The Securities and Exchange Commission's Inspector General offered lawmakers some ideas for revamping the federal securities laws, including extending the regulatory jurisdiction of the Public Company Accounting Oversight Board and amending the Investment Advisers Act to require the use of independent custodians by investment advisers and hedge funds.

The recommendations, detailed in a June 30 letter from SEC IG H. David Kotz, came in response to a June 15 request by Paul Kanjorski (D-Pa.), Chairman of the House Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises.

As previously reported, Kanjorski sent two letters to Kotz in June demanding an update on the OIG probe into allegations regarding Bernard Madoff and his firm, Bernard L. Madoff Investment Securities. That probe, which has been underway since December, is looking at why the SEC didn't uncover the alleged Ponzi scheme for years, despite tips and its own examinations and investigations.

Kanjorski had also requested that Kotz provide recommendations for modifying federal securities laws ahead of Congressional action on regulatory reform legislation, which is expected later this month.

"We are committed to producing, in an expeditious manner, thorough and comprehensive investigative and audit reports analyzing the reasons that the SEC did not uncover the Madoff Ponzi scheme notwithstanding examinations and investigations conducted over a period of nearly 20 years, as well as providing recommendations to improve the operations of the pertinent SEC divisions and offices," Kotz wrote. "While we have not yet completed the investigation, we are able to provide to you, at your request, several legislative suggestions that have arisen out of our Madoff investigatory work, which we believe will strengthen the ability of investors and the regulatory agencies to uncover frauds such as Ponzi schemes in the future."

Among the recommendations:

(1) Extend the regulatory jurisdiction of the PCAOB to audit reports prepared by a domestic registered or foreign public accounting firm regarding issuers, broker-dealers, investment advisers, and any companies subject to U.S. securities laws.

Kotz noted that extending the PCAOB's regulatory jurisdiction would allow for increased oversight of those accounting firms and reduce the risks associated with unknown accounting firms that have been able to avoid scrutiny. While he noted that H.R. 1212, as currently introduced, accomplishes many of these same goals, Kotz recommended that the legislation clarify that the PCAOB oversight be extended to audit reports prepared by a registered accounting firm which provides reports for investment advisers, investment companies, and other registered entities, as well as registered broker dealers.

(2) Amending the Investment Advisers Act of 1940 to require the use of independent custodians in a manner similar to Section 17(f) of the Investment Company Act of 1940, which requires the use of an independent custodian by mutual funds to help prevent investment advisers from fraudulently using the proceeds invested by new investors to make payments to old investors. Kotz said both investment advisers and hedge funds should be required to use an independent custodian.

While the SEC is currently proposing amendments to its custody rule under the Investment Advisers Act to require a written report from an independent public accountant that includes an opinion regarding the custodian's controls relating to custody of client assets if the client accounts are not maintained by an independent qualified custodian, Kotz wrote, "We believe that a more direct way to remedy this statutory loophole would be to amend the Investment Advisers Act in conformity with the Investment Company Act."

(3) Imposing a requirement of certification by senior officers of registered investment advisers that shows they conducted adequate due diligence in connection with investments. Kotz said the certification requirement should apply to all funds of hedge funds. The adequate level of due diligence required may be defined pursuant to a particular model of best practices, such as the Managed Fund Association model or the Alternative Investment Management Association model, or could be developed by the SEC.

(4) Amend the Exchange Act to authorize the SEC to award a bounty for information leading to the recovery of a civil penalty from any violator of the federal securities laws, not simply insider-trading violations. Kotz also suggested the Exchange Act be amended to provide specific criteria for awarding bounties, including a provision that where a whistleblower relies upon public information, such reliance doesn't constitute an absolute bar to recovering a bounty. The statute should also require that the whistleblower be provided with status reports at certain milestones during the investigation or examination that was based on the tip.

Kotz noted that a current SEC bounty program under Section 21A(e) of the Securities Exchange Act of 1934 is limited to insider-trading cases, and the stated criteria for judging bounty applications are "broad, somewhat vague, and not subject to judicial review."

Kotz's letter noted that the SEC is also recommending the legislative suggestions numbered 1 and 4 to the Subcommittee.

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