Wednesday, January 28, 2009

'Don't Ask, Don't Tell' Is Over, Dodd Tells Madoff Hearing; Schapiro, Geithner Sworn In

Opening a Senate Banking Commitee hearing Jan. 27 on the failure of regulators to catch alleged $50 bilion Ponzi schemer Bernard Madoff, the committee's chairman, Senator Christopher Dodd said he wanted to know how regulators missed the red flags, how many more 'Madoff schemes' could be out there, and "how to prevent crimes like these going forward - whether we require more resources or additional rulemaking or legislation. "

Joining the ranks of those who have invoked images of "It's the End of the [Regulatory] World As We Know It," (building on his own sounding of the alarm in 2007 and 2008 about the need for regulatory reform and the need to address the foreclosure crisis) Dodd said: "[T]his Committee is committed to strengthening regulation, rebuilding confidence, and, above all, sending a clear message to investors across the world: The era of 'Don’t Ask, Don’t Tell' on Wall St. is over." On this theme, see also "The End of the Financial World As We Know It," by Michael Lewis (author of Liar's Poker) and David Einhorn (president of Greenlight Capital) in the Jan. 3 NYT, and see a slightly different reference in Cox Steps Up, posted Dec. 8 in self-confessed 'audit geek' Michael Ramos' blog, The Eyeshade.)

SEC's Thomsen, Richards Testify
In written testimony before the Senate Banking Committee, SEC Enforcement Director Linda Thomsen provided general information on the SEC’s past investigations relating to Madoff which are a matter of public record, but did not go into any specifics on current investigations, noting (footnoting, actually), that she could not comment on pending litigation or the underlying investigations “in order to avoid jeopardizing the ongoing legal and investigative processes,” and in light of the ongoing internal investigation by the SEC’s Inspector General.

Dodd acknowledged, “we will respect these investigations and not ask you for facts which cannot be disclosed publicly at this time.” However, he added, “I will ask that you be thorough and hold responsible the people who facilitated this securities fraud.” As detailed further below, Dodd emphasized to the committee:

Red Flags Missed -Dodd Asks Why
Dodd recited the laundry list of red flags that waved before the SEC and others regarding Madoff, including the 2001 Barron’s article, “Don’t Ask, Don’t Tell,” questioning Madoff’s strategy and secrecy, the 19-page memorandum delivered by Harry Markopolos to the SEC in 2005 alleging Madoff Securities to be ‘the world’s largest Ponzi scheme,’ the fact that Madoff’s returns were ‘too good to be true,’ and the huge fund used a tiny audit firm with only one active accountant.

He then asked: “How could regulators have missed so many warning signs? Did the examination staffs lack adequate expertise or numbers? Were they intimidated by Mr. Madoff’s influence in the securities industry? Did they lack legal authority? Or, as I suspect, are there deeper problems?” He added, “Former Chairman Chris Cox has suggested as much.”

Limited staff cover over 10,000 Advisors, Hundreds of Thousands of Tips
Lori Richards, Director of the SEC’s Office of Compliance Inspections & Examinations, explained in general terms the agency's inspection and examination process for broker-dealers and advisers, nothing that due to the volume of investment advisers to be examined - which has ballooned in recent years, from 7,547 advisers in 2002, to nearly 11,300 today - vs. the relatively small size of the SEC’s staff dedicated to this area (425 people) - the frequency of inspections of individual firms on average (which used to be once every five years prior to 2002, she said) has lessened such that 14% of the registered advisors were examined last year. She added that such inspections, due to the volume that need to be conducted, do not amount to audits. However, she explained they focus on a risk-based approach.

Thomsen explained how the SEC handles tips, noting they receive hundreds of thousands of tips a year, arrive in a number of different forms, and exhibit differing levels of detail and credibility, noting, “We get telephone calls, handwritten letters, thick bound dossiers with numbered exhibits and extensive accounting analyses, complaint forms from the Enforcement Division’s Office of Internet Enforcement, newspaper articles with company names circled in red ink, formal referrals from other regulators, informal referrals from other Offices and Divisions of the SEC, notes from reformed fraudsters, anonymous scribbling, seemingly random pieces of a company’s financial statements, and occasional lengthy and disjointed diatribes that make no discernible securities-related claims.”

“While we appreciate and examine every lead we receive,” said Thomsen, reiterating some of the statistics provided by Richards, adding, “we simply do not have the resources to fully investigate them all. We use our experience, skill and judgment in attempting to triage these thousands of complaints so we can devote our attention to the most promising leads and the most serious potential violations. Because the process necessarily involves incomplete information and judgment calls made in a tight timeframe, we are also continually working on ways to improve our handling of complaints, tips and referrals to make optimal use of our limited resources."

Enforcement Strikes Back
Thomsen also struck back at detractors who challenged the SEC’s Enforcement strategy, saying, “In recent days there have been suggestions that the staff is not motivated to pursue the big case and somehow is inclined to look the other way. Nothing could be further from the truth. Based on my experience with the hard-working men and women in the Enforcement Division, our staff lives to bring cases, particularly big and difficult cases. The staff is bright, creative and professionally zealous; for most of us, nothing is more rewarding than pursuing a good case.”

“Athletes may score runs or kick goals, but we bring enforcement action,” said Thomsen, adding, “The filing of an enforcement action is one of the few solid benchmarks of success in the pursuit our mission.”

As to the future, Thomsen said, “Looking at what we can do to deter fraud or find it sooner, the steps fall into three general categories: law enforcement; law and regulation; and resources.” For further details, see Thomsen’s written testimony.

Others testifying at the hearing included FINRA Interim CEO Stephen Luparello, SIPC Pres. & CEO Stephen Harbeck, Prof. John C. Coffee of Columbia Law School, and Dr. Henry A. Backe, a partner in a medical practice whose retirement plan lost money with Madoff.

As an aside, one thing I found interesting was that the title of the hearing according to the Senate Banking Committee referred to the “Madoff Fraud,” while the cover page of the written testimony provided by SEC’s Thomsen and Richards refers to the “Madoff Matter.” This not-so-subtle difference in etymology is probably in deference to the fact that the “Matter” is still under “Investigation” [Inquiry] or what is commonly referred to as a MUI, as defined in the SEC’s Enforcement Manual circa Oct. 2008 - posted on the SEC website in the Division of Enforcement section. I don't know how long the Enforcement Manual has been posted on the SEC website; whereas it is fairly well known that the Division of Corporation Finance staff training manual - rechristened this year as Corp Fin’s Financial Reporting Manual – has been posted on the SEC website as a resource for the public for many years.

The Era of Don't Ask, Don't Tell on Wall Street is Over
Calling the Madoff fraud a “regulatory failure of historic proportions,” Dodd stated, “Even if this is an extraordinary case, the Madoff fraud makes crystal clear how critical transparency and accountability are to our markets’ continued success. It makes clear how inseparable proper oversight cops on the beat are to a dynamic, competitive financial system.”

“Our markets are only as strong as those who regulate them and the laws and values which market participants observe,” said Dodd. He added, “Going forward, the American people need to know that this Committee is committed to strengthening regulation, rebuilding confidence, and, above all, sending a clear message to investors across the world: The era of ‘Don’t Ask, Don’t Tell’ on Wall St. is over.”

Schapiro, Geithner Sworn In As Chairman (Secretary) of SEC (Treasury)
Dodd's overaching message of the end of "Don't Ask, Don't Tell" will not be lost on the new Chairman of the SEC, Mary L. Schapiro, and the new Secretary of the Treasury, Timothy F. Geithner, with respect to Wall Street regulation genearlly, and the use of - and oversight relating to the $700 billion Troubled Asset Recovery Program (TARP).

SEC's Thomsen noted in her written testimony for the Jan. 27 hearing ,"On the law and regulation front, as has been widely acknowledged, our current system includes many products and businesses that are largely unregulated (hedge funds, for example); products and businesses that are regulated only on the state level (many insurance products, for example); and balkanized regulation on the federal level (the different regulatory schemes that apply to broker-dealers and investment advisors, for example)." She added, "Consideration should be given to harmonizing the regulatory regimes that apply to ... similar products and businesses. Such harmonization could benefit not only the individual investor but also the market as a whole by contributing to restored market confidence."

Importantly, Thomsen also recommended, "On a more micro level, consideration should be given to quite specific steps that might contribute to slowing down or detecting fraud within an investment advisory business. For example, consideration could be given to requiring third party custody of customer assets, imposing requirements regarding qualifications, size and resources of accounting firms eligible to audit such businesses, or requiring additional disclosure."

Citing written responses from Schapiro to Senator Carl Levin,'s Sarah Johnson's noted in her Jan. 26 article, Schapiro Distances Herself From Cox, "[Schapiro] has indicated that her highest priorities are helping the Obama administration reform the financial regulatory system, and fixing the internal enforcement issues at the SEC, which have been criticized for failing on several occasions to notice Bernard Madoff's alleged $50-billion Ponzi-style fraud." See also Schapiro Agrees SEC Must Reconsider Key Areas Including Proxy Access, IFRS, by Malini Manickavasagam and Steven Marcy, in the Jan. 27 BNA Daily Report for Executives, also citing Schapiro's responses to Levin. For those interested in reading more detail -- props to Cheryl Graziano, VP Research & Operations of FEI's research affiliate, the Financial Executives Researh Foundation (FERF) - for noting this link where Senator Levin posted pdfs of his questions posed to, and answers received from, Schapiro and Geithner in connection with their confirmation by the Senate.

Separately, within a day of Geithner's taking office at Treasury, the agency announced, "In light of President Barack Obama's firm commitment to transparency, accountability and oversight in our government's approach to stabilizing the financial system, U.S. Treasury Secretary Tim Geithner today announced several key reforms to the Emergency Economic Stabilization Act (EESA). As one of his first acts as the 75th Treasury Secretary, Secretary Geithner outlined new, stepped up rules designed to limit the influence of lobbyists and special interests in the EESA process and ensure that investment decisions are guided by objective assessments in the best interest of the health and stability of the financial system."

See also GAO's report released on Jan. 22, High Risk Series: An Update, which identifies "Modernizing the U.S. Financial Regulatory System" as one of three new high risk areas, and see reports and other resources listed on the webpage of the Congressional Oversight Panel (COP), formed to conduct oversight on behalf of Congress on the TARP program.

For a change of pace in the reporting on the Madoff fraud - by someone who totally eschews "Don't Ask, Don't Tell" - check out "Bernard Madoff's Blog."

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