What's The Matter With The SEC?

Bernard L. Madoff pled guilty to 11 criminal counts and was sentenced to 150 years in prison and handed a forfeiture bill of $170 Billion. Those results of the Madoff scandal are called justice, but they'll do little to repair the damage to innocent investors stirred into his $50 Billion scheme because they trusted both their financial advisors and a U.S. securities industry that is celebrated endlessly in the media and regulated, and patrolled presumably, by the Securities and Exchange Commission.

Soon after the Madoff scandal broke, people following the story learned the name Harry Markopolos. Mr. Markopolos is a long-time investment manager and investigator from Boston who was not at all surprised by the discovery of the Madoff larceny. As an employee of Rampart Investment Management Company, Markopolos had been tracking the Madoff business ever since 2000, when his firm asked him to figure out the Madoff method in the hopes of replicating his success. Markopolos later testified that it took him a few minutes to suspect Madoff was a fraud and less than a day to confirm so and that investors in his scheme were in danger.

Markopolos advised his firm that Madoff was a fraud, but didn't just sit on that information to let others learn for themselves. Because he believed in the necessity of an honest and credible securities industry and that Madoff could harm America's reputation worldwide, Markopolos gathered evidence, wrote summaries of the Madoff fraud and delivered it all gift wrapped to the SEC. Markopolos gave his gifts in 2000, 2001, 2005, 2007 and 2008. Each time Markopolos contacted the SEC, his alarms were ignored.

The SEC didn't listen to Markopolos over the years, but in February, 2009 the 111th Congress was all ears. The BIG question Congress wanted answered by Markopolos was What's The Matter With The SEC? Aside from being an informant for Congress that day, Markopolos became a performance thinker whose message of improvement would gratify T&D pros everywhere. The basic problems at the SEC: Leadership, People, Learning.

I think leadership starts at the top. The tone at the top is very important... I thought that [Chairman] William Donaldson was great. He was a fox who came to guard the hen house... And I think that is what led to his dismissal in 2006.

In 2000, Congress heard there was an "overabundance" of revenue at the SEC and that as much as $1.5 Billion of that revenue was unnecessary for the SEC to carry out its mission. When the Madoff scandal broke in 2008, the SEC blamed lack of funding and understaffing. In 2000, the SEC prosecuted 69 cases of securities fraud, and by 2007 the number had dropped to 9. The message from the White House over that period was that the market can take care of itself, and the message at the SEC was "fraud is green lighted here." It's no wonder the SEC failed to prevent a Madoff when it begged for less resources and dismissed a Chairman who wanted an effective agency. Leaders in the White House, who appoint SEC Commissioners, got the SEC they wanted, an agency that didn't bother Wall Street and dismissed staff that believed in protecting all investors. Unfortunately, that result is inconsistent with the purpose and mission designed for the SEC when it was created during the Great Depression.

The SEC is overmatched. They are too slow. They are too young. They are too undereducated... the SEC is overlawyered and has too few staff with relative industry experience and professional credentials to find fraud, even when a multi-billion dollar case is handed to them on a silver platter.

For law enforcement and regulators, being overmatched must be among the worst predicaments. How did the SEC get there? "The Revolving Door," young people taking starter jobs as a stepping stone to the Shangri-La of Wall Street. "Hire senior people from industry," says Markopolos, and incentivize them to be aggressive, rather than chummy. The friendly and unaware "SEC would never have caught [Madoff]. He basically had to run out of money." Former SEC Chairman Harvey Pitt also assessed the Madoff disaster, "human failure... the SEC may have developed a blind spot because it's overlawyered and needs more traders, managers, and veterans of markets. That's been a weakness at the SEC."

"...the SEC needs to shed its keystone cops modus operandi and quickly turn itself into a learning, winning organization."

The SEC wasn't open to learning, and SEC lawyers and economists in particular. Markopolos convinced two SEC people in Boston that his suspicions were real, but his allies sent him to the New York Branch Chief of the SEC Enforcement Division and the Director of the Office of Risk Assessment in DC, two highly educated and placed people in the SEC who saw no evil.

The Markopolos learning prescription:

  • Listen to Tips! 54% of the frauds get discovered by tips, only 4% by agency auditors.
  • Communicate! Create a Center for All Lessons Learned that will be a think tank for diagnosing and defining the characteristics of fraud and a resource for anyone with a list of red flags in front of them.
  • Get Out of the Office! The SEC doesn't allow its people time or money to attend industry luncheons, dinners, cocktail parties and other low cost education and "word on the street" events.
  • Train Watchdogs, Not Lapdogs! SEC examiners need to improvise and talk to employees who's answers aren't scripted. Talk to traders, managers, operations people... and not compliance officers.

© 2009 Charles Fleeman