July 21, 2010
Dodd-Frank: Only You Can Prevent Ponzi Schemes
Posted by Christine Hurt
So, in the interview portion of our financial reform pageant, Erik asked me as a follow up to my Dodd-Frank & Madoff post:
Christine: What grade would you give to the Dodd-Frank provisions designed to make sure the SEC doesn’t drop the ball with future Madoffs? Do the provisions, including the bounty, ensure the SEC does the enforcement job it already has? Are there lessons for making other financial regulators more accountable and diligent? Are you worried about overzealous enforcement now?

I hate to say this, but I think Ponzi schemes are inevitable. Teenagers will always tell each other they love them to induce them to act in certain ways, and con artists will always be there to offer you unbelievable returns.  Regulating against human nature is impossible.  We have murder laws, but we'll always have murder.  So, the question is can any regulation help the SEC spot the Ponzi scheme before people lose money. 

First, Ponzi schemes aren't really illegal until someone doesn't get their money back.  Perhaps the schemes (like Madoff's) where he claims to make an investment and then doesn't do anything at all could be prosecuted prior to its collapse, but it would be hard to do.  Or, if someone holds himself out as something he isn't -- broker, investment adviser, etc. or offer an unregistered security.  Sometimes the SEC finds an ongoing scheme and in investigating, gets the target to obstruct justice or make a false statement, but usually someone has to lose money and complain about it first.  So, pretty much someone has to lose money before we can step in and prosecute.  So, it's hard to write any new SEC procedures that will prevent at least some loss.

In Madoff's case, there would have been some losses no matter when an investigation brought the scheme down, but fewer than in 2008 presumably.  But, someone at the SEC would have had to take complaints seriously.  Ironically, having a bounty system may create a greater number of credible complaints, leading the SEC to view them all with skepticism (a sort of market of lemons problem).  Remember, one of the reasons that the SEC was skeptical of Markopolos was because he wanted a reward.  Whistleblower protections may induce credible complaints, but bounties may induce an equal number of non-credible ones.

Madoff was also able to continue for a long time because he was an insider and human nature made the SEC investigators not suspect him.  Most garden variety Ponzi schemes are by industry outsiders, and the SEC is very good about prosecuting those low-hanging fruits.  Will regulation make SEC individuals rise above human nature?  No, but now experience will educate investigators to look out for insiders as well as outsiders.

Finally, Ponzi schemes will always pop up as long as their are people who want to make high returns in a quick period of time.  Human nature makes the victims look past red flags, particularly with affinity fraud.  Regulation can't really do much about that.

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