How To Prevent Another Madoff Scandal: Can a broken SEC ever be fixed?

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How To Prevent Another Madoff Scandal

Can a broken SEC ever be fixed? Probably not.


January 16, 2009 - by Laura Goldman
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For those of us that did not lose money, it is fun to dish about Bernard Madoff, but plenty of people and charities were hurt. We, as a capitalist nation, need to find a way to prevent this from happening again or, at the very least, make it harder.

In some ways, the entire past year was the financial world’s equivalent of 9/11. We need to react in a similar fashion. After 9/11, the Bush administration moved quickly to establish the new Department of Homeland Security with its infamous color-coded warnings.

The Obama administration needs to create a Financial Consumer Safety Agency for all financial products including investment along the lines of the Food and Drug Administration (FDA) or the Consumer Safety Products Commission. The mission of the agency would be to protect and educate the consumer about a wide range of financial products, not to punish the transgressor.

This agency should be staffed with savvy market professionals, not just lawyers. It should monitor investment products, credit cards, and mortgages. Currently, the regulation of consumer financial products is assigned to the agency that regulated the issuing institution instead of by the consumer that uses the product. No financial regulatory agency in Washington is focused on the consumer.

Many may question why I am advocating for the establishment of a yet another potentially useless bureaucracy instead of calling for the revamping of the Securities and Exchange Commission (SEC). In my opinion, the SEC is so broken that it can not be fixed. Incredibly, in these financially turbulent times, the SEC has reduced staff by 10%.

The SEC likes to think of itself as Wall Street’s cops. The beat cop in my neighborhood once derided this description and I agree with him. They are not cops. They are tasseled-loafer wearing lawyers who prefer to sit behind a desk rather than burning the shoe leather necessary to solve and prevent crimes.

The numbers bear me out. The New York Times reported that “U.S. government officials are on pace this year to bring the fewest prosecutions for securities fraud since at least 1991.” For the first 11 months of this year, there were 133 prosecutions. This is down from a high of 513 prosecutions in 2002. This is a 75% decline in prosecutions in a time period when the discovery of fraud has multiplied exponentially.

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.