Editor's note. This is the book's pivot chapter. The preceding chapters have documented failures — of the Commission (see [sec-oig-509-madoff-investigation]), of the solo auditor (see [fuerman-solo-auditor-red-flag]), of the feeder funds and their operational due diligence (see [clauss-roncalli-weisang-risk-lessons]), and of the affinity networks that absorbed and amplified all of them (see [owens-shores-informal-networks]). Robert J. Rhee's argument is that these are not separate failures. They are a single failure of the corporate bar's education. The chapters that follow — on the net-equity litigation (see [second-circuit-net-equity-madoff]) and on the moral arithmetic of clawback (see [sepinwall-righting-others-wrongs]) — describe the legal aftermath of the collapse Rhee diagnoses here.
Rhee's analytic move, in The Madoff Scandal, Market Regulatory Failure and the Business Education of Lawyers, 35 J. Corp. L. 363 (2009), is to refuse the bad-apple framing. The auditors signed off. The directors of the feeder funds signed off. Counsel signed off. The Commission, after multiple inquiries, signed off. When monitors who are formally independent of one another fail simultaneously and in the same direction, the diagnosis cannot be coincidence. Rhee locates the common cause in the professional formation of the gatekeepers themselves — and specifically in the formation of lawyers, who are the meta-gatekeepers of the disclosure system. The lawyer, in his account, is the actor who certifies that the auditor's letter is in order, that the offering memorandum says what it must say, that the adviser's Form ADV is complete. If the lawyer cannot evaluate the substance of what she is certifying, every downstream check inherits her blindness.
The Disclosure Faith and Its Limits
Since the Securities Act of 1933 and the Securities Exchange Act of 1934, the dominant American answer to fraud has been sunlight. Louis Brandeis's aphorism — that sunlight is the best disinfectant — sits behind § 5 registration, the periodic-reporting regime of §§ 13 and 15(d), and the antifraud rule under § 10(b) and Rule 10b-5, 17 C.F.R. § 240.10b-5. The premise is that markets, once given accurate information, will price securities and discipline issuers. The lawyer's role in that scheme is largely transactional: draft the disclosure, opine on its sufficiency, paper the diligence.
Rhee attacks the premise where it is weakest. Disclosure presupposes a reader who can evaluate what is disclosed. When the product is a split-strike conversion (buying a basket of large-cap equities, selling out-of-the-money index calls, and buying out-of-the-money index puts), the reader needs to be able to do something with volatility surfaces, correlation assumptions, and option pricing models. As the quantitative-finance chapter in this volume demonstrates, an analyst who actually ran the numbers would have seen impossible returns (see [bernard-boyle-split-strike]). The gatekeepers around BLMIS did not run the numbers, in part because nothing in their professional formation told them they had to. Disclosure, in the world Rhee describes, becomes a ritual rather than a constraint: the documents are produced, the boxes are checked, and the substantive question — does this strategy make economic sense? — is left to no one in particular.
This is more than a complaint about complacency. It is a structural argument. If the regulatory philosophy assumes that the market will police itself given information, and if the lawyers and accountants who supply that information cannot themselves evaluate it, the philosophy is hollow at its center. The Investment Advisers Act of 1940, which governs registered advisers and imposes a federal fiduciary duty under § 206, 15 U.S.C. § 80b-6, does not cure the problem. Bernard L. Madoff registered as an investment adviser only in 2006, and even then no one within the gatekeeper class around Bernard L. Madoff Investment Securities LLC ("BLMIS") was equipped to test whether his reported strategy could have produced his reported returns.
A Simultaneous Failure of Gatekeepers
Rhee's second move is to aggregate. The SEC Office of Inspector General catalogues the Commission's specific blunders in Investigation of Failure of the SEC to Uncover Bernard Madoff's Ponzi Scheme, Report No. OIG-509 (Aug. 31, 2009). Other contributors to this volume catalogue the analytic blindness of the quant community, the audit failure at Friehling & Horowitz, and the operational due-diligence collapse at the feeder funds. Rhee assembles them into one observation: the gatekeepers failed simultaneously and in the same direction. Auditors, directors, fund administrators, counsel to the feeder funds, and the federal regulator all deferred to the same surface representations. When that many independent monitors fail in the same way, the diagnosis is not bad luck. It is something closer to a professional culture that has stopped asking substantive questions.
For the lawyer specifically, the failure has a statutory shape. The Sarbanes-Oxley Act of 2002 § 307, 15 U.S.C. § 7245, directed the Commission to impose standards of professional conduct on attorneys appearing and practicing before it, including the obligation to report evidence of a material violation up the ladder to the chief legal officer or audit committee. Rhee's point is that § 307 presupposes a lawyer who can recognize a material violation when she sees one. Where the violation is embedded in the economics of a derivatives strategy rather than in the language of a 10-K, the up-the-ladder duty produces nothing — there is no ladder to climb if no one knows there is anything to report.
What "A Little More Business" Would Actually Mean
The essay's most provocative pages are pedagogical, and they deserve to be read by every law student who plans to practice in or near financial regulation. Rhee, who later wrote Essential Concepts of Business for Lawyers, is not proposing a survey of corporate-finance vocabulary. He is proposing a substantive sequence. Translated into a JD curriculum it would include: financial-statement literacy sufficient to read a balance sheet and reconcile it against a cash-flow statement; basic derivatives — what an option is, what a collar does, how implied volatility behaves; forensic accounting at the level of recognizing related-party transactions, round-trip trades, and unexplained custodial relationships; operational due diligence (ODD) of the kind that a competent feeder-fund counsel would have insisted upon (see [clauss-roncalli-weisang-risk-lessons]); and enough portfolio theory — present value, the capital asset pricing model, the Sharpe ratio — to know when a reported return series is mathematically implausible.
None of this is taught as a doctrinal requirement in most JD programs. A 3L can graduate having mastered the proxy rules without ever having computed a Sharpe ratio. That graduate then enters a securities practice, advises hedge funds, signs no-action letters, and sits across the table from clients whose business she cannot describe in its own vocabulary. Rhee does not argue that business literacy would have stopped Madoff — Harry Markopolos had the literacy and could not get the Commission to act (see [markopolos-no-one-would-listen]). He argues something more limited and harder to refute: a profession that cannot evaluate the substance of what it regulates cannot perform the gatekeeping function the statutory scheme assigns to it.
What the Essay Leaves on the Table
Two tensions in Rhee's argument are worth a student note. The first is the relationship between substantive literacy and professional liability. If lawyers are trained to evaluate financial substance, are they then exposed to a heightened standard of care under state malpractice doctrine, or under aiding-and-abetting theories that the Supreme Court narrowed in Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994), and reaffirmed in Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., 552 U.S. 148 (2008)? A more competent gatekeeper is a more culpable one when she fails. Rhee, supra, at 384, gestures at this without resolving it. The second tension is institutional. Even if every American law school added a required finance sequence tomorrow, the incentive architecture of the gatekeeper professions — fee dependence on issuers, reputational capture, the revolving door at the Commission — would remain. Substantive literacy cannot do its work without accompanying changes to the liability rules and compensation structures that determine when gatekeepers actually use what they know.
Doctrinal Takeaway
For the law-student reader, the doctrinal scaffold of Rhee's argument is the Investment Advisers Act gatekeeping regime: the antifraud and fiduciary duty under IAA § 206, 15 U.S.C. § 80b-6, as construed in SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180 (1963); the custody rule, 17 C.F.R. § 275.206(4)-2, which the Commission tightened in 2009 in direct response to BLMIS's self-custody arrangement; and the compliance program rule, 17 C.F.R. § 275.206(4)-7, which requires a written compliance program and a designated chief compliance officer. The post-Madoff amendments to the custody rule presumed an adviser's counsel who could read a custodial agreement against the realities of a prime-brokerage relationship. That presumption is exactly what Rhee says the legal academy has not earned. The doctrine the next generation of securities lawyers will be asked to administer — including the SIPA net-equity regime taken up in the next chapter (see [second-circuit-net-equity-madoff]) — assumes a fluency that the JD curriculum, as currently designed, does not deliver.