Where were the regulators in the Madoff mess? How was he able to operate a fraudulent business for so long? As a former advisor, registered as such with the Securities and Exchange Commission (SEC), I am absolutely astonished at the lack of oversight by the commission. Every registered investment advisor is expected to operate a compliant business, and the SEC staff periodically does surprise audits to ensure that they do. What’s more, every audit I am aware of has always resulted in some “findings”, where the advisor is deemed to be in violation with one or more of the rules or procedures, and at the very least, must demonstrate how the business will be reorganized to ensure it will not happen again. And these are legitimate businesses who for the most part are guilty of only minor infractions.
Occasionally an audit will uncover an unsavory practice of some kind that usually falls into the category of charging too much and delivering too little. But the cases where there is out-and-out fraud are rare.
In Madoff’s case, it appears that there were allegations of fraud that covered more than a 10 year period! One guy was an expert in the type of strategy Madoff seemed to have had so much success with, and he sent information to the SEC to prove that there was not enough option volume on the entire exchange to support the Madoff strategy. They ignored it, or they buried it, or they just let it die from inattention. I look forward to the congressional hearings where the SEC is grilled about this utter lack of diligence and ineptitude.
And there were other red flags, such as the fact that he apparently was paid commissions on trades, and he had an extremely high number of trades. Talk about a glaring conflict of interest! Madoff also had custody of client funds. Custody is an industry term that means that he went beyond just directing trades – he held things in a way that would have allowed him to actually divert money out of client accounts and into his own. The regulators take custody very seriously. Among other things, they require audited financial statements from every advisor who has custody. Presumably these financials were among the documents he submitted to the SEC that will ultimately prove to be fraudulent too. Did they look at them? Did they make any calls about them? Did they audit the auditors?
How could the SEC examiners be so incompetent?
I happen to believe that there is a huge danger in every bureaucracy. Once it becomes too entrenched, it’s chief aim becomes the preservation and perpetuation of itself. I wonder if the SEC examiners actually got out of their chairs, went to visit any actual people, and actually did any investigative work. I wonder whether they have any reason to exist at all!
What if we slashed the staff of the SEC to a tiny fraction of its current size, and used the money to pay bounty hunters, who, armed with the best technology, unencumbered by a bureaucratic organization, and motivated by a big payday, would root out real fraud and corruption?
Sadly, what is much more likely is that we will pass new laws and create new bureaucracies. We will burden the taxpayers with the cost of running the new bureaucracy, and it will ultimately fail just as miserably to protect our interests.
This time, instead of hollering “There outta be a law!”, we should insist that our regulators be more highly motivated to do the job of compliance with the laws we already have! And motivation has always been at the root of the problem. When regulators have no incentive to swim against the tide, and every incentive to go with the flow, how should we expect them to behave? When they have every incentive to hamstring advisors who want to run clean shops and no incentive to get up off their rear ends and actually go out and root out some crooks, why should we expect them to do anything constructive at all?
It’s time to hold the regulators accountable, too. Maybe we even need to have someone auditing them!