How to Madoff-Proof the SEC

What’s ailing the SEC? Everyone seems to have a different answer to that question these days. Do SEC staff need more supervision or less? Will throwing more money at the agency solve the problem?

The following highlight some recent diagnoses:

1. Investment advisory requirements
Two different entries on the Harvard Law School Corporate Governance Blog tackle the topic of how to fix the SEC. Blog authors Michael Raffan and Andrew Marsh fault, in part, the registration requirements for investment advisors. Madoff had both broker dealer and investment advisory businesses, and each type was subject to different SEC requirements. Madoff was able to evade the SEC, in part, because he initially registered only as a broker dealer, claiming that the problematic investment advisory business was not required to register because its fees came from trading commissions, rather than a percentage of assets under management or profits, according the Harvard law blog. An investigation in 2006 failed to detect fraud, but found the business was in breach of the investment adviser registration requirement. The investment advisory arm then became subject to the regular SEC inspection regime in 2006, according to the authors, though no inspections had been carried out before the firm’s collapse.

“If Madoff had been required to register as an investment advisor much sooner, there would have been a greater chance of detecting problems earlier,” according to the blog’s authors. “It also appears that SEC investigators lacked the financial sophistication to understand that Madoff’s financial results were highly suspect—even though a number of commercial banks and brokerage houses harbored suspicions about this business activity and therefore refused to deal with Madoff.”

Furthermore, the lack of rules prohibiting concentration of investment advisory functions (such as custodian, broker and administrator) provides an opening for corrupt firms to continue to perpetrate fraud, according to the authors.
 

2. Are SEC officials going easy on potential future employers?
Another Harvard law blog entry suggests that SEC staff may be protecting potential career prospects with more favorable case outcomes for big firms in major cities. A paper by Stavros Gadinis, who also authored the blog entry, analyzes SEC administrative cases, which the SEC controls more directly than court cases, and finds that big firms and their employees are less likely to receive a ban from the securities industry than small firms and their employees. It also suggests that big firms headquartered in “favorable locations” (the author doesn’t specify, but we’re assuming he means major cities) get lower sanctions than big firms around the country. Gadinis proposes that SEC staff, who often go on to work in big firms’ compliance departments, are protecting their career opportunities, resulting in discrepancies in treatment.

The blog entry does not provide data on how many SEC staff actually go on to work for big firms. (We’re not fully convinced.)

3. Institutional reorganization
A study by the U.S. Chamber of Commerce’s Center for Capital Markets Competiveness finds fault with agency principles and attitudes including a lack of strong management principles rewarding prompt action and adequately discouraging mistakes and unintended outcomes.

While the size of the SEC has increased in the past 30 years, it’s management structure has not altered significantly, according to the U.S. Chamber’s study. The study suggests:

• Realigning the Division of Trading and Markets and the Division of Investment Management into the Division of Investor Protection and Retail Financial Services Regulation, and a Division of Market Oversight and Operations;
• An accelerated conditional approval process for new investment products and services (such as Madoff’s investment advisor arm?)

The study offers the following five recommendations:

1. The five appointed Commissioners should play a greater ongoing role in interpretation and application of regulatory policy.

2. The SEC should create a chief operating officer position (COO) to oversee daily operations.

3. The SEC should establish a coordinating council, chaired by the COO, to resolve the issues or disagreements involving more than one division or office.

4. The SEC should expand staff with expertise in capital markets operations and business operations of regulated entities as well as financial economics.

5. The agency should develop a knowledge management program to transfer and preserve knowledge and experience of departing staff.

4. More Money, More Power?
SEC officials have their own suggestions for ways to improve the agency. Outgoing Enforcement Director Linda Thomsen suggested more resources (read: more money) is needed because the SEC has only enough to "pursue fires." 

Chair Mary Schapiro called for “tak[ing] the handcuffs off the enforcement division” in a speech to the Practising Law Institute, one of the first changes Schapiro intends to implement, she said.

“As if,” the Wall Street opined in response to Schapiro's call for more freedom. “The staff conducted its various half-hearted inquiries of Bernard Madoff over the years without ever consulting the Presidentially appointed commissioners,” according to the WSJ. Commissioners should be consulted more frequently and not left out of the loop, the editorial suggests.

“Private market participants spotted the fraud, while SEC lawyers couldn’t seem to grasp it. Rather than giving her staff lawyers still more autonomy, she should instead be supervising them more closely, while trying to harness the intelligence of the market place,” according to the Journal editorial.