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East Setauket firm triggered Madoff probe in 2004

Bernard Madoff walks out of Federal Court after

Bernard Madoff walks out of Federal Court after a bail hearing in Manhattan on Jan. 5. Madoff is now serving 150 years for securities fraud. (January 2009) Photo Credit: Getty Images

Back in 2003, officials at the East Setauket hedge fund firm Renaissance Technologies Llc weren't comfortable with the way Bernard Madoff was doing business.

The company's Meritage fund portfolio manager, Nat Simons, son of founder James Simons, couldn't figure out Madoff's strategy and seemed worried about potential problems.

Renaissance had an investment with Madoff through another hedge fund.

"It's high season on money managers, and Madoff's head would look pretty good above Eliot Spitzer's mantle," Nat Simons said in a company e-mail, referring to New York's then-attorney general.

Other Renaissance officials voiced concerns about Madoff in e-mails that were later examined by the Securities and Exchange Commission.

The Renaissance e-mails ultimately triggered an SEC probe of Madoff in 2004. But the discomfort voiced by Nat Simons and others failed to convince the SEC to take steps to investigate what later turned out to be a massive Ponzi scheme.

Officials at Renaissance, which cut its Madoff investment in half and later got out entirely, declined to comment. The firm's wealthy founder, James Simons, a philanthropist who is generally media shy, has given tens of millions of dollars over the years to Stony Brook University.

The bureaucratic dysfunction that hobbled the SEC in its probe of Madoff was spelled out in a recent 477-page report by the agency's inspector general, H. David Kotz. Inexperienced staff, communication problems, and intimidation by Madoff were issues Kotz explicitly noted as problems for the SEC. His report also suggested that a lack of firm leadership, limited analysis and poor decision making contributed to failure by the SEC. Despite numerous red flags, the SEC lost what Kotz said were excellent chances to stop Madoff.

SEC Chairwoman Mary Schapiro has said she is studying Kotz's findings. She said the agency has beefed up the enforcement division, improved fraud detection by examiners and centralized the handling of tips and intelligence.

The bureaucratic problems that appear to have hindered the SEC aren't unique to the agency. They broadly mirror what happened with other key intelligence failures in U.S. history, such as the Pearl Harbor and Sept. 11, 2001, attacks.

They are in a class by themselves, involving catastrophic losses of life and leading the country into war. But government and academic studies done of Pearl Harbor and 9/11 have noted that some of the same things that Kotz found plagued the SEC - inexperience, poor communications and inability to decipher clues - contributed to the failure to prevent or blunt the attacks.

For Matthew Cronin, assistant professor of management at George Mason University, staff inexperience is a big problem for bureaucracies like the SEC. "If you have somebody who is a novice, their mental model tells them what cues to pay attention to and what not to," said Cronin, who studies group collaboration.

The problem with novices is that they aren't yet molded by experience, said Cronin.

"Novices go into thinking about what they think is important but aren't sensitive to mistakes; [they] don't have a net for catching things that are hard to verbalize," said Cronin.

Dr. William Sparks, associate professor of behavioral science for the McCall School of Business at Queens University in North Carolina, thinks Madoff's larger-than-life "rock star" reputation intimidated inexperienced investigators, who tempered their actions. Kotz said Madoff did try to impress and intimidate junior SEC officials.

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