    [Senate Hearing 111-38]
    [From the U.S. Government Publishing Office]

                                                             S. Hrg. 111-38

       THE MADOFF INVESTMENT SECURITIES FRAUD: REGULATORY AND OVERSIGHT
                        CONCERNS AND THE NEED FOR REFORM

    =======================================================================

                                    HEARING

                                   before the

                                  COMMITTEE ON
                       BANKING,HOUSING,AND URBAN AFFAIRS
                              UNITED STATES SENATE

                         ONE HUNDRED ELEVENTH CONGRESS

                                 FIRST SESSION

                                       ON

       HOW THE SECURITIES REGULATORY SYSTEM FAILED TO DETECT THE MADOFF
     INVESTMENT SECURITIES FRAUD, THE EXTENT TO WHICH SECURITIES INSURANCE
             WILL ASSIST DEFRAUDED VICTIMS, AND THE NEED FOR REFORM

                                   __________

                                JANUARY 27, 2009

                                   __________

      Printed for the use of the Committee on Banking, Housing, and Urban
                                    Affairs

          Available at: http: //www.access.gpo.gov /congress /senate/
                                senate05sh.html

                       U.S. GOVERNMENT PRINTING OFFICE
    50-465 PDF                  WASHINGTON : 2009
    ----------------------------------------------------------------------
    For Sale by the Superintendent of Documents, U.S. Government Printing Office
    Internet: bookstore.gpo.gov  Phone: toll free (866) 512-1800; (202) 512�091800
    Fax: (202) 512�092104 Mail: Stop IDCC, Washington, DC 20402�090001

                COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

                   CHRISTOPHER J. DODD, Connecticut, Chairman

    TIM JOHNSON, South Dakota            RICHARD C. SHELBY, Alabama
    JACK REED, Rhode Island              ROBERT F. BENNETT, Utah
    CHARLES E. SCHUMER, New York         JIM BUNNING, Kentucky
    EVAN BAYH, Indiana                   MIKE CRAPO, Idaho
    ROBERT MENENDEZ, New Jersey          MEL MARTINEZ, Florida
    DANIEL K. AKAKA, Hawaii              BOB CORKER, Tennessee
    SHERROD BROWN, Ohio                  JIM DeMINT, South Carolina
    JON TESTER, Montana                  DAVID VITTER, Louisiana
    HERB KOHL, Wisconsin                 MIKE JOHANNS, Nebraska
    MARK R. WARNER, Virginia             KAY BAILEY HUTCHISON, Texas
    JEFF MERKLEY, Oregon
    MICHAEL F. BENNET, Colorado

                     Colin McGinnis, Acting Staff Director

                  William D. Duhnke, Republican Staff Director

                    Dean V. Shahinian, Legislative Assistant

                      Kate Szostak, Legislative Assistant

                    Brian Filipowich, Legislative Assistant

                      Drew Colbert, Legislative Assistant

                      Didem Nisanci, Legislative Assistant

                     David Stoopler, Legislative Assistant

                    Jonathan Davidson, Legislative Assistant

                      Tamara Fucile, Legislative Assistant

                     Emily Paladino, Legislative Assistant

                          Rob Lee, Legislative Fellow

                      Mark F. Oesterle, Republican Counsel

                 Andrew Olmem, Republican Legislative Assistant

                Hester Peirce, Republican Legislative Assistant

               Jonathan Graffeo, Republican Legislative Assistant

              Courtney Geduldig, Republican Legislative Assistant

               Sarah Novascone, Republican Legislative Assistant

                 Jason Tuber, Republican Legislative Assistant

                           Dawn Ratliff, Chief Clerk

                          Devin Hartley, Hearing Clerk

                          Shelvin Simmons, IT Director

                              Jim Crowell, Editor

                                      (ii)
    ?

                                C O N T E N T S

                                  ----------

                           TUESDAY, JANUARY 27, 2009

                                                                       Page

    Opening statement of Chairman Dodd...............................     1

    Opening statements, comments, or prepared statements of:
        Senator Shelby...............................................     4
        Senator Johnson
            Prepared statement.......................................    54
        Senator Menendez.............................................     6
        Senator Bennet...............................................     7
            Prepared statement.......................................    54
        Senator Johanns..............................................     7
        Senator Schumer..............................................     8
        Senator Merkley..............................................    10

                                   WITNESSES

    John C. Coffee, Jr., Adolf A. Berle Professor of Law, Columbia
      University Law School..........................................    11
        Prepared statement...........................................    55
        Response to written questions of:
            Senator Shelby...........................................    81
            Senator Johnson..........................................    82
            Senator Johanns..........................................    83
    Henry A. Backe, Jr., M.D., Orthopedic Surgeon, Fairfield,
      Connecticut....................................................    14
        Prepared statement...........................................    61
        Response to written questions of:
            Senator Johnson..........................................    83
            Senator Johanns..........................................    84
    Lori A. Richards, Director, Office of Compliance Inspections and
      Examinations, Securities and Exchange Commission...............    17
        Prepared statement...........................................    63
        Response to written questions of:
            Senator Dodd.............................................    84
            Senator Shelby...........................................    87
            Senator Johnson..........................................    89
            Senator Johanns..........................................    90
    Linda C. Thomsen, Director, Division of Enforcement, Securities
      and
      Exchange Commission............................................    19
        Prepared statement...........................................    67
        Response to written questions of:
            Senate Banking Committee.................................    91
            Senator Dodd.............................................    93
            Senator Shelby...........................................    98
            Senator Johnson..........................................   100
            Senator Johanns..........................................   104

                                     (iii)

    Stephen I. Luparello, Interim Chief Executive Officer, Financial
      Industry Regulatory Authority..................................    21
        Prepared statement...........................................    73
        Response to written questions of:
            Senator Dodd.............................................   107
            Senator Shelby...........................................   113
            Senator Johnson..........................................   114
            Senator Johanns..........................................   116
    Stephen P. Harbeck, President and CEO, Securities Investor
      Protection
      Corporation....................................................    23
        Prepared statement...........................................    77
        Response to written questions of:
            Senator Dodd.............................................   117
            Senator Shelby...........................................   117
            Senator Johnson..........................................   118
            Senator Johanns..........................................   119

                  Additional Material Supplied for the Record

    Harry Markopolos, Chartered Financial Analyst, Certified Fraud
      Examiner.......................................................   120
    Paul Hiller, Chief Fiscal Officer, Town of Fairfield, Connecticut   142
    Barbara Roper, Director of Investor Protection, Consumer
      Federation of America..........................................   144

     MADOFF INVESTMENT SECURITIES FRAUD: REGULATORY AND OVERSIGHT CONCERNS
                            AND THE NEED FOR REFORM

                                  ----------

                           TUESDAY, JANUARY 27, 2009

                                           U.S. Senate,
              Committee on Banking, Housing, and Urban Affairs,
                                                        Washington, DC.
        The Committee met at 10:04 a.m., in room SD-538, Dirksen
    Senate Office Building, Senator Christopher J. Dodd (Chairman
    of the Committee) presiding.

           OPENING STATEMENT OF CHAIRMAN CHRISTOPHER J. DODD

        Chairman Dodd. Good morning. The Committee will come to
    order. We meet today and the subject matter is the ``Madoff
    Investment Securities Fraud: Regulatory and Oversight Concerns
    and the Need for Reform.''
        First, let me welcome Members of our Committee. Let me
    begin by welcoming Michael Bennet, a new member of the U.S.
    Senate from Colorado. We are delighted to have you with us,
    Senator, and are looking forward to your service on this
    Committee.
        Senator Bennet. Good morning.
        Chairman Dodd. We also have a new Member, Mike Johanns from
    Idaho here as well. Thank you----
        Senator Johanns. Nebraska.
        Chairman Dodd. Excuse me. Nebraska. I apologize. Thank you
    for joining us.
        We have Senator Vitter, Senator DeMint as well, and Kay
    Bailey Hutchison is joining us, I believe. So new Members, we
    are getting larger and larger here. We are going to have to
    enlarge this circle somehow and wrap around the room. But I
    thank all of you for joining the Committee, and I am looking
    forward to your service on the Committee as well. I hope you
    will find it worthwhile. We have got a lot of work to do on
    this Committee. We will be making some announcements shortly
    about our agenda coming up as we see it over the next couple of
    months, and we look forward to your participation as well with
    us all. So thank you for joining the Committee. Thank you,
    Senator Bennet, as well.
        I will make a brief opening statement. I will turn to
    Senator Shelby for any opening comments he may have. And then,
    as is the custom, I will ask more of my colleagues if they
    would like to make some opening comments as well on the subject
    matter. Then we will hear from our witnesses and try and move
    along with a good, engaging question period as well.
        A year ago, the CEO of a very trusted and respected
    securities firm and a former Chairman of NASDAQ said the
    following, and I quote him: ``In today's regulatory
    environment, it is virtually impossible to violate rules. This
    is something that the public really doesn't understand. It's
    impossible for a violation to go undetected, certainly not for
    a considerable period of time.''
        The speaker was none other than Bernard Madoff, and that
    cunning statement, he knew then and we know now, was
    breathtaking in its deception. In stark contrast to Mr.
    Madoff's statement, his fraud is noteworthy for its duration--
    it may well have lasted for decades--and the amount of money
    investors lost, which was nearly $50 billion. But for all of
    this deception, Mr. Madoff was right about one thing: The
    public really didn't understand. Nor, it appears, did the
    regulators.
        Today, we are going to discuss how the securities
    regulatory system failed to detect a fraud of this magnitude,
    the extent to which securities insurance will assist defrauded
    victims, and what can be done to prevent this sort of thing
    from happening again.
        This much we do know: Since Bernard L. Madoff's Investment
    Securities LLC started in 1960, the firm has been subject to
    examination and oversight by the Securities and Exchange
    Commission and by the securities industry self-regulatory
    organization, the Financial Industry Regulatory Authority--or
    FINRA--and its predecessor, NASD.
        The firm's clients have limited insurance to the Securities
    Investor Protection Corporation--SIPC, as it is known. Mr.
    Madoff pioneered electronic trading systems and was the
    Chairman of the NASDAQ stock market. Members of his family held
    leadership positions in NASD.
        At some point decades ago, Mr. Madoff began accepting money
    to invest from individuals, charities, pension funds,
    institutions, and hedge funds. He sent these clients account
    statements on his firm's stationery. He charged only sales
    commissions. Reportedly, he told clients that the value of
    their accounts went up around 10 percent every year.
        His reputation grew quickly. Some investors begged to be
    introduced to Mr. Madoff and for him to invest their funds.
    Others were not so sure. In 2001, Barron's reported some
    experts doubted his methodology and were troubled by his
    secrecy in an article entitled ``Don't Ask, Don't Tell.''
        In 2005, derivatives expert Harry Markopolos gave the SEC
    staff a detailed paper entitled--and this is it--``The World's
    Largest Hedge Fund Is a Fraud.'' Now, that was sent out in
    2005, in which he stated that the Madoff Securities is ``the
    world's largest Ponzi scheme.'' He identified numerous red
    flags: returns that were too good to be true, consistent gains
    over 10 percent every year, in bull and bear markets alike;
    investment strategies that could not produce stated returns.
    There was Madoff's practice of charging only commissions rather
    than the much larger percentage of assets and profits typically
    charged by advisers, curiously leaving hundreds of millions of
    dollars on the table.
        It has been reported that the Madoff firm's auditor,
    Friehling & Horowitz, had only three employees, including a 78-
    year-old Florida retiree and a secretary. The one actual
    accountant at the firm certifies to AICPA, the organization,
    that he did not even perform audits. All of these red flags
    were ignored.
        In 2006, following the SEC examination, the Madoff
    brokerage firm also registered as an investment banker--an
    investment adviser, excuse me. Yet somehow regulators missed a
    massive fraud.
        Then on December 11, 2008, Mr. Madoff was arrested for
    securities fraud after he reportedly told his sons he had
    perpetrated a giant Ponzi scheme, that is, paying returns to
    certain investors out of the investments received from other
    investors. His assets and the firms have been frozen. As
    investigations are ongoing, let me say that we will respect
    these investigations and not ask the Members who are here
    today, the witnesses, for facts which cannot be disclosed
    publicly at this time. However, I will ask that you be thorough
    and hold responsible the people who facilitated this securities
    fraud.
        The media has reported breathlessly about certain
    celebrities who invested with Mr. Madoff, but most of those who
    lost their money because of massive fraud were not celebrities
    or Hollywood stars. Quite the contrary, they are
    municipalities, pension funds, charities, and individuals, one
    of whom is here today with us from my home State of
    Connecticut. Along with funds of funds, hedge funds, and
    foreign banks, these individuals have collectively lost
    billions of dollars. Some charities have shut down entirely
    because of this action. The town of Fairfield, Connecticut, has
    lost alone some $42 billion.
        Today, we will hear from a Connecticut physician, Dr. Henry
    Backe, who will testify to the pension losses experienced by
    his colleagues and the nurses and other medical staff who
    support them. 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?
        Former Chairman Chris Cox has suggested as much. On
    December 16, he announced that credible and specific
    allegations going back to at least 1999 were, and I quote him,
    ``repeatedly brought to the attention of the SEC staff but were
    never recommended to the Commission for action.'' Indeed, in a
    decade's worth of inquiries into Mr. Madoff's firm, the SEC had
    not so much as issued a single subpoena.
        For some investors, the breathtaking losses will be
    mitigated in part by SIPC's insurance fund. Today, we want to
    hear what types of investors would be covered by SIPC and to
    encourage SIPC to gather Madoff assets and provide payouts to
    eligible shareholders quickly.
        The Madoff fraud was a regulatory failure of historic
    proportions, but what is most disturbing about it is that it
    went undetected until the perpetrator himself confessed. How
    many other Madoff schemes are there out there? And do we have
    any idea? And what steps are we taking to see to it that we
    apprehend these people earlier?
        And so today we will also consider how to prevent crimes
    like these ongoing from going forward, whether we require more
    resources, additional rulemaking, or legislation. I will ask
    the SEC and FINRA to update this Committee every 3 months on
    the steps you are taking to prevent similar Madoff schemes in
    the future.
        Even if this is an extraordinary and out-of-the-ordinary
    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.
    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 that the era of ``don't ask, don't
    tell'' on Wall Street is over.
        And with that, let me turn to my colleague from Alabama,
    the former Chairman of the Committee, Senator Shelby.

                 STATEMENT OF SENATOR RICHARD C. SHELBY

        Senator Shelby. Thank you, Chairman Dodd.
        The Madoff fraud is disturbing, as Senator Dodd said, on
    several different levels. Most significantly, many Madoff
    investors have seen their money disappear virtually overnight.
    They are now scrambling to provide basic necessities, shelving
    plans of retirement or attempting to re-enter the workforce at
    a time when jobs are hard to come by. We learn daily of
    charities that are curtailing their activities because of their
    Madoff-related losses. These losses are particularly
    unfortunate because they appear to have been, at least to some
    extent, avoidable.
        Notwithstanding the numerous red flags waved under their
    noses, the SEC and the Financial Industry Regulatory Authority,
    or FINRA, missed crucial opportunities to detect the fraud when
    it was much smaller in scope. The fact that the regulators were
    put on notice through direct tips, press articles, and industry
    chatter raises serious questions about the state of our
    regulatory system.
        For example, in November of 2005, the SEC received a
    lengthy submission from a credible source repeating and
    elaborating upon allegations made in 1999 that outlined a
    detailed set of red flags that made the tipper very suspicious
    that Bernie Madoff's returns are not real, and raising the
    possibility that Madoff Securities is the world's largest Ponzi
    scheme.
        In the almost 20 pages that follow, the tipper, a
    derivatives expert, made a compelling case that something was
    amiss at Madoff Securities. He cited, among other things,
    Madoff's unusual compensation arrangement, the inability of the
    options market to sustain Madoff's strategy with the level of
    assets he had under management, the failure of firms using
    similar strategies to achieve comparable returns, and the
    mathematical impossibility of Madoff's returns. The tipster
    pointed to press articles and industry colleagues that shared
    similar suspicions about Madoff.
        While it would be impossible for the SEC to open a formal
    investigation in response to every tip that comes in, a
    reliable method of triage is necessary. Certain complaints can
    be dismissed for the lack of credibility. The tip that the SEC
    received in the Madoff case came from a tipper who had a track
    record of credibility with the SEC.
        During the course of investigating the tip, the staff
    discovered that Mr. Madoff lied to the SEC about both the
    number of customer accounts at his firm and the nature of
    trading in those accounts. Although the SEC staff forced Mr.
    Madoff to comply with the law by registering as an investment
    adviser, they refrained from digging deeper.
        I understand that FINRA did not receive a copy of the
    complaint at issue, but Madoff's firm was a member of FINRA for
    years. Public news articles also suggested a possible
    connection between potentially fraudulent activities at
    Madoff's and Madoff's brokerage activities. While FINRA does
    not have direct regulatory oversight over investment advisers,
    its investigators routinely ask questions about outside
    activities when they relate to the broker-dealer under their
    jurisdiction. Yet there is no indication that FINRA made any
    inquiries about these reports. I believe questions about the
    allegations as related to the brokerage business would not have
    been outside FINRA's purview and should have been asked.
        I want to be clear, Mr. Chairman. I am not suggesting that
    individuals within our regulatory structure are responsible for
    the Madoff scandal. Blame here is easily assigned. Madoff and
    anyone who assisted him in carrying out the fraud are
    responsible. Rather, today I am suggesting that our regulators'
    experience with the Madoff firm over the years did present
    opportunities to intervene, but they did not.
        Therefore, I see this hearing as an opportunity to identify
    the structural or internal impediments at the SEC and FINRA
    that allowed the Madoff fraud to thrive for so many years
    without being detected. The natural reaction of a regulatory
    agency confronting a failure of this magnitude is to cry lack
    of resources and lack of access, but I hope that we will hear
    more thoughtful analysis this morning than that.
        Regulators were at the Madoff firm on multiple occasions
    over the years, and at times they were armed with credible
    information suggesting that something was wrong. Were the
    concerns dismissed only after careful, objective, and thorough
    inquiry? Or were they swept under the rug due to carelessness
    or deference to who was at that time a respected founding
    member of the modern securities industry?
        All of here today would like the answers to those
    questions. If mistakes were made, let us get them out in the
    open and learn from them. If the structure failed, let us
    determine how it failed and fix it. If individuals failed, let
    us identify them and hold them accountable. Only then can we
    re-establish confidence in our regulators and begin to repair
    the damage done by Madoff and his accomplices.
        Thank you, Mr. Chairman.
        Chairman Dodd. Well, thank you very much, Senator.
        I mentioned Mr. Markopolos, who was planning to be with us
    today but got ill with the flu and could not come down. But I
    am going to ask consent that this, ``The World's Largest Hedge
    Fund Is a Fraud,'' and the subtitle here, ``Potential fallout
    of Bernie Madoff turns out to be a Ponzi scheme,'' this article
    written 4 years ago, and a statement of his be included in the
    record this morning as well, so we will take care of that.
    Without objection.
        With that, let me turn to Senator Menendez.

                  STATEMENT OF SENATOR ROBERT MENENDEZ

        Senator Menendez. Thank you, Mr. Chairman, for holding what
    I think is an incredibly important hearing to examine how our
    Federal regulators failed to uncover the largest Ponzi scheme
    in history and what we can do to prevent something like this
    from ever happening again.
        I have no doubt that 2008 will go down in history as one of
    the darkest years for our system of Federal financial
    regulation. The failure of regulators to check the
    irresponsibility on Wall Street allowed financial titans to
    grow so large and powerful that their collapse was a systemic
    disaster for our economy. Not only were regulators unable to
    rein in the reckless practices that ultimately led to these
    firms' downfall, we now know they were not even able to protect
    outright fraud and theft.
        Bernard Madoff is the most visible and incredible example
    of this calamitous failure, taking advantage of the lack of
    regulatory due diligence to steal billions of dollars over the
    course of decades. And just like the subprime mortgage
    meltdown, there were countless red flags--you mentioned a very
    detailed list of them, Mr. Chairman--that should have caught
    the attention of our regulators, but, unfortunately in this
    case the SEC seemed to be colorblind. This was not a small-time
    scam that only involved a few investors. It was an elaborate
    scheme that cost thousands of people an estimated $50 billion.
    And it is almost inconceivable to me how a single individual
    was able to steal $50 billion over the course of several
    decades without the SEC being able to detect any of it
    whatsoever.
        The shock caused by this modern-day heist has reverberated
    throughout Wall Street, further crippling investors' already
    weakened confidence that securities investing can be reasonably
    secure. And in addition to the scandal's effect on investor
    confidence, there are personal, tangible repercussions as many
    retirees who saved their entire life found out their nest eggs
    were just empty shells.
        Charities that fund projects for education and health care
    will have to dramatically cut back on the assistance they
    provided at a time in which their help is even more desperately
    needed. So an underprivileged child who has no investments and
    nothing to do with Wall Street might now be denied a
    scholarship to college because the charity can no longer afford
    it. Or a single mother without health care who relies on free
    clinics for treatment for her children might no longer have
    this option.
        It soon becomes clear that Mr. Madoff's scheme and the
    regulatory failures that followed it have more than just
    financiers as its victims. If we have learned anything from
    2008, we have learned that our regulatory system is broken down
    and it is in need of comprehensive reform. We simply cannot put
    a new paint job and pretend everything is OK. In my mind, we
    need a complete overhaul in order to fundamentally change the
    way business is conducted on Wall Street.
        But before we can prescribe a cure for the problems on Wall
    Street, we must first diagnose the illness. We have to examine
    how this scheme was perpetrated right under the notes of the
    Securities and Exchange Commission. Was it a lack of authority,
    a lack of resources, a lack of transparency? Or, much worse,
    was the root cause something much deeper, something indicative
    of a larger, more systemic problem facing the Securities and
    Exchange Commission?
        One thing is clear: The failure of our regulators has
    severely undermined the American people's confidence in the
    integrity of our capital markets. This lack of confidence
    threatens to keep credit frozen and prolong the recession
    unless we act responsibly and quickly. And I hope today, Mr.
    Chairman, we can get a better sense of what that might be and
    be able to move on it expeditiously.
        Chairman Dodd. Thank you, Senator, very much.
        Senator Corker.
        Senator Corker. Mr. Chairman, out of respect for the
    witnesses and all of you, I am going to wait and listen to
    them.
        Thank you.
        Chairman Dodd. Thank you very much.
        Senator Bennet, we do the early bird rule here, I tell the
    new Senators, and so if you get here early, you get to go
    first.

                 STATEMENT OF SENATOR MICHAEL F. BENNET

        Senator Bennet. Thank you, Mr. Chairman. I would like to
    first offer my gratitude to you and Ranking Member Shelby for
    your leadership of the Committee and for the hospitality and
    kindness that you and your staffs have shown me as the newest
    Member of this panel.
        As I take my seat on this Committee, I am aware that this
    is a crucial time in our history. Millions of Americans are out
    of work, struggling to keep a roof over the heads, and worried
    about how they are going to make ends meet. Today, I join you
    on behalf of the many Coloradans affected by the Bernie Madoff
    investment scandal, including the Nurse-Family Partnership, a
    Denver-based nonprofit organization that helps low-income
    families with children meet their health care needs. That
    organization lost a million-dollar contribution from a
    foundation that went under because of Madoff losses.
        I look forward to serving on this Committee, Mr. Chairman,
    and I ask that my full statement be entered into the record.
        Chairman Dodd. Absolutely. And welcome again.
        Senator Bennet. Thank you.
        Chairman Dodd. Senator Johanns.

                   STATEMENT OF SENATOR MIKE JOHANNS

        Senator Johanns. Since this is my first hearing, let me
    offer just a couple of thoughts in appreciation to our Chairman
    and our Ranking Member for pulling this hearing together. This
    is a very, very important issue.
        Turning to the present matter, we examine today how Bernie
    Madoff was able to pull off what really is regarded as the
    largest Ponzi scheme in history, effectively swindling
    thousands of investors out of billions of dollars, but even
    more significantly, how he did that over a period of decades,
    apparently without detection.
        If there was ever a time in our Nation's history where the
    public needs to rely on the regulators to know that their
    investments are safe and secure and that the regulators are
    doing their job, it is now. And yet I fear that we are sending
    absolutely the opposite message to people. The public needs
    that confidence.
        It is especially troubling to me to discover that the SEC
    ignored or failed to effectively follow up on a series of tips
    that warned of the wrongdoing, tips going back as far as 1999,
    if not further. I simply do not understand that. I do not
    understand it as a former mayor, as a former Governor, and as a
    former member of the United States Cabinet. I do not know how
    you could miss that. I do not understand how they could miss a
    memo that literally pointed out that this was a Ponzi scheme.
        I hope the witnesses today will provide needed information
    not only to the Members of this Committee but to the members of
    the public. I hope that the witnesses today will assure us that
    the regulatory plan in place is sufficient; or in the
    alternative, if it is not, point out to us where you think the
    problems existed and why this went so long without any action
    being taken.
        We will never be able to prevent or legislate against
    completely dishonest people. We recognize that. But when we are
    made aware of that dishonesty, it baffles me that action was
    not taken to bring the hammer down.
        With that, let me just again say, Mr. Chairman, Mr. Ranking
    Member, I appreciate the opportunity to be a Member of this
    very important Committee.
        Chairman Dodd. Well, we welcome you, Senator. Thank you
    very much, and you bring a wealth of experience to this
    Committee. We look forward to your deep involvement with us on
    these questions. So thank you very, very much.
        Senator Schumer.

                STATEMENT OF SENATOR CHARLES E. SCHUMER

        Senator Schumer. Thank you, Mr. Chairman. I want to thank
    you for holding this hearing, and Ranking Member Shelby as
    well.
        The Bernie Madoff fraud was a punch to the gut of our
    financial system which was already reeling from too many
    haymakers. While I remain confident that at the end of the day
    our financial markets will emerge upright and stronger than
    ever, this can only happen if everyone learns from the mistakes
    that were made.
        Madoff's fraud was so immense and obvious and took place
    over such a long period of time, it is simply inexplicable how
    the SEC missed it. It is as if there were a giant elephant
    standing next to the SEC in a rather small room for 25 years,
    and the SEC never noticed the elephant or even smelled the
    peanuts on his breath. And it is not as if the SEC was not
    looking around the room. Since 1982, the SEC and FINRA
    conducted eight examinations of Bernie Madoff's firm, and, of
    course, following up on the detailed tips provided by Harry
    Markopolos, whom the Chairman has wisely pursued in bringing
    here and getting his statements into the record, the SEC's
    Enforcement Division conducted a full investigation of Madoff's
    firm in 2006, and yet the SEC did not even come close to
    unraveling this fraud.
        All they had to do was peel away one layer of the onion
    skin, and it would have been apparent how broad and deep this
    fraud was. There are people who have told the story of asking
    Madoff about his investments, and when his explanation did not
    hold, they said, ``We are not investing.'' If they could figure
    this out, why couldn't the SEC?
        In short, Mr. Chairman, I think we are a far cry from the
    SEC that was established by Joseph Kennedy and Franklin
    Roosevelt in the 1930s. That SEC was one which aggressively
    sought out fraud and adopted its methods to best achieve its
    goals. Today's SEC appears stagnant and behind the times,
    almost always closing the barn door too late and slowly but
    surely failing in its principal message of maintaining investor
    confidence in the integrity of our capital markets.
        Our witnesses today are experts on the securities
    regulation, and I will defer to them on particulars. I am very
    interested in Professor Coffee's suggestions of a conservator
    of a type. But I think it is clear that major changes are
    necessary in how we regulate securities.
        One such change has already occurred: the rejection of the
    laissez-faire principle that we can have totally unregulated
    markets that function well. This flawed theory concocted by
    ivory tower academics and debunked countless times is
    particularly pragmatic when it is wielded by people who are in
    charge of actual regulation. As was too often the case in the
    last administration, one member of the SEC basically said that
    he did not even believe in the New Deal regulations that were
    put forward.
        So I am confident that the changing of the guard,
    particularly the appointment of Mary Schapiro as the new SEC
    Chairman, will be a good start toward reforming the SEC. But
    that is not enough. We must also take all due steps to improve
    the tools with which the SEC does its job.
        First and foremost, the SEC must have more resources. The
    enforcement and examination staff have actually shrunk in
    recent years, even as the number of investment advisers, such
    as Madoff's firms, that they must oversee has soared. The fact
    that the SEC was stretched too thin to conduct an examination
    of Madoff's investor advisory operations is inconceivable and
    something that we must address immediately.
        That is why Senator Shelby and I, among others, are
    introducing the Safe Markets Act today, which, among other
    things, would authorize the hiring of 100 new SEC enforcement
    staff as well as FBI agents and prosecutors to go after
    criminal fraud.
        But having sufficient resources is only half the equation.
    We also must ensure those resources are being well allocated.
    The SEC must have professionals in place who understand how
    markets work and who are able to detect complex financial
    frauds. Expanding the Office of Risk Assessment proposed by
    Chairman Donaldson would be a great first step toward this end,
    and I am wondering what the panelists think of that.
        There is no doubt that the SEC has some of the best lawyers
    in the country, but they also have to hire more of the top
    financial experts as well.
        Finally, as I suggested earlier this month in a little bit
    more of a parochial vein, the SEC's Office of Compliance
    Inspections and Examinations, as well as its Office of Risk
    Assessment, would be best served by moving their functions to
    Wall Street. It makes no sense to have the cops who are
    patrolling their beat hundreds of miles away. At the same
    timing, moving these functions to New York will improve the
    SEC's ability to hire top professionals with the skills and
    experience to detect complex financial frauds.
        I want to thank the witnesses and thank the Chairman. I
    look forward to the testimony. Unfortunately, I care about this
    but I will be in and out because we have a Finance Committee
    markup on the stimulus. So I want to apologize in advance to
    the witnesses, but I have read their testimony.
        Chairman Dodd. Thank you, Senator, very much. And I would
    point out that Connecticut is close to New York as well. It
    might be a venue----
        Senator Schumer. Right on the border would be fine with me,
    Mr. Chairman.
        [Laughter.]
        Chairman Dodd. Senator Warner.
        Senator Warner. Thank you, Mr. Chairman. I appreciate your
    holding this hearing. I would think that actually the
    Enforcement Division's location in the greater Washington area
    is still a pretty good place for it to be located.
        But we have got a lot of witnesses. I am anxious to hear
    their testimony, and I hope we have lots of time for questions,
    because I have got lots of questions.
        Thank you.
        Chairman Dodd. Thank you very much.
        Senator Merkley.

                   STATEMENT OF SENATOR JEFF MERKLEY

        Senator Merkley. Thank you very much, Mr. Chair, and I am
    delighted to join this Committee. I look forward to working
    with you and with our Ranking Member Senator Shelby.
        Certainly this is an extraordinary first hearing to
    participate in. As the leader of various nonprofits in the
    past, it is incomprehensible to me how even the most basic
    auditing efforts could not have revealed such massive fraud,
    and knowing that the type of oversight that is essential when
    there are massive assets at stake is certainly many steps up
    from that of a basic nonprofit.
        I look forward with great interest to understanding how we
    got where we are and how we are going to restore integrity in
    our financial markets and our investments.
        Thank you, Mr. Chairman.
        Chairman Dodd. Thank you, Senator, very much, and we are
    delighted that you have joined the Committee as well. Thank you
    for your willingness to serve with us.
        We will begin with Dr. Coffee as our first witness. We
    thank Professor Coffee for being here. He has been before this
    Committee on numerous occasions over the years.
        For those who are not aware of Professor Coffee's
    background, he is the Adolf A. Berle Professor of Law at
    Columbia Law School and renowned securities law expert who has
    helped this Committee on numerous occasions when I have been a
    Member of this Committee, and we thank you for being with us
    today.

     STATEMENT OF JOHN C. COFFEE, JR., ADOLF A. BERLE PROFESSOR OF
                  LAW, COLUMBIA UNIVERSITY LAW SCHOOL

        Mr. Coffee. Thank you. Chairman Dodd, Ranking Member
    Shelby, fellow Senators, I am happy to be here, and to begin
    let me paraphrase Warren Buffett: The tide has gone out on Wall
    Street, and we are now increasingly finding ``who has been
    swimming naked,'' because they show up when the tide goes out.
        Sadly, it has long been this way. In my written comments, I
    review a dozen different recent Ponzi schemes. I will not take
    your time to go through them today, but the generalization I
    would initially offer is that these spectacular frauds are
    usually discovered by investors on their collapse, sometimes by
    postal inspectors when there have been widespread mailings by
    people having no connection with the securities industry, and
    only occasionally by securities regulators. Thus, the point
    that I want to stress the most is that there are cost-
    effective, adequate remedies that can be implemented that have
    proven effectiveness, that have worked for years to prevent
    Ponzi schemes, but are not now applicable to most investment
    advisers or to most hedge funds. And I think these techniques
    should be adopted because we are probably going to be more
    successful at deterring and preventing Ponzi schemes than
    detecting ones once the fraud has begun.
        Let me begin also by emphasizing that Mr. Madoff is not
    really unique. Spectacular crook that he was, he is unique only
    in the absolute magnitude of this fraud, which is an order of
    magnitude greater, and the lengthy duration of his fraud, which
    does raise the questions you are all realizing, all focusing
    on, about the quality of regulatory supervision.
        But apart from that, Ponzi schemes are not rare. They are
    increasing and they are fairly recurrent. Professor Tamar
    Frankel has conducted an analysis of the losses suffered by
    investors based simply upon judicial decisions. She finds that
    in 2002, U.S. citizens lost $9.6 billion from Ponzi schemes,
    and there were four other years out of the last dozen years in
    which the losses suffered by U.S. citizens exceeded $1 billion.
    This is not a one-shot problem. This is something that happens
    regularly.
        Now, reviewing other Ponzi schemes, I find that there is
    increasing frequency and increasing scale, partly because we
    have seen a few bad apples in the hedge fund market. The Bayou
    Fund is probably the leading example. But the real cost of this
    fraud falls ultimately not just on individual investors, but it
    falls on investor confidence, and it is going to have a
    chilling shadow that is going to deter many hedge funds from
    being able to start or continue. So the costs here are more
    than just individual investors. It is a whole system of finance
    that is under a growing shadow. It is not going to be able to
    start again until we fix the system.
        Now, what would work to fix the system? Here I want to get
    to the basic reforms. I note in my testimony a striking
    contrast. In the 69 years that we have had the Investment
    Company Act of 1940, there has not been a single mutual fund,
    to my knowledge, that has failed because of a Ponzi scheme.
    There have been some frauds--relatively few--but not a real
    Ponzi scheme. The Ponzi schemes tend to occur either in
    unregulated hedge funds or, even more typically, in alternative
    investments put together by investment advisers, registered and
    unregistered.
        What explains the superior track record of mutual funds?
    Very simply, the leading characteristics, the leading
    distinction between a mutual fund and a hedge fund is the
    existence of an independent custodian, who is a trustee, who
    holds the investors' funds in a separate bank or broker-dealer
    account and does not let the money manager, the investment
    adviser, either have access to that fund or to misappropriate
    those funds. Rather, the custodian buys or sells securities at
    the instruction of the investment adviser, but it does not
    remit the funds to the care of the investment adviser. It
    simply gives the money back and forth to the investors.
        Now, when we have seen spectacular failures in the hedge
    fund industry, it has usually been those hedge funds--and they
    are the minority--that do not on their own decide to use an
    independent external custodian. Thus, here is where Mr. Madoff
    is particularly relevant. Mr. Madoff was, until 2006, a broker-
    dealer who gave investment advice. After 2006, he was a
    registered investment adviser, and he was required to use, by
    law, under the Investment Advisers Act, a ``qualified
    custodian.'' Who did he use as his qualified custodian?
    Pursuant to SEC rules, he used himself.
        Now, when you self-clear or when you are your own
    custodian, I think you are violating the first rule of common
    sense: You cannot be your own watchdog. This happened because
    the SEC, I am afraid, gave us an illusory rule. It was amended
    once in 2003, but not adequately. It still allows the
    investment adviser, where it has a broker-dealer affiliate, to
    use its own broker-dealer to be its own custodian. And I think
    that permits incest. The small, closely held broker-dealer firm
    wants to keep everything in-house and, thus, there is no
    accountability, no watchdog.
        There was a second significant SEC failure that I want to
    point to. Following Sarbanes-Oxley, broker-dealers were
    supposed to use accountants who are registered with the PCAOB,
    the Public Company Accounting Oversight Board. But on three
    occasions, the SEC adopted and extended an exemptive rule that
    said privately held broker-dealers that did not have public
    shareholders owning the broker-dealer firm did not have to use
    such a PCAOB-registered accountant. And that is why Mr. Madoff
    was able to use the fly-by-night accountant who has previously
    been described.
        Now, this kind of exemptive rule is, in my view,
    deregulation carried to excess--indeed, deregulation gone
    wild--because, again, you need to protect not simply
    shareholders but also customers. The premise of this exemptive
    rule, which was adopted and extended on three different
    occasions between 2003 and 2008, was that, well, because
    private broker-dealers do not have public customers, they do
    not need audited financial statements. That ignored that there
    was someone else called ``customers,'' and there were thousands
    of customers out there. And had you had to use a registered
    accounting firm, it would not have been possible to do what Mr.
    Madoff did or, even more evident, what the Bayou Fund did. The
    Bayou Fund was even more direct. They invented a bogus
    accounting firm that had no existence. They printed up fake
    stationery, and they wrote their own audit reports. That is two
    occasions in the last 2 or 3 years that this has happened, and
    I think it shows that we need to have a real auditor that has
    some accountability and is subject to the oversight of the
    PCAOB.
        Now, for the future, that problem is solved because this
    year, after Mr. Madoff, the SEC did not again extend this
    exemptive rule for privately held broker-dealers. But we still
    have the problem that you can self-clear, that you can be your
    own custodian, and I think that is a serious problem.
        I would note that the industry is coming to agree with me.
    The Investment Adviser Association, a leading trade group, has
    now endorsed the idea that there should be an external
    custodian for investment advisers, and I think that makes
    eminent sense. When you see the trade associations adopting
    reforms, I think it means its time is probably already overdue,
    we should move to that relatively quickly.
        OK. Now, there is one other topic that I think the
    Committee wants me to touch on briefly, and I do not want to
    speak too long. This Committee wants to focus on the quality of
    the regulatory supervision. I am not here to point fingers. The
    SEC's Inspector General is much better positioned than I to
    conduct a long investigation as to what happened within the
    SEC. But I do want to touch upon two purely legal conclusions.
    These relate to the need for examinations and to the
    jurisdiction of FINRA.
        Cost-constrained as the Office of Compliance Inspections
    and Examinations is--and it is very cost-constrained--and
    necessary as it is that under these circumstances they use
    risk-adjusted criteria, I do not believe they used proper risk-
    adjusted criteria in deciding not to examine Madoff securities
    in 2006. In 2006, the SEC knew that Mr. Madoff had investment
    advisory clients, and they compelled him to register as an
    investment adviser. Once you do that, the first question
    immediately is: Who is your custodian? What is the quality of
    the care and protection for those accounts? I think given the
    size of the investments at some $17 billion was already as of
    2006 under his investment and management, there was a need for
    an immediate examination of his records and the quality of the
    custodial care. And that was triggered by additional red flags
    that the Committee has also noticed, including the use of an
    unregistered accountant and the fact that there have been press
    reports not in secret little back rooms but in Barron's,
    questioning what was going on at Madoff Securities. That calls
    for an immediate need, even on the most constrained
    circumstances, for an immediate examination.
        Last conclusion, FINRA, and I am not talking about the
    personalities. I am saying simply that FINRA did have
    jurisdiction over Madoff Securities that extended to all of its
    activities. Prior to 2006, Madoff Securities was conducting its
    investment advice as part of its brokerage operations. There is
    an exemption in the Investment Advisers Act for a brokerage
    firm that permits it to give investment advice so long as that
    activity is solely incidental to its brokerage business.
    Therefore, whether or not they were properly using that
    exemption, they were claiming that exemption and saying in our
    brokerage business we are giving investment advice. That puts
    it fully within the scope of FINRA's jurisdiction.
        After 2006, now the only way Madoff conducted an investment
    advisory business was by using his own brokerage firm as the
    custodian. Therefore, the question that is squarely within
    FINRA's jurisdiction is: What kind of custodial services are
    you providing for this investment adviser--who is not legally
    separate, who is only one floor away? And I think, therefore,
    you had to ask: What is going on with respect to the custodial
    services you are providing to one of the largest investment
    advisers in America?
        All right. I do not want to go into further details about
    the quality of the supervision, but my point is that we do not
    have FINRA having no jurisdiction. They have broad
    jurisdiction. I once served on an NASD broker-dealer
    disciplinary committee, and I found that if a broker-dealer
    refused to answer any request by the NASD for books or records,
    they were subject to discipline, and they could be thrown out
    of the industry, and during my tenure on the NASD's own broker-
    dealer discipline Committee, we did throw people out of the
    industry because they refused to provide books and records in
    response to an NASD or FINRA request.
        So I think there was more that could have been done. The
    enforcement powers were there.
        Thank you.
        Chairman Dodd. Well, thank you very much, Professor Coffee.
    Very, very helpful, and obviously we will give the SEC and
    FINRA and some people a chance to respond to that, but I have
    sort of drawn the same conclusion you did.
        I wanted to thank Senator Shelby and other Members here.
    Ms. Schapiro has now been confirmed by the Senate. There was a
    glitch in the paperwork, and it required her being voted on
    again a second time. So she has been confirmed twice to be the
    Chairman of the SEC in the last few days. So I thank our
    colleagues for allowing that to go forward so she can be on the
    job. We thank you for that.
        Dr. Backe, we thank you for being here.

      STATEMENT OF HENRY A. BACKE, JR., M.D., ORTHOPEDIC SURGEON,
                         FAIRFIELD, CONNECTICUT

        Mr. Backe. Good morning, Senator Dodd and other Senators.
    Thank you for allowing me to speak on behalf of 140 United
    States taxpaying citizens from the State of Connecticut. I am
    an orthopedic surgeon and a partner of Orthopaedic Specialty
    Group, a medical practice located in Fairfield, Connecticut. We
    care for the medical needs of the insured and uninsured people
    of the greater Bridgeport, Connecticut, region of New England.
    OSG, incorporated in 1971, has been in existence for over 75
    years. We employ 130 people with annual incomes ranging from
    $28,000 to $130,000. We have some employees who have worked
    with us for over 30 years. OSG has had a retirement plan for
    its employees since the 1970s. We currently have 140
    participants.
        We have followed all the ERISA rules and regulations
    governing pension plans and have been diligent in our fiduciary
    responsibilities. We have hired pension administrators for
    recordkeeping; our pension documents have been kept current
    with appropriate amendments by our attorneys, and our
    accountants have completed every required filing since the
    plan's inception.
        Sixteen years ago, in 1992, we engaged Bernard Madoff
    Investment Securities Company to be our investment adviser and
    have invested all the plan's assets with Madoff. Participants
    in the plan include 15 doctors and 125 staff members such as
    nurses, x-ray technicians, medical assistants, and
    administrative personnel. The plan was funded by employee
    contributions, individual rollovers, and employer
    contributions. As of November 30, 2008, the plan had a net
    capital investment in the plan, of $11,581,000 and a statement
    balance of approximately $33 million.
        The partners of OSG have made routine visits to Madoff's
    offices in New York City since 1993. The OSG Plan took comfort
    in the fact that its assets were invested with a well-known,
    highly respected investment adviser and broker-dealer that was
    registered with the SEC and subject to routine examination and
    oversight by the SEC and FINRA. For over 15 years, the OSG Plan
    received confirmations from Madoff for thousands of securities
    transactions, mostly in blue-chip stocks of major U.S.
    corporations and U.S. Treasury securities. We also received
    from Madoff monthly statements of our account activity, as well
    as quarterly and annual portfolio management reports.
        The OSG Plan was audited by the U.S. Department of Labor in
    2005 and no concerns were raised. We also had an independent
    audit conducted in 2008, of 2007 and 2006, by a reputable
    accounting firm in Connecticut and, again, no concerns were
    raised.
        As recent as October 2008, we sent three of our partners to
    Madoff's office to discuss the volatile markets and check our
    investments. One partner, now 70 years of age, had over 30
    years' worth of retirement contributions and was interested in
    self-managing his account since he was preparing to retire. We
    were assured by Madoff's firm that his money was accessible and
    he could move it to a different type of account that he could
    manage at any time.
        The news in early December 2008 that all of the investment
    activity in Madoff was a sham and that Madoff was, in fact, the
    world's largest Ponzi scheme, was devastating to us. We have
    three senior employees close to retirement who now do not know
    when or whether they can stop working. This affects OSG's
    recruitment plan to hire new physicians. We gave two new
    physicians employment offers that we now are unsure we can
    honor because senior doctors with plans to retire soon have now
    decided they need to keep working full-time for many more
    years.
        Our employees are scared, worried, and angry. They express
    loss of confidence in the Federal Government and its agencies.
    Some have declined to have payroll deductions made for their
    plan contributions going forward. Some have expressed concerns
    that they will have to sell their homes when they retire since
    all their savings have been stolen.
        We have seen disagreements and friction among our employees
    over this matter. We fear we may have a very uncomfortable and
    very unhealthy work environment if this takes years to sort
    out. This is the last thing a medical practice needs when
    treating patients. Our physicians are some of the most well
    trained and highly respected orthopedists in the area, but our
    community's perception of OSG has changed. Partners have told
    me people have asked if we are closing down.
        We have had to hire multiple attorneys for OSG, our plan,
    and our employees. This month alone we have already incurred
    legal bills in excess of $70,000. I personally spend at least 2
    hours of my day dealing with this tragedy rather than taking
    care of patients.
        Then, to add further insult to injury, we learned that the
    SEC had information linking Madoff to the Ponzi scheme as far
    back as 1992, and that starting in 1999 a gentleman named Harry
    Markopolos regularly advised the SEC that Madoff was a giant
    Ponzi scheme--in fact, provided a road map to the SEC as to how
    to unmask Madoff as a fraud. But the agency allowed Madoff not
    only to continue in operation, but to continue to take in
    billions of additional dollars of victims' funds, including the
    funds of the OSG Plan.
        We learned next that it was highly likely that the
    Securities Investor Protection Corporation, which took over
    Madoff, may take the position that the OSG Plan participants
    were not individual customers of Madoff and each not entitled
    to SIPC coverage. Instead, it was likely that SIPC was going to
    treat the plan itself as the only customer of Madoff. In other
    words, the 140 participants in the plan, who lost a total of
    $11,581,000 capital investment, would have to share in a
    maximum recovery of $500,000. This is not right and it is not
    just.
        Our pension plan functioned as an individual retirement
    savings plan. Each participant received individual statements;
    each was able to roll over moneys from outside accounts to
    their own account within the pension plan. Each participant was
    allowed to, and some did, take out loans against their account.
    The intent was individual accounts, and the plan operated in
    that way. Madoff traded on behalf of the plan as one account.
    One of my partners spoke with an attorney from SIPC last month
    who advised him that the initial intent of SIPC was to cover
    the individual investor.
        Senators, the 140 participants in the OSG Plan are not
    wealthy hedge fund investors, nor are they beneficiaries of
    multimillion-dollar offshore trusts. They are regular working-
    class Americans, most of modest means who annually put aside a
    substantial percentage of their wages to try to ensure that
    they could enjoy a dignified retirement in the near or distant
    future. They were let down by Madoff, the regulators, the SEC,
    and FINRA. We hope and request that SIPC, which was created to
    protect small investors from harm, will help us as individuals.
        We respectfully request that our legislators ensure that
    participants in pension plans, be it ours or any other who
    invested through Madoff, will be covered by SIPC insurance
    individually, or that they are recompensed in some other manner
    by the Federal Government in light of the SEC's repeated
    failure to stop Madoff from stealing money. We would like to
    see the Government provide quality oversight through its
    agencies so that pension plans do not suffer this theft loss in
    the future. This would help restore the confidence and trust of
    Americans saving for retirement.
        We would like the IRS to clarify or expand what can be
    considered a theft loss in this situation and/or waive the
    maximum contribution restrictions for individuals or employers
    affected by Madoff so they can rebuild their pension plans on
    an accelerated schedule.
        On behalf of OSG, we, as citizens of the United States of
    America, appreciate your time and work on our behalf. What we
    need now more than anything is quick resolution to this issue
    so we can get back to our own professions and jobs taking care
    of the health of our fellow Americans.
        Thank you very much for your time.
        Chairman Dodd. Doctor, thank you very much for being here
    and for your testimony. We appreciate it very, very much and
    appreciate the passion that you bring to this in talking about
    the people you work with every day. So we thank you for that.
        Now I want to introduce Ms. Lori Richards. She is the
    Director of Compliance Inspections and Examinations at the U.S.
    Securities and Exchange Commission. She has served on the SEC
    staff for over 20 years, and we thank you for being here this
    morning.

     STATEMENT OF LORI A. RICHARDS, DIRECTOR, OFFICE OF COMPLIANCE
         INSPECTIONS AND EXAMINATIONS, SECURITIES AND EXCHANGE
                               COMMISSION

        Ms. Richards. Thank you, Chairman Dodd, Ranking Member
    Shelby, and Members of the Committee. I am Lori Richards,
    Director of the SEC's Office of Compliance Inspections and
    Examinations, and I appreciate the opportunity to appear before
    this Committee today to discuss the examination program and the
    functions of the SEC.
        In this regard, my views are my own, and they do not
    necessarily reflect the views of the Commission or any other
    member of the Commission staff.
        I want to assure the Committee at the outset that the SEC
    takes the alleged fraud by Mr. Madoff extremely seriously, and
    we are focused very hard on identifying possible improvements,
    both to regulation and to oversight, which might make fraud
    less likely to occur in the future and more likely to be
    detected.
        With the Commission's direction and under the new SEC
    Chairman, we expect that we will identify changes and
    improvements to both regulation and to oversight. I will share
    some of these ideas with you this morning. I also want to say I
    very much appreciate the testimony and hearing the testimony of
    Professor Coffee and also Dr. Backe.
        I begin by noting that I have served as a member of the
    Commission staff for more than 20 years, and that the agency's
    staff are dedicated, hard working, and keenly committed to the
    agency's mission to protect investors. Speaking as an examiner,
    we are focused hard on fraud, and we are committed to finding
    fraud.
        We examine firms that are registered with the SEC, and they
    vary in size and in type. They include many that are run
    honestly and in compliance with the law, and they also include
    firms that are engaged in deception, in dishonesty, in
    falsification of records, and fraud of various kinds.
        Examinations have identified many different types of
    frauds, including Ponzi schemes, that have sought to have been
    carefully hidden. The alleged fraud in this instance remains
    very much an ongoing matter under investigation by criminal
    authorities, by the SEC's Enforcement Division, and with
    respect to the SEC's past regulatory activities with respect to
    Madoff by the SEC's Inspector General.
        I am not authorized to provide specific information about
    past regulatory oversight of the Madoff firm, and I am not
    participating in the current investigation or examinations
    involving the Madoff firm. I can provide, however, the
    following general information concerning examinations of the
    Madoff business.
        Examinations of the Madoff broker-dealer firm did not find
    the fraud committed by Mr. Madoff. The Commission's examination
    staff did not examine his investment advisory operations, which
    first became registered with the SEC in late 2006. The SEC
    conducted limited-scope examinations of the Madoff broker-
    dealer operations for compliance with, among other things,
    trading rules that would require the best execution of orders,
    display of limit orders, and possible front-running, most
    recently in 2004 and 2005. The firm's investment advisory
    business became registered in 2006 and was not examined by the
    SEC. For the reasons that I noted, I must not discuss these
    examinations in any greater detail.
        Some broader information, however: Given the number of
    registered investment advisers today, there are over 11,000,
    and the fact that this population has grown very rapidly in
    recent years, the SEC cannot examine every investment adviser
    on a routine frequency. The SEC has 425 staff dedicated to
    examinations of all registered investment advisers and mutual
    funds, and approximately 315 staff dedicated to examinations of
    all registered broker-dealers.
        About 10 percent of registered investment advisers are
    examined every 3 years. These examinations are not audits. They
    are limited in their scope, and they are targeted to specific
    activities of a registered firm. Investment advisers are not
    subject to examination or oversight or regulation by a self-
    regulatory organization, and this differs from the oversight
    model for broker-dealers, who are subject to periodic, routine
    examinations by an SRO.
        Finally, I want to assure this Committee that we hold the
    protection of investors as our sole goal, and also that we are
    thinking expansively and creatively about changes that could
    reduce the opportunities for fraud and increase the likelihood
    of detection of fraud in the future. We very much look forward
    to working in this respect in this critical effort with the
    Commission and with incoming Chairman Schapiro.
        Among the areas that we will study are: the examination
    frequencies for investment advisers; the existence of
    unregistered funds and advisers; the different regulatory
    structures surrounding brokers and surrounding investment
    advisers; the existence of unregulated products; and
    strengthening the custody and audit requirements for regulated
    firms.
        We are also very much looking forward to ways, identifying
    ways that we at the SEC can improve our assessment of risk and
    at the adequacy of information that is required to be filed by
    registered securities firms that is used now to assess risk.
        We are looking at whether our risk assessment process would
    be improved with routine access to information such as, for
    example, the identity of an investment adviser's auditor, its
    custodian, its administrator, its performance returns, as well
    as additional information. Pulling all information together at
    the SEC so that SEC staff analysts can review it is a
    significant priority for us.
        We are also targeting firms for examinations to look at
    their custody of assets, and we are expanding our efforts to
    examine advisers and brokers in a coordinated approach to
    reduce the opportunities for firms to shift activities to areas
    where they are not subject to regulatory oversight.
        In these and other ways, we are committed to assuring the
    highest level of protection for American investors.
        I would be happy to provide additional information to this
    Committee in response to your questions.
        Chairman Dodd. Thank you very much, and we will come back.
    I have some obvious questions we need to raise.
        Ms. Linda Chatman Thomsen--is that a correct pronunciation?
        Ms. Thomsen. Yes, sir, it is.
        Chairman Dodd. She is the Director of the Division of
    Enforcement of the U.S. Securities and Exchange Commission. She
    has served on the SEC staff for 14 years, and we thank you for
    your service and thank you for being here today.

         STATEMENT OF LINDA C. THOMSEN, DIRECTOR, DIVISION OF
            ENFORCEMENT, SECURITIES AND EXCHANGE COMMISSION

        Ms. Thomsen. Thank you very much. Good morning, Chairman
    Dodd, Ranking Member Shelby, and Members of the Committee. I
    appreciate the opportunity to appear here today to discuss
    Madoff-related matters. I am Linda Thomsen, and for nearly 14
    years, it has been my very great privilege to serve on the
    staff of the Enforcement Division of the Securities and
    Exchange Commission. And as Ms. Richards mentioned, we all take
    these Madoff matters extremely seriously and appreciate this
    Committee's interest.
        I want to thank the Committee at the outset for
    understanding that because of our collective desire to preserve
    the integrity of the investigative and prosecution processes,
    there are matters that I cannot discuss. None of us wants to do
    anything that would jeopardize the process of holding
    perpetrators accountable.
        I should also note that my views, while informed by my
    experience as a member of the Commission staff, are my own and
    do not necessarily reflect the views of the Commission or any
    other member of the staff.
        On December 11, 2008, the SEC filed a lawsuit against
    Bernard Madoff and his firm. The Commission's complaint alleges
    that Mr. Madoff had been conducting a giant Ponzi scheme for
    years, with estimated losses of approximately $50 billion. That
    same day, the United States Attorney's Office for the Southern
    District of New York filed a related criminal action. These
    actions expose Mr. Madoff to billions of dollars in liability
    and decades of incarceration. Our investigations are
    continuing, and we are coordinating our efforts.
        I would like to step back and turn to the general topic of
    how we deal with tips and complaints and how they develop into
    cases.
        The Enforcement Division receives hundreds of thousands of
    tips each year. And while we appreciate and examine every lead
    we receive, we simply do not have the resources to fully
    investigate them all.
        The primary consideration in determining whether to pursue
    any particular tip depends on whether, based on judgment and
    experience, the tip provides sufficient information to suggest
    that it might lead to an enforcement action.
        When we have a promising lead, we investigate. We follow
    the evidence, we pursue the culpable, and we do so without fear
    or favor. When we begin, we usually do not know whether or not
    the law has been broken and, if so, by whom. We have to
    investigate. And when we investigate, we are resource-
    constrained. Every day we are compelled to make difficult
    judgments about which matters to pursue, which matters to stop
    pursuing, and which matters to forego pursuing at all. Every
    investigation we pursue, or continue to pursue, entails
    opportunity costs. A decision to pursue one matter means that
    we may be unable to pursue another.
        The staff of the Enforcement Division is devoted to public
    service and our mission of investor protection. The hard-
    working men and women of the staff live to bring cases,
    particularly big and difficult cases. The staff is bright,
    creative, and professionally zealous; for us, there is nothing
    more rewarding than pursuing, bringing, and winning a big case.
        We need only look at the days surrounding the bringing of
    the Madoff case to see ample evidence of the staff's
    commitment. During the Monday-to-Monday period between December
    8 and December 15, 2008--and the Madoff was brought in the
    middle of that period--the Commission also pursued a number of
    other matters, including suing an attorney for selling bogus
    notes; suing former Fidelity employees for taking illegal gifts
    and gratuities. We finalized some of the landmark auction rate
    securities cases, which quickly provided billions of dollars of
    liquidity to thousands of investors. We sued a Russian broker-
    dealer for operating in our markets in violation of our rules.
    We settled a complex reinsurance financial fraud matter. We
    brought a case involving a wide-ranging market manipulation and
    kickback scheme. And we filed a $350 million dollar settlement
    with Siemens for bribing foreign officials, the largest SEC
    Foreign Corrupt Practices Act settlement in the act's 30-year
    history.
        Everyone at the SEC wishes the alleged Madoff fraud had
    been discovered sooner. We are committed to finding ways to
    make fraud less likely and to make fraud detection more likely.
    But we need to acknowledge a hard truth our forefathers
    recognized: If men were angels, we wouldn't need government. We
    wouldn't need laws or law enforcement either. The reality is
    that people do break the law and when they do so, there is
    harm, and it is sometimes very significant harm.
        Among the steps we are taking on the enforcement front is
    looking for ways to identify, among all of the information we
    receive and develop, in addition to tips and complaints, other
    information, the systemic risks and emerging trends we should
    investigate. We are also making sure that enforcement personnel
    have access to market, trading, accounting, economic, and
    analytical expertise when they need it and that they have the
    training to know when they should call upon that expertise.
        We could also use more resources. We always do our utmost
    to do more with less. With more resources, we could do more.
    More resources would allow us to spend more time identifying
    risks and to pursue more investigations and to pursue them more
    deeply. We could invest more in technology that we would use to
    help maximize our effectiveness and efficiency.
        Finally, all of us need to do everything we can to
    encourage a culture, especially among those who make their
    livings from other people's investments, that embraces the idea
    that mere compliance with the law, narrowly viewed, is not the
    highest goal to which we aspire, but the base from which we
    start. We should all continue to work toward ensuring a system
    where those who work in it are responsible stewards of the
    treasures entrusted to them.
        Thank you very much, and I would be happy to answer
    questions.
        Chairman Dodd. Thank you very much.
        We have been joined by our colleague from Rhode Island,
    Senator Reed. Senator Reed, thank you for joining us. Do you
    want to make any quick comment at all?
        Senator Reed. No. Thank you, Mr. Chairman.
        Chairman Dodd. Let me turn next, if I can, to Stephen
    Luparello. Did I pronounce that correctly?
        Mr. Luparello. You did, Senator.
        Chairman Dodd. Mr. Luparello is the Interim Chief Executive
    Officer of FINRA. Mr. Luparello began at FINRA--its
    predecessor, the NASD--in 1996 and has since been the head of
    the Market Regulation Department and Senior Executive Vice
    President of Regulatory Operations.
        We thank you for being with us.

      STATEMENT OF STEPHEN I. LUPARELLO, INTERIM CHIEF EXECUTIVE
            OFFICER, FINANCIAL INDUSTRY REGULATORY AUTHORITY

        Mr. Luparello. Chairman Dodd, Ranking Member Shelby, and
    Members of the Committee, thank you for the opportunity to
    testify today. My name is Steve Luparello. I currently serve as
    Interim CEO of the Financial Industry Regulatory Authority.
    Also known as FINRA, we are the primary nongovernmental
    regulator for securities brokerage firms doing business in the
    United States.
        Unfortunately, we are all here today because the fraud that
    Bernard Madoff reportedly conducted has had tragic results for
    investors who entrusted their money to him. Investors are
    disillusioned and angry, and rightfully asking what happened to
    the system that was meant to protect them. There is no doubt
    that Madoff knew that system well, and perhaps that knowledge
    assisted him in avoiding detection and defrauding so many
    unsuspecting individuals and institutions.
        By all accounts, it appears that Madoff engaged in
    deceptive and manipulative conduct for an extended period of
    time during which he defrauded the customers who invested with
    him and misled those who had the responsibility to regulate
    him.
        Madoff's alleged fraud highlights how our current
    fragmented regulatory system can allow bad actors to engage in
    misconduct outside the view and reach of some regulators. It is
    undeniable that, in this instance, the system failed to protect
    investors. Investor protection is the core of FINRA's mission,
    and we share your commitment to identifying the regulatory gaps
    and weaknesses that allow this fraud to go undetected, as well
    as potential changes to the regulatory framework that could
    prevent it from happening in the future.
        Bernard Madoff's broker-dealer was registered with FINRA--
    and its predecessor organization, NASD--since 1960. Prior to
    2006, Mr. Madoff also operated an unregistered money management
    business. In 2006, the SEC required Mr. Madoff to register that
    money management business as an investment adviser.
        While Congress authorized FINRA to regulate broker-dealers
    in 1938, FINRA is not authorized to examine for or enforce
    compliance with the Investment Advisers Act. Only the SEC and
    the States have that authority. In fact, while we have the
    authority to bar broker-dealers and registered persons from the
    brokerage industry, FINRA is often powerless to prevent those
    persons from re-entering the financial services industry as
    advisers.
        Given the limitations imposed by Federal law, FINRA's
    authority over Madoff was and is limited to its broker-dealer
    operations, even though the Madoff registered investment
    adviser was in the same legal entity. For two decades, FINRA
    examined Madoff's broker-dealer operations at least every other
    year. We began a separate market regulation exam program in
    1996 and conducted that exam at the Madoff broker-dealer every
    year since. The Madoff broker-dealer consistently reported to
    FINRA that 90 percent of its revenues were generated by market
    making and 10 percent by proprietary trading.
        When examining the Madoff broker-dealer operation, FINRA
    found no evidence of trading for customer accounts, which is
    consistent with the market-making model, and no evidence of the
    kind of fraud that Bernard Madoff allegedly carried out through
    his advisory business.
        While we did receive a small number of customer complaints
    through the years, those complaints were filed by customers of
    other broker-dealers that had transacted business with the
    Madoff broker-dealer. FINRA did not receive any retail customer
    complaints that might have alerted us to the existence of the
    advisory accounts, and there were no complaints related to the
    investment advisory business.
        FINRA also did not receive any whistleblower complaints
    alleging either front-running or Ponzi schemes at the Madoff
    money management business, nor did the SEC share the tip it
    received or alert FINRA to any concern it may have had about
    Madoff.
        FINRA has long expressed concerns regarding a firm's
    ability to avoid our jurisdiction by keeping its customers
    outside the FINRA-registered broker-dealer. As early as the
    1980s, NASD officials issued public statements urging reform.
    As recently as this past August, FINRA's former CEO, Mary
    Schapiro, personally raised those issues with the SEC Chairman.
        Unfortunately, the statutory limits of FINRA's jurisdiction
    did not allow us to be an extra set of eyes looking at the
    totality of the Madoff business. Any number of
    misrepresentations that can facilitate a fraud like this,
    whether the firm had customers or it did not, whether the
    trades ran through the broker-dealer or they did not, whether
    the firm custodied the assets or they did not, likely would
    have come to light much earlier. And one of the key parts of
    the FINRA exam program is that we confirm the existence and
    location of customer assets that are reflected in customer
    accounts at the broker-dealer. We follow the money to where the
    regulated firm says it is and ensure that those customer assets
    are properly segregated from those of the firm itself.
        As I stated at the outset, what has happened to Madoff's
    investors is tragic. The fact is that no regulator is perfect
    and Ponzi schemes can be difficult to uncover. But that is all
    the more reason to give regulators the tools they need to
    ferret out such fraud.
        Mr. Chairman, investors should receive the same basic
    regulatory safeguards and protections no matter which
    investment product or service they choose. FINRA is committed
    to working with this Committee as it considers how best to move
    forward on these important issues.
        Thank you, and I would be happy to answer questions.
        Chairman Dodd. Thank you very much as well.
        Mr. Stephen Harbeck is the President and CEO of SIPC, the
    Securities Investor Protection Corporation and has been with
    SIPC since 1975. We thank you.

    STATEMENT OF STEPHEN P. HARBECK, PRESIDENT AND CEO, SECURITIES
                    INVESTOR PROTECTION CORPORATION

        Mr. Harbeck. Thank you, Mr. Chairman.
        Chairman Dodd, Ranking Member Shelby, and Members of the
    Committee, I appreciate the opportunity to appear before you
    today and discuss the work of SIPC, the Securities Investor
    Protection Corporation. I have been the President and CEO of
    SIPC for the past 6 years. I have worked at SIPC for 33 years
    and was general counsel prior to my appointment as President
    and CEO.
        SIPC was created in 1970 by a Federal statute, but that
    Federal statute specifically states that SIPC is not a
    government entity. It is a membership corporation of
    essentially all brokerage firms registered with the SEC.
    Membership is not voluntary. It is required by that law. Our
    resources include $1.7 billion worth of liquid assets in
    treasury bills that have been raised by assessments on our
    members. We also have a line of credit with an international
    consortium of banks and a $1 billion line of credit created by
    statute with the United States Treasury. SIPC has never used
    Government funds.
        SIPC has no regulatory role. It has no function in
    examinations, investigations, or discipline. SIPC relies on the
    SEC and FINRA to inform SIPC when brokerage firms' customers
    are in need of protection. Once that protection is deemed to be
    necessary, SIPC initiates a very specialized form of
    bankruptcy. Within that bankruptcy, SIPC can advance up to
    $500,000 worth of protection, of which a maximum of $100,000 is
    based on a claim for cash, and SIPC may also advance money for
    the administrative expenses of these bankruptcies. It is very
    important to note that customer assets are never used to pay
    administrative expenses such as legal fees or trustees' fees or
    rent.
        The year 2008, specifically the last calendar quarter of
    2008, was unlike any period in SIPC's prior 39-year history.
    The collapse of Lehman Brothers and subsequently the collapse
    of the Bernard Madoff Investment Securities firm present
    enormous challenges, but these cases present very, very
    different fact patterns.
        In the Lehman Brothers case, SIPC initiated a liquidation
    proceeding on September 19, a Friday, to assist and facilitate
    the sale of that firm's assets to Barclay's Bank. After a
    marathon hearing extending well past midnight, the United
    States Bankruptcy Court for the Southern District of New York
    approved that sale, and over the weekend, $142 billion of
    customer assets were transferred to either Barclay's Bank, the
    brokerage firm arm of Barclay's, or another firm. We are very
    pleased with that result. There are many other problems in the
    enormous nature of the Lehman Brothers case, but the initial
    stages have gone very well.
        The Madoff Investment Securities case is an entirely
    different matter. This was theft, pure and simple. The state of
    the records was such that--well, to go back to when we started
    the case, we initiated a liquidation proceeding on December 15,
    after Mr. Madoff confessed to having stolen property over
    decades.
        Unlike the Lehman Brothers case, where customer records
    were accurate, it became very apparent very early that the
    records that Mr. Madoff had been sending to investors bore
    little or no relation to reality. The records made it
    impossible for us to transfer all or any part of a customer's
    account to another solvent brokerage firm, as was done in
    Lehman Brothers. The claim forms, however, were sent by the
    trustee for the liquidation on an expedited basis. The claim
    forms were mailed to customers on January 2, and mailed to more
    than 8,000 people--in other words, to anyone on the books and
    records who may have ever done business with Madoff, if we
    could find an address for them. To date, over 900 claims have,
    in fact, been filed.
        The trustee in Madoff has requested information from all
    such customers as to how much money they have put in and how
    much money they have put out in this fraudulent scheme. In some
    situations, particularly where investors have not made
    withdrawals, it will be relatively easy to determine exactly
    how much a claimant has put into the scheme, and we hope that,
    using all available resources, we will be able to track and
    make determinations on all customer claims.
        In terms of the $50 billion figure that has been frequently
    cited, that is Mr. Madoff's figure, and it appears that this
    sum includes the phony annual profits that he reported as well
    as the contributions made by investors. As several people have
    said, this defalcation is on a completely different order of
    magnitude than any previous SIPA liquidation.
        Until customer claims are received and processed and
    further accounting work is accomplished, we will not know the
    extent of the draw on SIPC's resources. But with the maximum
    amount that SIPC can advance any one claimant being $500,000,
    even if the valid amount of the claim is much higher, that is
    the maximum amount that we can advance to any one customer.
        The trustee has taken possession of approximately $100
    million worth of assets. He has identified a total of
    approximately $830 million worth of liquid assets which he may
    be entitled to in relatively short order.
        In terms of legislative issues, certainly the sufficiency
    of SIPC's $1 billion line of credit, which was enacted in the
    original statute in 1970, may bear adjustment. There has been
    no adjustment since 1970, and using the Consumer Price Index, a
    $4.3 billion fund would seem--or line of credit would seem more
    appropriate. Further, the expansion of the securities markets
    themselves since 1970 might indicate that is an appropriate
    topic to discuss.
        As the Madoff case continues, we will figure exactly what
    other factors of our statute may call for adjustment or
    adjustment within our bylaws and, with that, I would be pleased
    to answer any of the Committee's questions.
        Chairman Dodd. Well, thank you very much. Let me thank all
    of you this morning for your testimony. It has been very, very
    helpful to hear some of the comments. Obviously, there are a
    lot of questions that I am sure my colleagues have.
        I am going to put the clock on here to about 8 minutes per
    Member. That is a little better than these short periods of
    time since we do not have an overwhelming number of us here,
    and we will move along if we can.
        Let me, first of all, I mentioned in my opening statement
    that I would like the SEC and FINRA to report every 3 months to
    this Committee on actions that you are taking to improve the
    effectiveness of examinations and the handling of credible tips
    in order to reduce the amount of investor fraud. Will you agree
    to that?
        Mr. Luparello. Absolutely, Senator.
        Ms. Richards. Yes, Senator.
        Chairman Dodd. All right. Thank you.
        Let me, if I can, first of all, in the case of Ms.
    Richards, I was struck when Professor Coffee was talking about
    the fact that this is not new, that Ponzi schemes have been
    around for a long time. Obviously, the fact that they are
    called ``Ponzi schemes'' indicate how long they have been
    around. But they are not new at all in the securities area. In
    fact, I think you cited one, some $4 billion, I think, at one
    period of time, and then a billion a year or something.
        Mr. Coffee. It was $9.6 billion in 2002 alone. That was the
    record year before 2008.
        Chairman Dodd. Yes. Well, I was impressed, Ms. Richards,
    when you cited some of the things that ought to be done now in
    response to Madoff. Why haven't they be done earlier? If, in
    fact, you have $9 billion worth of these schemes going on, why
    is it taking just the Madoff case for the SEC to respond in a
    way you did this morning by suggesting a number of steps should
    be taken? Why wasn't that done 10 years ago, or longer, if, in
    fact, this problem has been with us for as long as it has been?
        Ms. Richards. Yes, Senator, thank you for the question. I
    can commit to you that at the SEC we have been looking at ways
    to prevent fraud forever. For example, when we conduct
    examinations of a registered investment adviser, we are very
    intently focused on confirming the existence of those assets
    with a custodian--that is a routine aspect of our
    examinations--and as well looking at the account statements
    that are sent to customers and then matching them up with those
    custodian account statements.
        Chairman Dodd. What about some of the suggestions that were
    made by Professor Coffee in dealing with the custodial
    obligations of these financial advisers? Again, this is not
    new. This is the game. This is how it gets played. Was there
    some debate? You have been there for 20 years. You have been
    there for 14 years, Ms. Thomsen. Was there any debate or
    discussion at the SEC about these matters? Were they rejected
    as ideas? What has happened here?
        Ms. Richards. There has been debate about these ideas, in
    particular, the idea with respect to having an independent
    custodian of records. Now, any examiner would tell you that
    that is a strong internal control and that that is the most
    desirable situation, to have an independent entity in charge of
    customer assets.
        At the current time, by our estimates, as many as a
    thousand investment advisers have custody with an affiliated
    custodian, either a bank or a brokerage firm or a commissions
    merchant. That combination can give rise to--unless the entity
    is truly independent, it gives rise to the possibility for
    fraud. And so that is one of the changes that I hope that the
    Commission will strongly consider in the days ahead.
        Chairman Dodd. Is there some downside to this that I should
    know about as well?
        Ms. Richards. Well, there are costs. There would be
    additional costs for requiring an investment adviser to have a
    third-party custodian. That would change existing custodial
    relationships.
        Chairman Dodd. That is a cost to them.
        Ms. Richards. A cost to them.
        Chairman Dodd. That is not a great argument. Give me
    another one, if you have got one here.
        [Laughter.]
        Ms. Richards. I am not in the best position to argue the
    other side of this issue. As an examiner, having independence
    of accountants, of custodians, and of administrators I think is
    a strong internal control, and it is one that I believe the
    Commission will study very quickly in the coming days and
    weeks.
        Chairman Dodd. Well, I hope it goes beyond studying. I will
    speak for myself as the Chairman of this Committee. We want
    more than studies in these matters. If we are having this
    continuing problem with these cases, this one obviously
    becoming as celebrated as it is given the volume and the length
    of it over time. I have spoken to Ms. Schapiro about this. We
    raised the issue during her confirmation hearing. But,
    clearly--and I suspect I am speaking for all of us on this
    Committee--we want some action very quickly in this area. So I
    will be very interested in hearing some response about this
    particular point.
        Let me, if I can, because I am struck with the FINRA
    debate, if I may raise it, Mr. Luparello. This is deeply
    troubling, listening to Professor Coffee, and others have
    talked about this in the past. Was there any indication at
    FINRA that you did not want to deal with this matter? Here Mr.
    Madoff is a member of NASD, President of NASDAQ himself, his
    family deeply involved. Is there any evidence at all of some
    resistance on the part of FINRA to deal with this matter
    because of his involvement with NASD and with NASDAQ?
        Mr. Luparello. Absolutely not, Mr. Chairman. Professor
    Coffee may actually vest in us a little bit more jurisdiction
    than we have been able to exercise over the years. The Madoff
    firm, the Madoff firm represented year in and year out, in our
    examinations, in their Form BDs, and all publicly available
    information, that they were a wholesale market maker, one
    without customers. So the existence of the money management
    business, while perhaps known to some examiners, not to others,
    was seen as outside of our jurisdiction.
        Chairman Dodd. But it was not separated until after 2006.
    Up until that time, it is one entity. It is even one entity
    after that, for that--it is one floor away.
        Mr. Luparello. No, it is--that is correct, and it was--it
    was clearly an integrated entity from that standpoint. But
    from----
        Chairman Dodd. So merely someone saying to you, creating
    this fiction, in a sense, that FINRA all of a sudden has to
    stop everything, you cannot--do you believe the--I have read
    the statutory language, and it seems to me quite clear that the
    ability to reach and to get documents and evidence where there
    is suspicion of fraud does not have a bright line to it.
        Mr. Luparello. That is absolutely correct. The ability to
    compel documents from entities that are registered with us is
    very broad. Our ability to continue to investigate when it is
    conduct that is not brokerage conduct is somewhat more
    circumspect.
        Chairman Dodd. So if you just create this advisory
    operation here, you can avoid then FINRA really having any
    jurisdiction. Is that your argument?
        Mr. Luparello. That is the argument that has been made
    against us over the years.
        Chairman Dodd. In effect, then, you become worthless, in a
    sense. What is the purpose at this point? Creating that kind of
    a fiction merely then avoids any kind of real supervision.
        Mr. Luparello. Well, as we have testified, and as we have
    made statements over the years, the ability to basically take a
    small step and refer to your business as advisory business and,
    therefore, not be required to bring it into the broker-dealer
    has been a source of frustration for us over the years.
        Chairman Dodd. Let me come back to the SEC, if I may. I am
    still frustrated a bit by all of this. We have all talked about
    the Markopolos memos and evidence, the 19- , 20-page document
    that he sent to the SEC in 2005. But he states in there--and I
    do not know if I have it in front of me. I had it here. Did I
    give it to someone?
        There is a statement he makes in the opening page of that
    document--here it is; I can put it here--that I was struck by.
    He says, ``I have also spoken to the heads of various Wall
    Street equity derivative trading desks, and every single one of
    the seniors managers I spoke with told me that Bernie Madoff
    was a fraud.''
        So this was not just one individual. How did the SEC not
    pick up this? I understand--and, by the way, let me preface my
    remarks. I have great respect for the people who work with you
    and work in your operations. I think all of us do here. They
    work very, very hard, and I suspect the limitation of resources
    and other things are not inconsequential in this discussion. So
    I want it to be clear, at least from the Chairman's standpoint
    here, that I am not indicting a division at all. I have great
    respect for the people who work very, very hard every day.
        But you understand how mystifying it is that for literally
    decades, with warnings, I am told, by Wall Street firms that
    would have nothing to do with Madoff, the word was out on this
    guy. How does the SEC avoid not reacting to this?
        Ms. Thomsen. Mr. Chairman, I understand your frustration,
    and I think some of us share it. I have to say at the outset
    that the specifics of how we dealt with Mr. Markopolos'
    complaint and the investigation which we began and then closed
    are things we simply cannot discuss for many reasons, but most
    important in my mind is there is a criminal investigation. The
    allegations against Mr. Madoff right now are allegations, and
    they are extraordinarily serious allegations, and none of us
    want to get in the way of bringing a fraud to justice. But with
    that by way of background, let me step back and try to do it
    more broadly.
        As I say, we get thousands, hundreds of thousands of tips
    and leads every year, and many of them are written in language
    which is very similar to the language of Mr. Markopolos. And so
    we have to--they are not evidence in and of themselves, and
    what we have to do is try to establish that evidence. Sometimes
    people write us with information that is simply wrong.
    Sometimes it is misinterpreted, et cetera. So we have to take
    those leads or tips and from them try to develop--investigate
    and develop evidence.
        And then what we have to do--and this is the hardest thing
    that we have to do--as we develop the evidence, we go down
    roads and sometimes we find no evidence of fraud. And then we
    have to decide: Do we take another step? And we continue to do
    that until such time as we conclude that we have found a fraud
    or we have to stop. And deciding to stop is where you have to
    make the judgment call: Do I deploy resources somewhere else?
        You can never be 100 percent sure that there is not a
    problem. When you find a problem, you know there is a problem.
    When you are not finding a problem, you do not know whether
    that is because there is not a problem or because you have not
    found it yet. And that is done in the context where we have
    things to look at, not only do we have Mr. Madoff's firm, but
    thousands of other firms, thousands of other advisers, public
    companies.
        So it is really those kind of judgment calls that we have
    to make along the way, and I have to tell you that at a certain
    level, I think not finding something that is there is every law
    enforcer's, every cop's, every investigator's worse nightmare.
        Chairman Dodd. I understand that.
        Ms. Thomsen. We want to find them all.
        Chairman Dodd. But the SEC had done examinations. Isn't one
    of the simpler questions you might ask ``Who is your auditor?
    Who does your auditing?'' Would that be sort of a preliminary
    question?
        Ms. Thomsen. It is often a question.
        Chairman Dodd. And if you discovered it was three people in
    a room in New Jersey, one of which is a secretary, the other
    one does not do audits, I mean, would that jump out at you?
        Ms. Thomsen. In an investigation as opposed to an
    examination, we would certainly eventually look at, in most
    investigations, the role of the auditor. It depends on the
    investigative path you take whether or not that in and of
    itself is compelling. I do not know and I cannot talk about
    what was known about the particular circumstances here. But
    certainly red flags--we see red flags and we pursue red flags.
    Red flags do not necessarily mean that there is a fraud, and
    that is what we need to establish.
        Chairman Dodd. Well, we certainly know that the accounting
    firm was not registered with the PCAOB, and that is for sure. I
    wonder if you might--just a question quickly. Do you support
    not exempting nonpublic broker-dealers such as Madoff from
    being audited by an accounting firm that is not registered with
    the PCAOB?
        Ms. Thomsen. As an enforcement type, I support all efforts
    to put road blocks in the way, and speed bumps. One of the
    things I think is worth mentioning here is as we talk about
    Ponzi schemes, many Ponzi schemes are perpetrated by
    individuals and firms that have no registration whatsoever, so
    there is no examination speed bump along the way. In the last 2
    years, we have brought 70 actions involving Ponzi schemes, 70-
    ish, and a little less than half of them have involved
    emergency actions where we have tried to stop something that is
    ongoing and to freeze assets to get back to people.
        They are terrible schemes, and they harm investors, and
    when investors lose their life savings, whether it is $10,000
    or $10 million, it is always a tragedy.
        Chairman Dodd. So may I interpret from that that you would
    support extending Sarbanes-Oxley accounting requirements to
    these kinds of firms?
        Ms. Thomsen. I personally would.
        Chairman Dodd. Thank you very much.
        Senator Johanns, and let me say, Senator Shelby--the
    Appropriations Committee, the full Committee, is meeting to
    mark up the stimulus package, and he is a senior Member of that
    Committee and, therefore, could not stay, but he has asked me
    to submit a series of written questions he has for the panel,
    and I would ask you to respond to them at your earliest
    convenience, if you could.
        Ms. Thomsen. Of course.
        Chairman Dodd. Senator Johanns.
        Senator Johanns. Mr. Chairman, thank you.
        I must admit I sit here in amazement at what you are
    saying. Again, having been a Cabinet member, if somebody
    dropped a report on my desk or in my inbox this thorough, this
    complete, asking for an investigation, and it was titled ``The
    World's Largest Meat Packer Is a Fraud,'' holy smokes. I mean,
    I would have the Inspector General in my office. I would have
    my General Counsel in the office. These allegations are huge,
    and I suspect they were treated that way.
        Now, I do not want to interfere with an investigation. I
    have been around investigations enough to know you do not do
    that. You let the legal people do their thing. But I would like
    to know who saw this report and what action they took in
    response to seeing it.
        You know, did the top person say to the Inspector General,
    ``Holy smokes, this looks very, very serious. I want a no-hold-
    barred investigation''? And did the Inspector General engage? I
    want to know did the General Counsel engage. And I think I can
    know those things as a Member of this Committee without
    interfering in an investigation. I am not asking for anything.
    Is it possible for you to literally trace for us who touched
    this, who looked at it, what direction they gave in response to
    this document?
        Ms. Thomsen. That is precisely what the SEC's Inspector
    General is doing. That is another ongoing investigation, and
    that, as I understand it, is his mandate and what he is
    undertaking as to what--and, otherwise, I really cannot speak
    about it because of the issues with the criminal investigation,
    and others.
        And let me just say in that regard, without saying much
    more, among other things, just to demonstrate how very
    seriously we take it, some of the conduct in the prior
    investigation may itself have amounted to crimes, such as 1001
    violations or perjury, and we want to be sure to preserve the
    integrity of any criminal investigation.
        So I do understand the Inspector General is looking into
    precisely the questions you are asking, Senator, and will be
    delving into all of those details.
        Senator Johanns. That is good. It is good they have engaged
    now. That is positive. In a whole host of negative things, that
    is a positive thing. But I guess what I am interested in is did
    they engage way back. This was first reported to the Boston
    office in May 1999. This was reduced to writing and dated
    November 7, 2005. This gentlemen is a persistent guy. I mean,
    it is like he is knocking on the door of the regulatory people
    and, you know, it perplexes me that if it was reported to
    Boston, this kind of serious allegation, in May 1999 and he
    feels the need to follow up nearly 5, 6 years later, what
    happened in the interim?
        Ms. Thomsen. And, again, that is precisely--those are the
    topics that the SEC's Inspector General is pursuing.
        Senator Johanns. Let me ask you this, just for the
    reassurance of all of the investors out there, like the nurse
    in the doctor's office and the doctors, et cetera. If this is
    the course of conduct over a period of time with the SEC and
    whoever else is involved in this, how can you ensure to me and
    to investors out there that the light bulb is finally on and
    you are paying attention, that they are being protected today
    by your works?
        Ms. Thomsen. Sir, we are passionate about our work. We do
    it--people come to the SEC to do nothing other than enforce the
    law. As I said, those of us in the Enforcement Division want to
    bring cases. We want to stop fraudsters. We want to get every
    Ponzi schemer, every market manipulator, every insider trader.
    To us, they are nothing more than thieves and crooks and cheats
    and that is our mission. That is our passion.
        It is a sad truth that sometimes they get away with things
    for some period of time. I hate that. We all hate it and we are
    working as we have outlined to constantly improve our processes
    so that we can find more frauds and find them sooner.
        Senator Johanns. This gentleman, on page 15, he has a
    section here in his request for an investigation that says,
    ``Potential fallout if Bernie Madoff turns out to be a Ponzi
    scheme.'' It seems kind of prophetic figuring that this was
    written a few years ahead of when it was all figured out. But
    he lists these ten things that he thinks will happen if, in
    fact, this is a Ponzi scheme. How much of that has come true?
        Ms. Thomsen. Again, because of the ongoing investigation, I
    cannot respond specifically to anything that is part of the
    past investigation. I can say, as we all have, that any time
    any fraud goes on, market confidence is affected. If it is a
    little fraud, it may only be as to the one or two investors who
    are affected. But I think every fraud affects not only the
    confidence, for example, of the individuals involved, but the
    confidence across the board. I think fraud does terrible things
    to the market and market confidence.
        Senator Johanns. Here is what I would offer, and I see my
    time is running out and I don't want to extend beyond the time,
    but I understand the investigations. But here is what I would
    tell you. As a very, very junior Member of this Committee, I am
    going to pay very close attention to this investigation and
    there will be a day where the investigation is done where I
    will ask these questions again. Who knew? When did they know
    it? What action did they take? What was the result of that
    action? And who should be accountable to that?
        Again, having been in one of these positions where I sat
    where you did on some very uncomfortable days, if you made a
    mistake, you have to step up or we don't know how to fix it. We
    don't know what the right solution is. We don't know if it is a
    human problem, where somebody just dropped the ball, or we need
    to regulate more, because ultimately, the cost of this does go
    back to the people who make the investment. We want to make
    sure we do that right.
        So I guess what I would say to you, just to alert you, is I
    will accept your answer today that you don't want to interfere
    with investigations. I don't, either. But I don't intend to
    forget about this, either, because there will be a day where
    the investigation is over and I will need to know what
    happened.
        Ms. Thomsen. We welcome that inquiry and we don't intend to
    forget about it, either. Thank you, Senator.
        Senator Johanns. Thank you, Mr. Chairman.
        Chairman Dodd. Very good, Senator. Thank you very, very
    much.
        Senator Bennet.
        Senator Bennet. Thank you, Mr. Chairman.
        I just have one question, and I don't know if it is Ms.
    Thomsen or Ms. Richards who is the right person to answer it,
    but the resource constraints that you mentioned in your
    testimony, I am sure are very real, and I am sure also will
    persist for a very long time no matter what we do, just based
    on the volume of complaints that you get. I wondered as a
    general matter how you prioritize the complaints that come in.
    What kinds of things do you look at, characteristics of the
    firms?
        The Chairman mentioned the three people in New Jersey doing
    the auditing. I mean, is there a list of things and
    characteristics that you look at to decide what rises to the
    top of the pile and what can wait until later, and has this
    case in any way changed the way you are thinking about
    approaching the complaints that are coming in right now,
    because none of us, and I am sure you know that we can't wait
    to respond to this particular case.
        You mentioned, for example, the fact that, I think, there
    were 1,000 registered investment advisors that don't have an
    independent custodian. Is that a characteristic that you look
    at when a complaint comes in? So how do you set these
    priorities?
        Ms. Thomsen. Why don't I start a little on complaints and
    then perhaps Ms. Richards could talk a little bit about
    examinations, because there are risk factors that present
    themselves other than through the complaint process.
        But in the complaint process, and I have outlined this in a
    little more detail than I spoke earlier in my written
    testimony, which I forgot to ask be submitted for the record,
    but I hope it will be, we have a variety of complaints, as I
    say, hundreds of thousands every year. So obviously we have to
    try to find the ones that are the most fruitful to pursue. We
    look at things like the gravity of the allegations. The more
    serious the conduct that is alleged, the more likely it is to
    get more scrutiny. The more specific the information that is
    provided in a complaint, the more likely it is to be pursued.
        We look for things like whether or not it is in our
    jurisdiction, for example. The fact that we--take people who
    complain to us don't necessarily understand what we have
    jurisdiction over, so we have to sort out things where we might
    not have jurisdiction.
        We look for the source of the complaint. Is it, for
    example, someone who is having an argument with an ex-spouse, a
    frequent source, by the way, of tips about insider trading and
    some of them actually turn out to be quite fruitful. So we look
    for bias on the part of the complainant. So all of those
    factors get taken into account.
        If a tip or a complaint is about in a specific arena, so it
    is an accounting kind of complaint, for example, we try to get
    our Chief Accountant's Office looking at it to see whether
    there is--we bring expertise, if you will, to the complaint.
        We have also tried in some ways to reach out for leads.
    Despite the fact that we get hundreds of thousands of
    complaints unsolicited, we have developed systems to review
    suspicious activity reports, for example, because we think they
    oftentimes can contain relatively fruitful information that we
    should be pursuing.
        So it is all those factors. It is judgment, you know,
    informed by experience, and we try to--and we also actually,
    excuse me, we try to see whether we are getting multiple
    complaints about the same issue or entity, which is another way
    to suggest that this complaint has a little more credibility
    than another.
        And then I think it is fair to say that when we are
    deciding whether to do further investigation beyond the face of
    any complaint, we err on the side of doing more, but that is
    not an on/off switch. It is a decision you make every day. So
    you may, for example, in an insider trading case where you get
    a complaint, you might go and look at trading records or
    activities on the days in question and then you decide whether
    you go further than that. So those are decisions you make all
    along the way that tip--or a lead is just that, a lead, a
    beginning.
        Senator Bennet. If I could just ask--thank you for the
    answer. I am more concerned with whether or not there is a set
    of priorities that relate to the characteristics of the firm
    itself. I mean, obviously, you think about credibility of
    witnesses, you think about personal relationships, but
    Professor Coffee talked about some things that would be
    considered best practices even though they are not called for
    by the current regulatory apparatus or by statute.
        So do the people that are your investigators have a rubric
    of some kind that says, here are characteristics of firms that
    we think probably are operating well and fairly on behalf of
    their investors? Here are some characteristics where we worry
    more that there may be something going on.
        Ms. Thomsen. Absolutely, and on that, I am going to defer
    to my colleague, Lori Richards, who runs the examination
    program.
        Ms. Richards. We have exactly that kind of analysis and it
    is based--we do a couple of different kinds of analyses, but I
    think the one that most directly applies to your question is we
    do a risk assessment of every registered investment advisor,
    11,300, and we do it four times a year and it is based on the
    information in their filings with us. So right off the bat,
    there is a limitation, because it is based on what they tell
    us.
        But in that analysis of their filings, one of the factors
    that we look at is whether they have custody, whether they
    themselves have custody of customer assets. That is one of the
    risk factors that we look at, and as I said, I think there are
    toward 1,000 investment advisors that have that risk
    characteristic.
        The other kinds of risk characteristics that we look at are
    how is the investment advisor paid? Is he paid based on
    performance fees, for example, which may give him an incentive
    to inflate his performance or take risks with respect to the
    investments on behalf of clients in order to pump up his own
    fees? Does he have a disciplinary history? Is he a recidivist,
    such that there may be more of a risk that he or she could
    engage in additional misconduct?
        So we use all the data that is available to us in Form ADV
    to do that risk assessment. Now, one of the things that we
    believe very strongly is that we should pull in additional
    types of data and information and that--like intelligence
    agencies, if you think about it--or any organization that
    receives disparate types of information from multiple sources,
    from investors, from the media, from filings, from enforcement
    investigations, from examinations, a variety of types, of
    sources of information come into the agency.
        What we really believe is necessary is that we need to be
    able to harness all that information so that we are not just
    relying on the self-reported information by an investment
    advisor. We would have all information at an analyst's
    fingertips and we could make better risk assessments. So that
    is absolutely on top of our list.
        Then the other question about individual complaints and
    tips and press reports, we have a very active program of doing
    cause examinations. If we get a complaint or a tip or read an
    article in the paper that implicates possible violations of the
    law involving a registered firm that is in our jurisdiction, we
    prioritize that and send examiners in as soon as possible.
    Those examinations take up about 25 percent of our time.
        So I hope that answers your question. We are very much
    thinking about the risk characteristics that existed with
    respect to this particular firm and more broadly looking at
    ways that we can harness information to do a better job of
    assessing risk.
        Senator Bennet. Thank you. Thank you, Mr. Chairman.
        Chairman Dodd. Thank you, Senator.
        Before I turn to Senator Warner, clearly, you need to
    reevaluate the risk assessment. If we missed Madoff, it seems
    to me we have got to go back and revisit that whole model,
    don't you agree?
        Ms. Richards. I agree that the risk assessment is critical
    and I believe that we can get a better quality risk assessment
    by getting better quality information to the SEC staff to do a
    better job at risk assessment, because as I said in response to
    the last question, if we are only relying on self-reported
    information from investment advisors, in some instances, it is
    going to be reliable, and in other instances, it is subject to
    fabrication and lies.
        Chairman Dodd. Senator Warner.
        Senator Warner. Thank you, Mr. Chairman.
        I want to continue this line because Senator Bennet raised
    exactly where I was headed, too. You have got protocols. You
    have got to have some kind of checklist you go down, and while
    it may not be appropriate to micro-manage down to this level, I
    think you hear the Committee's enormous concern and frustration
    with how this enormous fraud went undetected for so long.
        So I would ask perhaps, Mr. Chairman, if we could get this
    list of their protocols and their checklists submitted to the
    Committee at some point so we could at least take a look at it.
    And clearly, as the Chairman said, and my question is going to
    be, do you think that risk assessment works, your current
    process? My sense is it clearly didn't in this case.
        You made, Ms. Richards, in some of your earlier comments,
    you raised the question of, for example, independent custodian,
    looking forward to studying that, and you raised the question
    about whether we should have certified auditors. But in this
    Madoff case, wouldn't the fact that there was not an
    independent custodian, the fact that there wasn't a certified
    auditor, have on your current risk assessment process bumped
    this up higher so that it would have gotten a little deeper
    looking?
        Ms. Richards. That is an excellent question and we are
    certainly going back and looking at this particular firm and at
    our risk assessment methodologies. I can't talk about this
    particular firm. I can say, however, that the risk assessment
    methodology--
        Senator Warner. You can't tell us whether, if you have got
    two red flags of a nonindependent custodian and a noncertified
    accountant, in any firm's case would be enough indication that
    this is something we need to dig into?
        Ms. Richards. I would be happy to share with you the
    factors that we look at in Form ADV. Whether the firm uses an
    affiliated custodian is one of the items. The identity of the
    accountants is not, and so that clearly is an item that I
    believe and----
        Senator Warner. What about--let us go to a couple of other
    areas. What about the fee structure? I mean, Mr. Madoff--as an
    investment advisory, I have been involved in this field for
    some time. It is rare to see an investment advisor who isn't
    going to charge a management fee and take a little percentage
    of the ups. Mr. Madoff represented that he was simply doing
    this--going to gain all his fees simply on execution of the
    trades. Isn't that in and of itself another red flag that
    should have said, hey, is this guy doing this all out of the
    his good heartedness?
        Ms. Richards. I can't speak about the particular Madoff
    filing, that how the----
        Senator Warner. Is the fee structure one of those factors?
        Ms. Richards. It is a risk factor.
        Senator Warner. Is the fee structure----
        Ms. Richards. Yes, Senator.
        Senator Warner. ----one of those factors?
        Ms. Richards. Yes, Senator.
        Senator Warner. What about the question of the actual
    performance of the fund? I mean, one of the things that is so
    stunning and perhaps should have been a red flag actually to
    investors, as well, in terms of the buyer beware, the fact that
    Mr. Madoff through up and down times had such absolutely
    consistent returns has to be an extraordinary outlier if you do
    any type of review of performance. Is performance of funds one
    of the criteria you look at?
        Ms. Richards. Many academics have said that presenting
    consistent returns over a period of time is indicative of
    something, and we certainly have read that academic literature.
    At the current time, hedge funds and investment advisors are
    not required to file with the SEC their performance returns so
    we don't have access to that data. We have recently relied on
    self-reported hedge fund performance returns to a private data
    base. So again, that data is not verified. We have no idea
    whether it is accurate or not. But we have used those private
    data sources in order to supplement our risk assessments and
    identify registered hedge fund advisors for examination. But we
    agree that performance returns can be very useful in
    identifying aberrations.
        Senator Warner. So currently, the risk assessment process
    does look at the independent status of the custodian or not----
        Ms. Richards. Yes.
        Senator Warner. ----does not look at whether the auditor is
    registered or certified or not, is that correct?
        Ms. Richards. Investment advisors are not required to
    submit the name of their----
        Senator Warner. It does look at the fee structure----
        Ms. Richards. Yes.
        Senator Warner. ----but does not look at performance?
        Ms. Richards. Yes, that is correct.
        Senator Warner. So two out of the four. If we had perhaps
    had all four of those as criteria, might that have led to a
    more thorough analysis, not just in this firm but in other
    firms?
        Ms. Richards. I so strongly believe that the risk
    assessment methodology has to be improved with better access,
    not just to this data, but I believe there are other types of
    data points, too, that would help us do better risk assessment.
        I do want to say, however, that we don't believe that firms
    not identified as high-risk for our purposes present no risk.
    Every investment advisor can be engaged in fraud. So risk
    assessment is a first start. It helps us to prioritize our
    examination resources. But one of the fundamental questions, I
    think, is whether all investment advisors should be subject to
    some routine level, some minimal level of examination
    oversight, because risk assessment--risk assessment gives you a
    way to prioritize risk but it doesn't tell you the situations
    where there is risk that you have not identified. So it can
    help us, but it is not the be all and end all.
        Senator Warner. One of the questions, and I know that
    Senator Shelby and Senator Schumer have talked about additional
    resources, and I saw your numbers, 425 in terms of investment
    advisors and I believe 300-and-some in terms of broker dealers,
    clearly, there may be need for additional personnel. But in
    addition to additional personnel, obviously, the complexity of
    the markets has exponentially increased over the last decade.
        As you look about additional resources, I would hope that
    continuing education and ongoing upgrading of the skills of
    your workforce, and sharing the Chairman's earlier comments, I
    know this is a dedicated agency with folks who really want to
    try to get the job done, but making sure that you stay abreast
    of what is going on in the markets and what are these new tools
    that as Wall Street continues to create new tools, is that part
    of your request or would that be part of your current----
        Ms. Richards. Yes, sir. I agree completely with everything
    you have said. When the agency received additional funding to
    pay examiners and other SEC staff at pay parity levels with
    other regulators, it really--thank you to this Committee for
    that--it really allowed us to hire and retain higher-qualified
    people and we need to continue to do that. In the examination
    program in particular, I really want us to hire quants,
    economists, and people who can analyze complex trading
    strategies and really help examiners really identify emerging
    risks----
        Senator Warner. And then to keep them current even after
    they have been hired, correct?
        Ms. Richards. Yes, and I would like us to improve our
    training programs. We have, I think, very good training
    programs, but I believe that we can work hard to improve them,
    to make sure that people are maintaining education and
    expertise.
        Senator Warner. Thank you.
        Mr. Luparello, I have got a question on FINRA. I believe
    you mentioned this earlier, but I just want to make sure I
    understand. Let us assume that we have got the FINRA folks in
    looking at a broker dealer. They are trying to get documents.
    They are trying to go forward. It is my understanding under the
    current situation that if the head of that broker dealer said,
    hold it, you can't go to those documents because those are my
    investment advisory documents, you immediately stop.
        Mr. Luparello. Well, it gets complicated in a situation
    like the Madoff situation when it was a single legal entity.
    That usually comes up more in the context where the other
    business lines are in separate affiliates and we clearly get
    stopped.
        Our ability to compel documents may take us a little bit of
    the way, but it will never allow us to go fully and investigate
    the parts of that single legal entity that are not the broker
    dealer parts of the entity. So in the advisory context, it gets
    complex because of the convergence between advisory business
    and brokerage business, which starts to look more and more----
        Senator Warner. But are you saying--because I hope you are
    not saying that if you have somebody in looking at a broker
    dealer and they thought they were onto something and they
    thought something smelled bad, and all of a sudden the CEO of
    the firm said, hold it, you can't go there because that is in
    our investment advisory part of our business, that even if you
    were legally precluded from going on, that you wouldn't come
    back and either relay that information to the SEC or someone.
    Tell me that is not the case.
        Mr. Luparello. You are absolutely correct. We will take----
        Senator Warner. So in this case, in the case of Madoff, my
    understanding was when he became an investment advisor, didn't
    he use the investment advisor reasoning as one way to preclude
    FINRA from looking----
        Mr. Luparello. Actually--I am sorry to interrupt, Senator.
        Senator Warner. No, go ahead.
        Mr. Luparello. He just fundamentally misrepresented the
    business to us. All of our examinations, including after 2006,
    the Form BD he filed after 2006 continued to represent no
    advisory business in the broker dealer, so----
        Senator Warner. And there was no--from your investigators,
    there was no skepticism about it? There was no red flag? They
    accepted that at face value?
        Mr. Luparello. There were no red flags presented to us and
    there were no indicia of any sort of customer activity in the
    books and records of----
        Senator Warner. But in the normal course, if there was that
    kind of bright line wall precluding you from investigating
    further because of the investment advisory component, that
    investigator might come back and say, hey, we need to turn this
    over to this SEC because this----
        Mr. Luparello. Absolutely. We often, in our examinations,
    investigations of broker dealers, take our jurisdiction as far
    as it can go, and then once we hit that jurisdictional dead
    end, refer that conduct over to the SEC. We do that hundreds of
    times a year in fraud cases and insider trading cases and other
    types of cases. Absolutely.
        Senator Warner. Thank you, Mr. Chairman.
        Chairman Dodd. Thank you, Senator. Very good questioning.
        Senator Corker.
        Senator Corker. Chairman, thank you for having this
    hearing. We all have a lot of logistical things that we are
    dealing with. I came back to this hearing in large part just to
    pay respect for those of you who testified and for putting a
    human face on this tragedy, especially, Dr. Backe, listening to
    your testimony and knowing of the many issues that that has
    presented within your firm, and I know that has happened all
    across America. I am most appreciative.
        I do want to follow up with Senator Warner's questioning
    about the actual FINRA-type examinations. I think most of us
    felt that for years when credit rating agencies gave credit
    ratings, they actually were doing something. I think we
    realized that they were taking the information that was given
    to them by others and just saying whether it was OK or not.
    There were actually no audits, no real accounting, and I know
    they were not hired to do that, but certainly a lot of faith
    was put into that process where really faith was not due.
        In FINRA, in your examination, do you all actually ping
    back, and when you said that he presented numbers to you that
    you didn't see any discrepancies in, do you all actually check
    accounts, do things that would give you the opportunity, far
    beyond credit rating agencies, to know that there is a problem
    or not?
        Mr. Luparello. Absolutely, Senator. We don't rely simply on
    the information that they provide to us when we do our
    examinations, and that is especially true when we are doing
    investigations. We attempt to probe past just the books and
    records of the broker dealer.
        Again, in the Madoff context, in our history of doing
    examinations, the firm always represented itself to us as a
    wholesale market making firm without customer accounts, and
    again, we were never the recipients of any sort of red flags in
    terms of whistleblower complaints or customer complaints that
    led us to have skepticism about that. Had we had skepticism
    about that, we would have pushed back a little farther.
        Senator Corker. You know, just for what it is worth, as a
    layman sitting here, that seems hard to digest, and just for
    what it is worth, I thought Professor Coffee's two comments
    that he made about the accounting firm's exemptive issue there
    and just all firms having custodial accounts were no-brainers.
    I mean, it is just almost something that you would expect would
    be happening.
        I know that most people around our country look at the
    banking institutions and they are concerned about whether they
    have deposit insurance. I know candidly myself, a year ago, I
    began making sure that whatever I had was insured. And yet you
    look at $11 million worth of investment, rising to $33 million
    in value, and you realize that there are huge issues here as it
    relates to making sure that the right things are happening. It
    seems like we focus more, Mr. Chairman, sometimes on the actual
    financial institutions, and yet in these cases there is far
    more risk.
        So I would just say in general, again, coming back just to
    say that this seems to me to be an issue that a lot of work
    needs to be done on, certainly at a minimum having custodial
    accounts so that the actual investment advisor is not touching
    the money. I know that I received numbers of e-mails from
    around the country from people assuring me that that was the
    case in their particular case. The SEC, I know that the two of
    you who have come to testify today probably are not directly
    involved in deciding some of the things that occurred with this
    particular case, but it does seem to me that huge amounts more
    in investment needs to take place to make sure that the public
    is protected.
        I don't know if that has been requested. I certainly hope
    that the new Chair, Ms. Schapiro, who was just approved, will
    come forth with intelligent askings in that regard, and I just
    want to say to all of you, I think the comments that were made
    on the front end about the public, not only are people directly
    affected, people that I am sure you have watched their families
    grow up and worked with them and I am sure you feel a sense of
    personal responsibility for what has occurred regardless of
    whether that is the case. You know these people.
        In addition to that, our economy, our country is built on
    trust in investing. I think it is incumbent upon us to do
    everything possible, especially during this particular time, to
    ensure that the public does feel that they can make investments
    and not put it in a mattress someplace because they feel that
    is the only safe place it can be.
        So with that, Mr. Chairman, not wanting to be redundant
    with some of the other questioning that has taken place, I
    thank you for the hearing. I look forward to working with you
    and others to ensure that we do everything possible to--I know
    things are going to happen in the future, and we all know that,
    but to make sure that we have done everything possible to
    ensure that it doesn't.
        Chairman Dodd. Thank you, Senator, very, very much. I
    appreciate that.
        Senator Merkley.
        Senator Merkley. Hi, Ms. Richards. In your comments, if I
    understood them correctly, you noted that the Enforcement
    Division receives hundreds of thousands of tips, that many of
    these tips involve arguments and language not dissimilar to the
    information that was provided in this document, ``The World's
    Largest Hedge Fund is a Fraud.'' I have read this document. I
    find it is an extraordinary document. I can't imagine that you
    receive more than a very occasional document of this magnitude.
    Am I correct in my impression that this type of extensive
    quantitative analysis, rigorous inspection of firms, is a very,
    very unusual type of document for you all to receive?
        Ms. Thomsen. I think I will take that because it was
    actually me that talked about the complaints that come to the
    Enforcement Division, and on a scale of--leaving aside anything
    in particular related to Mr. Madoff for the reasons I have
    previously discussed, a large--a long complaint with many
    exhibits and particular information is more rare than, say, an
    e-mail complaint. An e-mail complaint, we get hundreds, indeed
    some days thousands of those. So at a certain level, it is
    longer, more detailed.
        When we get it, we--but we do get many of them, and when we
    get them, we don't know unless and until we examine whether
    they are----
        Senator Merkley. Let me cut to the chase----
        Ms. Thomsen. Sure.
        Senator Merkley. ----because I don't think we are quite
    getting there. A document like this, this type of reasoning,
    this type of expertise, 29 red flags listed, do you get one of
    these a year? Do you get 100 of these a year? Do you get 1,000
    of these a year?
        Ms. Thomsen. I don't know the answer to that, but I can get
    back to you on that.
        Senator Merkley. OK. This document in which this individual
    says that he presented this information in May 1999. He is now
    writing in November 2005. He says, ``I have spoken to the heads
    of various Wall Street equity derivative trading desks and
    every single one of the senior managers I spoke with told me
    that Bernie Madoff was a fraud.'' He goes on to say, ``I have
    outlined in this document a detailed set of red flags that make
    me very suspicious that the returns aren't real, or if they are
    real, that they involve front-running customer order flow.'' He
    goes on to say that, ``I am very concerned about the personal
    safety of myself and my family as a result of this report'' and
    asking it not to be shared with anyone. He goes on to say that
    he is putting this forward in a situation where he should
    probably just not put his head up and speak out, but because he
    considers this a serious issue of public interest.
        He lays out 29 arguments, each one very carefully
    supported, involving a whole series of circumstances that could
    just not be the case. Now, I would expect a document like this,
    you would have analysts, quantitative analysts who understand
    the complex mathematical arguments he is making about why the
    returns couldn't be real, why you wouldn't organize a firm that
    would forego 4 percent revenues on a massive amount of
    investments, is there a document that you all have in which
    your team went through this and said, no, this is not real.
    This 29 arguments can be explained. Was this carefully
    evaluated by the SEC?
        Ms. Thomsen. Again, Senator, I know that this is
    frustrating to many, including myself, I cannot discuss what
    happened in connection to this particular complaint or the
    investigation.
        Senator Merkley. Let me speak more broadly.
        Ms. Thomsen. Sure.
        Senator Merkley. Do you have any concern that detailed
    complaints involving massive amounts of money are not getting
    the sort of rigorous examination that they need in order to
    make sure that our securities trading system has a high level
    of integrity?
        Ms. Thomsen. I have enormous concern that we have so much
    information that we have to find the right ways to mine it, to
    get to the highest priority investigations, the ones that
    present the greatest amount of risk, and that is what we have
    all been talking about. Regardless of whether we have a--we
    could get a long complaint that includes all kinds of
    information and it is all wrong. We could get a short complaint
    from someone who appears to be sort of not exactly coherent and
    it could be dead on. So finding ways to mine all the
    information we get and extract from it those leads that we can
    file with our resources is something that we are acutely
    focused on.
        We have recently formed a working group focusing on risk,
    and we are worrying about how we handle complaints to extract
    information. It is always the case that if you pull one
    complaint out of 100,000, regardless of what happens--but I
    understand your point. We are trying extremely hard----
        Senator Merkley. Let me move on to another area, if I
    could.
        Ms. Thomsen. Sure. Of course.
        Senator Merkley. I just came from a hearing involving
    health care and the conversations about prevention and how much
    dollar-for-dollar that that is smarter than curing disease
    after it happens. I think much the same applies in terms of
    preventing fraud. Rather than incorporating whether or not
    people have independent audits into a risk assessment model,
    why not absolutely require firms that are managing money and
    investments to have independent audits?
        Ms. Thomsen. I think I will defer to the examination side
    on this one.
        Ms. Richards. That is an excellent idea. We would much
    rather be in a prevention mode than in a detection and clean-up
    mode after the fraud has already occurred. So I know that
    prevention is going to be foremost in the minds of the
    Commission and the new Commission Chair when we start to
    evaluate whether these regulatory fixes could be implemented.
        Senator Merkley. Is it your all's testimony here today that
    the SEC now adamantly supports, then, requirements for
    independent audits?
        Ms. Richards. No, sir. I am not testifying on behalf of the
    Commission. I am testifying on behalf of myself. But as an
    examiner, I know the value of independent audits.
        Senator Merkley. Ms. Thomsen, does the SEC have a position
    on this?
        Ms. Thomsen. Like Ms. Richards, I am testifying for myself.
    I will say that as an enforcement type, the more regulatory
    requirements there are along the way, as you suggest, help
    prevent things and it makes--it is better for investors. And so
    to the extent--every fraud prevented is a victory in my book.
        Senator Merkley. I am puzzled why on this you can't answer
    for the SEC or have someone from the SEC provide us with that
    information, but let me ask a similar question, then. Would it
    make sense in your personal perspectives, based on the
    experience that you all have had, that the SEC require
    independent custodians rather than simply incorporating whether
    or not independent custodians exist into a risk model?
        Ms. Thomsen. In my personal opinion, yes.
        Ms. Richards. Yes, I agree.
        Senator Merkley. Mr. Chair, thank you.
        Chairman Dodd. Thank you, Senator, very, very much.
        Senator Merkley. Oh, I have 12 seconds. Can I ask one more
    question?
        Chairman Dodd. Certainly. Time is up.
        [Laughter.]
        Chairman Dodd. No, go ahead.
        Senator Merkley. I will try to be very quick. Dr. Backe, I
    appreciated your testimony. You made the point that right now,
    the investments, the accounts of the people who work with you
    are being treated as a single pool and only insured once for
    $500,000, not insured as individual accounts. I believe this
    question would go to Mr. Harbeck. Can you explain, is there a
    possibility that the individual investors in Dr. Backe's firm
    can be insured as individual investors?
        Mr. Harbeck. In the ordinary run of the mill situation with
    a pension fund, where the pension fund manages the dollars and
    the pension fund itself gives instructions to the brokerage
    firm with respect to purchases and sales and redemptions, that
    fund is the customer. That has been the law in the Second
    Circuit since the mid-1990s, the case of SEC v. Morgan Kennedy.
    It has been litigated and that precedent has never been
    overturned.
        401(k) plans may be different. Back in 1975, when that
    Morgan Kennedy case was decided, I don't believe if there were
    401(k) plans, they were not widely spread and widely used. The
    Doctor mentioned that some of his people had attempted to use
    self-managed plans. If the brokerage firm recognized the
    individual and sent individual statements to the individual,
    that person might well be considered a customer under a 401(k)
    plan. But not having seen the orthopedic group's paperwork, I
    can't tell you as I sit here today whether it would fit under
    one category or the other.
        Senator Merkley. I thank all of you for helping enlighten
    us on these issues, these very important issues. Thank you, Mr.
    Chair.
        Chairman Dodd. Thank you very much, and I have some
    questions regarding that, as well, when I get to the next round
    here, but I appreciate the Senator raising that issue. It is a
    very important one.
        Senator Jack Reed is the Chairman of our Subcommittee on
    the Securities Industry and I appreciate his work over the
    years.
        Senator Reed. Thank you, Mr. Chairman, and thank you,
    ladies and gentlemen, for your testimony.
        Ms. Thomsen, there could be a perception here that all of
    this activity by the SEC was rather passive, that the tips came
    in and you evaluated the tips. But with all these rumors
    swirling about, as described in this memorandum, was there any
    independent initiative by the SEC, or was there any information
    from an SEC official unrelated to these tips saying we have
    some suspicions?
        Ms. Thomsen. Again, leaving aside the Madoff situation for
    obvious reasons, tips and leads are just one source of
    investigation and cases for us. We do and have for the last
    several years engaged in trying to identify cases through a
    risk analysis which includes thinking about where there could
    be a problem and pursuing it on a systematic basis.
        And in my written testimony, for example, I talk about a
    case we just recently brought about pension accounting and
    pension assumptions which was a case that we developed when we
    realized that, after the San Diego case, that there were issues
    with pensions, there might well be issues with pension
    assumptions, and we went through a process of identifying which
    firms might have the greatest exposure and then triaged that
    until we ultimately led to a successful enforcement case. That
    is a process we would like to do more of because it is more
    affirmative.
        One of the things about enforcement, of course, that goes
    without saying is that we can't do anything until someone
    breaks the law. I would be very, very happy if they never did
    in terms of bringing an enforcement action, but whenever anyone
    breaks the law, we would like to be there as soon as possible,
    and one of the things we want to do is think affirmatively. So,
    among other things, we are looking forward to increased
    activity in the Office of Risk Assessment, as has been alluded
    to, because we would partner with them to identify things like
    that.
        We also, leaving aside the tip process, we use, as I just
    alluded to, our investigations as sources of problems. That is,
    if we see a problem in a particular firm, we think about the
    industry as a whole, say it is a public company and it is a
    certain kind of industry. We will think about that industry. We
    will try to look for outliers. So those are the kinds of things
    we are trying to do in addition to, as you would say, reacting.
    We do need to react, obviously, but we also need to be thinking
    proactively to where the problems are and trying to get there.
        Senator Reed. I understand that you cannot comment
    specifically on this particular case, but the specificity of
    the memorandum, the repeated sort of repetition, at what level
    would the decision be made to disregard or not to initiate an
    enforcement action?
        Ms. Thomsen. Again, I really can't talk specifically about
    the particulars with respect to this particular complaint. I
    can say that the supervisory structure and the decisionmaking
    process generally in enforcement is built around relatively
    small groups of investigators, an investigative attorney who
    usually comes to the SEC with some experience, a branch chief
    who typically has years of experience within the agency, and
    then an assistant director. These groups, these assistant
    director groups, if you will, relatively speaking, small----
        Senator Reed. May I just cut to the----
        Ms. Thomsen. Oh, sorry. Of course.
        Senator Reed. ----using Senator Merkley's comment, the
    chase. Would an issue of this magnitude or this repetition or
    this seriousness be brought to the attention of individual
    Commissioners or the Commission?
        Ms. Thomsen. Oh, the matters that come to the Commission
    from the enforcement staff fundamentally fall into two
    categories. One, when we initiate a formal investigation, we go
    to the Commission for authority to get subpoena power to
    initiate a formal investigation. The next time enforcement
    matters typically come to the Commission are when we recommend
    enforcement action.
        Senator Reed. So would a matter like this go to the
    Commission in any one of those capacities?
        Ms. Thomsen. A matter that is--without specificity to this
    particular matter, a matter that is not pursued, closed for
    whatever reason----
        Senator Reed. Let me ask it another way----
        Ms. Thomsen. ----typically does not go to the Commission.
        Senator Reed. If you are seeking subpoena power to
    investigate a matter like this, but not this matter----
        Ms. Thomsen. Yes, sir?
        Senator Reed. ----it would go to the Commission?
        Ms. Thomsen. If we are seeking subpoena power, we would----
        Senator Reed. If you are seeking to continue the
    investigation----
        Ms. Thomsen. We would go----
        Senator Reed. ----which obviously in this case you would
    presume you would need subpoena power, because I don't think
    Mr. Madoff or anyone like him would be willing to give you
    records, you would have to go to the Commission.
        Ms. Thomsen. If we seek subpoena power, we would go to the
    Commission.
        Chairman Dodd. Does it require their approval?
        Senator Reed. Pardon?
        Chairman Dodd. Does it require their approval?
        Senator Reed. Would it require their approval, then, or
    disapproval?
        Ms. Thomsen. For us to get subpoena power, we need the
    permission of the Commission, yes sir.
        Senator Reed. Thank you.
        Ms. Thomsen. We may also--I don't want to leave a
    misunderstanding.
        Senator Reed. Go ahead.
        Ms. Thomsen. We are able to investigate oftentimes quite
    far without subpoena power.
        Senator Reed. Professor Coffee, I am interested in the role
    of the feeder funds, because an impression that might be right
    or wrong, but that some people didn't realize they were
    investing with Mr. Madoff. They thought they were investing
    with other entities, which presumably are regulated by the SEC.
    So there are two issues here. One is the involvement of the SEC
    with these feeder funds, and second, just the fiduciary
    obligations of these funds to ensure that their investments are
    being applied.
        Mr. Coffee. That is a very legitimate concern. I think that
    is a very legitimate concern. A number of actions have been
    filed, including by distinguished universities like NYU and
    Yeshiva, against some of these feeder funds on the grounds that
    there were material misstatements and material omissions. What
    I would direct to this Committee's attention is there is at
    least one decision in the Southern District of New York that
    says even misstatements about whether you were diversifying or
    conducting diligence are never actionable under the Federal
    securities law. This is the South Cherry Street LLC v.
    Hennessey Group decision that is getting a lot of attention in
    New York because this is the subject of a great deal of pending
    litigation.
        So there could be a point at which this Committee might
    want to look and make sure that the feeder funds are actually
    subject to the anti-fraud rules, because some of these
    decisions seem to suggest that statements about diversification
    or due diligence are not actionable as securities fraud, and I
    think that would be the wrong result.
        But I think you are quite correct that this is the next
    area for these investigations to go. What did the feeder fund
    do? And the most alarming possibility, which no one here can
    comment on, is that we will find at some point that Madoff or
    his employees were making some kind of payments under the table
    to feeder funds, because that could explain why they took all
    of their funds and invested in him, and his whole business
    model as a broker dealer was based upon paying for order flow.
        So there is going to be an interesting concern for
    investigators on whether there were ever payments made to get
    feeder funds to invest in his fund. In his last year or two, he
    had to be desperate because it was collapsing around him, and I
    would suspect that it would have not been beyond him to pay the
    feeder funds under the table, because for decades, he had paid
    brokers to direct order flow to him and the two are not that
    functionally different.
        Senator Reed. May I ask one follow-up question to either
    Ms. Richards or Ms. Thomsen, and that is do you in your
    information gathering, and you have described in quite detail
    what you look at, and again, you are getting information that
    is limited to self-disclosure, do you in any way treat a feeder
    fund different than this purported investment advisor, in the
    sense that one is simply collecting money and giving it to
    someone making decisions about investments whereas the other
    entity supposedly is actually making decisions about where the
    money goes? Is there any difference, or are they all the same,
    as investment advisors?
        Ms. Richards. If it is a registered investment advisor, it
    would be subject to our examinations. Again, we can only
    examine, routinely, 10 percent of registered advisors.
        Senator Reed. Yes.
        Ms. Richards. I don't know that all--I don't know the
    extent of feeder funds that are not registered with the SEC,
    but to the extent they are registered with the SEC, they would
    be subject to routine examinations of, as I say, 10 percent, as
    well as cause exams or sweep exams.
        Senator Reed. Mr. Chairman, my time has expired. Thank you
    very much, ladies and gentlemen.
        Chairman Dodd. Did someone else want to comment? Were you
    going to make a comment?
        Senator Reed. Oh, excuse me. I don't want to cutoff a
    comment.
        Ms. Thomsen. No, but I would say that from an enforcement
    perspective, feeder fund or not, we are going to look at the
    facts and evidence of their behavior and the laws that apply to
    it. So there is no distinction other than the distinction as to
    their conduct.
        Senator Reed. Thank you very much. Thank you, Mr. Chairman.
        Chairman Dodd. Thank you, Senator.
        Senator Menendez.
        Senator Menendez. Thank you, Mr. Chairman.
        Chairman Dodd. Good job, Jack.
        Senator Menendez. I am especially troubled by the sheer
    magnitude of the warnings the SEC received in the Madoff case
    and either neglected to look into it or just scratched the
    surface and called it a day. Specific allegations were brought
    to the attention of the staff as early as 1999. But even after
    regulators conducted eight investigations over 16 years,
    virtually nothing was done.
        And so let me ask you, when your 2005 investigation
    revealed that Mr. Madoff misled the SEC about the strategy he
    used for customer accounts, withheld information about the
    accounts, violated SEC rules by operating as an unregistered
    investment advisor, didn't you think it was appropriate to use
    your subpoena power to collect information rather than just
    rely on Mr. Madoff's voluntary responses and submissions?
        Ms. Thomsen. Senator, as I have said, I cannot talk about
    the particulars of this investigation----
        Senator Menendez. Well, that is not satisfactory, so let me
    just change the question for you. You have a case, any case,
    and that case ultimately reveals to you that an individual
    creates a strategy that misled you about the way in which they
    used their customer accounts, that they withheld information
    from the accounts, that they violated SEC rules by operating as
    an unregistered investment advisor. In such a set of
    circumstances, regardless of who it was, wouldn't that say to
    you that, in fact, you should use your subpoena power to
    collect information rather than just accept voluntary
    submissions?
        Ms. Thomsen. If I may, sir, let me talk about when we use--
    when we get subpoena power versus not getting subpoena power
    because that may--without reference to particular items. We can
    investigate and do often investigate without subpoena power.
    Indeed, we bring actions. We go to the Commission and recommend
    action be brought when we have never had subpoena power. Some,
    we collect information. We can take testimony without
    subpoenas. We can get information from not only the persons and
    entities we are focused on, but from others. That is especially
    true in the regulated entity arena where the businesses feel
    that they need to give us the records in all events so they do
    it without need of subpoena. When people provide information to
    us, they are--regardless of whether they have a subpoena, they
    can be subject to 1001 criminal prosecution if they provide
    false information.
        So whether or not we seek a subpoena, it really depends on
    whether or not we need to have a subpoena to obtain certain
    kinds of records. Phone records, for example, we can never get
    without a subpoena. So those are decisions we make along the
    way.
        In terms of the information that we seek and the roads we
    go down, we go down roads until, in the best judgment of the
    investigator, it doesn't make any sense to continue, and we are
    never stopped by the fact that we need to get a subpoena.
    Getting----
        Senator Menendez. Well, I appreciate your answer telling me
    all the things you could do. What I am concerned is about what
    you do when there are a series of circumstances presented to
    you, not what you could do. The reality is, why would someone
    hide all of this information if it isn't for the reasons of
    fraud? Why would that not, in fact, instigate you to go much
    further?
        Ms. Thomsen. Again, if we think that there is fraud going
    on, we will continue. And while I cannot talk about the
    specifics of this particular case, we don't turn a blind eye to
    fraud. If we see it, if we suspect it, we pursue it. We don't
    want fraudsters out there. It is our job to find them and----
        Senator Menendez. So Mr. Madoff was smarter than all of
    you?
        Ms. Thomsen. Again, I can't comment on what we did or why
    we did it.
        Senator Menendez. Well, I have a real problem, Mr.
    Chairman. I understand the specifics of the case, but if I
    can't get even general answers to processes, how does one
    pursue a process so that we understand when the Commission is
    using its powers effectively and when it is not using its power
    effectively?
        I appreciate the broad statement that we don't let fraud go
    on, but gosh, the bottom line is you had a series of warning
    signs. You had an investigation. You had all the elements of
    why someone would, in fact, pursue it just for the purposes of
    fraud and that didn't generate anything. I don't get a sense
    that, in fact, you can give me what is your process to ensure
    that circumstances like this don't happen prospectively.
        Ms. Thomsen. Well, Senator, let me say this, that the
    Inspector General has the same concerns that you have, as we
    all do, to find out precisely what happened here, what steps
    were taken, and what decisions were made, and he is pursuing
    that with vigor and we are not getting in the way of that
    investigation.
        Senator Menendez. Dr. Coffee, let me ask you a question.
    Several of Mr. Madoff's family members worked for agencies
    responsible for regulating Mr. Madoff's firm. It seems to me
    that it might be simple human nature that people would not be
    as quick to investigate and punish one of their own if, in
    fact, they were family members versus being complete strangers.
    Do you think that this is an area of concern that we should be
    looking at?
        Mr. Coffee. I think that there are others within Madoff
    Securities that have to bear responsibility, and we have
    already heard from FINRA that they were never told about this
    investment advisory business. I would think the Chief
    Compliance Officer of Madoff Securities, who happens to be the
    brother of Bernie Madoff, has a lot to answer for in terms of
    whether he defrauded the SEC or FINRA in making false
    statements about the nonexistence of investment advisory
    clients or the failure to disclose what was the business they
    were actually doing. So I think there were many possible areas
    where there could have been false statements made to government
    agencies or to FINRA that are within the scope of Federal
    criminal law.
        Senator Menendez. And finally, Dr. Backe, let me ask you,
    you are one of the direct victims of the scheme. There are
    several from my home State of New Jersey that unfortunately
    face the same set of circumstances. While I know we don't focus
    on taxation issues in this Committee, it seems to me that one
    of the areas is that you all paid estimated taxes based on some
    phantom interest income, because you obviously were never
    really actually having your monies invested and having interest
    income which Mr. Madoff claimed that you did have. Have you
    received any guidance from the IRS or any other Federal agency
    about the possibility of being able to get back some of that
    money?
        Mr. Backe. Well, our situation is a little different
    because this was a pension fund, so it never was taxable
    income, and there lies our problem, because our experts and our
    consultants tell us that we are therefore not allowed to claim
    a theft loss. The company already took the deduction for the
    contribution for 2008, 2007, and 2006, so we can't make another
    contribution. We asked our accountants and asked them to ask
    other accountants if we could at least refund 2008, because
    basically the money never got invested. Actually, none of the
    money ever got invested all along.
        So we are in a bind because there is a lot of controversy
    out there whether or not a theft loss is applicable to pension
    funds. We also know that Madoff's records were in disarray, and
    we being a 401(k), we don't know whether the rules that SIPC
    uses really apply to our entity and we do not know where to
    turn, and that is one of the reasons I am here, to see if the
    government can step in and SIPC can step up and tell us, give
    us direction, what should we do? Thank you.
        Senator Menendez. Mr. Chairman, I hope we can, whether
    working with the Finance Committee or whomever, look at this
    question of phantom interest. It seems to me that it might very
    well be worthy of the IRS having a special unit to assist those
    people who were victims here who were paying what they
    ostensibly thought were clearly taxes that they owed and
    obviously they didn't owe, and the question is how to give some
    relief to some of these individuals along the way. It would be
    something, I think, worthy of pursuing and I appreciate----
        Chairman Dodd. My colleague, why don't you draft a letter
    for us to sign together with you to the Finance Committee and
    the IRS raising those issues and questions and asking for some
    responses. I would be glad to cosponsor with you.
        Senator Menendez. I am happy to do so.
        Chairman Dodd. I thank you, Senator, very much for your
    questions and reflecting. And just repeating again from
    earlier, I agree. I appreciate the SEC's willingness, and
    FINRA, to report to this Committee every 3 months on the
    recommendations you are going to be making regarding not just
    this fact situation, we intend obviously at the completion of
    the investigation to be fully informed as to how that was
    conducted and what the results were, and I appreciate the fact
    that even at this juncture, the SEC is sharing with the
    Committee some of the documentation so we have an ongoing
    appreciation of what is occurring, but also the recommendations
    as to how we avoid these kinds of schemes, which have been
    going on, as Professor Coffee points out, for a long, long
    time. I think his initial comments here were revealing in many
    ways, that the magnitude of this and the length of this may be
    unique, but the problem itself is an ongoing one and so we need
    to address that issue.
        I want to address the SIPC benefits issue that was raised
    by Senator Merkley but is important. I went back and looked,
    Mr. Harbeck. SIPC Chairman Armando Bucelo, at his confirmation
    hearing in May of 2006, testified, and I will quote him, he
    said, ``Our board is committed to maintaining adequate
    resources to fulfill SIPC's statutory mission. SIPC's fund now
    stands at well over $1.3 billion, a historic high. As Chairman,
    I have initiated a broad level investment committee to make
    sure SIPC continues to be prudent in management of the fund,
    that no taxpayer funds--I repeat, no taxpayer funds--have ever
    been used in the SIPC program and the board continually
    monitors the adequacy of SIPC funding.''
        So over the years, we have had confirmation hearings here.
    The question has been raised about whether or not additional
    funds were necessary. You indicated this morning in your
    testimony that you felt more funds were going to be necessary.
        Mr. Harbeck. Senator, we have done risk management analysis
    by outside consultants, and they informed us that the prospect
    of an event such as either Lehman Brothers or the Madoff
    failure would happen once in every 5,000 years. Two of them
    happened in the last calendar quarter of last year.
        This is such an outlier in terms of the potential exposure
    to SIPC that when one looks at the fact that the regulators in
    the ordinary course of their business will find a fraud at the
    $1 million level--it is very difficult to steal a million
    dollars from a brokerage firm. The prospect of stealing $10
    million from a brokerage firm has only happened 10 times in 39
    years. The regulators do a good job, generally speaking, of
    finding these kinds of actions.
        SIPC has initiated 322 cases over 39 years. In 230 of those
    cases, the net cost to SIPC of paying customers, paying
    administrative expenses, and closing the case was under $1
    million.
        So I cannot explain this event in the ordinary parlance of
    what happens historically. We will, if necessary, use our
    commercial lines of credit, and again, if necessary--and it is
    by no means certain that it will be--we will seek to use our
    Treasury line of credit.
        Chairman Dodd. You have had a $150 fee, an annual fee, for
    a long time.
        Mr. Harbeck. That is correct.
        Chairman Dodd. The 1970s, I think you said.
        Mr. Harbeck. No. Since 1995 was the last time we were on
    assessments based on net operating revenue.
        Chairman Dodd. I do not know if you are going to have a
    comment for today, but I would like to hear back from you, if
    you are going to be requesting an increase in that fee.
        Mr. Harbeck. The board is aware of the situation, and I am
    certain the board--at every board meeting we ever had, the
    issue of whether we have sufficient resources is always an
    issue. The last board meeting we did have was prior to the
    Madoff case. I am certain the board in 3 days' time will be
    dealing with this issue.
        Chairman Dodd. I would be very interested in hearing in the
    Committee the results of that. Let me ask you this. I am going
    to go back to Senator Merkley's question. I have the exact same
    question here, the question, obviously, that Dr. Backe is
    raising, and others will, I presume, as well.
        You made the distinction based on the--was it the Hennessey
    case?
        Mr. Harbeck. No. It is SEC v. Morgan----
        Chairman Dodd. I am sorry. That was another case.
        Mr. Harbeck. Yes, SEC v. Morgan Kennedy.
        Chairman Dodd. That was one, but it was prior to 401(k)s.
        Mr. Harbeck. Yes, sir.
        Chairman Dodd. This is a 401(k), as I understand it, Dr.
    Backe.
        Mr. Backe. Yes, that is correct.
        Chairman Dodd. I wonder, Professor Coffee, are you
    knowledgeable in this area?
        Mr. Coffee. I do not know as much as the other end of the
    table, but I am aware of it is Rule 100 under SIPC that deals
    with the nature of the custody. I think what--the SIPC rules or
    the tax rules?
        Chairman Dodd. The SIPC rules.
        Mr. Coffee. I think they were correctly explained earlier
    in his testimony that SIPC does look to whether the plaintiff
    can establish that there was indeed a customer account
    recognized by the brokerage firm. This could be through
    correspondence. It does not have to be a formal account.
        Chairman Dodd. And so the distinction being a pension fund
    or a 401(k) is the deciding factor?
        Mr. Coffee. I would say the distinction is whether or not
    the brokerage firm sent you account statements in your name.
    That would be the strongest evidence that they were recognizing
    you as a customer.
        You may want to correct me on that.
        Mr. Harbeck. No. I believe that is accurate. But, Senator,
    the one thing neither the independent trustee nor SIPC wants to
    do is discourage individuals from filing claims based on the
    documentation in their hands. We have urged anyone who believes
    they have been wronged in this matter to file a claim with the
    trustee, and the reason for that is there are very few things
    in law that are black and white. But one of the things that is
    black and white is that someone who does not submit a claim
    will not be paid.
        Chairman Dodd. Yes.
        Mr. Harbeck. So anybody who believes they are victimized
    here should submit a claim to the trustee.
        Chairman Dodd. I think the doctor is writing a claim right
    now.
        [Laughter.]
        Mr. Backe. I have already gotten 140 claim forms.
        Mr. Harbeck. They should be sent not to SIPC, but to the
    trustee, Irving Picard.
        Chairman Dodd. Now, there has been no decision reached on
    this matter yet.
        Mr. Harbeck. Absolutely not. Not without looking at the
    documents.
        Chairman Dodd. All right. I appreciate that.
        Let me, if I can, I wanted to mention, by the way, that
    Barbara Roper of the Consumer Federation of America has written
    to us, and I will ask consent that her correspondence with us
    regarding this matter be included in the record as well.
        Chairman Dodd. But I would like to--she raises the issue
    that has been raised already, but I would like to raise it
    again, if I could. She says, ``Do the regulators know why they
    did not recognize the Madoff scheme for years?'' Again, I know
    you do not want to comment on the specifics of this, but just
    as a broad matter, given again there is a history of this kind
    of behavior, granted on a smaller scale and maybe for less
    time, but from a 30,000-foot perspective rather than an
    individual case perspective, what is the answer to that
    question?
        Ms. Thomsen. Well, let me start and others can jump in. It
    is a collusive fraud or a very well orchestrated fraud with a
    few people. It is designed to be hidden. And let me talk
    specifically about Ponzi schemes because they in some ways are
    among the thorniest frauds that we encounter.
        A Ponzi scheme works as long as there is more money coming
    in than going out, and most Ponzi schemes are done in an
    unregulated environment. No one is in inspecting the firm. No
    one is reviewing their books and records. It is an entity that
    operates outside of a regulatory regime.
        It typically uses and exploits relationships, affinities,
    sometimes friends and what-not, and people come into an
    organization or into the investment with a high degree of
    trust. They also tend to use both a sense of exclusivity--that
    is, we are letting you invest with us, we do not let everybody
    in here--and a certain mistrust of outsiders looking in. So
    they encourage--or, rather, discourage discussing what is going
    on with the particular investment with anyone other than
    members of the organization.
        When, as happens in Ponzi schemes, those who invest get
    their money when they ask for it, they are not on notice that
    anything is going on, and in some instances, in some of the
    most elaborate Ponzi schemes where the returns are quite high,
    they are quite happy because they are getting good returns on
    their money--until it stops flowing in, and then the whole
    thing collapses very, very quickly. And they are very difficult
    to discover ahead of time unless you can find solicitations,
    and they are oftentimes not done in writing, but occasionally
    you find them, or if you find an investor who, for whatever
    reason, is suspicious of those returns and comes to someone so
    that you can go in early and explore.
        We have had success in Ponzi schemes where we have gotten
    money back to people, significant amounts, 60, 70 cents on the
    dollar, which is a very high percentage in this kind of scheme.
    But we also have to confront the psychology around Ponzi
    schemes, which is very, very difficult.
        Years ago, we prosecuted one--it was one where we did find
    a flyer, we did get in early, we were able to shut it down,
    freeze the assets, and get investments back to the investors,
    somewhere in the neighborhood of 60 cents on the dollar. And
    then the promoter who had been enjoined by our action started a
    new scheme, and the investors who had now only gotten 60 cents
    on their dollar back reinvested with that promoter. Indeed, I
    was in court with one of those investors. She was testifying
    about what had happened. And during the lunch break, she talked
    to the promoter and decided that she could invest with him
    again. And this was a woman of some sophistication.
        So that psychology is one of the things that we confront in
    frauds. I think until--well, if you are getting a good return
    from a promoter, it is difficult for people to see some of the
    flaws. And when you are in an unregulated environment, we do
    not have the regulatory speed bumps or other sources of
    information. That is one of the reasons. It is not terribly
    satisfying. We wish we could find all fraud.
        Chairman Dodd. I think if we had listened--I mean, I was
    struck, again, by Professor Coffee's comments at the outset
    that over the years, of the 16,000 mutual funds--I think that
    is roughly the number, that there has never been one. Is that
    what you said?
        Mr. Coffee. I am not aware of a Ponzi scheme in a public
    registered mutual fund.
        Chairman Dodd. Yes. So establishing some of the rules here
    would seem--again, one wonders why given the fact that over the
    years this is nothing new. In fact, as I said earlier, I think
    Mr. Ponzi dates back to the early part of the 20th century, so
    this is a century-old problem. And the resistance in the past
    to applying the same kind of regulatory structures to protect
    people in these matters I think have been revealing.
        Professor Coffee, you have heard the testimony this morning
    of our witnesses from the SEC and FINRA. Are there any
    additional thoughts your have or recommendations you would
    make?
        Mr. Coffee. Well, I would just mention two. They are not
    really in my testimony. And I am not going to engage at all in
    any kind of finger pointing.
        There is a matter that is being discussed, I think by many,
    as to whether or not the jurisdiction of FINRA should be
    expanded to give them jurisdiction over investment advisers. We
    have just heard that there is an iron wall. We may have some
    small disagreements about whether they get around that wall a
    little. But it is possible that FINRA should have jurisdiction
    over investment advisers or, alternatively, that investment
    advisers should have to have their own self-regulatory
    organization.
        There are going to be two sides to that question, and there
    is going to be some opposition from investment advisers. But I
    think that is one of the issues that should be on the table for
    Congress to at least recognize.
        There also is the question--and this will also spark
    division--as to whether SIPC, which I am not criticizing in any
    respect, should behave more like the FDIC and be assigned by
    Congress some regulatory responsibilities. That is, in the
    insurance business, we find that private insurers do direct
    their premiums to the relative risk. So the risky environmental
    company pays a higher premium for environmental insurance than
    one that complies with all best practices. Now there is a flat
    rate, as you just described, and that to a degree probably does
    subsidize the Bernard Madoffs of this world, because if the
    insurer was going to charge the premium based on relative risk,
    they would charge a higher insurance premium to those broker-
    dealers that did their own custodial work and did not use
    external custodians.
        That is the area where I think we could think about using
    SIPC and its insurance as something more of a deterrent to
    risky financial entrepreneurs. Again, that will be
    controversial also.
        Chairman Dodd. Yes. Do you want to comment on that?
        Mr. Harbeck. Well, the FDIC does have a built-in regulatory
    function as well as an insurance function. There is no
    comparable entities to the SEC or FINRA in--there is no self-
    regulatory world in the banking world.
        Senator, if you were to assign SIPC the role of inspections
    and examinations, I would seek to hire the experts. I would
    seek to hire the people who are already doing this. There are
    four or five levels of people that you have to fool. I would
    have to hire some of those people away from their current
    positions, and I am not certain that we would get a better
    result.
        Chairman Dodd. Well, that is an interesting question and
    one we will debate in this Committee.
        I am going to leave the record open. I wanted to ask
    quickly, too, because it has been raised, and that is the issue
    about staffing and resources. And you heard Senator Corker and
    others raise the issue, and certainly this is an important
    question, whether or not you have the adequate resources and
    personnel to do the jobs.
        I would ask that--and we will certainly ask Chairman
    Schapiro, but through the witnesses who are here today to
    convey back to the SEC, rather than waiting for another hearing
    on this matter, that as Chairman of the Committee, I would like
    to get a report on what sort of resources and personnel needs
    you feel, aside from the investigation that is going on right
    now, but what is inadequate, what is lacking here in order for
    you to do these jobs. And I read your testimony last evening,
    and you cite in some detail the personnel, just the absence of
    personnel and the number of cases you have to follow. And I
    respect that. I am not suggesting that that is not a problem at
    all. So I would like to get some indication as to what would be
    needed in this area. I am not going to suggest you are going to
    get what you are asking for, but I would like to know what you
    think you need.
        Ms. Thomsen. Of course. I would be happy to do that.
        Chairman Dodd. And then we will leave the record open as
    well regarding these additional questions my colleagues may ask
    as well. Some could not be here this morning because of the
    other matters that are ongoing here with the stimulus package
    and other questions before the Senate.
        But I thank all of you for being here, and, again, I want
    to say to you, to our witnesses from the SEC--and I think I
    express the views of all of us up here. There is a great deal
    of respect for the work done by people at the SEC. We are
    terribly disappointed in this particular case for the reasons
    you have heard this morning. There seems to have been a glaring
    missed obligation regarding this matter that went on so long
    with so many flags being raised, as mentioned earlier. But we
    should not allow that to necessarily be the view that we do not
    respect the work done by the many people who work at the SEC
    every day. I would not want the record to reflect that.
        Ms. Thomsen. Thank you.
        Chairman Dodd. I thank you all. The Committee will stand
    adjourned.
        [Whereupon, at 12:58 p.m., the hearing was adjourned.]
        [Prepared statements, response to written questions, and
    additional material supplied for the record follow:]

                   PREPARED STATEMENT OF SENATOR TIM JOHNSON

        Thank you, Mr. Chairman, for holding this hearing. It is
    unfortunate that we are here today to take a closer look at the fraud
    committed by Bernie Madoff--a clear example of a serious failure in our
    regulatory system. It could be months, or even years, before we fully
    understand what actually happened at Bernie L. Madoff Investment
    Securities L.L.C, but I am hopeful that the pending investigations will
    point to needed changes in the regulation, accounting, and auditing of
    securities firms, broker-dealers and investment advisors.
        While Congress will use the next few weeks to craft a stimulus bill
    to try to stabilize our economy, it is this Committee that will be
    responsible for examining the regulatory system and working toward
    solutions to ensure that the crisis we are currently experiencing never
    happens again. I am optimistic that the new SEC Chairman, Ms. Schapiro
    will make appropriate reforms within her agency, and engage with
    Congress to make the needed legislative changes to our system of
    securities and investment regulation.
                                     ______

                PREPARED STATEMENT OF SENATOR MICHAEL F. BENNET

        Thank you, Mr. Chairman. I would first like to offer my sincere
    gratitude to both you and the Ranking Member for your leadership of
    this Committee, and for the hospitality and kindness that you and your
    staffs have shown me as the newest Member of the panel.
        As I take my seat on this Committee, I am aware that I do so at a
    crucial time in our history. Millions of Americans are out of work,
    struggling to keep a roof over their heads, and worried about how
    they're going to make ends meet. This committee will face head-on the
    challenge of responding to an economy in crisis. Though I know that the
    job will not be easy, I accept my position on this committee with
    eagerness, humility, and a deep sense of responsibility to the
    Coloradans I represent.
        Today I join you on behalf of the many Coloradans affected by the
    Bernie Madoff investment scandal, including the Nurse-Family
    Partnership, a Denver-based non-profit organization that helps low-
    income families with children meet their healthcare needs. The
    organization lost a $1 million contribution from a foundation that went
    under because of Madoff losses.
        I also come on behalf of the Fire and Police Pension Association of
    Colorado, which was protected against losses only because time was on
    its side. For reasons unrelated to fraud concerns, last June the
    pension fund withdrew $5 million from an account directly handled by
    Bernie Madoff. Had this transfer not taken place, the situation could
    have been dire for some of the men and women who serve and protect the
    people of Colorado.
        There are certainly countless other Coloradans whose savings
    contribute to the unimaginable $50 billion in losses related to Bernie
    Madoff's investment scheme.
        It is crucial that we get to the bottom of what was clearly the
    utter failure of our regulatory system. I am confident that the
    witnesses we have here today, particularly those from the Securities
    and Exchange Commission, can shed some light on how this failure
    happened. I thank them all for being here. But getting answers is only
    the first step.
        We need to repair a seriously broken regulatory system under which
    investigators have consistently lacked the resources and big-picture
    perspective necessary to keep an eye on the financial activities of
    increasingly large investment entities.
        We also need to make sure that regulators foster proper
    relationships with the investors they oversee. We need to recruit and
    maintain a competent regulatory workforce at the SEC--a workforce that
    does not allow personal or social relationships to cloud its judgment.
        Finally, we must ensure that the foundations, non-profits,
    individuals, and retirees who have lost money as a result of this fraud
    have some recourse. There's been discussion of how much loss the
    Securities Investor Protection Corporation (SIPC) can cover, and I
    gather that it's not much. I am interested to see if there are other
    ways to provide some relief to victims who are still reeling from their
    losses.
        This Committee will lead the charge of repairing a regulatory
    system that has slipped off its tracks. I am honored to be the
    Committee's newest Member, and I look forward to our important work in
    the months ahead.
        Thank you.
                                     ______

                   PREPARED STATEMENT OF JOHN C. COFFEE, JR.
                        Adolf A. Berle Professor of Law,
                         Columbia University Law School
                                January 27, 2009

       The Madoff Investment Securities Fraud: Regulatory and Oversight
                        Concerns and the Need for Reform

        ``You only find out who's swimming naked when the tide goes out.''
                                             ----Warren Buffett
                       Annual Letter to Berkshire Hathaway shareholders

        Chairman Dodd, Ranking Member Shelby, and Fellow Senators, I am
    pleased and honored to be invited to testify here today. I have been
    asked to address reforms that might prevent future Ponzi schemes and
    the jurisdiction (or lack thereof) of the SEC and FINRA over investment
    advisers similar to Mr. Madoff. I will get to these points quickly
    without further delay.
    I. The Persistence of Ponzi Schemes
        The tide has gone out on Wall Street, and in Warren Buffet's words,
    we are now finding out ``who has been swimming naked.'' Sadly, it has
    been the recurrent pattern in Ponzi schemes, \1\ and similar investment
    frauds, that they are revealed not by regulatory detection and
    enforcement, but by their own collapse under the pressure of investor
    demands for redemption when the market sours (and investors become
    belatedly anxious). As a result in part of the spectacular collapse of
    the Madoff fraud, investors are now demanding redemption at a record
    level, and other Ponzi schemes are coming to light. Symptomatically,
    many of the recent Ponzi schemes show the same basic pattern and
    thereby also reveal what reforms could best prevent them at relatively
    low cost. In truth, the only features that are truly distinctive about
    the Madoff fraud are its extraordinary scale (an order of magnitude
    higher than any other such scheme) and its multi-decade duration.
    Uniquely, Mr. Madoff was able (i) to transcend traditional ``affinity
    fraud'' and move to a global scale through the use of ``feeder funds''
    (i.e., hedge funds that seek to diversify through investing in other
    funds--or ``fund of funds''), and (ii) to maintain investor confidence
    in his operation for several decades (which factor, of course,
    aggravates the problem of inadequate regulatory oversight).
    ---------------------------------------------------------------------------
         \1\ According to Wikipedia.com, ``A Ponzi scheme is a fraudulent
    investment corporation that pays returns to investors out of money paid
    by subsequent investors rather than from profits.'' The name comes from
    Charles Ponzi, who gained notoriety for such an investment scheme in
    Boston shortly after World War I. This definition may, however,
    overstate, as most Ponzi schemes do involve some real investments in
    assets or securities with only a portion of the new investors'
    investments being paid to the old investors.
    ---------------------------------------------------------------------------
        Ponzi schemes occur in all societies, and there have been similar
    scandals in Russia, Eastern Europe (particularly in Albania where one
    helped cause the fall of a government), India and, very recently, the
    U.K. In the U.S., although Ponzi schemes are infrequent and represent
    only a tiny minority of alternative investments, they do produce
    substantial losses on a recurring basis. Other scholars have computed
    the losses from Ponzi schemes, as shown by litigated court cases, and
    concluded that the prior record year was 2002 when ``over $9.6
    billion'' was lost. \2\ But annual losses of over $1 billion are
    frequent, with over $1.6 billion lost in 1995 and 1997 and over $1
    billion in 1996, 1990, and 1976. \3\ The amount so lost varies
    radically from year to year largely because Ponzi schemes tend to be
    uncovered only in periods of market stress--``when the tide goes out on
    Wall Street.''
    ---------------------------------------------------------------------------
         \2\ See Statement of Tamar Frankel, Professor of Law and Michaels
    Faculty Research Scholar, Boston University School of Law before the
    House Committee on Financial Services, January 5, 2009, at p. 2.
         \3\ Id.
    ---------------------------------------------------------------------------
        Any estimate of the total losses caused by Ponzi schemes is likely
    to understate, because litigated cases ignore those schemes in which
    the collapse is so complete that there is no hope of recovery and hence
    no incentive for litigation. In that light, it seems more important to
    examine some representative case histories in order to identify common
    denominators. The following appear to be the leading recent cases:

      1.  Bernard L. Madoff Investment Securities, LLC (``Madoff
            Securities''). On the facts known so far, two basic failures in
            internal controls are evident in the Madoff case: First, Madoff
            cleared his own trades and did not use either an independent
            custodian or a clearing broker to execute and clear his trades.
            Second, Madoff was audited by a small auditing firm, Friehling
            & Horowitz, which only had three employees. Of these three, one
            was a secretary; another was Jerome Horowitz, an 80-year-old,
            semi-retired partner, living in Florida, and the third was
            David Friehling, who was not subject to even the peer review
            process mandated by New York State because he claimed not to
            conduct audits (ironically, this may have truer than regulators
            realized). The Friehling & Horowitz firm was not registered
            with the Public Company Accounting Oversight Board (``PCAOB''),
            because of an overbroad exemptive rule (discussed below) that
            the SEC repeatedly adopted in the wake of Sarbanes-Oxley to
            spare broker-dealers that were not publicly held from the
            oversight of a PCAOB-registered auditor.

      2.  Bayou Group LLC. Organized in 1996 and re-organized in 2003, the
            Bayou Fund and its various successor hedge funds were all
            managed by Bayou Management LLC, and the trading activities of
            the group were conducted through a single, captive broker-
            dealer called Bayou Securities LLC. \4\ All these entities were
            owned and controlled by Sam Israel (``Israel''), the chief
            executive of Bayou Management. Thus, as in the case of Madoff,
            there was no independent custodian or clearing broker.
    ---------------------------------------------------------------------------
         \4\ This summary of the facts comes from In re Bayou Group LLC,
    2008 Bankr. LEXIS 3261 (Bankr. Ct. S.D.N.Y. October 16, 2008). Mr.
    Israel and others are now serving prison terms.

         Beginning in 1999 and continuing through 2005, Israel and his
            chief financial officer created a non-existent and entirely
            fictitious auditing firm, Richmond-Fairfield Associates, to
            generate false performance summaries and false financial
            statements to mislead investors. Weekly, monthly, quarterly,
            and annual financial reports were generated by this bogus
    ---------------------------------------------------------------------------
            auditing firm and distributed to investors.

         The Bayou Ponzi scheme collapsed in 2005, but it had lost money
            from its outset, pursuing an options trading strategy not
            unlike that which Bernard Madoff claimed to have been pursuing.
            Before its collapse, Israel caused the Bayou funds to make a
            bank transfer of $120 million from various accounts to a bank
            account at PostBank in Germany; $100 million of this amount was
            then transferred to a bank account controlled by Israel in the
            United States. This latter amount was seized by the Arizona
            Attorney General in May 2005 and restored to the bankrupt
            estate. Again, it needs to be underscored that such a $120
            million transfer to a foreign bank is precisely what a
            reputable independent custodian would not allow. Similarly, had
            the auditor for the Bayou Funds been required to have been
            registered with the PCAOB, it would have been comparatively
            simple for investors to check and ascertain whether they were
            dealing with a legitimate auditor (instead of an entirely bogus
            firm). Nor would Israel have dared to invent a bogus auditor.

         As of August 31, 2005, the loss that resulted from this classic
            Ponzi fraud exceeded $218 million. \5\
    ---------------------------------------------------------------------------
         \5\ Id. at 36.

      3.  Arthur Nadel and Scoop Management. Currently a fugitive from
            justice, Mr. Nadel ran six Florida-based hedge funds with
            reported assets of over $350 million. In the wake of the Madoff
            collapse, anxious investors sought redemptions, and Mr. Nadel
            disappeared. At least, a $50 million shortfall in funds has
            been reported. Red flags again are evident with respect to the
            auditing of these funds. In 2005, the Hedge Co. Net Index
            ousted Mr. Nadel's funds from its Web site index because of his
            failure to provide current audited results. \6\
    ---------------------------------------------------------------------------
         \6\ See ``Fund Fugitive's 1905 Finagling,'' N.Y. Post, January 20,
    2009, at p. 30.

      4.  Martin Armstrong and Princeton Economics International. This 7-
            year Ponzi scheme purported to trade currencies, in particular
            gold and silver, and raised over $3 billion. Investors who
            purchased his ``Princeton Notes'' appear to have lost over $700
            million. \7\ In January 2002, Republic Securities, the broker
            dealer that traded for Mr. Armstrong and handled his accounts,
            plead guilty to conspiracy and securities fraud charges and
            paid approximately $569 million in restitution. Although this
            represents the fairly unique case in which (i) there was a
            custodian, and (ii) it was complicit in the fraud, the $569
            million in restitution obtained from it shows that an
            independent custodian can at least provide restitution to
            victims.
    ---------------------------------------------------------------------------
         \7\ For the basic information on this case, I am relying on The
    Press Release issued by the U.S. Attorney's Office for the Southern
    District of New York on April 10, 2007 (available on LEXIS).

      5.  J.V. Huffman and Biltmore Financial Group. \8\ This relatively
            small $25 million fraud was uncovered by the North Carolina
            Secretary of State's Securities Division, and the SEC later
            brought suit in November 2008. Mr. Huffman assured investors
            that he ``operated like a mutual fund.'' His fraud continued
            for over 17 years. Like Mr. Madoff, Mr. Huffman paid a steady
            high return (as much as 16.54 percent in 2007, but never below
            8 percent). In fact, Mr. Huffman never invested his investors'
            funds in securities, mortgages, or other investments, but used
            them to subsidize his lavish lifestyle. In short, his modus
            operandi was similar to that of Madoff, but on a smaller scale,
            and he again did not use any custodian or clearing broker.
    ---------------------------------------------------------------------------
         \8\ See ``SEC Charges N.C. Resident, Biltmore Financial Group for
    Operating Multi-Million Dollar Ponzi Scheme,'' States News Service,
    November 12, 2008 (available on LEXIS).

      6.  Pinnacle Development Partners LLC and Gene O'Neal. \9\ Before its
            collapse in 2006, this real estate investment fund raised more
            than $69 million over 15 months by promising a 25 percent
            return on its notes in 45 days (later extended to 60 days).
            Some 2,000 investors (mainly in the United States) invested.
            According to the indictment, Mr. O'Neal ``recycled'' some $25
            million in invested capital from new investors to old
            investors. In order to foster the illusion of actual economic
            activity, real estate properties were transferred between
            Pinnacle's three partnerships with the sale price paid by one
            partnership being as much as 10 times the initial acquisition
            price paid by another partnership. Prior to the indictment, the
            SEC did obtain a preliminary injunction in this case.
    ---------------------------------------------------------------------------
         \9\ See ``Head of Purported Real Estate Investment Bund Indicted
    in $69 Million Ponzi Scheme,'' March 8, 2007, U.S. Fed News (available
    on LEXIS).

      7.  Other Noteworthy Cases. In 1997, John Bennett, Jr., was sentenced
            to prison (and served 11 years) in connection with a $700
            million Ponzi scheme that principally focused on churches,
            colleges, and cultural institutions. \10\ Promising to return
            to investors double the amount of their donations to his
            Foundation for New Era Philanthropy, he solicited individuals
            and institutions with an evangelical Christian orientation
            (again, as with Madoff, this is an example of ``affinity
            fraud''). In another high profile case, Martin Frankel looted
            around $200 million and then fled to Germany, carrying twelve
            passports and several million dollars worth of diamonds. J.T.
            Wallenbrock & Associates sold promissory notes, raising over
            $230 million from over 6,000 investors. \11\ Reed E. Slatkin
            perpetrated a classic Ponzi scheme that raised over $600
            million and continued for over 15 years. Using fake financial
            statements that referenced fake brokerage firms, he mainly
            solicited Hollywood entertainment figures and fellow
            Scientologists--again, an example of affinity fraud. \12\ To
            the best of my knowledge, with the exception of the Martin
            Armstrong case, there has not been a legitimate, independent
            custodian involved in any of these cases.
    ---------------------------------------------------------------------------
         \10\ See Infield, ``Similarities in Madoff Case and a Local One,''
    The Philadelphia Inquirer, December 17, 2008 at p. A-1.
         \11\ These cases are summarized in Jerry Markham, Mutual Fund
    Scandals--A Comparative Analysis of the Role of Corporate Governance in
    the Regulation of Collective Investments, 3 Hastings Bus. L. J. 67, 119
    (2006).
         \12\ See ``The 10 Nastiest Ponzi Schemes Ever,'' Business Pundit,
    December 15, 2008.

      8.  Summary. Although many more cases could be cited, two
            observations deserve emphasis: First, both the scale and
            frequency of Ponzi schemes seems to be increasing. Although
            Madoff is in a class by himself, the increase in the size of
            the typical Ponzi scheme appears to be the product of the
            growth of the hedge fund industry and the new popularity of
            alternative investment schemes. The SEC has also noted this
            correlation. \13\ Second, the increased frequency of Ponzi
            schemes contrasts sharply with the fact that no mutual fund
            registered under the Investment Company Act of 1940 has ever
            collapsed and been exposed as a Ponzi scheme. In fairness, the
            relevant contrast here is not between mutual funds and hedge
            funds (for example, Mr. Madoff was not running a hedge fund,
            but was an investment adviser). Rather, it is between mutual
            funds, which seem immune to Ponzi schemes, and other investment
            vehicles, which are less regulated and seem more vulnerable to
            fraud.
    ---------------------------------------------------------------------------
         \13\ See ``Registration Under the Advisers Act of Certain Hedge
    Fund Advisers,'' 69 Fed. Reg. 72054, at 72056 (Dec. 10, 2004) (noting
    that 51 enforcement cases had been brought in preceding 5 years against
    hedge fund advisers for losses exceeding an estimated $1.1 billion).
    ---------------------------------------------------------------------------
    II. Can Ponzi Schemes Be Efficiently Prevented?
        As just noted, a marked disparity exists between the seeming
    immunity of mutual funds and the relative vulnerability of other
    collective investment vehicles: mutual funds have not experienced Ponzi
    schemes, while hedge funds, other pooled investments (real estate
    investment trusts), and investment advisers have. In the past, Ponzi
    schemes were frauds perpetrated by solo entrepreneurs or a small,
    tight-knit group, working within a cohesive ``affinity group'' that
    trusted them because of their shared background. More recently,
    however, larger hedge funds--Bayou and Arthur Nadel's Scoop Management
    are the leading examples--have engaged in similar practices.
        What distinguishes mutual funds from hedge funds and investment
    advisers that may explain this disparity? Two differences stand out:
    (1) independent custodians, and (2) PCAOB-registered auditors. A third
    difference is the requirement of an independent board in the case of a
    mutual fund, but this difference is not easily generalized and would be
    infeasible for most investment advisers. Desirable as independent
    boards may be, they are unlikely to be able to stop a determined crook.
    The first two reforms are thus examined below:
    A. The Custodian
        Section 17(f) (``Custody of Securities'') of the Investment Company
    Act of 1940 requires a registered management company to ``place and
    maintain its securities and similar investments in the custody of'' a
    bank or a dealer admitted to a national securities exchange, ``subject
    to such rules and regulations as the Commission may from time to time
    prescribe fro the protection of investors.'' \14\ As amplified by SEC
    rules, the custodian requirement largely removes the ability of an
    investment adviser to pay the proceeds invested by new investors to old
    investors. The custodian will take the adviser's instructions to buy or
    sell securities, but not to remit the proceeds of sales to the adviser
    or to others (except in return for share redemptions by investors). At
    a stroke, this requirement eliminates the ability of the manager to
    ``recycle'' funds from new to old investors.
    ---------------------------------------------------------------------------
         \14\ See 15 U.S.C.  80a-17(f)(1). Section 17(f) also permits the
    management company to maintain securities with ``such company, but only
    in accordance with such rules and regulations or orders'' as the SEC
    may prescribe.
    ---------------------------------------------------------------------------
        In the nearly 70 years since the passage of the Investment Company
    Act of 1940, frauds have occurred in connection with mutual funds, but
    not true Ponzi schemes. Admittedly, a truly predatory investment
    adviser might find ways to circumvent the custodian requirement, but
    most Ponzi schemes appear to develop as acts of desperation as
    investment managers that have incurred losses struggle to hide them and
    ``borrow'' some of the funds from new investors in order to pay the
    promised return to the original investors. Their desperate hope is that
    they can eventually recoup their losses (indeed, this appears to have
    been the Bayou experience). Section 17(f) eliminates both this
    opportunity and incentive.
        In the case of hedge funds, because they are exempt from the
    Investment Company Act, \15\ Section 17(f) is simply inapplicable to
    them. To be sure, many and probably most hedge funds do use an
    independent custodian as a matter of ``best practices,'' but some do
    not (as the Bayou fund and the hedge funds run by Arthur Nadel appear
    to show). Thus, both the Bayou Funds and those run by Mr. Nadel were
    able to make large payments to their investment advisers at the point
    of collapse (for example, as discussed earlier, Bayou transferred $120
    million to a German bank, of which $100 million was quickly returned by
    that bank to Mr. Israel). The vulnerability of hedge funds thus seems
    obvious.
    ---------------------------------------------------------------------------
         \15\ See Sections 3(c)(1) and (7) of the Investment Company Act
    (exempting funds held by ``qualified purchasers'' and by less than 100
    owners where no public offering is made).
    ---------------------------------------------------------------------------
        In the case of investment advisers (and this is the category into
    which Madoff Securities falls), the SEC's rules are more complex. Under
    Rule 206(4)-2 (``Custody of Funds or Securities of Clients By
    Investment Advisers'') under the Investment Advisers Act of 1940, \16\
    an investment adviser must maintain client funds or securities with a
    ``qualified custodian.'' However, the term ``qualified custodian'' is
    defined by Rule 206(4)-2(c)(3) to include any broker-dealer registered
    under the Securities Exchange Act of 1934, at least to the extent that
    it is ``holding the client assets in customer accounts.'' This means
    that an investment adviser who was not itself a registered broker-
    dealer would have to use a clearing or prime broker to hold its
    customers' securities and funds. But to the extent that Madoff was a
    registered broker-dealer, he was permitted to clear his own trades
    through his own broker-dealer firm. Worse yet, because Mr. Madoff
    claimed to be trading through his British subsidiary, even Madoff's New
    York brokerage employees were not necessarily aware of his trading
    activities (as his trades were allegedly done through a foreign
    affiliate).
    ---------------------------------------------------------------------------
         \16\ See 17 CFR  275.206(4)-2.
    ---------------------------------------------------------------------------
        Obviously, the simplest most direct reform that has the greatest
    chance of preventing Ponzi schemes is to require use of an independent
    custodian--by both investment advisers and hedge funds. \17\
    ---------------------------------------------------------------------------
         \17\ This author originally made this proposal in a December 16,
    2008, Op/Ed piece for CNN.com. See Coffee, ``Where Was the SEC?''
    www.cnn.com. Since then, others have also endorsed this proposal, as
    discussed later.
    ---------------------------------------------------------------------------
    B. A PCAOB-Registered Auditor
        It has escaped almost no one's attention that Madoff Securities was
    ``audited'' by effectively a one-person auditing firm that was not
    registered with the Public Company Accounting Oversight Board
    (``PCAOB'').
        Why wasn't Friehling & Horowitz registered with PCAOB when it was
    auditing a broker-dealer with custody over more than $30 billion in
    customer accounts? Under the Sarbanes-Oxley Act, broker-dealers were
    required to use such a registered auditor. \18\ The answer here is
    simple, blunt and disappointing: the SEC exempted all broker-dealers
    that were privately held (i.e., not a publicly held ``reporting''
    company under the Securities Exchange Act of 1934) from the requirement
    that they use a PCAOB registered accountant. In Securities Exchange Act
    Release No. 34-54920, \19\ the SEC extended earlier orders issued in
    2003, 2004, and 2005 that exempted privately held broker-dealers from
    the obligation to use a registered public accounting firm.
    ---------------------------------------------------------------------------
         \18\ See Section 205(c)(2) of the Sarbanes-Oxley Act (amending
    Section 17(e) of the Securities Exchange Act to require use by a
    broker-dealer of a ``registered public accounting firm'').
         \19\ See 2006 SEC LEXIS 2886 (December 12, 2006).
    ---------------------------------------------------------------------------
        The rationale for this position seems both dubious and symptomatic.
    Although a privately held firm may have few shareholders who need
    properly audited financial statements, it may have many customers (and
    the SEC) who have an interest in knowing that appropriate auditing
    procedures have been followed. Because the SEC did not (in the wake of
    the Madoff scandal) renew this exemptive order in December, 2008, the
    point is now moot. For the future, privately held broker-dealers will
    be required to use PCAOB-registered auditors.
    C. The Insurer: SIPC
        The Securities Investment Protection Corporation (``SIPC'') is the
    functional analogue to the Federal Deposit Insurance Corporation
    (``FDIC''); the former protects customers of insolvent broker-dealers,
    while the latter protects depositors of insolvent banks. But the
    analogy between them is inexact for many reasons. A key difference is
    that SIPC is a ``passive safety net,'' which makes no significant
    effort to prevent failures or to price its insurance in terms of the
    riskiness of the individual broker-dealer firm. \20\
    ---------------------------------------------------------------------------
         \20\ This point is not original with this author. See Thomas W.
    Joo, Who Watches the Watchers? The Securities Investor Protection Act,
    Investor Confidence, and the Subsidization of Failure, 72 S. Calif. L.
    Rev. 1071 (1999).
    ---------------------------------------------------------------------------
        Normally, private insurers price their insurance in terms of the
    riskiness of the insured and its activities. A chemical company that
    was a toxic polluter would pay more for insurance covering
    environmental claims than an efficiently run chemical company that
    stayed well within both the law's requirements and industry ``best
    practices.'' Such pricing forces the polluter to internalize the costs
    of its own misconduct and creates a disincentive.
        In contrast, throughout its history, SIPC has either charged its
    broker-dealer members a flat fee (which has been as low as $150 in 1996
    and 1997) or made an annual percentage of revenues assessment (which
    has been as low as 0.065 percent during the 1990s). It thus does not
    distinguish between its member firms, even though they represent
    different risk levels. SIPC also has no watchdog powers over its
    members; it neither proscribes unsafe or unsound practices nor conducts
    examinations of its members.
        A private insurer would, of course, appraise the risk level of the
    insured's behavior. Thus, if a broker-dealer did not use an independent
    custodian, this failure would result in an increased premium to those
    of its customers who sought insurance covering the risk of insolvency
    and/or misappropriation of their accounts.
        To the extent that SIPC today neither plays a meaningful watchdog
    role (as the FDIC does) nor prices its insurance on a risk-adjusted
    basis, it is subsidizing high risk broker-dealers. Put differently, the
    future Bernie Madoffs are receiving an undeserved discount on their
    insurance costs that increases their incentive to commit fraud.
    Correspondingly, to the extent that broker-dealer customers are at
    least partially insured, they have less reason to fear risky or
    fraudulent broker-dealers--and so a ``moral hazard'' problem arises.
        These comments are not intended as criticisms of the current
    management of SIPC, which has no authority to play a watchdog rule
    today. But it does lead to three policy conclusions: (1) SIPC insurance
    should be risk-adjusted; (2) ``cheap'' SIPC insurance can be socially
    costly; and (3) SIPC could be given a watchdog role with respect to
    unsafe and unsound financial practices by broker-dealers, because they
    will ultimately bear the loss.
    D. Policy Conclusions
        The most important reform is to require an external and independent
    custodian for all collective investment vehicles. The SEC has adequate
    authority to do this for registered investment advisers, but lacks
    authority over hedge funds. Although some industry opposition can be
    expected, it is noteworthy that, in the wake of Madoff, the Investment
    Advisers Association (``IAA'') has already endorsed a requirement that
    all advisory assets be handled by external, independent custodians.
    \21\ This position may be their preferred alternative to another, more
    controversial policy recommendation that FINRA be given jurisdiction
    over investment advisers (on which I take no position). Still, it does
    suggest that any political opposition to a custodian requirement can be
    overcome.
    ---------------------------------------------------------------------------
         \21\ See Sara Hansward, ``Adviser Group Urges That Investor Assets
    Be Held By Custodians,'' Investment News, January 12, 2009, at p. 2.
    ---------------------------------------------------------------------------
    III. Regulatory Oversight
        The most obvious question that arises in the wake of the Madoff
    scandal was why regulators failed to detect the fraud, or to even
    conduct a detailed examination of his investment advisory business,
    over a multi-decade period. This question is being currently
    investigated by the SEC's Inspector General, and I will not attempt to
    prejudge this issue, anticipate his conclusions, or pass judgment on
    the Enforcement Division's performance in this case; nor am I well
    positioned to evaluate the credibility of the warnings that the SEC
    received.
        Still, two issues are more susceptible to a legal analysis from my
    perspective:
        First, although Madoff Securities was only required to register as
    an investment adviser by the SEC in 2006, Madoff Securities was not
    thereafter examined by the SEC's Office of Compliance Inspections and
    Examinations. Even given the severe cost constraints under which the
    SEC labors, was this omission justifiable?
        Second, given that the Financial Industry Regulatory Authority
    (``FINRA'') (and its predecessor, the NASD) had jurisdiction over
    Madoff Securities for several decades, was its failure to closely
    inspect the firm's advisory activities justifiable based on the
    argument that it lacked jurisdiction over investment advisers?
        In both cases, as discussed below, I believe the justifications for
    inattention are insufficient.
    A. SEC Examination
        Historically, investment advisers were examined by the SEC's Office
    of Compliance Inspections and Examinations in the first year after they
    registered with the SEC as investment advisers. Here, that would have
    been 2006 or 2007. Yet, because of cost constraints, no such
    examination was conducted, as this Office now uses risk-based criteria
    to determine which firms to examine.
        Although hindsight has 20/20 vision which overlooks how difficult
    it is to discern frauds, I must conclude that if the SEC's risk-
    adjusted criteria did not consider Madoff Securities to be a risky case
    that justified an early examination, those criteria need to be revised.
    The critical facts were that even, as of 2006, Madoff Securities (1)
    had many billions of dollars in customer accounts under its management,
    (2) did not use an external custodian or prime broker, but cleared its
    own trades; (3) used an unusual options trading strategy that on closer
    inspection seemed incapable of implementation; and (4) used the same
    trading strategy for all clients, rather than provided individualized
    investment advice--and so arguably resembled an unregistered investment
    company. Opaque trading strategies have long been an identifying
    characteristic of Ponzi schemes. Although Madoff Securities had long
    paid a high return to its investors, the strange consistency in these
    returns over decades was puzzling, had attracted much skeptical
    commentary within the industry, and was arguably as much a warning
    signal as a re-assuring factor. Still, if one fact stands out, it was
    the sheer magnitude of the amount under management. This and the fact
    that the Madoff Securities' advisory business had not previously been
    vetted by the SEC called out for an early examination.
    B. FINRA's Jurisdiction
        Prior to 2006, Madoff Securities was only a broker-dealer and not a
    registered investment adviser. Thus, during this period, I see no
    reason that FINRA (or at that time the NASD) should have abstained from
    examining and monitoring the advisory side of Madoff Securities. This
    side was never formally separated in a different subsidiary; nor was it
    even geographically remote.
        Section 202(a)(11) of the Investment Advisers Act defines the term
    ``investment adviser'' to mean ``any person who, for compensation,
    engages in the business of advising others . . . ,'' but then excludes
    from this definition ``(C) any broker or dealer whose performance of
    such services is solely incidental to the conduct of his business as a
    broker or dealer and who receives no special compensation therefore . .
    . '' \22\ Thus, if Madoff Securities was not registered as an
    investment adviser, it had to be taking the position (rightly or
    wrongly) that it was servicing these clients ``solely incidental to the
    conduct of'' its business as a broker-dealer. If so, that brokerage
    business was by definition within the NASD's and FINRA's jurisdiction.
    After 2006, when Madoff Securities did register as an investment
    adviser, it was required (as earlier discussed) by Section 206(4) of
    the Investment Advisers Act and Rule 206(4)-2 thereunder to use a
    ``qualified custodian'' to hold its customers' funds and securities. As
    earlier discussed, Madoff Securities, the investment adviser, could use
    (and did use) Madoff Securities, the broker dealer, as its ``qualified
    custodian'' (i.e., it could ``self-clear''). But this conduct in
    holding securities and executing trades was the conduct of a broker-
    dealer and was fully within the NASD's jurisdiction.
    ---------------------------------------------------------------------------
         \22\ See 15 U.S.C.  80b-2(a)(11).
    ---------------------------------------------------------------------------
        Finally, Madoff Securities had no right or privilege to resist any
    inspection by the NASD (or later FINRA) or to fail to provide
    information on the ground that its investment advisory business was
    exempt from NASD oversight. If it resisted on this ground, the NASD and
    FINRA had full power to discipline it severely. NASD Rule 8210 makes it
    clear beyond argument that the NASD can require a member firm to permit
    the NASD to inspect its books, records, and accounts and to provide
    other information. As the NASD further advised its members in its
    Notice to Members 00-18 (March 2000):

            Implicit in Rule 8210 is the idea that the NASD establishes and
            controls the conditions under which the information is provided
            and the examinations are conducted.

        I have previously served on an NASD disciplinary committee and
    found that any associated person of a member firm who resists a NASD
    investigation or directs others not to testify can be barred (and was
    so barred, in at least one instance during my term of service) from the
    industry for such resistance.
        Let me conclude with a simple illustration: Imagine that on an
    examination of a broker-dealer, the NASD found that several roulette
    wheels were in operation in one of its offices and gambling was
    occurring (legally or otherwise). In my judgment, even though such
    activity did not involve the conduct of a brokerage business, the NASD
    (and later FINRA) on such a discovery could and should seek to
    determine the impact of these activities on the broker-dealer's
    financial condition and its books and records. Similarly, on learning
    that Madoff Securities held billions of dollars of customer funds and
    securities for which it was the ``qualified custodian,'' it was
    incumbent on the NASD to examine the adequacy of the internal controls
    relating to the management, custody, and security of those accounts.
    Similarly, at this point, the NASD might have examined the audited
    financial statements of Madoff Securities and properly asked who the
    firm's unknown accountant was.
        I express no view on whether the NASD or FINRA necessarily should
    have uncovered the Madoff fraud, but I reject as overbroad the claim
    that they had no jurisdiction or reason to inquire.
        Thank you for your time and attention, and I would be happy to
    attempt to answer any questions that you may have.
                                     ______

                PREPARED STATEMENT OF HENRY A. BACKE, JR., M.D.
                   Orthopedic Surgeon, Fairfield, Connecticut
                                January 27, 2009

        Good morning Senators. Thank you for allowing me to speak on behalf
    of 140 United States taxpaying citizens from the State of Connecticut.
    I am an Orthopaedic Surgeon, and a Partner of Orthopaedic Specialty
    Group (``OSG''), a medical practice located in Fairfield, Connecticut.
    We care for the medical needs of the insured and uninsured people of
    the greater Bridgeport, Connecticut, region in New England. OSG,
    incorporated in 1971, has been in existence for over 75 years. We
    employ 130 people with annual incomes ranging from $28,000 to $130,000.
    We have some employees who have worked with us for over 30 years. OSG
    has had a retirement plan (the ``Plan'') for its employees since the
    1970s. We currently have 140 participants of which 34 are now employed
    elsewhere or retired. We have followed all the ERISA rules and
    regulations governing pension plans and have been diligent in our
    fiduciary responsibilities. We have hired pension administrators for
    recordkeeping; our pension documents have been kept current with
    appropriate amendments by attorneys, and our accountants have completed
    every required filing since the Plan's inception.
        Sixteen years ago, in 1992, we engaged Bernard Madoff Investment
    Securities Co. (``Madoff'') to be our investment advisor and have
    invested all the Plan's assets with Madoff. Participants in the Plan
    include 15 doctors and 125 staff members such as nurses, x-ray
    technicians, medical assistants and administrative personnel. The Plan
    was funded by employee contributions, individual rollovers, and
    employer contributions. As of November 30, 2008, the plan had a net
    capital investment with Madoff of $11,581,000 and a statement balance
    of approximately $33 million. The Partners of OSG have made routine
    visits to Madoff's offices in New York City since 1992. The OSG Plan
    took comfort in the fact that its assets were invested with a well
    known and highly respected investment adviser and broker-dealer that
    was registered with the SEC, and subject to routine examination and
    oversight by the SEC and FINRA. For over 16 years, the OSG Plan
    received confirmations from Madoff for thousands of securities
    transactions, mostly in blue chip stocks of major U.S. corporations and
    U.S. Treasury securities. We also received from Madoff monthly
    statements of our account activity, as well as quarterly and annual
    portfolio management reports.
        The OSG Plan was audited by the U.S. Department of Labor in 2005
    and no concerns were raised. We also had an independent audit conducted
    in 2008, by a reputable accounting firm in CT and again no concerns
    were raised. As recent as October 2008, we sent three of our Partners
    to Madoff's office to discuss the volatile markets and check on our
    investments. One Partner, now 70 years of age, had over 30 years worth
    of retirement contributions and was interested in self managing his
    account since he was preparing to retire. We were assured by Madoff
    that his money was accessible and he could move it to a different type
    of account that he could manage at any time.
        The news in early December 2008, that all the investment activity
    in Madoff was a sham, and that Madoff was in fact the world's largest
    Ponzi scheme, was devastating to us. We have three senior employees
    close to retirement who now do not know when or whether they can stop
    working. This affected OSG's recruitment planning to hire new
    physicians. We had given two new physicians employment offers that we
    are now unsure we can honor because senior doctors with plans to retire
    soon have now decided they need to keep working full time for many more
    years. Our employees are scared, worried and angry. They express loss
    of confidence in the Federal Government and its agencies. Some have
    declined to have payroll deductions made for their Plan contributions
    going forward. Some have expressed concerns that they will have to sell
    their homes when they retire since all their savings have been stolen.
    We have seen disagreements and friction among our employees over this
    matter. We fear we may have a very uncomfortable and unhealthy work
    environment if this takes years to sort out. This is the last thing a
    medical practice needs when treating patients. Our physicians are some
    of the most well trained and highly respected orthopaedists in the
    area, but our community's perception of OSG has changed. Partners have
    told me people ask if we are closing down.
        We have had to hire multiple attorneys for OSG, our Plan, and our
    employees. This month alone we have already incurred legal bills in
    excess of $70,000. I personally spend at least 2 hours of my day
    dealing with this tragedy rather than taking care of patients.
         Then, to add further insult to injury, we learned that the SEC had
    information linking Madoff to a Ponzi scheme as far back as 1992, and
    that starting in 1999 a gentleman named Harry Markopolos regularly
    advised the SEC that Madoff was a giant Ponzi scheme, and in fact
    provided a roadmap to the SEC as to how to unmask Madoff as a fraud.
    But the agency allowed Madoff not only to continue in operation, but to
    continue to take in billions of additional dollars of victim's funds,
    including the funds of the OSG Plan.
        We learned next that it was highly likely that the Securities
    Investor Protection Corporation (``SIPC''), which took over Madoff, may
    take the position that the OSG Plan participants were not individual
    customers of Madoff, and each not entitled to SIPC coverage. Instead,
    it was likely that SIPC was going to treat the plan itself as the only
    customer of Madoff. In other words, the 140 participants in the plan,
    who lost a total of $11,581,000 capital investment, would have to share
    in a maximum $500,000 recovery. This is not right or just. Our pension
    plan functioned as an individual retirement savings plan. Each
    participant received individual statements; each was able to rollover
    moneys from outside accounts to their own account within the Pension
    Plan. Each participant was allowed to, and some did, take out loans
    against their account. The intent was individual accounts and the plan
    operated in that way. Madoff traded on behalf of the Plan as one
    account. One of my Partners spoke with an attorney from SIPC who
    advised him that the initial intent of SIPC was to cover the individual
    investor.
        Senators, the 140 participants in the OSG plan are not wealthy
    hedge fund investors, nor are they beneficiaries of multimillion dollar
    offshore trusts. They are regular working class Americans, most of
    modest means who annually put aside a substantial percentage of their
    wages to try to ensure that they could enjoy a dignified retirement in
    the near or distant future. They were let down by Madoff, the
    regulators, the SEC and FINRA. We hope and request that SIPC, which was
    created to protect small investors from harm, will help us as
    individuals.
         We respectfully request that our legislators ensure that
    participants in pension plans, be it ours or any other who invested
    through Madoff, will be covered by SIPC insurance individually, or that
    they are recompensed in some other manner by the Federal Government in
    light of the SEC's repeated failure to stop Madoff from stealing money.
    We would like to see the government provide quality oversight through
    its agencies so that pension plans do not suffer this type of theft
    loss in the future. This would help to restore the confidence and trust
    of Americans saving for retirement.
        We would like the IRS to clarify or expand what can be considered a
    ``theft loss'' in this situation and/or waive the maximum contribution
    restrictions for individuals or employers affected by Madoff so they
    can rebuild their pension plans on an accelerated schedule.
        On behalf of OSG, we, as citizens of the United States of America,
    appreciate your time and work on our behalf. What we need now, more
    than anything, is quick resolution to this issue so we can get back to
    our own professions and jobs taking care of the health of our fellow
    Americans. Thank you.
                                     ______

                     PREPARED STATEMENT OF LORI A. RICHARDS
          Director, Office of Compliance Inspections and Examinations,
                       Securities and Exchange Commission
                                January 27, 2009

        Chairman Dodd, Ranking Member Shelby, and Members of the Committee,
    I appreciate the opportunity to appear before the Committee today on
    behalf of the Securities and Exchange Commission (``Commission'' or
    ``SEC'') to discuss the examination program and functions of the
    Commission. As evidenced by the Commission's recent enforcement action,
    and by the testimony of my colleague Linda Thomsen, the director of the
    Commission's Enforcement Division who is here with me today, the
    Commission is extremely concerned about the alleged fraudulent activity
    by Mr. Madoff.
        In my testimony today, I will discuss the Commission's examination
    program, including how firms and risk issues are selected for
    examination, and the steps taken during examinations. I will summarize
    very generally the examinations that were conducted of the Madoff
    broker-dealer operations, and the steps that we are taking to respond
    to the risk of this type of fraud. This is an ongoing matter, under
    investigation by both the SEC's Enforcement Division, and with respect
    to past regulatory activities, by the SEC's Office of Inspector
    General. I am not authorized to provide specific information about past
    regulatory oversight of this firm, and I am not participating in the
    current investigation or examinations of the firm. My views are my own
    and they do not necessarily represent the views of the Commission or
    other members of the staff.
        I begin by noting that I have served as a member of the
    Commission's staff for more than 20 years. The agency's staff are
    dedicated, hardworking, and keenly committed to the agency's mission to
    protect investors. Speaking as an examiner, we are focused hard on
    fraud, and we are committed to finding fraud. We examine many different
    firms--these include many that are run honestly and in compliance with
    the law, and they also include those that are engaged in deception,
    dishonesty, falsification of records and fraud of various kinds.
    Examinations have identified many different types of frauds, including
    carefully hidden Ponzi schemes. Examinations of the Madoff broker-
    dealer firm did not find the alleged fraud committed by Mr. Madoff, and
    the Commission's staff did not examine his advisory operations, which
    first became registered with the Commission in late 2006. I will
    describe the expansive steps that we are taking to identify possible
    improvements, both to regulation and to oversight, which might make
    fraud less likely to occur in the future and more likely to be
    detected. We are very much looking forward to working with new Chairman
    Schapiro and the Commission in this effort.
    I. The Commission's Examination Program
        The examination program of the SEC plays a valuable role in
    protecting investors: (See, Compliance, Office of Compliance
    Inspections and Examinations, http://www.sec.gov.)

            The purpose of examinations is to detect fraud and other
            violations of the securities laws, foster compliance with those
            laws, and help ensure that the Commission is continually made
            aware of developments and areas of potential risk in the
            securities industry. The examination program plays a critical
            role in encouraging compliance within the securities industry,
            which in turn also helps to protect investors and the
            securities markets generally.

        The Commission has 425 staff dedicated to examinations of
    registered investment advisers and mutual funds, and approximately 315
    staff dedicated to examinations of registered broker-dealers. Examiners
    are located in Washington, DC, and in the Commission's eleven regional
    offices in New York, Boston, Philadelphia, Atlanta, Miami, Chicago,
    Denver, Salt Lake City, Fort Worth, San Francisco, and Los Angeles. The
    Commission has large and diverse examination responsibilities. The
    registered population consists of approximately: 11,300 investment
    advisers--a population that has grown rapidly in recent years, as
    further described in this testimony; 950 fund complexes (representing
    over 4,600 registered funds); 5,500 broker-dealers (including 174,000
    branch offices and 676,000 registered representatives); and 600
    transfer agents. \1\ Institutions subject to examination include
    enterprises with multiple business units, tens of thousands of
    employees, registered and unregistered lines of business, and complex
    strategies and operational systems, as well as small one-person firms
    operating locally.
    ---------------------------------------------------------------------------
         \1\ There are also eleven exchanges, five clearing agencies, ten
    nationally recognized statistical rating organizations, SROs such as
    the Financial Industry Regulatory Authority (``FINRA'') and the
    Municipal Securities Rulemaking Board, and the Public Company
    Accounting Oversight Board (``PCAOB''), which are examined by
    Commission staff.
    ---------------------------------------------------------------------------
        Broker-dealers are subject to primary oversight by a self-
    regulatory organization (``SRO'') that conducts periodic routine
    examinations of its broker-dealer members. Investment advisers, mutual
    funds and other types of registrants are not subject to examination
    oversight by an SRO.
        The number of registered advisers has increased dramatically in
    recent years. From 1998 through 2002, the SEC staff examined every
    registered adviser using a periodic exam frequency of once every 5
    years at the most, and sought to examine newly registered advisers
    early in their operations. The staff was able to do this because the
    population of registered advisers was much smaller than it is today.
    Then, after 2002, the number of registered advisers increased by 50
    percent (in 2002, there were 7,547 advisers, and there are nearly
    11,300 today). A large number of the new registrants have been advisers
    to hedge funds. The growth in adviser registrants outstripped the
    staff's ability to examine every firm on a regular basis. As noted
    above, 425 staff people conduct examination oversight of investment
    advisers and mutual funds. \2\
    ---------------------------------------------------------------------------
         \2\ The number of staff available to conduct adviser and fund
    examinations has varied over the years. The staff numbers listed below
    include examiners, accountants, supervisors and support staff, as well
    as staff dedicated to the adviser filing program. 1997--318; 1998--320;
    1999--353; 2000--362; 2001--365; 2002--379; 2003--399; 2004--477;
    2005--489; 2006--475; 2007--425; 2008--425; 2009--425.
    ---------------------------------------------------------------------------
        Given the number of firms registered with the SEC, the Commission
    examines only a small portion of the securities business each year.
    Last year, for example, the Commission's staff conducted: 1,521
    investment adviser examinations (approximately 14 percent of the
    registered community); 219 fund complex examinations (approximately 23
    percent); and 135 transfer agent examinations (approximately 22
    percent). \3\ These examinations included: routine examinations of
    certain investment advisers, examinations ``for cause'' based on an
    indication of a compliance problem, and ``sweep'' examinations focused
    on a particular risk area. \4\ The staff also conducted 720 cause,
    oversight and sweep examinations of broker dealer firms. (Together with
    the routine and other examinations conducted by FINRA, approximately 57
    percent of broker-dealers were examined.)
    ---------------------------------------------------------------------------
         \3\ The staff also conducted inspections of selected exchanges,
    clearing agencies, nationally recognized statistical rating
    organizations, self-regulatory organizations, and the PCAOB.
         \4\ The Commission's examination program is conducting a small
    pilot program of deploying monitoring teams to remain in regular
    contact with a small number of the largest adviser complexes. This
    pilot is loosely modeled on the Federal Reserve's program of regular
    oversight for Large Complex Banking Organizations.
    ---------------------------------------------------------------------------
        Because only a small portion of registered firms can be examined
    each year, the process of selecting firms for examination and the area
    of the firm's activity for review is of crucial importance. Given the
    number of firms subject to examination oversight and the breadth of
    their operations, examinations are not audits and are not comprehensive
    in scope.
        Under the Commission's direction and guidance, OCIE has developed a
    risk-based program for selecting firms and activities for examination.
    This methodology has three components: 1) a risk-based methodology for
    selecting investment advisers for priority examination; 2) a
    methodology for identifying higher risk activities at registered
    securities firms; 3) cause examinations to target firms where specific
    indications of wrongdoing have been identified, and sweep examinations
    that focus on examining a particular risk across firms. The details of
    these methodologies are for internal use, though we have described them
    generally publicly, and they are summarized below.
    A. The Risk-Based Methodology for Selecting Investment Advisers for
            Priority Examination
        Given the growth in the number of registered firms, and the need
    for the Commission to use its resources most effectively, in 2003 the
    examination program transitioned to a risk-based approach. The risk-
    based approach is intended to prioritize registrants for examination,
    and to assign examination staff to those advisers and funds that appear
    to present the greatest potential for having an adverse impact on
    investors. This process does not suggest that registrants given lower
    priority do not present risk. Rather, it is a form of triage, to help
    match available staff resources to the most pressing risks. It seeks to
    identify advisers who should be given first priority in the allocation
    of staff resources. Higher risk advisers are those that should be
    allocated priority in terms of staff resources, and medium and lower
    risk advisers are given lower priority in the allocation of staff
    resources. The Commission's Strategic Plan summarizes the risk-based
    approach to examinations. The plan states:

            Risk-Based Inspection Cycles: The SEC will fully implement a
            risk-based methodology for selecting and setting examination
            and inspection cycles for investment advisers and funds. Larger
            or higher risk entities will be examined more frequently to
            ensure that the agency quickly identifies problems before they
            affect large pools of savings. \5\
    ---------------------------------------------------------------------------
         \5\ See SEC, 2004-2009 Strategic Plan, at 32.

        To assess relative risks and thereby prioritize advisory firms for
    examination, all investment advisers' filings with the Commission (on
    Form ADV), as well as results of any past examinations, are analyzed
    each year by surveillance staff in OCIE. \6\ Characteristics that may
    indicate heightened risk include: an adviser receiving performance-
    based fees; an adviser selling products or services other than
    investment advice to its advisory clients; an adviser engaging in
    principal transactions or cross transactions; an adviser compensating
    any person for client referrals; an adviser with custody of advisory
    clients cash and/or securities; and an adviser with a disciplinary
    history. \7\
    ---------------------------------------------------------------------------
         \6\ Many of an adviser's more detailed disclosures about the
    nature of its business and its conflicts of interest are set out in
    Form ADV Part 2. Currently, Part 2 is not filed with the SEC.
         \7\ An outside firm evaluated this risk assessment methodology in
    2008 and concluded that it appeared to have demonstrable value in
    identifying higher risk advisers.
    ---------------------------------------------------------------------------
        Based on this risk scoring process, advisers with risk scores in
    the top 10 percent are designated ``higher risk'' and placed on a 3-
    year examination cycle. That is, they will be scheduled for examination
    at least once in the following 3-year period.
    B. Identifying Risk Issues for Examination
        As noted, examiners also identify particular issues for focus
    during examinations. A key new tool that examiners use to identify such
    risks with respect to advisers, funds, broker-dealers and other types
    of firms, is a program known as the ``Risk Assessment Data base for
    Analysis and Reporting'' (or ``RADAR''). RADAR is a software tool that
    allows examiners to identify the risks they have observed in
    examinations, assess the risk's probability of occurrence and potential
    impact, and recommend possible responsive actions. RADAR allows the
    staff to see and to prioritize compliance risks for examination
    attention, investor education efforts, or other regulatory attention.
    Every examiner participates in the RADAR process.
        The use of RADAR has helped identify a large number of risks. Risk
    personnel in OCIE, working with the SEC's Office of Risk Assessment,
    then sort and analyze these risks to prioritize them. This process does
    not suggest that activities given lower priority do not present risk.
    Rather, again, it is a form of triage, to help match available staff
    resources to the most pressing risks.
        At the conclusion of the RADAR process, focus areas are identified
    internally to the Commission and other Commission staff as part of the
    examination program's annual goals. These and other focus areas are
    examined in special ``sweep'' examinations of a number of firms at
    once, or in routine examinations. The risk of theft and
    misappropriation of investor money and falsification of performance
    results is, of course, a focus area during examinations. In addition,
    among recent focus areas, were, for example:

        Valuation of illiquid or difficult to price securities;

        Manipulative rumors;

        Sales of securities to seniors;

        Controls over non-public information and to prevent insider
            trading;

        Adequacy of advisers and funds' compliance programs,
            supervision and governance;

        Undisclosed payments for business;

        Supervision and compliance over branch offices;

        Suitability of sales of complex structured products to
            retail investors;

        Advisers' performance claims;

        Sales practices in sales of variable annuity products and
            variable life insurance;

        Pricing, mark-ups, disclosure, suitability, and
            underwriting of fixed-income securities;

        Auction rate securities;

        Compliance with the net capital rule;

        Best execution, and execution quality of algorithmic and
            automated trading systems;

        Compliance with short sale rules;

        Broker-dealers' sales of microcap securities;

        Controls for information security and the prevention of
            identity theft;

        Anti-money laundering programs; and

        Business continuity planning.

    C. Cause and Sweep Examinations
        A cause examination is conducted when the staff receives specific
    indications of possible wrongdoing. The information can be obtained
    from any source, e.g.: a tip; another examination; an investor
    complaint; another office in the SEC; another regulator; or the press.
    Cause examinations play an important role--for advisers, funds, and
    broker-dealers, they generally take up between 20 percent and 25
    percent of staff resources in any given year. They give the staff the
    ability to respond very quickly to fast-breaking problems, once an
    indication of the possible problem becomes known.
        Sweep examinations are conducted to focus on a particular risk
    issue across a number of firms at once. They allow the staff to single
    out and analyze the severity of a risk and to identify compliance
    controls that are effective and ineffective, across a number of firms.
    General findings from sweep examinations and other types of
    examinations are used to assess emerging compliance risks, and are
    often made public in the staff's ComplianceAlerts, in order assist
    firms in preventative compliance efforts.
    II. The Madoff Investment Adviser Was Not Examined
        The SEC staff did not examine the Madoff investment adviser. The
    firm registered as an investment adviser in September 2006. As noted
    above, about 10 percent of registered investment advisers are examined
    routinely, every 3 years. \8\
    ---------------------------------------------------------------------------
         \8\ Advisers are required to update Form ADV information annually
    and as material information becomes inaccurate. A limitation on the
    risk assessment process is that it is based in part on information
    self-reported from Form ADV.
    ---------------------------------------------------------------------------
    III. Examinations of the Madoff Broker-Dealer
        The Madoff broker-dealer operation was subject to routine
    examination oversight by the firm's SRO, and was also subject to
    several limited-scope examinations by the SEC staff for compliance
    with, among other things, trading rules that require the best execution
    of customer orders, display of limit orders, and possible front-
    running, most recently in 2004 and 2005. These examinations were
    focused on the firm's broker-dealer activities. (As noted above, the
    firm's advisory business became registered in 2006 and was not
    examined.) For the reasons I noted, I must not discuss these
    examinations in any greater detail.
    IV. New Steps
        The Commission's staff is working hard to identify new steps,
    including both changes and improvements to regulation and oversight,
    which might make fraud less likely to occur. Among the issues that
    we're studying and I expect that we will study under the new Chair of
    the Commission, are the examination frequencies for investment
    advisers, the existence of unregistered advisers and funds, the
    different regulatory structures surrounding brokers and advisers, the
    existence of unregulated products, and strengthening the custody and
    audit requirements for regulated firms.
        We're also looking at ways to improve the assessment of risk--and
    at the adequacy of information required to be filed by registered firms
    and used to assess risks, and whether the risk assessment process would
    be improved with routine access to information such as, for example,
    the identity of an adviser's auditor, its custodian and administrator,
    performance returns, as well as other information. We're targeting
    firms for examinations of their custody of assets, and expanding our
    efforts to examine advisers and brokers in a coordinated approach to
    reduce the opportunities for firms to shift activities to areas where
    they are not subject to regulatory oversight.
        In a range of ways, we're thinking expansively and creatively about
    changes that could reduce opportunities for fraud, and we very much
    look forward to working with the Commission and Chairman Schapiro in
    this critical effort.
                                     ______

                     PREPARED STATEMENT OF LINDA C. THOMSEN
                       Director, Division of Enforcement,
                       Securities and Exchange Commission
                                January 27, 2009

        Good morning Chairman Dodd, Ranking Member Shelby, and Members of
    the Committee. I appreciate the opportunity to appear here today to
    discuss matters relating to the Ponzi scheme allegedly perpetrated by
    Bernard L. Madoff and related enforcement concerns. I am Linda Thomsen
    and for nearly 14 years it has been my privilege to serve on the staff
    of the Securities and Exchange Commission.
        Before I go any further I want to thank the Committee for
    understanding that because of our collective desire to preserve the
    integrity of the investigative and prosecution processes there are
    matters that I cannot discuss today. \1\ None of us wants to do
    anything that would jeopardize the process of holding the perpetrators
    accountable. That being said, I will try to address some of the
    overarching issues related to the Madoff situation. In that regard, my
    views are my own, and while they are informed by my years on the staff
    of the Commission, they do not necessarily reflect the views of the
    Commission or any other member of the staff.
    ---------------------------------------------------------------------------
         \1\ As set forth below in this testimony, the SEC filed a civil
    enforcement action alleging securities fraud against Bernard L. Madoff
    and Bernard L. Madoff Investment Securities LLC on December 11, 2008,
    and the United States Attorney's Office filed a parallel criminal
    action the same day. These actions are presently being litigated before
    the United States District Court for the Southern District of New York.
    Aside from the allegations of the publicly filed complaints, I cannot
    comment on the pending civil and criminal litigation or the underlying
    investigations in order to avoid jeopardizing the ongoing legal and
    investigative processes. In addition, I cannot comment on any
    historical SEC enforcement investigations of Mr. Madoff, his firm or
    associated persons because the information is non-public and the SEC's
    Office of the Inspector General is actively investigating any such
    prior matters. The SEC's Inspector General recently testified before
    the House of Representatives Financial Services Committee regarding the
    scope of his investigation. See H. David Kotz, Inspector General, U.S.
    Securities and Exchange Commission, Testimony Before the U.S. House of
    Representatives Committee on Financial Services, January 5, 2009,
    available at http://www.sec.gov/news/testimony/2009/ts010509hdk.htm
    ---------------------------------------------------------------------------
    Publicly Disclosed Investigations of Bernard L. Madoff, Bernard L.
            Madoff Investment Securities, LLC, and Associated Persons
        On December 11, 2008, the SEC sued Bernard L. Madoff and his firm,
    Bernard Madoff Investment Securities, LLC, for securities and
    investment advisory fraud in connection with an alleged Ponzi scheme
    that allegedly resulted in substantial losses to investors in the
    United States and other countries. The alleged scheme is outlined in
    the Commission's complaint filed in the United States District Court
    for the Southern District of New York, captioned United States
    Securities and Exchange Commission v. Bernard L. Madoff and Bernard L.
    Madoff Investment Securities LLC, 08 Civ. 10791 (LLS) (S.D.N.Y. Dec.
    11, 2008). The SEC's Enforcement Division is coordinating its ongoing
    investigation with that of the United States Attorney's Office for the
    Southern District of New York, which filed a parallel criminal action
    on December 11, 2008, in connection with of Mr. Madoff's alleged Ponzi
    scheme.
        With respect to past SEC enforcement investigations related to Mr.
    Madoff or his firm, two enforcement actions were filed by the SEC's New
    York Regional Office in 1992 alleging violations of the securities
    registration provisions in connection with offerings in which the
    investors' funds were invested in discretionary brokerage accounts with
    an unidentified broker-dealer, who in turn invested the money in the
    securities market. The unidentified broker-dealer in these cases was
    Bernard L. Madoff. The first matter was entitled SEC v. Avellino &
    Bienes, et al. \2\ In that case, two individuals, Frank Avellino and
    Michael Bienes, raised $441 million from 3200 investors through
    unregistered securities offerings. They formed an entity, Avellino &
    Bienes (``A&B''), which offered investors notes paying interest rates
    of between 13.5 and 20 percent. A&B collected the investors' monies in
    a pool or fund that was invested in discretionary brokerage accounts
    with Mr. Madoff's broker-dealer firm, and Mr. Madoff in turn invested
    the monies in the market. A&B received returns on the invested funds
    from Mr. Madoff, but kept the difference between the returns received
    from Mr. Madoff and the lesser amounts of interest paid on the A&B
    notes.
    ---------------------------------------------------------------------------
         \2\ SEC v. Avellino & Bienes, et al., Lit. Rel. No. 13443 (Nov.
    27, 1992).
    ---------------------------------------------------------------------------
        The second matter, SEC v. Telfran Associates Ltd., et al., was a
    spinoff from A&B and involved the creation of a feeder fund to A&B. \3\
    In Telfran, two individuals who had invested in A&B, Steven Mendelow
    and Edward Glantz, formed an entity called Telfran Associates. Telfran
    raised approximately $88 million from 800 investors through
    unregistered securities offerings over a period of 3 years. Telfran
    sold investors notes paying 15 percent interest, which they in turn
    invested in notes sold by A&B that paid between 15 and 19 percent
    interest. Since investor funds collected by A&B were invested with Mr.
    Madoff, the Telfran investor funds were also invested with Mr. Madoff,
    albeit indirectly.
    ---------------------------------------------------------------------------
         \3\ SEC v. Telfran Associates Ltd., et al., Lit. Rel. No. 13463
    (Dec. 9, 1992).
    ---------------------------------------------------------------------------
        Although the SEC was initially concerned that these unregistered
    offerings might be part of a huge fraud on the investors, the trustee
    appointed by the court in Avellino & Bienes found that the investor
    funds were all there. The returns on funds invested with Mr. Madoff
    appeared to be exceeding the returns the promoters had promised to pay
    their investors, so there were no apparent investor losses. \4\ In both
    cases, the SEC sued the entities offering the securities and their
    principals for violations of the securities registration provisions of
    the Federal securities laws. The SEC also sought the appointment of a
    trustee to redeem all outstanding notes and the appointment of an
    accounting firm to audit the firms' financial statements.
    ---------------------------------------------------------------------------
         \4\ Randall Smith, Wall Street Mystery Features A Big Board Rival,
    Wall St. J, Dec. 16, 1992, at C1.
    ---------------------------------------------------------------------------
        Both cases were settled by the promoters' consent to reimburse each
    investor the full amount of their investment and to submit to an audit
    by an accounting firm, and their further consent to be permanently
    enjoined from further unregistered offerings in violation of the
    Federal securities laws. In addition, each of the companies making the
    unregistered offerings agreed to pay a penalty of $250,000, and each of
    the principals in those companies agreed to pay a civil penalty of
    $50,000. \5\ By executing the SEC's consent orders, Avellino & Bienes,
    Telfran and their respective principals agreed to cease offering
    unregistered investment opportunities to the public. Because the court-
    appointed trustees in Avellino & Bienes concluded the investor funds
    were all there and all investor funds in both cases were ultimately
    reimbursed to the investors, the SEC did not pursue fraud charges in
    those cases. Neither Mr. Madoff nor his firm was named as a defendant
    in either case.
    ---------------------------------------------------------------------------
         \5\ SEC v. Avellino & Bienes, et al., Lit. Rel. No. 13880 (Nov.
    22, 1993); SEC v. Telfran Associates Ltd., et al., Lit. Rel. No. 13881
    (Nov. 22, 1993).
    ---------------------------------------------------------------------------
        As widely reported in the press, the SEC's New York Regional Office
    commenced another investigation of Mr. Madoff in early 2006. Two years
    later, in January 2008, that investigation was closed without any
    recommendation of enforcement action.
    Securities Regulators, Criminal Authorities, and Other Parties Who May
            Investigate the Alleged Ponzi Scheme and Related Matters
        Many securities regulators, criminal authorities, and private
    parties have the authority to investigate, or conduct civil discovery
    from, Mr. Madoff, his firm, and others who might potentially be held
    civilly or criminally liable in connection with the alleged Ponzi
    scheme. Together, these regulators, criminal authorities and other
    parties have an extremely broad range of possible remedies and
    sanctions.
        On December 11, 2008, the SEC filed a civil action alleging
    securities fraud against Mr. Madoff and his firm Bernard L. Madoff
    Investment Securities LLC in the United States District Court for the
    Southern District of New York. The Commission's complaint alleges that
    Mr. Madoff admitted to two senior employees of his firm that for many
    years he had been conducting the investment advisory business of his
    firm as a giant Ponzi scheme--using funds received from new investors
    to pay returns to previous investors--and estimated that the scheme has
    resulted in losses of approximately $50 billion. The complaint further
    alleges that Madoff also informed these senior employees of his firm
    that he had approximately $200-300 million left, which he planned to
    use to make payments to selected employees, family and friends before
    turning himself in to the authorities. \6\ The SEC immediately sought,
    and obtained, a preliminary injunction and other emergency relief to
    prevent the dissipation of any remaining assets. \7\ Among the other
    remedies available to the SEC in civil enforcement actions are
    disgorgement of ill-gotten gains, permanent injunctive relief against
    violations of the Federal securities laws, remedial undertakings, civil
    penalties, revocation of registration and investment advisor or
    industry bars, which may be either time-limited or permanent.
    ---------------------------------------------------------------------------
         \6\ SEC v. Bernard L. Madoff, et al., 08 Civ. 10791 (S.D.N.Y. Dec.
    11, 2008), Complaint at 2, 4-6.
         \7\ SEC v. Bernard L. Madoff, et al., 08 Civ. 10791, Order on
    Consent Imposing Preliminary Injunction, Freezing Assets and Granting
    Other Relief Against Defendants (Dec. 18, 2008).
    ---------------------------------------------------------------------------
        Also on December 11, 2008, the United States Attorney's Office for
    the Southern District of New York filed a criminal action against Mr.
    Madoff in connection with the alleged Ponzi scheme. Criminal
    authorities generally have authority to seek incarceration of criminal
    defendants, as well as to obtain criminal restitution and fines.
    Criminal authorities may also have the power to seek the imposition of
    conditions on an individual's liberty, such as probation, denial of
    voting rights, mandatory curfew and house arrest.
        All told, the two actions filed by the SEC and United States
    Attorney's Office alone (depending, of course, on findings of liability
    and guilt), expose Mr. Madoff to billions of dollars in liability and
    decades of incarceration. Both the SEC and the United States Attorney's
    Office are continuing our investigations and fact-finding. As is our
    practice, we and the Federal criminal prosecutors are coordinating our
    efforts as allowed by law.
        There are numerous other parties and entities that may be able to
    pursue Mr. Madoff, his firm and related entities or individuals. For
    example, the Financial Industry Regulatory Authority, or FINRA, may
    pursue disciplinary action against Mr. Madoff's in connection with any
    activities undertaken in its capacity as a registered broker-dealer.
    Like the SEC, FINRA can order disgorgement, impose civil fines and bar
    or impose conditions on the employment of an individual by any broker-
    dealer firm, again either permanently or for a specified time.
        The 50 States, as well as their respective securities regulators
    and criminal authorities, may also investigate and bring civil or
    criminal actions against Mr. Madoff, his firm and related entities or
    individuals under applicable state laws. Several states have reportedly
    commenced such investigations against Mr. Madoff or Madoff-related
    entities. State attorneys general, securities regulators and criminal
    authorities are authorized to seek many of the same sanctions as their
    Federal counterparts, though the available remedies and sanctions may
    vary to some extent under differing state laws. Further, any period of
    incarceration would be served in a state, rather than Federal, prison
    or other detention facility.
        The investors who reportedly incurred losses as a result of Mr.
    Madoff's alleged Ponzi scheme include a large number of foreign
    nationals, banks and corporations. To the extent foreign citizens,
    corporations and instrumentalities have suffered losses as a result of
    Mr. Madoff's alleged misconduct, foreign governments, their respective
    securities regulators and criminal authorities may also have power to
    investigate and bring actions under foreign law. For example, the
    United Kingdom's Serious Fraud Officehas reportedly commenced an
    investigation of Mr. Madoff, particularly the activities conducted
    through his London office.
        Private citizens and corporate entities may have standing to pursue
    civil actions against Madoff and associated entities or persons, either
    in the United States or in their home countries. Private civil actions
    are primarily brought to seek compensatory and possibly punitive
    damages. While many private actions have already been filed against Mr.
    Madoff and various others, the efficacy of these actions will depend in
    part on the existence and the amount of assets from which a judgment
    might be satisfied.
        Finally, in the SEC's action against Madoff, the United States
    District Court for the Southern District of New York granted the
    application of the Securities Investor Protection Corporation (SIPC)
    for the liquidation of Bernard L. Madoff Investment Securities LLC and
    appointed a trustee. The SIPC trustee will marshal the assets and
    process the claims of customers and creditors of Madoff's firm in an
    equitable manner. \8\
    ---------------------------------------------------------------------------
         \8\ Id.; see also Information for Madoff Customers, available at
    http://www.sec.gov/divisions/enforce/claims/madoffsipc.htm
    ---------------------------------------------------------------------------
    Enforcement Division Complaints, Tips, and Referrals
        The Enforcement Division receives hundreds of thousands of tips
    each year from various sources. Some are from credible sources who
    provide detailed information in support of the tip, and some consist of
    nothing more than newspaper clippings or printed promotional material
    sent with no further explanation. Some come from industry competitors,
    some from disgruntled present or former employees, some from present or
    former investors, and others are totally anonymous. On the one hand,
    complaints, tips, and referrals from the public often provide valuable
    information about potential securities violations; on the other hand,
    sources at times may be attempting to enlist the SEC's authority and
    resources in efforts to advance their own private interests, which may
    or may not be consistent with our enforcement mission.
        Complaints, tips, and referrals come to the Enforcement Division in
    every imaginable form. 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, 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.
        There are a number of major channels through which complaints, tips
    and referrals flow in to the Enforcement Division. First, there are
    calls and letters that are processed and screened by the Office of
    Investor Education as complaints, tips and referrals or ``CTRs.'' The
    most promising of these are forwarded to attorney staff in the
    Enforcement Division. Second, on the SEC's Web site, there is an
    Electronic Complaint Center that allows members of the public to record
    complaints and tips on simple online forms. The online complaints are
    reviewed and triaged by the professional staff of the Enforcement
    Division's Internet Enforcement Group, which refers them to staff for
    further investigation based on subject matter or geography.
        Yet another group of staff within the Division reviews and
    evaluates hundreds of ``Suspicious Activity Reports'' or ``SARS'' that
    are filed with Federal banking regulators by banks and financial
    institutions nationwide. SARS that potentially involve securities are
    forwarded to the SEC. After screening by experienced staff, promising
    referrals based on SARS are sent to enforcement staff throughout the
    country.
         FINRA and stock exchanges (referred to as ``Self-Regulatory
    Organizations'' or ``SROs'') are another source of referrals. The SROs
    provide continual and cutting-edge computerized surveillance of trading
    activities in their respective markets. They regularly report
    suspicious activities and trading anomalies to the Enforcement
    Division's Office of Market Surveillance through a variety of periodic
    reports. They also provide referrals regarding particular suspicious
    trades that may show possible insider trading ahead of a publicly
    announced transaction, such as a merger or acquisition. The SEC's
    Office of Market Surveillance automatically opens a preliminary
    investigation of each such referral and then forwards it to appropriate
    staff, generally based on geographic location of the issuer or
    suspected traders. The staff then becomes responsible for further
    inquiries that will either lead to the opening of a full investigation
    or the closure of the preliminary investigation.
        The Enforcement Division also receives referrals of potential
    securities law violations from other Offices and Divisions within the
    Commission. These referrals are either taken up directly by the
    Regional Office where the complaint was discovered or arose, or are
    directed to staff having appropriate expertise regarding the particular
    type of complaint. For example, referrals involving accounting issues
    are directed to the Office of the Chief Accountant in the Enforcement
    Division for further evaluation and referral to staff as appropriate.
    Similarly, referrals from throughout the Commission regarding over-the-
    counter stocks, potential microcap fraud and securities spam are
    directed to the Trading and Markets Enforcement Group, which has
    extensive experience in this market segment, for further evaluation and
    possible referral to staff.
        It is important to note that many complaints, tips and referrals
    are made directly to staff in the Office nearest the complainant and
    are investigated or addressed by that office. Among the options
    available to staff receiving a tip or lead are further investigation of
    the lead, declining to pursue the lead for lack of apparent merit,
    transfer of a potentially viable lead to an office with a closer
    geographical connection to the alleged misconduct, or referral of the
    lead to subject matter experts for further evaluation and possible
    assignment to staff.
        The primary consideration in determining whether to pursue any
    particular tip depends on whether, based on judgment and experience,
    the tip provides sufficient information to suggest that it might lead
    to an enforcement action involving a violation of the Federal
    securities law. This determination requires the exercise of judgment
    regarding, among other things: the source of the tip; the nature,
    accuracy and plausibility of the information provided; an assessment of
    how closely the information relates to a possible violation of Federal
    securities law; the validity and strength of the legal theory on which
    a potential violation would be based; the nature and type of evidence
    that would have to be gathered in the course of further investigation;
    the amount of resources the investigation might consume; and whether
    there are any obvious impediments that would prevent the information
    from leading to an enforcement action (for example, the conduct
    complained of is not securities-related).
        When we determine that we have a promising tip, we investigate. We
    follow the evidence where it leads and will pursue and develop evidence
    regarding the liability of a full array of persons and entities--from
    the central players to the peripheral actors--and we do so without fear
    or favor. In commencing an investigation, we usually do not know
    whether or not the law has been broken and, if so, by whom. We have to
    investigate, and our investigation may or may not lead to the filing of
    an enforcement action. We are resource constrained. The approximately
    3,500 employees of the SEC (of whom approximately 1,000 are in the
    Enforcement Division) are charged with regulating and policing an
    industry that, as described in Ms. Richards' testimony, includes over
    11,300 investment advisers, 4,600 registered mutual funds, over 5,500
    broker-dealers (with approximately 174,000 branch offices and 676,000
    registered representatives), as well as approximately 12,000 public
    companies. Every day we are compelled to make difficult judgments about
    which matters to pursue, which matters to stop pursuing, and which
    matters to forego pursuing at all. Every investigation we pursue, or
    continue to pursue, entails opportunity costs with respect to our
    limited resources. A decision to pursue one matter means that we may be
    unable to pursue another. No single case or investigation can ever be
    considered in a vacuum, but rather must be viewed as one of thousands
    of investigations and cases we are or could be pursuing at any given
    time.
        In pursuing our work, the staff of the Enforcement Division is
    devoted to public service and our mission of investor protection. 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 actions. The filing of an
    enforcement action is one of the few solid benchmarks of success in the
    pursuit our mission.
        One need only look at the 8 days surrounding the bringing of the
    Madoff case to see ample evidence of our commitment. During the Monday
    to Monday period between December 8 and December 15, 2008, the
    Commission also:

        Sued Mark Dreier, an attorney selling bogus notes; \9\
    ---------------------------------------------------------------------------
         \9\ SEC v. Marc S. Dreier, Lit. Rel. No. 20823 (Dec. 8, 2008).

        Brought an action against Fidelity traders for taking
            illegal gifts and gratuities; \10\
    ---------------------------------------------------------------------------
         \10\ Former Fidelity Employees to Pay More Than $1 Million to
    Settle SEC Charges for Improperly Accepting Lavish Gifts Paid For By
    Brokers, SEC Press Rel. No. 2008-291 (Dec. 11, 2008).

        Finalized some of the landmark auction rate securities
            cases, which provided billions of dollars of liquidity to
            thousands of investors within just months after that market
            froze; \11\
    ---------------------------------------------------------------------------
         \11\ SEC v. Citigroup Global Markets, Inc., et al., Lit. Rel. No.
    20824 (Dec. 11, 2008).

        Sued a Russian broker-dealer for operating in our markets
            in violation of our rules; \12\
    ---------------------------------------------------------------------------
         \12\ In the Matter of CentreInvest, Inc., OOO CentreInvest
    Securities, Vladimir Chekholko, William Herlyn, Dan Rapoport, and
    Svyatoslav Yenin, Exch. Act. Rel. No. 59067 (Dec. 8, 2008).

        Settled a complex financial fraud matter involving
            reinsurance; \13\
    ---------------------------------------------------------------------------
         \13\ SEC v. Zurich Financial Services, Lit. Rel. No. 20825 (Dec.
    11, 2008).

        Filed, in coordination with criminal authorities, an action
            to halt a wide-ranging market manipulation scheme; \14\ and
    ---------------------------------------------------------------------------
         \14\ SEC v. National Lampoon et al., Lit. Rel. No. 20828 (Dec. 15,
    2008).

        Filed a $350 million dollar settled action against Siemens
            for bribery of foreign officials in violation of the Foreign
            Corrupt Practices Act, \15\ the largest SEC settlement in the
            Act's 30-year history.
    ---------------------------------------------------------------------------
         \15\ SEC v. Siemens Aktiengesellschaft, Lit. Rel. No. 20829 (Dec.
    15, 2008).

        Everyone at the SEC wishes the alleged Madoff fraud had been
    discovered sooner. We are committed to finding way to make fraud less
    likely and fraud detection more likely. But we need to acknowledge a
    hard truth our forefathers recognized--if men were angels we wouldn't
    need government. We wouldn't need laws either. The reality is that
    people do break the law and when they do so, there is harm, sometimes
    great harm.
        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. On the enforcement front, we are looking for
    ways to help identify from among the various streams of information we
    receive and those that our staff independently develops, the systemic
    risks and emerging trends we should investigate. We have pursued risk-
    based investigations where we identify a potential trouble spot and
    then develop investigative plans to test whether the problem exists at
    a given company and the markers for the problem that might enable us to
    identify it more quickly in other firms.
        Just last week, we brought a case against General Motors involving
    pension accounting and related disclosures that was the result of that
    process. \16\ For the last several years, the SEC has been concerned
    about the adequacy of the assumptions underlying public issuers'
    pension accounting and related reserves, as well as related disclosure
    issues. In an analogous context, the Enforcement Division had already
    confronted substantial disclosure problems related to pension
    obligations in our enforcement action against the city of San Diego. In
    that case, the SEC brought an enforcement action against the city of
    San Diego for issuing bonds without adequately disclosing the city's
    overwhelming future pension obligations to city employees. \17\ We were
    concerned that the kind of pension-related disclosure and accounting
    issues we encountered in the San Diego case might be an even bigger
    problem in the context of corporations that are public issuers--which
    may have many more employees and much more complex pension obligations.
    Accordingly, the Enforcement Division decided to review pension
    accounting assumptions and related disclosures at a number of large
    public issuers, and the GM case announced last week was the result of
    that review. Our risk-based initiatives are resource-intensive and
    time-consuming, but they have produced results--both in terms of filed
    enforcement actions and the related deterrent effects in the market.
    ---------------------------------------------------------------------------
         \16\ SEC v. General Motors Corporation, Lit. Rel. No. 20861 (Jan.
    22, 2009).
         \17\ In the Matter of city of San Diego, California, Exch. Act
    Rel. No. 54745 (Nov. 14, 2006).
    ---------------------------------------------------------------------------
        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).
        For example, there are products that appear to be comparable from
    an investor's perspective that are in fact subject to widely varying
    degrees of oversight and regulatory risk (and indeed, these varying
    products are oftentimes sold to an investor by the same person). By the
    same token, in the course of a single conversation with a customer, an
    investment professional may be acting in his capacity as a broker-
    dealer or in his capacity as an investment adviser, with differing
    disclosure and legal obligations at any given moment, but the customer
    is usually unaware of any difference between these roles, and would
    find the distinctions bewildering in any event.
        Consideration should be given to harmonizing the regulatory regimes
    that apply to these 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.
        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.
        As to resources, over the past few years our job has grown
    substantially. Just one example is noted in Lori Richards' testimony.
    In 2002, there were 7,547 registered investment advisers; today, there
    are 11,300--an increase of 50 percent. The amount of resources
    available to the SEC has not kept pace with the rapid expansion in the
    securities market over the past few years--either in terms of the
    number of firms or the explosion in the types of new and increasingly
    complex products, including securities, hedge funds and related trading
    strategies, collateralized debt obligations, credit default swaps and
    financial derivative products, some of which were expressly designed to
    avoid SEC regulation and oversight. Nor have our resources expanded to
    address the ongoing globalization of the international financial
    markets.
        While we always do our utmost to do more with less, if we had more
    resources, we could clearly do more. We could do more investigations,
    file more enforcement actions and achieve more deterrence. More
    resources would also allow us to spend more time to determine whether a
    particular problem may be widespread in certain market segments--those
    risk based investigations I described earlier. Resources could also
    allow us to use more technology in our work. Technology can be quite
    useful in maximizing our effectiveness, but technology is often
    expensive, requires consistent maintenance, and must be periodically
    updated. We also need to be sure that enforcement personnel have access
    to market, trading, analytical, accounting and economic expertise when
    they need it and that they have the training to know when they should
    call upon that expertise. The agency's renewed focus on risk assessment
    will help to address these concerns.
        Finally, we need to focus on investor education and the creation of
    a strong compliance tone and culture in the securities industry. All of
    us need to encourage investors to be their own best advocates and to
    practice basic safe investing principles, such as skepticism and
    diversification. And all of us need to do everything we can to
    encourage a tone and culture, especially among those who make their
    livings from other people's investments, that mere compliance with the
    law, narrowly viewed, is not the highest goal to which we aspire, but
    the base from which we start. We should all work toward a system where
    those who work in it are responsible stewards of the treasures
    entrusted to them.
                                     ______

                   PREPARED STATEMENT OF STEPHEN I. LUPARELLO
                        Interim Chief Executive Officer,
                    Financial Industry Regulatory Authority
                                January 27, 2009

        Chairman Dodd, Ranking Member Shelby, and Members of the Committee,
    I am Steve Luparello and I currently serve as interim CEO of the
    Financial Industry Regulatory Authority, or FINRA. On behalf of FINRA,
    I would like to thank you for the opportunity to testify today.
        Unfortunately, we are all here today because the fraud that Bernard
    Madoff orchestrated has had tragic results for investors large and
    small who entrusted their money to him. Investors are disillusioned and
    angry, and are rightfully asking what happened to the system that was
    meant to protect them. It certainly appears that Madoff knew well the
    seams in that system that separated functional lines of regulation, and
    perhaps that knowledge assisted him in avoiding detection and
    defrauding so many unsuspecting individuals and institutions. By all
    accounts, it appears that Mr. Madoff engaged in deceptive and
    manipulative conduct for an extended period of time during which he
    defrauded the customers who invested with him and misled those who had
    the responsibility to regulate him.
        Even so, Mr. Madoff's alleged fraud highlights how our current
    fragmented regulatory system can allow bad actors to engage in
    misconduct outside the view and reach of some regulators. It is
    undeniable that, in this instance, the system failed to protect
    investors. Investor protection is the core of FINRA's mission, and we
    share your commitment to identifying the regulatory gaps and weaknesses
    that allowed this fraud to go undetected, as well as potential changes
    to the regulatory framework that could prevent it from happening in the
    future.
    FINRA
        FINRA is the largest non-governmental regulator for securities
    brokerage firms doing business in the United States. Congress mandated
    the creation of FINRA's predecessor, NASD, in 1938. Congress limited
    our authority to the enforcement of the Securities Exchange Act of
    1934, the rules of the Municipal Securities Rulemaking Board and FINRA
    rules. Under our fragmented system, broker-dealers are regulated under
    the Securities Exchange Act and investment advisers are regulated under
    the Investment Advisers Act of 1940. FINRA is not authorized to enforce
    compliance with the Investment Advisers Act. Authority to enforce that
    Act is granted solely to the SEC and to the states.
        FINRA registers and educates industry participants, examines
    broker-dealers and writes rules that those broker-dealers must follow;
    enforces those rules and the Federal securities laws; and informs and
    educates the investing public. All told, FINRA oversees approximately
    5,000 brokerage firms, about 172,000 branch offices and almost 665,000
    registered securities representatives.
        FINRA has a robust examination program with dedicated resources,
    including more than 1,000 employees. In administering our exam program,
    FINRA conducts both routine and cause examinations. Routine
    examinations are conducted on a regular schedule that is established
    based on a risk-profile model. This risk-profile model is very
    important: It permits us to focus our resources on the sources of most
    likely harm to average investors, and allows us to conduct our
    examinations more efficiently. We apply our risk-profile model
    according to the risks presented by each firm, and it is tailored
    according to the business that a particular firm conducts. Cause
    examinations are based on information that we receive, including
    investor complaints, referrals generated by our market surveillance
    systems, terminations of brokerage employees for cause, arbitrations
    and referrals from other regulators. FINRA consults with the SEC and
    state regulators about examination priorities and frequently conducts
    special ``sweep'' examinations with respect to issues of particular
    concern. In 2008, FINRA conducted over 2,500 routine examinations and
    nearly 7,000 cause examinations.
        FINRA brings disciplinary actions against broker-dealers and their
    employees that may result in sanctions, including fines, suspensions
    from the business and, in egregious cases, expulsion from the industry.
    FINRA frequently requires broker-dealers to provide restitution to
    harmed investors and often imposes other conditions on a firm's
    business to prevent repeated wrongdoing. In 2008, FINRA instituted
    disciplinary action in 1,060 cases. FINRA collected over $28 million in
    fines, either ordered or secured agreements in principle for
    restitution in excess of $1.8 billion, expelled or suspended 20 firms,
    barred 363 individuals from the industry and suspended 325 others.
    FINRA Oversight of Bernard L. Madoff Investment Securities' Broker-
            Dealer Operations
        Bernard Madoff's broker-dealer was registered with FINRA, and its
    predecessor organization, NASD, since 1960. Per the Committee's
    request, a complete list of the positions once held by Bernard Madoff
    with NASD or its affiliates is attached to this testimony as an
    addendum.
        In its regulatory filings and FINRA examinations, the Madoff
    broker-dealer has consistently held itself out as a wholesale market-
    making firm; that means it was a firm that was in the business of
    executing, as a market maker, order flow that other broker-dealers
    directed to it for execution and otherwise trading securities for the
    risk of its own proprietary accounts. These relationships with other
    broker-dealers are treated under regulatory rules as counter-party
    rather than customer relationships. The Madoff broker-dealer
    consistently reported that 90 percent of its revenue was generated by
    market making and 10 percent by proprietary trading. The broker-dealer
    consistently represented to FINRA that it had no retail or
    institutional customer accounts, a position that would be consistent
    with the business model of a wholesale market-maker.
    Examinations
         During the last 20 years, FINRA (or its predecessor, NASD)
    conducted regular exams of Madoff's broker-dealer operations at least
    every other year. Madoff's broker-dealer was on a 2-year examination
    cycle because it engaged in market making and was self-clearing. Based
    on this business model, our examinations tended to focus on areas such
    as the firm's financial and operational condition, supervisory system,
    supervisory and internal controls, AML compliance, internal
    communications and business continuity plans. In addition, in 1996 we
    began a separate market regulation exam program for broker-dealers, and
    we have conducted that exam of the Madoff broker-dealer on an annual
    basis since 1997. The Trading and Market Making Examination Program
    (TMMS) focuses on trading-related issues and is designed to complement
    FINRA's automated surveillance programs, as well as FINRA's examination
    programs for sales practice and financial and operational rules. TMMS
    exams focus on trade reporting, order handling and supervision.
        FINRA rules require any broker-dealer, including wholesale market
    makers such as Madoff, to comply with best execution and order-
    protection requirements for customer orders routed there by other
    broker-dealers, even though the executing broker-dealer does not have
    the direct customer relationship. The firm was also required to comply
    with recordkeeping and trade reporting requirements. The anti-fraud
    provisions of the Federal securities laws and FINRA rules applied to
    the Madoff broker-dealer's trading with other broker-dealer
    counterparties.
        In the course of FINRA's broker-dealer exams, we found no evidence
    of the fraud that Bernard Madoff carried out through its investment
    advisory business. While there have been some reports that victims of
    the fraud received statements from the Madoff broker-dealer, our
    examinations did not reveal the existence of customer relationships
    that the broker-dealer would have had in providing execution or custody
    of advisory assets, and they did not reveal that the Madoff broker-
    dealer in fact held client assets other than in a small number of
    inactive employee accounts. Also, FINRA did not receive customer
    complaints that might have alerted us to the existence of the alleged
    accounts.
        It is worth noting that in 2006, when the SEC examined Madoff's
    advisory business, the only violation that it apparently found was the
    firm's failure to register. Our subsequent examination of the firm in
    2007 was tailored to its wholesale market making operations, which
    resided in the broker-dealer.
    Disciplinary Actions Related to Madoff
        As discussed previously, the Madoff broker-dealer was subject to
    oversight by FINRA through, among other things, routine and cause
    examinations as well as more trading-focused exams. In addition, their
    trading was subject to oversight by our Market Regulation department.
    As a result, over the past 10 years, the Madoff broker-dealer was
    subject to both formal and informal (non-public) discipline, including:

        Censure and a $7,000 fine in July 2005 for limit-order
            display violations;

        Censure and an $8,500 fine in February 2007 for limit-order
            display and Manning violations;

        Censure and a $25,000 fine in August 2008 for violations
            relating to blue sheets; and

        Fourteen Cautionary Letters for technical trading and/or
            reporting violations.
    Complaints Related to Madoff
        FINRA has received and investigated 19 complaints against the
    Madoff broker-dealer since 1999. The complaints generally related to
    trade execution quality issues; none related to the investment advisory
    issues involved in the allegations against Bernard Madoff.
        FINRA did not receive any whistleblower complaints alleging either
    frontrunning or Ponzi schemes at the Madoff money management business,
    nor did the SEC share the tip it received or alert FINRA to any concern
    that it may have had with the firm.
    Issues Raised by the Madoff Fraud
        Custody and Feeder Funds. FINRA's role as a regulator requires us
    to be mindful of changes in the markets, market structure and new
    products in designing our examinations and the focus of our regulatory
    programs. We also adapt our programs to information that we learn
    through implementing those programs, conversations with other market
    regulators or from the experiences of other regulators when there is a
    significant breakdown in the regulatory scheme as is the case in the
    Madoff situation.
         Since learning of Mr. Madoff's arrest, FINRA has launched two
    broad reviews--one involving custody issues in joint broker-dealer
    investment advisers and the other involving the role of broker-dealers
    as feeders or finders to money managers such as Madoff.
        On the latter issue, FINRA launched an investigation to review the
    type of activity evident in the Madoff incident, in which finders or
    feeder funds referred business to a money manager or investment
    adviser. We are reviewing broker-dealers whose registered
    representatives may have referred clients to Madoff's advisory
    business. However, many of these finders and feeders are registered as
    investment advisers, not as broker-dealers, again compromising FINRA's
    reach in this important area.
        Need for Greater Information Sharing and Oversight of Dual
    Registrants. Since the SEC has broad jurisdiction to examine both the
    broker-dealer and investment adviser lines of business, we would
    propose a more formalized information sharing process between the SEC
    and FINRA to identify potential problems with dually registered firms.
    This could include notifications of when the Commission requires an
    existing broker-dealer to register as an investment adviser, as well as
    sharing statements or representations made to the SEC by an investment
    adviser that may be pertinent to an exam of the broker-dealer.
        Disparate Regulatory Oversight of Broker-Dealers and Investment
    Advisers. The Madoff affair illustrates how our fractured regulatory
    system can fail to protect investors. FINRA regulates broker-dealers,
    but not investment advisers, even though they provide services that are
    virtually indistinguishable to the average consumer. FINRA's authority,
    as noted above, does not extend to writing rules for, examining for or
    enforcing compliance with the Investment Advisers Act of 1940. That
    authority was granted to the SEC and the states. The limits of FINRA's
    jurisdiction have been recognized by the SEC, the Treasury Department
    in last year's Blueprint for Financial Markets, and by the investment
    adviser industry, which has always opposed the idea of FINRA or a
    FINRA-like organization to examine and enforce rules for registered
    advisers.
        For years, FINRA has argued for regulatory reform, so that
    consumers can be protected no matter what type of financial
    professional they hire. NASD issued public statements as far back as
    the late 1980s on this subject. We've submitted public comments to the
    SEC and Treasury on this disparity. In 2008, FINRA's former CEO, Mary
    Schapiro, personally raised these issues with then-SEC Chairman Cox.
        The absence of FINRA-type oversight of the investment adviser
    industry leaves their customers without an important layer of
    protection inherent in a vigorous examination and enforcement program-
    and the imposition of specific rules and requirements. It simply makes
    no sense to deprive investment adviser customers of the same level of
    oversight that broker-dealer customers receive.
        Broker-dealer regulation is subject to a very detailed set of rules
    established and enforced by FINRA that pertain to the conduct of
    advertising, customer account conduct and selling practices,
    limitations on compensation, financial responsibility, trading
    practices and reporting to FINRA of various statistical information
    used in the examination and enforcement practice. The investment
    advisory business is not subject to this level of regulation-even
    though many advisory services are virtually indistinguishable from the
    services of a broker-dealer.
        According to the SEC, the population of registered investment
    advisers has increased by more than 40 percent in recent years. (In
    2001, there were 7,400 advisers; there were almost 11,000 as of March
    2008.) As the SEC's Director of the Office of Compliance Inspections
    and Examinations stated last year, during this increase in the adviser
    population, ``our examiner staffing levels have not increased. Given
    this fact, we came to the conclusion that our limited resources would
    best be used in examining those firms and issues that have the greatest
    potential to pose harm to investors.'' \1\ While the SEC has attempted
    to use risk assessment to focus its resources on the areas of greatest
    risk, the fact remains that the number and frequency of exams relative
    to the population of investment advisers has dwindled.
    ---------------------------------------------------------------------------
         \1\ ``Focus Areas in SEC Examinations of Investment Advisers: The
    Top 10,'' Lori A. Richards, Director, Office of Compliance Inspections
    and Examinations, U.S. Securities and Exchange Commission, to the IA
    Compliance Best Practices Summit 2008, IA Week and the Investment
    Adviser Association (March 20, 2008).
    ---------------------------------------------------------------------------
        Need for Consistent Investor Protection Across Financial Services
    Channels. The type of investor protection gap inherent in the disparate
    treatment of broker-dealers and investment advisers is not isolated to
    that area. Unfortunately, our current fragmented system of financial
    regulation-where no single regulator has the full picture-leads to an
    environment where systemic and other risks may be left unchecked or go
    unnoticed, and investors are left without consistent and effective
    protections when dealing with financial professionals. Further, some
    products and services are completely outside the U.S. regulatory
    system.
        FINRA believes that it should be simpler for investors to know
    exactly what product they're buying, the legal protections they are
    entitled to and the qualifications of the person selling it. We believe
    that the solution to this problem is through greater regulatory
    harmonization--creating a regulatory system that gives retail investors
    the same protections and rights no matter what product they buy. At the
    very least, investors should be able to enter into any transaction
    knowing that:

        Every person selling a financial product is tested,
            qualified and licensed;

        The product's advertising is not misleading;

        Every product sold is appropriate for them; and

        There is full, comprehensive disclosure for all products
            being sold.

         Unfortunately, not all financial products come with these simple
    guarantees or protections.
         Establishing consistency among these four areas of investor
    protection would be a key first step in harmonizing the financial
    regulatory system. And equally as important in order to be effective,
    strong oversight and enforcement programs must accompany these investor
    protection obligations.
    Conclusion
        As I stated at the outset, what has happened to Madoff's investors
    is tragic. Investigations are ongoing and more information, no doubt,
    will emerge to assist all of us in analyzing exactly how this alleged
    fraud was executed. But some facts are already clear: the structure of
    our current regulatory structure keeps some activities out of the sight
    of some regulators, and those gaps and inconsistencies leave investors
    without the protections they believe they are receiving.
        When Americans are being asked to take on more of the
    responsibility to manage their own retirement funds and to save and
    invest for college tuition and mortgage down payments, they need a
    forward-thinking regulatory system to help them meet this growing
    responsibility. The individual investor is the most important player in
    the financial markets. Unfortunately, our system has not always
    sufficiently protected these individuals.
        A point made earlier, but one which bears repeating, is that
    investors deserve a consistent level of protection no matter which
    financial professionals or products they choose. Creating a system of
    consistent standards and vigorous oversight of financial
    professionals--no matter which license they hold--would enhance
    investor protection and help restore trust in our markets.
        FINRA is committed to working with other regulators and this
    Committee as you consider how best to restructure the U.S. financial
    regulatory system.
    Positions Once Held by Bernard Madoff With NASD or Its Affiliates:

        NASD Board: 1984, 1985, 1986, 1987

        SOES Users Committee: 1985, 1986, 1989 (Chair)

        Trading Committee: 1984, 1985 (Chair), 1986, 1987

        Board Surveillance Committee: 1990, 1989

        Limit Order Taskforce: 1989

        International Committee: 1985, 1986, 1989, 1992, 1993

        Strategic Planning Committee: 1990, 1991, 1992, 1993

        Advisory Council: 1983

        Long Range Planning Committee: 1989

        NASDAQ Board: 1989, 1990-1991 (Chairman)

        NASDAQ National Nominating Committee: 2001
                                     ______

                    PREPARED STATEMENT OF STEPHEN P. HARBECK
                     President and Chief Executive Officer,
                   Securities Investor Protection Corporation
                                January 27, 2009

        Chairman Dodd, Ranking Member Shelby, and Members of the Committee,
    thank you for the opportunity to appear before you today to discuss the
    work of the Securities Investor Protection Corporation, known as SIPC.
    My name is Stephen Harbeck and I have been the President and Chief
    Executive Officer of SIPC for the past 6 years. I have worked at SIPC
    for 33 years and was General Counsel prior to my appointment as
    President and CEO.
        SIPC was created under the Securities Investor Protection Act of
    1970 (``SIPA'') to provide specific financial protection to customers
    of failed securities broker-dealers. Although created under a Federal
    statute, SIPC is not a government entity. It is a membership
    corporation, the members of which are, with very limited exceptions,
    all entities registered with the Securities and Exchange Commission
    (``SEC'') as securities broker-dealers. Membership is not voluntary; it
    is required by law.
        As a fundamental part of its statutory mandate, SIPC administers
    the SIPC Fund from which advances are made to satisfy claims of
    customers. The Fund is supported by assessments on SIPC member firms
    and its assets currently total $1.7 billion. In addition, SIPC
    maintains a commercial line of credit with an international consortium
    of banks, and, by statute, has a $1 billion line of credit with the
    United States Treasury. SIPC has no authority to examine or investigate
    member firms. Those are the functions of the SEC and the Financial
    Industry Regulatory Authority which is a self-regulatory organization
    (``SRO) of the securities industry. When either of those entities or
    any other SRO informs SIPC that the customers of a brokerage firm are
    in need of the protections of SIPA, SIPC may initiate a customer
    protection proceeding to return to customers the contents of their
    securities accounts within specified limits. The proceedings are a
    specialized form of bankruptcy. A trustee and counsel are designated by
    SIPC, and appointed by the United States District Court, subject to a
    hearing on disinterestedness. The case is then referred to the
    appropriate Bankmptcy Court for all purposes.
         To the extent securities or cash is missing from customer
    accounts, SIPC may use its funds, within limits, to restore customer
    accounts to the appropriate account balances. SIPC may advance up to
    $500,000 per customer on account of missing securities, of which up to
    $100,000 may be based upon a claim for cash. SIPC does not protect
    customers against market loss in an account. It is also important to
    note that customer property is never used to pay any of the
    administration expenses, such as fees of accountants, lawyers or even
    the trustee in a SIPA proceeding.
        Through 2007, SIPC liquidated 317 brokerage firms, and returned
    over $15.7 billion in cash or securities to customers. Of that sum,
    SIPC used $322 million from the SIPC Fund to restore missing cash or
    securities. To date, SIPC has never used any government funds or
    borrowed under its commercial line of credit.
        2008 was very different from anything in our past history. In
    addition to three smaller cases, SIPC has faced in recent months two
    unprecedented events: the initiation of liquidation proceedings for
    Lehrnan Brothers Inc. in September 2008, and the liquidation of Bernard
    L. Madoff Investment Securities LLC, in December 2008. Both of those
    cases present significant challenges, but the two cases are very
    different.
    Lehman Brothers Inc.
        The Lehman Brothers Inc. (``LBI'') liquidation was preceded by the
    Chapter 11 filing of Lehman Brothers Holdings Inc. on September 15,
    2008. The Holding Company owned the SIPC member brokerage firm, LBI,
    which in turn held securities customer accounts. In order to facilitate
    the sale of brokerage assets, SIPC initiated a customer protection
    proceeding on Friday, September 19, 2008. On application by SIPC to the
    United States District Court for the Southern District of New York, LBI
    was placed in SIPA liquidation, James W. Giddens was appointed as
    trustee, and the law firm of Hughes Hubbard & Reed LLP was appointed as
    his counsel. That day, upon removal of the proceeding by the District
    Court, the United States Bankruptcy Court for the Southern District of
    New York held an extended hearing and approved the sale of assets of
    LBI to Barclays Bank.
        Over the following weekend, the trustee for LBI transferred
    customer account positions, which contained $142 billion in customer
    assets, to two broker-dealers, one of which was the brokerage arm of
    Barclays. As a result, many of the customers of the defunct firm were
    able to exercise control over their respective portfolios in a seamless
    way. While much remains to be done in every aspect of the LBI matter,
    the initial stages have proceeded very well.
    Bernard L. Madoff Investment Securities LLC
        The failure of Lehman Brothers Inc. was linked to the complex,
    systemic failure of the subprime mortgage situation. The failure of
    Bernard L. Madoff Investment Securities LLC, a registered securities
    broker-dealer and SIPC member, involved a very different problem: the
    theft of customer assets on an unprecedented scale. The firm was placed
    in a SIPA liquidation proceeding on December 15, 2008, after the
    principal of the firm, Bernard Madoff, confessed to having stolen
    customer property over a period of many years. Irving H. Picard was
    appointed as trustee, and the law firm of Baker & Hostetler LLP was
    appointed as his counsel.
        Unlike the LBI case, where customer records were accurate, it
    became apparent very early in the Madoff case that the customer
    statements Mr. Madoff had been sending to investors bore little or no
    relation to reality. The records sent to customers were inaccurate when
    compared to the inventory of securities actually held by the brokerage
    firm. For that reason, it was not possible to transfer all or part of
    any customer's account to another, solvent brokerage firm. Instead,
    pursuant to SIPA, Mr. Picard sought and received authority from the
    Bankruptcy Court for the Southern District of New York to publish a
    notice to customers and creditors, and to mail claim forms to them, as
    required by law, no later than January 9, 2009. The notice of the
    initiation of the case was published on January 2, 2009, and claim
    forms mailed to more than 8,000 investors at their addresses as they
    appeared on the Madoff firm's records within the last twelve months.
        The trustee has requested information from each customer as to the
    sums given to the Madoff brokerage firm, and sums withdrawn from the
    firm, to assist in the analysis of what each customer is owed. There
    are some situations, particularly where the investors have not made
    withdrawals, where it will be relatively easy to determine exactly how
    much a claimant put into the scheme. In other situations, the extended
    time period of the deception, coupled with numerous deposits with or
    withdrawals of assets from the brokerage over time, may make that
    reconstruction very difficult. SIPC and the trustee are committed to
    using all available resources to resolve these issues quickly.
        Mr. Madoff apparently has stated that he stole $50 billion. Even
    though this sum may include the annual ``profits'' he reported to
    investors in his fraudulent scheme, this defalcation is on a different
    order of magnitude than seen in any SIPA liquidation that has preceded
    it. Until customer claims are received and processed and further
    accounting and related work accomplished, SIPC will not know the extent
    of the demand on its resources. We can predict that the demand will be
    in excess of any previous case. Of course, the maximum amount under
    SIPA that SIPC can advance to any one claimant is $500,000 (including
    the $100,000 cash limit), even if the valid amount of the claim is much
    higher. The extent of recovery by customers beyond the amounts advanced
    by SIPC will depend upon the amount of customer property that the
    trustee is able to recover. To date, the trustee has identified over
    $830 million in liquid assets of the defunct brokerage firm that may be
    subject to recovery. Of these amounts, the trustee already has
    collected $91.8 million. Finally, the trustee has in place a team of
    highly trained attorneys, forensic accountants, and computer
    specialists, to assist him in locating and recovering assets. The
    trustee and SIPC will be aggressive in their pursuit of such
    recoveries.
        The Committee has expressed interest in a number of specific points
    concerning the Madoff case. In order to give the Committee a better
    understanding of those specifics, I would note the following:
    SIPC's Jurisdiction Over the Madoff Firm
        SIPC's jurisdiction is limited to brokerage firms registered as
    such with the SEC. Although there have been name changes over time, the
    Madoff firm has been a member of SIPC since SIPC's inception in 1970.
    The SIPA statute contemplates, and the Supreme Court agrees, that SIPC
    intervention is a last resort. When a brokerage firm is financially
    incapable of returning securities and cash in customer accounts, then
    and only then is SIPC involved. In the Madoff case, FINRA and the SEC
    presented SIPC with evidence that, at the very least, he Madoff
    brokerage firm owed customers $600,000,000 worth of stock that it did
    not have on hand. That was the factual predicate for the exercise of
    SIPC's jurisdiction.
        At the time of its failure, the Madoff firm was registered as both
    a brokerage firm and as an investment advisor, but there was only one
    corporate entity. SIPC does not have jurisdiction over any entity that
    is registered as an investment advisor.
    SIPC's Process and Timetable in the Madoff Case
        As mentioned above, SIPC filed its application for a decree
    declaring the customers of the Madoff firm to be in need of the
    protections available under SIPA on December 15, 2008. A trustee was
    appointed that day. On January 2, 2009, the trustee mailed a notice of
    the initiation of the SIPA proceeding and a claim form to the last
    known address of all customers, and to any other possible claimants
    then known to the trustee. Several hundred claims have been received by
    the trustee.
        The extended nature and scope of the theft over several decades
    makes this an unprecedented case. The SEC and SIPC have conferred at
    the staff level about the appropriate treatment of claims under these
    circumstances. SIPC's Board will review this issue on January 30. I
    expect a similarly rapid review of the issue by the SEC. The legal
    issues are as complex as they are unprecedented. In any event, I would
    hope that the trustee could begin satisfying simple, straightforward
    claims as early as February.
    The Sufficiency of the SIPC Fund
        Until all claims are filed and evaluated, it is not possible to
    determine exactly how much SIPC may be called upon to advance to the
    customers of the Madoff firm. Because SIPA limits the maximum advance
    SIPC may make with respect to any one customer claim, the call upon
    SIPC's resources is limited. By way of example, a perfectly valid claim
    for $100,000,000 would be eligible only for a maximum of $500,000 from
    SIPC. (Customers will also share, pro rata, in the corpus of ``customer
    property'' the trustee collects.) Until all claims are filed, and
    forensic accounting completed, it cannot be determined if SIPC's
    resources will be adequate.
    The Prospect of Statutory Amendment
        The failures of Lehmnan Brothers and Madoff call into question the
    sufficiency of SIPC's statutory line of credit with the United States
    Treasury. This credit line of $1 billion has not changed since 1970.
    Other refinements to the statute may also be considered. As this case
    moves forward and we have a clearer picture of the facts and their
    implications, SIPC will maintain a dialog with Congress about any
    issues that may give rise to the need for changes to SIPA.
        I would be pleased to answer any questions from the Committee.

            RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY
                          FROM JOHN C. COFFEE

    Q.1. The SEC's examiners were looking at the Madoff firm in
    2006 and were aware that he had misled them. Does it concern
    you that the enforcement staff did not try to get subpoena
    authority to look into the matter?

    A.1. To obtain subpoena authority, the SEC's enforcement staff
    must commence a ``formal'' investigation (as opposed to an
    ``informal'' once), and this requires a Commission vote. During
    this period, the SEC's enforcement staff in my judgment feared
    that their request might be rejected, might have resulted in
    other limitations being placed on their investigation, or
    simply might become contentious at the Commission level,
    thereby weakening their leverage in litigation. Thus, the staff
    may have sought in a number of cases to resolve cases at the
    ``informal'' stage. Obviously, this is unfortunate. By
    constraining the Enforcement Division, the Commission made it
    easier for some frauds to go undetected as a result of
    premature settlements.

    Q.2. In your estimation, is the fact that the SEC did not catch
    this fraud an indication of systemic problems in the Division
    of Enforcement and Office of Compliance Inspections and
    Examinations. If so, what are those problems?

    A.2. Although one failure does not alone demonstrate a systemic
    problem, I believe that the Office of Compliance, Inspections,
    and Examinations is systematically using poor criteria to
    determine in which instances to conduct an expedited
    examination. There also appears to be poor communication
    between the two offices, as the Division of Enforcement should
    have communicated the fact to the Office of Compliance,
    Inspections and Examinations that Madoff had mislead them (we
    simply do not know if this happened). Beyond this, the facts
    that (i) Madoff Securities served as a ``self-custodian'' for
    Madoff's investment advisory operations and (ii) Madoff used an
    unknown (and tiny) accounting firm that was not registered with
    the PCAOB should have been factors that lead to an immediate
    examination (as should the fact that Madoff had long resisted
    registration as an investment advisor). Admittedly, the Office
    of Compliance, Inspections, and Examinations cannot examine all
    brokers or investment advisers in all years, but these factors
    should have put Madoff at the top of the list (as should the
    immense amount of assets known to be under his investment
    management).
        That they did not shows that the Office is using very poor
    criteria for judging relative risk.

    Q.3. In your testimony, you noted that there appears to be a
    growing phenomenon of Ponzi schemes. You also discussed
    problems at unregulated entities. The Madoff fraud, however,
    seems to be another example of a growing trend of fraud at
    regulated entities. For example, we saw widespread market
    timing abuses perpetrated by registered investment advisors,
    mutual funds, and registered broker-dealers. We saw the
    collapse of the Consolidated Supervised Entity program. Often,
    rumors of problems at registered entities are swirling for
    years before the SEC reacts.
        Has the SEC been as effective as it should be at monitoring
    what is going on in the industries it regulates?

    A.3. Not at all! In part, it has been underfunding, and in part
    the Staff's recurrent passivity has been a consequence of a
    deregulatory bias that assumes that internal controls at firms
    are adequate to deter fraud. Finally, the ``market timing'' and
    option ``backdating'' scandals have shown that there are times
    when SEC officials have known of abuse but decided to tolerate
    it. To say the least, that is alarming.

    Q.4. Mr. Madoff was highly regarded by both the SEC and FINRA.
    He and his relatives served in advisory capacities to the two
    organizations.
        Do you believe that Mr. Madoff's status contributed to the
    fact that his fraud was not discovered by the SEC and FINRA?

    A.4. This is a matter of inference, rather than objective
    evidence, but I strongly suspect that Mr. Madoff's well-known
    industry status contributed to the ``light touch'' review that
    he received. The SEC's Inspector General reached a similar
    conclusion in his report on the Morgan Stanley investigation.
                                    ------

            RESPONSE TO WRITTEN QUESTIONS OF SENATOR JOHNSON
                          FROM JOHN C. COFFEE

    Q.1. The Madoff Ponzi scheme is one of the largest financial
    frauds in U.S. history. From point of view, how did the Madoff
    Ponzi Scheme fall through the cracks of the U.S. regulatory
    system?
        It is obvious to me that there are aspects of our
    regulatory system that do not work. Unfortunately, it took an
    economic crisis of the current magnitude for us to realize that
    changes are needed in the financial services' regulatory
    structure. What do you believe is the starting point for
    modernizing the regulation of securities entities, investments,
    broker-dealers, and investment advisors?

    A.1. Put very simply, hedge funds need to be subjected to SEC
    registration and SEC oversight for safety and soundness.
    Although the same close regulation as applies to mutual funds
    may not be necessary, the SEC should be able to review trading
    practices, including the over-the-counter swaps market, for
    excessive risk-taking. Finally, independent, unaffiliated
    custodians should be mandated for all investment advisers.

    Q.2. In hindsight, would you propose any changes to the
    relationships between the SEC and FASB and the SEC and the
    PCAOB?

    A.2. I do not believe that FASB or the PCAOB have any
    relationship to the Madoff scandal. From time to time, the FASB
    has been pressured to relax their accounting standards (this
    goes back to the ``expensing'' of stock options issue in the
    1990s), and it appears to be happening again with respect to
    ``mark to market'' accounting. But there is no easy cure.

    Q.3. The Madoff Ponzi scheme went undetected for possibly
    decades. Do you believe there are other fraudulent schemes in
    the United States that have gone undetected and could
    substantially harm families, retirees, communities,
    philanthropic organizations, and other investors as this one
    did?

    A.3. Almost certainly yes. And, subsequent to this hearing, the
    Allen Stanford Ponzi scheme was exposed, demonstrating this.
                                    ------

            RESPONSE TO WRITTEN QUESTIONS OF SENATOR JOHANNS
                          FROM JOHN C. COFFEE

    Q.1. What options from the Treasury's Blueprint for Regulatory
    Reform would you implement?

    A.1. The United States needs a ``systemic risk regulator''
    capable of monitoring capital adequacy, safety and soundness,
    and risk management practices at all financial institutions
    that are either ``too big'' or ``to entangled'' to fail. My
    specific reactions to the ``Blueprint'' proposal of The
    Treasury Department in April 2008 are set forth in detail in a
    long article entitled, ``Redesigning the SEC: Does the Treasury
    Have a Better Idea?'', which is forthcoming in the Virginia Law
    Review and is currently available on the SSRN Web site. I would
    be happy to e-mail or send it on request, but do not wish to
    impose it on you. Basically, I support the ``twin peaks'' model
    discussed in the Blueprint, under which a ``consumer protection
    agency'' (i.e., the SEC) would remain independent from the
    ``systemic risk regulation'' agency.
                                    ------

            RESPONSE TO WRITTEN QUESTIONS OF SENATOR JOHNSON
                        FROM HENRY A. BACKE, JR.

    Q.1. The Madoff Ponzi scheme is one of the largest financial
    frauds in U.S. history. From your point of view, how did the
    Madoff Ponzi scheme fall through the cracks of the U.S.
    regulatory system? Was there ever anything irregular in your
    dealings with Madoff's firm?

    A.1. The Madoff Ponzi Scheme fell through the cracks of the
    U.S. regulatory system numerous times because the Securities
    Exchange commission (SEC) did not investigate thoroughly Harry
    Markopolos' advice and warnings. Bernard Madoff was also
    allowed to be an investment advisor without being registered
    for many years. It seems apparent that no one should be able to
    be an investment advisor or Broker dealer without being
    registered in the United States.
        The SEC did a cursory investigation and never subpoenaed
    records or documents; they never investigated Bernard Madoff's
    investment advisory business where the fraud took place. If
    they had done so and checked that the securities he purported
    to own for his clients were in his companies name, they would
    have uncovered the fraud or potentially prevented the
    continuation of the Ponzi scheme.
        Either the investigators were incompetent or did not do a
    thorough investigation for some unknown reason to date.
        Bernard Madoff had significant influence as a SEC advisory
    panel member; he had conflicts of interest with the
    investigation and was allowed leniency in the investigations.
        To my knowledge there was never anything irregular about my
    Defined Contribution Pension plan's dealings with Madoff's
    firm.
                                    ------

            RESPONSE TO WRITTEN QUESTIONS OF SENATOR JOHANNS
                        FROM HENRY A. BACKE, JR.

    Q.1. What options from the Treasury's Blueprint for Regulatory
    Reform would you implement?

    A.1. Investment Advisors should not be able to use their own
    broker dealer to execute trades. Investment Advisors must be
    obligated to use an independent custodian. Broker dealers must
    use certified, registered accountants for audits and the audits
    should include confirming the securities exist in the
    appropriate name.
        The Securities Exchange Commission (SEC) and Finance
    Industry Regulatory Authority (FINRA) must have more
    jurisdiction to investigate broker dealers and any associated
    advisory business.
        There should be more transparency and public access to
    information regarding broker dealers and investment advisory
    businesses.
        SEC and FINRA should share information about firms they are
    investigating.
        SIPC limits should be adjusted to current value of the
    dollar to account for inflation. Broker dealers should pay
    higher premiums to ensure adequate funds to protect each
    individual investor.
        The SEC should examine more than 10 percent of Investment
    Advisor businesses each year. Every firm should be evaluated on
    a 5- to 10-year cycle.
        SIPC coverage is meaningless unless the definition of
    ``customer'' is extended to the individual investor. As of now,
    the broker dealers are using SIPC to their advantage.
                                    ------

             RESPONSE TO WRITTEN QUESTIONS OF SENATOR DODD
                         FROM LORI A. RICHARDS

    Q.1. Independent Custodian: At the hearing, Columbia Law School
    Professor John C. Coffee recommended ``the most important
    reform is to require an external and independent custodian for
    all collective investment vehicles.'' If the law required this,
    what impact might this have had in the Madoff situation or in
    other situations? Do you plan to study this recommendation to
    determine whether some type of custodial requirement would be
    appropriate to recommend to the Commission?

    A.1. Speaking as an examiner, separation of functions is an
    important control mechanism. We are working to identify
    measures that might make fraud less likely, which may include
    changes to the SEC's rules with respect to the custody of
    assets. As Chairman Schapiro testified on March 26, 2009,
    before the United States Senate Committee on Banking, Housing
    and Urban Affairs, she has asked the Commission's staff to work
    on a series of reforms to better protect investors when they
    place their money with a broker-dealer or an investment
    adviser. As noted, the Commission has already proposed rule
    amendments to require investment advisers with custody of
    client assets to undergo an annual ``surprise exam'' by an
    independent public accountant to confirm the safekeeping of
    those assets.

    Q.2. Oversight of FINRA Examinations: Please describe the scope
    of the Commission's authority over the examinations conducted
    by FINRA of broker-dealers and the extent and frequency of the
    Commission's supervision of FINRA's examinations. Include in
    this discussion examinations conducted pursuant to Section
    13(c) of the Securities Investor Protection Act, which provides
    that, subject to limited exceptions, the SRO of which a member
    of SIPC is a member shall inspect or examine such member for
    compliance with all applicable financial responsibility rules.

    A.2. Section 17(a) and (b) of the Securities Exchange Act of
    1934 (``Exchange Act'') provide Commission staff with the
    authority to conduct examinations of SROs. Section 19(g)(1) of
    the Exchange Act requires SROs to comply with the provisions of
    the Federal securities laws and the SRO's own rules and to
    enforce compliance by its members with these provisions.
        As part of its oversight of SROs, the Commission's
    examiners conduct comprehensive inspections of the SROs'
    regulatory programs. These inspections include FINRA District
    Offices, which are conducted on a 3-year cycle, and FINRA's
    Risk Oversight & Operational Regulation Group. During these
    inspections, the SEC staff inspectors review FINRA's
    examination and surveillance programs for member financial
    responsibility and operational compliance.
        In addition, the SEC examiners conduct ``oversight''
    examinations of broker-dealers to evaluate an SRO's examination
    work. The SEC conducts over 700 broker-dealer examinations each
    year. Generally between 150 and 200 of these are oversight
    examinations. Oversight examinations of broker-dealers serve
    the dual purposes of evaluating the quality and effectiveness
    of an SRO's examinations of its member firms, as well as
    detecting violations or compliance risks at broker-dealers.
    During an oversight examination, examiners analyze and sample a
    broker-dealer's records from the same time period and focus
    areas that the SRO reviewed during its examination. Particular
    emphasis is placed on certain identified risk areas that may
    include financial and net capital, sales practice and
    supervision, books and records, customer complaints,
    arbitrations, litigation, and anti-money laundering. These
    examinations may also include a review of whether the firm
    implemented any corrective measures recommended by the SRO.
        If these examinations and inspections identify deficiencies
    the SEC staff provides oversight comments to the SRO outlining
    the issue and requesting remedial action or other improvements.

    Q.3. Review of Auditor: Ms. Richards, you testified that you
    are looking at ``whether the risk assessment process would be
    improved with routine access to information such as, for
    example, the identity of an adviser's auditor.'' Please
    describe the types of information you are considering and
    whether the Commission has adequate legal authority to access
    such information.

    A.3. Given the number of registered firms, it is essential that
    we work to improve our risk-based oversight of broker-dealers
    and investment advisers. We believe that the risk assessment
    process utilized for examinations can be greatly enhanced by
    timely access to reliable information and data. The staff in
    the Office of Compliance Inspections and Examinations (OCIE),
    together with other agency staff, is presently working on an
    initiative to identify the key data points that would
    facilitate a risk-based oversight methodology and better allow
    the staff to identify and focus on those firms presenting the
    most risk. Once we have identified data points, we will explore
    how best to obtain the information and the agency's authority
    to do so.

    Q.4. SIPC: Mr. Harbeck in his testimony said that ``FINRA and
    the SEC presented SIPC with evidence that, at the very least,
    the Madoff brokerage firm owed customers $600,000,000 worth of
    stock that it did not have on hand. That was the factual
    predicate for the exercise of SIPC's jurisdiction.''
        Which Office, Division or other unit of the Commission
    presented SIPC with such evidence? Please provide the text of
    the Commission's communication to SIPC as well as the analysis
    that formed the basis of the conclusion underlying the
    communication.

    A.4. The Commission's Division of Trading and Markets is the
    agency's liaison with SIPC.

    Q.5. Resources and Examinations: The testimony states ``the
    Commission's staff did not examine his advisory operations,
    which first became registered with the Commission in late
    2006.'' Why did OCIE not conduct an examination of Bernard L.
    Madoff Investment Securities LLC when the broker-dealer
    registered as an investment adviser? Did OCIE lack sufficient
    resources to conduct examinations of newly registered
    investment advisers?

    A.5. Given the number of registrants, the SEC is not able to
    conduct routine periodic examinations of all newly registered
    investment advisers. Currently, there are more than 11,000
    investment advisers registered with the Commission, an increase
    of over 40 percent since 2001. The Commission has approximately
    425 staff dedicated to examining investment advisers (including
    advisers to hedge funds) and mutual funds. Due to the large
    investment adviser population and limited Commission resources,
    the SEC has implemented a risk-based approach to prioritize
    registrants for examination and to allocate examination
    resources to the most pressing risks. Based upon a risk-scoring
    process that includes information from a firm's Form ADV filing
    and its most recent examination (if any), advisers with risk
    scores in the top 10 percent are designated as ``higher risk''
    and are prioritized for examination, on a 3-year examination
    cycle. This does not mean that firms that score outside of that
    top 10 percent pose no risk; rather, the approach represents a
    form of triage for issues and registered entities that appear
    to pose the highest risk. Other firms may be examined for
    cause, randomly or as part of a sweep. Additional resources
    would allow the SEC to conduct more examinations, including of
    newly registered investment advisers, and to place all
    registered advisers and mutual funds on a periodic exam cycle.

    Q.6. Please describe the typical experience levels of staff who
    conduct exams of an investment advisor and of a broker-dealer.
    On average, how many new examiners are hired by your Office
    each year and what is their typical experience level?

    A.6. The SEC's examination staff is comprised of lawyers,
    accountants and examiners, many with CFAs and CPAs.
    Approximately 60 percent of current examination staff had
    private sector experience prior to joining the Commission.
    While the number of new examiners hired each year rises and
    falls due to various factors, we have seen a positive long term
    trend in the experience levels of new hires. Congress' pay
    parity legislation, implemented in 2002, provided the
    Commission with the authority to pay its staff higher salaries
    commensurate with other Federal financial regulators. This, in
    turn, allowed the Commission's examination program to bring in
    greater numbers of staff with experience in the securities
    industry, in auditing, and in compliance. Over 73 percent of
    the examination staff hired in the last 5 years had such
    experience prior to joining the Commission's staff.

    Q.7. Please explain the circumstances under which the
    Commission staff and FINRA (and its predecessor) staff
    conducted examinations of the broker-dealer Bernard L. Madoff
    Investment Securities LLC and their frequency. Do protocols for
    such exams include procedures that are designed to detect a
    Ponzi scheme?

    A.7. The Madoff broker-dealer operation was subject to routine
    examination oversight by FINRA. The broker-dealer was also
    subject to limited-scope examinations by SEC examination staff
    for compliance with, among other things, trading rules that
    require the best execution of customer orders, display of limit
    orders, and possible front-running, most recently in 2004 and
    2005. The SEC examinations were generally focused on the firm's
    compliance with applicable trading rules.
                                    ------

            RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY
                         FROM LORI A. RICHARDS

    Q.1. It is my understanding that the Madoff firm met all three
    risk factors that you outlined in a speech last year. With $17
    billion under management, the firm was large. There were
    questions about compliance and supervisory controls, and Bernie
    Madoff's brother was chief compliance officer for the firm. The
    secretive nature of the advisory business and the fact that it
    was solely funded through brokerage commissions presented
    increased compliance risk.
        Did your staff conduct an examination of the Madoff firm in
    its first year as an investment advisor? If not, why not?

    A.1. The Madoff broker-dealer operation was subject to routine
    examination oversight by FINRA. The broker-dealer was also
    subject to limited-scope examinations by SEC examination staff
    for compliance with, among other things, trading rules that
    require the best execution of customer orders, display of limit
    orders, and possible front-running, most recently in 2004 and
    2005. The SEC examinations were generally focused on the firm's
    compliance with applicable trading rules.
        The Commission's staff did not examine the Madoff firm's
    advisory operations, which first became registered with the
    Commission in late 2006 and thus subject to the SEC's
    examination authority at that time. Given the number of
    registrants, the SEC is not able to conduct routine periodic
    examinations of all newly registered investment advisers.
    Currently, there are more than 11,000 investment advisers
    registered with the Commission, an increase of over 40 percent
    since 2001. The Commission has approximately 425 staff
    dedicated to examining investment advisers (including advisers
    to hedge funds) and mutual funds. Due to the large investment
    adviser population and limited Commission resources, the SEC
    has implemented a risk-based approach to prioritize registrants
    for examination and to allocate examination resources to the
    most pressing risks. Based upon a risk-scoring process that
    includes information from a firm's Form ADV filing and its most
    recent examination (if any), advisers with risk scores in the
    top 10 percent are designated as ``higher risk'' and are
    prioritized for examination, on a 3-year examination cycle.
    This does not mean that firms that score outside of that top 10
    percent pose no risk; rather, the approach represents a form of
    triage for issues and registered entities that appear to pose
    the highest risk. Other firms may be examined for cause,
    randomly or as part of a sweep. Additional resources would
    allow the SEC to conduct more examinations, including of newly
    registered investment advisers, and to place all registered
    advisers and mutual funds on a periodic exam cycle.

    Q.2. In 2001, two journalists published articles that reported
    skepticism by former Madoff investors and experts about Mr.
    Madoff's ability to generate the types of returns he was
    producing through the investment strategy he was purporting to
    use and raised the specter of possible illegal conduct.
        Did your staff review these articles and, if so, what steps
    did your staff take to assess the validity of these claims?

    A.2. The Commission's Inspector General is conducting an
    investigation into the Commission's investigation and
    examinations of the Madoff firm and has requested the staff not
    to conduct any internal inquiries or reviews during the
    pendency of his investigation. As a result, until that review
    is completed, we are not in a position to answer this question.
    Generally, when preparing to conduct an examination of a
    registered firm, examiners typically review relevant news
    articles, as well as any prior examination reports, documents
    provided by the firm, and other research. During examinations
    of investment advisers and broker-dealers, the staff will seek
    to determine whether a firm is: conducting its activities in
    accordance with Federal securities laws and rules adopted under
    these laws (including, where applicable, the rules of SROs
    subject to the Commission's oversight); adhering to the
    disclosures it has made to investors; and implementing
    supervisory systems and/or compliance policies and procedures
    that are reasonably designed to ensure that the firm's
    operations are in compliance with the law.

    Q.3. FINRA contends that it had no responsibility to ask
    questions about Mr. Madoff's activities, even when he himself
    considered those activities to be part of his brokerage
    business and the defrauded customers were receiving brokerage
    statements. Part of your office's responsibility is overseeing
    SROs in their oversight of member firms.
        Do you concur with FINRA's position that Mr. Madoff's
    fraudulent activities were completely outside of FINRA's
    jurisdictional purview?

    A.3. In light of the ongoing Inspector General investigation
    into the Commission's investigations and examinations of the
    Madoff firm, since his request that the staff not conduct any
    inquiries or reviews during the pendency of his investigation,
    we have not conducted any inquiries or reviews of FINRA's
    examinations of the Madoff brokerage business, and are not in a
    position to comment on FINRA's response.

    Q.4. Please describe any tips that your office received about
    the Madoff firm and any actions your office took in response to
    those tips.

    A.4. On January 22, 2009, the Commission produced to the U.S.
    Senate Committee on Banking, Housing, and Urban Affairs copies
    of complaints received by the Commission regarding Madoff.
        In light of the fact that the Commission's Inspector
    General is conducting an investigation into the Commission's
    investigations and examinations of the Madoff firm and his
    request that the staff not conduct any internal inquiries or
    reviews during the pendency of his investigation, we are not in
    a position to provide further information as to actions taken
    in response to these complaints.
        Immediately upon her arrival at the Commission earlier this
    year, Chairman Schapiro asked her staff to conduct a
    comprehensive review of internal procedures used to evaluate
    the more than 700,000 tips, complaints, and referrals the SEC
    receives each year. In early March, the SEC announced that it
    enlisted the services of the Center for Enterprise
    Modernization, a federally funded research and development
    center operated by The MITRE Corporation, to help the SEC
    establish a centralized process that will more effectively
    identify valuable leads for potential enforcement action as
    well as areas of high risk for compliance examinations. The
    MITRE Corporation helped the SEC to scrutinize the agency's
    processes for receiving, tracking, analyzing, and acting upon
    the tips, complaints, and referrals from outside sources.
    Having recently completed this review, the MITRE Corporation is
    now in the process of helping the SEC identify ways it can
    begin immediately to improve the quality and efficiency of the
    agency's current procedures, and to help the agency acquire and
    implement technology solutions to assist the SEC staff in more
    effectively managing, analyzing and utilizing tips, complaints,
    and referrals.
                                    ------

            RESPONSE TO WRITTEN QUESTIONS OF SENATOR JOHNSON
                         FROM LORI A. RICHARDS

    Q.1. The Madoff Ponzi scheme is one of the largest financial
    frauds in U.S. history. From each of your points of view, how
    did the Madoff Ponzi Scheme fall through the cracks of the U.S.
    regulatory system?

    A.1. The examination program appreciates and shares the
    widespread concern about the agency's failure to detect the
    fraud perpetrated by Bernard Madoff. As previously noted, the
    Commission's Inspector General is conducting an investigation
    of these matters and has asked the staff not to conduct any
    independent inquiries or reviews. However, as noted during our
    testimony, the Commission did not conduct an examination of the
    Madoff firm's investment advisory business. Due to the large
    number of investment advisers, the SEC cannot examine all
    registered investment advisers on a routine basis. Currently,
    there are more than 11,000 investment advisers registered with
    the Commission, an increase of over 40 percent since 2001. The
    Commission has approximately 425 staff dedicated to examining
    investment advisers (including advisers to hedge funds) and
    mutual funds. Additional resources would allow the SEC to
    conduct more examinations, including of newly registered
    investment advisers, and to place all registered advisers and
    mutual funds on a periodic exam cycle.

    Q.2. There were numerous instances in which individuals and the
    press raised serious questions about the integrity of the
    Madoff business prior to December 11, 2008. How does the SEC
    determine which complaints are worthy of investigation?
        How does the SEC intend to restore confidence to the
    investors it is designed to protect after its failure to detect
    the Madoff scheme?

    A.2. As previously noted, Chairman Schapiro has taken immediate
    steps to improve the agency's ability to process and pursue
    appropriately the more than 700,000 tips and referrals it
    receives annually. The SEC has retained the Center for
    Enterprise Modernization a federally funded research and
    development center operated by The MITRE Corporation to help
    the SEC scrutinize the agency's processes for receiving,
    tracking, analyzing, and acting upon the tips, complaints, and
    referrals from outside sources. Having recently completed this
    review, the MITRE Corporation is now in the process of helping
    the SEC identify ways it can begin immediately to improve the
    quality and efficiency of the agency's current procedures, and
    to help the agency acquire and implement technology solutions
    to assist the SEC staff in more effectively managing, analyzing
    and utilizing tips, complaints, and referrals.
        In addition, as Chairman Schapiro testified on March 26,
    2009, before the United States Senate Committee on Banking,
    Housing and Urban Affairs, she has asked the Commission's staff
    to work on a series of reforms to better protect investors when
    they place their money with a broker-dealer or an investment
    adviser. On May 14, 2009, the Commission issued a proposal for
    rule amendments that would require registered investment
    advisers with custody of client assets to undergo an annual
    ``surprise exam'' by an independent public accountant to verify
    that those assets exist.

    Q.3. Would either of you suggest changes in the SEC's
    relationship with either the PCAOB or FASB to facilitate better
    transparency and accountability?

    A.3. I defer to the views of the Commission and the Office of
    the Chief Accountant with regard to these issues.
                                    ------

            RESPONSE TO WRITTEN QUESTIONS OF SENATOR JOHANNS
                         FROM LORI A. RICHARDS

    Q.1. What options from the Treasury's Blueprint for Regulatory
    Reform would you implement?

    A.1. I defer to the Chairman of the SEC and the Commission with
    regard to this issue. I look forward to working with the
    Chairman and Commissioners to consider these and other
    important reform measures.
                                    ------

    GENERAL RESPONSE TO QUESTIONS FROM THE SENATE BANKING COMMITTEE

    SEC Enforcement Division's Statement of Limitations Applicable to
            Responses to Questions From All Senators

        In March 2009, former Enforcement Director Linda Chatman
    Thomsen left the SEC to return to the private sector. SEC
    Chairman Mary Schapiro appointed Robert Khuzami, a former
    Federal prosecutor, as Director of Enforcement, a post he
    assumed on March 31, 2009. Accordingly, although Ms. Thomsen
    originally testified before this Committee, these responses are
    not made on behalf of Ms. Thomsen, but instead are made
    generally on behalf of the Division of Enforcement under its
    new Director Robert Khuzami. Mr. Khuzami makes these responses
    based on his conversations with the staff and not based on his
    own personal knowledge.
        The SEC filed a civil enforcement action alleging
    securities fraud against Bernard L. Madoff and Bernard L.
    Madoff Investment Securities LLC on December 11, 2008, and the
    United States Attorney's Office filed a parallel criminal
    action the same day. These actions are presently being
    litigated before the United States District Court for the
    Southern District of New York. Mr. Madoff subsequently admitted
    liability for securities fraud, accepted a permanent bar from
    the securities industry, forfeited virtually all of his assets
    in the criminal action and was recently sentenced to 150 years
    in prison. Mr. Madoff's attorney reportedly stated that Mr.
    Madoff has not yet decided whether to appeal his criminal
    sentence, and the amount of disgorgement and penalties to be
    ordered in the SEC's civil action has yet to be determined.
        Aside from these developments with respect to Mr. Madoff
    personally, the overall Madoff Ponzi scheme continues to be
    aggressively investigated by the SEC, the United States
    Attorneys' Office and the trustee addressing investor claims on
    behalf of the Securities Investors' Protection Corporation
    (SIPC). The SEC has not commented on, or made public any of the
    details regarding, any of its investigations or examinations
    involving Mr. Madoff or his firm to avoid jeopardizing the
    ongoing litigation and the continuing investigations of other
    individuals and entities who may have been involved in the
    fraud. These ongoing investigations are bearing fruit.
        On June 22, 2009, the SEC filed an action against Mr.
    Madoff's marketing solicitors--Cohmad Securities Corporation,
    its principals Maurice J. Cohn and Marcia B. Cohn, and
    registered representative Robert M. Jaffe-charging them with
    marketing investments with Madoff when they knew, or recklessly
    disregarded, facts indicating that Madoff was operating a
    fraud. On the same day, the SEC filed an action against Stanley
    Chais, a California-based adviser who oversaw three feeder
    funds that invested all of their assets with Madoff, resulting
    in $1 billion in investor losses when the Ponzi scheme
    collapsed. The SEC alleges that Chais misrepresented his role
    in managing the funds' assets and distributed account
    statements to investors that he should have known were false.
    Chais allegedly told Madoff that Chais did not want any losses
    in the feeder funds' trades, and so for nearly a decade, Madoff
    reported thousands of transactions on behalf of the feeder
    funds without a single loss on any equities trade. Previously,
    on March 18, 2009, the SEC charged the auditors of Mr. Madoff's
    broker-dealer firm, Friehling and Horowitz, CPAs, P.C. and
    individual CPA David G. Friehling, with securities fraud for
    representing they had conducted legitimate audits, when in fact
    they had not. The United States Attorney's Office also filed a
    parallel criminal action against the auditors.
        In each of these cases, Mr. Madoff's relationship with the
    defendants dates back at least a decade, if not considerably
    longer, and well before the SEC's investigation of Mr. Madoff's
    advisory business in 2006. The same is true of Mr. Madoff's
    relationships with the principals of other feeder funds, as
    well as other firms and individuals involved in his investment
    advisory business. Because these firms and individuals were
    already involved with Mr. Madoff before the SEC's prior
    investigation commenced in 2006, it is possible that
    representations made or facts discovered in the prior
    investigation may have some bearing on the pending litigation
    and continuing investigations. In addition to the defendants in
    these filed matters, the SEC is continuing to investigate other
    individuals and entities involved with Mr. Madoff or his firm,
    many of whom also may have played some role in the SEC's prior
    investigation. The SEC continues to investigate other firms and
    individuals who may have been involved with Mr. Madoff or his
    firm at other times as well.
        To preserve the integrity of the investigative and
    prosecution processes, there are questions specifically
    relating to Mr. Madoff that the Enforcement Division presently
    cannot answer. Aside from the allegations of the publicly filed
    complaints, the Enforcement Division cannot comment on the
    pending civil and criminal litigation or the underlying
    investigations to avoid jeopardizing those processes.
        The Enforcement Division is limited in its ability to
    provide further information on prior SEC enforcement
    investigations of Mr. Madoff, his firm or associated persons
    because the SEC's Office of the Inspector General is actively
    investigating all such prior matters and the Inspector General
    specifically requested that the Enforcement Division not
    conduct its own inquiry while his investigation was ongoing.
    The Inspector General testified before the House of
    Representatives Financial Services Committee regarding the
    scope of his investigation. See H. David Kotz, Inspector
    General, U.S. Securities and Exchange Commission, Testimony
    before the U.S. House of Representatives Committee on Financial
    Services, January 5, 2009, available at http://www.sec.gov/
    news/testimony/2009/ts010509hdk.htm. The Enforcement Division
    is informed that the Inspector General anticipates he will
    complete his investigation and provide a report to Congress in
    approximately August 2009.
        The SEC's Enforcement Division is mindful that this panel--
    and the public--is deeply concerned about the Division's
    failure to detect the fraud perpetrated by Mr. Madoff. In
    recognition of that, as the newly appointed Director of the
    Division of Enforcement, I testified before this Committee's
    Securities, Insurance and Investment Subcommittee on May 7,
    2009, that:

            Many have questioned our effectiveness in light of the
            revelations surrounding Bernard Madoff and his egregious
            conduct. Let me be clear--we failed in this instance in our
            mission to protect investors. Whatever explanations eventually
            surface, be they human failures, organizational shortcomings or
            deficiencies in process, or all three, there is no excuse, and
            not a day goes by that we in the Enforcement Division don't
            regret the consequences. But faced with this, we have done what
            any responsible public agency must do--we have used the episode
            as a wake-up call to undertake a rigorous self-assessment of
            how we do our job.

        The Enforcement Division assures this panel that we will
    work toward preventing such a failure in detection from
    happening again. We also ask that you consider this failure in
    the context of the Division's history of successful enforcement
    and vigorous efforts to protect investors, and the many
    talented and committed members of the enforcement staff who
    work very hard every day on behalf of investors.
        As Chairman Schapiro has previously testified, I can assure
    the Committee that as soon as we receive the Inspector
    General's report, the agency will promptly take all appropriate
    actions and address any remaining shortcomings. However, we
    want to make clear that we have not been waiting for the
    Inspector General's report to begin making potential
    improvements to our processes, whether or not they are directly
    related to the agency's handling of the Madoff investigation.
    We have begun to make substantial changes and have undertaken
    numerous initiatives aimed, in part, at addressing potential
    issues related to the Madoff matter.
                                    ------

             RESPONSE TO WRITTEN QUESTIONS OF SENATOR DODD
                 FOR LINDA C. THOMSEN BY ROBERT KHUZAMI

    Q.1. Enforcement Budget: Ms. Thomsen testified that ``The
    amount of resources available to the SEC has not kept pace with
    the rapid expansion in the securities market over the past few
    years--either in terms of the number of firms or the explosion
    in the types of new and increasingly complex products.''
        Are more resources needed by the Division of Enforcement to
    effectively perform its mission? Does the Commission plan to
    allocate more resources to Enforcement in the future, and if
    needed, ask for a larger annual budget?

    A.1. The Division of Enforcement needs more resources to more
    effectively perform its mission. The approximately 3,500
    employees of the SEC (of whom approximately 1000 are in the
    Enforcement Division) are charged with regulating and policing
    an industry that includes over 11,300 investment advisers,
    4,600 registered mutual funds, over 5,500 broker-dealers (with
    approximately 174,000 branch offices and 676,000 registered
    representatives), as well as approximately 12,000 public
    companies. The SEC receives up to approximately 750,000
    investor complaints annually. Every day Enforcement staff is
    compelled to make difficult judgments about which matters to
    pursue, which matters to stop pursuing, and which matters to
    forego pursuing at all.
        Chairman Schapiro has already requested additional
    resources for Enforcement through her appropriations testimony
    for 2010 and 2011. For 2010, the Chairman requested funds for
    approximately 50 new staff slots. For 2011, as the SEC will
    presumably assume an even broader regulatory role in the
    financial markets, the Chairman has requested funds for
    approximately 1000 additional staff. The staff increases
    requested by Chairman Schapiro provide a rough measure of the
    extent to which the SEC, and particularly the Division of
    Enforcement, are presently understaffed. While the Chairman's
    appropriations testimony does not distinguish between staff for
    the Enforcement Division as opposed to other Divisions,
    Enforcement has traditionally constituted by far the largest
    component of the SEC's budget and we anticipate that
    Enforcement's relative share of the SEC budget will likely
    increase over the next several years.

    Q.2. Handling Tips: Former SEC Chairman William Donaldson in a
    speech to the Securities Industry Association on November 3,
    2003, in the wake of the Commission staff's failure to act
    promptly on tips alleging that mutual funds had engaged in late
    trading and market timing, stated, ``I have ordered a
    reassessment of our policies and procedures on how tips are
    handled. Tips from whistleblowers are critical to our mission
    of pursuing violations of the Federal securities laws. I want
    to be sure that there is appropriate follow through on this
    type of information and that they are given expedited
    treatment.''
        Please describe the policies since 2003 that the Commission
    established and has observed governing how the staff and the
    Commission review unsolicited allegations of violations of the
    Federal securities laws or ``tips'' that it receives.

    A.2. As a preliminary matter, the Enforcement Division notes
    that the complaint from Mr. Markopolos was investigated. The
    SEC's New York Regional Office commenced an investigation of
    Mr. Madoff's investment advisory business in 2006. That
    investigation continued for 2 years until it was closed.
        In addition, it should be noted that in 2009 the SEC
    retained an independent consultant to assist in the development
    of new policies and procedures to address the handling of
    complaints, tips and referrals-not only in Enforcement, but
    throughout the agency. The consultant has completed the first
    of three anticipated phases of work, and will likely recommend
    and implement a centralized system of intake, triage and
    disposition of all complaints, tips and referrals throughout
    the agency.
        In general, with respect to the period from 2003 to the
    present, the SEC receives hundreds of thousands of complaints
    per year. While we appreciate and examine every lead we
    receive, 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.
        There are a number of major channels through which
    complaints, tips and referrals flow in to the Enforcement
    Division. First, there are calls and letters that are processed
    and screened by the Office of Investor Education as complaints,
    tips and referrals or ``CTRs.'' The most promising of these are
    forwarded to attorney staff in the Enforcement Division.
    Second, on the SEC's Web site, there is an Electronic Complaint
    Center that allows members of the public to record complaints
    and tips on simple online forms. The online complaints are
    reviewed and triaged by the professional staff of the
    Enforcement Division's Internet Enforcement Group, which refers
    them to staff for further investigation based on subject matter
    or geography.
        Yet another group of staff within the Division reviews and
    evaluates hundreds of ``Suspicious Activity Reports'' or
    ``SARS'' that are filed with Federal banking regulators by
    banks and financial institutions nationwide. SARS that
    potentially involve securities are forwarded to the SEC. After
    screening by experienced staff, promising referrals based on
    SARS are sent to enforcement staff throughout the country.
        FINRA and stock exchanges (referred to as ``Self-Regulatory
    Organizations'' or ``SROs'') are another source of referrals.
    The SROs provide continual and cutting-edge computerized
    surveillance of trading activities in their respective markets.
    They regularly report suspicious activities and trading
    anomalies to the Enforcement Division's Office of Market
    Surveillance through a variety of periodic reports. They also
    provide referrals regarding particular suspicious trades that
    may show possible insider trading ahead of a publicly announced
    transaction, such as a merger or acquisition. The SEC's Office
    of Market Surveillance automatically opens a preliminary
    investigation of each such referral and then forwards it to
    appropriate staff, generally based on geographic location of
    the issuer or suspected traders. The staff then becomes
    responsible for further inquiries that will either lead to the
    opening of a full investigation or the closure of the
    preliminary investigation.
        The Enforcement Division also receives referrals of
    potential securities law violations from other Offices and
    Divisions within the Commission. These referrals are either
    taken up directly by the Regional Office where the complaint
    was discovered or arose, or are directed to staff having
    appropriate expertise regarding the particular type of
    complaint. For example, referrals involving accounting issues
    are directed to the Office of the Chief Accountant in the
    Enforcement Division for further evaluation and referral to
    staff as appropriate. Similarly, referrals from throughout the
    Commission regarding over-the-counter stocks, potential
    microcap fraud and securities spam are directed to the Trading
    and Markets Enforcement Group, which has extensive experience
    in this market segment, for further evaluation and possible
    referral to staff.
        It is important to note that many complaints, tips and
    referrals are made directly to staff in the Office nearest the
    complainant and are investigated or addressed by that office.
    Among the options available to staff receiving a tip or lead
    are further investigation of the lead, declining to pursue the
    lead for lack of apparent merit, transfer of a potentially
    viable lead to an office with a closer geographical connection
    to the alleged misconduct, or referral of the lead to subject
    matter experts for further evaluation and possible assignment
    to staff.
        The primary consideration in determining whether to pursue
    any particular tip depends on whether, based on judgment and
    experience, the tip provides sufficient information to suggest
    that it might lead to an enforcement action involving a
    violation of the Federal securities law. This determination
    requires the exercise of judgment regarding, among other
    things: the source of the tip; the nature, accuracy and
    plausibility of the information provided; an assessment of how
    closely the information relates to a possible violation of
    Federal securities law; the validity and strength of the legal
    theory on which a potential violation would be based; the
    nature and type of evidence that would have to be gathered in
    the course of further investigation; the amount of resources
    the investigation might consume; and whether there are any
    obvious impediments that would prevent the information from
    leading to an enforcement action (for example, the conduct
    complained of is not securities-related).

    Q.3. In the hearing, Senator Merkley asked how many unsolicited
    tips of misconduct the agency receives that include the detail
    and sophisticated analysis of the Harry Markopolos document
    entitled ``The World's Largest Hedge Fund Is a Fraud.'' Please
    respond to Senator Merkley's question for the record.

    A.3. We are not in a position to respond precisely to this
    question, but we note that Enforcement Division receives
    hundreds of thousands of tips each year. Many tips are from
    insiders and other sophisticated industry professionals and it
    is not unusual to receive a tip in the form of a multi-page
    document that features extensive and sophisticated factual
    analysis. As an approximation, the Director of Enforcement
    personally receives by mail a very small portion of all
    complaints, tips and referrals received by the SEC-probably on
    the order of perhaps 10-15 complaints per week. Of these,
    approximately 2-5 complaints may be comprised of lengthy
    documents (often presented as bound folios with tabbed and
    annotated exhibits) and contain extensive analysis of the facts
    presented. Accordingly, the Director of Enforcement alone
    likely receives more than 100 complaints, tips and referrals
    each year that are similar in length, complexity and analysis
    to that presented by Mr. Markopolos.

    Q.4. Please describe how the Commission staff processed or
    reviewed the information that analyst Harry Markopolos provided
    regarding the conduct of Bernard Madoff and Bernard L. Madoff
    Investment Securities Inc. and his conclusion that it was a
    Ponzi scheme, including its determination not to bring an
    enforcement action for violations of the antifraud provisions
    of the securities laws?

    A.4. As a preliminary matter, the Enforcement Division
    investigated Mr. Markopolos' complaint. The SEC's New York
    Regional Office commenced an investigation of Mr. Madoff's
    investment advisory business in 2006 that continued for 2
    years, until it was closed without recommendation of further
    enforcement action in 2008. The Enforcement Division
    appreciates and shares the widespread concern about the
    Division's failure to detect the fraud perpetrated by Bernard
    Madoff. Because the investigation of this matter has been
    undertaken by the SEC's Office of the Inspector General,
    however, the Enforcement Division is not yet in a position to
    explain what happened or precisely what went wrong. The
    Inspector General specifically requested that the Enforcement
    Division not conduct its own inquiry during his investigation.
    Accordingly, the question cannot be answered at this time due
    the pendency of the Inspector General's investigation of this
    subject and due to the potential risk of compromising ongoing
    inquiries and litigation related to Mr. Madoff's fraud.

    Q.5. Disclosure of Information About an Auditor: The Madoff
    fraud reportedly amounted to $50 billion and the firm was
    audited by an extremely small accounting firm that does not
    appear to have had sufficient expertise or staff to conduct a
    proper audit of the Madoff firm. Ms. Richards testified that
    she was looking at ``whether the risk assessment process would
    be improved with routine access to information such as, for
    example, the identity of the advisor's auditor.'' Do you feel
    that regulators would be better able to protect investors if
    examiners in similar situations obtained and reviewed data
    about the size of an audit firm?

    A.5. The question refers to Ms. Richards' testimony regarding
    routine access to information in connection with examinations,
    and therefore the Division of Enforcement would defer to the
    views of the Office of Compliance Inspections and Examinations
    on this subject. In general, the Enforcement Division favors
    the greatest possible transparency regarding the operations and
    financial status of businesses operating in the securities
    industry.

    Q.6. SEC Staff: Analyst Harry Markopolos said that he felt that
    Bernard Madoff was operating the ``world's largest Ponzi
    scheme'' and over many years provided information to the
    Commission staff substantiating his view. He indicated that
    specific staff members in the Commission's Boston office
    recognized the seriousness of the situation and advocated
    Commission action. Mr. Markopolos was correct in his views and
    it is unfortunate that the efforts of these staff members did
    not result in action to stop the fraud at that time. In light
    of recent revelations about the fraud, has the Commission
    elevated these staff members who recognized the gravity of the
    conduct into appropriate positions of responsibility, so that
    the Commission can benefit from their good judgment?

    A.6. Most of the individuals in the Commission's Boston Office
    who dealt with Mr. Markopolos were already in relatively senior
    positions within the Enforcement Division and none of them have
    been further promoted. The Commission is indeed fortunate to
    have benefited from their good judgment, and continues to so
    benefit.

    Q.7. Market Surveillance: Does the Commission staff as a matter
    of policy regularly review and evaluate responsible financial
    press articles that suggest or allege misconduct or violations
    of the Federal securities laws? Please describe the relevant
    Commission policy and practices. Would the Commission's
    policies or practices have triggered a staff awareness of and
    review an article like ``Don't Ask, Don't Tell'' which appeared
    in Barron's May 7, 2001?

    A.7. The Commission's staff regularly reviews and evaluates
    responsible financial press articles. In particular, the 1000
    investigators in the Division of Enforcement continually review
    daily news reports in search of credible allegations of
    potential violations of the securities laws. Indeed, at times,
    multiple offices simultaneously seek to open an investigation
    based on a credible press article suggesting potential
    misconduct. News clips regarding the SEC, financial regulation
    and potential securities law violations are distributed
    throughout the agency on a daily basis. In addition, various
    regional offices of the Enforcement Division and the agency's
    centralized Office of Risk Assessment conduct additional
    surveys of credible press articles, as well as academic
    literature, suggesting possible securities violations. Without
    speculating as to staff's awareness or review of the particular
    Barron's article from 2001 cited in the question, the
    Enforcement Division recognizes Barron's as a credible news
    source and the agency occasionally circulates Barron's articles
    to all staff as part of the daily news clipping services.
                                    ------

            RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY
                 FOR LINDA C. THOMSEN BY ROBERT KHUZAMI

    Q.1. In a statement last month, former SEC Chairman Cox stated
    that the staff had ``credible and specific allegations
    regarding Mr. Madoff's financial wrongdoing, going back to at
    least 1999,'' but the staff never even asked the Commission for
    subpoena power. Instead, the staff relied on information
    voluntarily supplied by Mr. Madoff.
        In the face of credible and specific allegations, why
    didn't the Division of Enforcement staff feel it necessary to
    obtain subpoena power and pursue the investigation further,
    particularly after learning that Mr. Madoff had lied to them?
        How does the SEC's enforcement staff normally respond when
    it catches a person attempting to mislead the staff in this
    way?

    A.1. As noted above, the Division of Enforcement is not yet in
    a position to provide a response with regard to the particular
    investigative steps undertaken in the 2006 investigation. The
    Inspector General specifically requested that the Enforcement
    Division not conduct its own review of the 2006 investigation
    while his investigation is ongoing. In general, the Division of
    Enforcement seeks a Formal Order of Investigation (``Formal
    Order'') to obtain subpoena power when the facts and
    circumstances of a particular investigation indicate that
    subpoena power may be necessary to obtain documents or
    information the Division is seeking in the investigation.
        A Formal Order and the related subpoena powers are not
    necessary in every investigation. Most individuals and firms
    from whom the Division requests documents or information
    voluntarily comply with the Division's requests. In particular,
    entities and individuals that are registered with the
    Commission, such as broker-dealers, generally cooperate fully
    with such requests because they are subject to ongoing
    independent SEC books and records obligations that require them
    to produce certain books and records to the SEC on request and
    within a very short time frame. Accordingly, subpoenas are
    often unnecessary with respect to registered entities. If a
    registered entity refuses to comply with an SEC information
    request, they may face sanctions for violation of the SEC's
    books and records requirements, which may include, in
    appropriate cases, revocation of their registration with the
    Commission.
        When, however, the Enforcement staff has reason to believe
    that any individual or entity, whether registered or not, is
    uncooperative, or will not fully comply with a request for
    documents or information on a voluntary basis, they will not
    hesitate to seek a Formal Order and related subpoena powers.
    The issue of whether to seek subpoena power depends on all of
    the relevant facts and circumstances, including among other
    things the alleged violation, the nature and scope of the
    requests for documents or information and the responses
    thereto, whether the staff believes there are any omissions of
    material documents or information from the respondent's
    production, and the staff's past experience in obtaining
    documents and information from the respondent through voluntary
    requests or by subpoena. When confronted with an obvious
    omission from the documents or information produced, the
    staff's first step would likely be to request further
    production on a voluntary basis. If further production is not
    forthcoming, staff may obtain subpoena power.
        When the staff believes a respondent has lied to them, the
    staff will naturally be more cautious--if not highly
    skeptical--in assessing the respondent's credibility. Staff
    will also seek to either confirm or disprove the respondent's
    representations by seeking further verification, from the
    respondent, and when possible and appropriate, from other
    sources as well. Under these circumstances, the staff is
    generally quick to seek subpoena power, but the staff's
    response in any specific situation will depend upon all of the
    relevant facts and circumstances. Staff may consider, among
    other things, the nature of, and the motive or purpose for, the
    alleged lie, whether the respondent has provided other
    information from which the true facts can be ascertained, what
    remedies are available to the staff based on the true facts and
    the respondent's conduct when confronted with the true facts.
    Based on all of the facts and circumstances, the staff may seek
    subpoena power to compel further production. Alternatively,
    staff may decide that a subpoena is unnecessary or would serve
    no purpose, as, for example, when the respondent voluntarily
    produces all of the documents or information sought, or when
    staff already has access to the withheld documents or
    information from another source, or when the respondent
    voluntarily agrees to a settlement providing all relief the
    staff could possibly obtain through exercise of subpoena power
    and subsequent litigation. Finally, when appropriate, the staff
    may refer false statements to criminal authorities for
    prosecution under 18 U.S.C.  1001.

    Q.2. Ms. Thomsen, the New York office of the SEC conducted the
    2006 investigation of Madoff. I understand that you have
    entrusted the current Madoff investigation to not only the same
    regional office, but the same associate director who supervised
    the staff in that prior investigation.
        Why did you not assign the Madoff matter to the home office
    or another regional office to ensure a fully objective and
    thorough investigation?
        Are you concerned that the personnel who failed in the
    first instance have an interest in covering or mitigating that
    failure at this point in time?

    A.2. When new facts arise in cases previously investigated by
    staff, the Division of Enforcement generally assigns matters
    arising out of the new facts to the same staff who originally
    investigated the matter, as they are the individuals with the
    most experience in dealing with a particular respondent, and
    who are most familiar with the general facts and circumstances
    based on their prior investigation of the matter. Using at
    least some of the same staff generally expedites the
    investigation of new facts and maximizes our limited resources
    because of the important knowledge about the investigation or
    the party being investigated that the staff may have. If one or
    more of the responsible staff members has left the Commission
    by the time new facts are discovered, the Division will assign
    new staff as necessary to fill the vacancies. If the scope of
    the initial investigation has changed, the Division may also
    assign new staff to ensure adequate staffing. If the initial
    investigation did not lead to the discovery of the newly
    disclosed facts, and there is any concern that the personnel
    might attempt to cover up or mitigate their initial failure to
    discover these facts, the Division may assign new staff to work
    on the matter and may assign an independent supervisor to
    ensure that the investigation pertaining to the new facts is
    thorough, complete and unbiased by the prior investigation.
        Most of the staff members assigned to the Madoff
    investigation in December 2008 had no previous involvement with
    earlier investigations by the SEC into Madoff. In December
    2008, with the sole exception of the Associate Director, the
    Enforcement Division assembled an entirely new and expanded
    team of Enforcement staff who had no prior involvement in any
    investigation of Mr. Madoff or his firm. The Division also
    assigned a high level Associate Director for Enforcement from
    the Chicago Regional Office who had no prior involvement in any
    such investigation to ensure independent oversight and to serve
    as an additional supervisory resource.
                                    ------

            RESPONSE TO WRITTEN QUESTIONS OF SENATOR JOHNSON
                 FOR LINDA C. THOMSEN BY ROBERT KHUZAMI

    Q.1. The Madoff Ponzi scheme is one of the largest financial
    frauds in U.S. history. From each of your points of view, how
    did the Madoff Ponzi Scheme fall through the cracks of the U.S.
    regulatory system?

    A.1. The SEC's Enforcement Division is mindful that this
    panel--and the public--is deeply concerned about the Division's
    failure to detect the fraud perpetrated by Bernard Madoff.
    Because the investigation of this matter has been undertaken by
    the SEC's Office of the Inspector General, however, the
    Enforcement Division is not yet in a position to explain
    precisely what went wrong. The Inspector General specifically
    requested that the Enforcement Division not conduct its own
    inquiry while his investigation was pending. The Enforcement
    Division assures this panel that we will work toward preventing
    such a failure in detection from happening again. We also ask
    that you consider this failure in the context of the Division's
    history of successful enforcement and vigorous efforts to
    protect investors, and the many talented and committed members
    of the enforcement staff who work very hard every day on behalf
    of investors. We also want to make clear that we have not been
    waiting for the IG's report to begin making potential
    improvements to our processes, whether or not they are directly
    related to the agency's handling of the Madoff investigation.
    We have begun to make substantial changes and have undertaken
    numerous initiatives aimed, in part, at addressing potential
    issues related to the Madoff matter.

    Q.2. There were numerous instances in which individuals and the
    press raised serious questions about the integrity of the
    Madoff business prior to December 11, 2008. How does the SEC
    determine which complaints are worthy of investigation?

    A.2. As a preliminary matter, as set forth in former
    Enforcement Director Thomsen's testimony before this panel, the
    Enforcement Division determined that complaints about Mr.
    Madoff's investment advisory business, including the complaint
    by Harry Markopolos, were worthy of investigation. The SEC's
    New York Regional Office commenced an investigation of Mr.
    Madoff and his investment advisory business in 2006, and that
    investigation was closed without a recommendation of
    enforcement action in 2008.
        More generally, the SEC receives hundreds of thousands of
    complaints per year. While we appreciate and examine every lead
    we receive, we simply do not have the resources to fully
    investigate them all. We use our experience, skill and judgment
    in attempting to triage these hundreds of 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.
        There are a number of major channels through which
    complaints, tips and referrals flow in to the Enforcement
    Division. First, there are calls and letters that are processed
    and screened by the Office of Investor Education as complaints,
    tips and referrals or ``CTRs.'' The most promising of these are
    forwarded to attorney staff in the Enforcement Division.
    Second, on the SEC's Web site, there is an Electronic Complaint
    Center that allows members of the public to record complaints
    and tips on simple online forms. The online complaints are
    reviewed and triaged by the professional staff of the
    Enforcement Division's Office of Internet Enforcement, which
    refers them to staff for further investigation based on subject
    matter or geography.
        Yet another group of staff within the Division reviews and
    evaluates hundreds of ``Suspicious Activity Reports'' or
    ``SARS'' that are filed with Federal banking regulators by
    banks and financial institutions nationwide. SARS that
    potentially involve securities law violations are forwarded to
    the SEC. After screening by experienced staff, promising
    referrals based on SARS are sent to enforcement staff
    throughout the country.
        FINRA and stock exchanges (referred to as ``Self-Regulatory
    Organizations'' or ``SROs'') are another source of referrals.
    The SROs provide continual and cutting-edge computerized
    surveillance of trading activities in their respective markets.
    They regularly report suspicious activities and trading
    anomalies to the Enforcement Division's Office of Market
    Surveillance through a variety of periodic reports. They also
    provide referrals regarding particular suspicious trades that
    may show possible insider trading ahead of a publicly announced
    transaction, such as a merger or acquisition. The SEC's Office
    of Market Surveillance automatically opens a preliminary
    investigation of each such referral and then forwards it to
    appropriate staff, generally based on geographic location of
    the issuer or suspected traders. The staff then becomes
    responsible for further inquiries that will either lead to the
    opening of a full investigation or the closure of the
    preliminary investigation.
        The Enforcement Division also receives referrals of
    potential securities law violations from other Offices and
    Divisions within the Commission. These referrals are either
    taken up directly by the Regional Office where the complaint
    was discovered or arose, or are directed to staff having
    appropriate expertise regarding the particular type of
    complaint. For example, referrals involving accounting issues
    are directed to the Office of the Chief Accountant in the
    Enforcement Division for further evaluation and referral to
    staff as appropriate. Similarly, referrals from throughout the
    Commission regarding over-the-counter stocks, potential
    microcap fraud and securities spam are directed to the Trading
    and Markets Enforcement Group, which has extensive experience
    in this market segment, for further evaluation and possible
    referral to staff.
        It is important to note that many complaints, tips and
    referrals are made directly to staff in the Office nearest the
    complainant and are investigated or addressed by that office.
    Among the options available to staff receiving a tip or lead
    are further investigation of the lead, declining to pursue the
    lead for lack of apparent merit, transfer of a potentially
    viable lead to an office with a closer geographical connection
    to the alleged misconduct, or referral of the lead to subject
    matter experts for further evaluation and possible assignment
    to staff.
        The primary consideration in determining whether to pursue
    any particular tip is whether, based on judgment and
    experience, the tip provides sufficient information to suggest
    that it might lead to an enforcement action involving a
    violation of the Federal securities law. This determination
    requires the exercise of judgment regarding, among other
    things: the source of the tip; the nature, accuracy and
    plausibility of the information provided; an assessment of how
    closely the information relates to a possible violation of
    Federal securities law; the validity and strength of the legal
    theory on which a potential violation would be based; the
    nature and type of evidence that would have to be gathered in
    the course of further investigation; the amount of resources
    the investigation might consume; and whether there are any
    obvious impediments that would prevent the information from
    leading to an enforcement action (for example, the conduct
    complained of is not securities-related).
        When we determine that we have a promising tip, we
    investigate. We follow the evidence where it leads and will
    pursue and develop evidence regarding the liability of a full
    array of persons and entities--from the central players to the
    peripheral actors. In commencing an investigation, we usually
    do not know whether the law has been broken and, if so, by
    whom. We have to investigate, and our investigation may or may
    not lead to the filing of an enforcement action. We are
    resource constrained. The approximately 3,500 employees of the
    SEC (of whom approximately 1000 are in the Enforcement
    Division) are charged with regulating and policing an industry
    that includes over 11,300 investment advisers, 4,600 registered
    mutual funds, over 5,500 broker-dealers (with approximately
    174,000 branch offices and 676,000 registered representatives),
    as well as approximately 12,000 public companies. Every
    investigation we pursue, or continue to pursue, entails
    opportunity costs with respect to our limited resources. A
    decision to pursue one matter means that we may be unable to
    pursue another. No single case or investigation can ever be
    considered in a vacuum, but rather must be viewed as one of
    thousands of investigations and cases we are or could be
    pursuing.
        With that in mind, immediately upon her arrival at the
    Commission earlier this year, Chairman Schapiro asked her staff
    to conduct a comprehensive review of internal procedures used
    to evaluate the hundreds of thousands of tips, complaints, and
    referrals the SEC receives each year. In early March, the SEC
    announced that it enlisted the services of the Center for
    Enterprise Modernization, a federally funded research and
    development center operated by The MITRE Corporation, to help
    the SEC establish a centralized process that will more
    effectively identify valuable leads for potential enforcement
    action, as well as areas of high risk for compliance
    examinations. The MITRE Corporation helped the SEC to
    scrutinize the agency's processes for receiving, tracking,
    analyzing, and acting upon the tips, complaints, and referrals
    from outside sources. Having recently completed this review,
    the MITRE Corporation is now in the process of helping the SEC
    identify ways it can begin immediately to improve the quality
    and efficiency of the agency's current procedures, and to help
    the agency acquire and implement technology solutions to assist
    the SEC staff in more effectively managing, analyzing and
    utilizing tips, complaints, and referrals.

    Q.3. How does the SEC intend to restore confidence to the
    investors it is designed to protect after its failure to detect
    the Madoff scheme?

    A.3. Since the Madoff fraud came to light in December 2008, a
    new Chairman, Mary Schapiro, has been appointed to the
    Commission and she named me, Robert Khuzami, as the new
    Director of Enforcement. Under my leadership and that of
    Chairman Schapiro, the Enforcement Division has undertaken a
    broad range of initiatives aimed at restoring investor
    confidence.
        First and foremost, the Enforcement Division will restore
    investor confidence by continuing to bring securities
    enforcement actions to protect the interests of U.S. investors.
    Ponzi schemes--the form of fraud committed by Mr. Madoff--have
    always been aggressively pursued when detected by the Division
    of Enforcement. However, such schemes are notoriously difficult
    to detect because investors are reluctant to question what
    appears to be a steady stream of investment returns and,
    typically, the scheme is perpetrated by only a small group of
    insiders who go to great lengths to avoid detection.
    Nonetheless, in the 2 years before the Madoff scheme became
    public, the Division brought enforcement actions to halt more
    than 70 such schemes. Since the Madoff fraud became public, the
    Division has intensified its efforts with respect to Ponzi
    schemes, filing more than two dozen such cases in the last 6
    months.
        While the Enforcement Division best serves the investing
    public by bringing enforcement actions year in and year out,
    the Division is also considering ways it may be able to detect
    fraud better and sooner. At my direction, the Enforcement
    Division has undertaken a broad reexamination of its internal
    operations with the objective of becoming smarter, swifter,
    more strategic and more successful. The Division has assembled
    a number of internal advisory groups comprised of both senior
    management and line staff to propose specific changes with
    respect to various aspects of the Division's operations that
    will further that overall objective. Among the changes under
    consideration is a proposal to reorganize at least part of the
    Enforcement Division into specialized units to best utilize the
    Division's existing expertise and to foster the development of
    further expertise. In addition, the Division is considering
    streamlining its management structure to create a more nimble
    organization with fewer managers, and a correspondingly greater
    percentage of its personnel serving as frontline investigators
    pursuing fraud and wrongdoing. The Division is also actively
    seeking additional resources, particularly for information
    technology, which will lend a great advantage to the Division
    across the entire spectrum of its operations.
        The SEC has also retained an independent consultant to
    assist in the development of new policies and procedures to
    address the handling of complaints, tips and referrals--not
    only in Enforcement, but throughout the agency. In addition,
    the SEC is an active participant in the ongoing dialogue about
    regulatory reform in the financial services industry. In that
    regard, the SEC has already independently made a number of
    regulatory rule changes intended to remedy problems and abuses
    exposed by the ongoing financial crisis. For example, the SEC
    recently proposed a rule that would require that independent
    third parties maintain custody of client assets managed by an
    investment advisor, as a check against the advisor's
    misrepresentation or dissipation of client assets.
        It is important to bear in mind that neither the SEC nor
    any other regulator is a guarantor against fraud. Nonetheless,
    the SEC continually seeks to improve its use of all available
    resources to detect and stop fraud at the earliest possible
    moment.

    Q.4. Would either of you suggest changes in the SEC's
    relationship with either the PCAOB or FASB to facilitate better
    transparency and accountability?

    A.4. With respect to the issues raised in this question, the
    Enforcement Division defers to the views of the Commission and
    the Office of the Chief Accountant.
                                    ------

            RESPONSE TO WRITTEN QUESTIONS OF SENATOR JOHANNS
                 FOR LINDA C. THOMSEN BY ROBERT KHUZAMI

    Q.1. Who knew about Mr. Markopolos' report? At what date/time
    were they made aware? How far up the chain did the report make
    it? Were any investigatory actions taken?

    A.1. The Enforcement Division appreciates and shares the
    widespread concern about the Division's failure to detect the
    fraud perpetrated by Bernard Madoff. Because the investigation
    of this matter by the SEC's Office of the Inspector General is
    ongoing, however, the Enforcement Division is not yet in a
    position to explain what happened or precisely what went wrong.
    Indeed, the Inspector General specifically requested that the
    Enforcement Division not conduct its own inquiry during the
    pendency of his investigation. In her testimony, former
    Enforcement Director Thomsen described all prior Enforcement
    investigations of Mr. Madoff or his firm prior to 2006, as
    these are already matters of public record.
        With respect to past SEC enforcement investigations related
    to Mr. Madoff or his firm, two enforcement actions were filed
    by the SEC's New York Regional Office in 1992 alleging
    violations of the securities registration provisions in
    connection with offerings in which the investors' funds were
    invested in discretionary brokerage accounts with an
    unidentified broker-dealer, who in turn invested the money in
    the securities market. The unidentified broker-dealer in these
    cases was Bernard L. Madoff. The first matter was entitled SEC
    v. Avellino & Bienes, et al. \1\ In that case, two individuals,
    Frank Avellino and Michael Bienes, raised $441 million from
    3200 investors through unregistered securities offerings. They
    formed an entity, Avellino & Bienes (``A&B"), which offered
    investors notes paying interest rates of between 13.5 and 20
    percent. A&B collected the investors' monies in a pool or fund
    that was invested in discretionary brokerage accounts with Mr.
    Madoff's broker-dealer firm, and Mr. Madoff in turn invested
    the monies in the market. A&B received returns on the invested
    funds from Mr. Madoff, but kept the difference between the
    returns received from Mr. Madoff and the lesser amounts of
    interest paid on the A&B notes.
    ---------------------------------------------------------------------------
         \1\ SEC v. Avellino & Bienes et al., Lit. Rel. No. 13443 (Nov. 27,
    1992).
    ---------------------------------------------------------------------------
        The second matter, SEC v. Telfran Associates Ltd., et al.,
    was a spinoff from A&B and involved the creation of a feeder
    fund to A&B. \2\ In Telfran, two individuals who had invested
    in A&B, Steven Mendelow and Edward Glantz, formed an entity
    called Telfran Associates. Telfran raised approximately $88
    million from 800 investors through unregistered securities
    offerings over a period of 3 years. Telfran sold investors
    notes paying 15 percent interest, which they in turn invested
    in notes sold by A&B that paid between 15 and 19 percent
    interest. Since investor funds collected by A&B were invested
    with Mr. Madoff, the Telfran investor funds were also invested
    with Mr. Madoff, albeit indirectly.
    ---------------------------------------------------------------------------
         \2\ SEC v. Telfran Associates Ltd., et al., Lit. Rel. No. 13463
    (Dec. 9, 1992).
    ---------------------------------------------------------------------------
        Although the SEC was initially concerned that these
    unregistered offerings might be part of a huge fraud on the
    investors, the trustee appointed by the court in Avellino &
    Bienes found that the investor funds were all there. The
    returns on funds invested with Mr. Madoff appeared to be
    exceeding the returns the promoters had promised to pay their
    investors, so there were no apparent investor losses. \3\ In
    both cases, the SEC sued the entities offering the securities
    and their principals for violations of the securities
    registration provisions of the Federal securities laws. The SEC
    also sought the appointment of a trustee to redeem all
    outstanding notes and the appointment of an accounting firm to
    audit the firms' financial statements.
    ---------------------------------------------------------------------------
         \3\ Randall Smith, Wall Street Mystery Features A Big Board Rival,
    Wall St. J, Dec. 16, 1992 at C1.
    ---------------------------------------------------------------------------
        Both cases were settled by the promoters' consent to
    reimburse each investor the full amount of their investment and
    to submit to an audit by an accounting firm, and their further
    consent to be permanently enjoined from further unregistered
    offerings in violation of the Federal securities laws. In
    addition, each of the companies making the unregistered
    offerings agreed to pay a penalty of $250,000, and each of the
    principals in those companies agreed to pay a civil penalty of
    $50,000. \4\ By executing the SEC's consent orders, Avellino &
    Bienes, Telfran and their respective principals agreed to cease
    offering unregistered investment opportunities to the public.
    Because the court-appointed trustees in Avellino & Bienes
    concluded the investor funds were all there and all investor
    funds in both cases were ultimately reimbursed to the
    investors, the SEC did not pursue fraud charges in those cases.
    Neither Mr. Madoff nor his firm was named as a defendant in
    either case.
    ---------------------------------------------------------------------------
         \4\ SEC v. Avellino & Bienes et al., Lit. Rel. No. 13880 (Nov. 22,
    1993); SEC v. Telfran Associates Ltd., et al., Lit. Rel. No. 13881
    (Nov. 22, 1993).
    ---------------------------------------------------------------------------
        Because its existence had already been widely reported in
    the press, Ms. Thomsen also confirmed that the SEC's New York
    Regional Office commenced another investigation of Mr. Madoff
    in early 2006, which was closed 2 years later, in January 2008,
    without any recommendation of enforcement action.
        Ms. Thomsen also described to this Committee the pending
    litigation with respect to Mr. Madoff and his firm. On December
    11, 2008, the SEC sued Bernard L. Madoff and his firm, Bernard
    Madoff Investment Securities, LLC, for securities and
    investment advisory fraud in connection with the Ponzi scheme
    that resulted in substantial losses to investors in the United
    States and other countries. See United States Securities and
    Exchange Commission v. Bernard L. Madoff and Bernard L. Madoff
    Investment Securities LLC, 08 Civ. 10791 (LLS) (S.D.N.Y. Dec.
    11, 2008). The SEC's Enforcement Division is coordinating its
    ongoing investigation with that of the United States Attorney's
    Office for the Southern District of New York, which filed a
    parallel criminal action on December 11, 2008, in connection
    with of Mr. Madoff's alleged Ponzi scheme.
        In the pending litigation, Mr. Madoff admitted liability
    for securities fraud and agreed to a permanent bar from the
    securities industry. In the criminal action, he forfeited
    virtually all of his assets and was recently sentenced to 150
    years in prison. Mr. Madoff's attorney reportedly stated that
    Mr. Madoff has not yet determined whether to appeal his
    criminal sentence. In addition, the amount of any disgorgement
    or penalty to be paid by Mr. Madoff in the civil action filed
    by the SEC has yet to be determined.
        Aside from the developments related to Mr. Madoff
    personally, the SEC filed two actions on June 22, 2009, against
    Mr. Madoff's marketing solicitors and against an investment
    advisor who oversaw three feeder funds that invested all of
    their assets with Madoff. Previously, on March 18, 2009, the
    SEC charged the auditors of Mr. Madoff's broker-dealer firm
    with securities fraud for representing they had conducted
    legitimate audits, when in fact they had not. The United States
    Attorney's Office also filed a similar criminal action against
    the auditors. The SEC's investigation is ongoing.

    Q.2. It has been noted that much of the referral of new
    investors to Madoff's funds was done informally, by friends, or
    through a group of large independently managed feeder funds. Is
    there going to be an investigation into these fund-of-fund
    pros?

    A.2. The SEC's investigation of the overall Madoff Ponzi scheme
    is continuing. In general, the SEC's enforcement investigations
    address the conduct of any individual or entity that may have
    had any role in the perpetration of the fraud. Though some
    issues in the litigation regarding Mr. Madoff himself have been
    resolved by his admission of criminal and civil liability,
    criminal asset forfeiture and criminal sentencing to 150 years
    in prison, the SEC, the United States Attorney's Office and the
    SIPC trustee have continued to investigate the facts regarding
    the Madoff Ponzi scheme and others who may have been involved
    in the fraud. After months of work, the SEC recently filed two
    new enforcement actions in connection with the Madoff fraud. On
    June 22, 2009, the SEC filed an action against Mr. Madoff's
    marketing solicitors--Cohmad Securities Corporation, its
    principals Maurice J. Cohn and Marcia B. Cohn, and registered
    representative Robert M. Jaffe--in connection with their
    marketing of investments with Madoff, despite knowing or
    recklessly disregarding facts indicating that Mr. Madoff was
    operating a fraud. In a separate complaint filed the same day,
    the SEC also sued Stanley Chais, a California-based investment
    adviser who oversaw three feeder funds that invested all of
    their assets with Madoff, for misrepresenting his role in the
    management of the funds' assets and distributing account
    statements to investors that he should have known were false.

    Q.3. What options from the Treasury's Blueprint for Regulatory
    Reform would you implement?

    A.3. The Division of Enforcement defers to the views of the
    Chairman and Commissioners on the implementation of any options
    set forth in the Treasury's Blueprint for Regulatory Reform.
                                    ------

             RESPONSE TO WRITTEN QUESTIONS OF SENATOR DODD
                       FROM STEPHEN I. LUPARELLO

    Q.1. Please describe the scope, extent and limits of the
    authority of FINRA and of each of its predecessor entities--the
    National Association of Securities Dealers (NASD) and New York
    Stock Exchange Regulation (NYSER) (and its predecessor
    organizational unit within the New York Stock Exchange) B to
    examine the books, records, activities and premises of member
    broker-dealers during the past decade under (1) membership
    rules and policies of these regulators (e.g., NASD Rule 8210)
    and (2) the Federal securities laws and rules thereunder (e.g.,
    Exchange Act Sections 15A(g)(3)(A), 17(d)(1)(A), 17(k)(3),
    19(g)(1)).

    A.1. FINRA (and each of our predecessor entities) has authority
    to examine the books, records, activities and premises of a
    broker-dealer to the extent that they concern the firm's
    business as broker-dealer or municipal securities dealer. Thus,
    for example, we examine the sales practices of registered
    representatives and securities trading operations of broker-
    dealers for compliance with the Securities Exchange Act of 1934
    and FINRA rules. However, we lack the authority to examine a
    firm for compliance with the Investment Advisers Act of 1940 or
    other laws outside of our jurisdiction. Thus, for example, our
    jurisdiction does not extend to the sale practices of employees
    of a broker-dealer acting in their capacity as investment
    adviser representatives in assessing compliance with the
    Investment Advisers Act.

    Q.2. Does FINRA, and did its predecessor entities, as a matter
    of policy require appropriate staff to review and evaluate
    responsible financial press articles that suggest or allege
    misconduct or violations of rules over which FINRA has
    jurisdiction? Would these policies have triggered a review of,
    for example, an article like ``Don't Ask, Don't Tell'' which
    appeared in Barron's May 7, 2001?

    A.2. FINRA and its predecessors (NASD and NYSE member
    regulation) evaluate certain financial press articles related
    to the securities industry that suggest or allege misconduct or
    violations of rules for which FINRA has jurisdiction and has
    commenced investigations based on this type of information.
        Since the events surrounding the fraud by Bernard Madoff,
    FINRA has considered how it could better integrate the use of
    press articles as well as other potentially pertinent publicly
    available information into its regulatory programs. Enhanced
    procedures for pre-examination information gathering are among
    several new elements FINRA has designed for its examination
    program. This new exam element enhances FINRA's information
    gathering related to a firm's ownership and affiliate
    relationships and identifies potential concerns and conflicts
    of interest. The procedures include verification of information
    obtained, investigation into any potential conflicts of
    interest, and reconciliation of any discrepancies noted between
    information reported to FINRA and certain publicly available
    information. This will include a mandatory review of Form ADV
    and all other relevant findings.

    Q.3. We understand that some fraud victims had invested with
    Madoff for decades and that during some of these years, Mr.
    Madoff served as Chairman of Nasdaq (at that time an affiliate
    of the NASD) and members of his family served on committees of
    the NASD. Some observers have speculated that NASD employees
    may have been reluctant to rigorously examine a firm founded
    and controlled by a person of influence within the self-
    regulatory organization for fear of retaliation. How would you
    respond to such speculation? How does FINRA protect its
    examiners and staff who find regulatory violations from
    concerns about potential retaliation by representatives of
    member broker-dealers who occupy positions of influence within
    the self-regulatory organization?

    A.3. FINRA, like other regulators, seeks out the expertise of
    participants in the securities markets. This communication
    allows us to be more effective regulators. We are not bound in
    any way by the views of these market participants. FINRA's
    oversight of the Madoff broker-dealer was not affected by the
    fact that the Madoffs were known to some in our organization.
    Had we known evidence of this fraud, we would have vigorously
    investigated the firm. If our investigation indicated that
    fraud existed in the investment advisory operations, we would
    have promptly referred the matter to the SEC, which regulated
    the advisory operations. FINRA received and investigated 19
    complaints against the Madoff broker-dealer since 1999.
        FINRA consistently has demonstrated that it is willing to
    discipline a firm for wrongdoing, regardless of how well-known,
    well-respected or active it is. FINRA has taken action against
    the firms of sitting of former board members on several
    occasions. In fact, in one case that bears resemblance to the
    Madoff situation, FINRA's predecessor organization, NASD,
    sanctioned a former Board member who was CEO of a major market
    making firm, and two others associated with his firm, for
    supervisory failures and improper sales practices.
        On April 17, 2007, a NASD hearing panel found that Kenneth
    Pasternak, former CEO of Knight Securities, L.P. (now known as
    Knight Equity Markets, L.P.), and John Leighton, former head of
    the firm's Institutional Sales Desk, committed supervisory
    violations in connection with fraudulent sales to institutional
    customers. The hearing panel imposed a 2-year suspension in all
    supervisory capacities and a $100,000 fine upon Kenneth
    Pasternak, and a bar in all supervisory capacities and a
    $100,000 fine upon John Leighton.
        In a 2-1 decision, the panel found that Pasternak and
    Leighton failed to adequately supervise the trading of the
    firm's leading institutional sales trader, Joseph Leighton,
    John Leighton's brother. The ruling states that Kenneth
    Pasternak's response to numerous red flags was ``woefully
    inadequate,'' that Kenneth Pasternak and John Leighton ``never
    questioned Joseph Leighton's activities or confirmed he was
    providing his customers with best execution and a fair price,''
    and that the overall supervisory void ``allowed Joseph Leighton
    to take advantage of his customers over a 21-month period by
    filling orders at prices that netted Knight unreasonably high
    profits.''
        In April 2005, Joseph Leighton agreed to a bar from the
    securities industry and a payment of more than $4 million to
    settle charges by the SEC and NASD that he made millions of
    dollars from fraudulent trades with Knight's institutional
    customers. In December 2004, Knight paid more than $79 million
    to settle SEC and NASD charges against the firm arising from
    Joseph Leighton's conduct. More than $3.3 million of Joseph
    Leighton's monetary sanction and more than $66 million of the
    firm's monetary sanction was paid into a Fair Fund established
    by the SEC to compensate investors harmed by Joseph Leighton's
    fraud.
        A fundamental tenet of FINRA's organizational structure is
    that regulatory staff of FINRA and its subsidiaries conduct
    their duties and responsibilities with autonomy and
    independence. Undertakings imposed by the SEC on NASD in 1996
    concerning NASD's regulatory functions specifically provide
    that NASD's regulatory staff has sole discretion with respect
    to matters to be investigated and prosecuted
        Corporate bylaws of FINRA and FINRA Regulation prohibit
    FINRA Governors or FINRA Regulation Directors from
    participating directly or indirectly in any matter if the
    Governor or Director has a conflict of interest or bias or if
    circumstances otherwise exist where his or her fairness might
    reasonably be questioned (See FINRA Bylaws Article XV, Sec.
    4(a) and FINRA Regulation Bylaws Article IV, Sec. 4. 14(a)).
    FINRA's Board has adopted Corporate Governance Guidelines that
    urge Governors to direct questions and issues concerning
    FINRA's operations to FINRA's senior management and corporate
    secretary. Those Guidelines also direct Governors to ensure
    that any contact with FINRA staff's appropriate and non-
    disruptive to FINRA's business operations. FINRA trains its
    examiners and staff to ignore and escalate as appropriate any
    attempt by a firm under examination to intimidate or attempt to
    influence, and FINRA's Code of Conduct and ethics training
    focus on staff members avoiding any conflict of interest or any
    appearance of a conflict of interest.
        To protect its staff from retaliation or impermissible
    influence, FINRA has adopted policies that protect any staff
    member reporting concerns in good faith, including FINRA's Code
    of Conduct, and FINRA operates internal and anonymous reporting
    systems to collect, analyze and investigate any claim of
    violative behavior. FINRA has also voluntarily adopted a policy
    designed to apply the requirements of Section 307 of the
    Sarbanes-Oxley Act of 2002, which does not otherwise apply to
    FINRA, so that FINRA attorneys who become aware of evidence of
    a material violation of law affecting FINRA (including any act
    or failure to act by any of FINRA's officers, Governors or
    employees) must report such violation to FINRA's Executive Vice
    President and General Counsel (Corporate) or, in certain
    instances, to FINRA's Audit Committee.

    Q.4. Section 13(c) of the Securities Investor Protection Act
    provides that, subject to limited exceptions: ``The self-
    regulatory organization of which a member of SIPC is a member
    or in which it is a participant shall inspect or examine such
    member for compliance with all applicable financial
    responsibility rules.'' Pursuant to this authority, describe
    the examinations that FINRA performs of member broker-dealers.

    A.4. The key financial responsibility rules include the SEC's
    Net Capital Rule (SEC Rule 15c3-1), Customer Protection Rule
    (SEC Rule 15c3-3), and Books and Records Rules (SEC Rules 17a-3
    and 17a-4). All FINRA-regulated firms are subject to these
    rules. The net capital rule requires firms to maintain a
    certain minimum amount of net capital, based upon the type of
    business conducted. Firms that fail to maintain sufficient net
    capital are not permitted to conduct a securities business
    until they are once again in net capital compliance. Firms file
    financial reports monthly (or quarterly for firms involved in
    less complex business activities). Irrespective of reporting
    requirements, all firms must prepare monthly financial
    statements. FINRA conducts onsite financial examinations that
    review financial statements. The frequency of these
    examinations depends on the firm's size, business model and an
    assessment of the firm's risk. Broker-dealers that carry, or
    custody, customer assets receive financial examinations more
    frequently than those firms who do not carry customer accounts.
    Presently, examinations of firms that do carry customer
    accounts are generally done annually. FINRA's examination
    includes a review of the accuracy of the firm's financial
    statements and its most recent net capital computation. If a
    broker-dealer is determined to have been ``under net capital''
    during this most recent time period, the staff expands its
    review.
        The Customer Protection rule prohibits firms from co-
    mingling customer assets with proprietary assets or otherwise
    using customer property to finance the broker-dealer's
    activities. For the Customer Protection Rule, FINRA examiners
    will determine that clearing firms maintain proper possession
    or control of all fully paid or excess margin customer
    securities and that these firms maintain a Reserve Account bank
    balance sufficient to cover net balances due to customers. This
    is computed pursuant to a formula in the SEC's Customer
    Protection Rule. At introducing firms, examiners verify that
    the member firm is not holding any customer cash or securities.
    All broker-dealers must have sufficient books and records to
    support their financial statements and regulatory computations.
    For example, broker-dealers should maintain bank statements and
    reconciliations, statements from depositories, and statements
    from clearing firms for introducing broker-dealers. FINRA staff
    will verify a firm's financial records and computations made
    pursuant to SEC Rule 15c3-1 and 15c3-3 with these supporting
    documents.

    Q.5. You testified that ``in the course of FINRA's broker-
    dealer exams, we found no evidence of the fraud that Bernard
    Madoff carried out through its investment advisory business.''
    Did those examinations cover the entire premises of the Madoff
    brokerage firm, including the areas from which the Ponzi scheme
    was run? If not, please explain why they did not.

    A.5. During examinations of Bernard L. Madoff Investment
    Securities, LLC (``BLMIS''), a broker-dealer regulated by
    FINRA, examination staff conducted onsite reviews of various
    aspects of the broker-dealer's business, which engaged in
    wholesale market making. Those reviews encompassed, among other
    areas: supervision, supervisory controls, net capital adequacy,
    financial operations, internal controls, insider trading,
    trading risk controls, and trade reporting. Examination staff
    reviewed books and records related to the Madoff broker-dealer'
    s activities and areas of our examination focus. BLMIS did not
    record any of Madoff's investment advisory business on its
    books and records. Consequently, those books and records did
    not indicate that Madoff was engaged in a Ponzi scheme through
    his separate advisory business.

    Q.6. Please respond to the following hypothetical situation. If
    FINRA examiners are on the premises of a broker-dealer and want
    to examine certain records located there, and the firm CEO asks
    FINRA not to look at the records because they relate to
    investment advisory activities, would FINRA leave that part of
    the premises without determining or verifying the nature of the
    documents? If so, please clarify how examiners can detect when
    such a representation is inaccurate or records on the premises
    actually relate to an improper activity by the broker-dealer,
    such as misappropriating client funds?

    A.6. Pursuant to FINRA Rule 8210, FINRA staff has the right to
    inspect all books, records and accounts of a regulated broker-
    dealer firm as part of an examination. If a regulated firm also
    engages in investment advisory business, the FINRA staff would
    generally not examine that business line further--unless we
    were aware of red flags that the firm was misrepresenting it to
    be part of the broker-dealer--as FINRA has no jurisdiction to
    examine or enforce the Investment Advisers Act or the rules
    thereunder. FINRA staff would determine whether a denial of
    access was with or without merit. In this regard, a firm that
    denied access would be required to show that the documents
    related to the investment advisory activity rather than the
    brokerage business. In any event, should FINRA's examiners
    become aware of potential misconduct by the investment adviser
    through the course of our examination, FINRA would promptly
    refer that matter to the SEC or state regulator, as
    appropriate.

    Q.7. If the NASD in 2005 or earlier had received a credible
    allegation that the owner of a broker-dealer was running a
    Ponzi scheme from the firm premises, would the NASD have had
    the legal authority to examine the broker-dealer premises to
    determine whether it was a channel for a Ponzi scheme?

    A.7. If FINRA received an allegation that the owner of a
    broker-dealer was running a Ponzi scheme from the firm's
    premises, FINRA would promptly and vigorously investigate the
    allegation and pursue the investigation to the limits of its
    jurisdiction. If the owner was running a Ponzi scheme through a
    separate investment advisory business, FINRA would promptly
    refer the matter to the SEC or appropriate state regulator.

    Q.8. We understand that SIPC provides insurance coverage for
    customers of broker-dealers but not of investment advisers. The
    SIPC has determined that some Madoff fraud victims were broker-
    dealer customers for purposes of insurance under the Securities
    Investor Protection Act. You indicated that FINRA and its
    predecessor did not examine the activity that constituted the
    Madoff Ponzi scheme because it was deemed to be an investment
    advisory activity, which would seem to mean that fraud victims
    were investment advisory customers. If this is correct, please
    explain why the same fraud victims were treated by SIPC as
    Madoff broker-dealer customers and by FINRA and its predecessor
    as investment advisory and not broker-dealer customers.

    A.8. As we testified, our exams showed no customer accounts of
    the broker-dealer. While FINRA is not privy to SIPC's legal
    analysis, it appears as though Madoff's money management
    customers were led to believe that they were customers of a
    broker-dealer, irrespective of the fact that there was no
    record of them being customers of the registered broker-dealer.

    Q.9. Mr. Harbeck testified that ``FINRA and the SEC presented
    SIPC with evidence that, at the very least, the Madoff
    brokerage firm owed customers $600,000,000 worth of stock that
    it did not have on hand. That was the factual predicate for the
    exercise of SIPC's jurisdiction.'' Do you agree with this
    representation? If so, please identify the FINRA unit that
    presented this evidence to SIPC and provide the text of this
    communication to SIPC as well as the analysis that formed the
    basis of the conclusion. Please also explain why FINRA told
    SIPC that the brokerage firm owed customers stock that it did
    not have when FINRA has said that the transactions occurred
    within an investment advisor, which it lacked authority to
    examine, and not in the broker-dealer.

    A.9. At the request of the SEC and SIPC, FINRA provided
    approximately 5 examiners from its Member Regulation Department
    to assist the SEC's New York office in reviewing records during
    the first 3 weeks after the fraud came to light, including
    records that had not been made available during our prior
    examinations of the broker-dealer business. The information
    gleaned in the review process was provided to the SEC, and may
    have been used to arrive at the $600,000,000 figure.
                                    ------

            RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY
                       FROM STEPHEN I. LUPARELLO

    Q.1. Former SEC Chairman Cox directed the SEC's Inspector
    General to conduct a review of the SEC's failure to detect and
    stop the Madoff fraud. Is FINRA considering initiating a
    similar internal investigation into its oversight of the Madoff
    firm?

    A.1. FINRA's Board of Governors is currently conducting a
    review of FINRA's examination program as it relates to the
    detection of fraud, specifically Ponzi schemes, including that
    operated by Madoff. However, FINRA's internal review differs
    significantly from the SEC Inspector General's investigation in
    that FINRA, unlike the SEC, only had jurisdiction over Madoffs
    broker-dealer activity, and not the investment advisory
    business where the fraud took place. The special review
    committee is chaired by former U.S. Comptroller General Charles
    A. Bowsher.

    Q.2. FINRA, and before it, the NASD, was the self-regulatory
    organization responsible for overseeing the brokerage
    operations of the Madoff firm and, as part of that oversight,
    conducted examinations of the Madoff firm.
        Is it your position that FINRA examiners could not have
    asked any questions about the connections between Mr. Madoff's
    money management activities and the firm's brokerage operations
    that were reported in the press? Does it make a difference that
    Mr. Madoff himself considered his money management activities
    to fall within the brokerage business?

    A.2. If FINRA had been aware of red flags at the time of its
    examinations that Madoff was misrepresenting his money
    management business to customers and leading them to believe
    they were customers of the broker-dealer, we could have pursued
    information related to those concerns to the extent of our
    authority. Unfortunately, Federal law deprives FINRA of
    jurisdiction to enforce the principal statute that applies to
    the advisory business of a broker-dealer. Section 15A of the
    Securities Exchange Act of 1934 authorizes FINRA to enforce
    compliance with the Exchange Act, FINRA rules, and the rules of
    the Municipal Securities Rulemaking Board. FINRA lacks
    jurisdiction to examine for or to enforce compliance with the
    Investment Advisers Act of 1940 and the SEC rules under that
    Act, and we lack the authority to adopt our own rules under the
    Act. This is true even when the advisory business occurs in the
    same legal entity as the broker-dealer.
        While FINRA examiners at times see investment advisory
    customer accounts reflected on the books and records of a
    dually registered broker-dealer, this was not the case with the
    Madoff firm. Madoff's broker-dealer was a wholesale market
    maker and Madoff did not record any of his investment advisory
    business on the books and records of the broker-dealer. We were
    unaware at the time of our examinations that Mr. Madoff
    considered his money management activities as part of the
    broker-dealer. All books and records of the broker-dealer
    represented a contrary view.

    Q.3. Other fraudsters may feel emboldened by FINRA's public
    statements that it is not authorized to hold fraudsters like
    Mr. Madoff accountable.
        What steps did FINRA take after learning of the Madoff
    fraud to ensure that other large broker-dealers are not
    similarly defrauding customers or do you believe that, under
    your current statutory authority, you cannot take any
    additional steps to prevent and detect such frauds?

    A.3. Since learning of Mr. Madoff's arrest, FINRA has
    undertaken several initiatives to gather information and
    determine ways to enhance the ability of our regulatory
    programs to identify fraud within our jurisdiction. Those
    initiatives include:

          LConducting reviews of custody issues in dually
    registered broker-dealer/investment advisers and the role of
    broker-dealers as feeders to money managers;

          LDeveloping enhancements to our examination
    programs and procedures for the purpose of better detecting
    fraud during routine examinations;

          LInitiating a FINRA Board committee review of
    FINRA's examination programs with regard to fraud detection;

          LDeveloping training programs aimed at fraud
    detection;

          LReviewing our rules to identify potential
    changes that could assist us in detecting misconduct that could
    be indicative of fraud;

          LParticipating in discussions with other
    regulators about ways to improve fraud detection; and

          LEstablishing FINRA's Office of the Whistleblower
    to expedite the review of high-risk tips by FINRA senior staff
    and ensure a rapid response for tips believed to have merit.
                                    ------

            RESPONSE TO WRITTEN QUESTIONS OF SENATOR JOHNSON
                       FROM STEPHEN I. LUPARELLO

    Q.1. The Madoff Ponzi scheme is one of the largest financial
    frauds in U.S. history. From your point of view, how did the
    Madoff Ponzi Scheme fall through the cracks of the U.S.
    regulatory system?

    A.1. The fragmented system of financial regulation prevents
    FINRA from providing an additional component of protection for
    investment advisory customers--whether or not those services
    are provided within the same legal entity as the broker-dealer.
    We have long expressed our concerns regarding a firm's ability
    to avoid our jurisdiction by engaging in abusive practices
    through an advisory business. This case, in particular,
    highlights what can happen when a regulator like FINRA is only
    allowed jurisdiction with respect to one side of the business.
    There is little doubt that Madoff and others have cynically
    designed their schemes to fit between the jurisdictional cracks
    to decrease the likelihood of detection.

    Q.2. Are there any new authorities that FINRA could use to
    prevent this type of fraud from happening again?

    A.2. In our view, it is of paramount importance that investors
    are given consistent protections regardless of product or the
    registration of their financial services professional. We think
    that providing investment adviser customers with the same level
    of oversight that broker-dealer customers receive is an
    important part of achieving that consistency. FINRA believes
    the regulatory regime for investment advisers should be
    expanded to include an additional component of oversight by an
    independent regulatory organization, similar to that which
    exists for broker-dealers. We believe that regular and frequent
    exams are a vital component of effective oversight of financial
    professionals, and that the absence of FINRA-type oversight of
    the investment adviser industry leaves investors without that
    critical component of protection.

    Q.3. Bernie Madoff held many advisory positions with NASD and
    its affiliates during his career. Could he have used his
    influence on these boards and committees to influence actions
    (or lack thereof) by NASD (now FINRA) regarding his company or
    influence regulations affecting his company?

    A.3. FINRA, like other regulators, seeks out the expertise of
    participants in the securities markets. This communication
    allows us to be more effective regulators. We are not bound in
    any way by the views of these market participants. FINRA's
    oversight of the Madoff broker-dealer was not affected by the
    fact that the Madoffs were known to some in our organization.
    Had we known evidence of this fraud, we would have vigorously
    investigated the firm. If our investigation indicated that
    fraud existed in the advisory operations, we would have
    promptly referred the matter to the SEC, which regulated the
    advisory operations. FINRA received and investigated 19
    complaints against the Madoff broker-dealer since 1999.
        FINRA consistently has demonstrated that it is willing to
    discipline a firm for wrongdoing, regardless of how well-known,
    well-respected or active it is. FINRA has taken action against
    the firms of sitting or former board members on several
    occasions. In fact, in one case that bears resemblance to the
    Madoff situation, FINRA's predecessor organization, NASD,
    sanctioned a former Board member who was CEO of a major market
    making firm, and two others associated with his firm, for
    supervisory failures and improper sales practices.
        On April 17, 2007, an NASD hearing panel found that Kenneth
    Pasternak, former CEO of Knight Securities, L.P. (now known as
    Knight Equity Markets, L.P.), and John Leighton, former head of
    the firm's Institutional Sales Desk, committed supervisory
    violations in connection with fraudulent sales to institutional
    customers. The hearing panel imposed a 2-year suspension in all
    supervisory capacities and a $100,000 fine upon Kenneth
    Pasternak, and a bar in all supervisory capacities and a
    $100,000 fine upon John Leighton.
        In a 2-1 decision, the panel found that Pasternak and
    Leighton failed to adequately supervise the trading of the
    firm's leading institutional sales trader, Joseph Leighton,
    John Leighton's brother. The ruling states that Kenneth
    Pasternak's response to numerous red flags was ``woefully
    inadequate,'' that Kenneth Pasternak and John Leighton ``never
    questioned Joseph Leighton's activities or confirmed he was
    providing his customers with best execution and a fair price,''
    and that the overall supervisory void ``allowed Joseph Leighton
    to take advantage of his customers over a 21-month period by
    filling orders at prices that netted Knight unreasonably high
    profits.''
        In April 2005, Joseph Leighton agreed to a bar from the
    securities industry and a payment of more than $4 million to
    settle charges by the SEC and NASD that he made millions of
    dollars from fraudulent trades with Knight's institutional
    customers. In December 2004, Knight paid more than $79 million
    to settle SEC and NASD charges against the firm arising from
    Joseph Leighton's conduct. More than $3.3 million of Joseph
    Leighton's monetary sanction and more than $66 million of the
    firm's monetary sanction was paid into a Fair Fund established
    by the SEC to compensate investors harmed by Joseph Leighton's
    fraud.
                                    ------

            RESPONSE TO WRITTEN QUESTIONS OF SENATOR JOHANNS
                       FROM STEPHEN I. LUPARELLO

    Q.1. What options from the Treasury's Blueprint for Regulatory
    Reform would you implement?

    A.1. Treasury's Blueprint for Regulatory Reform recommends that
    Congress adopt ``statutory changes to harmonize the regulation
    and oversight of broker-dealers and investment advisers
    offering similar services to retail investors.'' It further
    recommends that investment advisers be subject to a self-
    regulatory regime similar to that of broker-dealers.
    (Blueprint, pp. 118-126.) FINRA fully supports implementation
    of these recommendations.
        As the SEC has noted, the population of registered
    investment advisers has increased by more than 30 percent since
    2005. Investment advisers now number 11,300--more than twice
    the number of broker-dealers. While the SEC has attempted to
    use risk assessment to focus its resources on the areas of
    greatest risk, the fact remains that the number and frequency
    of exams relative to the population of investment advisers has
    dwindled. Consider the contrast: FINRA oversees nearly 4,900
    broker-dealer firms and conducts approximately 2,500 regular
    exams each year. The SEC oversees more than 11,000 investment
    advisers, but in 2007 conducted fewer than 1,500 exams of those
    firms. The SEC has said recently that in some cases, a decade
    could pass without an examination of an investment adviser
    firm.
        We believe that regular and frequent exams are a vital
    component of effective oversight of financial professionals,
    and that the absence of FINRA-type oversight of the investment
    adviser industry leaves investors without that critical
    component of protection. In our view, it simply makes no sense
    to deprive investment adviser customers of the same level of
    oversight that broker-dealer customers receive.
                                    ------

             RESPONSE TO WRITTEN QUESTIONS OF SENATOR DODD
                        FROM STEPHEN P. HARBECK

    Q.1. SIPC Chairman Armando Bucelo at his Banking Committee
    confirmation hearing on May 16, 2006, testified that ``Our
    Board is committed to maintaining adequate resources to fulfill
    SIPC's statutory mission. SIPC's fund now stands at well over
    $1.3 billion, a historic high. As Chairman, I have initiated a
    Board-level Investment Committee to make sure that SIPC
    continues the prudent management of the fund.
        Following the Madoff situation, has the Board discussed or
    reviewed how to maintain adequate resources in its fund? Will
    it consider measures such as raising the fees on stock
    brokerage firms from its current level of $150 per year or
    charging different amounts of fees based on the amount of
    assets held by a firm or the risk posed by the firm?

    A.1. As noted above in my response to Senator Shelby, because
    it is possible that the SIPC Fund created by SIPA may fall
    below $1 billion in the near future, SIPC's Board, pursuant to
    the Corporation's By-laws, has reinstituted assessments on SIPC
    member brokerage firms at the rate of \1/4\ of 1 percent of
    each member's net operating revenues. That assessment begins on
    April 1, 2009. The assessment based upon net operating revenue
    replaces a flat fee of $150 which had been charged to each
    member annually, from 1996 through 2008. The Board has not
    considered charging members based upon perceived risk.

    Q.2. Please describe the basis on which SIPC determined that
    some Madoff fraud victims are eligible to receive SIPC
    insurance benefits.

    A.2. The persons protected under SIPA are ``customers.'' That
    is a defined term in the statute. It includes persons who
    deposited money with a SIPC member brokerage firm for the
    purpose of purchasing securities. Generally, these would be
    investors who directly dealt with the brokerage firm, and who
    had the right to exercise control over an account.
                                    ------

            RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY
                        FROM STEPHEN P. HARBECK

    Q.1. Mr. Harbeck, I understand that SIPC has approximately
    $1.7billion in assets, another $1 billion available through a
    Treasury line of credit, and an additional commercial line of
    credit.
        Do you expect these funding sources to be depleted? If so,
    what steps do you plan to take to address that possibility?

    A.1. I do not expect that the assets available to SIPC will be
    depleted as a result of SIPC's financial obligations to
    customers in the Madoff case. Nevertheless, because it is
    possible that the SIPC Fund created by the Securities Investor
    Protection Act (``SIPA'') may fall below $1 billion in the near
    future, SIPC's Board, pursuant to the Corporation's Bylaws, has
    reinstituted assessments on SIPC member brokerage firms at the
    rate of \1/4\ of 1 percent of each member's net operating
    revenues. That assessment begins on April, 2009. The assessment
    based upon net operating revenue replaces a flat fee of $150
    which had been charged to each member annually, from 1996
    through 2008.
                                    ------

            RESPONSE TO WRITTEN QUESTIONS OF SENATOR JOHNSON
                        FROM STEPHEN P. HARBECK

    Q.1. The Madoff Ponzi scheme is one of the largest financial
    frauds in U.S. history. From your point of view, how did the
    Madoff Ponzi Scheme fall through the cracks of the U.S.
    regulatory system?

    A.1. Certainly the regulatory regime should have identified the
    Madoff fraud long ago. But I simply cannot explain why Madoff
    was not stopped at an earlier point. I expect that the SEC
    Inspector General's investigatory report relating to Madoff
    will provide some insight. SIPC's experience is that the
    present regulatory regime does in fact identify the theft of
    customer property at a relatively early stage.
        In SIPC's 39-year history, there have been 322 brokerage
    firm failures requiring SIPC to intervene. In 294 such cases,
    the cost to SIPC of satisfying customer claims and paying
    administrative expenses was less than $5 million in each such
    case. Indeed, in 235 of those cases, the cost to SIPC was less
    than $1 million in each such case. I ascribe two reasons to
    this: First, SIPC and trustees appointed under SIPA are
    aggressive in seeking out wrongdoers and holding them
    financially responsible, thereby potentially deterring such
    future crimes. However, a second reason is there as well: the
    regulators usually locate, identify, and halt the theft at a
    relatively early stage. Compared with the foregoing historical
    statistics, the Madoff situation has no precedent.

    Q.2. Can you provide details on how the claims process will
    work for those investors affected by the Madoff Ponzi Scheme?
    How will SIPC conduct its liquidations of the Madoff firm? Does
    SIPC have the needed tools and resources to conduct this claims
    process?

    A.2. In some instances, such as the collapse of Lehman
    Brothers, Inc. (``LB!''), it is possible to transfer customer
    accounts in bulk to a solvent brokerage firm so that customers
    can gain prompt access to the assets in their accounts. This
    was not possible in the Madoff case as it now appears that all
    assets were stolen. Furthermore, the pervasiveness of the fraud
    in Madoff has made it necessary to reconstruct and scrutinize
    every account as to which a claim is filed.
        The forensic accounting required to properly assess claims
    in the Madoff case is detailed and time consuming. The trustee
    responsible for this process is working from non-Computerized
    records, under the control of the United States Attorney, at a
    crime scene. The fraud was under way for decades.
        In addition to publishing notice of the liquidation
    proceeding, the trustee mailed claim forms to all known
    customers and made the claim form available on the Internet.
    The claim forms are being returned to the trustee. The
    documentation submitted by the claimants is compared with the
    available records of the defunct firm. The claimants are
    analyzed on a ``net claim'' basis: Each claim will be evaluated
    on a ``money in less money removed'' from the scheme. Payment
    of ``easy'' claims has begun. However, the process is far more
    time consuming than in any other major case, where the debtor
    brokerage firm's records bear a relation to the reality of what
    the brokerage firm has in its possession. SIPC has begun to
    advance funds to the trustee to pay approved claims.
        I believe SIPC and the trustee have the tools and resources
    to conduct the liquidation proceeding. Moreover, the
    liquidation of LBI under SIPA, which began in September, 2008,
    is proceeding well. SIPC's ability to deal simultaneously with
    the LBI and Madoff failures demonstrates that SIPC's essential
    structure can withstand a very rigorous test. Any future
    restructuring of the regulatory system to deal with the failure
    of a large financial institution should recognize the inherent
    strength of the SIPA program.

    Q.3. Do you have any suggestions for needed changes to SIPC in
    light of the current situation?

    A.3. SIPC's Board will review the adequacy of the minimum
    target balance of the SIPC Fund, which is currently $ 1
    billion, and the adequacy of SIPC's line of credit with the
    United States Treasury, which is $1 billion.
        Litigation arising from the case may give rise to other
    suggested changes.
                                    ------

            RESPONSE TO WRITTEN QUESTIONS OF SENATOR JOHANNS
                        FROM STEPHEN P. HARBECK

    Q.1. When Mr. Madoff was arrested, he disclosed to authorities
    that his Ponzi scheme lost an estimated $50 billion. Is there
    any way to obtain an accurate figure?

    A.1. Mr. Madoff's reported estimate, and a subsequent higher
    estimate used in his criminal plea allocution, includes the
    fictitious profits he reported to his victims. The trustee will
    be reconstructing the actual amounts entrusted to the brokerage
    firm, and amounts withdrawn by each investor, from the Debtor's
    records, bank records, and documents submitted by the
    claimants.

    Q.2. How are you going to be able to distinguish between actual
    and phantom profits when the records are unreliable and in
    disarray at best and non-existent at worst?

    A.2. The trustee has noted that since there were no securities
    transactions done on behalf of the brokerage firm's clients for
    at least the last 13 years of the Ponzi Scheme, there were in
    fact no real profits. All profits were fictional. As noted
    above, the sources for verifying the money deposited with the
    firm will be the Debtor's records, bank records, and documents
    submitted by the claimants.
                     PREPARED STATEMENT OF HARRY MARKOPOLOS
             Chartered Financial Analyst, Certified Fraud Examiner
        Good Morning. Thank you for the opportunity to testify today before
    this Committee on the subject of the ``Madoff Ponzi Scheme.'' I will
    refer to Mr. Bernard Madoff, whose alleged fraud casts a stark light
    over the failures of the regulatory structures, procedures and
    institutions in place to prevent such crimes and is the subject of this
    hearing, as Madoff, BM, and Mr. Madoff interchangeably within my
    testimony.
        You will hear me talk a great deal about over-lawyering at the SEC
    very soon. Let me say I have nothing against lawyers. In fact, I have
    brought two of my own here with me today. On my right, I have Ms.
    Gaytri Kachroo, a brilliant transactional attorney and my long time
    general counsel for all personal and business matters. She is a partner
    at McCarter & English LLP (Boston), heading their international
    corporate practice and also represents investors and funds. On my left,
    counsel Phil Michael, of Troutman Sanders LLP, (NY) is a former deputy
    police commissioner and budget director for New York City, and now
    represents whistleblowers in fraud cases involving harm caused to
    government, and is a great strategist in such cases.
        As early as May 2000, I provided evidence to the SEC's Boston
    Regional Office that should have caused an investigation of Madoff. I
    re-submitted this evidence with additional support several times
    between 2000-2008, a period of 9 years. Yet nothing was done. Because
    nothing was done, I became fearful for the safety of my family until
    the SEC finally acknowledged, after Madoff had been arrested, that it
    had received credible evidence of Madoff's Ponzi Scheme several years
    earlier. There was an abject failure by the regulatory agencies we
    entrust as our watchdog. I hope that my testimony will provide you with
    further insights as to how the process failed and enable you to enact
    appropriate legislation that will prevent this from happening in the
    future. As a result of my experiences, I also have some suggestions
    that I would like to share with the Committee for it to consider as it
    develops its Congressional recommendations.
        I have broken my testimony into two parts:

      1.  Part I will provide an overview of my contacts with the SEC
            between 2000-2008 relating solely to the Madoff case with a
            time line of key events during the investigation. [Timeline
            Chart].

      2.  Part II consists of my recommendations on fixing the SEC so that
            it can become an effective securities regulator for the 21st
            century. [Charts of SEC and NASD/FINRA from 2000-2008].

        I find it difficult to compress my testimony because there were so
    many victims, the damages have been vast, and the scandal has ruined or
    harmed so many of our citizens. I feel that by writing this testimony
    in narrative form, the public will better understand what steps my team
    and I took, the order in which we took them, along with how and why we
    took them. The details will also afford the Committee the information
    necessary to ask the right questions and hopefully aid the Committee in
    ferreting out the truth and in restructuring the SEC which currently is
    non-functional and, as witnessed by the Madoff scandal, is harmful to
    our capital markets and harmful to our nation's reputation as a
    financial leader around the globe. In my testimony, wherever possible I
    have strived to present the mathematical concepts simply and to use
    word explanations instead of formulas.
    Part I--My Contacts With the SEC From 2000-2008
        Just as there is no ``I'' in ``TEAM,'' I had a brave, highly
    trained team that greatly assisted me throughout the 9-year Madoff
    investigation. Let me introduce the key team members to you. Neil
    Chelo, Chartered Financial Analyst (CFA), Financial Risk Manager (FRM)
    checked every formula, math calculation, modeling technique presented
    to the SEC from 2000 to the present. From late 2003 to the present, as
    Director of Research for Benchmark Plus, a Tacoma, WA based $1 billion
    plus fund of funds, Mr. Chelo went out of his way to interview key
    marketing and high level risk managers at several Madoff feeder funds.
    He also obtained Greenwich Sentry audited financial statements for the
    year's ending 2004, 2005, and 2006. Frank Casey, a former U.S. Army
    airborne ranger infantry officer with intelligence gathering
    experience, is the North American President for U.K.-based Fortune
    Asset Management, a $5 billion hedge fund advisory firm. Mr. Casey
    closely tracked the Madoff's feeder funds and collected their marketing
    documents, figured out Madoff's cash situation. He determined that
    Madoff's Ponzi was unraveling in June 2005 and May 2007 and in need of
    additional funds to keep the scheme going, and tabulated Madoff's
    likely assets under management. Institutional Investor's Michael
    Ocrant, a brilliant investigative journalist also made key
    contributions to our efforts to stop Madoff. Mr. Ocrant was the only
    team member to actually meet Mr. Madoff in person and to step inside
    Mr. Madoff's operation at great personal and professional risk to
    himself.
        These three gentlemen were my eyes and ears out in the hedge fund
    world, closely tracking who Madoff was dealing with, acquiring Madoff
    marketing literature and investigating directly with the staff of
    feeder funds into Mr. Madoff's fund to collect additional pieces of the
    puzzle. My army special operations background trained me to build
    intelligence networks, collect reports from field operatives, devise
    lists of additional questions to fill in the blanks, analyze the data,
    and send draft reports for review and error correction before
    submission to the SEC.
        In order to minimize the risk of discovery of our activities and
    the potential threat of harm to me and to my team, I submitted reports
    to the SEC without signing them. My team and I surmised that if Mr.
    Madoff gained knowledge of our activities, he may feel threatened
    enough to seek to stifle us. If Mr. Madoff was already facing life in
    prison, there was little to no downside for him to remove any such
    threat. At various points throughout these 9 years each of us feared
    for our lives. Our analysis lead us to conclude that Mr. Madoff''s fund
    and the secret walls around it posed great danger to those questioning
    and investigating them. We also concluded both the fund and the secrets
    that assisted its growth and development were of unimaginable size and
    complexity. Neither my team nor I had any personal knowledge of Mr.
    Madoff or his psychological make up. As such we had only the
    conclusions of our investigation into his fund to surmise of what he
    may have been capable. We did know, however, that he was one of the
    most powerful men on Wall Street and in a position to easily end our
    careers or worse.
        My first submission to the SEC was coordinated through Ed Manion,
    CFA, a member of the Boston Regional Office with 25 years of industry
    experience. Mr. Manion was a former trader at the Boston Company and a
    portfolio manager at Fidelity serving alongside Peter Lynch. He has
    been with the SEC for 15 years and, in my opinion, was the only person
    in the Boston Regional Office with the proper industry background to
    comprehend fully the size, scope and danger of the Madoff Ponzi scheme.
    Mr. Manion is a Chartered Financial Analyst (CFA) and is highly
    respected in Boston's financial district and is considered the go-to
    person for securities fraud cases in Boston. We would call Ed ``the
    SEC's hit-man,'' because when the SEC brought Ed in, people often ended
    up in jail via SEC criminal referrals to the DOJ. Throughout the past 9
    years, Ed Manion was the only SEC staff member who ever truly
    understood the Madoff scheme and the threat it posed to the public.
    Unfortunately, as I will soon relate, my experiences with other SEC
    officials proved to be a systemic disappointment, and led me to
    conclude that the SEC securities' lawyers if only through their
    investigative ineptitude and financial illiteracy colluded to maintain
    large frauds such as the one to which Madoff later confessed. In brief,
    SEC securities lawyers did not want to hear from a non-lawyer SEC
    staffer like Mr. Manion with 25 years of trading and portfolio
    management experience. As much as Boston's financial community looks up
    to and respects Ed Manion, that's how much the SEC looked down upon and
    ignored Mr. Manion's repeated requests for SEC enforcement action
    against Mr. Madoff.
        Without Mr. Manion's continued encouragement, I would have stopped
    the Madoff investigation after my October 2001 SEC Submission. Every
    time I threatened to quit the investigation, Mr. Manion would tell me I
    had a duty to the public to keep going no matter how badly the odds
    were stacked against us. I believe that the SEC would fire him if he
    were to testify before Congress about his role and that of the SEC
    during the past 9 years; but if the proper protections could be worked
    out in advance to safeguard his career and guarantee him another 3
    years until his government retirement, I recommend that the Committee
    speak with him. I owe him much thanks for his dedication to the effort
    of sharing Mr. Madoff's alleged fraud to the appropriate authorities
    within the SEC.
    Late 1999-2000
        I started the Madoff investigation in late 1999 and early 2000 as a
    result of Frank Casey, Senior Vice-President of Marketing for Rampart
    Investment Management Company, Inc., telling me about the fantastic
    returns of one Bernard Madoff (hereafter referred to as BM). Mr. Casey
    told me that investors he met with in New York considered BM to be the
    premier hedge fund manager because of his steady return streams with
    unusually low volatility. This unusually low volatility was attributed
    to BM having very few negative months, with the largest price decline
    in 1 month a reported minus 0.55 percent, or barely more than half a
    percent. Mr. Casey and one of my employer's partners, Mr. David Fraley,
    asked me to replicate BM's split-strike conversion strategy so that
    Rampart Investment Management Company, Inc. could offer this product
    and compete with BM for clients.
        A split-strike conversion strategy consists of 3 main parts. Part I
    is a basket or grouping of stocks that you purchase. Many managers will
    choose to purchase their stocks in index form such that the stock
    basket is a 100 percent match to the index options they plan on using
    as part of the strategy. Part II consists of the call options that you
    are selling to generate income. Part III consists of the put options
    that you will be buying to protect your stock portfolio from market
    price declines (these cost you money just like auto insurance does).
    Let's simplify even further, there are 3 sources of income from this
    strategy, stock price appreciation (i.e., the stocks go up in price),
    stock dividends which you receive every quarter as the stocks in your
    stock basket pay their quarterly dividends, and the income you receive
    from selling out-of-the-money call options. However, there are also 3
    sources of loss with this strategy. You lose when the stocks in your
    stock basket decline in price and you also lose money when you purchase
    put options to protect your stock basket from market price declines.
    The third source of loss is when the OEX index rises above the strike
    price of your short OEX index calls.
        As you can tell from reading the above, there are lots of moving
    parts in this strategy and it is best left to the experts. I would be
    happy to diagram this strategy out on a white board during testimony in
    an easier to understand form if you'd like. Since BM never actually
    used this strategy it may be a moot point.
        Suffice it to say that the strategy is complex enough, with enough
    moving parts, that even market professionals without derivatives
    experience would have trouble keeping track of all the moving parts and
    understanding them fully. This is probably why BM settled on marketing
    this split-strike strategy to his victims. He knew most wouldn't
    understand it and would be embarrassed to admit their ignorance so he
    would have less questions to answer. And, with Ponzi schemes, you never
    ever want the victims to understand how the sausage is made, nor do you
    want them asking too many questions.
        Mr. Casey obtained a one-page marketing document from the Broyhill
    All-Weather Fund, L.P. (May 2000 SEC Submission) which described the
    strategy, listed its monthly returns from 1993 through March 2000, and
    provided the background of the fund and its manager. I was told that
    ``Manager B'' was BM. The strategy and performance numbers foot with
    other information we collected in later years that all pointed to BM. I
    studied the Broyhill document and within 5 minutes suspected it was a
    fraud since the strategy as described was not capable of beating the
    typical percent return on U.S. Treasury Bills less fees and expenses.
    Once fees and expenses were included, the Split-Strike Conversion
    Strategy as depicted in the marketing document would have had trouble
    beating a 0 percent return.
        The reason I was immediately suspicious was that I had run a
    slightly similar, but actually functional, product that my firm called
    our Protected Equity Program (PEP). PEP delivered approximately two-
    thirds of the market's return with only one-third of the risk. To earn
    those types of returns we had to make a lot more good trading decisions
    than bad ones and sometimes our returns would greatly lag the market
    but then catch up later. The important point to remember is that even
    as good as this product was, it often lagged the market whereas BM's
    was always doing well under all market conditions which is, of course,
    impossible. However, our PEP strategy was vastly superior to BM's in
    that we owned the actual stock in index form with perfect replication
    and did not have the single stock risk included in BM's strategy. Here
    my expertise with the product helped me to quickly determine BM
    couldn't have been using a split-strike strategy as he described to
    earn the kind of always positive return stream that he claimed.
        Let me explain this critical difference, BM said that he purchased
    a basket of 30-35 stocks that closely replicated the OEX Standard &
    Poor's 100 stock index. But, of course, if you are using only 30-35
    stocks to replicate a 100 stock index you have to assume a much higher
    degree of risk, by taking larger position weights than are in the
    underlying 100 stock index. You don't get compensated with extra
    returns by taking this additional risk, and you should experience a
    performance penalty when your 30-35 stock basket under-performs the 100
    stock index. Let's assume that BM owned 33 stocks and each stock was
    3.03 percent of his portfolio totaling 100 percent of his stock
    portfolio (33 stocks x 3.03 percent invested in each stock = 100
    percent of his stock portfolio). Now let's say that one of those stocks
    during the 7\1/4\ year time period from 1993 to March 2000 put in an
    Enron, WorldCom or Global Crossing type of performance and went to
    zero. BM would be down 3.03 percent for that month [\1/33\ = 3.03
    percent]. The odds of a 30-35 stock portfolio not experiencing heavy
    single stock losses over a 7\1/4\ time period ranged between slim and
    none.
        Furthermore, BM's strategy required all or substantially all of the
    stocks in his portfolio to rise during the month, something which
    wasn't sustainable for 7\1/4\ years straight without interruption. If
    BM had said he owned the OEX Standard & Poor's 100 stock index in its
    entirety, he would have passed my initial 5 minute sniff test but,
    fortunately for us, he was not a sophisticated enough fraudster to get
    his portfolio construction math correct and I suspected fraud
    immediately.
        I then spent a couple of hours inputting BM's monthly returns into
    an excel spreadsheet and modeling against the S&P 500 Stock Index's
    monthly returns. BM made a key error in how he presented his
    performance because he kept comparing himself to the S&P 500 stock
    index when his strategy purported to replicate the S&P 100 stock index.
    That signaled a startling lack of sophistication on his part since
    there was a noticeably large difference in price returns between the
    two indices. This lack of sophistication on BM's part was a recurring
    theme during the 9-year investigation. BM's math never made sense, his
    performance charts were clearly deceiving, and his return stream never
    resembled any known financial instrument or strategy. As will be made
    clear in the rest of this story, to believe in BM was to believe in the
    impossible.
        BM said he was earning 82 percent of the S&P 500's return with less
    than 22 percent of the risk. More alarmingly, his returns only had a 6
    percent correlation to the S&P 500 Stock Index when I would have
    expected to see something like a 50 percent correlation and wouldn't
    have questioned any correlation figures between 30 percent-60 percent.
    A 6 percent correlation was so low as to signal ``FRAUD'' in flashing
    red letters. The easiest explanation for why a 6 percent correlation is
    so low as to be wholly unbelievable is that if your returns are coming
    from the S&P 100 stock index, you had better at least partially
    resemble that stock index's performance. Having only a 6 percent
    resemblance in a situation where, due to the price limiting performance
    of the put and call options, one would expect a 30-60 percent
    correlation, was outside the bounds of rationality. The biggest, most
    glaring tip-off that this had to be a fraud was that BM only reported 3
    down months out of 87 months whereas the S&P 500 was down 28 months
    during that time period. No money manager is only down 3.4 percent of
    the time. That would be equivalent to a major league baseball player
    batting .966 and no one suspecting that this player was cheating, and
    therefore fictional.
        A quick glance at Exhibit 1 of my May 2000 SEC Submission next to
    the letter ``C'' shows the ``Cumulative Performance of Manager B''
    where Manager B is BM. Note how the line goes up at nearly a perfectly
    rising 45 degree angle with no noticeable downturns whatsoever from
    1993 through March 2000. Now ask yourself, how can any manager's
    performance be that perfectly smooth and in only the up direction when
    markets go down as well as up? Then ask yourself what the managers of
    these feeder funds were thinking as they performed due diligence or
    even if they were thinking while they performed due diligence. Yes, BM
    was a ``no-brainer'' investment but only in the sense that you had to
    have no brains whatsoever to invest into such an unbelievable
    performance record that bears no resemblance to any other investment
    managers' track record throughout recorded human history.
        I then assembled OEX Standard & Poor's 100 Index Option open
    interest and volume statistics from the Chicago Board Options Exchange
    (CBOE) as reported in the Wall Street Journal's Money & Investing
    Section. There were not enough OEX index options in existence for BM to
    be managing the Split-Strike Conversion Strategy he purported to be
    running. This test took me less than 30 minutes to complete. At this
    point, I was incredulous as to how any fund would willingly invest in
    such an obvious fraud.
        In less than 4 hours I knew I had proved mathematically that BM was
    a fraud and so I then furthered my analysis and developed two alternate
    fraud hypotheses to explain what might be happening. Fraud hypothesis 1
    was that BM was simply a Ponzi scheme and the returns were fictional.
    Fraud hypothesis 2 was that the returns were real but they were being
    illegally generated by front-running Madoff Securities broker-dealer
    order flow and the split-strike conversion strategy was a mere
    ``front'' or ``cover.'' Either way, BM was committing a fraud and
    should go to prison.
        I ran some option pricing model calculations to determine how much
    money BM could earn by illegally front-running his stock order flow
    through Madoff Securities (page 4, 2000 SEC Submission) and determined
    that he could earn 3-12 cents per share for time periods of 1-15
    minutes if he was front-running order flow. That meant returns of 30
    percent-60 percent, given the size of the assets under management we
    believed he had; front-running seemed like a likely possibility in 2000
    and 2001. To double check my modeling techniques and calculations, I
    had my assistant, derivatives portfolio manager Neil Chelo, CFA and
    Daniel DiBartolomeo, one of the world's most accomplished financial
    mathematicians, review my work. Both gentlemen concluded that either
    Hypothesis I or II was, in fact, correct and that BM was a fraudster.
    However, in 2000 and 2001 we did not have enough information on hand to
    determine which of the two fraud hypotheses was correct. During later
    time periods as Mr. Casey, Mr. Chelo, and Mr. Ocrant kept tabulating
    higher and higher assets under management totals, the front-running
    fraud hypothesis became unworkable because BM's illegal trading
    activity could not have gone undetected by his firm's brokerage
    customers.
        I spent hours writing my eight-page 2000 SEC Submission and
    arranged with the Boston SEC's Ed Manion to meet with the Boston
    Regional Director of Enforcement (DOE), Attorney Grant Ward in May
    2000. Given Mr. Ward's position and my understanding of his mandate, I
    was shocked by his financial illiteracy and inability to understand any
    of the concepts presented in that submission. Mr. Manion and I compared
    notes after the meeting and neither of us believed that the Boston
    Region's DOE had understood any of the information presented. Little
    did I know that over the next several years I would come to understand
    that financial illiteracy among the SEC's securities lawyers was pretty
    much universal with few exceptions.
    2001
        In 2001, the Boston SEC's Ed Manion and I spoke often of the lack
    of follow up to my May 2000 SEC Submission. Immediately after 9-11, Mr.
    Manion called me, convinced that my work had somehow fallen through the
    cracks and never made it to the responsible parties in the New York
    Regional Office. In October 2001 or thereabouts, I resubmitted my
    original 8-page report, wrote an additional 3 pages and included 2
    pages entitled ``Madoff Investment Process Explained.'' The New York
    Regional Office never contacted me after either my May 2000 or October
    2001 SEC Submissions. To my mind, the mathematical analysis provided
    compelling proof that an investigation was required. Yet, none was
    conducted to my knowledge.
    2002
        In 2002, I continued my research into BM. I took a key trip to
    Europe with Access International Advisors Limited to market a
    Statistical Options Arbitrage Strategy that I had developed. During
    that trip I met with 14 French and Swiss private client banks and hedge
    fund of funds (FOF's). All bragged about how BM had closed his hedge
    fund to new investors but ``they had special access to Madoff and he'd
    accept new money from them.'' It was during this trip that I knew that
    BM was most likely a Ponzi Scheme and that he was not front-running. If
    BM was really front-running he would not want new money because
    additional money to invest would bring down his returns and also raise
    the odds of getting caught. My European trip allowed me to lower the
    odds that the front-running fraud hypothesis was true and focus more
    effort on my Ponzi scheme fraud hypothesis, which simplified the
    investigation. BM's masterful use of a ``hook'' by playing hard to get
    and his false lure of exclusivity were symptomatic of a Ponzi scheme.
    The dead give-away was BM's need for new money, another trait of Ponzi
    schemes, because Ponzi managers always need ever increasing amounts of
    new money flowing in the door to pay off old investors. I also came to
    realize that several European royal families were invested with BM. I
    met several counts and princes during my trip and it seemed they all
    were invested with BM or were marketing BM's strategies to noble
    families throughout Europe. BM had a marketing strategy that appeared
    to be based on false trust, not analysis.
    2003-2004
        My records for 2003 and 2004 are non-existent due to my leaving my
    former employer at the end of August 2004 and not taking a copy of my
    e-mail archives with me. I am sure I worked on the case, but I don't
    have any supporting documentation at this time. I have a non-
    functioning hard drive from my old home PC which I am sending out to
    see if any 1999-2004 home e-mails can be recovered that relate to this
    case. Unfortunately, my former employer was always on the leading edge
    of technology, rapidly acquiring and putting the newest, high-speed
    servers into service. The firm was a derivatives' management company,
    requiring machines that could run millions of calculations quickly.
    Therefore it is unlikely old e-mail records have been maintained before
    the mandatory 7-year e-mail retention period was enacted into law, but
    it can be asked for these records.
    2005
        In June 2005 (see page 11 of my November 7, 2005, SEC Submission)
    Frank Casey sent me an e-mail where I substituted ``ABCDEFGH'' for the
    name of the individual, showing that BM was attempting to borrow funds
    from a major European bank. This was our first inkling that BM was
    struggling to keep his Ponzi scheme afloat.
        Fortunately, I have plenty of e-mails from the last quarter of 2005
    and it was a very busy quarter for the Madoff investigation. In late
    October, most likely on October 25, 2005, I met with Mike Garrity,
    Branch Chief, of the SEC's Boston Regional Office. Mr. Ed Manion, CFA
    felt that Mr. Garrity was a conscientious, hard-working Branch Chief
    who would give me a fair and impartial hearing that might be what was
    needed to get this case re-submitted to the SEC's New York Office. Ed
    Manion scheduled an appointment for me with Mr. Garrity and I thought
    that perhaps the third time submitting this case would turn out to be
    the charm.
        I met with Mr. Garrity for several hours and found him to be very
    patient and eager to master the details of the case. Unlike my
    disastrous May 2000 meeting with that office's Director of Enforcement,
    Attorney Grant Ward, I found Mr. Garrity to be interested and fully
    engaged in my telling of the scheme. Some of the derivatives math was
    difficult for him to understand, so I went to the white board and
    diagrammed out Madoff's purported strategy and its obvious failings
    until he understood it. A few of the more difficult concepts required
    repeated trips up to the white board but at the end of our meeting, it
    was clear that Mr. Garrity understood the scheme, it's size, and it's
    threat to the capital markets.
        Mr. Garrity promised to follow up and he was true to his word.
    About a week or so later, Mike Garrity called me back telling me that
    he did some investigating and found some irregularities but that he
    couldn't tell me what they were, only that he was in contact with the
    New York Regional Office and wanted to put me in touch with a Branch
    Chief there for follow on investigation. He also said that I would have
    to identify myself as ``the Boston Whistleblower'' when I called
    because he wanted to protect my identity to the extent possible.
        Perhaps the most impressive thing about Mr. Garrity was his
    willingness to think outside of the box. He was able to imagine the
    impossibility of Madoff's returns and understand that BM's returns were
    too good to be true and this obviously concerned him. He told me that
    if BM were located within the New England region, he would have had an
    inspection team inside BM's operation the very next day.
        On Friday, November 4, 2005, Mr. Garrity sent me the names and
    contact information for Doria Bachenheimer and Meaghan Cheung. (Branch
    Chief). I called the latter and revealed my identity, and e-mailed her
    a revised 21-page report. I then e-mailed my thanks to Mike Garrity and
    informed him that I would be working the case with New York. On Monday,
    November 7, 2007, I sent Ms. Cheung the report which the Wall Street
    Journal has now posted online less everything past Attachment 1. This
    report further detailed BM's fraud.
        My experience with New York Branch Chief Meaghan Cheung was akin to
    my previous discussions with Attorney Grant Ward, and demonstrated to
    me an SEC failure in providing appropriate personnel to understand the
    case I was submitting. Ms. Cheung also never grasped any of the
    concepts in my report, nor was she ambitious enough or courteous enough
    to ask questions of me. Her arrogance was highly unprofessional given
    my understanding of her responsibility and mandate. When I questioned
    whether she understood the proofs, she dismissed me by telling me that
    she handled the multi-billion dollar Adelphia case. I then replied that
    Adelphia was merely a few billion dollar accounting fraud and that
    Madoff was a much more complex derivatives fraud that was easily
    several times the size of the Adelphia fraud. Ms. Cheung never
    expressed even the slightest interest in asking me questions; she told
    me that she had my report and that if they needed more information they
    would call me. She never initiated a call to me. I did follow-up. I was
    the one always calling her. She was unresponsive and mostly
    uncommunicative when I did call, demonstrating a lack of interest and
    acumen for this area of investigation.
        In December 2005, I decided that the third time was not a charm and
    that the SEC was, once again, not going to pursue the Madoff case. I
    also decided that if I was going to continue my investigation and
    attempt to involve the authorities, I should ensure my personal safety
    in case of possible efforts to silence me and end my investigation. I
    decided that I should go to the press. I went to Pat Burns,
    communications director at Taxpayers Against Fraud, an educational
    group that supports the False Claims Act, for advice and assistance on
    how to have my Madoff case materials investigated by the press. Mr.
    Burns put me in contact with John Wilke, senior investigative reporter
    for the Wall Street Journal's Washington Bureau. Mr. Wilke and I would
    become friends over the course of the next 3 years. Unfortunately, as
    eager as Mr. Wilke was to investigate the Madoff story, it appeared
    that the Wall Street Journal's editors never gave their approval for
    him to start investigating. As you will see from my extensive e-mail
    correspondence with him over the next several months, there were
    several points in time when he was getting ready to book air travel to
    start the story and then would get called off at the last minute. I
    never determined if the senior editors at the Wall Street Journal
    failed to authorize this investigation.
    2006
        On March 3, 2006, I had a 5-minute call with NY Branch Chief Cheung
    (Conversation memo e-mail to Frank Casey and Neil Chelo, Friday, March
    3, 2006, 3:23 p.m.). When I mentioned that my derivatives expertise
    would be needed to break the case open, she dismissed me by saying that
    the SEC's Washington Headquarters had Ph.D.'s in an economics analysis
    unit with derivatives expertise. When I pointed out that the SEC likely
    didn't have any Ph.D.'s on staff with derivatives trading experience
    who truly understood how these financial instruments worked because a
    true derivatives expert couldn't afford to work for SEC pay, she
    ignored me. She was in ``listen only mode.'' A trained investigator
    would have kept me on the phone for as long as possible, asking me as
    many open-ended questions as possible in order to advance their
    investigation. But as is typical for the SEC, too many of the staff
    lawyers lack any financial industry experience or training in how to
    conduct investigations. In my experience, once a case is turned into
    the SEC, the SEC claims ownership of it and will no longer involve the
    investigator. The SEC never called me. I had to call the SEC repeatedly
    in order to try to move the case forward and with little to no
    response. This may go a long way in explaining the SEC's long and
    consistent history of regulatory failures.
        In the 2006 case materials you will see long strings of e-mails
    between myself, Neil Chelo and Frank Casey as we pushed the
    investigation forward because we felt that the SEC was not doing any
    work to advance the case. At the time, the SEC's reputation was
    slipping in the press, due to reports of its failure to investigate the
    Pequot insider-trading investigation. Additionally, the Integral
    Partners derivatives' Ponzi scheme from 5 years earlier was just
    beginning to go to trial. If the SEC could not successfully investigate
    and bring to justice a $50 million derivatives' Ponzi scheme, how would
    it handle a $30 billion derivatives Ponzi scheme? My team and I were on
    our own. We continued to vigorously pursue the investigation.
        Perhaps the biggest breakthrough during the year was my September
    29, 2006, telephone call to Matt Moran, Esq., Vice President of
    Marketing, for the Chicago Board Options Exchange. Mr. Moran confirmed
    to me that several OEX Standard & Poor's 100 index options traders were
    upset and believed that BM was a fraudster. Mr. Moran said he couldn't
    talk to either the Wall Street Journal. or the SEC without permission
    but that if these organizations went through proper channels and got
    permission from Lynn Howard, the CBOE's Public Relations Head, then the
    CBOE staff and traders would be able to cooperate with an investigation
    and answer questions. This was exciting news! Unfortunately, neither
    the Wall Street Journal. nor the SEC were inclined to even pick up a
    phone and dial any of the leads I had provided to them. It is a
    sickening thought but if the SEC had bothered to pick up the phone and
    spend even 1 hour contacting the leads, then BM could have been stopped
    in early 2006. One hour of phone calls was the difference between
    almost 3 more years of fraud and untold billions of additional investor
    losses. That's how close we were and how far we were from busting this
    case wide open in 2006.
    2007
        2007 was apparently a tough year for BM. Frank Casey got a hold of
    key May 2007 offering documents from Prospect Capital, a San Francisco
    based firm that was marketing the ``Wickford Fund LP,'' which promised
    to deliver a swap that paid out between 3 to 3\1/4\ times whatever BM's
    returns were less borrowing costs and management fees. Here I am using
    BM fund and Fairfield Sentry, a Greenwich, CT feeder fund
    interchangeably. This was a clear signal that BM was running low on new
    funds to keep his Ponzi scheme afloat.
        In order to keep paying out funds to existing investors, a Ponzi
    operator must ensure that new funds are continually coming in the door
    to offset the outflow of payments to old investors. Creating a
    leveraged swap product was a sign that the inflow of new dollars was
    insufficient to keep the scheme going and that BM needed to create
    additional incentives sufficient to attract new money.
        In a June 29, 2007, e-mail document submission to New York SEC
    Branch Chief, Meaghan Cheung I forwarded these offering documents to
    her office and copied Ed Manion of the Boston SEC Office. I also
    included updated April 2007 performance data from Fairfield Greenwich
    Group. The interesting thing about the performance data was that BM was
    noticeably stepping down his stated returns. If you look closely at the
    data, you will see that he went from double-digit returns from 1991-
    2000, but that all subsequent years returns were in single digits, a
    clear sign that he needed to cut back on the payouts to old investors
    in order to conserve cash and keep the scheme going. How the SEC could
    look at the same data we did and not arrive at the same conclusions
    that we did is hard to fathom. One would have to seriously question
    their industry experience and investigative expertise to have missed
    the red flags contained in the June 29, 2007, SEC Submission.
        The Prospect Capital ``Wickford Fund LP'' performance chart just
    jumps out of the page at any experienced investment professional.
    Notice how the unlevered Sentry Fund performance is a steadily rising
    line. Well, that type of rising line without any downward interruption
    does not exist in the capital markets for any asset class over any
    meaningfully long period of time. Above that steadily rising line is an
    exponentially rising line that depicts what the ``Wickford Fund LP's''
    returns, using 3.1 to 1 leverage, would have been like if the fund had
    existed back in time. Let me explain 3 to 1 leverage. If a Madoff
    investor wanted to invest $1 million with BM he could do that on an
    unlevered basis without borrowing any money. Now Wickford Fund was
    allowing this same investor to invest her $1 million and borrow an
    additional $2 million so that she could now invest a full $3 million
    with BM. Nothing is free in finance and you can be sure there is a bank
    lending this investor the $2 million dollars she is borrowing and
    charging a profitable interest rate for providing this service.
    Wickford Fund LP is even happier to do this because they now get to
    charge 3 times as much in management fees because the investment amount
    is now $3 million and not $1 million. BM is also happier because
    instead of receiving $1 million, he's taking in $3 million and cheating
    not only the investor but the bank that is lending the investor the
    additional $2 million. This leveraged performance return line as
    provided on the graph not only does not exist for any asset class but
    any student of biology will recognize it as denoting a growth curve for
    natural organisms such as for population. How can any capital market
    return over any length of time only go up and never down? How did so-
    called due diligence ``professionals'' at the Madoff feeder funds miss
    this? How did the SEC's staff miss this? If a picture says a thousand
    words, then this picture said ``FRAUD'' a thousand times over.
        In retrospect, perhaps I should have explained every single page to
    the SEC's New York Office. But, I was dismissed and ignored making any
    further attempts to explain on my part impossible. I do not know
    whether the cause was political interference or incompetence but the
    result was a refusal to look and an unwillingness to grasp even the
    simplest explanations for the red flags present in the ``Wickford Fund
    LP'' offering documents. Every phone call to Meaghan Cheung made me
    feel diminished as a person, so I consciously chose to e-mail her so
    that I didn't have to undergo unpleasant and unsatisfying telephone
    calls.
        On July 10, 2007, Neil Chelo collected a key set of financial
    statements for 2004, 2005, and 2006 for BM's largest feeder fund--
    Greenwich Sentry, L.P. Here I am using Greenwich Sentry and Fairfield
    Sentry interchangeably believing them to have the same ownership.
    Again, red flags popped up everywhere. Greenwich Sentry used three
    different auditors over that 3-year period which is a major red flag.
    Berkow, Schecter & Company LLP out of Stamford, CT, was the auditor in
    2004, Price Waterhouse Coopers (Rotterdam, The Netherlands) was the
    auditor for 2005, and Price Waterhouse Coopers (Toronto, Canada) was
    the auditor for 2006. This raised suspicions in my mind that Greenwich
    Sentry L.P. might be ``auditor shopping.''
        The financial statements themselves were nothing but a giant red
    flag to any investment professional looking at them because BM was in
    U.S. Treasury bills at year-end and there were no investment positions
    to mark to market. How convenient for a fraudster not to have any
    trading positions for an auditor to inspect. Since U.S. Treasury Bills
    exist in book-entry form only, how convenient not to have any physical
    securities on hand to inspect either.
        In late July, I also analyzed a BM portfolio that Neil Chelo
    obtained, dated February 28, 2007, which contained a 51 stock
    portfolio, OEX Standard & Poor's Index call options and OEX Standard &
    Poor's Index put options. The portfolio as constructed did not look
    capable of earning a positive return and I marked it as having lost .32
    percent but Frank Casey sent me a performance number for February that
    showed a loss about a third of what this portfolio produced.
    Inconsistencies like this were so constant throughout the
    investigation, we had become immune to them. We would have been
    surprised only if something associated with BM actually made sense.
        Neil Chelo lined up Amit Zjayvergiya, Fairfield Sentry's Head of
    Risk Management, for a 45-minute phone interview. Mr. Zjayvergiya's
    answers to Mr. Chelo's questions are listed in a August 24, 2007, e-
    mail. We discovered from this interview that BM's largest feeder fund,
    a fund with over $7 billion invested in BM, was not asking any of
    questions one would expect of a firm purporting to conduct due-
    diligence. Mr. Chelo is professionally certified as a Financial Risk
    Manager and asked several key risk management questions of Mr.
    Zjayvergiya and he did not receive satisfactory answers. I actually had
    hopes this interview would be longer and more intensive with full
    responses to the two full pages of questions I had sent to Mr. Chelo.
    Nevertheless our doubts were confirmed by the information we obtained.
    2008
        2008 was a strange year for everyone in global finance and our team
    was no exception. Because of market turbulence all of us were busy with
    other matters and let our BM investigation drop by the wayside with one
    exception which occurred in April. A good friend of mine, a University
    of Chicago Ph.D. in finance, Mr. Rudi Schadt, Oppenheimer Funds'
    Director of Risk Management, ran into a fellow University of Chicago
    Ph.D., a Mr. Jonathan Sokobin who was the SEC's new Director of Risk
    Assessment in Washington. Mr. Schadt, who was familiar with my work in
    the field of risk management, put Mr. Sokobin in touch with me in late
    March 2008. Mr. Sokobin asked that I call him, which I did a couple of
    days later. I wanted to give him a heads-up on some new emerging risks
    that I saw looming over the horizon. After our call, I felt that I had
    established my bona fides as a risk expert and felt comfortable enough
    to send him my updated, 32-page, December 22, 2005, SEC Submission
    along with a short 4 paragraph e-mail. I tried calling back a few times
    but never got through and gave up. I never heard from Mr. Sokobin
    again. At this point I truly had given up on the BM investigation.
        Why did BM suddenly turn himself in on Thursday, December 11, 2008?
    Clearly, it was because he could not meet cash redemption requests by
    the feeder funds and fund of funds. Due to the seductive steadiness of
    his returns and the purported liquidity of his strategy, the fund of
    funds, in a down market, would consider him the best in their lineup of
    managers and would most likely go to him first with their redemption
    requests. Many hedge funds invest in illiquid securities for which they
    might have trouble finding buyers in a down market. Therefore, rather
    than sell in a down market when there may be no buyers and drive prices
    even lower than they were already, these fund of fund managers felt
    that they would have less negative price impact by asking BM to redeem
    what they considered to be their ``safe'' investments. BM's strategy of
    investing in highly liquid, blue-chip stocks seemed tailor made for
    easy redemptions. Therefore the fund of funds managers went to BM first
    (and most reliable investment) and this is what brought about his
    downfall. Too many hedge fund investors were asking to redeem their
    money and BM ended up with too many of these redemption requests which
    brought the entire house of cards down around him.
    Concluding Thoughts
        The e-mails, marketing materials, conversation records and SEC
    Submissions you have as part of my official document submission to
    Congress are what four unpaid volunteers accomplished in our spare time
    to try and stop BM. We don't pretend to know what really happened on
    the mysterious 17th floor of the Lipstick Building at BM's corporate
    offices. Every bit of information we obtained was in the public domain.
    We never had any secret insider documents or smoking gun e-mails. We
    did what we could to stop BM from bilking the public. All of us feel
    very badly that we failed to achieve a positive result.
        There were many things we definitely did not know. We never
    conceived that any high net worth professional investor would have 100
    percent of their money invested in hedge funds. To investment
    professionals, a proper allocation to hedge funds would range between 0
    percent-25 percent, and certainly any such allocation would be spread
    among several managers, not given in its entirety to just one manager.
    And being from the institutional side of the business, we closely
    tracked the feeder funds and fund of funds that were investing in BM,
    but never realized that charities and individual investors were
    investing 100 percent of their money with BM. We also missed the
    obvious, that BM was Jewish, and as a result, he would be preying most
    heavily on the Jewish community because Ponzi schemes are first and
    foremost an affinity fraud.
        We more closely tracked BM's affinity fraud through Europe which
    was a different community of victims from those targeted in the U.S. In
    Europe the affinity groups sought by the BM feeder funds were mainly
    European royal families, the high born old money families, and the
    nouveau riche. In Europe, the victims were mostly blue blood families.
    BM was truly masterful in using his feeder funds to draw in people
    close in make-up to the owners of the feeder funds. In this way he was
    able to expand his affinity victims to those beyond that of the Jewish
    community and gain entry into other affinity communities as well.
        I am sure that we missed many other clues, warning signs and red
    flags but assure you that we did the best that we could with the
    information we dared collect. Every time we raised our heads to collect
    information, we exposed ourselves to discovery and feared the result.
        By this time, law enforcement officials know a lot more than we do.
    The four of us will be waiting to find out what really went on behind
    closed doors. For those who ask why we did not go to FINRA and turn in
    Madoff, the answer is simple: Bernie Madoff was Chairman of their
    predecessor organization and his brother Peter was former Vice-
    Chairman. We were concerned we would have tipped off the target too
    directly and exposed ourselves to great harm. To those who ask why we
    did not turn in Madoff to the FBI, we believed the FBI would have
    rejected us because they would have expected the SEC to bring the case
    as subject matter experts on securities fraud. Given our treatment at
    the hands of the SEC, we doubted we would have been credible to the
    FBI.
        And, I wish to clear the air on a very important matter about
    ethics, public trust, civic duty and what this all says about self-
    regulation in the capital markets. The four of us did our best to do
    our duty as private citizens and industry experts to stop what we knew
    to be the most complex and sinister fraud in American history. We were
    probably a lot more foolish than brave to keep up our pursuit in the
    face of such long odds. What troubles us is that hundreds of highly
    knowledgeable men and women also knew that BM was a fraud and walked
    away silently, saying nothing and doing nothing. They avoided investing
    time, energy and money to disclose what they also felt was certain
    fraud. How can we go forward without assurance that others will not
    shirk their civic duty? We can ask ourselves would the result have been
    different if those others had raised their voices and what does that
    say about self-regulated markets?
        To the victims, words cannot express our sorrow at your loss. Let
    this be a lesson to us all. White collar crime is a cancer on this
    nation's soul and our tolerance of it speaks volumes about where we
    need to go as a nation if we are to survive the current economic
    troubles we find ourselves facing; because these troubles were of our
    own making and due solely to unchecked, unregulated greed. We get the
    government and the regulators that we deserve, so let us be sure to
    hold not only our government and our regulators accountable, but also
    ourselves for permitting these situations to occur.
        Thank you and May God Bless the United States of America.

    Part II--Rebuilding the SEC
    The Current Situation Is Dire but Fixable: There Is No Where To Go but
            Up!
        Securities fraud is a scourge on the marketplace. Investors who
    suspect fraud or who aren't confident that a level playing field exists
    will properly require higher returns. To the companies trying to raise
    capital in the marketplace, investors' higher return requirements mean
    a higher, unaffordable cost of capital or worse, the total
    unavailability of capital at any price. Today, thanks to the lack of
    effective regulation and oversight, our capital markets are barely
    functioning. Markets need to be fair, efficient and transparent in
    order to work properly. They also need to be regulated in order to
    ensure a constant availability of credit at affordable rates.
        Right now, investors are afraid and do not trust the banks,
    insurance companies, brokerage firms, credit ratings agencies,
    investment managers, hedge funds, or other financial institutions nor
    should they. Investors particularly do not trust our nation's financial
    regulators, particularly the Federal Reserve Bank (FED) and U.S.
    Treasury who have both told them repeatedly that things were fine, when
    in fact, things were only about to get worse. The ultimate insult to
    investors is the FED's refusal to tell us which financial institutions
    are borrowing from the Discount Window and how much they are borrowing.
    This startling lack of transparency from regulators has led to a
    massive lack of investor confidence. Only by providing investors with
    full transparency and allowing them to make rational investment
    decisions, will our capital markets find the proper price levels so
    that buyers can find sellers and sellers can find buyers.
        Investors want to know that the financial firms they are dealing
    with are solvent and right now they feel that our government isn't
    telling them the truth about the solvency of this nation's largest
    financial institutions so the entire system remains paralyzed,
    needlessly wondering who the zombie financial institutions are. My
    advice is to take the pain up front and either nationalize or close the
    zombie financial institutions as soon as possible and put the
    uncertainty to rest. Trust will not be restored until full transparency
    is restored.
        Every single one of this nation's too many financial regulators
    failed to earn their paychecks. This is the reason our financial system
    has been on the verge of collapse over these past several months.
    Unfortunately, as bad a regulator as the SEC currently is, and the SEC
    certainly is a bad regulator, it's the best of a very sorry lot.
    Compared to the FED which has led this nation to the abyss of national
    bankruptcy by it's refusal and inability to regulate the banks, the SEC
    actually looks halfway competent. Thanks to the ineptitude of financial
    regulators, Wall Street as we once knew it ceases to exist and too many
    of the nation's largest banks are on government life support, too weak
    to lend and too battered to survive as currently constituted.
        Our nation has too many financial regulators. The separation and
    lack of connection and communication between them leaves too many
    gaping holes for financial predators to engage in ``regulator
    arbitrage'' and exploit these regulatory gaps where no one regulator is
    the monitor. In more than one financial institution, employees have two
    different business cards. One card has their registered investment
    advisor title (which falls under SEC regulation) and the other has
    their bank title (which falls under banking regulators). When the FED
    comes in to question them, they say they're under the SEC's
    jurisdiction and when the SEC comes in to question them, they say
    they're under the FED's jurisdiction. Clearly this situation has to be
    corrected so firms cannot play one regulator against the other or
    worse, choose to be regulated by the most incompetent regulator
    available while avoiding the most vigorous and thorough regulators.
        The goal needs to be to combine regulatory functions into as few a
    number as possible to prevent regulatory arbitrage, centralize command
    and control, ensure unity of effort, eliminate expensive duplication of
    effort, and minimize the number of regulators to which American
    businesses have to answer. To this end, I recommend that one super-
    regulatory department be formed and that it be called the Financial
    Supervision Authority (FSA). Under it's command would come the SEC, the
    FED, a national insurance regulator and some sort of combined Treasury/
    DOJ law enforcement function with staffs of dedicated litigators to
    carry out both criminal and civil enforcement for all three. All
    banking regulators should be merged into the FED so that only one
    national banking regulator exists. The FED Chairman, Vice-Chairman, and
    Governors who set monetary policy can be spun out into a separate,
    independent operating units, but since they've shown themselves to be
    such incompetent regulators, this critical function would be stripped
    away from them. Pension regulation should be moved from the Department
    of Labor to the SEC. Futures and commodities regulation should be moved
    from the CFTC to the SEC. Cross-functional teams of regulators from the
    SEC, FED, national insurance regulator and Treasury/DOJ should be sent
    on audits together whenever possible to prevent regulatory arbitrage. I
    envision the inspection arms to be the SEC, FED and national insurance
    regulator while the Treasury/DOJ litigators house the litigation teams
    that take legal action against defendants. American businesses deserve
    to have a simpler, easier to understand set of rules to abide by and
    they also deserve to have competent regulation at an affordable price.
    Right now financial institutions pay a lot in fees for regulation but
    they aren't getting their money's worth. Government needs to give
    business regulation that provides a value-proposition, where fees paid
    to regulators equal value received by business.
    The SEC Is a Failed Regulator: But It Can't Remain One
        The story I have related in Part 1 underscores the deeply flawed
    connections or lack thereof between financial regulators as well as the
    systemic failures of the SEC. These systemic failures are instantiated
    by my particular experiences with the SEC as explained above but also
    generally replete in the history of the SEC over the past few decades.
    Let me provide you with a representative list of only some of the
    agency's major failures. During the tech bubble years, the SEC ignored
    the Wall Street Analysts' recommendations, almost all of which were
    ``buy recommendations'' even though these same analysts privately
    advised a few privileged investors to sell these over-priced or
    worthless securities, leading up to the 2000-2003 bear market. In 2003,
    the SEC's Boston Regional Office turned away Mr. Peter Scannell, the
    Putnam market-timing whistleblower. Fortunately, Mr. Scannell survived
    a vicious beating and went to both the Massachusetts Securities
    Division (MSD) and the New York Attorney General (NYAG) who believed
    him and enforced the nation's first market-timing scandals while the
    SEC watched from the sidelines until embarrassed enough to finally
    enter the fray with enforcement actions of its own. In 2007 and 2008,
    the Auction Rate Securities scandal hit the headlines, and once again
    the SEC remained busy looking the other way, protecting predatory
    investment banks from defrauded investors. And, once again, the NYAG
    and MSD conducted effective and timely enforcement actions to ensure
    that defrauded investors got their money back. More recently, the SEC
    watched quietly but did nothing to prevent the train wreck as the
    nation's five largest domestic investment banks either failed like
    Lehman, were rescued by government forced acquisitions like Bear
    Stearns and Merrill Lynch, or became bank holding companies in order to
    survive like Goldman Sachs and Morgan Stanley. And today, no investor
    knows what the bank's balance sheets look like because the SEC is
    refusing to enforce transparency rules.
        When the industry you purported to regulate implodes and the
    nation's financial system is frozen, then it is safe to say that you've
    failed as a regulator. It is also safe to say that the SEC has lost the
    nation's confidence. The executive branch and Congress are faced with
    the following critical question--do we disband the SEC, merge it out of
    existence, or fix it?
    Rebuilding the SEC
        I come before you not to bury the SEC but to assist you in helping
    to tear down and rebuild an SEC capable of effectively regulating
    capital markets in the 21st century. I promise to be blunt in my
    assessment of where the SEC is today and where it needs to go in the
    short term and long term. No punches will be pulled regardless of the
    SEC's embarrassment. Until the SEC admits to and embraces its failures,
    it will not be able to recover and rebuild. ``Denial'' is not just a
    river in Egypt, it's the mindset that the SEC has adopted. It has
    blamed everything on a lack of staff and resources while refusing to
    admit to its underlying problems. I know that I am tired of their lame
    excuses and I suspect that Congress and the American public are also
    tired of the SEC's shameless attempts to deflect blame. It's high time
    and past time for some personal responsibility on the part of the SEC's
    senior staff. Our nation's capital markets didn't fall so far and so
    fast without a lot of help from regulators who failed to regulate. At
    the very least the SEC's senior staff should be making profuse
    apologies to Mr. Madoff's victims. Instead all I've heard are SEC
    promises to look into what happened with my repeated SEC Submissions
    which told the SEC exactly where to look to find the fraud.
        In my dealings with the SEC I have noted many deficiencies and will
    point those out in enough detail so that the new management team can
    fix them in the next 4 years. I believe the one over-arching deficiency
    is that the SEC is a group of 3,500 chickens tasked to chase down and
    catch foxes which are faster, stronger and smarter than they are. It's
    painfully apparent that few foxes are being caught and that Bernie
    Madoff, like too many other securities fraudsters, had to turn himself
    in because the chickens couldn't catch him even when told exactly where
    to look. As currently staffed, the SEC would have trouble finding first
    base at Fenway Park if seated in the Red Sox dugout and given an
    afternoon to find it. Taxpayers have not gotten their money's worth
    from the SEC and this agency's failures to regulate may end up costing
    taxpayers trillions in government bailouts.
    Dramatically Upgrading SEC Employee Qualifications and Educational
            Budgets
        Amazingly, the SEC does not give its employees a simple entrance
    exam to test their knowledge of the capital markets! Therefore is it
    any wonder when SEC staffers don't know a put option from a call
    option, a convertible arbitrage strategy from a long/short strategy,
    the left side of the balance sheet from the right side, or an interest
    only security from a principle only security. By failing to hire
    industry savvy people, the SEC immediately sets their employees up for
    failure and so it should not be surprising that the SEC has become a
    failed regulator.
        A good way for Congress to find out exactly what I mean when I say
    the SEC doesn't have enough staff with industry credentials is to query
    the SEC senior staff that come before your Committee. Ask them--``Do
    you have any financial industry professional certifications?'' ``Have
    you ever worked on a trading desk?'' ``What accounting, business or
    finance degrees do you hold?'' ``What financial instruments have you
    traded in a professional capacity?''
        If Congress decides to keep the SEC in existence, then upgrading
    its staff, increasing its resources, and wholly revamping its
    compensation model is in order. In order to attract competent staff, a
    test of financial industry knowledge equivalent to the Chartered
    Financial Analysts Level I exam should be administered to each
    prospective employee to ensure that new employees have a thorough
    understanding of both sides of a balance sheet, an income statement,
    the capital markets, the instruments that are traded and the formulas
    incorporated within these instruments. Talented Certified Public
    Accountants (CPA's), Chartered Financial Analysts (CFA's), Certified
    Financial Planners (CFP's), Certified Fraud Examiners (CFE's),
    Certified Internal Auditors (CIA's), Chartered Alternative Investment
    Analysts (CAIA's), MBA's, finance Ph.D.'s and others with industry
    backgrounds need to be recruited to replace current staffers. One thing
    the incoming SEC Chair should do right away is order a skills inventory
    of the current SEC staff to measure the exact skills shortfalls with
    which she is now faced. My bet is that Ms. Shapiro will find that she
    has too many attorneys and too few professionals with any sort of
    relevant financial background.
        I recommend that the Chair ask the SEC senior staff to provide her
    with a complete skills listing of the current SEC staff. Knowing how
    many SEC employees hold accounting, business, and finance degrees
    versus how many hold law degrees would be a useful first step in
    quantifying the mismatches between skills on hand versus skills
    required to properly regulate. Determining how many SEC employees have
    ever worked on a trading desk would be particularly illuminating for
    the new Chair. Ditto for how many SEC employees are CAIA's, CIA's,
    CPA's, CFA's, CFE's, CFP's, and FRM's. My bet is that the SEC staff is
    critically short of employees with credible industry experience.
        I caution the SEC to avoid focusing on any one of the above
    professional certifications at the expense of the rest because all are
    relevant and necessary. The SEC also needs to avoid having too many
    people with educational and professional backgrounds that are too
    alike. Diversity will ensure that group-think is kept at bay and that
    the SEC embraces multiple relevant skill sets. Right now the SEC is
    over-lawyered. Hopefully it can transition away from this toxic mix as
    quickly as possible.
        I would like to see the SEC expand its tuition reimbursement
    program to pay 100 percent of relevant post-graduate education courses
    with 1 year of additional government service for each year of graduate
    education. Currently, the SEC does not allow its staff time out of the
    office to attend industry luncheons, dinners, cocktail parties, etc.
    nor does it pay for their attendance at these low cost learning events.
    SEC staffers need to be encouraged to attend industry conferences,
    particularly those venues where brand new securities are being
    featured, so that they are not caught flat-footed and behind the curve
    when these securities enter the marketplace. Because people tend to say
    and do things when they are traveling that they would never do at home,
    conferences are the ideal venue for the SEC to find out what's
    happening in the industry and, more importantly, what's about to
    happen. Sending SEC staff to conferences with a written information
    collection plan, under the supervision of a senior person, with the
    goal of obtaining information and marketing literature about new
    products and querying attendees about frauds within the industry is a
    cost-effective solution to keeping the SEC on level ground with the
    industry it regulates.
        Large cities with robust financial centers have financial analyst
    societies and economic clubs which hold educational meetings of just
    the sort the SEC staff needs. For example, in my hometown, the Boston
    Security Analysts Society has 5,000 members and holds educational
    lunches at least twice weekly, but the SEC won't reimburse its staff to
    attend these luncheons even though firms within the industry do. New
    York and Washington also have sizable analysts societies but rarely
    does anyone see SEC staff attending these educational events and we all
    know it isn't because the SEC has no need for greater industry
    knowledge. Either the SEC is anti-intellectual and intentionally
    maintaining staff uneducated about the capital markets or it is merely
    being ignorant. In either case, not to budget for it's staff's
    education is indefensible in the 21st century. SEC employees are
    knowledge workers, not unthinking, replaceable cogs and deserve to have
    the required educational resources available to them to do their jobs.
        To further illustrate the anti-intellectual bias of the SEC,
    consider what the SEC staff has printed on their business cards. If
    you're expecting to see Certified Public Accountant, Certified
    Financial Planner, Certified Fraud Examiner, Certified Internal
    Auditor, Financial Risk Manager, Chartered Financial Analyst, Chartered
    Alternative Investment Analyst, or some other sort of highly sought
    after professional designation, you will be sorely disappointed. For
    some unfathomable reason, most of the very few credentialed SEC
    staffers do not have their professional designations printed on their
    business cards. Why not? One would almost think that the SEC's top
    leadership was going out of its way to drive good people out of the SEC
    and destroy the morale of those who stay. The all too few SEC staffers
    I know with industry credentials have all told me they are not allowed
    to have these designations printed on their business cards. The only
    reason for this that makes sense is that if the SEC allowed its few
    credentialed staff to put these credentials on their business cards it
    would expose the overall lack of talent within the SEC. Therefore, one
    thing I would immediately recommend is that relevant industry
    credentials be printed on the Staff's business cards ASAP. Not only is
    this good for morale, but it also tells you which staff are worth
    keeping and which ones need to be told to find new jobs because their
    skills aren't relevant and don't meet either the SEC's or the investing
    public's needs.
        Another shocking revelation is that MAR Hedge published an expose
    on BM on May 1, 2001, while Barron's published their copycat BM expose
    on May 7, 2001, but the SEC doesn't pay for subscriptions to industry
    publications for its staff so their staff likely never read these
    damning articles which each contained numerous red flags. That's right,
    if the SEC staff want to read industry publications they have to pay
    for them on their own because the SEC won't pay for them. I remember
    that after reading both of these Madoff expose articles, Neil Chelo,
    Frank Casey and I felt 100 percent certain that the SEC would be
    shutting down BM within days. What we didn't know at the time was that
    the SEC doesn't read industry publications. We were shocked.
        If you walk into any sizable investment industry firm, it will have
    a library of professional publications for the staff to use as a
    resource. Typical journals on hand would be the Journal of Accounting,
    Journal of Portfolio Management, Financial Analysts Journal, Journal of
    Investing, Journal of Indexing, Journal of Financial Economics, and the
    list goes on and on. But, if you walk into an SEC Regional Office, you
    won't see any of these journals nor will you see an investment library
    worthy of the name. If an SEC Regional Office does have an investment
    library, it is usually the effort of one lone, highly motivated,
    employee who stocks a bookshelf on his/her own time, paying for the
    publications him or herself. This begs the question, where do SEC
    staffers actually go to research an investment strategy, find out which
    formulas to use to determine investment performance, or figure out what
    a CDO squared is? Apparently all the SEC staff uses is Google and
    Wikipedia because both are free. Lots of luck figuring out today's
    complex financial instruments using free web resources. No wonder
    industry predators run circles around the SEC's staff. It's easy to
    fool people from an ignorant regulator that goes out of its way to
    ensure that its staff remains uneducated and under-resourced.
        The SEC has exactly the wrong staff for the 21st century and a
    staff that's incapable of comprehending the financial instruments it is
    charged with regulating. Even if the SEC did provide a sensible
    publications budget for its staff so that staff could subscribe to the
    Wall Street Journal, Barron's, Business Week, and formed research
    libraries containing all the important financial journals, its staff
    would still need to understand what instruments are being regulated and
    which formulas are being used. The faulty recruitment of unnecessary
    and inefficient and incompetent human resources would remain.
        To properly regulate the finance industry, the SEC needs to hire
    people who know how to take apart complex financial instruments and put
    them back together again. If an SEC staffer doesn't know derivatives
    math, portfolio construction math, arbitrage pricing theory, the
    Capital Asset Pricing Model, both normal and non-normal statistics,
    financial statement analysis, balance sheet metrics, or performance
    presentation formulas then they shouldn't be hired other than to fill
    administrative or clerical positions.
        For instance, a person I know rather well in the Boston office,
    with over 10 years of industry experience, a double major under-
    graduate degree in economics and math from an Ivy League school, with
    an MBA degree and a Chartered Financial Analysts designation wanted to
    leave her job as a senior analyst at a large mutual fund company in
    order to have another child. She wanted out of the rat race where 60
    hour work weeks were both common and expected so she applied for a job
    with the SEC. During her interview she was told that she was 1)
    overqualified with too much industry experience, 2) over educated and
    3) that she wouldn't be happy inspecting paperwork and would likely
    quit in frustration so the SEC didn't plan on offering her the job.
    This is deeply problematic as it underscores the lack of a proper
    recruitment policy to equip the SEC with appropriate personnel for the
    work with which it is mandated and the expertise expected in order to
    appropriately monitor our financial institutions and their numerous
    transactions. The SEC apparently is only interested in administrative
    verification, to ensure compliance with existing (outdated) securities
    laws. Is it any wonder, given the current SEC staff, that major
    financial felonies go unpunished while minor paperwork transgressions
    are flagged for attention?
        Besides upgrading its staff at the junior and mid-levels, the SEC
    needs to recruit foxes to join the SEC staff in senior, very high
    paying positions that offer lucrative incentive pay for catching foxes
    and bringing them to justice. The revolving door between industry and
    regulators can be precluded if the SEC recruits highly successful
    industry practitioners who have succeeded financially during their long
    careers and now want to serve the American Public by fighting
    securities abuses. The ideal candidates would all have gray hair (or no
    hair at all) and the SEC would be the capstone on their already
    illustrious careers. The main hiring criteria would be that each
    candidate would have to submit a written list of securities frauds that
    he/she would attack and list the estimated dollar recoveries for each
    of these frauds. These ``foxes'' would then be brought on board
    specifically to lead mission-oriented task forces dedicated to closing
    down these previously undiscovered frauds, restoring trust in the
    marketplace, thereby lowering the cost of capital and minimizing the
    regulatory burdens for honest American businesses. My theory is that
    it's better to target your enforcement efforts at known fraudsters
    while leaving honest American businesses alone other than for
    occasional but thorough spot inspection visits. The fraudsters would be
    terrified but most businesses would be relieved if the SEC adopted the
    proposed regulatory scheme.
        In summary, the SEC needs to stop hiring more of the same people
    it's already been hiring. What the SEC needs to do is test its staff,
    identify who to retain, get rid of those who either don't have the
    proper skills sets for their specific mandates at a 21st century level
    or don't want to obtain those skills, hire foxes from industry to lead
    the enforcement and examination teams, increase the pay levels, and
    expand its educational budgets to ensure that the SEC becomes a forward
    leaning, learning organization that is more than a match for the
    industry it regulates.
    The SEC Needs To Adopt Industry Compensation Guidelines in Order To
            Compete
        Compensation at the SEC needs to be both increased and expanded to
    include incentive compensation tied to how much in enforcement revenues
    each office collects. Industry pays a base salary plus a year-end bonus
    that is tied directly to revenues brought into the firm. The SEC needs
    to adopt the industry's compensation guidelines in order to compete for
    talent. Of course, the SEC Commissioners would continue to approve the
    levels of the fines for enforcement actions because it would be a clear
    conflict of interest to have the enforcement and examinations staff set
    the fines that lead to their own compensation. Each SEC Regional Office
    should get back some pre-set percentage of the fines it brings in, and
    I recommend a 5 percent level initially, toward that office's bonus
    pool. Regional enforcement teams that do great work and bring in a $100
    million case settlement deserve to be compensated for their excellence.
    And, to prevent taxpayers from having to pony up these multi-million
    dollar bonus pools, I recommend that fines be triple the amount of
    actual damages, that the guilty transgressors pay the actual costs of
    the government's investigation, and that SEC staff bonuses also be paid
    for by the guilty transgressors.
        In expensive financial centers like New York, Boston, Chicago, Los
    Angeles, and San Francisco, cost of living adjustments bringing base
    compensation to the $200,000 level make sense plus the award of annual
    year-end bonuses but only when merited. In the lower cost regions, a
    $100,000-$150,000 base compensation would be fair, adjusted to local
    prevailing wage and cost data. This would be enough to attract the
    nation's best, brightest and most experienced industry practitioners.
    All compensation over and above the base compensation amount would come
    from each regional office's bonus pool and be tied directly to the
    fines (revenues) that each office generates. People who do not perform
    and bring in good quality cases that result in settlement awards to the
    government will get asked to leave and make room for people who can
    come in and produce solid cases.
        To be effective, the SEC cannot afford to be less talented and
    educated than the industry, and I would argue it can't even strive to
    be as good as the industry, it needs to be better! If the incoming
    Chair sets her sights too low, that's an admission of defeat and our
    capital markets can't afford to have this agency continue to fail. If
    our regulators continue to fail, then our capital markets won't recover
    because investors won't return until they are assured of a fair deal
    with full disclosure.
        I would also institute quantifiable metrics to measure the new,
    21st Century regulatory effectiveness. Obvious metrics are revenue from
    fines, dollar damages to investors recovered, dollar damages to
    investors prevented, fine revenues per employee per regional office,
    and the number of complaints from Congress to the regulators
    complaining about the severity of the fines or the thoroughness of the
    government's investigations. Let me tell you a story about a very
    competent and talented SEC attorney in the Boston Regional Office who
    says that every time he receives a phone call from Washington SEC
    Headquarters calling him off an investigation, it's for one reason and
    one reason only--because that is the only way the predator financial
    institution he is currently investigating can escape justice and escape
    making restitution to the victims. If the number of Congressional
    complaints ever went down year after year it could only have one of
    three meanings: 1) better Members of Congress, 2) the SEC is doing such
    a magnificent job of fraud detection that white collar crime actually
    drops or 3) a worse job by the SEC that year.
    Raise the Enforcement Bar To Incorporate Good Ethics Into the SEC's
            Mission Focus
        Just because it is not illegal doesn't mean the SEC should ignore
    unethical behavior in the marketplace, which it has been doing for
    several decades now by trusting the industry to self-regulate its way
    to good behavior. The SEC must change its mission toward ensuring full
    transparency, fair play, and zero tolerance for unethical financial
    dealings. Note that I didn't say the SEC's mission should tend away
    from ``enforcing the nation's securities laws.'' Given that there is no
    way to keep a set of securities laws on the books that is up to date
    and fully accounts for all of the bad behavior that financial predators
    can and will engage in, the SEC needs to recognize that securities laws
    are not the be all and end all of regulation, they are merely the
    absolute bare minimum standards which market participants must follow.
    Securities laws will never be fully up to date or always relevant. The
    current crisis will see that new, more relevant laws are enacted, but
    after these crises pass, securities laws will once again quickly become
    obsolete until the next crises appears. We need to end this cycle of
    overdependence on a series of rapidly outdated securities laws as our
    basis for enforcement and err on the side of protecting our investors.
        The SEC's main focus is to mindlessly check to see if registered
    firms paperwork is in order and complies with the law as written. If a
    firm happens to be a financial predator and is engaged in market-timing
    or selling auction rate securities, the SEC's lawyers will not be
    concerned because market-timing and auction rate securities aren't
    illegal, merely unethical. If that firm's paperwork meets legal
    requirements, the SEC will give these financial predators a free pass
    just like it has always done. You will note that the SEC has said that
    the market-timing of mutual funds was not illegal, which may explain
    why the SEC turned away the Putnam whistleblower, Peter Scannell in
    2003. The long-term, buy and hold mutual fund investors who lost that
    billions in returns to market-timers as a result of these actions and
    omissions, certainly would agree that this activity was unethical and
    they deserved to have this money returned to their retirement accounts.
    Auction rate securities issuers and investors ended up similarly
    disappointed thanks to the SEC's willingness to foster an ``anything
    goes'' climate on Wall Street. Enough of the securities' lawyers
    robotic simple compliance audits, let's shift the 21st century's
    capital markets to a higher plane, and start to insist on ethical
    capital markets that give all investors a fair deal with full
    transparency.
        The bare minimum requirement of compliance with securities' law
    does not serve the higher standards and needs of today's financial
    markets and the pace of modern market practices. Policy standards and
    requirements including, good ethics, fair dealings, full transparency,
    and full disclosure need to be adopted and enforced. The SEC needs to
    shift its focus away from the lowest common denominator, mere
    securities law enforcement, and upgrade it to change we can believe in
    by ensuring full transparency, fair play and zero tolerance for
    unethical financial dealings.
    Revamping the Examination Process
        I am not sure how many of you have ever undergone an SEC inspection
    visit. I was a portfolio manager, then chief investment officer, at a
    multi-billion dollar equity derivatives asset management firm, and
    equity derivatives was considered a ``high risk'' area by the SEC. My
    firm received SEC inspection visits every 3 years like clockwork. I've
    been through these examinations and will tell you about their many
    obvious flaws. First, the SEC never once was able to send in an
    examiner with any derivatives knowledge. It was a good thing my firm
    was honest because if we weren't, we could have pulled a Madoff on them
    and they would have been none the wiser. Second, the SEC audit teams
    are very young and they rarely have any industry experience. Third, the
    teams come in with a typed up list of documents and records they wish
    to examine. They hand this list to the inspected firm's compliance
    officer (CO). The CO then takes them to a conference room and the firm
    provides the pile of documents and records which the SEC team inspects
    diligently. So, if a firm were so inclined, it could keep a second set
    of falsified but pristine records yet commit the equivalent of mass
    financial murder and get away with it, just as long as the firm had at
    least one set of (falsified) books and records that were in compliance.
        Now let's examine what is wrong with the examination process
    described above. First, the team only interacts with the inspected
    firm's compliance team, not the traders, not the portfolio managers,
    not the client service officers, not the marketing staff, not the
    information technology department and not management. The problem with
    this process is that the SEC examiners only examine paperwork but
    neglect the tremendous human intelligence gathering opportunities that
    are sitting right outside the conference room. What these SEC examiners
    need to be doing is sending one or two people out on the trading floors
    and into the portfolio manager's offices to ask leading, probing
    questions. During every single such unscripted interview, the SEC
    examiner should ask, ``Is there anything going on here that is
    suspicious, unethical or even illegal that I should know about? Are you
    aware of any suspicious, unethical or even illegal activity at any
    competing firms that we should be aware of? And, during that interview,
    the SEC examiner should be handing out his/her business card, asking
    that person to call them personally if they ever run across anything
    the SEC should be looking into either at their firm or any other firm.
    Unless everybody at a particular firm is dishonest, if fraud is
    present, at least these standard internal auditing techniques will
    result in a materially significant number of new enforcement cases.
    These are internal auditing techniques that well trained accountants,
    internal auditors, and fraud examiners use when conducting audits or
    investigations. But at present, the SEC staff is so untrained, it's
    almost as if this concept of talking to a firm's employees is advanced
    rocket science. It is my belief that SEC examiners are so inexperienced
    and unfamiliar with financial concepts that they are literally afraid
    to interact with real finance industry professionals and choose to
    remain isolated in conference rooms inspecting pieces of paper.
        From her first day in office, the incoming SEC Chair needs to get
    these examiners to focus on interacting with industry professionals and
    querying them on what's going on in their firms and their competitors'
    firms. Sitting like ducks in the inspected firm's conference room and
    getting fed controlled bits of paper by the firm's compliance staff
    isn't getting the job done. As currently constituted, the current
    examination process is an insult to common sense, a waste of taxpayers'
    money, and it can't be good for SEC employees' morale either. This also
    reinforces the need to increase the pay scale and add incentive
    compensation such that more qualified people apply for and take SEC
    jobs. Unless and until the SEC puts real finance professionals on those
    examination teams, their odds of finding the next Bernie Madoff range
    from slim to none.
        When a financial analyst is about to visit a company to determine
    whether or not to invest in that company's stock, the first thing he/
    she does is go to a Bloomberg and analyze the firm's capital structure,
    it's financial statements, financial statement ratios, look up the
    firm's weighted cost of capital, and start running horizontal and
    vertical analyses of the financial statements looking for trends and
    outliers. The trained analyst will also use his/her Bloomberg to read
    all the news stories on the company, look at the firm's SEC filings,
    and use all of the information above to build a set of questions he/she
    needs to answer in order to arrive at an intelligent investment
    decision. The analyst will also obtain Wall Street analyst research
    reports and read them all to see what information other analysts'
    research on this company's main strengths and weaknesses.
        Unfortunately, the SEC staff examiner doesn't do this. The main
    reason is lack of training on use of a Bloomberg machine. In the rare
    event the staff has know how, most SEC Regional Offices are lucky to
    have even one Bloomberg machine for the entire region's use. Whereas
    your typical investment firm would have one Bloomberg per analyst,
    trader and portfolio manager, the SEC unwisely only funds one per
    office! For SEC compliance and examinations' the use and need for
    Bloomberg machines are an inherent industry requirement. The work in
    brief cannot be done without it. Those Bloomberg machines are the
    lifeblood of the industry, they contain much of the data an SEC staffer
    would need for any fraud analysis of a company.
        Here is a quick example so that you understand how vitally
    important a Bloomberg machine is to securities enforcement. If you type
    in a company's stock ticker symbol, say ABC then hit ``WACC'' equity
    go, ABC Company's weighted cost of capital would pop up on your screen.
    Let's say ABC Company a weighted average cost of capital of 10 percent
    between its outstanding debt which pays an average of 6 percent
    interest and its equity which has a 14 percent cost associated with it
    and the mix between debt and equity is 50/50 [(.5 x 6 percent) + (.5 x
    14 percent) = 10 percent cost of capital]. Assume that ABC Company is a
    Defense Contractor and bids ``cost plus 3 percent'' on an Iraqi War
    contract yet the company's cost of capital is 10 percent. This is a
    clear sign that ABC Company is likely cheating the Defense Department
    on that contract since no company would willingly accept any contracts
    which fall under its cost of capital. Working for 3 percent when a
    firm's cost of capital is 10 percent would quickly lead the firm into
    bankruptcy since that contract would be costing the firm a minus 7
    percent return if the costs being passed onto the government were
    accurate. A good SEC examiner would immediately suspect ABC Company was
    padding the costs in its Iraqi War contract and alert the DOD's Defense
    Criminal Investigation Service to conduct a fraud audit. If everyone in
    industry is using Bloombergs except for the SEC, it is little wonder
    the SEC can't find fraud. The staff does not have the tools and
    training necessary to do their jobs.
        In case you are still not convinced, take the following challenge.
    Name one major securities fraud case that the SEC busted wide open on
    its own without the felon first turning himself in? Give up? The last
    major pre-emptive SEC strike was Ivan Boesky, for insider trading
    violations over two decades ago. Today's SEC staff are more like
    financial crime scene investigators, coming in after the fraud scheme
    has already collapsed, toe-tagging the victims, trying to figure out
    who the bad guys were and how the fraud scheme occurred. To date the
    SEC's inability or unwillingness to regulate and more importantly to
    implement regulation with adequate tools and training have potentially
    cost us trillions in the recent financial crisis.
    An Alternative Course of Action: Disbanding the SEC
        Fortunately, the U.S. already has two very competent securities'
    regulators who do a truly fantastic job and at an unbelievably low
    cost. Unfortunately, they are the New York Attorney General's office
    (NYAG) and the Massachusetts Securities Division (MSD). The NYAG and
    MSD have busted open the Wall Street analysts' bogus stock
    recommendations scandal, the mutual fund market-timing scandals, the
    auction rate securities scandals and a whole host of other industry
    violations. Where has the SEC been beforehand while all of these frauds
    were being committed? Sitting safely on the sidelines watching the
    fraud go by, daring not to get involved for fear of upsetting their
    masters on Wall Street. And this is the nicer, kinder explanation. Many
    investors may claim the SEC has been intentionally missing in action so
    as to aid and abet financial industry fraud to ensure that predatory
    financial institutions remain safe from investors. From an investors'
    perspective, the only two regulators that have stood up and made
    investors whole are the NYAG and MSD. These two regulators need to be
    publicly commended for the great job they are doing on behalf of
    investors everywhere.
        Therefore, one alternative solution for Congress to consider is to
    disband the SEC and give its budget to the NYAG and MSD to hire staff
    and keep doing what they've been doing which is a darn good job of
    protecting investors. One reason these two states have competent
    regulators is that New York City is the world's largest financial
    center while Boston is the world's fourth largest financial center.
    London is No. 2 while Tokyo is No. 3. Somehow, I doubt that the NYAG
    and MSD would be hiring many people from the SEC, choosing instead to
    find competent employees with industry experience locally to do the job
    more efficiently. From an efficiency standpoint, the NYAG and MSG
    employ far fewer people at much lower cost and do a much better job of
    securities regulation than the SEC. If the state regulators are
    providing more regulatory bang for the buck, an option would be to fund
    them and zero out the SEC's budget. After all, we let poorly performing
    private companies fail, why not let poorly performing government
    agencies fail too?
        Congress should always keep its options open regarding further
    funding of the SEC. If this agency continues to fail to regulate,
    holding the threat of disbandment over their heads by giving its budget
    to state securities regulators is the ideal high card for the Congress
    to keep in its pocket to ensure that the SEC understands it can either
    improve or disappear. The SEC's most committed staffers will not allow
    their agency to fail, nor will they allow anyone more senior to them
    within the agency to lead it down the wrong path. Plus, the threat of
    extinction does have a certain way of focusing attention and
    accomplishing goals more quickly than would otherwise be the case.
    Hopefully this alternative path will impose Congress's will over the
    SEC such that the agency meets all Congressional deadlines and
    mandates.
    An Alternative Course of Action: Assigning the NYAG and MSD To Enforce
            Large, Industry-Wide Cases and Let the SEC Conduct the Routine,
            Paperwork Inspections
        This is similar to the enforcement reality already in effect where
    the NYAG and MSD discover the truly big industry-wide frauds and
    conduct nationwide enforcement actions to recover investor assets. The
    SEC seems to be a captive agency that purposely ignores the large
    frauds, focusing only on the minor transgressions it can find during
    the normal, routine examination process. This alternative course of
    action formalizes the reality on the ground today.
        Congress could fund the NYAG and MSG so that it could do more of
    the large securities fraud enforcement cases at which it has developed
    great expertise. The SEC could keep its current budget and continue to
    police up the misdemeanors it seems to do passably well.
        This alternative has the advantage of playing to each regulator's
    strengths. The NYAG and MSD don't have the SEC's thousands of employees
    with which to conduct nationwide inspections of regulated firms.
    However, the NYAG and MSD do have a deep bench of experienced
    litigators and investigators with pit bull tenacity. As they say, it's
    not the size of the dog in the fight, it's the size of the fight in the
    dog that matters. The SEC has 3,500 employees and can continue to
    muddle along, handling the low-level securities violations it has a
    known appetite for while avoiding the large fraud cases which it
    doesn't seem to have either the heart nor the skill to attack.
    Recommendations for the New SEC Chair
        Given the SEC's current crisis situation it cannot be managed
    toward greatness, it needs to be led there. No amount of management can
    save the SEC. You manage budgets and resources but you have to lead
    people, and the best place to lead from is the front, setting the
    example for everyone behind you to follow. It will take a first-rate
    job of leadership, hard work and a bigger budget to turn around this
    agency but I know it can be done. Ms. Shapiro has been given every good
    leader's dream, to take command of an organization that has nowhere to
    go but up.
        If, by year-end 2009 there is not a dramatically measurable
    improvement in the number of cases brought and SEC staff morale has not
    improved, then a replacement Chair needs to be hired. President Obama
    needs to go through regulatory agency heads like Lincoln went through
    generals in order to give the American people the government we deserve
    and the government we've been paying for all along. Our President needs
    to keep hiring and firing until he, like Lincoln, has found leaders who
    can create winning organizations. We can't afford any more 9-11s,
    Hurricane Katrina's or any other massive governmental failures like the
    near collapse of our nation's financial system.
        At this point the SEC desperately needs new leadership at the very
    top. I feel very sorry for the staff in the eleven (11) Regional
    Offices for not receiving the proper training, resources, and support
    from their headquarters over a period of decades. What the SEC
    headquarters no longer needs is a building full of career bureaucrats
    shuffling paper. The new SEC Chair needs to come in and clean house
    with a wide broom, sweeping out the top ranks and bringing in a new,
    results oriented senior leadership team to replace the one that has
    failed us so miserably.
        My recommendation to the incoming SEC Chairman is to spend 1 week
    each month at each of the eleven (11) different Regional Offices during
    the first year, spending each day that week with a different
    examination team looking at how they do their jobs. After each day's
    work has ended, I would take that team out to dinner for a full de-
    briefing, asking them what tools, training and resources they need to
    do their jobs better. Once I got back to Washington, I'd crack the whip
    and make sure my senior staff pushed those tools and resources down to
    my examination teams on an expedited basis. Senior staff that can't
    deliver resources to the Regional Offices quickly enough need to be
    identified and terminated. Examination teams are the tip of the spear
    and the SEC can only be as good as those teams in the field are, so
    they must take absolute top priority.
        The new SEC Commissioner should consider moving the SEC out of
    Washington because Washington is a political center not a financial
    center, so you won't find the most qualified finance people there for
    the job at hand. Since New York is the world's largest financial center
    and Boston is the world's fourth largest financial center, moving the
    SEC to either West Chester County, NY, or Connecticut, in between those
    two major financial centers makes a lot of sense. If the SEC wants to
    attract the top talent, relocating its headquarters to somewhere
    between Rye, NY, and New Haven, CT, is where this agency will best
    attract the foxes with industry experience it so desperately needs.
        If the SEC's senior staff is as bad as it appears to be, then
    recognize that quickly and move to replace these people expeditiously.
    Far better to clean house at the top in order to show the new
    leadership team is serious about bailing out this sinking ship and
    getting it turned around in the opposite direction. Plus, I would
    rather have empty desks in Washington versus keeping the dead wood on
    board; because allowing dead wood to linger sends the wrong message to
    the Regional Offices. While senior staff positions remain unfilled,
    promote lower ranking employees into senior roles on an acting basis to
    discover the up and coming future leaders of this agency. You will
    identify good talent using this method.
        Reinvigorating and reforming the Office of Risk Assessment is
    another task on the new SEC Commissioner's plate because the SEC needs
    to put its best, most experienced finance professionals there. New
    inspection checklists have to be devised for every new financial
    product, structured product, derivative security, hybrid security,
    corporate entity--and all before these products are sold into the
    marketplace! Being even 1 day late to regulate is simply unacceptable.
    Examination audit checklists also need to be totally rebuilt so that
    obvious frauds such as the Madoff Ponzi scheme are never missed again.
    Base audit checklists for each type of firm that's out there need to be
    developed. Then, specific additional audit checklists that test for new
    and different, even never before seen frauds, have to be developed and
    tested in the field. The Office of Risk Assessment needs to be
    continually thinking of how to create fraudulent products, how to cook
    the books more creatively, how to launder money more effectively, and
    then design effective counter-measures for the examination teams to
    use.
        I also recommend that the SEC Chair require that the examination
    teams add at least one or more audit steps on top of whatever
    checklists they've been given using their own imagination and
    creativity. Those examination team-created audit steps that uncover
    fraud can then be adopted system-wide. This agency needs every employee
    making contributions in order to achieve greatness. I would expect the
    new Chair to demand contributions from all levels of the agency and to
    listen to all ideas from staff, no matter what their rank or pay grade.
        To further increase the SEC's auditing effectiveness, I would
    organize a ``Center for All Lessons Learned (CALL)'' similar to what
    the U.S. Army has been using with great effectiveness for decades. CALL
    will collect and sort through every fraud that the SEC finds. These
    frauds would be diagnosed for both common and unique elements so that
    the odds of future frauds going unchecked are further reduced. I
    recommend that the SEC adopt the Association of Certified Fraud
    Examiner's Fraud Tree contained in Volume I of the Certified Fraud
    Examiner's Manual for use because it lists hundreds of different
    financial frauds and categorizes them into easy to understand
    categories and sub-categories. In other words, the SEC needs to shed
    its ``keystone cops modus operandi'' and quickly turn itself into a
    ``learning, winning organization'' that instills confidence in all SEC
    employees, regulated firms and the investing public. CALL would be a
    password protected, online web based resource for all SEC employees to
    use and, more importantly, to contribute to themselves. The SEC needs
    to be able to learn at a faster pace than the bad guys they are
    fighting, and the only way to increase the SEC's decisionmaking quickly
    is to demand that all levels of the organization pitch in and
    contribute their lessons learned. The old top down, command from above
    approach doesn't work in the modern era and must be abandoned if the
    SEC is to achieve greatness. The SEC currently has a staff of 3,500 and
    every single one of those thirty-five hundred brains needs to be turned
    on and contributing.
        Another Office needs to be formed within the SEC similar to the
    National Transportation Safety Board's accident investigation teams. I
    would call this the Office the ``National Financial Safety Board.'' MIT
    Professor Andrew Lo has been advocating this low cost approach to
    sending in inspection teams after each financial institution blow up to
    diagnose exactly what went wrong and in what sequence that led these
    institutions to fail. Whenever a public company, broker-dealer, hedge
    fund, or registered investment advisor blows up, lets send in an SEC
    investigation team to collect the valuable lessons learned and add them
    to the SEC's knowledge base. I recommend that this office's knowledge
    base be made publicly available on the SEC's Web site for companies,
    accountants, and investors to use in preventing whatever blowups can be
    prevented by avoiding the mistakes of companies that have failed. From
    the Madoff case alone we have plenty of useful lessons for the public--
    for example--never allocate more than 20 percent to any one investment
    manager, never put 100 percent of your eggs in one basket, make sure
    the investment manager uses an independent third party custodian, the
    proper allocation to hedge funds ranges from 0 percent-25 percent of
    total assets, etc.
        Currently the size and frequency of the blowups is increasing at an
    alarming rate and the SEC needs to act quickly to turn those numbers in
    the opposite direction because we can't continue in the direction we've
    been going for much longer. This National Financial Safety Board would
    not prevent all future blowups from happening, but if it made our
    nation's financial system safer and the blowups less frequent and of
    smaller size, then we will all benefit. It is clear that we can't
    afford 2009 to be worse than 2008 because we barely survived 2008's
    financial disasters. The time to act on this is now.
        Finally, I would add one more Directorate, the Office of the
    Whistleblower, to centralize the handling and investigation of
    whistleblower tips. Currently, the SEC's eleven (11) Regional Offices
    handle whistleblower complaints on an individualized, ad hoc basis.
    Every whistleblower who comes in with a tip is handled differently and
    no one tracks the whistleblower with the particular complaint she has
    brought with the object of the complaint, a particular company or
    individual. One would think that if ABC Company has received five
    complaints this year and its nearest competitors received no complaints
    this year, that this would be meaningful information and merit close
    scrutiny. Complaints from within industry or by investors have got to
    be the cheapest, most effective way to identify fraudsters, yet this
    valuable resource is currently ignored by the SEC. There can be no good
    reason for dismissing this valuable tool.
        If my experience is any guide, the treatment accorded
    whistleblowers ranges from dismissive to outright unwelcome yet
    whistleblowers are the best, and cheapest source of great and not so
    great cases. The great cases cannot be culled from among the many cases
    submitted if SEC staff does not answer the phone or read its mail.
    Whistleblowers are the single largest source for fraud detection
    according to the Association of Certified Fraud Examiner's (ACFE) 2008
    Report to the Nation (Chapter 3, page 22, www.acfe.com). According to
    the ACFE, whistleblower tips were responsible for detecting 54.1
    percent of fraud schemes at public companies whereas external audits
    account for a meager 4.1 percent of fraud cases detected (note: the SEC
    would be considered an external auditor). Therefore whistleblowers are
    a full thirteen (13) times more effective than the SEC's external
    audits yet there is no Office of the Whistleblower. Who wouldn't want
    the SEC to become thirteen (13) times more effective?
        The Internal Revenue Service (IRS) started its Office of the
    Whistleblower in December 2006 and in two short years has grown this
    office to a staff of 17. The IRS now receives the largest cases with
    the absolute best quality of evidence in its history. Consider the cost
    of 17 IRS employees versus the billions in additional tax revenues
    they'll be responsible for bringing into the U.S. Treasury.
        The IRS offers bounty payments to whistleblowers of 15 percent-30
    percent for cases that lead to successful recoveries to the U.S.
    Treasury. These bounty payments do not come out of the IRS's budget nor
    do the taxpayers pay these bounties. All bounty payments are made by
    the guilty defendants. Therefore this is a no cost program that funds
    itself and allows the IRS Staff to cherry pick from the cases that
    literally walk in the door, selecting the credible cases for immediate
    investigation.
        I recommend that the SEC expand and reinvigorate its almost never
    used whistleblower bounty program. Section 21A(e) of the 1934 Act
    allows the SEC to pay a bounty of up to 30 percent to whistleblowers
    but only for insider-trading theory cases. The way this works is, the
    SEC can fine the guilty defendant triple the amount of its ill-gotten
    gains or losses avoided for insider trading and can award up to 10
    percent (10 percent) of the penalty amount to the whistleblower (triple
    damages x 10 percent maximum bounty award = 30 percent potential
    maximum reward).
        Unfortunately, unlike the IRS's Whistleblower Program and the False
    Claims Act, the SEC's reward payments are not mandatory and the SEC can
    refuse to pay these rewards without explanation. If Congress would
    expand this program to include all forms of securities' violations and
    make the reward payments mandatory, hundreds of cases would likely walk
    in the door each year, and many of these would be high quality cases
    that would lead to billions in investor recoveries similar to the
    billions that the False Claims Act (31 U.S.C. sections 3729-3733)
    already provides each year.
        We have two major government agencies, the Department of Justice
    and the Internal Revenue Service, that use whistleblower programs to
    identify cases that they would otherwise know nothing about. To date
    False Claims Act recoveries total over $22 billion since 1986. For
    every $1 spent in enforcement, the False Claims Act returns $15 in
    recoveries from fraudsters. This proves that such a program works and
    is not a speculative enterprise on the part of the government. We need
    the SEC to become as effective as the Department of Justice and the
    Internal Revenue Service at fraud enforcement.
        I recommend that each tip, upon receipt, be logged in, given a case
    number, and for credible tips with real evidence behind them, the
    whistleblower and whistleblower's counsel be put in contact with the
    relevant SEC operating unit that is best able to investigate the
    complaint. Hopefully this will prevent a repeat of my experiences
    during the Madoff Case, where over the years I kept submitting better
    and more detailed case filings but ran into trouble because Boston's
    SEC Regional Office believed me but New York's SEC Regional Office
    apparently did not. Standardizing the treatment of whistleblowers to
    ensure that they are not ignored or mistreated should be a priority for
    the SEC. An annual reporting to Congress of whistleblower complaints
    and the SEC's follow-up actions should be mandatory.
        Let me add one more important point concerning the issue of self-
    regulation and whistleblowing: consider that perhaps hundreds of
    finance professionals around the globe knew that Madoff was a fraudster
    or at least suspected that he was. How many of these people contacted
    the SEC with their suspicions? Unfortunately, I may have been the only
    one. If a whistleblower wanted to, how would they know who to contact
    at the SEC since there is no ``Office of the Whistleblower?'' I believe
    that by adding such an office, we would see honest firms sending in
    evidence against their crooked competitors. Getting rid of the shysters
    is in everyone's best interest and restoring trust in the U.S. capital
    markets is imperative if we are to restore our nation's economy to
    health. If I'm the CEO of an honest firm and I hire new employees who
    worked across the street at a competitor and then find out from these
    new employees that my competitor is dishonest, it would be in my
    economic self-interest and in the interest of good public policy to
    turn them into the SEC.
        If self-regulation is ever going to work, we need to find ways to
    advertise it, reward it, and measure it. Currently, the SEC is doing
    none of the above. Every tool, every resource, and every person has to
    be brought to bear in the fight against white-collar crime. Government
    has coddled, accepted, and ignored white-collar crime for too long. It
    is time the Nation woke up and recognized that it's not the armed
    robbers or drug dealers who cause us the most economic harm, it's the
    white-collar criminals living in the most expensive homes and who have
    the most impressive resumes who harm us the most. They steal our
    pensions, bankrupt our companies, and destroy thousands of jobs,
    ruining countless lives. No agency is better situated than the SEC to
    attack high-level white-collar crime. Therefore, the SEC is too
    important to allow too continue to fail.
        Thank you for the opportunity to present my recommendations on how
    to rebuild the SEC into the world's best securities regulator, it has
    been a singular honor for me to appear before you today.
                                     ______

                       PREPARED STATEMENT OF PAUL HILLER
              Chief Fiscal Officer, Town of Fairfield, Connecticut

        I am Paul Hiller and I have had the privilege of serving as the
    Chief Fiscal Officer for the Town of Fairfield Connecticut for the past
    10 years. Fairfield is a predominantly suburban community located on
    Long Island Sound and approximately 55 miles east of New York City. It
    proudly serves as the home to 2 outstanding Universities--Fairfield and
    Sacred Heart Universities--and is the home for the world headquarters
    of General Electric. Fairfield has a long and proud heritage dating
    back to its founding in 1639. It has the unique distinction of being
    one of the very few towns or cities throughout our nation granted the
    cherished triple a (AAA) rating by all 3 major rating agencies.
        In June 1997 our Pension Board made an initial investment, based
    upon a recommendation of our Pension Advisor, to make an initial
    investment of pension assets into the Broad Market Fund sponsored by
    Tremont Advisors. This investment into this Fund was followed by
    additional allocations of pension assets in 2000, 2001, and 2003. These
    investments which totaled a little over $21 million eventually
    increased to a ``reported'' level of $41,885,901.22 as of November 30,
    2008. Throughout this entire time, the Pension Board were cognizant
    that these funds were supposed to be administered and managed by the
    Tremont organization and then later by the Maxam organization who hired
    their own investment manager and their own auditors. The Pension Board
    was aware that both these funds hired Bernard L. Madoff and his firm to
    be the investment manager for these funds. None of the fund's legal
    documents or partnership agreements disclosed the identity of these
    securities firm. It was assumed by the Pension Board that all
    securities trades and the custody of all securities was being managed
    properly by the fund managers and properly audited and that the Pension
    Board advisors performed due diligence to monitor these investments.
        The Pensions for the Town of Fairfield cover 971 active employees
    in a Defined Benefit Plan and 595 retired beneficiaries or vested
    pensioners. All of these past and present employees have contributed
    from their earnings into the Plan. And, in addition, the Town of
    Fairfield contributed general funds into this Plan. The Pension Funds
    of Fairfield have since 2000 been in an enviable status of being
    overfunded on an actuarial basis, with assets totaling over
    $350,000,000 until this past year and this apparent fraud. This comes
    as a result of decisions made by the Pension Board, upon
    recommendations by Pension advisors over the years, and quality
    management by varied money managers. The Pension Board always had an
    investment policy which required diversification and never invested
    more than 10 percent of the Fund with any investment management firm.
        On December 11, 2008, our Pension Board and I were shocked to learn
    through press reports of this apparent massive fraud. The Pension Board
    has recently hired attorneys to seek to recover lost funds through any
    means possible. The apparent loss of this investment because of alleged
    fraud has caused significant adverse impact on our pension fund and our
    community. The Pension Board works very hard to protect the retirement
    funds set aside for government employees. We hope that these hearings
    will shed light on this entire situation and we thank you for your
    time.

                           LETTER FROM BARBARA ROPER
        Director of Investor Protection, Consumer Federation of America