Madoff Scandal: Who Was Really Asleep at the Switch?

Financial scandals often produce palliatives rather than cures, and the Madoff scandal has been no exception. In a rush to appear responsive in the wake of the scandal, regulators are spewing out marginally relevant remedies while leaving the underlying causes of the scandal unaddressed.

New approaches to the custody of assets, whistleblowers, and jurisdictional issues are being developed while there is no evidence of any attempt to address the failure of FINRA, the private organization that oversees member broker-dealers, to expose Madoff's Ponzi scheme. Rather, the SEC--under the leadership of former FINRA executives--is poised to reward FINRA for its failure by recommending an expansion of its regulatory turf to include all investment advisers. Unfortunately, the net effect of the Madoff scandal may very well be a reduction in investor protection.

A Question of Custody
The Madoff scandal was a custody scandal. An analogy may be helpful here. When Child Services visits a home to check up on a child's welfare, a necessary predicate to assessing the child's well being is confirming that the child is actually in the home. The assets on Madoff clients' account statements, like children missing from the custody of their guardians, were not there. Regulatory inspections failed to discover that the assets were not there. The SEC accordingly has proposed new custody rules that require registered investment advisers with custody of client assets: 1) to submit to an annual surprise audit and, in certain cases, 2) retain a registered accountant to review their custody procedures.

These rules might marginally improve the safety of client assets, but they will not even apply to brokers like Madoff (although they will apply to registered investment advisers who invested with Madoff). Madoff was not a registered investment adviser until the very end of a fraud that began in the early 1990s.

This is not unusual. The SEC has spent several decades helping brokers avoid regulation as investment advisers, most notably by adopting an exemptive rule that was later declared illegal by a federal court and interpreting a narrow exemption from investment adviser regulation so broadly than any broker could rely on it. The Madoff Custody Rules will not apply to future Madoffs, whose regulation will be left in the hands of FINRA, their "self-regulator."

The Limits of Whistleblowers
Prior to the proposal of the Madoff Custody Rules, the SEC had announced the Madoff Whistleblowing Procedures. Many have blamed the Madoff scandal on the SEC's failure to act on tips provided by Harry Markopolos as early as 1999. The SEC should have investigated Markopolos' claims because they were credible and detailed, and the SEC plans to overhaul the management of whistleblower tips and seek authority to compensate whistleblowers. Again, these procedures may marginally improve investor protection, but they do not attack the root causes of the Madoff scandal.

Whistleblowers are an extremely inefficient means of detecting misconduct. The SEC receives hundreds of thousands of complaints every year, only a tiny fraction of which reflect illegal conduct. If the SEC committed the resources necessary to conduct a thorough investigation of every complaint, it would do nothing else. The potential benefits of the Madoff Whistleblower Procedures may be more than offset by the costs. Overinvesting in whistleblower management may divert resources that could generate greater fraud detection, such as through improved inspections by regulators--the professional whistleblowers.

The SEC cannot be faulted here, for such overinvestment is an unavoidable response to the Madoff scandal. The behavioral sciences have long established our strong bias for converting, with the benefit of hindsight, unintelligible background noise in a cacophony of information into a siren that no rational person could have missed. Blaming the scandal on Markopolos' ignored tips also satisfies our bias for precise, simple explanations over accurate, complex ones. Policymakers' rabid focus on Markopolos' whistleblowing to the exclusion of more important regulatory causes of the Madoff scandal evidences both of these biases.

The SEC can be blamed, however, for failing to inspect Madoff in 2006 after he registered as an investment adviser. A core part of an inspection would have been confirming that client assets were actually there. Never-inspected, new registrants should be inspected promptly. Never-inspected, new registrants that show up at your doorstep with $17 billion in assets under management should be inspected immediately. Click for next page >>

 

FINRA's Failure
The SEC staff has instituted a surveillance program that automatically sifts through registration information to identify risk factors. Although we can reasonably expect that the current version of the program will sound alarm bells upon the registration of the next Madoff-size firm, we should not rely on it to prevent the next Madoff scandal. When Madoff registered in 2006, his fraud already had been under way for more than a decade. Prior to Madoff's 2006 investment adviser registration, he was subject to inspection and regulation only by FINRA.

The major regulatory cause of the Madoff scandal was not a failure of SEC oversight at all, but the failure by FINRA to ensure that his clients' assets were actually in the custody of his firm. The assets in these accounts, we now know, were a fiction. FINRA is also responsible for regulating brokers' advisory activities conducted outside of the firm, but there is no evidence that FINRA ever looked into Madoff's advisory activities. Either FINRA knew about these activities and failed to examine them, or it did not know about them and should have. If FINRA had carefully reviewed these activities, it would quickly have discovered that most assets were illusory.

The best way to protect against a Madoff-type custody fraud may be to invest in mutual funds, because they are subject to the strongest custody regulation. At the end of the day even the safety of mutual fund assets depends ultimately on regulators. The intangible and complex nature of financial markets makes such dependence unavoidable.

At least when regulators fail they should be honest about what went wrong. We do not know what went wrong at FINRA because it has successfully denied any responsibility for the Madoff scandal. Perhaps FINRA feared to confront Madoff, a former member of FINRA's own board of governors, or Madoff was sophisticated enough to stymie routine inspections. We don't know because FINRA won't tell us.

 

A Troubling Post-Mortem
In late 2008, the stars were hardly aligned for an honest evaluation of what went wrong in the Madoff affair. FINRA had a natural interest in protecting itself. FINRA's head, Mary Schapiro, had been nominated by President Obama to run the SEC, which created an even stronger incentive not to rock that boat. In contrast, the SEC was a natural, easy target for having ignored Markopolos' warnings, having botched its oversight of investment banks Bear Stearns, Lehman Brothers, and Merrill Lynch, and by having been controlled by the losing party in the November election. Once Schapiro had been confirmed at the SEC, there was no incentive to let the former administration off the hook, much less to cast doubt on FINRA's lapses while Madoff made off with billions of client assets.

FINRA also had strategic reasons to deny any responsibility for the Madoff scandal. For years, it has lobbied to expand its jurisdiction to include investment advisers. Its failed oversight of Madoff's advisory activities threatened to place a cloud over its competence in this role, so FINRA has cast the scandal as a failure of investment adviser regulation (and therefore an SEC failure), even though for almost the entire period of the scandal Madoff was not a registered investment adviser. Madoff avoided regulation as an investment adviser (and by the SEC) until 2006 in reliance on the SEC's longstanding and absurdly broad interpretation of a narrow statutory exemption from adviser regulation for brokers. That is why Madoff as a broker was subject only to FINRA regulation. FINRA has claimed that the scandal illustrates the risk of the "absence of FINRA-type oversight of the investment adviser industry," yet "FINRA-type oversight" was the only oversight to which Madoff was subject until 2006.

FINRA's twisted post mortem of the Madoff scandal would not matter so much if it were not being used to do further damage to investor-protection regulation. FINRA has cited Madoff to ratchet up its lobbying effort to be granted regulatory control over investment advisers. Two of FINRA's leading champions on this issue in the past now run the SEC (Chairman Schapiro and Commissioner Elise Walter, who, like Schapiro, came to the SEC directly from FINRA). Not surprisingly, these two are taking the lead in pushing legislation designed to anoint FINRA--the private membership organization where both were recently employed--as the new regulator for advisers. It is unclear why they have not recused themselves from a matter that so directly affects the interests of their former employer.

If Congress enacts this legislation, the "FINRA-type oversight" that was primarily responsible for the Madoff scandal will be extended to all investment advisers. FINRA also has made it clear that, if it becomes the investment adviser self-regulatory organization, it will adopt a universal standard of care that dilutes fiduciary principles as necessary to accommodate brokers' less client-centric business model. But President Obama's white paper on financial regulation argues on Page 71 that brokers' "legal standard should be raised to the fiduciary standard" and the narrow statutory exemption for brokers should be repealed. Obama has flatly rejected the SEC's and FINRA's longstanding positions. The regulators would do well to think harder about palliatives and start working toward a cure.

Mercer Bullard is president and founder of Fund Democracy, a mutual fund shareholder advocacy organization, an associate professor of law at the University of Mississippi School of Law, a senior adviser for financial planning firm Plancorp Inc., and a former assistant chief counsel at the Securities and Exchange Commission. The views expressed in this article do not necessarily reflect the views of Morningstar.com

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