations, issuing reports, or furnishing analyses on securities, either 

directly or through publications. A person or firm must satisfy all three elements 

to be regulated under the Advisers Act. 

The Commission’s Division of Investment Management construes these statutory 

elements broadly. For example, “compensation” refers to the receipt of any 

economic benefit. With respect to the “business” element, an investment 

advisory business need not be the person’s or firm’s sole or principal business 

activity. Rather, this element is satisfied under any of the following 

circumstances: the person or firm holds himself or itself out as an investment 

adviser or as providing investment advice; the person or firm receives separate 

or additional compensation for providing advice about securities; or the person or 

firm typically provides advice about specific securities or specific categories of 

securities. 

Moreover, the Division of Investment Management views a person or firm to have 

satisfied the “advice about securities” element if the advice or reports relate to 

securities. The Division has stated that providing one or more of the following 

also could satisfy this advice about securities element: advice about market 

trends; advice in the form of statistical or historical data (unless the data is no 

more than an objective report of facts on a non-selective basis); advice about the 

selection of an investment adviser; advice concerning the advantages of 

investing in securities instead of other types of investments; or a list of securities 

from which a client can choose, even if the adviser does not make specific 

recommendations from the list. 

Form ADV. Investment advisers register with the SEC using the SEC “Form 

ADV,” which is the “Uniform Application for Investment Adviser Registration.” 

Investment advisers use Form ADV to register with the Commission, register with 

one or more state securities authorities, and to amend those registrations as 

required by Instruction No. 4 to Form ADV and Advisers Act rules. 

Form ADV consists of three parts: Part 1A, Part 1B, and Part II. Advisers 

are required to submit Part 1A of this Form to the SEC annually. The SEC 

maintains the information submitted in Part 1A and makes it available to the 

public. Advisers are not required to provide a copy of Part II of Form ADV to the 

SEC, absent a specific request. Instead, advisers must retain a copy of Part II in 

their files. Currently, Part II is deemed to be “filed” with the SEC when advisers 

update the form and place a copy in their files. Advisers are required to retain 

Part II of Form ADV on-site and provide it (or a document containing the 

information therein) to new clients and offer it annually to existing clients. 
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Report No. 470 

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The three parts of Form ADV are as follows: 

 

• Part 1A asks for information about an investment adviser’s business 

practices, the persons who own and control the adviser, and the persons 

who provide investment advice on an adviser’s behalf. Part 1A also 

contains several supplementary schedules, which ask advisers to provide 

information about their direct owners and executive officers, indirect 

owners, and disciplinary events involving themselves and their affiliates. 

All advisers registering with the SEC or any of the state securities 

authorities must complete Part 1A. 

• Part 1B asks for disclosure information that is required by state securities 

authorities. An adviser is required to complete Part 1B only if it is applying 

for registration with, or is registered as, an investment adviser with a state 

securities authority. If an adviser is only registered with the SEC, the 

adviser is not required to complete Part 1B. Part 1B is not utilized by the 

SEC for federally registered investment advisers. 

• Part II of Form ADV requires an adviser to provide information related to 

its services and fees, types of clients, investment advice, methods for 

analysis, sources of information and investment strategies, other business 

activities, other financial industry activities or affiliations, conditions for 

managing accounts and its balance sheet. An adviser is required to keep 

the information in Part II current, deliver it to prospective clients, and 

annually offer it to current clients. 

Filing of the Form ADV. Advisers file Part 1 of Form ADV electronically with the 

Commission through the Investment Adviser Registration Depository (IARD) 

system. The IARD is an electronic filing system that facilitates investment 

adviser registration, regulatory review, and the public disclosure of information 

from investment advisers. The Financial Industry Regulatory Authority (FINRA) 

developed and operates the IARD system. 

Advisers are required to update Form ADV each year by filing an annual 

updating amendment within 90 days after the end of its fiscal year. In addition to 

an adviser’s annual updated filing, an adviser must amend its Form ADV by filing 

additional amendments whenever an adviser’s responses to certain questions on 

Form ADV become inaccurate. Failure to update a Form ADV is a violation of 

SEC Rule 204-12

 and similar state rules and could lead to the revocation of an 

adviser’s registration. 

2

 17 C.F.R. § 275.204-1. 
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If an adviser needs to withdraw its registration status with the SEC, the adviser is 

required to file Form ADV-W. For example, an adviser would file a Form ADV-W 

if its assets under management fell below $25 million. 

Exclusions from the Definition of Investment Adviser. Certain individuals or 

entities are excluded from the definition of an investment adviser, such as 

domestic banks and bank holding companies and lawyers, accountants, 

engineers and teachers, if their performance of advisory services is solely 

incidental to their professions. Brokers and dealers are also excluded from the 

definition of investment adviser if their performance of advisory services is solely 

incidental to the conduct of their business as brokers and dealers and they do not 

receive any special compensation for their advisory services. 

The Advisers Act gives the SEC the authority to exclude, by rules and regulations 

or order, other persons and firms it determines not to be within the intent of the 

Adviser Act definition of investment adviser. 

Number of Investment Advisers vs. SEC Examination Staff. As shown in 

Table 1, in FY 2009 there were 11,292 registered advisers and approximately 

452 OCIE Investment Adviser and Investment Company examination staff.3

 The 

number of registered advisers has steadily grown each year, from 7,686 in FY 

2003. The examination staff of the Office of Compliance Inspections and 

Examinations (OCIE) has also grown since 2003, but the growth in examination 

staff has not kept pace with the growth in the number of registered advisers. 

Table 1: Investment Adviser Registrants and SEC Investment Adviser and 

Investment Company Examination Staff 

Year Total Investment 

Adviser Registrants 

SEC Investment Adviser 

and Investment Company 

Examination Staff 

2003 7,686 399 

2004 7,959 477 

2005 8,535 489 

2006 9,017 475 

2007 10,662 425 

2008 10,817 425 

2009 11,292 452 

Source: SEC’s Office of Compliance Inspections and Examinations

Types of OCIE Examinations. OCIE examines investment advisers, investment 

companies, broker-dealers, transfer agents, clearing agencies, self-regulatory 

agencies, and nationally recognized statistical rating organizations. For 

 

3

 The same OCIE staff examines both investment advisers and investment companies. 
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Report No. 470 

Page 15 

investment advisers and investment companies, OCIE generally conducts three 

types of examinations: cause, routine and sweep. 

Cause Examinations are conducted when staff have reason to believe that there 

have been violations of the federal securities laws. In these examinations, staff 

review irregular activity, determine if violations have occurred, gather supporting 

documentation, perform interviews and prepare analyses as evidence of 

violations. Cause examinations are conducted at both main and branch offices. 

Routine examinations are conducted periodically and test an entity’s compliance 

with applicable laws and regulations. In routine examinations, OCIE looks at 

compliance with the law in a specified number of areas. Because of the size and 

complexity of the investment management industry relative to SEC examination 

resources, OCIE has developed a risk-based methodology that is uses to identify 

“high risk” advisory firms and funds that are selected for routine examinations. 

Using its risk-rating system, OCIE assigns a risk level to each adviser based on: 

(1) information contained in firms’ annual registration filings (Form ADV); (2) 

assessment made during previous examinations of that entity; and/or (3) staff 

evaluations or other risk criteria. OCIE’s Branch of Surveillance and Reporting 

was created to, among other things, help monitor registered entities and develop 

initial risk profiles based on certain quantitative inputs. 

OCIE conducts routine examinations of investment advisers and investment 

companies classified as “high risk” on a cycle. Once an investment adviser or 

investment company is classified as “high risk, the firm is placed on a three-year 

examination cycle. Currently, OCIE is not able to meet its three year goal 

because of the work required during examinations and limited staff resources. 

Sweep examinations scrutinize a specific activity, control, or compliance area at 

a number of firms. The purpose of these examinations is to determine the 

extent, scope, and danger of emerging risks in the regulated community. Sweep 

examinations allow the staff to obtain a more comprehensive view of a particular 

risk, assess the gravity of the risk, evaluate the compliance performance of 

individual firms and compare it with that of their peers, and recommend 

regulatory solutions. 

Bernard Madoff Investment Securities, LLC (BMIS)

In September 2006, the Madoff firm, BMIS, was first dually registered with the 

Commission as a broker-dealer and as an investment adviser. It was registered 

as a broker-dealer on January 19, 1960 and as a registered investment adviser 

on September 12, 2006. BMIS has been a member of the NASD (now FINRA) 

since March 25, 1960. The firm was also a member of other self-regulatory 

organizations and the Securities Investor Protection Corporation (SIPC). The 
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Report No. 470 

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firm was organized as a limited liability company and was almost wholly owned 

by its principal, Bernard L. Madoff, and members of his family. Many of the 

positions at BMIS, including legal and compliance positions, were staffed by 

Madoff’s relatives. BMIS did not have an internal audit department. Any internal 

audits were conducted by the firm’s own back office personnel. The firm’s 

outside auditor was a small and relatively unknown firm. 

Commission Examinations of Madoff. Prior to Madoff’s admission that he was 

running a Ponzi scheme in December 2008, the SEC conducted two 

investigations and three examinations that could have revealed that Madoff was 

operating a Ponzi scheme. These investigations and examinations were based 

on detailed and credible complaints that raised the possibility that Madoff was 

misrepresenting his trading and could have been operating a Ponzi scheme. 

After Madoff admitted to operating a Ponzi scheme, OCIE opened a cause 

examination of BMIS’s investment advisory business. 

First Enforcement Investigation and Examination 

The first Enforcement investigation and first examination were conducted in 1992 

after the SEC received information that led it to suspect that Avellino & Bienes, a 

firm for which Madoff was managing money, was selling unregistered securities 

and conducting a Ponzi scheme. The SEC’s investigation focused on Avellino & 

Bienes and did not investigate the possibility that Madoff was the one who was in 

fact operating the Ponzi scheme. 

During the course of its investigation of Avellino & Bienes, the SEC conducted an 

examination of BMIS. The examination was limited to verifying that BMIS was 

properly segregating Avellino & Bienes’ October 1992 month-end securities 

positions in BMIS’s segregated accounts at the Depository Trust Company 

(DTC). In conducting its examination, the examiners relied exclusively on DTC 

records produced by BMIS. 

Two Parallel OCIE Cause Examinations 

In 2004 and 2005, the SEC’s examination unit, OCIE, conducted two parallel 

cause examinations of BMIS. The 2004 examination was initiated by a complaint 

that OCIE received from a manager of a hedge fund. OCIE focused its 

examination on the possibility that BMIS was front-running.4

 However, the 

examination never determined if BMIS was in fact front-running, the examination 

was never officially closed, and OCIE did not produce an examination report. 

4

 Front-running is the practice whereby one executes a trade with advance knowledge of pending orders 

from other investors. 
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During the 2004 examination, the examiners raised the issue of whether BMIS 

was acting as an unregistered investment adviser. It appeared to the assistant 

director responsible for the examination that Madoff and his firm were attempting 

to evade investment adviser registration, and the examination was expanded to 

examine the investment adviser issue. A member of the examination team 

drafted a memorandum about whether BMIS met the definition of investment 

adviser, but the memorandum was never finalized and the team did not pursue or 

resolve the issue of BMIS’s investment adviser status. 

The 2005 examination was conducted by the SEC’s New York Regional Office 

(NERO) based on the SEC’s review of a series of internal e-mails between 

employees at another SEC registrant. An investment management examiner in 

NERO had been conducting a routine examination of an unrelated registrant 

when he discovered internal e-mails that raised questions about whether Madoff 

was involved in illegal activity involving managed accounts. These internal 

e-mails described the red flags the registrant’s employees identified while 

performing due diligence on their Madoff-related investment, including Madoff’s 

highly incredible fills for equity trades, his misrepresentation of his options 

trading, his secrecy, his auditor, his highly consistent and non-volatile returns 

over several years, and his fee structure. 

Despite the allegations about Madoff’s management of customer accounts, like 

the 2004 examination, the 2005 examination was focused on whether BMIS was 

front-running. Also similar to the conduct of the 2004 examination, NERO 

examiners began researching the issue of whether Madoff should be registered 

as an investment adviser due to his investment discretion over certain hedge 

fund accounts, but the investment adviser registration issue was not pursued or 

resolved. The supervisor of the examination determined that the examiners 

should not pursue the investment adviser issue because the examiners had 

already spent several months on the examination and the supervisor felt that 

Madoff would likely fall into the investment adviser exclusion for broker-dealers 

and not be required to register. Neither the 2004 nor the 2005 examination 

teams consulted with the Division of Investment Management regarding BMIS’s 

investment adviser status. When the Division of Investment Management was 

contacted in 2006 during Enforcement’s investigation of Madoff and his firm, the 

Division of Investment Management opined that BMIS did meet the definition of 

Investment Adviser and was required to register with the Commission.

In addition, there were initial significant delays in the commencement of both the 

2004 and 2005 cause examinations. The scope of both examinations was 

narrowly focused on the possibility of front-running, with no significant attempts 

made to analyze the numerous red flags about Madoff’s trading and returns. 
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Report No. 470 

Page 18 

Both examinations were open at the same time in different offices without either 

office knowing the other one was conducting an identical examination. In fact, 

Madoff himself informed one of the examination teams that the other examination 

team had already received certain requested information. Both examinations 

concluded with numerous unresolved questions and without any significant 

attempt to examine the possibility that Madoff was misrepresenting his trading 

and operating a Ponzi scheme. 

2006 Enforcement Investigation 

Enforcement formally opened an investigation of BMIS in January 2006, based 

upon a detailed complaint that Harry Markopolos, an independent fraud 

investigator, provided to Enforcement in 2005. Since 2000, Markopolos had 

been providing credible complaints to Enforcement analyzing why Madoff must 

be running a Ponzi scheme. Markopolos’ 2005 Complaint was entitled “The 

World’s Largest Hedge Fund is a Fraud” and detailed approximately 30 red flags 

indicating that Madoff was operating a Ponzi scheme, a scenario it described as 

“highly likely.” The red flags included the impossibility of Madoff’s returns, 

particularly the consistency of those returns, and the unrealistic volume of 

options Madoff represented that he had traded. 

Although Markopolos’ complaint focused on why Madoff’s returns could not be 

legitimate, the NERO Enforcement team investigating Markopolos’ complaint 

decided to open the matter to investigate (1) whether BMIS, a registered brokerdealer, provided investment advisory services to large hedge funds in violation of 

the registration requirements of the Investment Advisers Act of 1940, and (2) 

whether BMIS engaged in any fraudulent activities in connection with these 

services. 

During its investigation, the staff learned from a broker-dealer examiner that 

during a recent examination of BMIS by NERO’s broker-dealer examination staff, 

Madoff failed to disclose to the staff both the nature of the trading conducted in 

the hedge fund accounts and also the number of such accounts at BMIS. 

When closing its investigation in 2007, the Enforcement staff stated that they had 

“found no evidence of fraud” but “did find, however, that BMIS acted as an 

[unregistered] investment adviser to certain hedge funds, institutions, and high 

net worth individuals in violation of the registration requirements of the Advisers 

Act.” The Enforcement staff also found that Madoff’s largest hedge fund client, 

Fairfield Greenwich Group (FGG), “did not adequately disclose to its investors 

[BMIS’s] advisory role and merely described [BMIS] as an executing broker to 

FGG’s accounts.” 
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As a result of this investigation and discussions with SEC staff, BMIS filed Part 1 

of its Form ADV with the Commission on August 25, 2006, and its registration as 

an investment adviser became effective on September 12, 2006. In addition, 

FGG revised its disclosures to investors to reflect BMIS’s advisory role. In its 

Closing Recommendation, Enforcement stated that it recommended closing the 

investigation because both BMIS and FGG voluntarily remedied the violations 

that the Enforcement staff had identified, and the staff had determined that the 

violations were not so serious as to warrant an Enforcement action or further 

investigation. 

BMIS’s Form ADV Filings. BMIS filed its first Form ADV with the Commission 

on August 25, 2006, and this filing became effective on September 12, 2006. 

BMIS subsequently made an annual filing on January 24, 2007, an amended 

filing on March 8, 2007, and an annual filing on January 7, 2008.5

 As described 

later in the report, these filings contained false information. 

Objectives 

In light of the findings in the OIG’s August 31, 2009 Report of Investigation 

entitled “Investigation of Failure of the SEC to Uncover Bernard Madoff’s Ponzi 

Scheme,” the OIG conducted a review of the Commission’s process for selecting 

which investment advisers and investment companies to examine. The 

objectives of the review were to: 

• Determine the Commission’s rationale for not performing an examination 

of BMIS’s investment advisory business soon after the firm registered as 

an investment adviser in 2006; and 

• Make recommendations to improve OCIE’s process for selecting 

investment advisers and investment companies for examination. 

5

 An Investment Adviser’s first Form ADV filing is not effective upon filing. All subsequent Form ADV filings 

are effective on the filing date. 
Findings and Recommendations 

Finding 1: OCIE’s Risk Rating Process Did Not 

Provide for a Routine Examination of BMIS 

Because BMIS Was Classified As a Medium Risk 

Firm. 

OCIE never initiated a routine examination of BMIS primarily 

because OCIE rated BMIS as a “medium risk” firm based on 

its answers to certain Form ADV questions. OCIE only 

examines a small portion of randomly selected firms that are 

designated as low and medium risk. BMIS was never 

randomly selected. 

OCIE’s goal is to conduct routine examinations of “high risk” 

firms within three years of a firm’s receipt of such 

designation. 

OCIE’s Risk Rating Classifications. OCIE assigns each registered investment 

adviser a “low,” “medium,” or “high” risk rating. OCIE started this practice in 2003 

and fully implemented it in fiscal year 2004. The risk rating is initially based on 

each adviser’s response to certain questions in Form ADV Part 1 (Form ADV 

rating). Based on these answers, OCIE assigns a score for each answer. The 

answer to only one question on Form ADV has the potential to result in a 

negative point value. The cumulative value of all of the points culminates into an 

overall “low,” “medium,” or “high” risk rating. Ratings are assigned as follows: 

OCIE assigns the risk scores to firms through an automated means, whereby 

each adviser’s Form ADV information is uploaded into a pre-formatted Excel 

spreadsheet. Using pre-calculated fields, once the Form ADV information 

populates the Excel spreadsheet, an adviser’s risk score for each pertinent 

question and an adviser’s overall risk score is calculated. 

When BMIS registered as an investment adviser in 2006, BMIS was classified as 

“medium risk,” based on its answers to the questions provided on its Form ADV 

Part 1.6

 BMIS filed two subsequent Form ADVs in 2007 and 2008. Both of these 

Form ADVs resulted in BMIS being assigned a “medium risk” designation7 in 

2007 and 2008 as well. Only firms categorized as “high risk” trigger routine OCIE 

 

6

 BMIS made misrepresentations on several parts of Form ADV, as discussed in Finding 3 of this report. 

7

 The Commission does not disclose what risk rating a particular investment adviser or investment company 

has received. 

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Report No. 470 

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examinations within three years of receiving the “high risk” rating. As discussed 

later in this report, BMIS made misrepresentations on its Form ADV filings and 

had it answered truthfully, BMIS may have been classified as “high risk.” 

To ascertain the Form ADV rating, OCIE uses an algorithm to calculate a 

numeric score for each firm based on certain affiliations, business activities, 

compensation arrangements, and other disclosure items that could pose conflicts 

of interest.8

 Examples include participation or interest in client transactions, 

managing portfolios for individuals, and receiving performance fees. OCIE 

determines the risk profile of all registered investment advisers every year using 

the risk algorithm. 

Although the risk algorithm allows OCIE to determine an investment adviser’s 

relative risk profile in the absence of an examination risk rating, it is potentially 

limited because it does not measure the effectiveness of the investment adviser’s 

compliance controls, which are designed to mitigate conflicts of interest or other 

risks that could harm investors. Rather, it relies on information that serves 

largely as proxy measures of the firm’s compliance-related controls. OCIE has 

recognized these limitations and taken some steps to evaluate the effectiveness 

of its methodology.9 However, to date, OCIE has only made limited changes to 

its risk rating process to resolve this issue. 

OCIE may also develop a risk rating for an investment adviser based upon 

information obtained through an examination (OCIE examination rating). The 

examination rating is weighted more heavily than the Form ADV rating since it is 

based upon more complete information. The examination rating may differ from 

the Form ADV rating in the following ways: 

• Routine examination. A routine examination may cause an investment 

adviser’s examination rating to be higher or lower than or to stay the same 

as the Form ADV rating. OCIE represented that it is not uncommon for an 

examination rating to be lower than a Form ADV rating, especially if an 

OCIE examination finds that an adviser has good controls in place to 

mitigate risks. 

• A “cause” or “sweep” examination. Because these examinations only 

have a narrow focus, OCIE will rarely lower a risk rating based on these 

examination results. A cause or sweep examination will only result in an 

examination rating being higher or the same as a Form ADV rating. 

8

 The risk algorithm, developed by OCIE and the SEC Office of Economic Analysis (OEA), is a formula 

using values of various factors to derive a relative ranking for the firm’s compliance risk. 9

 General Accountability Office Report No. 07-1053: Securities and Exchange Commission: Steps Being 

Taken to Make Examination Program More Risk-Based and Transparent, August 2007, page 12. 
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Report No. 470 

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Ultimately, staff in the regional office responsible for overseeing the activities of 

an adviser is able to adjust upward or downward the risk profile for an adviser. 

These determinations may be based on the staff’s assessment of the adviser 

derived from various sources, both internal and external sources.10 Regional 

offices develop a final examination plan for each fiscal year. During the year, 

regional offices may interact with additional information that would cause a firm’s 

risk level to be adjusted upward (i.e. a cause examination). 

The largest investment advisers, based upon the dollar amount of assets under 

management, have an OCIE examination rating of “high” by default. The ratings 

of these firms based on Form ADV, however, may be different. According to 

Form ADV filings, the assets under management of some of the largest firms hit 

$1.2 trillion in FY 2008. 

BMIS Was Classified as a Medium Risk Investment Adviser. BMIS reported 

assets under management of $11.7 billion, $13.2 billion, and $17.1 billion on its 

2006, 2007, and 2008 Form ADV filings, respectively. As a result, BMIS was 

never automatically classified as “high risk.” 

Further, because OCIE never conducted a formal examination of BMIS’s 

investment advisory business,11 OCIE never developed a risk rating of BMIS 

based on an OCIE examination. Therefore, given the above, OCIE’s rating of 

BMIS was “medium” – the same as BMIS’s Form ADV rating. We found this 

problematic because BMIS was examined and investigated by OCIE and 

Enforcement repeatedly, BMIS was found to be operating as an (unregistered) 

investment adviser, and OCIE and Enforcement found that Madoff lied about 

BMIS’s advisory role. Our review found that even though OCIE did not 

specifically examine BMIS’s advisory business, OCIE should have assigned a 

higher examination rating to BMIS, based on the results of OCIE’s and 

Enforcement’s prior examinations and findings. 

Risk Ratings of Registered Investment Advisers. Table 2 shows the risk 

ratings of the registered investment advisers as of September 30, 2008, 

according to Form ADV and OCIE examinations. 

10 Sources of information that may be reviewed by the staff include, among others, SEC filings, relevant tips 

and complaints, publicly available news and media reports, as well as internally generated analysis of 

information prepared by OCIE and other SEC Offices and Divisions. 11 OCIE never formally examined BMIS’s investment advisory business prior to Madoff’s confession that he 

was running a Ponzi scheme. However, OCIE and Enforcement did look at several aspects of BMIS’s 

advisory business during their examinations and investigations. After Madoff’s confession in December 

2008, OCIE initiated a formal cause examination of BMIS’s investment advisory business. 
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Report No. 470 

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Table 2: Suggested Investment Adviser Risk Ratings According to Form 

ADV and OCIE Examinations 

Risk Level Per Filings 

(Form ADV) 

Percent 

of Total 

Per ADV and 

Supplemental Data 

(Including Exams) 

Percent 

of Total 

Low 

Medium 

High 9% 11% 

Total 11,292 100% 11,292 100% 

Source: OIG Generated based on OCIE information

OCIE’s Process for Examining Investment Advisers and Investment 

Companies. Between 1998 and 2003, OCIE routine examinations accounted for 

about 90 percent of OCIE examinations. During this period, OCIE generally tried 

to examine each firm at least once every five years. However, the growth in the 

number of investment advisers, from 5,700 to about 7,700, and the breadth of 

their operations, did not allow OCIE to maintain this routine examination cycle. 

Also, OCIE concluded that routine examinations were not the best tool for 

identifying emerging compliance problems because firms were selected for 

examination based predominately on the passage of time and not on their 

particular risk characteristics.12 

Around 2004, OCIE began implementing a risk-based approach to examining 

investment advisers and investment companies. OCIE believes this approach 

better ensures that OCIE concentrates its resources on higher risk advisers and 

investment companies. OCIE shifted its focus from performing routine 

examinations of all registered investment advisers and investment companies, 

regardless of compliance risks, to attempting to examine advisers and 

investment companies that receive a “high risk” rating at least once every three 

years. Advisers rated as “high risk” comprise about ten percent of registered 

investment advisers.13 

For the remaining “lower risk” advisers and investment companies (those 

classified as low and medium risk), each year OCIE coordinates with economists 

at the Commission to generate a random sample of advisers and investment 

companies for OCIE to potentially examine. All of the lower risk advisers that 

were registered as of September 2006, 2007 and 2008 and had not been 

recently examined were placed in separate pools for each year. From these 

pools, either the Commission’s Office of Economic analysis or its Office of Risk 

 

12 General Accountability Office Report No. 07-1053: Securities and Exchange Commission: Steps Being 

Taken to Make Examination Program More Risk-Based and Transparent, August 2007, page 9. 13 Examinations are initiated based on each adviser’s risk profile. Examinations of investment companies 

are conducted concurrently with examinations of their advisers. At a minimum, however, investment 

companies will be deemed “high risk” if the funds have not been examined within last seven years. 
Review of Commission’s Process For Selecting IA & Inv Co. for Exams November 19, 2009

Report No. 470 

Page 24 

cted firms. 

 

Assessment randomly selected 400-500 advisers for potential routine OCIE 

examinations. BMIS was included in the pools for each of the three years, but 

was never randomly selected.14 Even if BMIS had been randomly selected, 

there was no guarantee that Madoff’s advisory business would have been 

examined on a routine basis; being part of the group of randomly selected 

advisers only signifies that these advisers are placed on a list for potential 

examination. According to OCIE, each year the regional offices conduct routine 

examinations of about 200 of the randomly sele

The effectiveness of OCIE’s risk-based approach depends on its ability to 

accurately assess the level of risk at individual firms because inaccurately 

categorizing firms as lower-risk could result in harmful practices persisting 

undetected.15

Conclusion 

BMIS was classified as a medium risk firm on the basis of the answers it 

provided in its Form ADV. In addition, because OCIE had not conducted a 

formal examination of BMIS’s advisory activities, BMIS’s rating was deemed to 

be “medium risk,” matching the “medium risk” rating per BMIS’s Form ADV. 

However, as discussed later in this report, BMIS’s operations (including issues 

directly related to its investment advisory operations) had been examined 

numerous times by OCIE and Enforcement, BMIS was found to be operating as 

an (unregistered) investment adviser, and OCIE and Enforcement found that 

Madoff misrepresented BMIS’s advisory role and activities. 

BMIS’s registration as an investment adviser was prompted by an Enforcement 

investigation, which should have automatically resulted in BMIS receiving an 

initially higher risk rating than it would have received had its registration not been 

a condition of Enforcement closing its investigation. Moreover, findings from 

OCIE’s prior cause examinations of BMIS and from Enforcement’s investigations 

involving BMIS should have prompted OCIE to question BMIS’s “medium” Form 

ADV rating. Due to OCIE and Enforcement’s prior examinations and 

investigations, OCIE should have scheduled a cause examination of Madoff 

immediately upon his registration as an investment adviser. As discussed later in 

the report, it appears that OCIE’s investment adviser unit was not adequately 

informed of the multiple issues that arose with Madoff during prior OCIE 

examinations and Enforcement investigations. 

14 BMIS’s placement in the risk assessment process did not have an effect on the likelihood that BMIS 

would be chosen for a cause or sweep examination. 

15 General Accountability Office Report No. 07-1053: Securities and Exchange Commission: Steps Being 

Taken to Make Examination Program More Risk-Based and Transparent, August 2007, pages 3-4. 
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Report No. 470 

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Recommendation 1: 

The Office of Compliance Inspections and Examinations (OCIE) should 

implement a procedure requiring, as part its process for creating a risk 

rating for an investment adviser, that OCIE staff perform a search of 

Commission databases containing information about past examinations, 

investigations, and filings related to the investment adviser. 

Recommendation 2: 

The Office of Compliance Inspections and Examinations (OCIE) should 

change the risk rating of an investment adviser based on pertinent 

information garnered from all Divisions and Offices of the Commission, 

including information from OCIE examinations and Enforcement 

investigations, regardless of whether the information was learned during 

an examination conducted to look specifically at a firm’s investment 

advisory business. 

Finding 2: OCIE Should Have Immediately 

Scheduled a Cause Examination of BMIS when 

BMIS Registered as an Investment Adviser. 

BMIS registered as an investment adviser in 2006 as a 

condition of Enforcement closing its investigation. The 

Enforcement investigation that began in 2006 found that 

BMIS acted as an (unregistered) investment adviser to 

certain hedge funds, institutions, and high net worth 

individuals in violation of the registration requirements of the 

Advisers Act. 

Enforcement stated that BMIS’s investment adviser registration was a “good 

result” because it would expose Madoff and his firm to “extra regulatory scrutiny.” 

However, there is no indication that anyone on the Enforcement staff ever 

suggested that OCIE’s investment adviser examination staff conduct a cause 

examination of BMIS.16 This fact is troubling because the Enforcement 

investigation (which included the assistance of an OCIE broker-dealer examiner) 

revealed that Madoff did not fully disclose either the nature of the trading BMIS 

16 OIG Investigative Report: Investigation of Failure of the SEC to Uncover Bernard Madoff’s Ponzi Scheme 

– Public Version, Report No. 509, August 31, 2009 (hereinafter “OIG Investigative Report No. 509”), page 

357. 
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Report No. 470 

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conducted in hedge fund accounts or the number of such accounts at BMIS,17

that BMIS commingled billions of dollars of equities among its investment 

advisory accounts and with its broker-dealer proprietary account,18 and that the 

investor disclosures of BMIS’s largest hedge fund client did not adequately 

describe BMIS’s advisory role.19 Some of the problems identified in this 

investigation related to BMIS’s investment advisory operations; therefore, both 

Enforcement and OCIE’s broker-dealer examination staff should have promptly 

notified OCIE’s investment adviser examination unit. At that point, OCIE should 

have immediately scheduled a cause examination. 

Enforcement Investigation of Madoff. On January 4, 2006, Enforcement 

opened a formal investigation of BMIS. The investigation was instigated by a 

November 2005 detailed complaint from Harry Markopolos, an independent fraud 

investigator, who alleged that Madoff was running a Ponzi scheme and that the 

returns reported by BMIS’s hedge fund clients were the result of fraud 

perpetuated by Madoff and his firm. Enforcement also learned from an OCIE 

broker-dealer examiner that BMIS did not fully disclose to OCIE examination staff 

the nature of the trading conducted in BMIS’s hedge fund accounts or the 

number of accounts that BMIS operated. 

According to the Enforcement team assigned to the investigation, the 

investigation was opened to determine (1) whether BMIS, a registered brokerdealer, provided investment advisory services to large hedge funds in violation of 

the registration requirements of the Investment Advisers Act of 1940, and (2) 

whether BMIS engaged in any fraudulent activities in connection with these 

services. 

During its investigation, the staff learned from a broker-dealer examiner that 

during a recent examination of BMIS by NERO’s broker-dealer examination staff, 

Madoff failed to disclose to the staff both the nature of the trading conducted in 

the hedge fund accounts and also the number of such accounts at BMIS. 

When closing its investigation in 2007, the Enforcement team stated that it had 

“found no evidence of fraud” but “did find, however, that BMIS acted as an 

[unregistered] investment adviser to certain hedge funds, institutions, and high 

net worth individuals in violation of the registration requirements of the Advisers 

Act.” The Enforcement team also found that BMIS’s largest hedge fund client, 

FGG, “did not adequately disclose to its investors [BMIS’s] advisory role and 

merely described [BMIS] as an executing broker to FGG’s accounts.” 

17 Enforcement learned of this non-disclosure during a preliminary inquiry, prior to opening the 2006 Madoff 

investigation. 

18 OIG Investigative Report No. 509, page 358. 19 FGG subsequently revised its disclosures to investors to reflect BMIS’s advisory role. 
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As a result of the investigation and discussions with SEC staff, BMIS filed its first 

Form ADV with the Commission on August 25, 2006, and its registration as an 

investment adviser became effective on September 12, 2006. FGG also revised 

its disclosures to investors to reflect BMIS’s advisory role. 

In its Closing Recommendation, Enforcement stated that it recommended closing 

the investigation because both BMIS and FGG voluntarily remedied the violations 

that the SEC identified, and the SEC determined that the violations were not so 

serious as to warrant an Enforcement action or further investigation. 

Enforcement stated that BMIS’s registration as an investment adviser was a 

“good result” because it would expose BMIS to “extra regulatory scrutiny.” 

However, there is no indication that anyone on the Enforcement staff ever 

suggested that OCIE’s investment adviser examination staff conduct an 

examination of BMIS.20 This fact is troubling because the investigation identified 

the following significant issues: 

• Madoff did not fully disclose to SEC staff either the nature of the 

trading conducted in hedge fund accounts controlled by BMIS or 

the number of such accounts at BMIS.21

• BMIS commingled billions of dollars of equities among its 

investment advisory accounts and with BMIS’s broker-dealer 

proprietary account. This commingling should have been of serious 

concern to the SEC because it is a violation of the custody rule for 

investment advisers.22

• BMIS acted as an investment adviser to certain hedge funds, 

institutions, and high net worth individuals, in violation of the 

requirements of the Advisers Act. 

• FGG’s disclosures to its investors did not adequately describe 

BMIS’s advisory role and described BMIS as merely an executing 

broker to FGG’s accounts.23 

The 2006 Enforcement investigation of BMIS was comprised of staff at NERO 

who were assisted by one OCIE broker-dealer examiner who had previously 

conducted an examination of BMIS and identified numerous misrepresentations 

made by Madoff. Many of the problems identified in the Enforcement 

investigation related to BMIS’s investment advisory operations; therefore, OCIE’s 

20 OIG Investigative Report No. 509, page 357. 21 Enforcement learned of this non-disclosure during a preliminary inquiry, prior to opening the 2006 Madoff 

investigation. 

22 OIG Investigative Report No. 509, page 358. 23 FGG subsequently revised its disclosures to investors to reflect BMIS’s advisory role. 
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Report No. 470 

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advisory unit should have been provided with the information that was learned in 

the investigation upon BMIS’s application for investment adviser registration. 

Once this information was brought to the attention of OCIE’s adviser unit, OCIE 

should have immediately scheduled a cause examination of BMIS. 

We believe that Enforcement’s failure to communicate with OCIE’s investment 

adviser unit and OCIE’s broker-dealer examination unit’s failure to communicate 

with its investment adviser examination unit is particularly troubling and led to 

OCIE’s failure to conduct an examination of BMIS’s advisory business. An OCIE 

Branch Chief testified that BMIS might have been subject to a “cause exam” 

immediately after it registered had the investment adviser examination staff been 

informed that Madoff had made misrepresentations to Enforcement and OCIE 

broker-dealer examination staff.24 

OCIE initiates cause examinations when firms are believed to be in violation of 

the federal securities laws. In these examinations, staff review irregular activity, 

determine if violations have occurred, gather supporting documentation, perform 

interviews, and prepare analyses as evidence of violations. OCIE’s brokerdealer unit was already aware that BMIS had violated the Advisers Act, failed to 

disclose pertinent aspects of its business, and commingled accounts. This fact 

should have been communicated to OCIE’s investment adviser unit as soon as 

Enforcement prompted BMIS to register as an investment adviser in 2006, and a 

cause examination should have been immediately scheduled. 

OCIE finally opened up a cause examination of BMIS’s investment advisory 

business after Madoff admitted to operating a Ponzi scheme in December 2008. 

Recommendation 3: 

The Division of Enforcement and the Office of Compliance Inspections 

and Examinations should establish and adhere to a joint protocol providing 

for the sharing of all pertinent information (e.g., securities laws violations, 

disciplinary history, tips, complaints and referrals) identified during the 

course of an investigation or examination or otherwise. 

Recommendation 4: 

The Office of Compliance Inspections and Examinations (OCIE) should 

establish a procedure to thoroughly evaluate negative information that it 

receives about an investment adviser and use this information to 

determine when it is appropriate to conduct a cause examination of an 

24 OIG Investigative Report No. 509, page 357. 
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investment adviser. OCIE should ensure its procedure provides for timely 

opening of a cause examination. 

Recommendation 5: 

When the Office of Compliance Inspections and Examinations (OCIE) 

becomes aware of negative information pertaining to an investment 

adviser, OCIE should examine the investment adviser’s Form ADV filings 

and document and investigate discrepancies existing between the 

adviser’s Form ADV and information that OCIE previously learned about 

the registrant. 

Finding 3: BMIS Made Misrepresentations on its 

Form ADV Filings, and OCIE Should Have Been 

Aware of These Misrepresentations. 

BMIS consistently made misrepresentations on its Form 

ADV filings, especially by understating its assets under 

management and the number of clients to whom BMIS 

provided investment advisory services. BMIS also 

misrepresented the nature of its advisory business and failed 

to disclose the entities that referred business to BMIS. 

Prior to BMIS’s first Form ADV Filing in August 2006, OCIE should have been 

aware that Madoff lied to OCIE and Enforcement staff during the course of their 

examinations and investigations. Further, an Enforcement investigation found 

that BMIS was acting as an investment adviser without being registered as such. 

As a result of this investigation, BMIS registered as an investment adviser. 

Nevertheless, OCIE did not adequately scrutinize any of BMIS’s Form ADV 

filings. Had OCIE done so, OCIE should have concluded that BMIS made 

misrepresentations in the Form ADV filings. 

Had BMIS provided accurate information on its Form ADVs, it may have been 

classified as a “high risk” adviser and therefore subject to a routine OCIE 

examination within three years of receiving a “high risk” rating. 

We found that OCIE’s risk rating process does not give adequate weight to an 

investment adviser’s level of assets under management and the number of 

clients that receive investment advisory services. We believe that advisers with 

more assets under management and more clients who receive advisory services 

should receive progressively higher risk scores. 
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Report No. 470 

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We reviewed Part 1 of BMIS’s 2006, 2007, and 2008 filings. BMIS reported the 

same information in each filing with only two exceptions. In its 2006 filing, BMIS 

reported that it did not provide investment advisory services to any clients; in 

2007 and 2008 filings, BMIS reported 11-25 clients for this category. In its 2006 

through 2008 filings, BMIS reported assets under management of $11.7 billion, 

$13.2 billion and $17.1 billion, respectively. 

The SEC does not require registrants to file Part II of Form ADV with the 

Commission. The OIG obtained Part II from SEC examination staff. 

The following is a summary of the lies and misrepresentations that we identified 

through discussions with Commission management.25 

Misrepresentations in Part 1 of Form ADV (2006, 2007 and 2008 

filings) 

1) Item 5 Part B(3) asks: “Approximately how many firms or other persons

solicit advisory clients on your behalf?” BMIS selected “0.” 

In September 2009, Commission management told the OIG that the SEC 

had evidence of at least two other firms that referred business to BMIS. 

One client, Cohmad, referred business to Madoff at the time of BMIS’s 

Form ADV filings. Avellino & Bienes referred business to BMIS in 1992, 

but no action was taken to determine if it or any successor firm referred 

business to BMIS at the time of BMIS’s ADV filings. 

Risk Rating Point Score 

BMIS’s risk score for this question would have been higher had it 

accurately disclosed its practices. BMIS was assigned points for this 

answer. Had BMIS disclosed at least clients, its risk score would have 

been 

2) Item 5 Part C asks: “To approximately how many clients did you provide 

investment advisory services during your most recently completed fiscal 

year?” BMIS selected “0” in the 2006 filing and “11-25” in the 2007 and 

2008 filings. 

If Part 1 of BMIS’s 2006 ADV were to have been carefully reviewed, 

BMIS’s answer to this question should have raised serious questions and 

concerns, because it would have immediately appeared to a reviewer to 

25 For purposes of this report, “Commission Management” is defined as “senior officials (SK-15 and above) 

such as Division Chiefs, Deputy/Associate/Assistant Directors, Office/Division heads, etc.” 
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Report No. 470 

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be facially inaccurate. Although BMIS represented that it had provided no 

clients with advisory services during the past fiscal year, in BMIS’s 

response to the following question (Item 5 Part D), BMIS stated that its 

clients included high net worth individuals, banking or thrift institutions, 

pension and profit sharing plans, charitable organizations, and 

corporations or other businesses. BMIS also represented in response to 

Item 5 Part F that it had over $11 billion in assets under management. 

Consequently, had BMIS’s ADV been carefully reviewed, BMIS’s 

response to Item 5 Part C would have appeared dubious and raised 

questions that required further investigation. 

Moreover, on the face of its response, BMIS was taking the incredible 

position that it had provided no investment advisory services to clients in 

the past year – a position directly contrary to an express finding made by 

Enforcement. If Enforcement had made OCIE investment adviser 

examiners aware of its investigation and determination that BMIS did have 

advisory clients that BMIS had failed to disclose, then BMIS’s response 

should have raised immediate red flags with investment adviser 

examiners. 

In addition, OCIE broker-dealer examiners and Enforcement investigators 

had information as early as 2005 that could have been relied upon by 

investment adviser examiners to discredit BMIS’s response to the above 

item. The information included the following: 

• On May 27, 2005, OCIE examiners discussed a discrepancy 

involving a potential client of BMIS’s called “Auriga International.” 

In an e-mail exchange, one OCIE examiner said that Madoff stated 

that he was not familiar with Auriga International. The other OCIE 

examiner thought this was “weird” because “Bloomberg reports 

Auriga had discretionary accounts with B. Madoff.”26 

• In late 2005 and early 2006, an Enforcement investigation (which 

was staffed with one OCIE examiner) found that Madoff lied about 

the number and identity of his firm’s investors and withheld account 

information from the examination staff. Madoff did not disclose to 

the examination staff some of the accounts in which he 

implemented his trading strategy. Further, on June 7, 2006, an 

Enforcement staff person informed three other SEC staff persons 

that Madoff had produced a list of 86 “previously undisclosed” 

accounts, totaling $336.5 million.27 

26 OIG Investigative Report No. 509, page 208. 27 OIG Investigative Report No. 509, pages 319 and 321. 
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Report No. 470 

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After Madoff admitted to operating a Ponzi scheme, Commission 

management learned that BMIS had more than 4,000 active accounts 

(clients) as of December 2008. 

Risk Rating Point Score 

, BMIS’s risk weighting would have been 

unaffected. 

We believe that an investment adviser’s risk score should be progressively 

higher, based on the number of clients to whom an investment adviser 

provides services. As the pervasiveness of the harm caused by Madoff’s 

fraud illustrates, the more clients an adviser has, the greater the potential 

harm to investors. A key aspect of the SEC’s mission is to protect 

investors. Consequently, the number of clients an investment adviser has 

should be associated with a risk rating. 

3) Item 5 Part D: “What types of clients do you have? Indicate the 

approximate percentage that each type of client comprises of your total 

number of clients.” BMIS indicated the following: 

• High net worth individuals: 11-25%; 

• Banking or thrift institutions: up to 10%; 

• Pension and profit sharing plans (other than plan 

participants): up to 10%; 

• Other pooled investment vehicles (e.g., hedge funds): 51-

75%; 

• Charitable organizations: up to 10%; and 

• Corporations or other businesses not previously listed: 11-

25%. 

In September 2009, Commission management told the OIG that this 

response was potentially a lie since it did not reflect the proportions from 

more than 4,000 BMIS accounts. 

Risk Rating Point Score 

BMIS’s risk score for this question would have been significantly higher 

had it accurately disclosed its practices. BMIS was assigned points 

based on its answers. Assuming that BMIS misrepresented the types of 
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Report No. 470 

Page 33 

clients he advised, the maximum number of points that could have been 

assigned to BMIS would have been points. 

4) Item 5 Parts F(1) and F(2): “Do you provide continuous and regular 

supervisory or management services to securities portfolios? If yes, what 

is the amount of your assets under management and total number of 

accounts?” BMIS reported assets under management of $11.7 billion to 

$17.1 billion in BMIS’s filings between 2006 and 2008. In each year, 

BMIS reported only 23 accounts. 

As discussed in item number 2 above, as early as 2005, OCIE brokerdealer examiners believed that Madoff had under-reported the number of 

accounts that he managed, and in its 2005 investigation, Enforcement 

learned that Madoff had under-reported the number of accounts that he 

managed. 

After BMIS admitted to operating a Ponzi scheme in December 2008, 

Commission Management stated that BMIS severely underreported 

BMIS’s assets and that BMIS had more than 4,000 active accounts 

(clients) and over $60 billion in purported assets as of December 2008. 

Risk Rating Point Score 

BMIS was assigned points for its 

answer, 

 

OCIE assigns a limited number of points to all investment advisers that 

report at least $1 in assets under management. We believe this method is 

problematic because advisers with $100,000 in assets under management 

carry the same risk weight as those with significantly higher assets under 

management. 

We believe this 

method is problematic because advisers that carry $100,000 in assets 

under management carry the same risk weight as those that carry up to 

$277 billion. To illustrate this point, the 20 largest firms, by assets under 

management, receive an automatic risk rating of “high,” regardless of their 

individual scores. The twenty-first largest firm reported $273 billion in 

assets under management. This firm was assigned points and rated a 

“medium” risk. Clearly, this firm appears to be riskier and pose more of a 
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Report No. 470 

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n 

 

risk to the investing public than a firm that manages only $100,000 in 

assets. 

5) Item 8 Part C(3): “Do you or any related person have discretionary

authority to determine the broker or dealer to be used for a purchase or 

sale of securities for a client’s account?” BMIS said “no.” 

OCIE had information as early as 2005 that it could have relied upon to 

discredit BMIS’s answer to this question. 

During a 2005 examination of BMIS, an OCIE broker-dealer examiner 

recalled that Madoff said he executed trades after hours in London, 

England.28 Further, when an OCIE broker-dealer examiner drafted a list 

of questions to ask Madoff, he included a question requesting clarificatio

about which “markets in London” Madoff was using to clear trades and 

how the associated securities settled.29 An OCIE broker-dealer examiner 

informed Enforcement staff about Madoff’s representation that he 

executed trades for hedge funds in Europe.30

 

In September 2009, Commission management told the OIG that BMIS’s 

answer to this question was illogical, because if Madoff was supposedly 

executing trades with foreign brokers overseas, then BMIS was exercising 

some discretion regarding which foreign broker(s) to trade through. If 

BMIS’s answer was truly “no,” this fact would have meant that BMIS had 

no discretion regarding which broker-dealers to trade through. 

Risk Rating Point Score 

, BMIS’s risk weighting would have been 

unaffected. 

6) Item 8 Part F: “Do you or any related person, directly or indirectly, 

compensate any person for client referrals?” BMIS said “no.” 

OCIE had information as early as 2005 that it could have relied upon to 

discredit BMIS’s answer to this question. 

A 2005 OCIE examination found that Cohmad’s June 30, 2005 FOCUS 

Report (Form X-17A-5 Part III) identified the existence of a related-party 

28 OIG Investigative Report No. 509, page 192. 29 OIG Investigative Report No. 509, page 204. 30 OIG Investigative Report No. 509, page 277. 
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entity, owned by a minority shareholder that provided 90% of Cohmad’s 

revenues. Further, OCIE broker-dealer examiners identified substantial 

monthly checks from Madoff to Cohmad. The examiners never received a 

satisfactory response from Madoff as to why the checks were made to 

Cohmad and described Madoff’s explanation as “odd.”31 

 

In September 2009, Commission Management told the OIG that BMIS did 

in fact compensate persons for such referrals, (e.g., BMIS compensated 

Cohmad Securities Corporation, an SEC-registered broker-dealer - Madoff 

was a minority owner of Cohmad). Further, the SEC’s investment adviser 

rules require one to disclose when compensation is paid for referrals. 

Risk Rating Point Score 

 BMIS’s risk score for this question would have been significantly higher 

had it accurately disclosed its practices. BMIS was assigned points for 

his answer. Had BMIS told the truth, BMIS’s risk score for this question 

would have been points. 

7) Item 9 Part B(2): “Do any of your related persons have custody of any of 

your advisory clients’ securities?” BMIS said “no.” 

Madoff told the SEC examination and investigation staff different stories 

about where the equity trades for his investors were executed and 

cleared.32 During the 2005 NERO examination, Madoff informed the 

examination staff that his London affiliate, Madoff Securities International 

Limited (MSIL), was settling the orders, and Barclays Capital in London 

was clearing the equity trades.33 In September 2009, Commission 

management told the OIG that this response was false as Madoff was 

contending that a UK affiliate had custody of certain assets. 

Risk Rating Point Score 

 BMIS’s risk score for this question would have been significantly higher 

had it accurately disclosed its practices. Madoff was assigned points 

for his answer. Assuming Madoff lied in his Form ADV response, BMIS’s 

risk score for this question should have been points. 

31 OIG Investigative Report No. 509, pages 177-178. 32 OIG Investigative Report No. 509, page 315. 33 OIG Investigative Report No. 509, page 315. 
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Report No. 470 

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Misrepresentations in Part II of Form ADV (2008 filing) 

Investment Advisers do not file Part II of Form ADV with the Commission, and 

therefore OCIE does not assign any risk weighting to the answers provided by 

advisers in Part II of Form ADV. 

8) Item 3 Part A(2) states: “Types of Investments. Applicant offers advice on 

the following: (check those that apply).” BMIS was engaged in OTC 

options trading, but BMIS did not check the box related to options. 

However, BMIS did check an “other” box and disclosed that BMIS traded 

index-based options. 

OCIE had information as early as 2005 that it could have relied upon to 

discredit BMIS’s response to the above item. 

 

A December 13, 2005, e-mail exchange between an Enforcement 

investigator and a broker-dealer examiner stated that Madoff lied to the 

examination staff by telling the staff that he stopped using options as part 

of his trading strategy in January 2004. Yet, BMIS’s client account 

statements showed trading in the S&P 100 Index options throughout 2004 

and up to October 2005, the last month for which data was produced.34 

Enforcement staff further discussed this fact in e-mails dated December 

15, 2005. The Enforcement investigation was closed without the receipt of 

a complete (or convincing) explanation from Madoff about the 

discrepancy.35

Further, while Madoff claimed to have had billions of dollars invested in 

undocumented OTC options contracts, on January 23, 2006, Madoff told 

Enforcement that he had no documentation of options contracts other than 

what was produced (e.g., no written contract between purchaser and 

counter-party).36 

In September 2009, Commission management told us that BMIS should 

probably have checked the box on Form ADV related to options and 

possibly another box called “securities traded over-the-counter.” 

9) Item 7 Part C: This item pertains to other business activities. BMIS 

checked a box that states: “The principal business of applicant or its 

principal executive officers involves something other than providing 

investment advice.” 

34 OIG Investigative Report No. 509, page 271. 35 OIG Investigative Report No. 509, pages 272-273. 36 OIG Investigative Report No. 509, page 285. 
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Report No. 470 

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According to Commission management, this response implies that BMIS 

was principally a market maker and secondarily an investment adviser. In 

reality, BMIS’s principal business was its advisory business, which was 

the business within which it operated the Ponzi scheme. 

OCIE had information in 2004 upon which it could have relied to show that 

BMIS’s response was, at best, misleading. In both the 2004 and 2005 

OCIE cause examinations, OCIE broker-dealer staff learned that BMIS’s 

advisory business was making significantly more money for BMIS than 

was its market making business. In fact, examiners conducting the 2005 

examination discovered that without the advisory business, BMIS would 

have been losing $10-20 million per year.37

 

10) Item 13B asks: “Does the applicant or a related person have any 

arrangements, oral or in writing, where it directly or indirectly compensates 

any person for client referrals?” BMIS answered “no.” 

Commission management told the OIG that BMIS was providing such 

compensation. For example, BMIS compensated Cohmad Securities, a 

registered broker-dealer that referred business to BMIS and in which 

Madoff had a minority interest. 

11) Commission management told the OIG that the narrative portions of 

BMIS’s Form ADV (Part II) contained “lies on their face” in reference to the 

description of BMIS’s business.

BMIS’s Overall Risk Score Would have Been Higher Had BMIS Accurately 

Completed its Form ADV or Had OCIE Verified the Information. An analysis 

of misrepresentations by BMIS with respect to all of the above items of Part 1 of 

Form ADV demonstrates that BMIS’s risk-weighted score would have been 

significantly higher had BMIS accurately completed Part 1 of Form ADV or had 

SEC staff verified the information on BMIS’s Form ADV and identified the 

misrepresentations. BMIS’s score based on accurate answers to Form ADV 

questions may have given it a high risk rating. Thus, BMIS may have been 

designated a “high risk” firm and subject to an OCIE examination within three 

years of such a rating. 

BMIS’s score was based on its 2006, 2007, and 2008 Form ADV responses. 

Were BMIS to have provided accurate answers, it would have received as many 

as additional points, bringing its overall score to . A score of or higher 

equates to a “high risk” firm. Thus, BMIS may have been designated a “high risk” 

37 OIG Investigative Report No. 509, pages 103-04, 214. 
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Page 38 

firm had BMIS accurately completed Part 1 of Form ADV or had OCIE verified 

the information on BMIS’s ADV. 

While OCIE generally cannot take responsibility for investment advisers that 

make misrepresentations on their Form ADV, in this case, due to the numerous 

examinations and investigations already conducted either by OCIE or with the 

assistance of OCIE, OCIE should have been aware that many of the statements 

made by BMIS in its ADV contradicted the information they had learned about his 

operations. In addition, since Enforcement actually concluded in its investigation 

that Madoff failed to disclose to the examination staff both the nature of the 

trading conducted in the hedge fund accounts and also the number of such 

accounts at BMIS, BMIS’s Form ADV should have been carefully scrutinized for 

lies and misrepresentations. 

Had OCIE adequately reviewed any of BMIS’s Form ADVs, or even simply relied 

upon the information about BMIS’s lies and misrepresentations that were 

discovered during previous examinations and investigations, OCIE should have 

learned that BMIS was a “high risk” firm that, at a minimum, should have been 

subject to the three-year examination cycle. 

Recommendation 6: 

The Office of Compliance Inspections and Examinations (OCIE) should 

establish a procedure to thoroughly evaluate an investment adviser’s 

Form ADVs when OCIE becomes aware of issues or problems with an 

investment adviser. OCIE should document areas where it believes a 

Form ADV contains false information and initiate appropriate action, such 

as commencing a cause examination. 

Recommendation 7: 

The Office of Compliance Inspections and Examinations (OCIE) should 

re-evaluate the point scores that it assigns to advisers based on their 

reported assets under management. OCIE should assign progressively 

higher risk weightings to firms that have greater assets under 

management. 

Recommendation 8: 

The Office of Compliance Inspections and Examinations (OCIE) should 

re-evaluate the point scores that it assigns to firms based on their reported 

number of clients to which they provide investment advisory services. 

OCIE should assign progressively higher risk weightings to investment 

advisers that serve a larger number of clients. 
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Report No. 470 

Page 39 

Finding 4: Form ADV Should Require Additional 

Information. 

Form ADV has not been substantively updated since 2000, 

when it was first required to be filed electronically with the 

Commission. We believe that OCIE could identify additional 

risk factors if registrants were required to include additional 

information in Form ADV about funds that the adviser 

manages, including information about fund performance and 

fund auditor. Further, the fund’s auditor should be required 

to file its opinion with the Commission. 

Performance Information. Investment advisers are not currently required to 

report to the SEC information regarding the performance of funds under 

management for the current year or any prior years. 

BMIS never provided performance information 

 thus, the Commission never received performance information 

from BMIS. 

If investment advisers were required to report performance information for the 

current and prior years of operation, OCIE could analyze this information to 

determine which investment advisers’ performance consistently fell outside the 

normal parameters. OCIE could subsequently assign progressively higher risk 

weights to performance outliers, in accordance with how far off a firm’s 

performance was from established parameters. 

BMIS was a performance outlier in that the returns it reported to investors were 

consistently and significantly higher than any of the benchmark indexes. 

Moreover, unlike the market and its competitors, BMIS rarely reported negative 

returns. 

Information about Hedge Funds. Currently, the Commission is only able to 

gather a limited amount of information about hedge funds. According to 

Commission management, the risk of fraudulent activities is greatest with hedge 

funds, and most Ponzi schemes occur through hedge funds. It could be 

beneficial if investment advisers were required to report on Form ADV 

information about their hedge funds’ service providers, custodians, auditors, and 

administrators. If OCIE detected a problem with one of these entities, OCIE 

could then electronically review additional Form ADVs to determine which 

investment advisers were using the same entities and take appropriate action. 
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Report No. 470 

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Further, investment advisers should report on Form ADV current auditors and 

amend the form when an auditor is changed. OCIE could review this information 

to determine whether a firm’s auditor is from a reputable accounting firm. 

BMIS’s auditor was part of a small, unknown firm and was alleged to be a related 

party to Madoff. The OIG investigation regarding why the SEC failed to uncover 

Madoff’s Ponzi scheme concluded that BMIS’s auditor was not independent; and 

therefore, there was no assurance that BMIS’s audits were properly conducted. 

After Madoff confessed to running a Ponzi scheme, a New York staff attorney in 

Enforcement investigated Madoff’s accountant, David Friehling. Within a few 

hours of obtaining the work papers, the staff attorney determined that no audit 

work had been done and testified that there were red flags, which included the 

absence of any formal work papers, the work papers that were produced did not 

comply with generally accepted auditing standards, and there was almost nothing 

indicating that any audit work had been performed.38

Finally, an investment adviser’s auditor should file information with the SEC 

relaying the auditor’s opinion. This filing would provide OCIE with independent 

information regarding the safety of client assets. 

If this additional information was included in Form ADV and properly analyzed, it 

would allow OCIE to more readily identify red flags associated with investment 

advisers. 

Recommendation 9: 

The Office of Compliance Inspections and Examinations (OCIE) should 

recommend to the Chairman’s office that it institute a Commission 

rulemaking that would require the following additional information to be 

reported as part of Form ADV: 

• Performance information; 

• A fund’s service providers, custodians, auditors and administrators, 

and applicable information about these entities; 

• A hedge fund’s current auditor and any changes in the auditor; and 

• The auditor’s opinion of the firm. 

38 OIG Investigative Report No. 509, page 95. 
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Report No. 470 

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Finding 5: Part II of Form ADV Should Be Filed 

with the Commission. 

Up until 2000, investment advisers were required to file Parts 

1 and II of Form ADV with the Commission in hard copy. In 

2000, advisers began filing Part 1 of Form ADV electronically 

with the Commission and were no longer automatically 

required to provide a copy of Part II to the Commission. 

Part II of Form ADV contains pertinent disclosures about an 

investment adviser’s advisory services, fees, types of clients, 

the types of investments on which the adviser offers advice, 

an adviser’s other business activities, affiliates, conditions for 

managing accounts, and compensation information. 

Part II of ADV was required to be filed with the SEC until 2000 when the 

Commission adopted new rules under the Advisers Act requiring that registered 

advisers make filings with the Commission electronically through the IARD 

system.39 At that time, the Commission exempted advisers from submitting Part 

II to the Commission because the IARD was not ready to accept those filings.40 

The exemption was intended to be temporary, but nine years later, investment 

advisers are still not required to file Part II of their Form ADV electronically or 

even file a paper copy with the Commission, absent a specific request from the 

Commission. Instead, advisers need only retain a copy of Part II of their Form 

ADV in their files. Currently, Part II is deemed to be “filed” with the SEC when 

advisers update the form and place a copy in their files. 

It appears to the OIG that considering Form ADV Part II “filed” with the 

Commission when an adviser places it in his filing cabinet is an inadequate 

procedure. The phantom nature of the filing process is highlighted by the fact 

that the Commission must make a formal request to an adviser to be furnished 

with Part II. In addition, there is no requirement that information from ADV Part II 

be made widely available to investors through either the adviser’s website or the 

IARD system. The current requirements (or lack thereof) create the potential for 

fraud and other abuses. 

Our review found that Part II of Form ADV should be filed with the Commission. 

This document provides pertinent disclosures about an investment adviser’s 

39 See SEC Rule: Electronic Filing by Investment Advisers; Amendments to Form ADV, IA Release No. 

1897 (Sept. 12, 2000), 65 FR 57438 (Sept. 22, 2000). 

40 See SEC Proposed Rule: Amendments to Form ADV, IA Release No. 34-57419, 73 FR 13958, 

March 14, 2008. 
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advisory services, fees, types of clients, types of investments on which the 

adviser offers advice, an adviser’s other business activities, affiliates, conditions 

for managing accounts, and compensation information, among other things. 

On March 3, 2008, the Commission proposed a rule to amend Part II of Form 

ADV.41 The rule proposed that registered investment advisers fill out Part II of 

Form ADV in a narrative form using “plain English” and file it electronically with 

the Commission. The rule also proposed that Part II of Form ADV describe an 

adviser’s services, fees, business practices, and conflicts of interest with clients. 

This rule has not been finalized, nor is it currently on the Commission calendar 

for finalization. To finalize a rule, the Commission must consider all public 

comments that pertained to the proposed rule and incorporate these comments 

into a final rule, which is adopted by vote of the full Commission. Once adopted, 

the rule becomes a part of the official rules that govern the securities industry. 

Neither the proposed rule, nor SEC technology, currently provide for an efficient 

means to analyze the narrative data. Electronically tagging the narrative data 

could assist OCIE with this task. Given the more than 11,000 registered 

investment advisers, it would be extremely beneficial if OCIE had the means to 

efficiently analyze narrative data in the aggregate. 

Recommendation 10: 

The Commission should finalize the proposed rule titled Amendments to 

Form ADV [Release No. IA-2711; 34-57419]. In finalizing this rule, the 

Commission should consider what, if any, additional information 

investment advisers should include in Part II of Form ADV by consulting 

with the Office of Compliance Inspections and Examinations (OCIE) and 

the Division of Investment Management (IM). Further, the Commission, in 

consultation with OCIE and IM, should consider provisions that would 

assist OCIE to efficiently and effectively review and analyze the 

information in Part II of Form ADV. 

41 See SEC Proposed Rule: Amendments to Form ADV, IA Release No. 34-57419, 73 FR 13958, 

March 14, 2008. 
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Finding 6: OCIE Identified Certain Risks But 

These Risks Have Not Been Addressed 

OCIE internal documentation identified a risk that hedge 

fund custodian statements could be fictitious, and the assets 

may not be verifiable. Another risk stated that since 

investment advisers are not required to file Part II of Form 

ADV with the Commission, the SEC does not receive 

important information regarding potential conflicts of interest 

involving investment advisers. While these issues have 

been identified, neither issue has been resolved. 

In 2006, OCIE developed a written Action Plan that summarized key risks 

identified by the OCIE staff. The Action Plan contained 48 risks, listed in the 

order of importance (the most significant risk was listed first, etc.). For each risk, 

the Action Plan included OCIE recommended actions to mitigate the risks, 

actions taken to address the risks, OCIE’s plans for further action, and the risk 

level. The risk levels ranged from tier I (highest risk) to tier III (lowest risk). Per 

OCIE’s documentation, risks rated as Tier I required immediate action, those 

rated as Tier II required action in due course and risks rated as Tier III did not 

require any action at the time the risks were identified. 

This document identified the following risks: 

 

Hedge Funds – Custody Misappropriation 

OCIE recorded risk number eight as follows: 

Advisers to hedge funds have custody of client assets, with 

sole discretion over the disposition assets and custodian 

statements being delivered to an insider at the adviser. Any 

custodian statements that are provided to customers may 

not be verifiable, be fictitious, or may be prepared by a nonUS custodian. Furthermore, the statements may not be 

audited by a legitimate, independent auditor. If the auditor 

has provided a negative opinion or no opinion, investors in 

the fund may not be notified. 

OCIE rated this risk as a Tier I risk. To address this risk, in 2005, OCIE 

recommended, among other actions, adding staff, commencing a rule-making 

process, examining this area across many investment advisers, initiating a staff 

study, and raising awareness. As a matter of practice, however, prior to Madoff’s 

confession that he was running a Ponzi scheme, OCIE did not obtain third party 
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Report No. 470 

Page 44 

 

verifications. OCIE said that obtaining third party verifications was difficult and 

time-consuming. In some cases, the SEC has no regulatory authority over third 

parties, which has resulted in third parties not responding to the SEC. Further, 

OCIE’s staff resources have not kept pace with the growth in the number of 

registered investment advisers. In light of the Madoff scandal, however, OCIE 

has now begun incorporating third party verifications into its examinations. 

Form ADV Part II 

OCIE recorded risk number 35 as follows: 

Customers are not receiving important disclosures, and 

examiners have little access to such disclosures, because 

Form ADV Part II is difficult to read and is not available 

online. Part II should be written in plain English and made 

available online. This would permit it to be readily reviewed 

by examiners, either during the risk-targeting process or onsite. 

As discussed in finding 5 above, our review found that Part II of Form ADV 

should be filed with the Commission. This document provides pertinent 

disclosures about an investment adviser’s advisory services, fees, types of 

clients, types of investments on which the adviser offers advice, an adviser’s 

other business activities, affiliates, conditions for managing accounts and 

compensation information, among other things. 

On March 3, 2008, the Commission proposed a rule to amend Part II of Form 

ADV.42 The rule proposed that registered investment advisers fill out Part II of 

Form ADV in a narrative form using “plain English” and file it electronically with 

the Commission. The rule also proposed that Part II of Form ADV describe an 

adviser’s services, fees, business practices, and conflicts of interest with clients. 

This rule has not been finalized, nor is it currently on the Commission calendar 

for finalization. Recommendation 9 in Finding 5 pertains to finalizing this rule. 

Recommendation 11: 

The Office of Compliance Inspections and Examinations (OCIE) should 

develop and adhere to policies and procedures for conducting third party 

verifications, such that OCIE verifies the existence of assets, custodian 

statements, and other relevant criteria. 

42 SEC Proposed rule: Amendments to Form ADV, Release No. 34-57419, 73 FR 13958, March 14, 2008. 
Appendix I

Acronyms 

Advisers Act Investment Advisers Act of 1940 

BMIS Bernard Madoff Investment Securities, LLC 

DTC Depository Trust Company 

Enforcement Division of Enforcement 

FGG Fairfield Greenwich Group 

FINRA Financial Industry Regulatory Authority 

Form ADV Uniform Application for Investment Adviser Registration

IARD Investment Adviser Registration Depository 

IARD system Investment Adviser Registration Depository system 

IM Division of Investment Management 

Madoff Bernard L. Madoff 

MSIL Madoff Securities International Limited 

NASD National Association of Securities Dealers 

NERO Northeastern Regional Office 

OCIE Office of Compliance, Inspections and Examinations 

OEA Office of Economic Analysis 

OIG Office of the Inspector General 

SEC or 

Commission 

U.S. Securities and Exchange Commission 

SIPC Securities Investor Protection Corporation 

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Appendix II

Scope and Methodology 

This review was not conducted in accordance with the government auditing 

standards. 

Scope. The scope includes of a review of SEC’s Examinations conducted on 

Madoff dating from 1992 to 2006. Specifically, the scope consists of a review of 

Enforcement’s investigation and examination conducted in 1992, OCIE’s Cause 

Examinations conducted in 2004 and 2005, and Enforcement’s January 2006 

investigation on Madoff. Also, we examined the BMIS Form ADV filings and 

reviewed the OIG investigative report Investigation of Failure of the SEC to 

Uncover Bernard Madoff’s Ponzi Scheme, Report No. 509. 

Methodology. To address the review’s first objective to determine whether the 

Commission’s rationale for not performing an examination of BMIS’ investment 

advisory business soon after the firm registered as an investment adviser in 

2006, we interviewed staff from OCIE and Enforcement. We also reviewed: 

• BMIS’ Form ADV filings; 

• OCIE’s process for rating investment advisers as “low,” “medium,” and 

“high;” 

• OCIE’s process for identifying risks related to investment advisers; and 

• OCIE’s process for examining investment advisers. 

To address the review’s second objective to develop recommendations to 

improve OCIE’s process for selecting investment advisers and investment 

companies for examination, we: 

• Reviewed and analyzed relevant information from OIG’s investigative 

report Investigation of Failure of the SEC to Uncover Bernard Madoff’s 

Ponzi Scheme, Report No. 509; 

• Examined OCIE’s process for choosing investment advisers and 

investment companies for examination; 

• Interviewed OCIE officials to determine why OCIE did not initiate an 

examination of BMIS after BMIS filed its first Form ADV with the 

Commission in August 2006; and 

• Interviewed Enforcement and the Division of Investment Management 

staff. 

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Appendix II

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Prior OIG Coverage. On August 31, 2009, the OIG issued Investigation of 

Failure of the SEC to Uncover Bernard Madoff’s Ponzi Scheme, Report No. 509.

This report analyzed the reasons why the Commission did not believe that the 

allegations and tips the Commission received about Madoff were credible. The 

investigation found that the SEC received more than ample information in the 

form of detailed and substantive complaints over a period of many years to 

warrant a thorough and comprehensive examination and/or investigation of 

Madoff and BMIS for operating a Ponzi scheme. Despite three examinations and 

two investigations of BMIS, a thorough and competent investigation or 

examination was never performed, and the SEC never identified the Ponzi 

scheme that Madoff operated. 

On September 29, 2009, the OIG issued Program Improvements Needed Within 

the SEC’s Division of Enforcement, Report No. 467. The review identified issues 

that prevented Enforcement from accomplishing its mission to enforce the 

securities laws and protect investors and identified needed programmatic 

improvements. The report found that Enforcement staff lacked adequate 

guidance on how to appropriately analyze complaints and did not conduct a 

thorough review of the complaints brought to its attention prior to Madoff’s 

confession. 

 

On September 29, 2009, the OIG issued Review and Analysis of OCIE 

Examinations of Bernard L. Madoff Investment Securities, LLC, Report No. 468. 

The report found that OCIE examiners made critical mistakes in nearly every 

aspect of their examinations of Madoff and BMIS and missed significant 

opportunities to uncover Madoff’s Ponzi scheme. The report concluded that OCIE 

examiners did not properly plan or conduct their examinations of Madoff, and 

because of these failures, were unable to discover Madoff’s fraud. 
Appendix III 

Criteria 

Form ADV: Uniform Application for Investment Adviser Registration. 

Investment advisers are required to file this Form with the SEC at least annually. 

SEC Proposed Rule: Amendments to Form ADV, Release No. 34-57419, 73 

FR 13958, March 14, 2008. Proposes requiring investment advisers registered 

with the SEC to deliver to clients and prospective clients a brochure written in 

plain English and to file electronically Part II of Form ADV with the SEC. 

SEC Rule 204-1: 17 C.F.R. §275.204-1. Requires investment advisers to 

update Form ADV on an annual basis and as warranted, in accordance with 

instructions to Form ADV. 

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Appendix IV

List of Recommendations 

Recommendation 1: 

The Office of Compliance Inspections and Examinations (OCIE) should 

implement a procedure requiring, as part its process for creating a risk rating for 

an investment adviser, that OCIE staff perform a search of Commission 

databases containing information about past examinations, investigations, and 

filings related to the investment adviser. 

Recommendation 2: 

The Office of Compliance Inspections and Examinations (OCIE) should change 

the risk rating of an investment adviser based on pertinent information garnered 

from all Divisions and Offices of the Commission, including information from 

OCIE examinations and Enforcement investigations, regardless of whether the 

information was learned during an examination conducted to look specifically at a 

firm’s investment advisory business. 

Recommendation 3: 

The Division of Enforcement and the Office of Compliance Inspections and 

Examinations should establish and adhere to a joint protocol providing for the 

sharing of all pertinent information (e.g., securities laws violations, disciplinary 

history, tips, complaints and referrals) identified during the course of an 

investigation or examination or otherwise. 

Recommendation 4: 

The Office of Compliance Inspections and Examinations (OCIE) should establish 

a procedure to thoroughly evaluate negative information that it receives about an 

investment adviser and use this information to determine when it is appropriate to 

conduct a cause examination of an investment adviser. OCIE should ensure its 

procedure provides for timely opening of a cause examination. 

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Appendix IV

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Report No. 470 

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Recommendation 5: 

When the Office of Compliance Inspections and Examinations (OCIE) becomes 

aware of negative information pertaining to an investment adviser, OCIE should 

examine the investment adviser’s Form ADV filings and document and 

investigate discrepancies existing between the adviser’s Form ADV and 

information that OCIE previously learned about the registrant. 

Recommendation 6: 

The Office of Compliance Inspections and Examinations (OCIE) should establish 

a procedure to thoroughly evaluate an investment adviser’s Form ADVs when 

OCIE becomes aware of issues or problems with an investment adviser. OCIE 

should document areas where it believes a Form ADV contains false information 

and initiate appropriate action, such as commencing a cause examination. 

Recommendation 7: 

The Office of Compliance Inspections and Examinations (OCIE) should reevaluate the point scores that it assigns to advisers based on their reported 

assets under management. OCIE should assign progressively higher risk 

weightings to firms that have greater assets under management. 

Recommendation 8: 

The Office of Compliance Inspections and Examinations (OCIE) should reevaluate the point scores that it assigns to firms based on their reported number 

of clients to which they provide investment advisory services. OCIE should 

assign progressively higher risk weightings to investment advisers that serve a 

larger number of clients. 
Appendix IV

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Recommendation 9: 

The Office of Compliance Inspections and Examinations (OCIE) should 

recommend to the Chairman’s office that it institute a Commission rulemaking 

that would require the following additional information to be reported as part of 

Form ADV: 

• Performance information; 

• A fund’s service providers, custodians, auditors and administrators, and 

applicable information about these entities; 

• A hedge fund’s current auditor and any changes in the auditor; and 

• The auditor’s opinion of the firm. 

Recommendation 10: 

The Commission should finalize the proposed rule titled Amendments to Form 

ADV [Release No. IA-2711; 34-57419]. In finalizing this rule, the Commission 

should consider what, if any, additional information investment advisers should 

include in Part II of Form ADV by consulting with The Office of Compliance 

Inspections and Examinations (OCIE) and the Division of Investment 

Management (IM). Further, the Commission, in consultation with OCIE and IM, 

should consider provisions that would assist OCIE to efficiently and effectively 

review and analyze the information in Part II of Form ADV. 

Recommendation 11: 

The Office of Compliance Inspections and Examinations (OCIE) should develop 

and adhere to policies and procedures for conducting third party verifications, 

such that OCIE verifies the existence of assets, custodian statements, and other 

relevant criteria. 
Appendix V

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Management Comments 

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Appendix V

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Appendix VI

OIG Response to Management’s Comments 

The Office of Inspector General (OIG) is pleased that the Office of Compliance 

Inspections and Examinations (OCIE) agreed with all 11 recommendations in this 

report. We believe that these recommendations are crucial to ensuring that 

necessary improvements are made to OCIE’s process for selecting investment 

advisers and investment companies for examination. 

As the August 31, 2009 OIG Report entitled “Investigation of Failure of the SEC 

to Uncover Bernard Madoff’s Ponzi Scheme” detailed, the SEC Enforcement 

Division (Enforcement) concluded its formal investigation into Harry Markopolos’ 

complaint in 2006, finding that Bernard Madoff Investment Securities, LLP 

(BMIS) acted as an unregistered investment adviser to certain hedge funds, 

institutions, and high net worth individuals in violation of the registration 

requirements of the Advisers Act. The Enforcement staff also found that BMIS’s 

largest hedge fund client, Fairfield Greenwich Group, did not adequately disclose 

to its investors BMIS’s advisory role and merely described BMIS as an executing 

broker to Fairfield Greenwich Group’s accounts. 

The Enforcement staff closed the examination when BMIS agreed to register with 

the Commission as an investment adviser. The Enforcement staff stated that 

BMIS’s investment adviser registration was a “good result” because it would 

expose Madoff and his firm to “extra regulatory scrutiny.” They further noted that 

BMIS’s agreement to register as an investment adviser was “a positive 

development for law enforcement” because BMIS would “be subject to continued 

on-site inspections.” However, despite the accumulated evidence that the SEC 

had regarding Madoff’s misrepresentations and possible fraud, OCIE never 

conducted an examination of BMIS. 

We believe that OCIE should take immediate steps to implement these 

recommendations. We are encouraged that OCIE is acknowledging that 

significant improvements must be made with respect to its processes and that it 

intends to deploy sophisticated technologies to address the issues raised in our 

report. We strongly encourage OCIE and the Commission to make available the 

necessary resources to ensure that OCIE is better able to select investment 

advisers and investment companies for examination and better equipped to 

conduct comprehensive examinations of these entities. The strength of our 

capital markets relies on investor confidence, which in turn depends on vigorous 

regulatory oversight. Investors will only have confidence in our capital markets 

when they believe that the SEC’s oversight is vigorous and competent. Thus, it 

is critical that OCIE take the necessary steps to improve its operations forthwith. 

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Appendix VI

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The OIG plans to follow up to ensure that all 11 recommendations are 

implemented in full and report back to the Congress on the status of these 

efforts. We also plan to conduct a follow-up audit to determine whether the 

changes to OCIE’s operations are having the desired and appropriate effect. 

 
Audit Request and Ideas 

The Office of Inspector General welcomes your input. If you would like to 

request an audit in the future or have an audit idea, please contact us at: 

U.S. Securities and Exchange Commission 

Office of Inspector General 

Attn: Assistant Inspector General, Audits (Audit Request/Idea) 

100 F Street, N.E. 

Washington D.C. 20549-2736 

Tel. #: 202-551-6061 

Fax #: 202-772-9265 

Email: oig@sec.gov

Hotline 

To report fraud, waste, abuse, and mismanagement at SEC, contact the 

Office of Inspector General at: 

Phone: 877.442.0854 

Web-Based Hotline Complaint Form: 

www.reportlineweb.com/sec_oig