SEC Publishes Full Audit Report On Why It Failed to Uncover Madoff's Fraud

Source: BNA - Securities Law Daily
Date: September 08, 2009

Securities and Exchange Commission:

The Securities and Exchange Commission late Sept. 4 published the full version of its inspector general's report chronicling the failure of its enforcement and examinations staff to uncover Bernard Madoff's fraud despite numerous red flags dating as far back as 1992.

In the 477-page report, which included redacted portions of testimony, Inspector General H. David Kotz urged “appropriate action … on an employee-by-employee basis” to ensure the effectiveness of future examinations and inspections.

Apart from that suggestion, Kotz promised to provide two additional reports with more “specific and concrete” recommendations for improving operations in the agency's Division of Enforcement and the Office of Compliance Inspections and Examinations. Kotz earlier told Congress that he would provide those reports by the end of September.

In a statement accompanying the full report's publication, SEC Chairman Mary Schapiro pledged that her agency in the coming weeks “will continue to closely review the full report and learn every lesson we can to help build upon the many reforms we have already put into place since January.”

Meanwhile, Kotz's findings continued to elicit harsh criticism of the agency from lawmakers. The latest reprimand came Sept. 3, when Rep. Edolphus Towns (D-N.Y.) announced that the House Oversight Committee, which he chairs, plans to review employee recruitment and retention at the SEC. To facilitate that review, he asked Schapiro to provide a briefing on various hiring issues and the role of senior managers in providing guidance to junior staff.

Madoff's Stature Was a Factor

Earlier, on Sept. 2, Schapiro released the report's lengthy executive summary, which contained the embarrassing revelation that the agency received six substantive complaints about Madoff—including one dating back to 1992—and carried out three examinations and two inspections of Madoff's firm, but nonetheless failed to detect his fraud. The report attributed this failure to a lack of experience and due diligence on the part of Enforcement and OCIE staff. Had the staff taken “basic steps,” the SEC “could have uncovered the Ponzi scheme well before Madoff confessed” in December 2008.

However, contrary to speculation by some, the IG found no evidence that SEC personnel were financially or otherwise inappropriately connected to Madoff or his family, or that a senior SEC official's courtship with and eventual marriage to Madoff's niece had any influence on the conduct of the SEC's oversight. However, the full report showed that Madoff's industry prominence—he was formerly chairman of Nasdaq and regularly participated in SEC roundtables—intimidated examiners.

For instance, one examiner admitted to Kotz that in light of “Madoff's reputation at that time as a large broker-dealer, there may not have been any thought to look into Madoff's operation any further.” The report further stated: “There is evidence that the examination team was well aware of Madoff's reputation and that this may have factored into their decision not to scrutinize Madoff's operation more carefully.”

Towns Questions Link Between Pay, Effectiveness

Meanwhile, in a letter to Schapiro, Towns queried whether the level of experience has improved since Congress in 2002 authorized the agency to increase compensation. According to Towns, the legislation was passed in light of the “problem of high turnover and inexperience among SEC attorneys and examiners.” Since then, SEC employees have been compensated at a level “considerably higher” than most federal employees. However, the IG's report calls “into question the effectiveness” of the 2002 legislation and the agency's “ability” to recruit and retain experienced professionals, Towns contended.

Although Towns suggested that higher pay has not improved the SEC's regulatory ability, Sen. Charles Schumer (D-N.Y.) earlier in the day took a different tack, saying increased funding would enable the commission to hire more knowledgeable professionals. Specifically, Schumer said he plans to introduce legislation that would allow the agency to spend all of the fees that it earns from the more than 35,000 entities that it oversees. Freeing the agency from the federal appropriations process, Schumer contended, would enable it to hire people with wider professional experience, leading to greatly improved regulation.

SEC Needs Mass Troops

Stephen Crimmins, a partner at K&L Gates LLP and formerly deputy chief litigation counsel in the SEC's Enforcement Division, Sept. 4 agreed with Schumer's view that the IG report “underscores the need to move the SEC into the same self-funding approach” that banking regulators, such as the Federal Deposit Insurance Corporation, already enjoy. The SEC has been starved of resources for decades, Crimmins said.

Self-funding, Crimmins explained, would not simply mean paying individual employees more, but having the budget to expand the staff. To be effective, the SEC needs more staff that can be “proactive.” The agency needs “mass troops” to adequately respond to anomalies and “jump into action quickly.”

According to Crimmins, SEC staff that could have responded effectively to clues about Madoff's fraud were busy fighting other wars, such as corporate scandals and options backdating cases. The agency could not simply hire more staff, as banking regulators could, but rather had to disperse staff to battle other potential securities law violations. Calling to mind White House Chief of Staff Rahm Emanuel's famous statement to “never let a serious crisis go to waste,” Crimmins applauded Schumer's initiative.

Supervisors Forced to Shift Focus

For his part, Towns called attention to internal management at the SEC as well. In his letter, he asked Schapiro to explain the role of senior managers in supervising cases and what guidance they provided “frontline staff” in the Madoff case. Kotz's report recounted several cases in which newly qualified attorneys closed cases despite information indicating that Madoff was not trading on behalf of customers' accounts, contrary to what customers' account statements represented.

In chronicling the series of missteps in overseeing Madoff, Kotz's report also pointed a finger at SEC supervisors confronted by difficult choices. According to Crimmins, who spent eight of his 14 years at the SEC in management, supervisors have to make choices and prioritize, particularly at an agency on a “shoestring budget.”

Kotz's audit uncovered exactly this thinking among SEC supervisors. For instance, the full report recounted that work on a Madoff examination “came to a halt as OCIE shifted its focus to other priorities. Two examiners, the report said, “were directed by their supervisors to focus on a mutual fund revenue sharing sweep being conducted by OCIE.” In an e-mail, one examiner explained to a branch chief: “I believe that those who are participating in the mutual fund project are supposed to make that project a priority … But, I'm not sure where the hedge fund [Madoff] project falls on our list of priorities right now.” The branch chief responded: “Get the mutual fund work completed first.”

Towns requested that Schapiro address all five of his questions in a “briefing” by Sept. 11. He also pledged that his committee would hold hearings on the subject “in the near future.” The Senate Banking Committee, meanwhile, has scheduled a Sept. 10 hearing on Kotz's report.

By Malini Manickavasagam

The full IG report is available on the agency's Web site at http://www.sec.gov/news/studies/2009/oig-509.pdf. Towns' letter to Schapiro is available at http://oversight.house.gov/documents/20090904153734.pdf.