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News January 5, 2009 Issue

Hearing Suggests that Madoff Fraud May Lead to Overhaul of Adviser Regulation and Examinations

The House Financial Services Committee’s January 5 hearing on "Assessing the Madoff Ponzi [Scheme] and the Need for Regulatory Reform" provided scant new details about the SEC’s investigation of Bernard Madoff’s $50 billion investment fraud. In fact, early in the hearing the SEC’s inspector general testified that he would not "provide any conclusions or findings with regard to the allegations that have been raised," nor would he "make any preliminary judgments" about the investigation.

But the hearing did provide a clear and startling indication that the Madoff scandal will be used as a pretext for those who seek to overhaul broker-dealer and investment adviser regulation.

Here, the Congressman to watch is Rep. Spencer Bachus (R-AL).

During his opening remarks, Bachus said that the Madoff scandal highlighted the need for a new statutory and regulatory structure. The "differential regulatory treatment of broker-dealers and investment advisers" was one of the factors that allowed Madoff to get away with his fraud for as long as he did, Bachus asserted.

Let’s roll the tape: FINRA, said Bachus, "inspected Madoff’s broker-dealer … every other year beginning in 1989. But because FINRA’s jurisdiction is limited to broker-dealers, it had no authority to inspect his affiliated investor-adviser [sic]. And that’s where the fraud was perpetrated and operated from that shop. And while the SEC has authority to inspect investment advisers, it typically inspects only a small percentage of the 11,000 federally-registered firms in any given year. In fact, Mr. Madoff’s firm was never subjected to such an examination."

Bachus then noted that independent studies have found that "many investors simply cannot distinguish between the obligations and responsibilities of brokers, investment advisers, financial planners, financial advisers, or consultants." So, as part of its consideration of financial services reform, the House Financial Services Committee "should examine whether the Madoff scandal argues for harmonizing the regulation of broker-dealers and investment advisers so that schemes, such as the Madoff scheme, do not go undiscovered and are limited in their scope before causing such catastrophic consequences."


But let’s think about this for a minute. Was Bachus right about FINRA not having jurisdiction over Madoff’s firm?

Here’s what we’ve been told: Prior to 2006, Madoff managed money under the guise of discretionary brokerage accounts. During that time, of course, FINRA examiners would have had every right to go in and review those discretionary brokerage accounts.

But we’ve also heard that Madoff might have told FINRA examiners that those discretionary brokerage accounts were off-limits, because they were part of his then-unregistered money management firm. If he did, in fact, hold up his hand to FINRA examiners and say, "Nope. Can’t see those accounts on the 17th floor because they are part of my unregistered advisory firm," query whether FINRA examiners would have challenged that assertion and tested whether or not those accounts were truly advisory accounts. (Imagine the brou-ha-ha that would result if FINRA double-checked advisory accounts to confirm that they were not, in fact, brokerage accounts.)

In any event, Madoff’s discretionary brokerage accounts magically were transformed into advisory accounts in 2006, when the SEC took the interpretive position that discretionary brokerage accounts should be treated as advisory accounts. And so he registered as an adviser with the SEC. [Editor’s note: A reader helpfully pointed out that presumably, those accounts remained brokerage accounts, but just added an advisory overlay. So FINRA still would have had jurisdiction to look at them, even after their 2006 conversion].

Let’s get back to the hearing. Rep. Bachus seemed concerned that Madoff simultaneously functioned as an adviser, broker, and custodian of client assets. That, he said, "was very odd." When a brokerage firm and an advisory firm "are one entity," he asked, "does that cause some opportunity for mischief?"

SEC inspector general David Kotz agreed, saying that that would be something his office would look at. The question, he said, is whether Madoff’s status as a dual-registrant should have "immediately jumped out" as a concern, based on the "forms that were filled out."

Bachus also noted that although Madoff managed about "a hundred" times the number of assets that would trigger SEC registration (an apparent reference to the $25 million assets under management threshold), Madoff did not register as an investment adviser until 2006. That, he said, might be a "red flag."

The status of Madoff’s firm as a dual registrant intrigued other Committee members as well. Rep. Brad Sherman (D-CA) noted that "there’s this myth" that at Madoff’s firm, "the 16th floor was cool" but "the 17th floor was where the fraud was going on." But, he said, there should be no segregation: "It’s one entity, one fraudulent entity, and that entity was filing financial statements with the SEC and with FINRA every year for many years."

Not surprisingly, participants in the hearing questioned the adequacy of the SEC’s examination program. In his testimony, Kotz said his office will be reviewing OCIE’s examination and inspection procedures. This, he said, will include "an analysis of what policies and procedures were then and are currently in place" and whether those policies and procedures are being followed. He also said that his office would consider whether there are "gaps" in the SEC’s policies and procedures "relating to operations involving voluntary private investment pools, such as hedge funds, because they are subject to limited oversight by the SEC, and whether any such gaps may lead to fraudulent activities not being detected."

Kotz also said his office would review the relationships between different divisions and offices within the Commission, and whether there is sufficient intra-agency collaboration and communication between the agency components to ensure comprehensive oversight of regulated entities.

Rep. Dean Heller (R-NV) asked Kotz what he believed an "ideal period of time between audits of an investment adviser or a securities firm" should be. Kotz responded by saying that his office was looking into both the adequacy and frequency of SEC examinations. Not only will the SEC’s inspector general look at whether the SEC’s examination program has enough resources to conduct sufficiently frequent examinations, he said, but it will also determine "whether these examinations are done appropriately." Even if the SEC has adequate resources "and you can do more examinations," the question is whether the examinations are "yielding the results" and "are fruitful," Kotz said. "First, I think we need to determine that the examinations would find what they are supposed to find," he said. Then, if "it’s just a matter of the frequency, then I think we would make recommendations that they increase the frequency."

Bachus also focused on the fact that Madoff’s investment returns were suspiciously smooth. Kotz testified that his office would investigate whether the SEC staff possesses the requisite expertise to adequately assess advisers’ reported returns, or whether there needs to be additional SEC training to ensure that the SEC does have that expertise. (Of course, investment advisers are not currently required to report their returns to the SEC.)

Among the other areas Kotz said his office would investigate:

  • The SEC’s response to the Madoff-related complaints that it received;
  • Conflicts of interest regarding relationships between SEC officials and Madoff family members;
  • The conduct of examinations and/or inspections of Madoff’s firm, and whether any red flags were overlooked by SEC examiners and inspectors; and
  • The extent to which Madoff’s reputation and status affected SEC decisions regarding his firm.