Thanks to a series of Congressional hearings and a scathing 457-page report by the Securities and Exchange Commission (SEC) Inspector General (IG), we now have a pretty good idea of how the SEC failed to detect the infamous Bernie Madoff Ponzi scheme (inexperienced staff, investigations with an overly narrow focus, a failure to thoroughly investigate credible tips and complaints, poor supervision by senior management, a lack of communication between the various SEC offices investigating the case, an inexplicable failure to verify Madoff’s trading with an independent third party, a culture of deference to Wall Street, etc.). At one hearing, Harry Markopolos—a financial analyst and fraud examiner who tried several times to tip the SEC off about Madoff—told Congress that the “SEC staff was not capable of finding ice cream at a Dairy Queen” and that the SEC attorneys couldn’t “find steak at an Outback.”
Now the million dollar (or $65 billion) question is: how do we actually turn things around at the SEC so that it can once again become a “junkyard” watchdog capable of protecting investors from the next big Ponzi scheme?
Yesterday, the SEC IG issued two follow-up reports with a whopping 58 recommendations for improving the SEC’s investigative and enforcement practices in the wake of the agency’s massive failure in the Madoff case. Near and dear to our heart were the numerous recommendations for improving the agency’s handling of whistleblower tips and complaints. For example:
- “Require tips and complaints to be reviewed by at least two individuals experienced in the subject matter prior to deciding not to take further action;”
- “Establish guidance to require that all complaints that appear on the surface to be credible and compelling be probed further by in-depth interviews with the sources to assess the complaints validity and to determine what issues need to be investigated. Such guidance should also require that staff obtain all relevant documentation related to such complaints;” and
- “All Office of Compliance Inspections and Examinations (“OCIE”)-related tips and/or complaints that are not vetted within 30 days of receipt should be brought to the attention of the OCIE Director with an explanation for the delay.”
As you can probably tell, many of these recommendations are painfully obvious (e.g., “Put in place procedures to ensure that investigations are assigned to teams where at least one individual on the team has specific and sufficient knowledge of the subject matter” and “When an examination team is pulled off the examination for a project of higher priority, upon completion of that project, the examination team should return to their examination and bring the examination to a conclusion.”). The fact that these systems aren’t already in place should give some indication of how far behind the SEC has fallen and how urgent the IG’s recommendations are.
We’re glad to hear that SEC management concurs with all 58 of the recommendations and will be submitting corrective action plans to the IG within 45 days, but the ultimate test will be to see how quickly and effectively the SEC leadership can actually implement these recommendations. It’s absolutely imperative that SEC Chair Mary Schapiro, Director of Enforcement Robert Khuzami, and OCIE Acting Director John Walsh make these reforms a top priority, and that Congress and the IG conduct diligent oversight to ensure the right systems are eventually put in place.
In the meantime, we hope Congress and the SEC leadership will consider some other promising ideas for improving the agency’s investigation and enforcement practices. For example, Markopolos has put forth a number of intriguing proposals for attracting more qualified staffers and encouraging more whistleblowers to come forward with tips and complaints:
- Increase compensation for SEC staffers and make it tied to the amount of enforcement revenue each office collects;
- Devise success metrics based on how much fraud is actually uncovered, rather than how much paper is inspected;
- Establish an SEC Office of the Whistleblower to oversee the handling of whistleblower tips (Markopolos often cites the Association of Certified Fraud Examiners’ 2008 Report to the Nation, which found that insider tips detected 54.1% of uncovered fraud at public companies); and
- Utilize Section 21A(e) of the Securities Exchange Act of 1934, which authorizes the SEC to award bounties to informants. Markoplos also recommends making the payments mandatory and expanding the program to cover all types of securities violations.
And while the SEC IG reports make it abundantly clear that throwing more money at the agency won’t necessarily solve its multitude of internal problems, Sen. Charles Schumer (D-NY), who sits on the Senate Banking Committee, has put forth an interesting proposal to change how the SEC is funded. Under Sen. Schumer’s plan, the SEC would be funded by the fees it charges to financial institutions. While some people might be rightfully skeptical of any legislation coming from a Senator who has taken in $1.65 million from the financial services industry since the beginning of the year, Schumer claims his legislation will increase the SEC’s budget by 75 percent. If this would help the agency attract more talent and implement the SEC IG’s recommendations, we hope Congress will give it some serious consideration.
-- Michael Smallberg