Dec. 15 (Bloomberg) -- U.S. regulators never inspected Bernard Madoff’s investment advisory business, alleged to be a Ponzi scheme that cost investors $50 billion, after he subjected it to oversight two years ago, people familiar with the case said.

The Securities and Exchange Commission hadn’t examined Madoff’s books since he registered the unit with the agency in September 2006, two people said, declining to be identified because the reviews aren’t public. The SEC tries to inspect advisers at least every five years and to scrutinize newly registered firms in their first year, former agency officials and securities lawyers said.

Madoff, 70, who had advised the SEC how to regulate markets and donated regularly to politicians, was arrested Dec. 11 and charged with operating what he told his sons was a long-running Ponzi scheme in the New York-based firm’s business advising rich people, hedge funds and institutions. His ability to avoid detection may fuel debate about the SEC’s effectiveness and the adequacy of its resources for policing money managers.

“Given what the SEC claims is the magnitude of the fraud, this is something you would hope an inspection would have uncovered,” said Mercer Bullard, a University of Mississippi law professor and former mutual-fund attorney at the SEC. “It’s hard to imagine a fraud of this alleged size not being accompanied by significant and pervasive compliance problems.”

Unregistered Business

Federal officials investigating Madoff have found evidence he ran an unregistered money-management business along with his firm’s brokerage and investment-advisory units, said two people familiar with the matter who declined to be identified because the probe isn’t public. Madoff had kept his firm’s financial statements under lock and key and was “cryptic” about its advisory activities when discussing them with employees, the SEC said in a lawsuit against him last week.

Authorities are examining why Madoff’s wife, Ruth Madoff, is listed on transactions under scrutiny, the people said, emphasizing they haven’t determined that she or other people did anything wrong.

Madoff is scheduled to appear in federal court in Manhattan at noon on Dec. 19 for a hearing in the SEC case, according to his lawyer, Ira “Ike” Sorkin, of Dickstein Shapiro LLP in New York.

“This is a tragedy,” said Sorkin, a former U.S. prosecutor and SEC enforcement lawyer. “We are going to fight through these events and try to minimize the losses as much as possible.”

The Inspectors

The SEC’s Office of Compliance Inspections and Examinations deploys teams from Washington and 11 regional offices to scout for fraud and gauge brokerages and investment managers’ adherence to securities laws. Its roster of full-time employees peaked at 880 in fiscal 2006, according to agency budget requests. The regulator expects to have 796 full-time workers in its inspections office for the fiscal year ending next September.

SEC inspectors examined Madoff’s brokerage in 2005, finding three violations of so-called best-execution rules, which require that customer trades be made at the most advantageous prices, agency spokesman John Nester said in a Dec. 12 statement. The SEC’s enforcement division completed an investigation involving the company last year without bringing a claim, Nester said.

The SEC opened that inquiry after tipsters and press reports said Madoff’s purported investment returns may have resulted from front running, in which traders buy shares for their own account before filling customers’ orders, a person familiar with the inquiry said. The agency found no evidence that the brokerage did anything improper, the person said.

Florida Accountants

More than a decade earlier, in 1992, Madoff faced regulatory scrutiny as part of a lawsuit the SEC brought against two Florida accountants, whom it accused of raising $441 million while selling unregistered securities over three decades, according to SEC statements and a press report at the time.

Madoff told the Wall Street Journal at the time that he had managed the funds unaware they had been raised illegally. The SEC determined that the investors’ money was all accounted for, and didn’t accuse him of wrongdoing, according to the report.

Sixteen years later, on Dec. 11, the SEC and U.S. prosecutors announced in federal court in Manhattan that Madoff had confessed. His advisory business was “all just one big lie,” Madoff had allegedly said. The business had been insolvent for years, with losses of more than $50 billion, according to the SEC’s account of his statement. Madoff delivered the confession to his sons, Mark and Andrew, who turned him in, according to Martin Flumenbaum, a lawyer representing the brothers.

Untangling the Mess

On the morning of Madoff’s arrest, more than a dozen SEC inspectors assembled at his office in Manhattan and have since worked overtime to untangle the mess. Though some investigators initially thought the $50 billion total was too high, they now see it as plausible, people familiar with the matter said. The increasing tally is still below that, one person said.

“It’s a very high priority,” SEC Enforcement Director Linda Thomsen said today of the Madoff case at a news conference in Washington. She defended the agency’s record, saying “if you look at all we’ve done, we follow the evidence where it leads and we bring as many cases as we can to protect investors.”

The Securities Investor Protection Corp. announced today that it is liquidating Madoff’s brokerage and named Irving Picard, a lawyer at Gibbons PC in New York, trustee to return cash and securities to customers. While the Washington-based SIPC provides as much as $500,000 in insurance for any missing money in individual brokerage accounts, it does not protect against investment losses.

‘Wouldn’t Surprise Me’

Such a large Ponzi scheme -- in which early investors are paid with money raised from subsequent victims -- should prompt lawmakers to review how the U.S. polices brokerages, wealth managers and unregistered advisers, such as hedge funds, said James Cox, a securities law professor at Duke University in Durham, North Carolina.

“There are just so many people out there who are and aren’t registered that it really just overwhelms the system,” Cox said. “There is no easy way to expand the regulatory net unless we’re willing to put the might of the federal budget behind it to carry out more inspections.”

Barry Barbash, a former head of the SEC’s investment management division, said the agency has tried to focus its inspections on money managers who pose the biggest risks. The regulator uses criteria such as which securities a firm is buying and who its clients are, said Barbash, a partner at Willkie Farr & Gallagher LLP in Washington.

“Given the state of SEC resources and given the way that they go about determining whether an inspection is necessary, it wouldn’t surprise me that a newly registered firm wasn’t inspected,” Barbash said. Willkie Farr is the primary outside counsel to Bloomberg L.P., the parent company of Bloomberg News.

Campaign Donations

Any suspicions about Madoff may have been damped because of his association with industry groups, watchdogs and politicians.

He sat on a committee of academics, regulators and executives formed in 2000 by former SEC Chairman Arthur Levitt to advise the agency on new stock-market rules in response to the growth of electronic trading. Madoff has led the trading committee at the Securities Industry Association, Wall Street’s biggest trade group, and served as chairman of the Nasdaq Stock Market.

Since 2000, he has given at least $100,000 to the Democratic Senatorial Campaign Committee and more than $23,000 to the party’s candidates, including Senator Charles Schumer of New York and Senator Frank Lautenberg of New Jersey, who leads a charitable foundation that invested with Madoff.

“You can see where people would pull the shades down over their eyes in terms of recognizing what could be one of the great frauds of our time,” Levitt said in a Bloomberg Television interview. “I’ve known him for nearly 35 years, and I’m absolutely astonished.”

Levitt is a senior adviser to the Carlyle Group and a board member of Bloomberg LP.

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

Last Updated: December 15, 2008 18:39 EST