Prof. Jayanth R. Varma's Financial Markets Blog

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Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation

© Prof. Jayanth R. Varma
jrvarma@iima.ac.in

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Tue, 20 Oct 2009

SEC response to Madoff failure

I have a column in the Financial Express yesterday about the SEC response to its failure to detect the Madoff fraud and what this means for other securities regulators worldwide. Some of my related blog posts can be found here, here and here.

After its dismal failure to detect the Madoff fraud despite plenty of warnings, the US SEC conducted a review by its own Inspector General of what went wrong. This report published in August was uninteresting as it explained it all away as incompetence and inexperience of the staff concerned.

This explanation was not completely convincing given the detailed information that people like Markopolos provided to the SEC over several years. In any case, there is little point in a 450 page report that reaches a conclusion that could be arrived at simply by applying Hanlon’s Razor: “Never attribute to malice what can be adequately explained by stupidity.”

At the end of September, however, the Inspector General released two more reports (totalling 130 pages) indicating that incompetence might not be the whole story. A survey carried out by the Inspector General found that 24 percent of the SEC enforcement staff felt that cases were improperly influenced or directed by management and 13% stated that they had observed lack of impartiality in performance of official duties.

In this article, however, I will focus on the Inspector General’s recommendations (which the SEC has already accepted) for improving the enforcement and inspections processes at the SEC. These recommendations represent very significant changes in the mindset of how to run these divisions not only at the SEC but at other regulators worldwide.

The report recommends that 50% of the staff and management associated with examination activities should have qualifications like the Certified Fraud Examiner and Certified in Financial Forensics. This recommendation is a sanitised version of what Markopolos recommended when he testified to the US Congress in February about the SEC failure to uncover Madoff despite his detailed complaints.

Markoplos argued that talented CPAs, CFAs, CFPs, CFEs, CIAs, CAIAs, MBAs, finance PhDs and others with finance backgrounds need to be recruited to replace current SEC staffers. He also claimed that SEC staffers with credentials like CPA and CFA are not allowed to have their designations printed on their business cards presumably because if the SEC allowed its few credentialled staff to do so, it would expose the overall lack of talent within the SEC.

The Inspector General recommends that all examiners should have access to relevant industry publications and third-party database subscriptions sufficient to develop examination leads and stay current with industry trends. It also talks about establishing a system for searching and screening news articles and information from relevant industry sources for potential securities law violations.

This recommendation responds at least partially to Markopolos’s testimony that most of the time all the SEC uses is Google and Wikipedia because both are free and the SEC regional offices do not have access to industry publications and academic journals.

The SEC estimates that it would cost $300,000-$400,000 annually to provide data access in one room in each office; providing access to each examiner will cost a lot more. It also estimates that it would cost $3-4 million to implement the system for searching news reports and other media, but this appears to be a one time cost rather than an annual cost.

The Inspector General wants examiners to have direct access to the databases of the exchanges, depositories, clearing corporations and various self-regulatory organisations rather than having to get data from these agencies as and when required. This is a huge change of mindset because it blurs the distinction between the self-regulatory organisations as first line regulators and the SEC as the apex regulator. It moves the SEC into the regulatory frontline.

In line with this change, the SEC proposes to train its examiners in the mechanics of securities settlement (both in the US and in major foreign markets), in the trading databases maintained by the various exchanges as well as in the methods to access the expertise of foreign regulators, exchanges, and clearing/settlement agencies.

Turning to investigation, the Inspector General wants all investigation teams to have at least one individual on the team with specific and sufficient knowledge of the subject matter (like Ponzi schemes or options trading) as well as access to at least one additional individual who also has such expertise or knowledge.

During the last quarter century, many regulators elsewhere in the world have looked upon the SEC as the gold standard in securities regulation enforcement and have consciously or unconsciously fashioned themselves on the SEC.

The lesson from Madoff is that the role model should not be the SEC of recent decades but the SEC of the 1930s and 1940s under chairmen like Douglas who believed that the management of the SEC was a higher form of business management. Or perhaps, the role model should be the modern New York Attorney General’s Office.

For regulators who are far behind even the current SEC in terms of talent and resources, the SEC experience should be a wake-up call to put their houses in order.

Posted at 12:32 on Tue, 20 Oct 2009     View/Post Comments (1)     permanent link