How To Prevent Another Madoff Scandal
Can a broken SEC ever be fixed? Probably not.
The SEC does not have a consumer focus. Its enforcement model that focuses only on disclosure is outdated. The SEC does not rule on the probity of an investment just if all the risk factors were disclosed. Industry members joke that a prospectus for a Ponzi scheme would pass inspection as long as the scam was fully was disclosed.
The enforcement staff of the SEC seems to be afraid of their own shadow. I suspect that they were afraid to go after Bernard Madoff because of his stature on Wall Street as former chairman of the NASDAQ exchange. A rule recently implemented makes it necessary to clear enforcement actions against prominent individuals with the top of the totem pole of the SEC. This is another barrier to getting the job done.
As has been widely reported in the press, Harry Markopolos, a derivatives trader, began writing the Boston office of the SEC in 1999 to warn them about Madoff’s asset management business. In response to being informed of the huge size of Madoff’s money management business, the SEC did nothing except require that he register the operation.
Ironically, this might have helped him more than hurt him. The registration made his business more legitimate in certain people’s eyes. Some investors mistakenly have thought buying a registered hedge fund affords them similar protection to SIPC (Securities Investor Protection Corporation) and FDIC (Federal Deposit Insurance Corporation).
Most investors do not understand how lax the SEC registration process for a fund is. It is done on an honor system without even a perusal of the person registering by SEC staffers. They do not even Google new registrants. I uncovered a case of a principal of a SEC registered hedge fund that had 10 criminal violations in his native England. The SEC attorneys told me that they are not authorized to place an international call to the police in England to verify this person.
The SEC audit no longer serves to protect the consumer but has become a search for the picayune. Even though the SEC audited him twice, they incredibly did not uncover the Ponzi scheme of Madoff Securities. They only found petty violations of arcane securities law.
That is pretty much typical of the work of the SEC. The chief compliance officer of a securities firm in Florida recently told me that the SEC spent half a day of the audit of his firm verifying that the firm’s payments of cell phone bills was for employees of the firm not customers. Although there is a SEC rule that forbids all but minimal payments to customers, the SEC effort appears to be bogged down in minutiae. They are unable to see the forest through the trees.
As someone who as dealt with the Boston office of the SEC twice, I can echo Markopolos’s experience. The SEC office in Boston would not take my complaint about the criminal hedge fund principal, so I referred the case to Secretary of State of Massachusetts William Galvin. The authorities in Massachusetts closed down the hedge fund and are in the process of recovering the $34 million dollars in assets that was misallocated. One principal paid a fine of over $1 million and the other is still fighting the case.
The SEC later joined the enforcement action and apologized for not listening to me, but that is not good enough. It would be wonderful if a Financial Consumer Safety Commission was established.
At the very least, all of the enforcement agencies of the securities and banking industry need to be combined into one agency with a greatly expanded budget and a new mission to help the consumer.
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Laura Goldman worked on Wall Street for 25 years for such firms as Merrill Lynch and Paine Webber. She now owns her own money management firm, LSG capital, in Tel Aviv, Israel.
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15 Comments
1. AL:I am 300% sure that simple enforcement of existing legislation would stop this scum in first year of operation. New, more restrictive legislation will damage more 10 000 law abiding businesses, rather than stop some fraudsters who spit on the law with decades of impunity from authorities. Naked shorting, anyone?
Jan 16, 2009 - 3:07 am 2. Sidney Raphael:The proposal to establish a government investor safety commission sounds an awful lot like proposals to regulate guns. That is, honest investment vehicles will have all sorts of complicated, onerous, expensive stumbling blocks placed in front of them, while shady groups will slither through loopholes and blind spots in the government regulatory scheme. The result will be that plenty of shady operators will find ways to get onto the market, while honest investment vehicles will be hobbled.
Does the writer of this proposal actually think new laws will will sanitize the human tendency to finagle finances? Who will the author put in charge of her scheme? Charles Rangel?
Jan 16, 2009 - 8:51 am 3. Kurt Brouwer:Laura:
My reason for commenting on this is quite simple. I have noticed a lack of clarity as to why — or more importantly — how it could have happened.
We do not need the SEC to unearth a scheme like this one. There is a simple rule that investors can follow and I believe they will avoid these schemes and that is, have an independent custodian for your assets.
This investment fraud was made possible chiefly because investors with Madoff did not have an independent custodian for the assets entrusted to his firm. If there had been an independent custodian, I think the scheme would never have been possible. For example, it appears that Madoff did not make the trades in clients accounts that he claimed to have made. If those clients had an independent custodian, they would have seen their account holdings and transactions on the statement. If Madoff claimed to have made a given trade, but it never hit the client’s acount, a serious red flag would have been raised. Also, the returns he claimed were exaggerated. If clients were receiving accurate statements from the custodian, they would have known his performance claims were false.
Jan 16, 2009 - 8:51 am 4. Barry:The tools of enforcement are there but you will never overcome the temptation of greed, of both criminals and “victims”.
Jan 16, 2009 - 8:59 am 5. David S:The SEC has been hobbled by Bush. Under Obama, heads will roll, improvements will be made, and prosecutions will increase. No need for additional bureaucracy – we just need to use the one we have.
DS
Jan 16, 2009 - 11:50 am 6. Laura Goldman:I agree with the importance of an independent custodian and administratior. That is why I did not invest in Madoff in the first place.
Jan 16, 2009 - 12:23 pm 7. thegre8_1:Maybe, the SEC should mandate that, but I do not think it ever will.
My whole point is that the SEC needs to be set on fire and be rebuilt from the ground up. It needs to be staffed with market professionals not lawyers.
Put Jim Cramer or Larry Kudlow in charge of the SEC if you want reform.
Jan 16, 2009 - 1:36 pm 8. Fat Man:“Under Obama, heads will roll, improvements will be made, and prosecutions will increase.”
Clearly satire or the author has not been paying attention, PEBO nominated an SEC lifer to be the chairman. She will do nothing different than what has been done before. That is why she was nominated.
The staff cuts are because the SEC’s cheif source of fees — IPO prospectuses and merger proxies are way off and they don’t need the people who spent their time reviewing such documents.
Jan 16, 2009 - 7:39 pm 9. Jim:Madoff did not perform this huge fraud over decades without help from lots of people-employees, family members, auditors, et al. Why didn’t any of them turn him in? The fact is, no one likes a whistleblower. If the SEC offered lucrative rewards, bounties and prosecutorial immunity in exchange for hard evidence on fraudulent activities, Madoff would have been exposed years ago.
Jan 17, 2009 - 4:49 am 10. Knights13:Madoff has become the picture boy of fraud for this year. There are many like Madoff working overtime as we speak.
Jan 18, 2009 - 3:55 pm 11. paparay:Laws, regulations out the whazoo! This will not stop the scoundrels. The only way to protect society is to eliminate them. String ‘em up! Quickly and publicly. Imagine, the jerk sits in his penthouse under “house arrest” while the lawyers fix the game for him. As a former chief of police in LA said once, “you don’t kill a rabid dog to teach other dogs not to go rabid, you do it to protect society.” I know for sure that if you or I stole even $1,000. we would be in jail. He should be also. Oh sure #5, blame it all on Bush. Where was Queen Frank, Dodd, et al, while all this was going down?
Jan 18, 2009 - 5:13 pm 12. Burke:I agree with Mark Cuban, and for this matter, SEC’s own chairman Christopher Cox, that the cure to our ailings is more transparency. And transparency, or at least a significant step towards transparency, can be achieved through the use of well defined and open-source standards, like XRBL, that would allow for instant checks and balances, detailed statistical analysis and comparisons, for the sake of audit efficiency and accuracy. Anomalies would be much easier to spot, as would the use of cooked-up software like the one Madoff probably used. What’s more, XRBL could allow unprecedented public scrutiny over government spending.
I’m basically parotting Cuban here, so for the real deal:
Jan 19, 2009 - 6:01 pm 13. Jim:http://blogmaverick.com/2008/12/16/the-sec-madoff-and-xbrl/
I believe that the Peoples Republic of China has the death penalty for fraud. Surely there must be some Chinese bank or investor that was robbed by Madoff. If that is the case, he can be extradited to China for trial and execution. I understand they sell body parts of executed criminals. Perhaps the Chinese can sell his body parts on Ebay to help recover money for compensation of victims. I bet Madoff’s gall would fetch a real good price:)
Jan 19, 2009 - 6:31 pm 14. Jim:C’mon Burke! Do you really think the use of XBRL would have caught Madoff? His two man (very small for a large hedge fund) audit firm deliberatly helped Madoff maintain the fraud. Any junion auditor, still wet behind the ears, could of figured this out. Bernie’s auditors will be going to jail with him.
Jan 19, 2009 - 6:36 pm 15. Burke:Jim,
I don’t think XRBL is a miracle solution, but I sure think it would have made it so much more difficult for him to cook his books and last that long. Of course, I know no other hedge fund had been able to retroactively replicate his results, which in itself was a good reason to investigate him. And as we know, the SEC has declined investigating his operations multiple times. But the use of an open-source standard like XRBL, and possibly the introduction of legislation warranting mandatory online statements for all financial products, would allow for better client vigilance, and the development of very sophisticated analysis tools. Of course, any client willingly participating in a very secretive and shady operation, is only begging to be defrauded, or for their money to be used for unlawful purposes. Transparency is a two-way street…
That said, I agree his audit firm should join him in jail, as should the software programmers who provided technical support for his scam, and other complicit employees. I’m still baffled that it was his sons who finally denounced him. No whistleblower at Madoff’s…
Jan 20, 2009 - 12:28 pm