This week the second Congressional hearing into the Bernard Madoff fraud took place in Washington. Senators took the opportunity to grill SEC officials in an ongoing attempt to uncover how Madoff got away with such a massive fraud for so long and how the SEC can help ensure it doesn't happen again.
On hand to testify were Professor John Coffee of Columbia University Law School; 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, an orthopedic surgeon whose practice was swindled by Madoff.
Senator Charles Schumer, D-New York, was first to note that it’s “inexplicable how the SEC missed the Madoff fraud.” He pointed out that there had been a total of eight SEC and FINRA examinations conducted on Madoff’s firm since 1982, with the SEC conducting a “full investigation” in 1996.
After Schumer introduced his SAFE Markets Act, the hearing focused on ways the SEC could be revamped to detect fraud more efficiently.
Three areas in particular were brought to light during testimony: the SEC’s process for examining and investigating tips and complaints, the use of independent custodians for investment advisers and the SEC’s risk assessment profile for regular ongoing examinations.
The SEC’s Richards said that with the growing population of registered investment advisers, now reaching over 11,000, the “SEC cannot examine every one on a regular basis.” The Commission has more than 420 employees dedicated to these examinations of registered investment advisers, and in general about 10 percent of those firms are examined every three years, she added.
Those examinations are initiated based on the Commission’s risk assessment ratings, something that senators at the hearing also called into question. “We will study the examination process and frequency for investment advisers, as well as the existence of unregistered funds and advisers,” said Richards, who also acknowledged that there are ways to improve the Commission’s assessment of risk.
Richards explained that the Commission uses a risk assessment four times per year on every registered investment adviser, based on the information in their Form ADV filings. These ADV forms are submitted each year by every registered investment adviser and contain information about the firm and its business operations.
“But there is a limitation because that is information they’re voluntarily giving to us,” Richards said. The information used for these risk assessments includes whether the firm has custody of customer assets and how the investment adviser is paid — whether paid on performance fees, which might give an incentive to take risks, or some other structure. The risk assessment also takes into account whether the firm has a disciplinary history.
Not included in the risk assessment is the name of the investment adviser’s auditor, nor performance numbers, both of which could be useful in determining the risk of an investment adviser firm, argued senators.
Senator Christopher Dodd, D-Connecticut, chairman of the Committee on Banking, Housing and Urban Affairs, quickly pointed out that, “Clearly we need to reevaluate that risk assessment.” Richards agreed that better-quality risk assessment would come from better-quality information.
“The process could be improved with access to different information — the identity of an investment adviser's custodian or administrator and their returns. We could pull that information together at the SEC for analysis to review,” said Richards.
Richards said that she feels strongly that the Commission should pull in additional types of information from a variety of sources. “We need to be able to harness all the information and not just rely on self-reported information,” she said.
Additional resources could help as well, said Richards. “When the agency received additional funding to pay examiners and other staff, it allowed us to hire and retain higher-qualified people,” she explained. “We need to continue to do that and hire quants and economists who can analyze complex trading strategies and identify emerging risk areas.”
While the risk assessment process is a key area to deter and catch potential fraud, follow-up on tips and complaints received by the Commission was also a big topic in light of the many complaints that had been filed with the SEC regarding Madoff’s operations.
The SEC's Thomsen testified that the SEC receives “hundreds of thousands of tips each year” and that they obviously do not have the resources to fully investigate all of them.
Senator Dodd focused on the complaint lodged by Harry Markopolos in 2005 entitled, “The World’s Largest Hedge Fund Is a Fraud,” a 19-page step-by-step outline of potential fraud by Madoff, and asked why such a seemingly straightforward, strong piece of information did not lead to an investigation.
Thomsen responded that many of the tips the SEC receives are “written in language similar to the language in Mr. Markopolos’,” and that they are not evidence in and of themselves. But she could not comment specifically on the path of the Markopolos tip once it reached the SEC, or on who saw it or what action if any was taken.
When asked how exactly complaints are prioritized and what would signal a high-priority complaint, Thomsen said it was important to pursue the complaints that are the most “fruitful.”
She explained that the SEC looks at several angles — such as the gravity of the allegations, with more serious misconduct more likely to receive heavy scrutiny. Complaints providing more-specific information would also be more likely to be pursued.
“We also look at the source of the complaint — is it someone having an argument with an ex-spouse, for example. And we look at bias on the part of the complainant,” said Thomsen. She added that the Commission takes into account the expertise of the complainant in a specific area and whether there have been multiple complaints about the same firm.
Ultimately, she said, “When we’re deciding for further investigation, we err on the side of doing more.”
When probed further by Senator Jeff Merkley, D-Oregon, who said, “I can’t imagine that you receive more than an occasional document of this magnitude with this type of extensive quantitative analysis and rigorous inspection,” Thomsen answered, “We do get many of them.” When pressed for specific numbers by Merkley, she said she didn’t know the answer.
Yet another issue that the SEC officials were pressed on was the use of outside custodians for investment advisers. Columbia Law's Coffee had previously described how Madoff and other investment advisers are allowed to use their own broker-dealer operations as custodian, something he sees as beyond common sense.
When asked why the SEC did not already require investment advisers to have independent custodians for their assets, the Commission's Richards said there was some debate around the topic but that she supported it: “It shows strong internal control and is the most desirable situation ... it’s one of the changes I hope the Commission will strongly consider."
Both Richards and Thomsen said that in their personal opinion they believe that it would make sense for the SEC to require independent custodians for investment advisers.