Jan. 5 (Bloomberg) -- U.S. lawmakers, critical of the Securities and Exchange Commission’s failure to uncover Bernard Madoff’s alleged $50 billion fraud, demanded the agency speed up an internal investigation of its missteps to help in their overhaul of market regulations.

The SEC must report what happened, “so we can do our jobs and make sure the laws and authorities are in place to see that this never happens again,” said Paul Kanjorski, chairman the House subcommittee overseeing capital markets, at a hearing in Washington today. “Our regulatory system has failed miserably and we must rebuild it.”

SEC Inspector General H. David Kotz said his staff will issue reports on a “rolling basis” within months as it examines how inspections and probes involving Madoff since 1992 overlooked what may be the biggest Ponzi scheme in history. Madoff, 70, was charged Dec. 11 with securities fraud after allegedly telling his sons his business was “one big lie.”

The hearing is the first in a series of congressional forums this year to close regulatory “loopholes” and consider whether market watchdogs need additional authority or funding, Kanjorski said. Lawmakers including Ron Paul, a Texas Republican and unsuccessful presidential candidate in 2008, said the SEC’s oversight of Madoff shows it should be scaled back or eliminated. At times, frustrations flared.

“Who is responsible for protecting the securities investor, because I want to tell that person that they suck at it,” said Representative Gary Ackerman, a New York Democrat. “This is a spike in the heart of the investment community that makes America run.”

Senate Demand

Senate Banking Committee Chairman Christopher Dodd and Senator Richard Shelby, the panel’s top Republican, said they would conduct their own examination. Dodd, a Connecticut Democrat, and Alabama’s Shelby sent a letter to SEC Chairman Christopher Cox today requesting copies of all complaints the SEC received, reports on investigations and internal e-mails that mentioned Madoff or his firm. They set a Jan. 22 deadline.

Kotz said the internal inquiry will examine how Madoff’s status, developed while sitting on SEC advisory committees, leading Securities Industry Association panels and serving as chairman of the Nasdaq Stock Market, “may have affected commission decisions regarding investigations, examinations and inspections of his firm.”

There may have been “some complicity with the SEC,” said U.S. Representative David Scott, a Georgia Democrat. Investigators need to “get the heads of the people at the SEC that allowed this to happen. That needs to be the first order of business.”

Agency Resources

Kotz told the House committee the internal review will also consider whether the agency’s enforcement division and Office of Compliance Inspections and Examinations need more resources or whether additional funds would be wasted. His staff will seek documents, interview agency officials and review e-mails from current and former staff members, the inspector general said in his testimony. He set Jan. 16 for SEC enforcement and examinations units to deliver relevant records.

The inspector general’s office has scheduled an interview this month with Harry Markopolos, a former money manager who says he sent the SEC a 19-page document in November 2005 alleging that Madoff’s firm was a fraud.

Cox called for the internal review on Dec. 16 after saying the agency failed to act on “credible and specific allegations” of wrongdoing by Madoff dating back to at least 1999. The enforcement staff never recommended commissioners take action against Madoff, he said.

‘Structural Faults’

“No one should infer from this terrible situation that the working personnel of the SEC were at fault,” House Financial Services Committee Chairman Barney Frank said at today’s meeting. “There were some structural faults here.”

Markopolos, 52, the former chief investment officer at Rampart Investment Management in Boston canceled his appearance because he was “worn down” and wanted more time to prepare his remarks, Frank said. The former money manager now investigates financial frauds for institutional investors.

Madoff hasn’t formally responded to the charges or entered a plea. His clients included banks, hedge funds, charities, universities and wealthy individuals. They had about $37 billion with Bernard L. Madoff Investment Securities LLC, according to a Bloomberg News tally of disclosures and press reports.

“We conducted our affairs in good faith in the belief that the SEC would never allow this sort of scheme to be conducted,” Allan Goldstein, 76, a retired textile entrepreneur who began investing with Madoff in the 1980s, told lawmakers at the hearings. “I believe my government has failed us and we have suffered tragically as a result.”

Previous Investigations

The SEC’s investigators had a brush with Madoff in 1992 while suing two Florida accountants for allegedly selling $441 million in unregistered securities. The regulator, then headed by Republican Richard Breeden, said the accountants began raising money in 1962 and placing it with Madoff while promising investors returns of 13.5 percent to 20 percent, according to court documents obtained by Bloomberg.

Auditors hired to unravel the case asked Madoff for copies of account statements, which he provided, the records show. He wasn’t accused of wrongdoing.

Markopolos raised his concerns with an examiner in the SEC’s Boston office in 2000, saying that Madoff’s returns were too good to be true, and pressed the agency to scrutinize Madoff’s business until last year, the Wall Street Journal reported Dec. 18. In the document, sent to the SEC three months after Cox became chairman, Markopolos laid out a list of “red flags,” and claimed Madoff must either be trading ahead of client orders, a practice known as front-running, or, more likely, running the world’s largest Ponzi scheme.

Front-Running Focus

SEC investigators in New York, where Madoff’s firm is based, focused on front-running, and after encountering obstacles didn’t finish verifying trades Madoff said were for advisory clients, a person with knowledge of the agency’s efforts said last month.

His company’s trades were cleared through a single account at Depository Trust & Clearing Corp., making it difficult to distinguish transactions specifically for Madoff’s advisory business, the person said.

Some transactions were completed through foreign brokerages, which meant the agency would have had to persuade other regulators to collect the data. Instead, SEC investigators closed the case in 2007 after Madoff agreed to register his investment advisory business.

“What we may have in the Madoff case is not necessarily a lack of enforcement and oversight tools, but a failure to use them,” said Representative Spencer Bachus, top Republican on the House committee. The failures to detect the suspected fraud do not yet warrant “broad new legislative or regulatory mandates on the rest of the securities industry,” he said.

To contact the reporter on this story: Jesse Westbrook in Washington at jwestbrook1@bloomberg.net; David Scheer in New York at dscheer@bloomberg.net.

Last Updated: January 5, 2009 18:52 EST