The SEC has Failed Us

The SEC has Failed Us: What now?

Courtesy of Jacob Zamansky

The alleged Ponzi scheme perpetrated by Bernie Madoff should be the death-knell for the SEC. The SEC ignored numerous red flags waved by investors going back ten years. It was a not-so-well-kept secret across Wall Street that Mr. Madoff’s reported returns were fictitious and in 2001, Barron’s published a story entitled, “Don’t Ask, Don’t Tell; Bernie Madoff is so secretive, he even asks investors to keep mum.”

The signs were there. Period. And the SEC decided to lazily ignore the problem and is continuing to claim jurisdictional road blocks. It argued that Mr. Madoff didn’t register as an investment advisor, but that is not true. He was registered in 2006 and the SEC was required to examinie his operation then, and every five years thereafter.

In light of its recent performance, to make excuses at this point this is nothing less than insulting to investors.

Our financial regulatory system has failed. Therefore, steps must be taken to correct the problem now. If the United States wishes to remain the financial capital of the world, we must take a leadership role immediately.

Many factors such as securitization, leverage, asset bubbles, conflicts and outright fraud contributed to the economy’s downfall. But in general, I believe that it is self-regulation and inadequate oversight that provided the essential glue for the confluence of issues that have led to the economy’s collapse. One needs to not look any further than the fact that Bernie Madoff himself presided over the NASDAQ, which at the time served as one of the key financial regulators overseeing him and those of his ilk. Moreover, he was able to perpetrate his alleged schemes knowing the SEC was asleep at the wheel.

Nearly at every turn there are examples of Wall Street’s influence over regulation:

For example, in 2002 Wall Street successfully lobbied the SEC to adopt directives that would be “equivalent” to proposed European Union (E.U.) regulation that would have put the big five U.S. investment banks under the umbrella of E.U. regulatory authority. In response, the SEC, perhaps unwittingly, created as a result the Consolidated Supervised Entity (”CSE”), which relaxed net capital requirements and green-lighted unlimited debt/equity ratio leverage. This action permitted firms like Merrill Lynch and Bear Stearns to leverage their assets up to 40:1 with cataclysmic results for the financial system.

Another long-term and distressing trend is that the SEC Chairman and its top regulatory executives moved freely between the financial services industry and government positions. This resulted in a failure to manage conflicts. For example, in a scathing report issued by the Commission’s inspector general’s office, it was determined that the SEC’s Miami office found Bear Stearns improperly priced its collateralized debt obligations in 2005. An SEC official who later joined a major securities law firm gleefully informed Bear Stearns that the SEC would squash the investigation saying, “Christmas came early.”

The report went on to disclose numerous situations where conflicts clearly affected the SEC’s judgment including that an employee improperly used her position with regard to a family member’s dispute with a broker, potential insider trading and even one instance where one of the SEC’s own attorneys had not maintained his bar status in 14 years. The well documented case of the SEC’s handling of the Pequot insider trading allegations is another black eye.

Most of these scandals occurred under the watch of Chairman Christopher Cox, who prior to serving in the U.S. House of Representatives was a partner a Lanthan & Watkins, a go-to securities law firm for much of Wall Street. Chairman Cox’s laissez-faire oversight of the securities market makes Harvey Pitt’s famous “kindler, gentler” SEC look downright forceful. Plainly put, if Chairman Cox were the coach of a professional sports team, he would have been fired a few weeks into his first season.

Regulatory reform does not stop with the SEC. The current Secretary of the Treasury is easily the poster child of Wall Street’s “regulation domination.” In 2006, Secretary Paulson established the “Committee on Capital Markets Regulation,” a.k.a. “The Paulson Committee”, which set out to reduce the regulatory burden on the financial services industry. The Committee consisted exclusively of representatives of investment banks, auditors and corporate issuers. There were no representatives of either institutional or individual investors. Their targets were:

Ø Sarbanes-Oxley Act – particularly reforms designed to improve internal controls and the ability for Attorney Generals to prosecute corporate malfeasance

Ø Reducing litigation liability for auditors

Ø Making it harder to “prove” securities fraud

The proposals would have basically left securities and corporate fraud unchecked, which is exactly what Wall Street wanted. Though Wall Street’s meltdown has tempered Secretary Paulson appetite for additional deregulation, his oversight of the TARP funds appears to be engineered by the industry as well. Wall Street banks were provided billions in direct funding without any questions asked. And instead of using the funds to break the credit log jam, Wall Street is hoarding the money for its own purposes.

The key to a new Obama regulatory regime is expanded rules of play and stronger leadership. New regulation must be written on the basis of transparency, full disclosure and an end to conflicts of interest all together. Among the key focal points, I recommend:

Ø There has to be a complete overhaul of all the “grey” areas that continue to slip through the cracks. Indeed, it’s unclear whether the SEC should have had oversight of Mr. Madoff’s investment business because it was structured separately from his broker-dealer operation.

Ø There needs to entirely be more transparency for investment advisors, the credit default swaps market and hedge funds. Hedge fund regulation must go further than the so-called “Goldstein Rule,” which was a feeble attempt by the SEC to require fund managers simply to “register.” It’s notable that when the SEC was told it couldn’t require hedge funds to register as a matter of law, the agency choose to “punt” and not pursue such powers with Congress. To rein-in the damage they can cause, hedge funds, broker-dealers, market makers and investment advisors alike should be subject to periodic audits for systemic risk and “style drift.” Such an audit would expose Ponzi schemes, ala Mr. Madoff.

Ø And if there are breaches of regulations, the penalty must fit the crime. Gone should be the days when thirteen of the largest investment banks are fined a paltry $15 million collectively for violations, as was the case when the SEC found evidence of wrongdoing related to auction rate securities (ARS) years before the market froze. Paltry fines have been the cost of doing business for too long. Enforcement action should be discouraging enough to prevent violations.

Ø Finally, let investor arbitration be a stronger check for industry wrongdoing. FINRA must eliminate the requirement of one industry arbitrator sitting on each three member panel. This will make arbitration hearings fairer for investors – creating a more level playing field because the industry arbitrator is inherently partial.

What is going to give the Madoff scandal major impact is that very influential people have been profoundly affected including Senator Frank Lautenberg, real estate magnate and Daily News editor Mort Zuckerman, movie director Stephen Spielberg, among others. While there are countless individual investors that learned long ago of the SEC’s dormant ways, the agency’s negligence in the Madoff case has dramatically raised awareness of the agency’s ineffectiveness. I’m hopefully that the investor protection I’ve long been calling for is finally implemented.