Madoff Case Inspires Wide SEC Review

The identity crisis at the Securities and Exchange Commission took another lurch last week, with vows from the agency’s top internal watchdog that his staff will determine whether the SEC has enough resources and competence to investigate companies properly.

SEC Inspector General David Kotz appeared before the House Financial Services Committee to discuss the alleged $50 billion Ponzi scheme involving Wall Street money manager Bernard Madoff. The Madoff case has turned into a disaster for the SEC, amid allegations that Madoff critics voiced their concerns to the Commission for years with no follow up from SEC enforcement officials. Kotz told the committee he will look into mishandling of the Madoff case specifically, but also examine SEC enforcement operations overall.

“It is my view that at the end of these investigative efforts, there needs to be … concrete and specific recommendations as appropriate to ensure that the SEC has sufficient systems and resources to enable it to respond appropriately and effectively to complaints and detect fraud through its examinations and inspections,” Kotz said.

Lawmakers have said the information gathered at last week’s hearing—the first of many related to the Madoff case—will help inform their efforts to reform business regulation more broadly. U.S. Rep. Paul Kanjorski (D-Penn.) bluntly said Corporate America can expect “the most substantial rewrite of the laws governing the U.S. financial markets since the Great Depression.”

Right now corporate executives can do little more than parse the statements of public officials to get a sense of what comes next, and remarks at the hearing made clear that lawmakers are still far from agreeing on a course of action. But overhauling the rules that govern the U.S. financial markets was a top priority for Congress and the Obama Administration long before Madoff entered the picture. Indeed, many believe that Barack Obama’s nominee to be the next SEC chair, Mary Schapiro, portends sweeping changes in SEC operations and oversight—including the possibility of breaking up the agency entirely.

Cox

Notably absent from last week’s hearing was embattled current SEC Chairman Christopher Cox. Critics (and there are plenty of them) say Cox spent his tenure fiddling with relatively unimportant regulatory efforts while the financial system burned due to lack of vigorous enforcement. Cox has already said he will leave the SEC as soon as the Obama Administration takes office and the Senate confirms Schapiro’s appointment, presumably sometime later this month.

Days after Madoff was arrested and charged with fraud in December, Cox issued a statement saying he was “gravely concerned by the apparent multiple failures over at least a decade” to investigate the allegations against Madoff or to seek formal authority to pursue them. He also noted that staff didn’t use its subpoena power, but instead relied on information voluntarily supplied by Madoff and his firm.

Noting that Madoff served on an SEC advisory committee, Kotz said he’ll review whether Madoff’s status or reputation had any influence on Commission decisions involving Madoff and his firm.

Kotz said he has already sent a document preservation notice to the entire agency and sent document requests to the Enforcement Division and OCIE. His office is also reviewing e-mails from current and former SEC employees and contractors in its headquarters and New York and Boston regional offices.

Also among those Kotz said he plans to interview is Harry Markopolos, who submitted a report to the SEC in 2005 alleging that Madoff was running a Ponzi scheme. Markopolos was scheduled to testify before the committee on Jan. 5 but lawmakers said he postponed, asking for more time to prepare.

Questions of Effectiveness

In response to a question from Rep. Gregory Meeks (D-N.Y.) about the SEC’s ability to carry out its duties, Kotz said he plans to look at the SEC’s overall complaint procedures and the enforcement operation to determine “whether it is a question of resources … or whether the process is so broken that additional resources wouldn’t make a difference.”

KOTZ AGENDA

The following excerpt was taken from David Kotz’s testimony before the U.S. House of Representatives Committee on Financial Services.

The following are specific issues that we currently intend to investigate:

1. The SEC’s response to complaints it received regarding the activities of Bernard Madoff, including any complaints sent to the Division of Enforcement, OCIE, the Office of Risk Assessment and/or the Office of Investor Education and Advocacy. We plan to trace the path of these complaints through the Commission from inception, reviewing what, if any, investigative or other work was conducted with respect to these allegations, and analyze whether the complaints were handled in accordance with Commission policies and procedures and whether further work should have been conducted;

2. Allegations of conflicts of interest regarding relationships between any SEC officials or staff and members of the Madoff family, including examining the role a former SEC official who allegedly had a personal relationship with a Madoff family member may have played in the examination or other work conducted by the SEC with respect to Bernard Madoff or related entities, and whether such role or such relationship in any way affected the manner in which the SEC conducted its regulatory oversight of Bernard Madoff and any related entities;

3. The conduct of examinations and/or inspections of Bernard Madoff Investment Securities LLC by the SEC and an analysis of whether there were “red flags” that were overlooked by SEC examiners and inspectors (which may have been identified by other entities conducting due diligence), that could have led to a more comprehensive examination and inspection, including a review of whether the SEC violated its own policies and procedures by not conducting timely reviews or examinations of Bernard Madoff’s activities and filings; and

4. The extent to which the reputation and status of Bernard Madoff and the fact that he served on SEC Advisory Committees, participated on securities industry boards and panels, and had social and professional relationships with SEC officials, may have affected Commission decisions regarding investigations, examinations and inspections of his firm.

In addition to these specific issues and depending upon the information that we learn during the course of our investigation, we plan to consider analyzing the following broader issues, as appropriate:

1. The complaint handling procedures of the Division of Enforcement, including a review of how complaints are processed, internal incentives that may affect the decision whether to take action with respect to a complaint, an analysis of which complaints are brought to the Commissioners’ and Chairman’s attention, and whether tangible and specific complaints are being reviewed and followed-up on appropriately;

2. The OCIE examination and inspection procedures, including an analysis of what policies and procedures were then and are currently in place, whether these policies and procedures are being followed and/or whether there are gaps in these policies and procedures relating to operations involving voluntary private investment pools, such as hedge funds, because they are subject to limited oversight by the SEC, and whether any such gaps may lead to fraudulent activities not being detected; and

3. The relationships between different divisions and offices within the Commission and whether there is sufficient intra-agency collaboration and communication between the Agency components to ensure comprehensive oversight of regulated entities.

Source

SEC (Jan. 5, 2009).

Later during the questioning, Kotz said he wants to examine whether or not the SEC as a whole is effective in its oversight of the financial markets. “We plan to do a comprehensive overview of both the Enforcement Division and the compliance unit to ensure that we don’t … just pass on findings with respect to Mr. Madoff, but that we look at the whole system in place to see if it can adequately detect fraud,” he said.

That includes looking at the Enforcement Division’s procedures to handle complaints and OCIE’s examination and inspection procedures, as well as whether Commission policies are being followed and whether gaps exist in oversight of private investment vehicles such as hedge funds, he said.

Kotz said he hopes to issue a report on his findings “in a matter of months,” and may issue reports on a rolling basis as particular issues can be investigated.

Lawmakers, meanwhile, don’t appear any closer to resolving the debate on how to reform financial services regulation. Kanjorski, who described the Madoff scandal as a “deeply disturbing event that’s raised questions about the effectiveness of our regulatory system,” said that system has “failed miserably” and needs to be rebuilt.

Bachus

But Alabama Rep. Spencer Bachus, ranking Republican on the committee, said: “What we have in the Madoff case is not necessarily a lack of enforcement and oversight tools, but a failure to use them.” Bachus suggested lawmakers consider harmonizing the regulation of investment advisers, who are generally overseen by the SEC, and broker-dealers, who are regulated by the Financial Industry Regulatory Authority.

“While the failures of regulatory and private sector due diligence exposed by the Madoff matter are obvious, they don’t lead me to conclude at this stage that what’s needed are broad new legislative or regulatory mandates on the rest of the securities industry,” Bachus said.

Bachus noted that FINRA inspected Madoff’s broker-dealer operations every other year, while Madoff’s affiliated investment advisory firm—where the alleged fraud was perpetrated—was never examined by the SEC.

As part of its consideration of reforms to the U.S. financial regulatory structure, Bachus said the committee “should examine whether the Madoff scandal argues for harmonizing the regulation of broker-dealers and investment advisers.”

Meanwhile, leaders of the Senate Banking Committee notified the SEC in a Jan. 5 letter that they’re examining the regulatory performance of the SEC and FINRA in the Madoff case, and requested documents and information be submitted to the committee by Jan. 22.