Why The SEC Missed Madoff

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Why The SEC Missed Madoff
Liz Moyer, 12.17.08, 06:00 PM EST
SEC investigators were duped by Madoff, too. Can Wall Street's fuzz get its own house in order?

The SEC's fiscal year 2008 authorized spending budget: $906 million.

The estimated financial toll from the alleged Madoff swindle: $50 billion.


The price of regulatory reform? At this point, probably worth the money.

As details continue to emerge in the prosecution of brokerage chief Bernard Madoff's alleged $50 billion Ponzi scheme, the Securities and Exchange Commission has gone on the defensive.

Critics have long argued that the agency, which sees enforcement of federal securities laws as its primary mission, lacks the teeth to stop financial fraud in its tracks and should be abolished or fundamentally changed.

SEC Chairman Christopher Cox said Tuesday and again on Wednesday that the agency would investigate its own failure to investigate Madoff. The SEC had been tipped as early as 1999 that Madoff, a former Nasdaq chairman and fixture on Wall Street for decades, was running his private investment vehicles as a Ponzi scheme. The SEC sent examiners to the firm twice, including an enforcement team last year, but came up with nothing.

Worse, since no subpoena power was requested, the SEC conducted its investigations with documents provided by Madoff, and now it appears he kept an extensive collection of books and false records, Cox said Tuesday.

Cox can't even guarantee that there aren't more problems like this Madoff scheme out there. "We say that a rising tide lifts all boats," Cox said at a press conference Wednesday. "When the economic tide goes out, some of the skeletons that wash up on shore are Ponzi schemes such as this one. So one of the ways that these things are unhappily discovered is the roof falls in because of market conditions. "

The Madoff Ponzi


That addresses one of the key criticisms of the SEC, a 70-year-old agency established by President Roosevelt in the 1930s in response to the market abuses that preceded the Crash of 1929: It is reactionary.

"They fell asleep at the switch and it won't be the first time," says Anthony Sabino, a law and business professor at St. John's University.

Sabino says the SEC needs 25% more money and a lot more resources to do its job. "They are the most underfunded agency in the federal system," he says.

So far this year the SEC has endured withering criticism of its failure to keep tabs on the liquidity positions of major investment banks and its monitoring of trading abuses like naked short-selling. Now it has stumbled on another core competence: fraud detection.

In its annual report, the SEC cites 671 enforcement actions in fiscal year 2008. Insider trading actions increased 25% and market manipulation actions increased 45%. Between 2004 and 2008, the SEC has ordered $12.9 billion of penalties and disgorgement.

The largest group of its 3,500 employees is assigned to enforcement (1,169), after that compliance (807) and corporate finance (175). More than half the budget, $595 million, was spent on enforcing compliance with federal securities laws, the annual report says.

Madoff, a 70-year-old investment adviser who also heads a market making brokerage firm, was arrested last Thursday and charged with fraud in a scheme that has left hundreds of wealthy and seemingly sophisticated investors, including charities, with nothing.

Already, lawmakers are lining up to schedule the inevitable hearings into why no one picked up on the fraud before now, especially since the SEC admits it had compelling evidence since at least 1999 that something wasn't quite right at the firm Bernie Madoff ran.

Paul Kanjorski, a Pennsylvania Democrat, is one of them. On Wednesday he promised hearings in January on the matter by the House Financial Services Subcommittee. "Before we act on legislation in the 111th Congress to restructure the regulatory system for the financial services industry and enhance investor protection, we need to understand how Mr. Madoff organized his many business operations and how he perpetrated these frauds," Kanjorski said.

On Thursday, President-elect Barack Obama is expected to announce his nominee to lead the SEC. Late Wednesday, the Wall Street Journal reported that his appointee is Mary Schapiro, now chief executive of the Financial Industry Regulatory Authority, Wall Street's non-governmental watchdog.

An Obama transition team spokesperson would say only that "no announcement has been made." But Schapiro would seem an apt choice. She's a former SEC commissioner (and former acting chairman) and was chair of the Commodity Futures Trading Commission under President Clinton.

The Madoff scandal has renewed calls for reform at the SEC, but Cox won't be there to implement them--he's made it clear that he'll step down at the end of the current administration.

Next year was setting up to be a year of debate on how to overhaul regulation of the financial markets. In releasing its blueprint for future regulatory reform in March 2008, the Treasury Department advocated eventually merging the SEC and the Commodity Futures Trading Commission, as differences between the products they regulate has become "increasingly blurred."

The blueprint only recommended this as an "intermediate goal"--with no time frame attached. Ultimately, the idea would be for the government to create a "business conduct" regulator that would assume many of the oversight responsibilities of the SEC and CFTC.

No structural reform can change another facet of life at the SEC that critics often point out: Its law-intensive work attracts people from Wall Street who later jump right back into the private sector, often with lucrative assignments.

The SEC's coziness with Wall Street was a point raised by a former SEC investigator, Gary Aguirre, who was fired in 2005 after investigating possible insider trading by Pequot Capital. Aguirre has contended for three years that political considerations blocked him from pursuing the investigation, particularly after it involved interviewing the well-connected Wall Street chief John Mack, now of Morgan Stanley (nyse: MS - news - people ).

A joint report by the Senate judiciary and finance committees in August 2007 sided with Aguirre and sharply rebuked the SEC's failure to pursue the case. More recently the SEC's inspector general recommended disciplining senior SEC officials, but an administrative law judge ruled against him.

Aguirre, who lives in San Diego, says President-elect Obama should recreate the SEC with a completely different culture and realign it with its mission of enforcement. The failure to vigorously investigate Madoff before now "is a new low," Aguirre said Wednesday. "But it is absolutely consistent with everything that has happened this year."

Additional reporting by Brian Wingfield.