After dismissing complaints that might have uncovered Bernard Madoff's $65 billion fraud, the U.S. Securities and Exchange Commission must reform how it reviews tips and conducts examinations, the SEC's internal watchdog said on Tuesday.

SEC Inspector General David Kotz outlined 58 recommendations to overhaul the agency and in particular its compliance unit, where staff made critical mistakes in nearly every aspect of their examinations of Madoff and his business, the report said.

Examiners did not properly plan or conduct their examinations of Madoff, and because of these failures, were unable to discover Madoff's fraud, the report said, referring to the Office of Compliance, Inspections and Examinations.

High on Kotz's list of 37 recommendations for the SEC compliance unit is to create a protocol detailing how staff can identify red flags and potential securities violations based on information gleaned from sources.

In a response to Kotz, the compliance unit said it agreed with the recommendations and noted that some of them would require more funding and resources for the agency.

Madoff, 71, pleaded guilty in March to Wall Street's biggest investment fraud and is serving a 150-year prison term.

Earlier this month, Kotz issued a blistering critique of how the SEC missed numerous red flags, failed to follow up properly on leads and disregarded tips that might have uncovered Madoff's massive investment fraud. Madoff used a Ponzi scheme, in which money from earlier investors is used to pay the later ones, until the fraud collapsed as redemption requests overwhelmed the money available.

That report found that the SEC compliance unit lacked staff with enough expertise to identify signs of fraud and failed to take a closer look at numerous contradictions discovered during examinations. SEC examiners also did not acquire and analyze trading data from an independent source, the report said.

Kotz urged the SEC to require examination staff to verify a sample of transactions with an independent third party.

The recommendations also included some 21 improvements for the SEC enforcement unit, such as creating formal guidance for agency lawyers to evaluate various types of complaints.

The SEC enforcement division said it agreed with the recommendations, and has already made it easier for staff to use subpoenas when investigating cases.

SEC Chairman Mary Schapiro and top agency enforcement and examination officials have publicly apologized for the agency's botched handling of tips about Madoff and have vowed to make sweeping changes.

(Reporting by Rachelle Younglai; editing by Andre Grenon and Matthew Lewis)