By Pam Martens: October 30, 2013
The trial of five former employees of Bernard Madoff’s Ponzi operation is currently playing out in Manhattan as the U.S. Justice Department weighs bringing charges against JPMorgan Chase, where Madoff had his primary business banking account, for ignoring flashing red lights that a fraud was taking place.
According to lawsuits filed by Irving Picard, the Trustee handling the Madoff recovery fund, JPMorgan knew that Madoff was supposed to be engaged in managing stock portfolios for hundreds of clients. JPMorgan even created structured investments that allowed investors to make leveraged bets on the returns achieved by Madoff. But the Madoff business bank account that JPMorgan Chase oversaw, showed billions of dollars in cash being wired in and out but no payments ever going to any party engaged in processing or clearing a stock trade. Under Wall Street’s Know Your Customer Rule, the activity in the account should have been reported to U.S. regulators because it was completely incompatible with transactions that would be happening in a legitimate investment advisory account.
On October 28, 2008, less than two months before the Madoff Ponzi scheme collapsed following a confession by Madoff, JPMorgan finally did reveal its suspicions to a regulator that Madoff was running a fraud – to the Serious Organized Crime Agency. That regulator is based in the United Kingdom. According to Picard, JPMorgan never reported its suspicions to U.S. authorities.
But there are four other major Wall Street firms and their high-priced lawyers who have some explaining to do. According to prosecutors trying the current case against the five former employees, Madoff was funneling tens of millions of dollars that he was stealing from his investment advisory clients into his broker-dealer operation. Madoff has heretofore said this was a legitimate business. One such check for $31 million was dated December 28, 1999.
That was a little more than three months after Madoff started a business with four of the biggest names on Wall Street, effectively putting these primary dealers to the U.S. government’s Treasury auctions in business with the biggest financial felon in U.S. history.
On September 14, 1999, Citigroup’s Smith Barney, Morgan Stanley, Merrill Lynch and Goldman Sachs partnered with Madoff to compete with the New York Stock Exchange in a venture called Primex Trading. When Wall Street behemoths create a joint venture with a much smaller firm like Madoff’s, it would be expected that the top law firms on Wall Street would have been crawling all over its books and conducting a thorough due diligence.(Major European banks were harmed in the Madoff collapse. No major Wall Street bank had any serious exposure.)
Madoff had purchased the rights to a new technology called Financial Auction Network (FAN) created by Christopher Keith, a 17-year veteran of technology creation at the New York Stock Exchange (NYSE). Keith had retired from the NYSE and started a technology think tank in lower Manhattan in the early 1990s called Exchange Lab. FAN was one of the early technology offerings and the rights to develop it were bought by Madoff, ostensibly with stolen customer funds it now appears. The firm that emerged was Primex Trading, a division of Primex Holdings.
In addition to Keith from the New York Stock Exchange, Primex hired Glen Shipway, the Executive Vice President of Nasdaq, whose duties had included market surveillance of broker dealers. Madoff and his big Wall Street partners told the press that the purpose of the venture was to bring better price execution on stock trades to the investing public. A very different motive was at work.
The real goal for Primex was to legitimize the highly questionable practice of “internalization,” where big Wall Street firms match their customers’ buy and sell orders in house.
On October 29, 2002, the Securities and Exchange Commission (SEC) held a Market Structure Hearing to look at internalization, among other market issues. (We now know from the ongoing Madoff trial in Manhattan that in 2002, Madoff’s business was insolvent, even though he was paying for order flow, i.e., for trades to be sent to his firm.) Below are relevant excerpts from that SEC hearing:
“[Edward] Kwalwasser, [Group Executive Vice President at the NYSE in charge of regulation at the time]: I think we have to look at, from a market perspective, and when we talk about payment for order flow and internalization. The last panel — first panel agreed that one of the characteristics of a National Market System that we all said — who were sitting here said was really good, was that customer orders should be able to interact without the benefit of a dealer. Both internalization and payment for order flow are distortions of that public good that we all agree was there. And, to the extent that those orders aren’t in the marketplace, they’re not helping create the best price for all orders in the marketplace…I never thought Bernie [Madoff] was a bad guy. I started out, however, out of law school representing people in the record industry and in the rock-and-roll part of the business. And to think that the securities industry has a lower code of conduct than the record industry is really, I think, something that I — I never wanted to believe would be part of an industry that I was working at…
“[Bernard] Madoff: …Now, we came up with a — with a system, and joined in partnership with — with four of the largest firms that exist today in — in the United States and NASDAQ, to build a system that — that achieves that. I won’t mention the name of the system because this is not to be a marketing effort.
“[Robert] COLBY [SEC]: Primex System.
“[Bernard] Madoff: But — but, basically, the concern that all of these firms had was that they wanted to internalize their order flow, but they all very fully realized that the danger of having these various pockets of liquidity not visible to everybody and not allowing orders to interact, this was a problem unto itself. And even though that may be what a lot of people would like to do, if you — if you degrade the market in such a way that you really don’t do what you’re supposed to do for the investor, then you really have no marketplace, anyhow. So we went about building this type of system that would allow firms to internalize their order flow, allow orders to interact with limit orders, and to do it anonymously…”
In the end, the Primex idea failed. Nasdaq licensed the Primex Auction System and ran it for two years before abruptly shutting it down on January 16, 2004. Madoff was left with just his Ponzi scheme and a third market operation facing competition from every direction.
Below is the timeline of the Wall Street big boys’ venture into a trading scheme with Madoff:
September 14, 1999: Mainstream media report that Citigroup’s Salomon Smith Barney, Morgan Stanley, Goldman Sachs, and Merrill Lynch are investing alongside Bernard L. Madoff Investment Securities as partners in Primex Trading.
March 31, 2000: Primex announces that the NASD, parent of Nasdaq, has approved moving forward with its agreement to license the Primex Auction System for U.S. equities.
December 17, 2001: Nasdaq begins operation of the Primex Auction System with trading limited to the 30 stocks of the Dow Jones Industrial Average.
January 7, 2002: Nasdaq adds the stocks in the S&P 100 to the Primex Auction System.
January 22, 2002: the Nasdaq 100 stocks are added to the Primex Auction System.
March 3, 2003: Nasdaq announces that the SEC has given permanent approval to the Primex Auction System.
December 31, 2003: Nasdaq announces that it will cease offering the Primex Auction System, effective January 16, 2004.