At today’s second Congressional Hearing into the Bernard Madoff alleged fraud, Senator Charles Schumer, D-New York, took the opportunity to announce a new bill aimed at preventing fraud on the Street.
The bill, co-sponsored by Schumer and Senator Richard Shelby, R-Alabama, is called the Supplemental Anti-Fraud Enforcement Markets Act or SAFE Markets Act.
Schumer was one of the first lawmakers to speak at the hearing, declaring that, “Major changes are necessary in how we regulate securities.” He said that today’s SEC appeared to be stagnant and behind the times and the commission needed better tools and resources to do its job effectively.
The SAFE Markets Act calls for an additional $110 million in funding for the hiring of 500 new FBI agents, 50 new Assistant U.S. Attorneys and 100 new SEC Enforcement Officials.
“We want to ensure the professionals are in place who understand how the markets work and expanding the SEC office of risk assessment would be a great first step,” said Schumer.
Schumer also went so far as to call for moving the SEC Office of Compliance, Inspection and Examinations and the Office of Risk Assessment to the Wall Street area. “There is no sense in cops patrolling their beat from hundreds of miles away,” he added.
On hand to testify today in front of lawmakers was Professor John Coffee of Columbia University Law School, as well as SEC Director of Enforcement, Linda Thomsen, and the Commission’s Director of Compliance, Inspections and Examinations, Lori Richards, as well as Stephen Luparello, interim CEO of the Financial Industry Regulatory Authority (FINRA) and Dr. Henry Backe, Orthopedic Surgeon whose practice was swindled by Madoff.
Professor Coffee, who was described as a renowned securities law expert, was on hand to set the stage for what changes are necessary to bring the SEC up to date and prevent and detect fraud better moving forward.
Coffee explained that the Madoff scam was not entirely unique, except for its sheer magnitude, and that Ponzi schemes are “increasingly and fairly recurrent,” he said.
Coffee pointed to research findings that put the year 2002 on the map for U.S. citizens losing about $9.6 billion in Ponzi schemes and that during at least four out of the last twelve years losses have exceeded $1 billion per year.
To fix the system, Coffee said there are “cost effective, adequate remedies that can be implemented.” He explained that since the Investment Company Act of 1940 not a single mutual fund has failed due to a Ponzi scheme as they occur in more of the unregulated firm types – hedge funds and alternative investments.
“The superior track record for mutual funds is due to the existence of an independent custodian who is a trustee and holds the investor funds in a separate bank or broker-dealer account,” said Coffee.
Madoff in particular did not use an outside custodian and instead used his own brokerage firm; something that Coffee says should be stopped. “Being your own custodian violates the first rule of common sense, you can’t be your own watchdog,” he said.
Coffee added that the Investment Advisors Association has also moved to endorse the idea of external custodians for investment advisors. “I think we can count on moving in that direction very quickly,” he said.
The second glaring change to the system occurred quietly after the Madoff fraud came to light. An SEC exemption previously allowed privately held brokerage firms to use auditors that were not registered with the Public Company Accounting Oversight Board (PCAOB). It has since been closed, but Coffee said, “Madoff was able to use a fly-by-night accountant and this kind of exemptive rule is de-regulation to excess,” Coffee said.
Coffee also called the SEC’s risk assessment methodology to task and said that, “I don’t believe they used the proper risk adjusted criteria in deciding not to investigate Madoff.”
He explained that the SEC knew that Madoff has investment advisory clients and compelled him to register, signaling he had previously been deceptive about it.
“The first question when he registered should have been who is your custodian and what is the quality and care of the protection for your accounts,” said Coffee, adding that the sheer size of the accounts should have been flagged for immediate examination of records and quality of custodial care.
How did the SEC officials from the Office of Enforcement and the Office of Compliance, Inspections and Examinations respond to the senate’s inquiry into the Madoff fraud and potential changes to prevent fraud going forward?
Continuing coverage will focus on these topics.