Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

SEC response to Madoff failure

I have a column
in the Financial Express yesterday about the SEC response
to its failure to detect the Madoff fraud and what this means for
other securities regulators worldwide. Some of my related blog posts
can be found here,
here
and here.

After its dismal failure to detect the Madoff fraud despite plenty of
warnings, the US SEC conducted a review by its own Inspector General
of what went wrong. This report published in August was uninteresting
as it explained it all away as incompetence and inexperience of the
staff concerned.

This explanation was not completely convincing given the detailed
information that people like Markopolos provided to the SEC over
several years. In any case, there is little point in a 450 page report
that reaches a conclusion that could be arrived at simply by applying
Hanlon’s Razor: “Never attribute to malice what can be adequately
explained by stupidity.”

At the end of September, however, the Inspector General released two
more reports (totalling 130 pages) indicating that incompetence might
not be the whole story. A survey carried out by the Inspector General
found that 24 percent of the SEC enforcement staff felt that cases
were improperly influenced or directed by management and 13% stated
that they had observed lack of impartiality in performance of official
duties.

In this article, however, I will focus on the Inspector General’s
recommendations (which the SEC has already accepted) for improving the
enforcement and inspections processes at the SEC. These
recommendations represent very significant changes in the mindset of
how to run these divisions not only at the SEC but at other regulators
worldwide.

The report recommends that 50% of the staff and management associated
with examination activities should have qualifications like the
Certified Fraud Examiner and Certified in Financial Forensics. This
recommendation is a sanitised version of what Markopolos recommended
when he testified to the US Congress in February about the SEC failure
to uncover Madoff despite his detailed complaints.

Markoplos argued that talented CPAs, CFAs, CFPs, CFEs, CIAs, CAIAs,
MBAs, finance PhDs and others with finance backgrounds need to be
recruited to replace current SEC staffers. He also claimed that SEC
staffers with credentials like CPA and CFA are not allowed to have
their designations printed on their business cards presumably because
if the SEC allowed its few credentialled staff to do so, it would
expose the overall lack of talent within the SEC.

The Inspector General recommends that all examiners should have access
to relevant industry publications and third-party database
subscriptions sufficient to develop examination leads and stay current
with industry trends. It also talks about establishing a system for
searching and screening news articles and information from relevant
industry sources for potential securities law violations.

This recommendation responds at least partially to Markopolos’s
testimony that most of the time all the SEC uses is Google and
Wikipedia because both are free and the SEC regional offices do not
have access to industry publications and academic journals.

The SEC estimates that it would cost $300,000-$400,000 annually to
provide data access in one room in each office; providing access to
each examiner will cost a lot more. It also estimates that it would
cost $3-4 million to implement the system for searching news reports
and other media, but this appears to be a one time cost rather than an
annual cost.

The Inspector General wants examiners to have direct access to the
databases of the exchanges, depositories, clearing corporations and
various self-regulatory organisations rather than having to get data
from these agencies as and when required. This is a huge change of
mindset because it blurs the distinction between the self-regulatory
organisations as first line regulators and the SEC as the apex
regulator. It moves the SEC into the regulatory frontline.

In line with this change, the SEC proposes to train its examiners in
the mechanics of securities settlement (both in the US and in major
foreign markets), in the trading databases maintained by the various
exchanges as well as in the methods to access the expertise of foreign
regulators, exchanges, and clearing/settlement agencies.

Turning to investigation, the Inspector General wants all
investigation teams to have at least one individual on the team with
specific and sufficient knowledge of the subject matter (like Ponzi
schemes or options trading) as well as access to at least one
additional individual who also has such expertise or knowledge.

During the last quarter century, many regulators elsewhere in the
world have looked upon the SEC as the gold standard in securities
regulation enforcement and have consciously or unconsciously fashioned
themselves on the SEC.

The lesson from Madoff is that the role model should not be the SEC of
recent decades but the SEC of the 1930s and 1940s under chairmen like
Douglas who believed that the management of the SEC was a higher form
of business management. Or perhaps, the role model should be the
modern New York Attorney General’s Office.

For regulators who are far behind even the current SEC in terms of
talent and resources, the SEC experience should be a wake-up call to
put their houses in order.

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