Sept. 2 (Bloomberg) -- The U.S. Securities and Exchange Commission repeatedly missed chances to catch Bernard Madoff’s $65 billion fraud over 16 years by assigning inexperienced investigators and accepting “implausible” explanations after catching him in lies, the agency’s internal watchdog said.

At least six warnings from sources including a money manager, a “respected hedge-fund manager” and a firm that studied Madoff’s business failed to spur a “thorough and competent” probe, Inspector General H. David Kotz wrote in a summary of a report released today. Madoff, in an interview with Kotz, said even he “was astonished” when investigators failed to check trading records that would have exposed his scam.

“Despite numerous credible and detailed complaints, the SEC never properly examined or investigated Madoff’s trading and never took the necessary, but basic, steps to determine if Madoff was operating a Ponzi scheme,” Kotz wrote.

The report is the most exhaustive look yet into the SEC’s failure to detect a fraud that spanned decades and burned thousands of investors, including universities, charities and affluent clients. Lawmakers crafting a regulatory overhaul have awaited Kotz’s findings since agency officials rebuffed questions at hearings in January and February, citing the continuing Madoff inquiry.

Kotz, in the 22-page summary, said he didn’t find that senior SEC officials tried to improperly influence or interfere with inquiries. Nor did he find that an SEC employee’s romantic relationship with Madoff’s niece had any affect on the agency’s examinations. The full 451-page investigative report includes more than 500 exhibits, according to his office.

‘Lessons Learned’

“It is a failure that we continue to regret, and one that has led us to reform in many ways how we regulate markets and protect investors,” SEC Chairman Mary Schapiro said in a statement, adding that the agency is overhauling its enforcement and inspection units and reforming how it handles tips. “We have been reviewing our practices and procedures, addressing shortcomings, and implementing the lessons learned.”

Madoff, 71, is serving a 150-year prison sentence after pleading guilty to a fraud that federal investigators said dated to at least the 1980s. The scam funneled funds from new clients to pay returns that were purportedly generated by a stock and options trading strategy known as a split-strike conversion. SEC investigators have said Madoff and employees at his New York- based firm, Bernard L. Madoff Investment Securities LLC, used a variety of ruses, such as creating sham trading records, to avoid detection.

SEC Chairmen

Kotz faults the agency’s efforts since 1992, a period that spanned the tenure of five SEC chairmen, Richard Breeden, Arthur Levitt, Harvey Pitt, William Donaldson and Christopher Cox. Levitt, the only Democrat among the five, is a board member of Bloomberg LP, the parent of Bloomberg News.

In June 1992, the agency was alerted to an investment firm that was raising funds by selling unregistered securities and funneling the money to Madoff, who purportedly managed it. An “inexperienced” team of investigators focused on the fundraisers, ignoring “red flags,” such as Madoff’s suspiciously consistent returns, Kotz said.

Another chance came in 2000, when former money manager Harry Markopolos approached the SEC with an eight-page report, suggesting that Madoff’s purported returns weren’t possible. At a congressional hearing in February, Markopolos described years of frustration in dealing with the agency’s “investigative ineptitude and financial illiteracy,” saying the agency repeatedly refused to look into his warnings.

‘Inexperienced Staff’

In that case, Kotz wrote, “the relatively inexperienced enforcement staff failed to appreciate the significance of the analysis in the complaint, and almost immediately expressed skepticism and disbelief.” Though investigators soon caught Madoff in lies, they failed to look into inconsistencies and accepted his explanations. They also rebuffed Markopolos’s offer to provide more evidence, and remained “confused about certain critical and fundamental aspects of Madoff’s operations.”

In May 2003, a hedge-fund manager presented the SEC with another series of “red flags” that his fund had identified while performing due diligence to two so-called feeder funds that invested with Madoff, Kotz wrote.

That time, the SEC’s examinations office appointed a Washington-based group of brokerage inspectors, rather than staff who specialize in examining money managers, according to the report. The team focused on whether Madoff was front- running, or trading ahead of client orders. When the leader was asked why, he said “that was the area of expertise for my crew,” Kotz wrote in the report.

Mutual-Fund Focus

The examiners discovered that Madoff’s money management business dwarfed his market-making operations, Kotz said. They failed to collect trading data before they were “abruptly” instructed put the review on the backburner and focus on mutual- fund issues then making headlines.

About the same time, a New York-based SEC examiner stumbled onto a cache of e-mails while inspecting another firm, providing “a step-by-step analysis” that cast doubt on Madoff’s reported options trading. A team formed, and again focused on front- running. When they asked Madoff about his options trades, he said that was no longer part of his strategy.

“Madoff made efforts during the examination to impress and even intimidate the junior examiners from the SEC,” Kotz noted. One of the examiners “characterized Madoff as ‘a wonderful storyteller’ and ‘very captivating speaker,’” he wrote. Another examiner said Madoff “would repeatedly drop the names of high- up people in the SEC.”

New Laws

U.S. Representative Paul Kanjorski, a Pennsylvania Democrat and head of the House Financial Services capital markets subcommittee, said the report will guide efforts to revamp financial regulation.

The case “highlights the need to adopt new securities laws to reward internal and external whistleblowers,” Kanjorski said, adding that revisions should be made to increase the money recovered by defrauded investors.

Kotz’s report “reminds us how essential it is that we improve both financial regulation and the competence of the regulator,” said Senate Banking Committee Chairman Christopher Dodd, a Connecticut Democrat whose committee oversees the SEC. Dodd’s panel will hold a hearing on Sept. 10 about ways to “modernize financial regulations,” he said.

Madoff’s scheme unraveled in December as he struggled to meet mounting investor withdrawals. Days after Madoff’s arrest, the SEC chairman, Cox, faulted staff for failing to act on “credible and specific allegations” about the operation for at least a decade.

Recommendations Readied

Kotz told Congress he will issue recommendations this month for improving the SEC’s oversight and inquiries. The review was requested by Cox before he stepped down as chairman in January.

Schapiro, who took the SEC’s helm seven weeks after Madoff’s arrest, has focused on overhauling the agency. She repealed policies blamed for slowing investigations, hired an outside firm to create a system for screening tips about misconduct and appointed Robert Khuzami, a former federal prosecutor to oversee enforcement.

Khuzami last month announced the unit’s biggest reorganization in at least three decades, aimed at speeding investigations and honing expertise. The overhaul will leave fewer management layers, more front-line investigators, and at least five specialist teams focused on emerging and complex areas of the market. The SEC is also taking steps to make it easier for investigators to issue subpoenas and reward people for aiding probes.

The criminal case against Madoff is U.S. v. Madoff, 09-cr- 213, U.S. District Court, Southern District of New York (Manhattan).

To contact the reporter on this story: David Scheer in New York at dscheer@bloomberg.net.

Last Updated: September 2, 2009 17:35 EDT