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Former SEC Chairman Pitt: Outside, Independent Exams Necessary

As FINRA and the SEC have been called to task in the wake of the Madoff scandal, former SEC Chairman Harvey Pitt spoke to Advanced Trading about what should be done to improve regulatory oversight.

Following last week’s initial Congressional meeting on the Bernard Madoff fraud, many have voiced their opinion that changes are on the horizon for the securities industry’s regulatory bodies.

Both FINRA and the SEC have been called to task in the wake of the Madoff scandal, and former SEC Chairman Harvey Pitt spoke to Advanced Trading about what should be done to improve regulatory oversight.

“I think what’s needed it not more regulation or less regulation – what’s needed is smarter regulation,” says Pitt, who is now CEO of Washington, D.C.-based Kalorama Partners, a global business-consulting firm.

“Trying to predict what Congress might do is always a hazardous undertaking,” says Pitt. “That said there are a couple of things to keep in mind in light of the Madoff situation. First is to realize that when somebody is engaged in committing a deliberate fraud and maintaining double sets of books it’s very difficult for the government to catch that kind of person,” he notes.

Pitt also says that many sophisticated investors were duped, putting in context that while the regulatory bodies might have taken missteps and that these types of events cannot be tolerated and must be corrected, the deception was very high level.

The main source of blame and the main area of change to come out of this case is the examination program, according to Pitt.

“I believe the SEC’s current examination program which was put in place in the mid-90s is really not well calculated to help the SEC succeed,” says Pitt. “It really is almost destined to produce failure.”

He explains that a quick calculation of the numbers of registered entities regulated by the SEC numbers approximately 11,000 investment advisors and more than 6,000 broker-dealers, as well as transfer agents, clearing agencies, etc. “No matter what budget changes are made, the SEC is never going to have enough people or money to catch all of that,” says Pitt.

What is really necessary to facilitate better regulation, says Pitt, is a “different paradigm for the inspection and examination process.” He adds that going back to his tenure in 2003 this is something he had voiced concern over. “I thought the SEC’s examination program even then was badly broken,” continues Pitt.

The solution according to Pitt would be to require all regulated entities and all portfolio managers to obtain completely independent examinations by an outside firm. These examinations would be subject to the SEC’s required standards and would have to be completely independent firms.

“Then they would have a thorough review done every year or in the case of smaller firms perhaps every other year,” says Pitt. “And effectively prepare a report given to the entity as well as to the SEC.” He emphasizes that these outside examiners would have to be completely independent with no other association to the securities market and would be subject to strict SEC guidelines and approval.

Pitt explains that by having independent outside examinations required it would help ensure that qualified eyes were overseeing the examinations. “It also has the added advantage of not having the cost paid for by tax payers,” he says.

In the end, Pitt says that the Madoff fall out should not be about blame or finger pointing, but rather preventing something similar from ever happening again. “I don’t necessarily see any responsibility on the part of FINRA or the SEC, I see human failure and a system that is expected to operate more efficiently than it did,” says Pitt.

“It is a serious problem and requires some serious thinking about how to solve it. The finger pointing is not going to get us any closer to a better system and we need a better system. This one let us down,” he adds.

As the SEC prepares for yet more changes as its new incoming chairperson Mary Schapiro readies to take over, Pitt says this will be a good thing. “I believe Mary Schapiro is enormously capable of making certain that the system regulates effectively and vigorously and protects investors.”

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