[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) 512ï¿½091800  
Fax: (202) 512ï¿½092104 Mail: Stop IDCC, Washington, DC 20402ï¿½090001


            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









