How the SEC Got in Bed with the Madoffs. Literally.

Inside the twisted loyalties and conflicts that kept Wall Street’s top cop from catching one of the biggest Ponzi schemes in history.

12.16.08 11:35 PM ET

Since the story of Bernard Madoff’s massive Ponzi scheme broke, a recurring theme has been shock over how Wall Street’s top cop—the Securities and Exchange Commission—missed so many red flags. Knowing more about who did the SEC’s investigations makes it all less surprising.

In 1999 and then again in 2004, Eric Swanson, an assistant director in the inspections division of the SEC, was part of the team that examined Madoff’s brokerage firm. During those exams, the SEC team said it found almost nothing wrong, certainly not the fraud that the firm’s chief executive, Bernard Madoff admitted to last Thursday evening, as he sat in the FBI’s New York offices with his one wrist handcuffed to a chair and the other holding a telephone he used to contact his attorney, the famed white-collar lawyer Ira Lee Sorkin.

Madoff sat in the FBI’s New York offices with one wrist handcuffed to a chair and the other holding a telephone he used to contact his attorney.

Swanson doesn’t lead the SEC office in charge of such inspections; Lori Richards has that job. But he is noteworthy for another reason: Swanson married Madoff’s niece, Shana, in 2007, and knew members of the Madoff family well. Shana was the Madoff firm’s compliance counsel, one of the people in charge of making sure the firm played by the rules. The two had met at industry conferences.

In 2006, while at the SEC, Swanson sat on a panel sponsored by the Securities Traders Association, a leading market trade group that deals with regulators and the government over policy issue. Also on that panel was Robert Colby, the head of market regulation at the SEC, and Mark Madoff, Bernard’s son, who worked at the firm as well. Adding another level of intrigue, Swanson’s future and current father in law, Peter Madofff, is in charge of compliance for the Madoff operations. Swanson is now the general counsel for a company called BATs, which is an electronic trading company. As most people on Wall Street know, Bernard Madoff is one of the fathers of the electronic trading business, having been one of the founders of the Nasdaq stock market.

After I broke the story of Shana Madoff's relationship with Eric Swanson Monday night on CNBC, the criticism of the SEC's handling of the case and its conflicts heated up. The following day, SEC chairman Chris Cox launched an internal investigation on how the SEC dropped the ball, despite numerous "credible and specific allegations regarding Mr. Madoff's financial wrongdoing, going back to at least 1999, (that) were repeatedly brought to the attention of SEC staff, but were never recommended to the Commission for action."

I doubt an in-house investigation will do much to satisfy the SEC critics given the size and scope of the scandal and the Swanson-Madoff family connection, which has been a particular source of tension among the many investors who lost big money from the Madoff scam. If you live in New York, you don’t have to look far to find victims. A friend of mine is a member of the exclusive Glen Oaks country club in Long Island, which was one of the pools of wealth the Madoff operations focused on. He told me at least 100 of the club’s approximately 200 members lost money, “I know of at least 10 people who lost $20 to $30 million each,” he said.

He also told me that while Madoff himself may be Public Enemy No. 1, the SEC is a close second. What they can’t understand is how securities regulators ignored at least one letter calling Madoff’s operations a “Ponzi Scheme,” and a slew of red flags –including nearly two decades of uninterrupted positive returns, and an auditor who worked out of a tiny one-man shop in upstate New York. And that’s why, in their view, Eric Swanson’s relationship with Shana Madoff and her family is so significant, and why in my view, the SEC must be replaced by an agency where such ties are disclosed or eliminated.

The SEC as an institution is loaded with conflicts of interest. Former SEC enforcement attorneys are littered across Wall Street. Many others work at big law firms that have lucrative contracts with big Wall Street firms. It’s called the revolving door, and its one of Wall Street’s dirty little secrets: You work at of Wall Street’s regulating institutions, and then graduate to the big bucks on the street a few years later. The dealings between the two sides are hardly adversarial; they appear on panels together; they negotiate regulations, set broad policy and also and most significantly negotiate fines and civil charges the SEC might ultimately bring for violations of securities laws.

I have to say upfront, I have no reason to believe either Shana Madoff, her dad, Peter Madoff, or Swanson himself did anything wrong. So far, my sources close to the investigation say prosecutors are focusing on Bernard Madoff as the sole mastermind of the swindle. Two nights ago, I spoke to Rusty Wing, the attorney for Peter Madoff, who spoke on behalf of Shana. He went to great lengths to point out that Swanson and Shana Madoff were acquaintances during the SEC’s various investigations of the Madoff firm, and weren’t romantically involved until sometime later. A spokesman for Swanson said he “intends to fully co-operate” with the SEC investigation into his relationship with the Madoffs and that “his romantic relationship with his wife began years after the compliance team he helped supervise made an inquiry about Bernard Madoff’s securities operations.”

Lori Richards, Swanson’s old boss, has issued a similar statement on behalf of the SEC stating that Swanson only worked on exams in 1999 and 2004, not a subsequent 2005 examination (in all cases the SEC came up relatively empty handed) and that the “SEC has very strict rules prohibiting SEC staff from participating in matters involving firms where they have a personal interest. Subsequently, Swanson did not work on any other examination matters involving the Madoff firm before leaving the agency."

All of which, I believe, misses the larger point, which goes beyond whether Swanson, Shana Madoff or anyone other than Bernard are responsible for what may be the largest Ponzi in modern history. Conflicts of interest are rarely of the Blagojevich variety—where people in power allegedly demand actual monetary payoffs from people who can benefit from their power. Conflicts of interest are more often much more subtle. In bureaucratic institutions like the SEC they stifle skepticism and impose group think of the sort that people you’re regulating or investigating couldn’t have done anything wrong, because, well, you know them so well.

I’ve seen the SEC in action for so many years. SEC attorneys are by and large good people who want to do the right thing. But they haven’t broken a scandal in years, precisely because the people they’re regulating are often their friends so they’re less inclined to think the worse of people they actually like.

If you don’t believe me, listen to Arthur Levitt, the former SEC chairman talk about Bernard 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."

Later when questioned by the New York Post about whether he was too close to Madoff, Levitt fired back: "I knew Bernie the way I know Sandy Weill (the former CEO of Citigroup) or Tully,” a reference to Dan Tully, the former CEO of Merrill Lynch. “He received no special breaks from the commission."

But that’s exactly my point. Levitt was close to both Weill and Tully—he worked for Weill early in his career, and during his time at the SEC, Weill’s firm was often the focus of some of the most serious scandals in the securities business. As for Tully, Levitt told me on several occasions how much he admired the former Merrill chief, who he appointed to head a commission in the 1990s to reform abuses in the brokerage business. It’s worth noting that the brokerage business, including Tully’s old firm, later violated some of the reforms the “Tully Commission” advocated.

Bernie Madoff found his way onto some of these same commissions as well, where he worked with people like Levitt to develop rules and regulations and became a well known, and well-liked figure. I met Bernie a couple years ago, when I interviewed him for my book, King of The Club, which was about former New York Stock Exchange Chairman Dick Grasso. I liked him as well, but unlike the SEC, I checked out what he was saying.

The solution: Disband the SEC once and for all, and leave the enforcement of securities laws to criminal authorities. If civil fines and actions don’t deter bad behavior, maybe jail time will.

UPDATE: Here's one conflict several NYSE floor traders say I left out of today's column: Eric Swanson participated and supervised the floor-trader investigation during the Grasso and post Dick Grasso era at the NYSE. Those investigations, the allegations of improprieties and the subsequent civil settlements, and plea deals where a couple of specialists went to jail, were one of the key factors in the NYSE losing ground to electronic trading platforms, like the Nasdaq, where Bernard Madoff was chairman, and BATS, where Swanson is now the general counsel. What these traders are saying is that he should have been barred from joining a company that benefitted from his regulatory activities.

In a statement, Swanson's spokesman said: "Mr. Swanson participated and supervised examinations of allegations that specialists were trading ahead of customer orders. As a result of those examinations, several specialist firms publicly settled SEC enforcement actions alleging violations of exchange and SEC rules, and paid millions of dollars in fines and restitution. In addition, the NYSE also publicly settled an enforcement action brought by the SEC for failing to adequately regulate its market."

He declined to comment further.

Charles Gasparino appears as a daily member of CNBC's ensemble. Gasparino, in his role as on-air Editor, provides reports based on his reporting throughout the day and has broken some of the biggest stories affecting the financial markets in recent months. He is also a columnist for Trader Monthly Magazine, and a freelance writer for the New York Post, Forbes and other publications.

Editor’s Note: This article has been updated to reflect the correct spelling of Governor Blagojevich’s name.