January 06, 2009
Madoff and SEC Reform
Posted by Lisa Fairfax

Yesterday the House Committee on Financial Services held a hearing on the Madoff ponzi scheme and the “Need for Regulatory Reform.” According to the Committee’s website, the hearing was designed to help guide Congress in “undertaking the most substantial rewrite of the laws governing the U.S. financial markets since the Great Depression.”  It is not clear what that means with respect to the SEC, but testimony from David Kotz, the SEC’s Inspector General, indicated that the Madoff scheme had prompted a more comprehensive review of the SEC and its oversight and enforcement capabilities. Thus, in addition to investigating the allegations related to Madoff and exploring the reasons for the failure to follow up on those allegations (including potential conflicts of interests and undue consideration of the status/reputation of Madoff), Kotz noted that the SEC’s investigation would include “an evaluation of broader issues regarding the overall operations of the Division of Enforcement and OCIE [Office of Compliance Inspections and Examinations] that would bear on the specific questions we are examining, and provide overarching and comprehensive recommendations to ensure that the Commission fulfills its mission of protecting investors, facilitating capital formation and maintaining fair, orderly and efficient markets.” That seems like quite a lot.

According to Kotz, the “broader” investigation would include review of the following

"(a) 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;

"(b) 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

"(c) 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."

This broader agenda appears to be a response to concern, from members of Congress and others, that the SEC’s failure to detect the massive fraud associated with the Madoff ponzi scheme may reflect some systemic failure with the SEC more generally. An understandable concern. That is, on the one hand, it seems understandable to wonder how the SEC could have missed such fraud, especially after allegations were raised as early as 1999 with respect to Madoff. And certainly it seems understandable to wonder what other frauds may currently exists that have flown under the radar. On the other hand, the fact that an agency fails to uncover even massive fraud does not necessarily signal the need for substantial overhaul. Indeed, no detection system is perfect, and in some cases ponzi schemes, particularly affinity fraud schemes, are the most difficult to detect. And hence sometimes fraud will occur despite our best efforts. To be sure, while it is too soon to know, it could be that this case does not represent an example of our best efforts. Moreover, I have no doubt that improvements can be made and lessons can be learned from re-evaluating the current regime. In this regard, it is important to determine whether and to what extent there are flaws (big or small) in our current system and what changes can be made to increase the likelihood of detecting fraud in the future--even if those changes do not amount to an overhaul of the system.

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