[Senate Hearing 111-368]
[From the U.S. Government Publishing Office]



                                                        S. Hrg. 111-368


   OVERSIGHT OF THE SECURITIES AND EXCHANGE COMMISSION'S FAILURE TO 
                             IDENTIFY THE 
   BERNARD L. MADOFF PONZI SCHEME AND HOW TO IMPROVE SEC PERFORMANCE

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

                                HEARING

                               before the

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

                     ONE HUNDRED ELEVENTH CONGRESS

                             FIRST SESSION

                                   ON

  ANALYZING THE SEC'S OVERSIGHT AND EXAMINATION OF THE ACTIVITIES OF 
BERNARD L. MADOFF AND BERNARD L. MADOFF INVESTMENT SECURITIES, LLC AND 
       WHY IT FAILED TO IDENTIFY THE PONZI SCHEME, AND TO ASSESS 
 RECOMMENDATIONS FOR HOW TO IMPROVE THE REGULATORY PERFORMANCE OF THE 
                                  SEC

                               __________

                           SEPTEMBER 10, 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





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            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

                    Edward Silverman, Staff Director

        William D. Duhnke, Republican Staff Director and Counsel

                     Dean Shahinian, Senior Counsel

                      Mark Jickling, CRS Detailee

                      Matthew Green, FDIC Detailee

                 Brian Filipowich, Legislative Assistant

                Mark Oesterle, Republican Chief Counsel

                Hester Peirce, Republican Senior Counsel

                   Jonah Crane, 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

                              ----------                              

                      THURSDAY, SEPTEMBER 10, 2009

                                                                   Page

Opening statement of Chairman Dodd...............................     1
    Prepared statement...........................................    49
Opening statements, comments, or prepared statement of:
    Senator Shelby...............................................     4
        Prepared statement.......................................    50
    Senator Johnson
        Prepared statement.......................................    50
    Senator Reed
        Prepared statement.......................................    51
    Senator Schumer..............................................    25

                               WITNESSES

H. David Kotz, Esq., Inspector General, Securities and Exchange 
  Commission.....................................................     6
    Prepared statement...........................................    51
    Response to written question of:
        Chaiman Dodd.............................................   106
Harry Markopolos, Chartered Financial Analyst and Certified Fraud 

  Examiner.......................................................    30
    Prepared statement...........................................    60
John Walsh, Acting Director, Office of Compliance Inspections and 
  Examinations, Securities and Exchange Commission...............    32
    Prepared statement...........................................    95
    Responses to written questions of:
        Chairman Dodd............................................   110
        Senator Brown............................................   117
Robert Khuzami, Director, Division of Enforcement, Securities And 
  Exchange Commission............................................    32
    Prepared statement...........................................    95
    Responses to written questions of:
        Chairman Dodd............................................   120
        Senator Brown............................................   138

                                 (iii)

 
                    OVERSIGHT OF THE SECURITIES AND 
 EXCHANGE COMMISSION'S FAILURE TO IDENTIFY THE BERNARD L. MADOFF PONZI 
               SCHEME AND HOW TO IMPROVE SEC PERFORMANCE

                              ----------                              


                      THURSDAY, SEPTEMBER 10, 2009

                                       U.S. Senate,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.
    The Committee met at 2:33 p.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. The Committee will come to order, and let me 
thank all of our guests here today in the Banking Committee, my 
colleagues and staff. Today's hearing is entitled ``Oversight 
of the SEC's Failure to Identify the Bernard L. Madoff Ponzi 
Scheme and How to Improve SEC Performance.'' Let me thank the 
staff and others for the work they have done on this issue and 
the follow-on we will need to do as well, not that this one 
hearing is going to complete the examination of this question, 
because obviously the significance of it Americans are well 
aware of, including the most recent reports about taped 
conversations between Mr. Madoff and others in which his 
contempt for the process, the SEC, and the American people is 
quite evident. Obviously, as he says, ``First of all, this 
conversation never took place, OK?'' Some indication of what we 
are--the individual, the psychopathic individual we are dealing 
with on these issues.
    I am going to make some brief opening comments, and then I 
will turn to Senator Shelby for opening comments, and following 
the Bob Corker rule, there will be no statements made by any 
other member of the Committee until the opening round.
    [Laughter.]
    Chairman Dodd. This way we can get through this thing and 
make sure we get two rounds in. I tease Bob Corker about his 
preference.
    Senator Menendez. Mr. Chairman, is that who we have to be 
thankful to?
    Chairman Dodd. I do not know. Ask Bob Corker about that 
rule.
    [Laughter.]
    Chairman Dodd. I have teased him about it along the way. 
And, again, if anyone feels absolutely compelled that they 
would like to say something, obviously I try to accommodate my 
colleagues' requests. But if it would be all right, we would 
like to move along and cover the ground.
    Let me begin. Bernie Madoff stole $50 billion, and maybe 
more. He stole from individuals, he stole from pensions funds, 
he stole from charities and municipalities, communities like 
Fairfield in my home State of Connecticut. He stole more than 
money. He stole the retirement savings and the economic 
security of families and individuals, organizations, and 
charities all across the United States. And the very agency 
charged with the responsibility of policing Mr. Madoff, the 
Securities and Exchange Commission, did not stop him. There can 
be no excuse for that colossal failure. But I demand, as my 
colleagues do here, Democrats and Republicans, that victims of 
this fraud--some of whom hail from my home State and many, of 
course, all across the country that have testified before this 
Committee, as some have, also demand an explanation. How did 
this happen? What went on? Who was on the beat? What was going 
on that allowed this colossal--colossal--thievery to occur?
    And so today we hold our third hearing on Ponzi schemes, 
and our second on the Madoff fraud, in particular, to find out 
how this could possibly have happened and what we need to do as 
a Government, as an Exchange Commission, as well as the 
Congress of the United States, to minimize this ever occurring 
again.
    Incredibly, it emerged late last year that the SEC staff 
had received multiple complaints over a period of 16 years--16 
years, from 1992 to 2008--that Bernie Madoff's business was not 
legitimate, but had not taken any effective action. To his 
credit, then-Chairman Christopher Cox directed the SEC 
Inspector General to conduct a full investigation of why these 
credible reports had been ignored. The Inspector General 
released a report last week, and it is deeply disturbing, to 
put it mildly.
    As the report indicates, the SEC received, and I am 
quoting:

        more than ample information in the form of detailed and 
        substantive complaints, but a thorough and competent 
        investigation or examination was never performed.

The report goes on to describe an embarrassing series of 
internal failures at the SEC.
    One, incompetent supervisors directed their offices to look 
only for the types of fraud they understood and failed to 
recognize the type actually being committed in the Madoff case.
    Number two, inexperienced SEC staff simply accepted Mr. 
Madoff's claims without making the single phone call or sending 
the single letter that it would have taken to verify the 
information they were given.
    Number three, no one ever thought it merited a closer look 
when Mr. Madoff said he traded in Europe with a firm that 
reported there was no activity--when a firm that reported there 
was no activity in the account.
    And, fourthly, divisions and offices failed to coordinate 
or share information.
    This is ugly stuff, to put it mildly. Beginning in 1992, 16 
years ago, 17 years ago, the SEC received information that 
should have led to the quick end of Bernie Madoff's Ponzi 
scheme. But because the task of following up on that 
information was assigned to junior staff or supervisors with 
insufficient experience in the securities market, because that 
staff failed to ask obvious questions or take simple steps to 
verify what Mr. Madoff told them, and because their supervisors 
actually discouraged in some cases further investigation--in 
short, because the SEC failed to do its job, Bernie Madoff 
stole $50 billion.
    Today we are going to hear from the Inspector General about 
his report. We will hear from Harry Markopolos, an individual 
we have talked about on this Committee, who early, early on 
sent the warning signals in detailed information about what he 
determined was a Ponzi scheme. Mr. Markopolos is an investment 
analyst who continually attempted to get the SEC's attention 
with regard to the Madoff fraud about his ideas for improving 
the organization. And we will hear from the heads of the Office 
of Compliance Inspections and Examinations and the Division of 
Enforcement about what the SEC has done in light of the Madoff 
revelations and about what Chairman Schapiro intends to do 
going forward.
    There are several clear steps that I believe--and I hope my 
colleagues and others would agree--that need to be taken. One, 
the SEC staff should be trained in markets and investment 
strategies so they can know fraud when they see it, and the SEC 
should hire staff with real-world experience. The very culture 
needs to be reformed to encourage aggressive oversight. Staff 
should verify self-serving statements of facts made by targets 
of investigations. And coordination between the SEC's offices 
and divisions must be improved, and that is a point, by the 
way, that I am going to come back to over and over again, this 
idea of coordinating activities so we do not have these kind of 
stovepiped problems. And the SEC is not the only organization 
that suffers from a stovepipe mentality. That was all across 
Government, for that matter, but particularly here where 
divisions within the organization are required to communicate 
with each other, so you share information and knowledge 
arriving at decisions as to whether or not to go forward in 
matters like this. And, last, there should be a more rigorous 
system of evaluating outside tips and allegations, including 
articles in the financial press.
    Well, like many Americans who have obviously been following 
this event since last fall, I am stunned and angry, as many 
people are in this country, that this fraud was allowed to 
happen. But I also believe that the SEC can do better.
    Let me say as well, because obviously we are going to talk 
today about the SEC, a lot of people work there. And this is 
not part of my prepared remarks. I have a high regard for the 
many, many people who work at the SEC and do a terrific job 
every day. And so I do not want this to be seen as some 
sweeping indictment of everybody who works at this 
organization. Far from it. I have a high regard for people who 
dedicate their lives, work long hours to ferret out problems 
that exist. And so this is really trying to find out where we 
go from here, obviously how this happened, and how we can step 
forward. And I am pretty confident I speak for all of us up 
here to reflect the respect we have for the literally hundreds 
of people who dedicate their lives at this agency. And I thank 
you personally for the kind of work you do. And we are just 
going to ask you to help us to make sure that we minimize if 
not prohibit and stop forever this kind of an event ever 
occurring again.
    I literally get emails every day, almost every day from 
constituents of mine in Connecticut. These are not wealthy 
people. These are people who work every day, work hard every 
day to save and retire to provide some security for themselves. 
They have been ruined, at least in their minds, by what has 
happened here. They have been wiped out by what has happened.
    Dr. Backe, who was a constituent of mine, testified in 
January before this very Committee about what happened to him 
and the people in his medical practice in Connecticut. These 
people have literally been devastated by what has occurred. And 
I do not know if there is any way we can compensate them 
adequately. SIPC does not seem to be able to require us to be 
able to do much about it. I would like to hear my colleagues' 
thoughts on what we might do, or the SEC. But we have got to 
make sure this does not happen again. But I do not want every 
individual working at the SEC to feel somehow this is an 
indictment across the spectrum of everyone there. Hardly from 
it. But, clearly, we have got to do a better job, and this is 
infuriating, what happened in this case.
    With that, let me turn to Senator Shelby.

             STATEMENT OF SENATOR RICHARD C. SHELBY

    Senator Shelby. Thank you, Mr. Chairman.
    Last January, right here in this room, a little more than 1 
month after Bernard Madoff confessed to running a $50 billion 
multi-decade Ponzi scheme, this Committee held a hearing to try 
to understand how a fraud of that magnitude could go undetected 
by the Securities and Exchange Commission for so many years. 
Unfortunately, that hearing yielded few answers.
    In the intervening 7 months since, the SEC's Inspector 
General, who is with us today, has been piecing together what 
really happened. His report sets out a chronology that tracks 
15 years of missed opportunities and considerable incompetence. 
The IG found that the Office of Compliance Inspections and 
Examinations and the Division of Enforcement at the Securities 
and Exchange Commission were made aware at least six times that 
there might be something wrong in Madoff's firm. Potentially 
fruitful leads were not pursued, while significant staff 
resources were devoted to running down clearly unproductive 
avenues.
    Investigations were unfocused, understaffed, and improperly 
documented. Communication across the SEC offices was so badly 
flawed that Madoff himself had to alert the New York examiners 
that their counterparts in the Washington office of the SEC had 
been looking at similar issues.
    The IG determined that the SEC culture and organizational 
structure discouraged employees at the SEC from reaching out to 
one another to share market intelligence, obtain expert advice, 
or to compare notes about their cases. The Securities and 
Exchange employees did not give weight to colleagues' 
recommendations, so a tip found credible by one group of 
staffers would be dismissed hastily by another.
    The report also documents that Mr. Madoff, despite his 
persistent misrepresentations to the Securities and Exchange 
Commission, received greater deference by the staff at the SEC 
than the tippers who spotted his fraud. Ultimately, in each 
case the report indicates that the lingering questions and 
concerns of the SEC employees was swept under the rug by 
impatient and inflexible supervisors at the SEC who concluded 
that asking the logical next question would take too long or 
would be outside the scope of the examination. How absurd.
    In the aftermath of the botched Madoff investigation, the 
SEC has claimed that more funding will address its failures? 
Will it? The report, however, clearly describes an agency that 
does not know how to use the information and resources it 
already has. Fixing the SEC will not merely involve more 
resources. It is going to take much more. The Commission is 
going to have to make a broad-based change if it hopes to 
become a smarter, more flexible, more productive, and 
ultimately accountable organization.
    I am hopeful that the SEC will learn from its failures and 
seize this opportunity to reform itself from within. If it 
refuses to do so, Congress will do it for them.
    Thank you, Mr. Chairman.
    Chairman Dodd. Thank you very much, Senator.
    I will now introduce our panelists, and these introductions 
are a little bit longer than I normally give, but I think it is 
important to note that these are some very, very talented 
people who have recently joined the SEC to come on board, and I 
think knowing a bit about their backgrounds in a public setting 
like this will hopefully be a source of some encouragement to 
people about steps that have already been taken under the 
leadership of the SEC.
    First of all, I welcome David Kotz, who is not with the SEC 
but, rather, is the Inspector General of the SEC. He joined the 
SEC in December of 2007 and previously had served as Inspector 
General for the Peace Corps. Having been a former Peace Corps 
volunteer when Thomas Jefferson was President of the United 
States, going back a number of years--it seems that long.
    [Laughter.]
    Chairman Dodd. I welcome your previous experience in 
covering the Peace Corps. Prior to that, he worked at the U.S. 
Agency for International Development and in private law firms, 
and he prepared the extensive report we are examining today. 
And he will be our first witness.
    In the second panel, you have already heard me talk about 
Harry Markopolos who spoke with and met with and gave detailed 
analysis to the SEC staff raising questions about whether 
Bernie Madoff was violating securities laws such as by 
operating a Ponzi scheme from 2000 to 2008, over an 8-year 
period. Mr. Markopolos holds professional certifications as a 
chartered financial analyst and as a certified fraud examiner. 
He is a past president of the Boston Security Analysts Society. 
He currently works as an independent fraud investigator with 
attorneys pursuing actions under the False Claims Act and other 
statutes. From 1991 to 2004, he worked with Rampart Investment 
Management Company where he became its chief investment 
officer.
    John Walsh was appointed the Acting Director of the Office 
of Compliance Inspections and Examinations at the SEC in August 
of 2009, just a few weeks ago. He has served at the SEC for 20 
years, including service in the Office of General Counsel, the 
Division of Enforcement, and the Special Counsel to Chairman 
Arthur Levitt. He has been a member of the OCIE staff since its 
creation in 1995.
    Robert Khuzami--and I hope I pronounced that correctly--was 
appointed as Director of the SEC Division of Enforcement in 
February of 2009 and came to the SEC from Deutsche Bank where 
he had served as general counsel for the Americas since 2004, 
earlier as global head of litigation and regulatory 
investigations, and prior to this, Mr. Khuzami served as a 
Federal prosecutor for 11 years with the U.S. Attorney's Office 
for the Southern District of New York prosecuting complex 
securities and white-collar criminal matters, including insider 
trading, Ponzi schemes, and accounting fraud--obviously an 
extensive background.
    We thank all of our witnesses today for being with us. Mr. 
Kotz, we will begin with you. I am going to have the lights on 
here to watch your time. We do not want to cut you too short, 
but we would like you to move along as well to get to the 
questions. So thank you again for the tremendous work you have 
done and that of your staff in preparing this report.

STATEMENT OF H. DAVID KOTZ, ESQ., INSPECTOR GENERAL, SECURITIES 
                    AND EXCHANGE COMMISSION

    Mr. Kotz. Thank you for the opportunity to testify today 
before this Committee as Inspector General of the Securities 
and Exchange Commission. In my testimony, I am representing the 
Office of Inspector General, and the views that I express are 
those of my office and do not necessarily reflect the views of 
the Commission.
    Immediately after Bernard Madoff confessed to operating a 
multi-billion-dollar Ponzi scheme, my office commenced an 
investigation into why the SEC had failed to discover this 
scheme. On December 17, 2003, we issued an agency-wide document 
preservation notice and submitted requests for email records 
from the SEC's Office of Information Technology. Over the 
course of the investigation, we saw emails from over 70 current 
and former SEC employees for various time periods relevant to 
the investigation, ranging from 1999 to 2009. In all, we 
estimate that we obtained and searched approximately 3.7 
million emails.
    During the investigation we also reviewed work papers and 
examination files of the SEC examinations of Madoff from 1990 
to December 11, 2008, and sought documentation from third 
parties, such as FINRA and DTC, to undertake our own analysis 
of Madoff's trading records.
    To assist us in the investigation, we retained two sets of 
outside consultants. In February 2009, we retained FTI 
Consulting, Inc. to aid with the review of the examinations of 
Madoff that were conducted by the SEC. In June 2009, we 
retained First Advantage Litigation Consulting Services to 
assist us in the restoration and production of additional 
Madoff-related emails that the SEC had been unable to provide 
due to gaps in electronic data.
    We also conducted 140 testimonies under oath or interviews 
of 122 individuals with knowledge of facts or circumstances 
surrounding the SEC's examinations and/or investigations of 
Madoff. I would like to acknowledge the extraordinary efforts 
of the OIG investigative team that I have been honored to lead 
in conducting this important investigation. These included 
Deputy Inspector General Noelle Frangipane, Assistant Inspector 
General for Investigations David Fielder, and Senior Counsels 
Heidi Steiber, David Witherspoon, and Christopher Wilson, as 
well as my assistant, Roberta Raftovich. Without their 
incredible devotion and exceptional work, we would not have 
been able to complete the investigation and present a thorough 
and comprehensive report within such a short period of time.
    On August 31, 2009, we issued to the SEC Chairman a 
comprehensive report of investigation in the Madoff matter 
containing over 450 pages of analysis. In our report, we found 
that between June 1992 and December 2008 when Madoff confessed, 
the SEC received six substantive complaints that raised 
significant red flags concerning Madoff's investment adviser 
operations and should have led to questions about whether 
Madoff was actually engaged in trading. We also found that the 
SEC was aware of two articles regarding Madoff's investment 
operations that appeared in reputable publications in 2001 and 
questioned Madoff's unusually consistent investment returns.
    Our report concluded that notwithstanding these six 
complaints and two articles, the SEC never conducted a 
competent and thorough examination or investigation of Madoff 
for operating a Ponzi scheme and that, had such a proper 
examination or investigation been conducted, the SEC would have 
been able to uncover the fraud.
    The first complaint, which was received by the SEC in 1992, 
alleged that an unregistered investment company was offering 
100-percent safe investments with high and extremely consistent 
rates of return over significant periods of time to special 
customers.
    The second complaint was very specific, and different 
versions of it were provided to the SEC in May 2000, March 
2001, and October 2005. The complaint submitted in 2005, 
entitled ``The World's Largest Hedge Fund is a Fraud,'' 
detailed approximately 30 red flags indicating that Madoff was 
operating a Ponzi scheme, a scenario it described as ``highly 
likely.''
    In May 2003, the SEC received a third complaint from a 
respected hedge fund manager identifying numerous concerns 
about Madoff's strategy and purported returns. Specifically, 
the complaint questioned whether Madoff was actually trading 
options in the volume he claimed and noted that Madoff's 
strategy and purported returns had no correlation to the 
overall equity markets in over 10 years. According to an SEC 
manager, the complaint laid out issues that were ``indicia of a 
Ponzi scheme.''
    The fourth complaint was part of a series of internal 
emails of another registrant that the SEC discovered in April 
2004. The emails described the red flags that a registrant's 
employees had identified while performing due diligence on 
their own Madoff investment using widely available information. 
These red flags identified included Madoff's incredible and 
highly unusual fills for equity trades, his misrepresentation 
of his options trading, and his unusually consistent, non-
volatile returns over several years. One of the internal emails 
provided a clear, step-by-step analysis of why Madoff must be 
misrepresenting his options trading. The SEC examiners who 
initially discovered the emails viewed them as indicating 
``some suspicion as to whether Madoff is trading at all.''
    The SEC received the fifth complaint in October 2005 from 
an anonymous informant, which stated:

        I know that Madoff's company is very secretive about their 
        operations and they refuse to disclose anything. If my 
        suspicions are true, then they are running a highly 
        sophisticated scheme on a massive scale. And they have been 
        doing it for a long time.

    The sixth complaint was sent to the SEC by a ``concerned 
citizen'' in December 2006 and advised the SEC to look into 
Madoff and his firm, referencing a potential scandal of major 
proportion which was executed by the investment firm Bernard L. 
Madoff.
    In March 2008, the SEC Chairman's office received another 
copy of the 2006 complaint, with the additional information 
that Madoff kept two sets of records and implying that a false 
set of records were kept on Madoff's computer.
    These complaints all contained specific information and 
could not have been fully and adequately resolved without a 
thorough examination and investigation of Madoff for operating 
a Ponzi scheme.
    According to our FTI experts, the most critical step in 
examining or investigating a potential Ponzi scheme is to 
verify the subject's trading through an independent third 
party. We found that the SEC conducted two investigations and 
three examinations related to Madoff's investment adviser 
business based on the detailed and credible complaints that 
raised the possibility that Madoff could have been operating a 
Ponzi scheme. Yet at no time did the SEC ever verify Madoff's 
trading through an independent third party and never actually 
conducted a Ponzi scheme examination or investigation of 
Madoff.
    In the first examination and investigation conducted in 
1992 based on suspicions that a Madoff associate had been 
operating a Ponzi scheme, the SEC focused its efforts on 
Madoff's associate and never thoroughly scrutinized Madoff's 
operations even after learning that Madoff made all the 
investment decisions and claimed to achieve remarkably 
consistent returns over a period of numerous years with a very 
basic trading strategy. The SEC seemed not to have considered 
the possibility that Madoff could have taken the money that he 
used to pay the associate's customers back from other brokerage 
clients.
    In 2004 and 2005, the SEC's examination unit, OCIE, 
conducted two parallel cause examinations of Madoff. The exams 
were similarly flawed. There were significant delays in the 
commencement of the examinations, notwithstanding the urgency 
of the complaints, and the teams assembled were relatively 
inexperienced. The scopes of the exams were in both cases too 
narrowly focused on the possibility of front-running, with no 
significant attempts made to analyze the numerous red flags 
about Madoff's trading and returns.
    During both these examinations, the exam team discovered 
suspicious information and evidence and caught Madoff in 
contradictions and inconsistencies. However, they either 
disregarded these concerns or simply asked Madoff about them 
and accepted his seemingly implausible answers at face value.
    Astoundingly, both examinations were open at the same time 
in different offices without either office knowing the other 
one was conducting a virtually identical investigation. In 
fact, it was Madoff himself who informed one of the exam teams 
that the other team had already received the information being 
sought from him.
    Both examinations failed to follow up with outside 
entities. In the first examination, the examiners drafted a 
letter to the NASD seeking independent trade data, but never 
sent the letter, claiming it would have been too time-consuming 
to review the data they would have obtained. Our expert opined 
that had this letter been sent, the data collected would have 
provided the information necessary to reveal Madoff's Ponzi 
scheme.
    In the second examination, the OCIE Assistant Director 
obtained information from a financial institution that Madoff 
claimed he used to clear his trades, indicating there was no 
transaction activity in Madoff's account for a specified time 
period, but failed to conduct any follow-up or even share this 
information with the exam team. The investigation that arose 
from a complaint that explicitly stated it was highly likely 
that Madoff was operating a Ponzi scheme never really 
investigated the possibility of a Ponzi scheme. The Enforcement 
staff failed to appreciate the significance of the analysis in 
the complaint and directed most of their investigation at 
determining whether Madoff should register as an investment 
adviser.
    The Enforcement staff again almost immediately caught 
Madoff in lies and misrepresentations, but failed to follow up 
on inconsistencies. In fact, when Madoff provided evasive or 
contradictory answers to important questions in testimony, the 
staff simply accepted his explanations as plausible.
    Although the Enforcement staff attempted to seek 
information from independent third parties, they failed to 
follow up. For example, when they received a report from the 
NASD that Madoff had no option positions on a certain date, 
they did not take any further steps. Further, Enforcement 
drafted, but decided not to send, a letter seeking 
documentation from European counterparties. Had any of these 
efforts been fully executed, they would have led to Madoff's 
Ponzi scheme being uncovered.
    We have recommended that the Chairman carefully review our 
report and share with OCIE and Enforcement management the 
portions of this report that relate to performance failures by 
those employees who still work at the SEC so that appropriate 
action is taken on an employee-by-employee basis. My office 
also plans to issue three additional reports relating to the 
SEC's failures regarding Madoff. Because of the systematic 
breakdowns we found in our investigation, we plan to issue two 
separate audit reports providing the SEC with specific and 
concrete recommendations to improve the operations of both OCIE 
and Enforcement. FTI is finalizing a report that will describe 
its analysis of OCIE's exam process and provide numerous 
``lessons learned,'' with specific and concrete recommendations 
to improve nearly every aspect of OCIE's operations. These 
recommendations, which are currently in draft status, are 
detailed in my written testimony.
    We are also finalizing a report that analyzes ``lessons 
learned'' from the Enforcement investigations of Madoff and 
prescribes concrete recommendations for improvement within 
Enforcement. The Enforcement-related recommendations we are 
currently considering are also detailed in my written 
statement.
    Both reports containing recommendations to OCIE and 
Enforcement will be finalized and issued within the next few 
weeks. We also plan to issue an additional report in November 
2009 analyzing the reasons why OCIE's investment adviser unit 
did not conduct an examination of Madoff after he was forced to 
register as an investment adviser.
    My office is committed to following up on all the 
recommendations that we will be making to ensure that 
significant changes and improvements are made in the SEC's 
operations as a result of our findings. We are confident that 
under Chairman Schapiro's leadership the SEC will take the 
appropriate steps to implement our recommendations and ensure 
that fundamental changes are made in the SEC's operations so 
that the errors and failings we found in our investigation are 
properly remedied and not repeated.
    Thank you.
    Chairman Dodd. Thank you very much for the very 
comprehensive work you and your staff have done, and we 
appreciate it.
    I am going to ask the Clerk to keep on about 7 or 8 minutes 
here for the first round, because we have a second panel to go 
to and I know several colleagues have other oversight hearings 
and responsibilities. They will be coming in and out. And I am 
going to leave the record open, by the way, for questions, as 
well, if they are unable to make it here, so they have a chance 
to make sure their questions will be answered, and I would 
appreciate, to the extent you have got a lot of work in front 
of you and recommendations, if you would also respond to these 
questions as soon as possible. I would make that similar 
request for our second panel. In fact, I am making it now, so 
they can hear that, as well.
    Let me just quickly, if I can, jump in. The report 
describes a number of very critical instances in which the SEC 
staff failed to see information--you have just enumerated these 
in your testimony--getting information from third parties to 
verify Mr. Madoff's claims about his trades. Steps as simple as 
sending a letter that was already drafted, in fact, in one 
case, a drafted letter just needed to be sent that might have 
brought an end to this thing years ago, or making a single 
phone call to the Depository Trust Corporation or the National 
Association of Securities, NASD. Just a single phone call, is 
that what you are saying, a single letter being sent, a single 
phone call having been made, in your view, could have brought 
this to a screeching halt and exposed it for what it was?
    Mr. Kotz. Senator, that is right. The concern was that they 
would get tremendous amounts of information that would take a 
long time to peruse. But, in fact, of course, since Madoff 
wasn't engaged in trading, they would have received very little 
information and immediately they would have seen that on 
certain days that Madoff was claiming in customer statements he 
had $2 billion in options, for example, there are no records of 
those.
    Chairman Dodd. He made no trades?
    Mr. Kotz. That is right. I mean, he had a broker-dealer 
operation and he had firm trades, but it was in very different 
amounts. It was certainly--we actually--during the course of 
our investigation, we went to DTC and we got specific dates, 
for example, the date that Madoff testified before the SEC, and 
we compared the documents, the customer statements, with the 
documents from the DTC and immediately we saw that there was no 
question that Madoff wasn't making anywhere near the volume 
that he said he was, and with respect to the NASD, as well. I 
mean, there are entities that clear trades. Those are 
independent entities. Madoff can't give them documents. Those 
documents are independent. And had they done that, they would 
have uncovered this scheme.
    Chairman Dodd. So a single phone call, a single letter, 
would have exposed this for what this was----
    Mr. Kotz. Yes, that is right.
    Chairman Dodd. That is your testimony. To what do you 
attribute--again, and this is a broad question, but try and be 
brief in your answer--the lack of follow-through? I mean, is it 
agency culture? Lack of staff commitment? Staff not wanting to 
antagonize powerful people within the industry? The Office of 
Compliance Investigations, Examination, and Enforcement, do 
they employ trusting people? I presume they do, but I raise the 
question with you here. What should the SEC do, in your view, 
as a general matter to address this issue?
    Mr. Kotz. Well, I think there are a couple of reasons. One, 
they were too trusting of Madoff. I think a lot of people just 
simply didn't believe that Madoff could be operating a Ponzi 
scheme, notwithstanding the fact that they got complaints that 
gave indicia of that Ponzi scheme.
    I think also they set the scope of their examinations and 
investigations too narrowly. So when the junior folks wanted to 
continue, the senior people said, that is not within the scope.
    I think that there was too much of an emphasis on numbers, 
how many exams were going to get done that year. And there was 
a certain time period where the examiners were at Madoff's firm 
conducting an examination. They wanted to continue and their 
supervisor said, time is up, we have to move on to the next 
one, without really going back to ensure that you did a full 
and thorough job on that one.
    I think skepticism is very important, no matter who it is. 
I mean, Madoff certainly used the fact that he was the sole 
contact for many of the examinations, particularly involving 
junior examiners. They sat with Bernie Madoff for hours a day. 
He told them stories about how he was on the short list to be 
the next SEC Chairman and gave them information, dropped a lot 
of names. And there wasn't sufficient support from the senior-
level people. You cannot allow a junior-level person to be put 
in that position.
    Madoff was very aggressive when they would ask for 
information that he didn't want to provide and they didn't get 
enough support and back-up from their senior-level people. 
Madoff tried to focus them toward front running, toward these 
limited areas so they would not get to the real issues, and he 
was successful in doing that.
    Chairman Dodd. There are 41 recommendations, by my count, 
that you make in your report. I know you are going to make 
some--there is a follow-on you are going to be doing with some 
recommendations. But the 41 I have counted--this is a hard 
question to ask you, but I would like you to try anyway--how do 
you prioritize these? In the recommendations, which are the 
ones that you believe are deserving of immediate attention to 
minimize, if not entirely stop, this kind of example from 
happening again?
    Mr. Kotz. Yes. I mean, I think there are specific things 
that have to be done within particularly the examination 
program in terms of ensuring that when a complaint comes in, 
all aspects of the complaint are reviewed. They have to ensure 
that the planning memorandum are done appropriately. They have 
to ensure that the conduct of the exam is done sufficiently. 
They have to go to independent third parties. I think those are 
very important areas.
    I think you mentioned earlier about coordination among 
staff. I think that is one that has to be addressed right away. 
You cannot have a situation where one side of the SEC doesn't 
know what the other side is doing. I mean, in that examination, 
the examiners were ready to confront Madoff with some 
misrepresentations, inconsistencies. When they confronted him, 
he pushed back at them by saying, ``I already provided this to 
your colleagues.'' They were embarrassed. They were taken 
aback. And it is difficult to continue that momentum in an 
examination when it seems as though the individual you are 
examining knows more than you do. So that is one, I think, that 
has to be remedied right away.
    I mean, the fact is that the SEC as a whole got numerous 
complaints over the years, but nobody kind of counted it up to 
see, hey, wait a minute. We have got this complaint and this 
complaint and this complaint, and taking it all in, there must 
be more to it than just simply front running. So that is 
something, I think, that must be addressed right away.
    Chairman Dodd. Steven Pearlstein writes for the Washington 
Post--and I agree writes a good column--wrote a column recently 
in which he suggested there is a culture at the SEC--and I am 
not going to quote him exactly, I don't remember the exact 
words he used--that minimizes the following on of tips, that 
there is sort of a rejection of the tips coming in as just not 
really worthy of follow-on. Do you agree with that?
    Mr. Kotz. Certainly, in the case of Harry Markopolos's 
complaint, the enforcement investigators felt that he wasn't an 
insider and immediately discounted his complaint. And we asked 
them when we did the investigation, what else could Harry 
Markopolos have provided other than perhaps, ``Bernie Madoff 
told me he was operating a Ponzi scheme,'' and if he had 
provided that, then we wouldn't need the SEC.
    So there was that case, that unless it is an insider, that 
they had concerns about Harry Markopolos because he made 
reference to a bounty, that he is only out for money, and they 
discounted him based on that, when in fact, if you look 
carefully at his complaint, he had two scenarios. One was a 
Ponzi scheme, which he viewed as highly likely. One was front 
running, which he viewed as unlikely. Front running was the one 
that he could potentially get a bounty, not for the Ponzi 
scheme. So if he was really out for a bounty, he would have 
pushed the other one, not the Ponzi scheme.
    But yes, there was definitely a sense, particularly in the 
investigations that we looked at, of them not taking seriously 
enough complaints like Harry Markopolos's complaint because 
that person was an insider, because the information wasn't 
given to them wrapped up in a bow. And clearly, the SEC got 
sufficient information to then move the ball--I mean, that was 
one of our concerns about the entire process. The SEC got 
detailed complaints. They never really took it anywhere from 
where the complaints were, notwithstanding the fact that they 
spent significant time. And as you say, doing other things, for 
example, contacting independent third parties, would have 
immediately moved the ball.
    Chairman Dodd. Yes. How about, just in terms of you have 
the Boston office, the New York office. These things kind of go 
on. Are there jealousies within offices, who initiates an 
investigation, who gets it, who gets credit? Is that a problem? 
Did you encounter that?
    Mr. Kotz. You know, it is interesting, because the Boston 
office was very impressed with Harry Markopolos's complaint, 
understood Harry Markopolos's complaint----
    Chairman Dodd. They wanted an investigation.
    Mr. Kotz. They wanted an investigation.
    Chairman Dodd. They sent it down to New York.
    Mr. Kotz. Right. At that time, there was a concern in the 
agency that offices were hoarding cases, and so, rightly so, 
the Boston office felt they shouldn't hoard this case. They 
should send it to New York where Madoff was. It didn't make 
sense for Boston to do it.
    But when the heads of the Boston office sent it to New 
York, they made special efforts. They had the head of the 
Boston office email the head of the New York office directly to 
make sure that they understood this is not a complaint we just 
want to give you because we want to take the good ones. This 
was a very significant complaint. Then they followed a couple--
--
    Chairman Dodd. Was that an extraordinary kind of 
communication?
    Mr. Kotz. Yes, it was, absolutely. And then they followed 
up a couple weeks later to make sure that someone was assigned 
to that case, even after the first follow-up. So they did what 
they could to ensure that New York was doing it appropriately. 
Ironically, had they hoarded the case, as was the case and was 
a concern within the agency, they would have likely taken the 
appropriate steps to uncover the Ponzi scheme.
    Chairman Dodd. Last, and my time is up, but I want to raise 
the silo problem that you have already addressed to some 
degree. And I say, this is not a unique problem. I mean, this--
we see this, I think, in private organizations as well as 
public ones, this kind of approach where there is not the kind 
of communication between divisions for a variety of reasons. 
How serious a problem is this, and what do you recommend be 
done about it?
    Mr. Kotz. Yes. I mean, I think on the examination side, it 
was a concern. You had broker-dealer examiners conducting the 
examinations who didn't understand the investment manager side. 
I do believe, and John Walsh will talk about that later, that 
that issue has been rectified and now they are doing exams with 
the joint groups. So I think that that is on its way to being 
resolved.
    On the enforcement side, the concern was Madoff would say 
that his trading was in Europe. Well, we have an Office of 
International Affairs. If you have questions about trading in 
Europe, you go to the Office of International Affairs. That is 
their purpose. The Enforcement Division didn't do that, and I 
think that is something that needs to be encouraged among 
enforcement attorneys. If they don't understand particular 
issues, they need to seek assistance in the agency. There are 
people in the agency who do understand it, but they need to 
seek assistance from them so that they can properly conduct 
these investigations.
    Chairman Dodd. Is there anything as simple as an 
interagency task force that sits down periodically with each 
other to talk about various cases to determine whether or not 
there ought to be some cross-pollination in their efforts?
    Mr. Kotz. I think that is a good idea. I think where you 
have an investigation that involves foreign issues, I think 
that there should be some recording that efforts were made by 
the enforcement investigators, almost like a check list, that 
they checked off that they spoke to this office. So you force 
people--there wasn't sufficient planning. When they first got 
this complaint, they didn't sit down and say, how do we go 
about investigating a Ponzi scheme, because if they had done 
that, the first thing they would have said was, let us go to 
independent third parties. They need to have that process in 
place. They need to have the experience to understand and they 
need to be required to take certain steps, and a step involving 
European trading would be asking questions of our international 
folks.
    Chairman Dodd. My time is long since up, but I just want to 
make sure as you get these reports and the further examination 
of recommendations, whether or not we actually hold another 
hearing on this or not, but I want to maintain that we get that 
information right away from you, and obviously we will follow 
up with it. But I want you to keep very much in contact with 
this Committee on these recommendations, and specifically if 
there are any statutory recommendations.\1\ I am not 
recommending there be any at this point, but I would like to 
know whether or not you think there needs to be, whether or not 
this Committee has to take some action beyond holding hearings 
as to whether or not--whether it is additional resources for 
the SEC to do a job or anything else. I think all of us would 
like to know whether or not you are making any 
recommendations&ich would require the action by the Congress. I 
want to know that, OK?
---------------------------------------------------------------------------
    \1\ H. David Kotz's additional recommendations sent to Chairman 
Dodd are available in Committee files.
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    Mr. Kotz. Absolutely.
    Chairman Dodd. Thank you.
    Senator Shelby.
    Senator Shelby. Thank you. Mr. Kotz, would just simply 
providing more resources without other structural changes 
address the problems you have identified at the SEC?
    Mr. Kotz. Yes, I think it is more than just resources.
    Senator Shelby. Absolutely.
    Mr. Kotz. Yes.
    Senator Shelby. It is structure, too, isn't it, and 
leadership?
    Mr. Kotz. Yes. Yes. Because while resources was a factor in 
that they didn't have a branch chief on certain examinations, 
at the end of the day, the SEC spent years examining and 
investigating Madoff
    Senator Shelby. And found nothing.
    Mr. Kotz.----but didn't do the appropriate things. So 
additional people, if they are not going to do the appropriate 
things, will not solve the problem.
    Senator Shelby. Just waste resources?
    Mr. Kotz. Yes.
    Senator Shelby. In your report, and it is very lengthy and 
thorough and we appreciate what you have done, it noted that 
some investors viewed the fact that the SEC had inspected the 
Madoff firm as a sort of regulatory seal of approval for the 
firm. What steps can be taken, in your judgment, to help 
investors understand that the fact that a firm registered with 
or inspected by the Securities and Exchange Commission does not 
mean that the firm is legitimate or guarantee that it is 
operating in full compliance with the law? How do we thread 
that needle there?
    Mr. Kotz. Yes. I think there has to be a better educational 
process, without a doubt, because that was a significant issue. 
We found folks who reinvested with Madoff based on their 
feeling that the SEC had checked out Madoff. I had a very 
sophisticated hedge fund individual say to me he knew for sure 
that Madoff wasn't running a Ponzi scheme because he had seen 
Harry Markopolos's complaint and he knew that the SEC would 
look at that carefully and there is no way they wouldn't have 
caught the Ponzi scheme.
    So part of that means the SEC needs to do a better job in 
its investigations, but they also need to explain to the public 
and investors out there exactly what it means when they close 
an investigation. It doesn't mean they are doing everything 
right, and Bernie Madoff certainly used that fact, constantly 
referring to the SEC just being in here, which they were, as a 
way to convince people who were perhaps hesitant about 
investing with him.
    Senator Shelby. Your report also describes a series of 
failures at the SEC that enabled Mr. Madoff to continue to 
swindle the investors for decades. Given that failures occurred 
repeatedly and throughout different part of the Securities and 
Exchange Commission, can we assume that other similar frauds 
are likely occurring or have occurred without detection?
    Mr. Kotz. Well, I mean, we haven't looked at other specific 
matters----
    Senator Shelby. I know that.
    Mr. Kotz.----but yes, it was a concern that the same 
pattern seemed to take place across the spectrum. If you look 
at the examinations and investigations from 1992 until the 
present, it was very similar--limited focus, not enough 
aggressiveness in the investigations and examinations, 
inexperienced junior people not being supported by supervisors. 
So it is a great concern.
    Obviously, we spent a lot of time analyzing the Madoff 
situation and issued a very long report, but we don't know what 
else is out there and it is a great concern that these seem to 
be systematic issues. And I think the agency needs to address 
those issues in a systematic way.
    Senator Shelby. In some of your recommended reforms in your 
report, you offer a number of recommendations at the end of 
your report to improve the process by which matters are 
handled. Very important. One of the examiners you talked to, 
however, lamented the fact that, and I will quote, ``the 
typical SEC examiner walks into a room where there are a bunch 
of dead bodies lying around and they notice that the clocks are 
10 minutes fast.'' In other words, they notice the wrong thing.
    Are you concerned that even if your recommendations are 
implemented, we hope, that the culture of the SEC is such that 
examiners will be rewarded for focusing only on technical 
violations of the securities laws rather than the real 
substance, looking behind compliance check lists and 
identifying more serious problems such as this massive fraud?
    Mr. Kotz. Yes. I mean, that is a concern. We devote an 
entire section of the report to many interviews we had with 
folks outside in the private sector who conducted due diligence 
and we tried to compare the methods that they used when they 
conducted due diligence to what the SEC used. And what we found 
was exactly that. They take a more holistic approach. They look 
at larger issues rather than kind of a check list approach. Did 
you file this form? Was this signed? Are the clocks on time? Et 
cetera. And so it is a concern.
    I think that the way to resolve that is to get more input 
from these private sector folks. There are a lot of very smart 
people in the private sector who make very good decisions about 
investments, folks who looked at Madoff and immediately 
realized that there was something wrong with his returns. The 
SEC can get--have educational opportunities for training from 
these outside entities, and I think that will help them to 
focus more on big picture issues rather than have a check list 
and go by and not notice the fraud in the corner of the room.
    Senator Shelby. You also noted in your report, you spoke 
with private entities that had conducted due diligence that you 
have alluded to and concluded that Madoff's purported returns 
were not legitimate. In other words, they raised concern. Given 
that there seem to have been many people who suspected 
something was wrong at the Madoff firm, why do you think that 
more whistleblowers did not come forward to the SEC, or were 
there enough whistleblowers but not enough diligence at the 
SEC?
    Mr. Kotz. I mean, I think that there were sufficient 
complaints. I think that there were a lot of people who were 
skeptical about Madoff's returns. He was using what even the 
SEC examiners called a plain vanilla trading strategy. There 
was no magic in his split-strike conversion strategy.
    I don't think that there were a lot of people who did due 
diligence who necessarily assumed it was a Ponzi scheme. Many 
people thought he was doing perhaps something else illegal, but 
not necessarily a Ponzi scheme. So that may be a reason why 
there wasn't more people----
    Senator Shelby. But had reason to believe that something 
was not right, didn't they?
    Mr. Kotz. Yes. Yes. And people told us that they are 
nervous about coming forward. I mean, I think one of the other 
issues to look at is to encourage people to come forward.
    Senator Shelby. Absolutely.
    Mr. Kotz. People are nervous to come forward. One of the 
individuals who came forward came forward anonymously, asked us 
to keep his name anonymous in this report. Many of the people 
we talked to about due diligence asked specifically not to have 
their name reported. When the report came out, even though we 
took out their names, they called and said, ``Are you sure 
there is no way that our name is anywhere in the report?'' I 
mean, there is a concern out there about bringing information 
forward.
    So when you have somebody like Harry Markopolos who is 
willing to come forward, you have to take that and do the 
appropriate investigation. But I think something has to be done 
to look at how to encourage more people to file complaints, 
because the folks out in private industry, they have a good 
sense of what is going on.
    Senator Shelby. Is it mind boggling to you, as you did your 
research and investigation here, that a fraud of such 
magnitude, $50 billion or more--I assume one of the largest the 
SEC has ever dealt with or failed to deal with--how could it 
have happened, right?
    Mr. Kotz. Absolutely. Absolutely. And certainly, Bernie 
Madoff had a very good reputation, and I think that played a 
part in this whole issue, which is no one really believed that 
Bernie Madoff could be operating a Ponzi scheme. And I think 
that that is a reason why many investors continued to invest 
with him.
    My position would be, after doing this investigation, that 
if you get a complaint that says Bernie Madoff is operating a 
Ponzi scheme, you need to be able to believe it in order to 
conduct an appropriate investigation. At that point, you need 
to allow for the possibility that it is happening and check it 
out. And when you start checking it out and you see Bernie 
Madoff saying things that are contradictory, you need to keep 
going.
    Senator Shelby. He not only fooled the investors, he fooled 
the SEC big time, didn't he?
    Mr. Kotz. Yes, he did.
    Senator Shelby. Thank you.
    Chairman Dodd. Thank you very much, Senator.
    The Chairman of the Securities Subcommittee, Jack Reed.
    Senator Reed. Thank you, Mr. Chairman.
    Thank you, Mr. Kotz, for an extraordinarily insightful and 
informative report. We appreciate it very much, your efforts.
    Approximately how many tips, complaints, accusations, do 
you think the SEC gets a year?
    Mr. Kotz. Oh, thousands. I wouldn't know the exact number, 
but yes, quite a number.
    Senator Reed. Which they are not of the order of 
specificity and detail of Mr. Markopolos's, clearly, but----
    Mr. Kotz. Yes. Yes.
    Senator Reed. But clearly, going forward, are you confident 
that there is a triage system, for want of a better term, in 
place to separate those that are not on, at least first 
inspection, compelling and identify the compelling ones?
    Mr. Kotz. Yes. Well, one thing the SEC is definitely doing 
is revamping that entire system. So they have made great 
efforts, and the SEC folks can talk about it in more detail, 
but there has been a major effort led by Chairman Schapiro to 
revamp that entire process. I think there were some concerns 
about the triage system, but they are certainly exerting a 
great deal of energy to fix that system so that there is a good 
triage system in place.
    Senator Reed. Let me turn to another area going forward. 
That is the data and the systems that the SEC has. Everyone has 
alluded to it, the Chairman and Senator Shelby, about the 
stovepiping. You have indicated very clearly two groups going 
in, one being played off against the other by Madoff. Is the 
plan, or is the capability there today to basically go to a 
terminal and be able to call up all the information relative to 
a particular individual, a particular case?
    Mr. Kotz. Yes. I mean, I think that there needs to be some 
improvements in that area. I mean, ironically, the exam program 
actually had a system for putting examinations into a data 
base. The problem was two-fold. One, the folks who did the exam 
didn't put them in, and the folks who looked, who were doing 
another exam, didn't check. So in this case, the two exams were 
operating at the same time, but the exam wasn't in the system 
and the other entity didn't check to see if the exam was in the 
system anyway. So when you have those data bases, they have to 
be used. I think that the SEC is making renewed efforts to 
ensure that they put information into the data bases so that 
people know what the other side is doing.
    Senator Reed. That is kind of surprising. I would assume 
that entering the data was a basic requirement of the 
investigative team, and they failed to do that?
    Mr. Kotz. Yes, that is right.
    Senator Reed. And was there any--is that routine, or is 
that an exception in this case?
    Mr. Kotz. At that time, we understood it was not uncommon 
for people not to put their exams in the data base. I believe 
that things have changed since then----
    Senator Reed. Yes.
    Mr. Kotz.----but at that time, we were told in our 
investigation that it wasn't uncommon at all.
    Senator Reed. Was Madoff aware of the structural and 
cultural shortcomings which allowed him to operate so 
successfully? I mean, did he have better intel than the SEC?
    Mr. Kotz. Well, I mean, he was certainly aware that the SEC 
was conducting two examinations of him at the same time. And 
certainly, he used his knowledge generally in the industry to 
impress the examiners. So in many ways, he knew which buttons 
to push. He knew how to impress the examiners and he knew how 
to get them off the track that would have disclosed the Ponzi 
scheme.
    Senator Reed. Again, this whole area, this has been 
extraordinarily shocking to all of us and your report has been 
extremely helpful and useful. There are changes that you have 
alluded to with respect to technology, with respect to entering 
cases, different enforcement policies. I presume, but I don't 
want to put a conclusion forward without your comment, that at 
least the SEC seems to be headed in the right direction now.
    Mr. Kotz. Absolutely. I mean, this thing has really 
affected the SEC greatly, and Chairman Schapiro understands the 
importance of changing things. I have met with her many times 
on these issues. We are going to make many, many 
recommendations. A lot of things have been begun. Even before 
our report came out, I was asked to provide briefings along the 
way so they could understand how the process would work. We 
will follow up with two reports in the next few weeks that will 
make 50-some-odd recommendations that we will ensure are 
implemented. So the SEC understands, I believe, that things 
need to be done and are taking actions.
    Senator Reed. This is my final question. The more I sort of 
look at institutions and different aspects, both here in the 
United States and across the globe, culture plays a huge role 
in how people operate, how institutions operate. Can you make 
any comments upon the culture then of the SEC and the culture 
now? Are there variables that you would sort of point to in 
terms of that have to be changed that aren't strictly resource, 
that aren't strictly sort of organizational charts?
    Mr. Kotz. Yes, I think there are a couple. I think, 
historically, the Enforcement Division, in my opinion, has been 
very resistant to changes in general. There is a new Director, 
Mr. Khuzami, who is undergoing a major restructuring and there 
will be significant changes in the Enforcement Division, which 
is something that I think is unique to his leadership. I think 
that is something that may not have happened that much in the 
past. So that is an area where I think things are going to be 
different today than they were previously.
    Senator Reed. Thank you very much. Thank you.
    Chairman Dodd. Thank you very much, Senator.
    Senator Johanns.
    Senator Johanns. Mr. Chairman, thank you.
    Let me just express my appreciation for the Chairman and 
the Ranking Member following up on this. I think it is 
enormously important.
    Since this story broke, we have all had an opportunity, I 
am sure, to watch the victims interviewed, and the tragic 
stories, I mean, just make you want to weep for them, people 
who are in their senior years who just have no chance of making 
this money back. I mean, they are not going to live long 
enough.
    I read your report and I reach the obvious conclusion: The 
Federal Government blew it. What is their remedy? Where do they 
go from here?
    Mr. Kotz. Yes; I do not know. There are, I guess, legal 
issues about what victims can do. Through the course of our 
investigation, we met victims as well, and they were not--you 
know, as Senator Dodd said, they were not real rich people. 
They were not people who lost $100 million and have $100 
million left. You know, I talked to people who said for them 
December 11th was their 9/11. December 11th was like September 
11th for them. Their lives were devastated. And there is no 
question that we in the Federal Government must do better.
    Senator Johanns. I do not want to necessarily draw you into 
a political debate because that is not the purpose of this 
hearing, but so many things are happening these days, big, 
huge, Federal Government programs--health care and on and on. 
And I read something like this, and I just wonder. Tell me 
something that will assure me that the Federal Government can 
handle what it is setting out to embrace when it does this so 
poorly.
    Mr. Kotz. Well, I cannot speak for the health care system, 
but, I mean, it is a concern, at least on the SEC level, that 
there were so many opportunities, it seemed relatively easy to 
uncover this, and it was not done. So I can understand why 
there is a concern about the operation of a Government agency.
    I do think, however, that the SEC can improve its 
operations so that it gets better and it is able to do its job 
in the long run.
    Senator Johanns. You know, that is the other part that I 
take away from your report, that, boy, this was, when you 
really came down to it, kind of a no-brainer. You say that 
very, very easy to scratch into this even a little bit below 
the surface, and you are kind of in the midst of this enormous 
Ponzi scheme going on.
    Did you find any evidence of undue influence being placed 
upon the examiner or the investigator? Was there anything that 
caused you to believe that there was more to the story here 
than just sloppy work?
    Mr. Kotz. When we started the investigation, we also came 
to that kind of conclusion. There is no way in the world this 
was not some type of corruption. There has to be something 
happening. This many people could not have missed this much. 
And we followed up on numerous leads in that area, and we 
retraced every examination and investigation, reading all the 
emails, as I said, 3.7 million emails, reviewing all the 
emails, and we found that there was no evidence of improper 
influence from the top. We looked very carefully into the 
allegations about Eric Swanson, who married Shana Madoff; we 
found there was no evidence that that relationship had any 
impact.
    We did find that Madoff was able to use his stature to 
impress the junior examiners, so in that way, Madoff was able 
to use his influence. But there was nothing that we found that 
was direct, and we looked very hard, followed up on a lot of 
leads in that area, and there was just no evidence that it 
happened.
    And if you talk to the examiners and you go through the 
documents, you can see exactly how it happened, and there was 
no point in time where, you know, something switched or they 
were about to get something and somebody pulled them off. There 
was just no evidence of anything from the top or improper 
influence.
    Senator Johanns. You know, and I do not know if I should be 
reassured by that or not, because what you have just described 
for me is massive, complete, total bureaucratic incompetence. 
You know, they were not even doing it because they were on the 
take or being bought off. They just simply were incompetent.
    Mr. Kotz. And, in fact, many of the examiners and 
investigators, particularly the junior ones, actually worked 
very hard on these examinations and investigations. They spent 
a lot of time. They were not lazy and, you know, just filing 
out at 4 o'clock. They spent a lot of time working on it. But 
they were not going in the right direction. They were not doing 
the right thing. They spent a lot of time spinning their wheels 
when if they had just gone to an independent third party, it 
would have come out.
    Senator Johanns. Let me ask you this, and let me lay a 
little ground work for this. Fifty-billion dollars plus got out 
the back door before this thing collapsed, and, you know, the 
reality is I do not know if we caught up with it so much as it 
just collapsed. You have got statements being published every 
month or on whatever periodic basis. You have got investigators 
in there turning things inside and out, trying to figure out 
this and that and the next thing. You have got an organization 
that apparently is claiming it is doing trades and it is not 
doing trades. You have got customers that are calling in and 
saying, ``What is going on here?'' For intents and purposes, it 
is acting like it is actually doing something, when actually 
what it really is doing is getting the money out the back door. 
And I appreciate the importance of this question, but it is a 
question that needs to be asked.
    Do you believe that Bernie Madoff, with all of that going 
on, acted alone?
    Mr. Kotz. I am really not in a position to be able to know. 
We really did not look into that aspect of the operations. We 
focused on the SEC. So I do not know that I could give an 
educated answer on that question.
    It seems to me to have been----
    Chairman Dodd. Why don't you give an uneducated answer?
    [Laughter.]
    Mr. Kotz. I can give an uneducated answer on any question, 
I guess.
    It seems to me it was a pretty large enterprise, that it 
would be difficult even for Bernie Madoff to pull off himself. 
But that is not based on information that I found during the 
investigation, just based on kind of some understanding of how 
this worked.
    Senator Johanns. You know, what I am driving at here is 
this: You probably have people in the hearing room who are 
victims. You have certainly got people who are watching this on 
TV who are victims. Their lawyers and probably themselves are 
trying to figure out where does this tangled web lead to, and 
if we follow in this direction, there may be assets out there 
that we have not yet tapped into. And although people, I think 
sadly, are only going to get pennies on the dollar by pursuing 
that, that is still something. And that is why I think that 
question is enormously important, because if we have any role 
here, it is to protect the public. And I think you are saying 
beyond any shadow of a doubt, the Federal Government, with this 
agency that is supposed to protect the public, failed 
miserably.
    So help me try to figure out how this Committee embraces 
this very difficult issue and picks up the mantle for these 
poor people and helps them do what we should have done years 
ago, which is protect them.
    Mr. Kotz. One thing I can say, you know, in the course of 
our investigation, we had communications with Federal 
prosecutors who are working on the prosecution of folks related 
to the Madoff Ponzi scheme. And I can tell you that they are 
working very earnestly to ensure that if there are people out 
there who worked with Bernie Madoff, that they come to justice. 
So I can assure you that a lot of actions are being taken in 
that respect.
    And then, you know, there are obviously questions about how 
to refund the investors the money, but we are not specifically 
involved with that. But as I said, I heard heart-wrenching 
stories myself about people whose lives were destroyed because 
of what happened, and through no fault of their own. You know, 
I talk to people about, ``Well, weren't your surprised that you 
kept getting these solid returns when everybody else was losing 
money in the market?'' One person said to me, ``You know, I was 
very concerned about it. But 3 days before Madoff confessed, I 
got a statement, and the statement showed that I still had 
money in it.'' He said, ``When you get a bank statement, do you 
go to the bank to see if the cash is still in there?'' He 
believed that the money was there. He did not have any reason 
to think it was not. He was concerned about it. But he saw that 
he had a statement. Why would he believe that it was all made 
up?
    Senator Johanns. Let me just ask one last question, if the 
Chairman will permit me. As you know, in another life I worked 
with an Inspector General--I was Secretary of the Department of 
Agriculture--and grew to really respect the work of our 
Inspector General. I cannot always say I celebrated those 
briefings that I would get, but I grew to respect their work.
    Do you find it shocking, flabbergasting, that, you know, 
you have got a whistleblower, you have got a road map that 
pretty well lays out a Ponzi scheme, that you folks were not 
brought into this earlier? I think if I would have gotten a 
letter like that, I would have, first of all, fainted and, once 
revived, I would have called my Inspector General, my General 
Counsel, my Deputy, and the White House and everybody else 
under the sun to say, ``We have got to do something about 
this.''
    Mr. Kotz. Yes, I mean, it is interesting because one of the 
things we found in the investigation is that all of these 
complaints were kept at relatively low levels. Our office was 
not involved. It was not even at the highest level of the 
Enforcement Division or the Compliance Office. It was 
relatively junior and mid-level folks that made the decisions 
to look into it and close the case. And, really, the Commission 
was never informed about the Markopolos complaint. Our office 
was never--and it was really dealt with at more of a junior 
level.
    Senator Johanns. Thank you, Mr. Chairman.
    Chairman Dodd. Well, Senator, those are great questions. I 
thank Senator Johanns immensely. Very important. And I think 
all of us share those questions as well, and this Committee is 
going to take a look at the victims and the compensation issue 
to some degree. I am not encouraged by some of the answers I 
have received already, but certainly pursuing, for whatever it 
is worth--in my mind, this could never have been a one-man 
operation, in my view. You do not steal $50 billion and engage 
in phony transactions over a period of time of this length and 
do it by yourself. That just defies logic, in my view. So I 
welcome the fact that there is a serious investigation being 
pursued, and that may offer some opportunity to provide some 
compensation to victims, as Senator Johanns has pointed out. 
But there may be other means as well, and we need to examine 
that possibility to deal with this. But it is a flabbergasting 
case, and so we are very interested in other recommendations 
you would make.
    Let me turn to Senator Menendez. Let me just inform my 
colleagues, there is a vote that is going to occur in about 4 
minutes, 5 minutes, and what I would like to recommend is that 
Senator Menendez go forward with his questions, and that those 
of us go and cast votes. We will recess after your questions 
and come right back and finish up. Senator Merkley has 
questions, I know, and others may come back, and then we will 
try to get to that second panel very quickly.
    But, Senator Menendez, why don't you go ahead?
    Senator Menendez. Well, thank you, Mr. Chairman. I 
appreciate that.
    Let me just make a comment. I was listening to our 
colleague, Senator Johanns, at the beginning of his 
questioning, and I appreciate it. I have the same dismay he has 
about how the Securities and Exchange Commission worked in this 
regard. And I know you raised the question as to whether if we 
cannot have a successful agency do this, how do we have a 
successful agency do something else?
    I come to a different point of view on that. It is how we 
correct this. It is similar to the consequences of, before you 
were the Secretary of Agriculture, the discrimination that 
black and Hispanic farmers faced in the Department of 
Agriculture that has been recognized most recently in $1 
billion settlement. And so the question is: Do we have less of 
a Department of Agriculture or do we correct what was wrong? In 
this case, do we correct what is wrong with the SEC? And so I 
look at it in that vein.
    I clearly believe the SEC staff was, from everything I have 
read of your report, grossly untrained, uncoordinated, and lazy 
in their investigations. One SEC team consisted only of lawyers 
without any traders in it, thus lacking the expertise to do, I 
think, a lot of the critical analysis and questions that were 
necessary to do the job.
    You mentioned the lack of coordination between New York and 
Washington offices, independently conducting investigations and 
finding that out only through Madoff, who used that against 
them, repeatedly not sending documents for third-party 
verification of transactions that Madoff made or supposedly 
made, because they believed that the volumes of documents they 
would get back would be too voluminous for them to review.
    Now, it does not take a fraud investigator or a rocket 
scientist to figure out that verifying information with third 
parties is necessary to find out if someone's veracity is 
legitimate or not. It is pretty amazing to me. I am a lawyer by 
training, but I do not even think it takes a lawyer to 
understand that third-party veracity is important.
    So my question is: Who is held accountable for this grossly 
incompetent performance?
    Mr. Kotz. Well, I think the entire SEC should be held 
accountable for what happened. Clearly, there are systemic 
problems, and for that reason we are having reports with 
recommendations to deal with the systemic issues. I also 
recommend that my report be shared, to the extent that there 
are current SEC employees who are still here, with the 
supervisors of those SEC employees to make a determination on 
an employee-by-employee basis about what to do about those 
specific situations.
    Senator Menendez. How many people who worked at the SEC 
made mistakes in the course of these five severely botched 
investigations?
    Mr. Kotz. I would say over 20.
    Senator Menendez. Over 20. And of those 20 people, to your 
knowledge, how many have been fired because of this gross 
incompetence?
    Mr. Kotz. Well, I do not believe anybody has been fired 
specifically related to this investigation report.
    Senator Menendez. Well, I have to tell you, it seems to me 
that you could not run a company and you cannot conduct a 
Government service in which you have gross incompetence and 
those people are allowed to stay at their jobs. So we will look 
forward to seeing what the SEC is going to do here, because the 
first thing you have to do is clean house. If there is a 
culture of incompetence, you have to change that culture, at 
the end of the day.
    You know, it seems to me--let me ask you, when the 2005 
investigation revealed that Madoff misled the SEC about the 
strategy he used for customer accounts, withheld information 
about the accounts and violated SEC rules by operating as an 
unregistered investment adviser, why didn't the SEC use its 
subpoena power to collect information from both Madoff and 
independent third parties rather than just rely on Madoff's 
work?
    Mr. Kotz. Well, the information that we received from the 
investigators who handled the matter was that Madoff responded 
to their document request. They would ask for documents; he 
would produce documents. So at least in the enforcement 
investigation, they did not feel subpoena power was necessary.
    The truth is they could have gone to the independent third 
parties without subpoenas. The SEC certainly has the ability to 
get records from NASD, now FINRA. The SEC oversees them, and 
the SEC can get DTC records as well. When we did our 
investigation, we went to DTC, we asked them for records, they 
provided them. It was no problem.
    So there was no question that they could have received the 
information, even without a subpoena.
    Senator Menendez. So it was not a denial of information. It 
was their gross incompetence in even pursuing the information.
    Mr. Kotz. Right. They never asked for the right 
information. They never either asked for it in the first place 
or followed through on their requests.
    Senator Menendez. Now, Mr. Kotz, I understand you were not 
the Inspector General during this period of time, so let me 
preface my question there. I appreciate the work you have done 
here. But who at the SEC is responsible for overseeing that 
investigations are done properly and that leads are followed up 
on?
    Mr. Kotz. Well, I would say the heads of the Enforcement 
Division are responsible for ensuring that investigations 
within that Division are conducted appropriately.
    Senator Menendez. And I agree with you. But didn't we 
Inspector Generals of the department during this period of 
time? Where were they?
    Mr. Kotz. There was an Inspector General who came in prior 
to me, yes.
    Senator Menendez. And where were they?
    Mr. Kotz. Well----
    Senator Menendez. I mean, we had a 16-year period here from 
1992 to 2008. Where was the Inspector General?
    Mr. Kotz. There was no complaint ever brought to the 
Inspector General's attention. I mean, no one ever brought any 
complaint to the Inspector General. The Inspector General's 
office was not aware of any issue. And, in fact, an Office of 
Inspector General cannot go out and do a Ponzi scheme 
investigation.
    Senator Menendez. So you have reviewed this, and in the 16 
years there was not one complaint at the Inspector General's 
office about what Madoff was doing?
    Mr. Kotz. That is correct.
    Senator Menendez. OK. That is critically important.
    Let me ask you one last question. Isn't it something to 
consider that an effective and objective audit of Madoff would 
have quickly revealed his scheme? Since Madoff's Funds was non-
public, he was not required to have an audit from the PCAOB. 
Doesn't this scandal show the need to more closely monitor 
private firms as well as public companies?
    Mr. Kotz. I think that that is correct. I think that that 
would have assisted in this process. To the extent the SEC did 
not catch it, you would have had another avenue to catch it. So 
I agree with that.
    Senator Menendez. And one final question. In your opinion, 
based upon what you have found in terms of this incompetence 
and negligence here--those are my words, not yours, but 
certainly I believe they are incompetent and negligent--should 
other SEC investigations be reopened based on the incompetence 
in this case?
    Mr. Kotz. Well, if there is certainly information leading 
them to believe that the same circumstances occurred, then I 
would say yes.
    Senator Menendez. Thank you very much.
    We stand in recess until the call of the Chair. Thank you.
    [Recess.]

            STATEMENT OF SENATOR CHARLES E. SCHUMER

    Senator Schumer. [Presiding.] The hearing will come to 
order. Senator Dodd had another pressing engagement, so he 
asked me to chair the second part of this hearing. So what we 
are going to do, since I am the last questioner of the 
Inspector General, I will give a brief opening statement, ask 
the Inspector General a few questions, and then we will get 
right along to the second panel. Oh, there will be one other 
person coming back to ask questions when I am finished.
    So first, Inspector General, I want to thank you for 
testifying and conducting this investigation of the SEC's 
failure to ferret out Bernie Madoff's decades-long fraud. With 
everything we already know about the scope and the scale of 
Madoff's fraud, I was still stunned by the details of your 
report. In fact, I am starting to believe the only thing more 
amazing than the size of his Ponzi scheme was the failure of 
the SEC to catch him. Like the old saying goes, the SEC 
apparently couldn't hit the broad side of a barn if you gave 
them a shotgun and directions. And, in fact, we will see later 
from Mr. Markopolos, I read what he sent to the SEC. It was 
almost like color-by-numbers. All they had to do was take the 
No. 6 pencil and color in the No. 6 little lines and they would 
have found the whole thing. It is just utterly amazing.
    As you absolutely made clear, there were so many warnings 
and inconsistencies, you would think the Madoff file would have 
been one giant red flag. And yet time and time again, tips were 
ignored, inquiries were waylaid. He was able to bully the 
agency into submission before full investigations were even 
started. Just breathtaking.
    And I worry not only about the SEC's ability to catch the 
next swindler, but also about its ability to do its most basic 
job, which is to oversee the capital markets. One thing that 
has become clear to me is that as our markets have evolved, the 
SEC has simply not kept pace. While the financial world has 
only gotten more and more sophisticated, the agency has at best 
stood still, if not gone backward in terms of staffing, 
resources, and sophistication.
    I have great confidence in the work of Chairman Schapiro 
and the changes she is trying to bring to the agency, but 
frankly, the SEC is outgunned. The SEC staff of 3,650 oversees 
35,000 entities. The sheriff of Wall Street is trying to police 
a town full of Howitzers with a six-shooter.
    The SEC clearly needs more resources, but it is only one of 
two financial regulators that must go begging to Congress every 
year for appropriations, even though it brings millions more in 
fees than Congress allows it to spend. This leaves the SEC 
without a stable source of funding that would allow them to 
invest in the personnel and technology they need to keep pace 
with the markets they are supposed to police.
    That is why I plan to introduce legislation allowing the 
SEC to keep all of the transaction and registration fees it 
collects from public companies so it can attract and retain the 
kind of expertise required to catch sophisticated thieves and 
invest in the technology required to monitor today's rapidly 
expanding and increasingly complex markets.
    The bottom line is, while the SEC may need new laws and new 
tools, they had all the laws necessary on the books to catch 
Madoff. They didn't have the personnel, the expertise, the 
sophistication, the organization. They need better people, more 
of them, better paid, and people who are paid enough that they 
stay a long period of time, they don't just come for 3 years 
and then leave and go to a hedge fund, because a lot of this is 
simple experience and the SEC people didn't have it.
    Now, I have a few quick questions for you, because I know 
my colleague, Jeff Merkley, has been waiting patiently, and he 
always is very patient, but very good. So let me ask you these 
questions.
    First, if you had to assign a letter grade to the SEC for 
its performance in the six Madoff investigations, what would it 
be, from A to F?
    Mr. Kotz. F.
    Senator Schumer. If you could go lower, would you give them 
a lower grade than that?
    Mr. Kotz. Perhaps.
    Senator Schumer. Yes, F and left back, or I don't know 
what. OK.
    Your report highlights the inexperience and lack of 
resources as important causes of the SEC's failures in this 
case. So would you support the concept--I am not asking you the 
language, but the concept of the bill I plan to introduce that 
would result in millions more dollars in funding for the SEC by 
allowing the fees to go directly to funding the SEC as it used 
to be and would allow them to invest in better and more 
qualified personnel?
    Mr. Kotz. Well, I think, certainly, resources was something 
that we saw that had an impact in the different examinations 
and investigations that were conducted. For example, in one of 
the major examinations, there was no branch chief on the exam. 
So the junior examiners were left kind of to their own devices, 
didn't get enough support. That was because they didn't have an 
available person. Another examination was moving forward, 
making some progress, and they decided to put it on the back 
burner in favor of another matter. That was an issue, also, 
that relates to resources.
    The limited focus decisions perhaps also relate to 
resources in that they decided that they had the manpower to 
look at a discrete issue rather than looking at larger issues. 
There was the request for documents, but they were concerned 
with obtaining mountains of documents which they didn't feel 
they had resources to look at. So there is no question that 
there were aspects of what I found that relates to a lack of 
resources.
    Senator Schumer. All right. Senator Merkley?
    Senator Merkley. Thank you very much, Mr. Chair, and thank 
you for your testimony.
    Earlier this year, we had the chance to take a little bit 
of a look at this and it is nice to revisit now with your 
report. Your report emphasizes very starkly the number of 
investigations over a span of 16 years, six investigations, and 
the fact that there were both sophisticated and very 
straightforward measures that should have caused a real 
interest on the part of the SEC.
    On the sophisticated side, we have this extraordinary 
report from Mr. Markopolos with 29 red flags. I read this 
earlier this year and I asked the question of another SEC 
member, how often do you get such a sophisticated critique as 
opposed to just a simple tip that maybe there is something 
wrong somewhere? So I want to ask you the same question. Is 
this quite an unusual document, for someone to lay out such a 
sophisticated analysis of a firm and 29 red flags?
    Mr. Kotz. We asked that question to many people in our 
investigation and the answer was almost uniform. It was very 
unusual. There were people who told us, even people who dealt 
with complaints directly who had never seen such a detailed 
complaint.
    Senator Merkley. So on the one hand, we have this very 
sophisticated point, and then we have many people with simpler 
observations, that there was no evidence of counterparties, 
that a standard consistent return on a hedge fund doesn't match 
the experience of any hedge fund anywhere under the sun, under 
varying market conditions, that there wasn't evidence of 
corresponding trades, et cetera, et cetera, and so forth, just 
very simple.
    So I look at this and I think even a novice investigator--
even a novice investigator seeing such a sophisticated report 
on the one hand, or simple, basic, how can this possibly 
square, ought to be intrigued and say there is something here 
to look after. I just simply can't accept that it is simply a 
case of inexperience or a case of resources. Was there a 
general culture of lack of curiosity, lack of wanting to 
inconvenience big players, a lack of reward to investigators 
who had hard-hitting investigations? Did it damage their career 
paths? What are the managerial issues? I really didn't see in 
your report any kind of real sign of the culture that generated 
such failure.
    Mr. Kotz. There was certainly concern about the focus being 
on finishing the investigation and moving on to the next 
matter, and so for that reason, they didn't want necessarily to 
look at the larger issues. They would stick to the more limited 
issues, which were easier to deal with, which were resolved 
quickly.
    We were surprised, as well, that the enforcement 
investigators simply didn't understand how unusual Madoff's 
investments were, and they asked Madoff in the testimony how--
he said that he had an amazing gut feel for the market. His gut 
feel was based on standing on the trading floor. He could feel 
when the market would move. And Madoff was able--he had perfect 
timing. He was able to get in and out every day in nearly the 
exact right point. And we asked them, how did you believe 
Madoff's explanation, and they simply didn't understand that it 
was so unusual to have such consistent returns over a long 
period of time that no one else was able to duplicate.
    Senator Merkley. Does this raise serious questions about 
the type of training that the investigators receive?
    Mr. Kotz. Yes. I think, absolutely, and that is one of the 
things, I think, that Enforcement is now looking to change. I 
think in the past, the SEC Enforcement lawyers were 
generalists. They were very smart, hard-working individuals, 
but they didn't have a particular specialized experience in an 
area, and I don't think that in this case that was sufficient. 
You could be a very smart person, but if you don't understand 
options or trading, you are not capable of doing that type of 
investigation.
    So I think that there is a move toward specialization, 
which will allow people who really understand how to operate a 
case, to take an investigation. One of our recommendations that 
we are considering is to require at least a certain number of 
individuals on every investigation that had done a Ponzi scheme 
investigation before. None of the people in the enforcement 
investigation had ever done a Ponzi scheme. None of them really 
knew how to do a Ponzi scheme. You cannot do a Ponzi scheme 
investigation without understanding how to do it. Just being a 
smart person who is a generalist, I don't think is sufficient.
    Senator Merkley. How could, in the face of such a 
comprehensive report like Mr. Markopolos compiled, how could 
the investigative team not include an experienced investigator 
who would have knowledge of Ponzi schemes?
    Mr. Kotz. That is a very good question. At no point in time 
was there anybody on the case who had done a Ponzi scheme 
investigation before. At no point in time did they go and sit 
down and say, let us see, how does one do a Ponzi scheme 
investigation? If we don't know, because we haven't had 
experience, let us go to our many colleagues who know. They 
didn't. They didn't know the information that was needed and 
they didn't seek out that information from others in order to 
know it themselves.
    Senator Merkley. Did you happen to ask the investigators an 
awkward question, but the awkward question would be along this 
line. Were you concerned that if you pushed and prodded, that 
complaints would be made to your superiors and your career 
might be damaged?
    Mr. Kotz. We did ask those questions to all the major 
players in all the examinations and investigations and they 
said no. We did not find that they were concerned that they 
would attack Bernie Madoff or make allegations of Bernie Madoff 
and their careers would be affected. I think there are some 
Enforcement lawyers who would like to bring a case against 
somebody like Bernie Madoff. But they simply didn't have the 
skills to be able to match up with him.
    Senator Merkley. Did the SEC routinely bring in 
consultants, folks who might have a career knowledge, 
sophisticated knowledge, to come in for 2 hours to review a 
case or provide advice or direction or any type of assistance?
    Mr. Kotz. We weren't aware of that happening in the course 
of these examinations and investigations, and when we spoke to 
folks from the outside, they said they would be willing to do 
it, if asked. And that is one of the areas that we are looking 
at toward recommendations, to encourage private sector folks to 
explain to the SEC individuals how to go about and conduct this 
due diligence.
    Senator Merkley. The investigations occurred over this 16-
year period, so that is an extensive length of time with many, 
many different folks involved, and so I don't direct this 
toward any one individual, but we did have from 2005 to 2008 
Christopher Cox, who had this management philosophy of light-
touch regulation. Was there any sort of equivalent in the 
investigative branch of being kind of light-touch investigators 
for fear of, I don't know, discouraging, inappropriately 
interfering with firms, or so on and so forth?
    Mr. Kotz. I didn't find that that was happening, at least 
in connection with the Madoff investigations and examinations.
    Senator Merkley. Well, I appreciate your report very much 
and the series of recommendations. I am not completely 
satisfied, because there has to be a factor of a culture of 
management that affects what type of investigators you hire, 
whether you hire consultants, whether you press folks to really 
get to the bottom, whether you ask common-sense questions about 
what seems out of sync, whether there are mentors in the 
department you can consult with, et cetera. I just feel like if 
we are going to have a very successful team in the future, that 
management philosophy is going to be critical to putting us 
back on track.
    Mr. Kotz. Yes, I agree with that. Absolutely.
    Senator Schumer. Thank you, Senator Merkley. Thank you, Mr. 
Kotz.
    We are now going to call our next panel forward, Harry 
Markopolos, John Walsh, Robert Khuzami. Please come forward.
    [Pause.]
    Senator Schumer. OK. Let us get started. I know that 
Senator Dodd has already introduced the witnesses, so we are 
not going to do that again. Each of you has a limit, Mr. 
Markopolos--seven, Mr. Walsh and Mr. Khuzami--five each. 
Please, so we have some time for questions, try to keep your 
statements within those limits. There is a little clock up 
there. Your entire statement will be read into the record, so 
it will be part of the record.
    Mr. Markopolos, you may begin.

STATEMENT OF HARRY MARKOPOLOS, CHARTERED FINANCIAL ANALYST AND 
                    CERTIFIED FRAUD EXAMINER

    Mr. Markopolos. Thank you, Mr. Chairman. Thank you, Ranking 
Member. Thank you, Members of the Committee.
    I was responsible for approximately one-third of the 
Inspector General's 477-page report, either directly or 
indirectly, so I can speak to that one-third of the report. I 
did submit three different complaints to the SEC in May of 
2000, March of 2001, and in the fall of 2005.
    If the Inspector General's report was falsified, 
inaccurate, or a whitewash, I would be denouncing it before you 
today. But I find this report to be extremely accurate, 
exceptionally well written, phenomenally well researched. It is 
very comprehensive. It is hard hitting. It gets right to the 
fact of the matter. In a nutshell, the SEC staff was not 
capable of finding ice cream at a Dairy Queen.
    But I never at any point in time saw any criminal activity 
by any member of the Securities and Exchange Commission. I do 
not believe that such criminal activity occurred. I know that 
the Inspector General was very comprehensive in his 
investigation. He went down all avenues. He was looking--he was 
asking pointed questions, asking if there was any inappropriate 
behavior by SEC staff at the highest levels of the 
organization, at the lowest levels of the organization, mainly 
at the teams and branch chief levels, and at all levels in 
between, and he never determined that such activity occurred. I 
suspect that he would have found it. He was digging as hard as 
he could.
    Certainly, it would have been far less damaging to the 
reputation of the SEC if criminal activity had been found and 
it could blame one or two bad apples in the bunch and say it 
was their fault and they were going to prison. They were trying 
very hard to make that criminal case. I do not believe that 
such a case existed. They certainly never found one. I doubt 
that there was any criminal activity.
    The report was so well done. The Inspector General went 
down every avenue. And when you do an investigation, you have 
to go down every avenue, and most of those will be dead ends. 
This was a typical investigation except that it was 
exceptionally well performed and I commend it to you. It is 
great reading. For the victims out there, and I know you are 
watching, you definitely want to read all 477 pages. It is hard 
hitting. It is like watching a train wreck in slow motion from 
477 different angles and it has the same tragic ending on each 
page.
    It is unbelievable. Sadly, it is true. It is a true report. 
Keep in mind that the Madoff case was the ``Twilight Zone'' of 
all fraud cases. There was nothing about this case that was 
ever believable. The scope--Mr. Madoff was in 40 different 
countries. He had over 339 fund of funds feeding him in new 
victims. Over 59 different management companies were involved 
with Mr. Madoff, in over 40 nations. He had a lot of help. This 
is perhaps the biggest international conspiracy of modern 
times. It is a record-breaker of cases.
    I think it shows that the SEC is currently not functional 
at present, but they are on the right track. The SEC prior to 
December 11 was not in the fight versus fraudsters. Fraudsters 
are winning on all fronts. They are winning the battle. None of 
this Nation's financial regulators did their jobs. Basically, 
our financial regulators--all of them--stole their paychecks 
from the taxpayers.
    White collar fraud is a cancer on this Nation's soul. It is 
the white collar fraudsters that cause the most damage. It is 
not the violent criminals. It is not the bank robbers. It is 
not the armed robbers. It is not the drug dealers. It is the 
white collar fraudsters. They have the best resumes. They went 
to the best schools, live in the nicest homes, in the finest 
neighborhoods. And yet they cause the most damage. They are the 
ones that bankrupt our companies, destroy pensions, destroy 
life savings of victims.
    And let me tell you how this report affected me personally. 
I had lost faith in all government prior to December 11, and it 
wasn't until I met Mr. Kotz and saw the investigation that he 
underwent that restored my faith. Mr. Kotz and the entire 
Inspector General's team reaffirmed my faith in government. 
This hard-hitting report is as honest as the day is long. It is 
a great report.
    I have three young sons, all aged six or under, at home 
watching today. And when they grow up, I hope that they will 
turn out to be like David Kotz. That is how much I think of the 
Inspector General. It is a hard-hitting report. I don't think 
there has ever been a finer report released. I commend it to 
everybody.
    I want to thank Mary Schapiro for her moral courage and 
leadership in allowing this report to be written and released 
to the public, knowing how damaging it would be to the 
reputation of the SEC. But before you can recover, you have to 
hit rock bottom, and I think this report takes the SEC to rock 
bottom. But they have made tremendous improvements since 
February 4, and I have seen a lot of those improvements. I am 
impressed.
    The pace of reform at the SEC, it is certainly not taking 
place at the speed of government. Mary Schapiro likes to tell 
her staff that she wants them to act like her hair is on fire. 
I think she actually misstates the case. I think she has been 
on fire lately. The pace of reforms is rapid, but it needs to 
keep that same pace going forward. The job is far from done. 
You have to crawl before you can walk, and you have to walk 
before you can run. And right now, the SEC is learning how to 
crawl all over again.
    They are heading in the right direction. They have probably 
been out of the fraud fight for about two decades and they need 
to get back into the fight. Thank you, Mr. Chairman.
    Senator Schumer. Thank you, Mr. Markopolos, not just for 
your testimony, but for your persistence and courage. I think 
when the chapters are written on how this happened and how it 
is corrected, you deservedly will play a large and stellar 
role.
    Mr. Walsh.

STATEMENT OF JOHN WALSH, ACTING DIRECTOR, OFFICE OF COMPLIANCE 
     INSPECTIONS AND EXAMINATIONS, SECURITIES AND EXCHANGE 
                           COMMISSION

    Mr. Walsh. Chairman Dodd, Ranking Member Shelby, Senator 
Schumer, and Members of the Committee, I appreciate the 
opportunity to appear before the Committee today to testify on 
behalf of the Securities and Exchange Commission. My name is 
John Walsh and I am the Acting Director of the Office of 
Compliance Inspections and Examinations at the SEC.
    First, let me say without qualification that we all 
sincerely regret that we did not detect the Madoff fraud. As I 
believe I speak here for everyone in the Examination program, 
we view the Madoff case as a terribly unfortunate example of 
what happens when we fail in our mission. The type of fraud 
perpetrated by Mr. Madoff is the kind of misconduct we spend 
our days trying to uncover. That is why we feel the way we do, 
and that is why we are working so diligently to address the 
problems that contributed to this failure.
    Let me assure you, we have not been sitting idly by 
awaiting the Inspector General's report. Indeed, from the time 
that we first learned of Madoff's fraud, we have been working 
hard to revamp the way that we operate. Since being appointed 
Acting Director last month, my most important goal has been to 
continue to reshape the Examination program.
    For example, we are actively recruiting staff with 
specialized industry experience. We are enhancing our training 
programs, including widespread participation in outside 
courses, such as the Certified Fraud Examiner Program. We are 
requiring examiners to routinely reach out to counterparties, 
custodians, and customers to verify that assets actually exist. 
We are integrating broker-dealer and investment adviser 
examinations to make sure that the right expertise is being 
deployed in every examination. We are considering new risk 
assessment techniques to more proactively identify areas of 
risk to investors. We are ensuring that examiners know they 
have management's support as they follow the facts, wherever 
the facts lead.
    But we know more can be done. So like others in the agency, 
we are carefully studying the Inspector General's report and 
will continue to do so. The report shows that some examiners 
asked the right questions, but it also shows we did not pursue 
all the answers. The report shows that some examiners were 
moving forward on the right path, but we did not take all 
necessary steps. To put it bluntly, the report shows that we 
simply didn't do what we needed to do and investors have 
suffered.
    Going forward, you have our commitment that we will 
continue to learn from our mistakes and we will continue to 
assess how we can improve our examinations. Thank you.
    Senator Schumer. Thank you, Mr. Walsh, for your candor.
    Mr. Khuzami.

STATEMENT OF ROBERT KHUZAMI, DIRECTOR, DIVISION OF ENFORCEMENT, 
               SECURITIES AND EXCHANGE COMMISSION

    Mr. Khuzami. Chairman Dodd, Ranking Member Shelby, Members 
of the Committee, thank you for this opportunity to testify on 
behalf of the Securities and Exchange Commission.
    Having read the Inspector General's report and its litany 
of missed opportunities, it is clear that no one can or should 
defend, excuse, or deflect responsibility for the SEC's 
handling of the Madoff matter. Simply stated, in this case, we 
failed in our fundamental mission to protect investors and we 
must continue vigorously to reform the way we operate.
    We have read the letters from harmed investors that were 
filed with the court in connection with Madoff's sentencing. It 
is a sobering and humbling experience. I am here to commit to 
you and to investors across the country that we will carefully 
study the findings of the Inspector General's report and any 
forthcoming audits and that we will implement the changes 
necessary to strengthen our Enforcement and Examinations 
Program.
    I am also here to personally pledge my unwavering 
commitment and unconditional efforts toward revitalizing the 
Enforcement Division and firmly reestablishing the trust and 
respect of the investors whom we are charged to protect. I know 
that my colleagues from the Office of Compliance Inspections 
and Examinations share this commitment.
    As you may know, even before the Inspector General's report 
was issued, this agency had already begun to institute 
extensive reforms. These include hiring additional staff with 
expertise, streamlining its management, expanding training, 
restructuring our processes to better share information, 
leveraging the knowledge of third parties, eliminating 
unnecessary process and procedure, and revamping the way we 
handle the hundreds and thousands of tips and complaints and 
referrals that we receive each year.
    Despite these changes, we recognize that more needs to be 
done. We intend to learn every lesson we can to help buildupon 
the reforms we have already put into place.
    With respect to the Division of Enforcement, almost 
immediately after beginning my tenure as Director of the 
Division on March 30 of this year, I, together with other 
Enforcement staff, commenced a top-to-bottom self-assessment of 
our operations. The marching orders were, think creatively and 
there are no sacred cows. That self-assessment resulted in 
numerous changes we are now implementing. Collectively, they 
have been described as the biggest reorganization in at least 
three decades of the Division of Enforcement.
    These changes, which will begin to address some of the 
issues raised by the Inspector General, include creating five 
specialized investigative units, national in scope, where we 
will combine expertise, training, and industry and 
investigative know-how to conduct smarter and more proactive 
investigations.
    To reduce management levels by almost 40 percent and deploy 
those experienced investigators back full-time to the critical 
work of conducting front-line investigations.
    And establishing an Office of Market Intelligence, a single 
unit within the Enforcement Division armed with enhanced 
technology where we will collect, analyze, prioritize, and 
monitor the more than 700,000 tips and complaints the agency 
receives annually.
    Over the past year, the criticisms surrounding the SEC in 
the Madoff fraud has been sharp and steady. We have taken the 
lessons to heart and we are in the process of implementing a 
far-reaching program of change and improvement. There has been 
no complacency. It is not business as usual. There is an 
institution-wide commitment to heightened levels of tenacity 
and professionalism.
    Criticism of the SEC arising from the Madoff fraud, 
however, should not obscure the 75-year tradition of vigorous 
enforcement resulting from the dedicated efforts of thousands 
of public servants who work tirelessly every day, and with 
impressive results, to protect the investing public. These 
staff members continue to vigorously investigate wide ranges of 
activities, cases relating to the credit crisis, market abuse, 
accounting and financial fraud, structured products, and fraud 
involving hedge funds and investment advisors.
    To take just one example, since Chairman Schapiro took 
leadership in January, the SEC has filed 45 separate 
enforcement actions involving Ponzi schemes, substantially more 
than the same period in 2008.
    Our mission is investor protection and the Madoff case 
serves as a terrible reminder to each of us of the consequences 
of not getting the job done properly. It is a lesson we will 
not and should not forget. Our job is to protect investors from 
wrong-doers and to hold those wrong-doers accountable for their 
actions.
    We recognize that as we hold others accountable, we must 
also be ready to accept responsibility for our failures. We 
stand ready to do so. And again, on behalf of the Commission, 
we pledge our commitment to do everything in our power to 
regain your confidence and the confidence of the investing 
public. Thank you for your time.
    Senator Schumer. Thank you, Mr. Khuzami.
    I have a whole bunch of questions here, but first, I just 
want to ask Mr. Walsh--he was there at the time. Still, when 
you read Mr. Kotz's report, when you see Mr. Markopolos' 
complaint, it is just astounding. I mean, this was not just a 
mistake. This was not just saying we regret it. Even Mr. 
Khuzami says, ``I am not going to mar the 75-year tradition of 
the agency.''
    Well, you know, when I got to Congress in 1980, the SEC was 
one of the premier civil service organizations in the 
Government, a little like the Justice Department. And, wow, has 
it gone downhill. It is just amazing. Of course it will mar it.
    So my first question--you can speak from, you know, 
reassociated a little--how the heck did this happen? 
Markopolos, who is a man of great integrity, says he could not 
find any fraud. Kotz, who is a man of integrity, says he cannot 
find any fraud. It was just sheer incompetence. But the 
incompetence, when you read the IG report, I mean, you did not 
have to have any training as an investigator to do the kinds of 
follow-up that might have revealed this to happen. All you had 
to do was have an IQ of about 100 and even a semi-desire to 
find out what happened. You did not have to have a burning 
desire. You did not have to turn over every stone.
    So please share with us--because I am still befuddled, and 
maybe, Mr. Khuzami, because you have had to think about this a 
lot. Markopolos has spoken on this, and we have his articles 
and things like that. Just share with us how the heck this 
happened. Because most people, if they just read what happened, 
they would say there has got to be fraud. You know, somebody 
had to deliberately do some of these things to let Madoff 
escape. Now, we have no evidence of that, and it is unfair to 
leap to that conclusion, and I do not. But I am just totally 
befuddled. The most rudimentary--in other words, if you sent a 
15-year-old, you know, a sophomore in high school, and said 
here is what is going on, figure out, you know, just follow it 
through, as a homework assignment, they would know to do some 
of these things.
    Tell me, what was going on here? Was there an attitude that 
we should not look, you know, this soft touch, whatever it is 
called, investigating? Just, you know--and I do not cast any 
shadow on your integrity at all, Mr. Walsh, but just I need to 
know, we need to know, America needs to know. It is just too 
confounding to accept an answer, ``Well, gee, it was a mistake, 
a very bad mistake, we are sorry.''
    By the way--and this will be my next question to all of 
you. It makes you think there must be 30 more of these, maybe 
not of the scope of Madoff, but there has got to be more of 
them. We were in the go-go 2000s. Other people had to be 
thinking of this. I just read about some Brooklyn Ponzi scheme 
uncovered yesterday. There must be scores more of these if the 
investigating ability was so rudimentary and so flawed.
    Go ahead, Mr. Walsh.
    Mr. Walsh. Well, Senator, I attribute it to two primary 
causes, and both of these were highlighted by the Inspector 
General, and I agree with him.
    One I think was the failure to obtain third-party 
verification of the information that Madoff was giving them, 
and this was very unfortunate.
    Senator Schumer. Did the SEC fail to get third-party 
verification routinely on just about everything?
    Mr. Walsh. At the time these examinations were done, third-
party verification was used as the examiners believed 
appropriate. We have changed that. We now require third-party 
verification as a routine part of our examinations. We provided 
detailed training to examiners to make sure they understand how 
they----
    Senator Schumer. Look, I am not asking you how you have 
corrected it.
    Mr. Walsh. Yes, sir.
    Senator Schumer. I understand that. I am asking, because 
you have got to know the whole--so there was, almost never, was 
there third-party verification?
    Mr. Walsh. It was done occasionally, but as we saw here, 
sir, too many people decided it was not needed in their 
particular examination. So I believe that was the first----
    Senator Schumer. Would the SEC--you have been there 20 
years. Would the SEC, the year you first came in, do more 
third-party verification than they did in your 18th year?
    Mr. Walsh. It is difficult for me to say, to quantify, and 
to be honest, I am really not sure. Probably we do so much more 
in 2009 than we have ever done before. It is hard to say, sir. 
I have only been an examiner for some years, and actually I am 
the in-house lawyer for the----
    Senator Schumer. You are trying to catch somebody who might 
be fraudulent, and you have some allegations, pretty serious 
ones, like Markopolos----
    Mr. Walsh. I can tell you--I am sorry.
    Senator Schumer. Again, you do not have to be Albert 
Einstein to figure out you ought to get some third-party 
verification and not accept the potential defrauder at their 
word.
    Mr. Walsh. Yes, sir, you are absolutely correct.
    Senator Schumer. Markopolos, what do you think about this?
    Mr. Markopolos. Trained fraud examiners know that you never 
go to the person that you suspect of a fraud first. You go to 
that person last.
    Senator Schumer. Exactly.
    Mr. Markopolos. You go to all the other people in the 
organization.
    Senator Schumer. Right.
    Mr. Markopolos. You question them. You build a chain of 
documents, and you verify everything. And here the examiners 
found and caught Mr. Madoff in numerous lies, and yet they had 
no professional----
    Senator Schumer. Why do you think? It is just befuddling.
    Mr. Markopolos. They had no professional skepticism. They 
had no formal fraud examination training. And so they took the 
lies, and they did not dig deeper, and they did not increase 
the scope of their examination. They did not request more 
resources. It was a failure of Fraud Examination 101, it was a 
failure of Audit 101, and it was a failure of Finance 101.
    Senator Schumer. It almost seems they had an attitude that 
they did not want to find things. Is that fair to say?
    Mr. Markopolos. They lacked any kind of regulatory zeal. 
They were not compensated or measured on the quality of the 
exams or the amount of fraud caught. They were measured and 
rewarded through promotions basically on the number of exams 
conducted, which is a meaningless statistic.
    Senator Schumer. Of course.
    Mr. Markopolos. We should care about the number of frauds 
caught and the number of frauds that we deterred and the amount 
of damages that we recovered for an investor, so they were 
measuring the wrong things and promoting based upon the wrong 
measurements.
    Senator Schumer. So you are saying that the basic system of 
incentives probably was not just neutral, but pushed people 
away from doing a thorough investigation.
    Mr. Markopolos. That is correct.
    Senator Schumer. Mr. Khuzami, do you agree with that?
    Mr. Khuzami. Well, Senator, I guess I would start slightly 
differently, certainly on the enforcement side. What we know is 
that, look, the Enforcement Division recently and during the 
time of these events has brought numerous cases based on vague 
complaints, based on press articles. The IG testified earlier 
they did not find any evidence that the investigative folks 
were lazy or not committed. So we know that the investigators 
know how to do the job, and there is a long history of cases to 
underscore that. So the question really for me was this 
appeared to be, to use an overused term, a perfect storm; that 
a confluence of events, including a lack of experience by the 
individuals, a lack of going to sources of competence to get 
advice, perhaps some personality conflicts, a lack of rigorous 
supervision, and a number of other factors meant that--and 
perhaps Mr. Madoff himself, who, while there was a finding that 
there was not undue influence, you know, it takes a little 
while for you to wrap your mind around the fact, I suspect, if 
you are not careful, that someone like Mr. Madoff may be 
running a $50 billion Ponzi scheme. There are lots of indicia 
of legitimacy that he had, from the nature of his institutional 
investors to his stature to other factors.
    So I think, unfortunately--and this was the terrible 
result--all these factors came together to lead to the 
conclusion that we missed this. But it was not for reasons that 
I think you can draw significantly greater lessons across the 
entire Division.
    Senator Schumer. I used to watch ``Dragnet'' when I was a 
kid. I watch ``Law and Order.'' I mean, I am not an 
investigator. I know that especially if someone brings up a 
complaint three or four times, you go check with someone else.
    Mr. Khuzami. That is correct. And there was consultation 
that was made----
    Senator Schumer. No, no, no, but you look for third-party--
you go out and----
    Mr. Khuzami. Absolutely right.
    Senator Schumer. And they would have caught him cold, 
right?
    Mr. Khuzami. Absolutely right, and we do that across whole 
categories of our investigations. Third-party verification, not 
just in the investment adviser context, but in every case.
    Senator Schumer. You are a starting policeman in the 
investigator's unit. You know to do third-party verification.
    Mr. Khuzami. That is correct.
    Mr. Walsh. Yes, sir, I agree, with examinations as well, 
and we are emphasizing that very strongly to make sure people 
do that.
    Senator Schumer. So let me ask all three of you: It seems 
to me almost a certainty, given how bad things were with 
Madoff, that there are probably other Ponzi schemes--I do not 
know how large--that they have not uncovered yet. What do you 
have to say about that? Markopolos first.
    Mr. Markopolos. Certainly, there are. There is always fraud 
present. The fraudsters are very smart. This past year helped 
collapse a lot of the Ponzi schemes because you always need new 
money coming in, and investors are very gun-shy these days, and 
rightly so. So we are seeing a lot more of them collapse, and 
that is why you are reading about so many. So I am sure there 
are more out there and more fraudsters to be caught.
    Senator Schumer. Would you guys agree--Walsh, Khuzami--that 
there are probably more?
    Mr. Walsh. We are actively looking for more. We have gone 
out very vigorously and conducted examinations of entities that 
have----
    Senator Schumer. I take it there is third-party 
verification now.
    Mr. Walsh. Yes, sir, absolutely.
    Senator Schumer. And do you think there are more?
    Mr. Walsh. We have actually encountered problems. We have 
referred some to the Division of Enforcement for further 
action.
    Senator Schumer. What do you think the likelihood is there 
are more?
    Mr. Walsh. We are looking for them, yes, sir.
    Senator Schumer. Mr. Khuzami?
    Mr. Khuzami. There is always more, Senator.
    Senator Schumer. Would any of them be, you know, in the 
billion or tens of--you know, Madoff was $50 billion. Stanford 
was, what, $8 to $10 billion or something?
    Mr. Khuzami. That is correct.
    Senator Schumer. Could they be in the billion-dollar range, 
or those would have been uncovered already?
    Mr. Khuzami. There is no guarantee that there is not, but I 
agree with Mr. Markopolos that the economic cycle has shaken 
out a lot of the schemes that would otherwise exist, and that 
is why we have been able to bring, along with concerted effort, 
45 this year alone.
    Senator Schumer. Right. The other thing that worries me 
related to this is, you know, with new technology and 
increasingly dark markets, it is harder to uncover some of 
these things, and it makes it more difficult. Do you agree with 
that? Do all of you agree that it would be more difficult given 
we have less transparency in the markets these days rather than 
more?
    Mr. Khuzami. Absolutely right, Senator. More complex 
products and less transparency equals a greater possibility of 
fraud and wrongdoing.
    Senator Schumer. And it would be one of the arguments, at 
least from the fraud point of view, that we ought to lighten up 
these dark markets, or at least shine some light into them, 
right?
    Mr. Khuzami. I think that is correct.
    Senator Schumer. Do you agree, Mr. Walsh?
    Mr. Walsh. Yes, sir, absolutely.
    Senator Schumer. Mr. Markopolos?
    Mr. Markopolos. The cockroaches always head for the dark 
rooms. We need to shed light in there.
    Senator Schumer. My father was an exterminator, so I may 
not be an investigator.
    [Laughter.]
    Senator Schumer. But I know that much.
    OK. Now, let me ask you this. I mean, Markopolos has 
mentioned, as has Mr. Kotz, some of the skills, the skills an 
investigator needs. Do the personnel at the SEC have those 
skills?
    Mr. Khuzami. Senator, they either have the skills, they 
have the capacity to develop them, and together with some of 
the reforms that we have undertaken, we will get to the place 
that we need to be in order to be ready to fulfill our mission.
    Senator Schumer. Are you able and willing to fire people 
who just are not up to the job?
    Mr. Khuzami. Well, Senator, there are various restrictions 
on what we are able to do in that regard, but we can get to 
where we need to be through a variety of methods. We, for 
example, are creating specialized units which will really, 
through repeated investigations of the same nature, additional 
training, and hiring specialists who are focused in these 
areas, go a long way toward creating the kind of expertise that 
we need.
    Senator Schumer. All right. One example. SEC has a lot of 
lawyers, sort of lawyer-heavy. I think in the Division of 
Enforcement most of the people are general litigators. I am a 
lawyer. Being a lawyer does not necessarily make you good with 
numbers, and that is what you need to know to figure these 
things out.
    So my question--and this is to Mr. Khuzami and Mr. Walsh: 
Who in the Enforcement or Compliance Inspections Divisions has 
the ability to do the necessary analysis and forensic 
accounting investigations in this world of very complex 
structured products, quantitative trading, and a lot of it 
hidden? You know, not hidden for a nefarious purpose. They do 
not like their trades to be revealed. What percentage of people 
at the Enforcement and Compliance Divisions have real 
experience working in the markets, trading these products, 
making quantitative models, developing trading technology 
systems, versus, say, the percentage of people who are lawyers?
    Mr. Khuzami. Well, look, Senator, we are clearly not where 
we need to be in terms of the acquisition of individuals with 
some of those skills. That is why these specialized units and 
the additional hiring will help very much. We are not going to 
get to a point in the near future where large numbers of our 
staff have the kind of skills that you are talking about. But 
that does not mean we will be handicapped by any means, because 
what you really need is centers of competence, places where 
people know they can go to get the advice and the expertise 
that they need. And that can exist within the Division of 
Enforcement, that can exist in the sister divisions of the 
agency, and that can exist through training programs.
    So while my hiring goals may not allow me to have the kind 
of----
    Senator Schumer. How many new people have you hired since 
you have come in?
    Mr. Khuzami. Well, we received a re-appropriation that 
allowed us to hire approximately 25 in 2009, and we have----
    Senator Schumer. I helped get you that appropriation.
    Mr. Khuzami. You did, and we are very thankful for that, 
Senator.
    Senator Schumer. Yes, but it is not close to enough.
    Mr. Khuzami. I agree. I agree. We have additional requests 
for fiscal year 2010 and a significant request for 2011.
    Senator Schumer. What do you think of the proposal, all 
three of you, that I made, which is that the SEC should be able 
to use the fees that it gets--registration, and other things? I 
mean, right now it is about $1.5 billion and they only get 
about $800 million of it.
    Mr. Khuzami. Senator, I think from my perspective, it is a 
very good idea, not only for the amount of the funding but for 
the predictability of it. We cannot even budget long term for 
certain kinds of projects that--we cannot go into the out-years 
because we do not know for certain whether or not the funds 
will be there. So things like IT budgets, which by definition 
are long-term projects, suffer.
    Senator Schumer. Right. And I suppose even personnel. If 
personnel knows there is going to be a growing revenue stream 
and they are likely, if they are good, to be promoted, get 
salary increases, they will stay longer. Because isn't one of 
your problems lack of experience?
    Mr. Khuzami. That is correct, and also being able to react 
quickly. Some of the banking regulators can hire immediately 
when they are facing an imminent crisis. They can bring large 
numbers of people on with specialties. We cannot do that.
    Senator Schumer. Well, they are funded the way--we would 
not have to get you this special little appropriation for a 
smaller number of people.
    What do you have to say about those kind of funding things, 
Markopolos?
    Mr. Markopolos. I definitely concur. You need to increase 
the funding in the industry, and I was a member of the industry 
for 17 years. We paid those SEC fees. And yet the money was 
diverted to the general Treasury and it was not diverted----
    Senator Schumer. So you would support the proposal I made.
    Mr. Markopolos. I support it 100 percent. Thank you.
    Senator Schumer. How about you, Mr. Walsh?
    Mr. Walsh. Absolutely. We are seeking to attract greater 
expertise to the program, hiring more senior staff who can come 
in from the industry and bring their knowledge with them. And I 
believe the proposal you are suggesting, sir, would really help 
us do that.
    Senator Schumer. Right. You know, on tapes that were 
revealed by the media today, here is what Madoff said when he 
coached his employees who were coming in. You may have heard 
this. It came out today. He said to those who were going to be 
interviewed by the SEC, ``You do not have to be too brilliant 
with these guys''--this is his quote--``because you know they 
work for 5 years at the Commission, then they become a 
compliance manager at a hedge fund now.'' That is the problem. 
They are there a short time, and then they go away.
    Do you agree with--I mean, Madoff's analysis, as crooked as 
he was, was correct in this area. Right?
    Mr. Khuzami. Certainly, we would like to retain our best 
talent for as long as we can. You know, turnover is not always 
a bad thing. As you may know, Senator, I----
    Senator Schumer. It depends who turns over.
    Mr. Khuzami. It depends on who turns over. I worked in an 
office as a prosecutor where turnover was in the 5- to 7-year 
range, but it did not stop it from being one of the premier law 
enforcement offices in the country.
    Senator Schumer. All right. Well, I was glad one of the 
people turned over in your office and came and worked for me.
    Mr. Walsh, is turnover greater today than it was 20 years 
ago at the SEC when you started?
    Mr. Walsh. Turnover has gone up and down, usually because 
of what is happening out in the marketplace. We have had a 
period of time where it has been relatively low. I think----
    Senator Schumer. Since the market crashed.
    Mr. Walsh. Yes, sir.
    Senator Schumer. But before that, was it up higher than 
it----
    Mr. Walsh. Yes, it was much higher, and we also have the 
same problem my colleague has described, that hanging onto the 
people we want to keep, it is always a challenge.
    Senator Schumer. OK. Let us see here. I have a few more 
questions, but Senator Merkley has been waiting patiently, so I 
am going to reserve a second round for me and turn it over to 
Senator Merkley.
    Senator Merkley. Thank you very much, Mr. Chair.
    I want to start, Mr. Markopolos, you said that your three 
sons were watching at home. I just want them to know what a 
courageous thing you did in reporting your belief that there 
was fraud at this firm. When I first read your 29 red flags 
report, you began it by asking for confidentiality, very 
limited circulation of who you were because of concerns for 
your safety and the safety of your family, and I think when you 
are taking on a multi-billion-dollar enterprise, those concerns 
were very legitimate, but you put the interest of our nation 
and our finances first, took some personal risk, and I applaud 
you for it.
    Mr. Markopolos. Thank you, Senator.
    Senator Merkley. I keep coming back to try and understand 
the cultural factor, because I simply can't believe that the 
capable folks coming out of--even if they came relatively 
freshly out of college--weren't able to see the basic, simple 
elements involved. And sometimes one gives the benefit of the 
doubt, and in some cases, one gives a massive benefit of the 
doubt, and there are cultural factors as to why that occurs.
    I want to get some sense, is there any kind of regular 
socializing that goes on between the SEC team and the financial 
world where people know each other, know each other 
individually, are invited to parties, are invited to go to see 
shows together? Do invitations come from the financial 
community to the investigators? Is there any kind of that kind 
of mixing that makes people more friends than adversaries?
    Mr. Walsh. Sir, we are very concerned about excessive 
fraternization because we feel it could create a conflict of 
interest and dull people's judgment and the vigor of their 
work. We have ethical rules where if someone wants to 
socialize, it must be a widely attended gathering. They should 
come in for ethics approval in advance. We take that very 
seriously. So I would hope that if there is that level of 
fraternization that a conflict of interest has arisen, someone 
who was engaging in that will certainly be recused from any 
future work relating to that firm.
    Senator Merkley. So the industry doesn't invite people to 
conferences in Hawaii?
    Mr. Walsh. Well, they do invite people to conferences and 
they can be very valuable for gathering intelligence and 
picking up on risks and trends and sometimes just the chatter 
in the background in the industry. But again, that goes through 
a very careful review and approval process to makes sure that 
the people that go to those conferences don't suffer from 
conflicts of interest while they are there.
    Senator Merkley. Does anyone else want to comment on that?
    Mr. Khuzami. Well, it is perhaps less of a problem in 
enforcement, because we by definition have an adversarial or 
potentially adversarial relationships with the institutions and 
individuals that we regulate. On the other hand, there is some 
value in that kind of outreach and participation because we are 
able to inform the investing community and the institutions of 
what we think is wrong and where we think they should clean up 
their act. And as long as you maintain a proper distance, I 
think those kind of arrangements can be beneficial.
    Mr. Markopolos. I would definitely like to comment. I don't 
think the SEC staff is out there enough with industry 
professionals at the conferences. They do not allow time off 
for staff members to attend security analyst meetings, to 
attend Economic Club meetings, to attend CPA Society meetings. 
They need to get out there and mingle with industry 
participants. And they also need to have something very simple 
that I carry with me, a business card, and the SEC doesn't even 
provide their own staff with business cards.
    So how are you going to get a fraud referral if you go to 
an industry event, which they typically don't go anyway? How 
are you going to find out what is going on if you are not out 
there? And how are you going to be educated upon the new 
products that are coming out every day, every week, every 
month, if you are not attending industry events, and they 
typically do not fund those or allow the time off.
    So I think they need to get out there more. You don't need 
to fraternize. That would be bad. But you need to at least show 
up, and they don't even show up.
    Senator Merkley. Is that something you are all taking a 
look at, in terms of staying up with understanding these exotic 
financial vehicles and so forth?
    Mr. Khuzami. Certainly. In terms of training and education, 
absolutely right. Through our specialization efforts and 
through enhanced training, we are clearly moving in the 
direction of acquiring greater knowledge and greater exposure 
in those areas.
    Mr. Walsh. Yes, sir, I would agree.
    Senator Merkley. Another challenge, and I think it was 
referred to by Senator Schumer, is that folks might come to 
your organization looking down the road and seeing the 
possibility of much higher-paying jobs in private industry, the 
same industry that they are regulating. Is the revolving door 
and the potential for much better remuneration down the road a 
problem in folks not wanting to be kind of too hard hitting in 
their investigations or offending key power brokers in the 
industry?
    Mr. Khuzami. Senator, this is an issue that came up when I 
was with the Department of Justice and continues to come up 
now. My general view is, if you want to attract good talent, 
then there is always that risk. There is no getting away from 
it, particularly for individuals who work in cities with high 
cost of living. That is just a risk. But the alternative, which 
is to accept people who find themselves less marketable, I 
don't think is palatable, either.
    But at the same time, my view is that the way that an 
individual makes themselves potentially marketable for future 
employment is by no means to pull your punches or somehow not 
conduct vigorous investigations. If anything, it is the 
opposite, that enforcement attorneys and prosecutors are very 
interested in significant cases, thorough investigations, 
cutting areas of the law, and even sometimes high-profile cases 
in order to later enhance their employment opportunities. Those 
are all good things. And employers, on the other hand, are not 
interested in hiring, in my experience, people who are willing 
to not conduct those kinds of investigations or not respected 
by their colleagues and peers and don't have influence within 
the community.
    So I recognize the problem in the abstract. I don't think 
it is as big a problem in reality.
    Mr. Walsh. Sir, I would add, if I could, we have a 
procedure where when someone is leaving, we take a look back 
over their work over a period of time before they left, a year, 
and if there is any conflict that we can see between where they 
are going and the work they have done over that period of time, 
we take it out and we make sure that, in fact, they weren't 
pulling punches and they weren't doing things they shouldn't 
have done.
    Senator Merkley. I see I am over my time. Can I ask one 
last question here?
    Senator Schumer. Please.
    Senator Merkley. One of the issues that came up in the 
Madoff situation is about the firm's auditor. So does the SEC 
review information about who a firm's auditor is, whether the 
auditor's firm's capability reflects competence, a track record 
elsewhere? Is there a change of practice in this area? And am I 
right in thinking that had the inadequacy of the auditing 
function been looked into, that this might have been a real 
clue to the situation?
    Mr. Walsh. Certainly, sir, we are looking at it much more 
actively today. And, in fact, that is one of the high-risk 
elements that we are now considering as we sift through the 
community to see if there are, in fact, other problems lurking 
out there. Absolutely, it is getting a lot more attention 
today.
    Senator Merkley. I will just close by noting that I think 
the SEC's incompetent examinations actually greatly served Mr. 
Madoff because it suggested to folks rumors of the 
investigations, the fact he could say he had been investigated 
and cleared said to people, this firm is credible and gave them 
greater confidence in investing and it just points out how 
incredibly important this function is to the correct 
functioning of our markets and the protection of the public. I 
understand that you are doing everything in your power to put 
the SEC back on course and I thank you for it.
    Senator Schumer. OK. I have a few more questions and then 
we will finish up.
    Mr. Markopolos, you make 14 recommendations to the SEC 
based on your experience. If you had to choose, tell me the two 
you consider the most important.
    Mr. Markopolos. The best tool that the SEC could use, in my 
opinion, is the pink slip. It is a piece of paper that every 
employee could understand. There need to be a number of them. I 
suspect about half the staff, or perhaps more----
    Senator Schumer. Explain to everybody who might be 
listening to this what the pink slip is.
    Mr. Markopolos. The pink slip is when you get called into 
account and you get fired for doing a bad job or not being 
competent on the job. I think many of the examiners and many of 
the enforcement attorneys lack confidence at the basic skill 
levels. There needs to be a skill inventory conducted of the 
staff. They need to take multiple choice exams. Those that 
don't cut the mustard, let them go. Everybody's performance 
needs to be closely reviewed and they basically need to start 
weeding out staff.
    Senator Schumer. Now, there are limitations on the ability 
to weed out staff. Would you, Mr. Khuzami, or you, Mr. Walsh, 
comment on those, and does the SEC need to change the rules? 
Are these rules? Are they statutes? Do they get in the way? 
Could you just generally comment on Mr. Markopolos's suggestion 
of pink slipping people?
    Mr. Khuzami. Well, Senator, I guess I can't let the comment 
pass without responding to the substance of it first, which 
would be that certainly in my experience, in the 5 months I 
have been with the Division, I would not agree by any stretch 
of the imagination of the numbers of people that Mr. Markopolos 
suggests are deserving of pink slips. I have seen the 
performance of these people. They are committed. They are hard 
working. They are excellent at what they do. And if there is 
something that we need to do, it is to train them better and to 
provide them opportunities for greater expertise
    Senator Schumer. But the question just leaps out. If that 
is the case, how did they miss Madoff?
    Mr. Khuzami. Senator, as I explained----
    Senator Schumer. If they are so confident----
    Mr. Khuzami. I can't--Senator, as I said, there are a 
number of variables that came together to cause this terrible 
consequence. My only point is that it is not emblematic of the 
entire Division.
    Senator Schumer. OK. But how about the ability to get rid 
of people who aren't good? We can disagree as to how many there 
might be.
    Mr. Khuzami. Well, Senator----
    Senator Schumer. Are your hands too tied in that regard?
    Mr. Khuzami. Senator, we are doing more in respect to--we 
are adopting, for example, in 2010 an enhanced Performance 
Management System which will allow us to better evaluate set 
objectives and evaluate the performance of individual 
attorneys. The ability to impose discipline or to terminate 
lawyers is not, in my view, is not an impediment to achieving 
where it is that we need to get.
    Senator Schumer. Mr. Walsh?
    Mr. Walsh. I would agree. I think, certainly, we have a 
very skilled staff. To me, as I read the Inspector General's 
report, one of the truly heartbreaking elements is that there 
was expertise on the staff. There were people who could have 
played the proper role in solving the problem and they just 
weren't brought to bear on the particular problem, on the 
particular issue.
    Senator Schumer. You know, this is just so confounding. You 
are saying your staff was competent. They have the tools. They 
have this. And it just didn't happen. It is just not going to 
add up to people.
    Mr. Markopolos, do you want to comment?
    Mr. Markopolos. Yes. I think it is very hard to soar like 
an eagle when you are surrounded by turkeys, and there are a 
lot of turkeys that need to be let go.
    Senator Schumer. OK, but Mr. Khuzami and Walsh are saying 
there are many more eagles than turkeys. They just happened to 
miss this thing.
    Mr. Markopolos. A lot of these--most of these attorneys at 
the SEC, honestly, I don't think they could find steak at an 
Outback.
    Senator Schumer. Well, here is what I want to ask you, Mr. 
Markopolos. Make believe there is a wall between Walsh and 
Khuzami, OK, because they seem like decent people and have very 
good reputations. Do you think they are just doing this because 
that is the job of somebody, to defend their employees, and 
maybe deep down inside them, they realize there needs to be a 
whole lot more competence?
    Mr. Markopolos. I think so. I think it is the institution 
talking, not the men. At least, I hope not. I think there needs 
to be a different model of compensation. It needs to be 
results-based. It needs to be salaries--better salaries. If you 
pay peanuts, then you shouldn't wonder why you end up with 
monkeys. You need to increase the salary and give these people 
the bonuses that they probably deserve, make them success-
based, make them revenue-based for bringing in the big cases.
    Senator Schumer. That relates to a second question. There 
are salary caps, limits. Do you think, Mr. Khuzami and Mr. 
Walsh, that they interfere with the ability to get the best 
people and retain the best people? Would it be better if the 
compensation levels were changed so you could pay more, at 
least to some of the top people? I don't just mean the senior 
advisors, but maybe you need ten really cracker-jack 
investigators who get paid more than others, and you can't do 
that given the present rules. Is it possible the pay scales, 
way of promoting, seniority and all that need to be changed in 
an agency like this?
    Mr. Khuzami. Senator, I think that greater flexibility in 
both the ability and the amount that we could pay people would 
be very helpful, particularly as we recruit market specialists, 
structurers, traders, others who came from Wall Street who, 
although may have a difficult finding a job now, may soon find 
themselves in demand and making many multiples of that.
    Senator Schumer. Right. So you would say that you need more 
flexibility. Do the top salaries have to be raised, or what you 
can pay for some certain key people have to be raised?
    Mr. Khuzami. I agree completely, Senator.
    Senator Schumer. Mr. Walsh?
    Mr. Walsh. Yes, sir. That would really help us attract the 
talent we need. We are constantly competing with Wall Street to 
draw in people who have the skills we need to regulate Wall 
Street.
    Senator Schumer. Obviously. OK. That was your first--I 
asked you for two, Mr. Markopolos. Give me the second.
    Mr. Markopolos. The second, almost as important, would be 
to minimize, if not eliminate, the influence and the over-
lawyering at this agency. Put people with capital market----
    Senator Schumer. I didn't hear that. Minimize the influence 
of what?
    Mr. Markopolos. Of the attorneys at the SEC. There are too 
many--the attorneys are running the show and they have failed 
miserably. It is time to give people with capital markets 
experience a chance. I have to think we can do better. We 
understand the frauds of the 21st century. We know these 
instruments. We know the structured product. We know the math. 
We know the derivative. We know how they are put together 
again. The law--there are too many lawyers and the law is too 
low of a bar for behavior. Securities law is down here. The 
behavior we need to shoot for is way up here and it is called 
good ethics, it is called good transparency, and open----
    Senator Schumer. That is two separate issues. One is making 
the standard higher. That has to be done statutorily or that 
could be done administratively?
    Mr. Markopolos. I think administratively. You would have 
to--the lawyers only look at the low bar, the law. You need to 
raise that.
    Senator Schumer. One is lawyers versus investigators. I 
asked them about that, but we will come back to that. But the 
first one is, do you think the actual standard of criminality 
has to be changed or at least of what fraud is?
    Mr. Markopolos. Yes. You need to increase the bar and make 
it more expansive, give these guys more tools.
    Senator Schumer. OK. Do you gentlemen agree with that? You 
need some statutory or regulatory changes in defining what 
fraud is?
    Mr. Khuzami. Senator, I don't think it is so much the 
definition
    Senator Schumer. And I don't just mean fraud. I mean the 
other crimes, too, whatever they are----
    Mr. Khuzami. We generally don't lack for statutory vehicles 
to charge individuals. There are issues, as you know, with 
respect to our ability to have jurisdiction over security-based 
swaps agreements and hedge funds, for example, which would 
greatly aid our investigations, as would the requirement that 
hedge funds and others have standard audit trail information so 
that we can more quickly analyze their trading patterns.
    Senator Schumer. Right. Mr. Walsh, do you have anything to 
add?
    Mr. Walsh. No, I agree with my colleague on that.
    Senator Schumer. And what about the second comment? Mr. 
Markopolos's comments were really two. The second was, too many 
lawyers, not enough market experienced people. I sort of asked 
you that before.
    Mr. Walsh. Well, as--I am sorry. Go ahead, please.
    Mr. Khuzami. Look, we are all about increasing our 
specialization. That is the thrust behind so many of the 
reforms we have implemented. I will say at the same time, there 
are astounding examples of work in complicated capital markets 
areas that the staff has done. Just to take an example, in the 
New York office, one of our flagship offices, many of the same 
groups that were involved in this case did the sham finite 
reinsurance cases involving AIG, RenaissanceRe, and others, 
highly complicated, structured transactions in which no risk 
was being transferred, transactions done solely to augment 
balance sheets and earnings. We did those cases and we did them 
well, $800 million worth of disgorgement and penalties that 
went back to investors, 24 enforcement actions, criminal 
convictions. We have that capability. We can do a lot more with 
some specialized expertise.
    Senator Schumer. OK.
    Mr. Walsh. The examination program actually has relatively 
few lawyers. I am the lawyer for the program, but there are 
only 13 percent of us. Most examiners are accountants. Many of 
them are very fine forensic accountants. But I believe where we 
really need to grow, and I believe I agree with you on this, is 
to have more financial analysts, to have more trading 
specialists, people who understand difficult valuation issues, 
and that is really--
    Senator Schumer. Very logical.
    Mr. Walsh. Yes, sir.
    Senator Schumer. You don't have the resources to do that 
right now, do you?
    Mr. Khuzami. No, we do not.
    Senator Schumer. OK. And so just to reiterate, the kind of 
legislation I have introduced is really very much needed, 
really if you are going to stop all these futures schemes as 
the markets get more complicated. Do you agree, Mr. Khuzami?
    Mr. Khuzami. That may be the single best thing that you 
could do, Senator.
    Senator Schumer. Mr. Walsh?
    Mr. Walsh. Yes, sir.
    Senator Schumer. Mr. Markopolos?
    Mr. Markopolos. Yes, Senator.
    Senator Schumer. Good. Last question. The Inspector 
General's report states, on a conference call about two Madoff 
exams, quote:

        a senior-level Washington, D.C. examiner reminded the junior 
        examiners that Madoff, quote, `was a very well-connected, 
        powerful person,' which one of the New York examiners 
        interpreted to raise a concern for them pushing Madoff too 
        hard.

    Mr. Markopolos, did you feel that Mr. Madoff's stature in 
the investment community was an impediment to the SEC 
uncovering his Ponzi scheme?
    Mr. Markopolos. Yes, Senator, I do. I feel there is a 
protective species on Wall Street where the biggest and most 
powerful firms are given a free pass or a ``get out of jail'' 
card and they go after the small fry.
    Senator Schumer. Mr. Walsh, could that have been true?
    Mr. Walsh. Well, sir, it is very difficult. I think the 
Inspector General concluded that while there was no direct 
interference in the examination by supervisors, he did, I 
believe, conclude that it could have been a secondary effect in 
what happened. We are taking this very seriously. We have 
established an internal hotline, so SEC examiners anywhere 
around the country, as soon as they believe they are being 
intimidated or a firm is acting unreasonably or 
inappropriately, they can call the hotline and it will ring on 
the desk, my desk and the desk of a number of senior people who 
work with me. We are moving very quickly to make sure that this 
type of intimidation----
    Senator Schumer. But I think what they are saying here is 
you wouldn't call a hotline. What Mr. Markopolos is agreeing 
with and what the Inspector General was saying was, because he 
was a powerful person, they sort of instinctively might not 
have been as tough as if he was a less powerful, less well-
connected person----
    Mr. Walsh. Well, we are all----
    Senator Schumer.----not a hotline that is going to change 
that.
    Mr. Walsh. Well, sir, I----
    Senator Schumer. Let me ask Mr. Khuzami
    Mr. Walsh. Sorry.
    Senator Schumer.----what are you doing to deal with the 
issue that both the Inspector General and Mr. Markopolos had 
pointed out, to try to get into these sort of psychological 
barriers?
    Mr. Khuzami. Senator, I think the way to deal with 
something like that is tone at the top and communication and 
involved supervision, supervisors and managers who recognize 
the situations where perhaps a more junior person may be 
susceptible to that kind of influence, and that supervisor 
intervenes and closely monitors to make sure that that is not 
happening.
    Senator Schumer. OK. Good. Does anyone want to add 
anything, because if not, we will close the hearing and thank 
you for your time. But do you have any more comments, Mr. 
Markopolos?
    Mr. Markopolos. No, I do not. Thank you, Senator.
    Senator Schumer. Any more metaphors? You are pretty good 
with those.
    [Laughter.]
    Mr. Markopolos. No. Thank you.
    Senator Schumer. OK. Mr. Khuzami or Mr. Walsh, any 
comments?
    Mr. Khuzami. No----
    Senator Schumer. You are not big on the metaphors.
    Mr. Khuzami. No, too many metaphors.
    Senator Schumer. Right. OK.
    Mr. Walsh. Thank you.
    Senator Schumer. I like metaphors, as people know.
    I thank all of you for coming, and the hearing is closed.
    [Whereupon, at 5:12 p.m., the hearing was adjourned.]
    [Prepared statements and responses to written questions 
follow:]
           PREPARED STATEMENT OF CHAIRMAN CHRISTOPHER J. DODD
    Bernard Madoff stole $50 billion.
    He stole from individuals and pension funds and charities and 
municipalities like Fairfield in my home state. He stole more than 
money. He stole the retirement savings and the economic security of 
families across the country.
    And the Securities and Exchange Commission didn't stop him.
    There can be no excuse for that colossal failure. But I demand--the 
victims of this fraud, some of whom hail from my state and have 
testified before this Committee, demand--an explanation. And so today, 
we hold our third hearing on Ponzi schemes--and our second on the 
Madoff fraud in particular--to find out how this could possibly have 
happened, and what we need to do to make sure it can never happen 
again.
    Incredibly, it emerged late last year that SEC staff had received 
multiple complaints over a period of sixteen years that Madoff's 
business was not legitimate, but hadn't taken any effective action. To 
his credit, then-Chairman Christopher Cox directed the SEC Inspector 
General to conduct a full investigation of why these credible reports 
had been ignored.
    The Inspector General released a report last week, and it is deeply 
disturbing. As the report indicates, ``The SEC received more than ample 
information in the form of detailed and substantive complaints,'' but 
``a thorough and competent investigation or examination was never 
performed.''
    The report goes on to describe an embarrassing series of internal 
failures at the SEC:

    Incompetent supervisors directed their offices to look only 
        for the types of fraud they understood and failed to recognize 
        the type actually being committed in the Madoff case.

    Inexperienced SEC staff simply accepted Madoff's claims 
        without making the single phone call or sending the single 
        letter that it would have taken to verify his information.

    No one ever thought it merited a closer look when Madoff 
        said he traded in Europe with a firm that reported there was no 
        activity in the account.

    Divisions and offices failed to coordinate or share 
        information.

    It is ugly stuff. Beginning in 1992--1992!--the SEC received 
information that should have led to a quick end for Bernie Madoff's 
Ponzi scheme.
    But because the task of following up on that information was 
assigned to junior staff or supervisors with insufficient experience in 
the securities market, because that staff failed to ask obvious 
questions or take simple steps to verify what Madoff told them, because 
their supervisors actually discouraged further investigation--in short, 
because the SEC failed to do its job, Madoff stole $50 billion.
    Today, we will hear from the Inspector General about his report. We 
will hear from Harry Markopolos, an investment analyst who continually 
attempted to get the SEC's attention with regards to the Madoff fraud 
about his ideas for improving the organization. And we will hear from 
the heads of the Office of Compliance, Inspections, and Examinations 
and the Division of Enforcement about what the SEC has done in light of 
the Madoff revelations, and about what Chairman Schapiro intends to do 
going forward.
    There are several clear steps that should be taken:

    SEC staff should be trained in markets and investment 
        strategies so they can know fraud when they see it, and the SEC 
        should hire staff with real world experience.

    The very culture needs to be reformed to encourage 
        aggressive oversight.

    Staff should verify self-serving statements of facts made 
        by targets of investigations.

    Coordination among the SEC's offices and divisions must be 
        improved.

    There should be a more rigorous system for evaluating 
        outside tips and allegations, including articles in the 
        financial press.

    Like many Americans, I am stunned and angry that this fraud was 
allowed to happen. But I also believe that the SEC can do better. And I 
look forward to discussing how in today's hearing.
                                 ______
                                 
            PREPARED STATEMENT OF SENATOR RICHARD C. SHELBY
    Thank you, Mr. Chairman.
    Last January, a little more than 1 month after Bernard Madoff 
confessed to running a $50 billion multi-decade Ponzi scheme, this 
Committee held a hearing to try to understand how a fraud of that 
magnitude could go undetected by the Securities and Exchange Commission 
for so many years.
    Unfortunately, that hearing yielded few answers.
    In the intervening 7 months, the SEC's Inspector General has been 
piecing together what really happened. His report sets out a chronology 
that tracks fifteen years of missed opportunities and considerable 
incompetence.
    The IG found that the Office of Compliance Inspections and 
Examinations and the Division of Enforcement were made aware at least 
six times that there might be something wrong at Madoff's firm.
    Potentially fruitful leads were not pursued while significant staff 
resources were devoted to running down clearly unproductive avenues.
    Investigations were unfocused, understaffed, and improperly 
documented. Communication across SEC offices was so badly flawed that 
Madoff himself had to alert the New York examiners that their 
counterparts in the Washington office had been looking at similar 
issues.
    The IG determined that SEC culture and organizational structure 
discouraged employees from reaching out to one another to share market 
intelligence, obtain expert advice, or compare notes about their cases.
    SEC employees did not give weight to colleagues' recommendations, 
so a tip found credible by one group of staffers would be dismissed 
hastily by another.
    The report also documents that Mr. Madoff, despite his persistent 
misrepresentations to the SEC, received greater deference by the staff 
than the tippers who spotted his fraud.
    Ultimately, in each case, the report indicates that the lingering 
questions and concerns of SEC employees were swept under the rug by 
impatient and inflexible supervisors who concluded that asking the 
logical next questions would take too long or would be outside the 
scope of the examination.
    In the aftermath of the botched Madoff investigation, the SEC has 
claimed that more funding will address its failures. The report 
however, clearly describes an agency that does not know how to use the 
information and resources it already has. Fixing the SEC will not 
merely involve more resources.
    The Commission is going to have to make broad-based changes if it 
hopes to become a smarter, more flexible, more productive and 
ultimately more accountable organization.
    I am hopeful that the SEC will learn from its failures and seize 
this opportunity to reform itself from within. If it refuses to do so, 
Congress will do it for them.
    Thank you Mr. Chairman.
                                 ______
                                 
               PREPARED STATEMENT OF SENATOR TIM JOHNSON
    Thank you Chairman Dodd for holding today's hearing. Following the 
recent release of the SEC's Inspector General's ``Investigation of 
Failure of the SEC to uncover Bernard Madoff's Ponzi scheme,'' I think 
it is crucial that this Committee continues its oversight role of the 
SEC. The report highlights the numerous mistakes the agency made, the 
red flags that were missed, and a too narrow examination focus that 
prevented the agency from taking a ``big picture'' look at the business 
Bernard Madoff was running. These grave mistakes call into question the 
job the SEC was doing, and more importantly cost some American 
investors their life savings.
    I applaud Chairman Schapiro for the efforts she has made to reform 
how the SEC regulates markets and protect investors. It is the role of 
this Committee to help determine if the changes that were made are the 
right changes to prevent fraud, like that which was perpetrated by 
Bernard Madoff, from happening again. While massive cases like the 
Madoff ponzi scheme rightfully grab headlines, we must also focus on 
smaller fraudulent schemes which also hurt investors.
    It is my goal to ensure that the SEC has the right tools and 
appropriate resources; that investors have access, information, and 
protection, and that industry participants have certainty and rules 
that allow them to compete fairly both at home and abroad. I look 
forward to hearing more from today's witnesses, and I look forward to 
working with members of this Committee as we consider how to better 
regulate the securities industry and reassure investors that our 
markets are safe.
                                 ______
                                 
                PREPARED STATEMENT OF SENATOR JACK REED
    The Securities and Exchange Commission's handling of the Madoff 
case is shocking, and reveals fundamental problems with the agency's 
operations, organization, and culture. The cop on the beat missed 
dozens of clues while Madoff robbed charities, families, and investors. 
Between 1992 and 2008, the SEC ignored red flags from six detailed 
complaints, and two studies that sounded alarm bells. The SEC also 
conducted five separate reviews during the decade and a half that 
Madoff ran his operations, but failed to take basic steps that would 
have uncovered the fraud. How did so many examiners and so many 
investigations fail to close the loop on this Ponzi scheme? How did 
they fail to complete the minimal follow-up and third-party 
verification that would have brought down a multi-billion dollar scam 
artist?
    At a Securities Subcommittee hearing I chaired back in May, we took 
a close look at the SEC's Enforcement Division and heard from the 
Government Accountability Office about how resource problems and policy 
changes undermined the Agency's ability to bring enforcement actions. 
But I am afraid the Inspector General's findings illuminate much deeper 
issues than scarce resources and changes in policy, and raise questions 
about examiner competence and agency culture.
    I have consistently fought to give the SEC the robust resources and 
authority it needs to aggressively fight fraud and other abuses in the 
securities markets. And I will continue to do so. But I hope today's 
hearing helps us to continue to identify the underlying issues and 
problems at the agency that led to this preventable travesty. This 
hearing should help provide further transparency and accountability, 
and allow Congress to identify concrete steps to rebuild the agency, 
including steps beyond simply adding resources and authority.
    I want to close by saying that while the SEC is currently suffering 
from a very tarnished reputation, one that it deserves based on its 
failures in recent years, the agency historically has been a symbol of 
strength and toughness in the markets for decades, thanks in large part 
to its dedicated staff. I believe under its new leadership and under 
the attention of Congress, the SEC can once again become the aggressive 
watchdog it once was and restore confidence in our securities markets.
                                 ______
                                 
                  PREPARED STATEMENT OF H. DAVID KOTZ
         Inspector General, Securities and Exchange Commission
                           September 10, 2009
Introduction
    Good afternoon. Thank you for the opportunity to testify today 
before this Committee on the subject of ``Oversight of the SEC's 
Failure to Identify the Bernard L. Madoff Ponzi Scheme and How to 
Improve SEC Performance'' as the Inspector General of the Securities 
and Exchange Commission (SEC). I appreciate the interest of the 
Chairman, as well as the other members of the Committee, in the SEC and 
the Office of Inspector General (OIG). In my testimony today, I am 
representing the OIG, and the views that I express are those of my 
Office, and do not necessarily reflect the views of the Commission or 
any Commissioners.
    Since being appointed as the Inspector General of the SEC in 
December 2007, my Office has issued numerous audit and investigative 
reports involving issues critical to SEC operations and the investing 
public. These have included comprehensive audit reports on important 
topics such as the factors that led to the collapse of Bear Stearns, 
the Division of Enforcement's (Enforcement) efforts pertaining to 
complaints about naked short selling, and the SEC's oversight of credit 
rating agencies. We have also issued investigative reports regarding a 
wide range of allegations including claims of improper securities 
trading by SEC employees, preferential treatment given to high-level 
securities industry officials, retaliatory termination, Enforcement's 
failure to vigorously pursue an investigation, and perjury by 
supervisory Commission attorneys.
Request To Undertake Madoff Investigation
    On the late evening of December 16, 2008, former SEC Chairman 
Christopher Cox contacted me and asked my Office to undertake an 
investigation into allegations made to the SEC regarding Bernard L. 
Madoff (Madoff), who had just confessed to operating a multi-billion 
dollar Ponzi scheme, and the reasons why the SEC had found these 
allegations to be not credible.
Commencement of our Madoff Investigation
    We began our investigation immediately. On December 18, 2008, we 
issued a document preservation notice to the entire SEC, stating that 
the OIG had initiated an investigation regarding all Commission 
examinations, investigations or inquiries involving Madoff, and/or any 
related individuals or entities. We formally requested that each SEC 
employee and contractor preserve all electronically stored information 
and paper records related to Madoff in their original format.
    We also took immediate steps to begin gathering evidence. On 
December 17, 2008, we initiated our first request for email records 
from the SEC's Office of Information Technology (OIT). Over the course 
of the investigation, the OIG made numerous requests from OIT for 
emails, including: (1) all emails of former Office of Compliance 
Inspections and Examinations (OCIE) employee Eric Swanson during his 
tenure with the SEC; (2) all emails of six staff members who were 
involved in the SEC's investigation of the Madoff firm that was 
initiated in 2006 for the period from January 2006 through January 
2008; (3) all emails for SEC Headquarters, New York Regional Office 
(NYRO) and Boston Regional Office (BRO) staff members from January 1, 
1999, through December 11, 2008, that contained the word ``Madoff''; 
(4) additional emails for approximately 68 current and former SEC 
employees for various time periods relevant to the investigation, 
ranging from 1999 to 2009. In all, we estimate that we obtained and 
searched approximately 3.7 million emails during the course of our 
investigation.
    On December 24, 2008, we sent comprehensive document requests to 
both Enforcement and OCIE, specifying the documents and records we 
required to be produced for the investigation. We followed up with 
memoranda to OCIE in April, May and June of 2009. We also had follow-up 
communications with Enforcement on January 21, 2009 and July 22, 2009. 
We further had numerous email and telephonic communications with both 
OCIE and Enforcement regarding the scope and timing of the document 
requests and responses, as well as meetings to clarify and expand the 
document requests as necessary. We collected all the information 
produced in response to our document production request. We then 
carefully reviewed and analyzed the investigative records of all SEC 
investigations conducted relating to Madoff, the Madoff firm, members 
of Madoff's family, and Madoff's associates from 1975 to the present.
    During the investigation, we also reviewed the workpapers and 
examination files of nine SEC examinations of Madoff's firms from 1990 
to December 11, 2008. Where documents from the examinations were not 
available, we sought testimony and conducted interviews of current and 
former SEC personnel who had worked on the examinations.
    We also sought information and documentation from third parties in 
order to undertake our own analysis of Madoff's trading records. During 
the course of the OIG investigation, we requested and obtained records 
from: (1) the Depository Trust Company (DTC) relating to position 
reports for Madoff's firm; (2) the National Securities Clearing 
Corporation (NSCC) relating to clearing data records for executions 
effected by Madoff's firm; and (3) the Financial Industry Regulatory 
Authority (FINRA) Order Audit Trail System data (OATS) submitted by 
Madoff's firm for six National Association of Securities Dealers 
Automated Quotations (NASDAQ)-listed stocks and the NASDAQ Automated 
Confirmation of Transactions (ACT) data base for a trading period in 
March of 2005.
Retention of Experts
    In order to assist us in the Madoff investigation, we retained two 
sets of outside consultants. In February 2009, we retained FTI 
Consulting, Inc. (FTI engagement team) to assist with the review of the 
examinations of Madoff and his firms that were conducted by the SEC. 
Members of the FTI engagement team engaged by the OIG included Charles 
R. Lundelis, Jr., Senior Managing Director, Forensic and Litigation 
Consulting; Simon Wu, Managing Director, Forensic and Litigation 
Consulting; John C. Crittenden III, Managing Director, Corporate 
Finance Group; and James Conversano, Director, Forensic and Litigation 
Consulting. Each individual member of the FTI engagement team brought a 
unique and specialized experience to the analyses that FTI engagement 
team conducted, including expertise in complex financial fraud 
investigations, securities-related inspections and examinations, hedge 
fund operations, cash-flow analysis and valuations, market regulation 
rules, market structure issues, accounting fraud, investment 
suitability, the underwriting process and compliance and due diligence 
practices.
    At our direction, the FTI engagement team conducted a thorough 
review of all relevant workpapers and documents associated with the 
OCIE examinations of Madoff's firm, scrutinized the conduct of the 
Madoff-related SEC examinations and investigations, and analyzed 
whether the SEC examiners overlooked red flags that could have led to 
the discovery of Madoff's Ponzi scheme. The FTI engagement team also 
replicated aspects of the OCIE cause examinations of Madoff to 
determine whether the SEC sought the appropriate information in the 
examinations and analyzed that information correctly.
    In addition, OIT advised us during the course of our investigation 
that there were substantial gaps in the emails we were seeking to 
review as part of our investigation because of failures to back up 
tapes, hardware or software failures during the backup process, and/or 
lost, mislabeled or corrupted tapes. In order to ensure that we were 
able to conduct a thorough and comprehensive investigation, in June 
2009, we retained the services of First Advantage Litigation Consulting 
Services (First Advantage) to assist us in the restoration and 
production of relevant electronic data. First Advantage's team had 
significant experience in leading numerous large-scale electronic 
discovery consulting projects, as well as assisting with highly 
sensitive and confidential investigations for corporations and the 
Federal Bureau of Investigation.
    In connection with its retention on the Madoff investigation, First 
Advantage provided consulting and technical support to the OIG and the 
SEC, and was able to successfully preserve and restore potentially 
relevant data within the universe of electronic data we had requested 
from OIT. As a result, we were able to review additional Madoff-related 
emails that were pertinent to our investigation.
Testimony and Interviews Conducted in the Madoff Investigation
    We also conducted 140 testimonies under oath or interviews of 122 
individuals with knowledge of facts or circumstances surrounding the 
SEC's examinations and/or investigations of Madoff and his firms. We 
interviewed all current or former SEC employees who had played any 
significant role in the SEC's significant examinations and 
investigations of Madoff and his firms over a period spanning 
approximately 20 years.
The OIG's Investigative Team
    I think it appropriate to acknowledge the extraordinary efforts of 
the OIG Investigative team that I have been honored to lead in 
conducting this important investigation. These included Deputy 
Inspector General Noelle Frangipane, Assistant Inspector General for 
Investigations David Fielder, and Senior Counsels Heidi Steiber, David 
Witherspoon and Christopher Wilson. Additional assistance was provided 
to this investigation by my Assistant, Roberta Raftovich, in 
coordinating many of the administrative aspects of compiling the 
report. Without the incredible devotion and exceptional work of these 
individuals, we would not have been able to complete this investigation 
and present a thorough and comprehensive report within such a short 
period of time.
Issuance of Comprehensive Report of Investigation
    On August 31, 2009, we issued to the Chairman of the SEC a 
comprehensive report of investigation (ROI) in the Madoff matter 
containing over 450 pages of analysis. The ROI detailed the SEC's 
response to all complaints it received regarding the activities of 
Madoff and his firms, and traced the path of these complaints through 
the Commission from their inception, reviewing what, if any, 
investigative or examination work was conducted with respect to the 
allegations. Further, the ROI assessed the conduct of examinations and/
or investigations of Madoff and his firm by the SEC and analyzed 
whether the SEC examiners or investigators overlooked red flags (which 
other entities conducting due diligence may have been identified) that 
could have led to a more comprehensive examination or investigation and 
possibly the discovery of Madoff's Ponzi scheme.
    Our ROI also analyzed the allegations of conflicts of interest 
arising from relationships between any SEC officials or staff and 
members of the Madoff family. This included an examination of the role 
that former SEC OCIE Assistant Director Eric Swanson (Swanson), who 
eventually married Madoff's niece Shana Madoff, may have played in the 
examination or other work conducted by the SEC with respect to Madoff 
or related entities, and whether such role or relationship in any way 
affected the manner in which the SEC conducted its regulatory oversight 
of Madoff and any related entities.
    We have also considered the extent to which the reputation and 
status of Madoff and the fact that he served on SEC Advisory 
Committees, participated on securities industry boards and panels, and 
had social and professional relationships with SEC officials, may have 
affected Commission decisions regarding investigations, examinations 
and inspections of his firm.
Results of the Madoff Investigation
    The OIG investigation found that between June 1992 and December 
2008 when Madoff confessed, the SEC received six substantive complaints 
that raised significant red flags concerning Madoff's investment 
adviser operations and should have led to questions about whether 
Madoff was actually engaged in trading. We also found that the SEC was 
aware of two articles regarding Madoff's investment operations that 
appeared in reputable publications in 2001 and questioned Madoff's 
unusually consistent investment returns.
    Our report concluded that notwithstanding these six complaints and 
two articles, the SEC never conducted a competent and thorough 
examination or investigation of Madoff for operating a Ponzi scheme and 
that, had such a proper examination or investigation been conducted, 
the SEC would have been able to uncover the fraud.
    The first complaint, which was brought to the SEC's attention in 
1992, related to allegations that an unregistered investment company 
was offering ``100 percent'' safe investments with high and extremely 
consistent rates of return over significant periods of time to 
``special'' customers. The SEC actually suspected the investment 
company was operating a Ponzi scheme and learned in its investigation 
that all of the investments were placed entirely through Madoff and 
consistent returns were claimed to have been achieved for numerous 
years without a single loss.
    The second complaint was very specific, and different versions of 
it were provided to the SEC in May 2000, March 2001 and October 2005. 
The complaint submitted in 2005 was entitled, ``The World's Largest 
Hedge Fund is a Fraud,'' and detailed approximately 30 red flags 
indicating that Madoff was operating a Ponzi scheme, a scenario it 
described as ``highly likely.'' These red flags included the 
impossibility of Madoff's returns, particularly the consistency of 
those returns and the unrealistic volume of options Madoff represented 
to have traded.
    In May 2003, the SEC received a third complaint from a respected 
hedge fund manager identifying numerous concerns about Madoff's 
strategy and purported returns. Specifically, the complaint questioned 
whether Madoff was actually trading options in the volume he claimed, 
noted that Madoff's strategy and purported returns were not duplicable 
by anyone else, and stated that Madoff's strategy had no correlation to 
the overall equity markets in over 10 years. According to an SEC 
manager, the hedge fund manager's complaint laid out issues that were 
``indicia of a Ponzi scheme.''
    The fourth complaint was part of a series of internal emails of 
another registrant that the SEC discovered in April 2004. The emails 
described the red flags that a registrant's employees had identified 
while performing due diligence on their own Madoff investment using 
publicly available information. The red flags identified included 
Madoff's incredible and highly unusual fills for equity trades, his 
misrepresentation of his options trading, and his unusually consistent, 
non-volatile returns over several years. One of the internal emails 
provided a step-by-step analysis of why Madoff must be misrepresenting 
his options trading. The email clearly explained that Madoff could not 
be trading on an options exchange because of insufficient volume and 
could not be trading options over-the-counter because it was 
inconceivable that he could find a counterparty for the trading. The 
SEC examiners who initially discovered the emails viewed them as 
indicating ``some suspicion as to whether Madoff is trading at all.''
    The SEC received the fifth complaint in October 2005 from an 
anonymous informant. This complaint stated, ``I know that Madoff [sic] 
company is very secretive about their operations and they refuse to 
disclose anything. If my suspicions are true, then they are running a 
highly sophisticated scheme on a massive scale. And they have been 
doing it for a long time.'' The informant also stated, ``After a short 
period of time, I decided to withdraw all my money (over $5 million).''
    The sixth complaint was sent to the SEC by a ``concerned citizen'' 
in December 2006, and advised the SEC to look into Madoff and his firm 
as follows:

        Your attention is directed to a scandal of major proportion 
        which was executed by the investment firm Bernard L. Madoff . . 
        . Assets well in excess of $10 Billion owned by the late 
        [investor], an ultra-wealthy long time client of the Madoff 
        firm have been `co-mingled' with funds controlled by the Madoff 
        company with gains thereon retained by Madoff.

    In March 2008, the SEC Chairman's Office received a second copy of 
the previous complaint, with additional information from the same 
source regarding Madoff's involvement with the investor's money, as 
follows:

        It may be of interest to you to that Mr. Bernard Madoff keeps 
        two (2) sets of records. The most interesting of which is on 
        his computer which is always on his person.

    The two 2001 journal articles also raised significant questions 
about Madoff's unusually consistent returns. One of the articles noted 
his ``astonishing ability to time the market and move to cash in the 
underlying securities before market conditions turn negative and the 
related ability to buy and sell the underlying stocks without 
noticeably affecting the market.'' This article also observed that 
``experts ask why no one has been able to duplicate similar returns 
using [Madoff's] strategy.'' The second article quoted a former Madoff 
investor as saying, ``Anybody who's a seasoned hedge-fund investor 
knows the split-strike conversion is not the whole story. To take it at 
face value is a bit naive.''
    The complaints all contained specific information and could not 
have been fully and adequately resolved without a thorough examination 
and investigation of Madoff for operating a Ponzi scheme. The journal 
articles should have reinforced the concerns expressed in the 
complaints about how Madoff could have been achieving such unusually 
high returns.
    According to the FTI engagement team, the most critical step in 
examining or investigating a potential Ponzi scheme is to verify the 
subject's trading through an independent third party. The OIG 
investigation found that the SEC conducted two investigations and three 
examinations related to Madoff's investment adviser business based upon 
the detailed and credible complaints that raised the possibility that 
Madoff was misrepresenting his trading and could have been operating a 
Ponzi scheme. Yet, at no time did the SEC ever verify Madoff's trading 
through an independent third party and, in fact, SEC staff never 
actually conducted a Ponzi scheme examination or investigation of 
Madoff.
    The first examination and first Enforcement investigation involving 
Madoff were conducted in 1992 after the SEC received information that 
led it to suspect that a Madoff associate had been conducting a Ponzi 
scheme. Yet, the SEC focused its efforts on Madoff's associate and 
never thoroughly scrutinized Madoff's operations even after learning 
that Madoff made all the investment decisions and being apprised of the 
remarkably consistent returns Madoff had claimed to achieve over a 
period of numerous years with a basic trading strategy. While the SEC 
ensured that all of Madoff's associate's customers received their money 
back, it took no steps to investigate Madoff. The SEC focused its 
investigation too narrowly and seemed not to have considered the 
possibility that Madoff could have taken the money that was used to pay 
back his associate's customers from other clients for which Madoff may 
have had held discretionary brokerage accounts. In the examination of 
Madoff, although the SEC did seek records maintained by DTC (an 
independent third party), they obtained those DTC records from Madoff 
rather than going to DTC itself to verify if trading occurred. Had the 
SEC sought records from DTC, there is an excellent chance it would have 
uncovered Madoff's Ponzi scheme in 1992.
    In 2004 and 2005, the SEC's examination unit, OCIE, conducted two 
parallel cause examinations of Madoff based upon the hedge fund 
manager's complaint and the series of internal emails the SEC had 
discovered. The examinations were remarkably similar in nature. There 
were initial significant delays in the commencement of the 
examinations, notwithstanding the urgency of the complaints. The teams 
assembled were relatively inexperienced, and there was insufficient 
planning for the examinations. The scopes of the examination were in 
both cases too narrowly focused on the possibility of front-running, 
with no significant attempts made to analyze the numerous red flags 
about Madoff's trading and returns.
    During the course of both these examinations, the examination teams 
discovered suspicious information and evidence and caught Madoff in 
contradictions and inconsistencies. However, they either disregarded 
these concerns or simply asked Madoff about them. Even when Madoff's 
answers were seemingly implausible, the SEC examiners accepted them at 
face value.
    In both examinations, the examiners made the surprising discovery 
that Madoff's mysterious hedge fund business was making significantly 
more money than his well-known market-making operation. However, none 
of the examiners identified this revelation as a cause for concern.
    Astoundingly, both examinations were open at the same time in 
different offices without either office knowing the other one was 
conducting a virtually identical examination. In fact, it was Madoff 
himself who informed one of the examination teams that the other 
examination team had already received the information being sought from 
him.
    In the first of the two OCIE examinations, the examiners drafted a 
letter to the National Association of Securities Dealers (NASD) 
(another independent third party) seeking independent trade data, but 
they never sent the letter, claiming that it would have been too time-
consuming to review the data they would have obtained. The OIG's expert 
opined that had the letter to the NASD been sent, the data collected 
would have provided the information necessary to reveal Madoff's Ponzi 
scheme. In the second examination, the OCIE Assistant Director sent a 
document request to a financial institution that Madoff claimed he used 
to clear his trades, requesting trading done by or on behalf of 
particular Madoff feeder funds during a specific time period, and 
received a response that there was no transaction activity in Madoff's 
account for that period. However, the Assistant Director did not 
determine that the response required any follow-up and the examiners 
working under the Assistant Director testified that the response was 
not shared with them.
    Both examinations concluded with numerous unresolved questions and 
without any significant attempt to examine the possibility that Madoff 
was misrepresenting his trading and operating a Ponzi scheme.
    The investigation that arose from the most detailed complaint 
provided to the SEC, which explicitly stated it was ``highly likely'' 
that ``Madoff was operating a Ponzi scheme,'' never really investigated 
the possibility of a Ponzi scheme. The relatively inexperienced 
Enforcement staff failed to appreciate the significance of the analysis 
in the complaint, and almost immediately expressed skepticism and 
disbelief about the complaint. Most of the investigation was directed 
at determining whether Madoff should register as an investment adviser 
or whether Madoff's hedge fund investors' disclosures were adequate.
    As with the examinations, the Enforcement staff almost immediately 
caught Madoff in lies and misrepresentations, but failed to follow up 
on inconsistencies. They rebuffed offers of additional evidence from 
the complainant, and were confused about certain critical and 
fundamental aspects of Madoff's operations. When Madoff provided 
evasive or contradictory answers to important questions in testimony, 
the staff simply accepted his explanations as plausible. Although the 
Enforcement staff made attempts to seek information from independent 
third parties, they failed to follow up on these requests. They reached 
out to the NASD and asked for information on whether Madoff had options 
positions on a certain date. However, when they received a report that 
there were in fact no options positions on that date, they did not take 
any further steps. An Enforcement staff attorney made several attempts 
to obtain documentation from European counterparties (another 
independent third party) and, although a letter was drafted, the 
Enforcement staff decided not to send it. Had any of these efforts been 
fully executed, they would have led to Madoff's Ponzi scheme being 
uncovered.
    The OIG also found that numerous private entities conducted basic 
due diligence of Madoff's operations and, without regulatory authority 
to compel information, came to the conclusion that an investment with 
Madoff was unwise. Specifically, Madoff's description of both his 
equity and options trading practices immediately led to suspicions 
about his operations. With respect to his purported trading strategy, 
many private entities simply did not believe that it was possible for 
Madoff to achieve his stated level of returns using a strategy 
described by some industry leaders as common and unsophisticated. In 
addition, there was a great deal of suspicion about Madoff's purported 
options trading, with several entities not believing that Madoff could 
be trading options in such high volumes where there was no evidence 
that any counterparties had been trading options with Madoff.
    The private entities' conclusions were drawn from the same red 
flags regarding Madoff's operations that the SEC considered in its 
examinations and investigations, but ultimately dismissed.
    We also found that investors who may have been uncertain about 
whether to invest with Madoff were reassured by the fact that the SEC 
had investigated and/or examined Madoff, or entities that did business 
with Madoff, and found no evidence of fraud. Moreover, we found that 
Madoff proactively informed potential investors that the SEC had 
examined his operations. When potential investors expressed hesitation 
about investing with Madoff, he cited the prior SEC examinations to 
establish credibility and allay suspicions or investor doubts that may 
have arisen while due diligence was being conducted. Thus, the fact the 
SEC had conducted examinations and investigations and did not detect 
the fraud lent credibility to Madoff's operations and had the effect of 
encouraging additional individuals and entities to invest with him.
    We did not, however, find evidence that any SEC personnel who 
worked on an SEC examination or investigation of Madoff or his firms 
had any financial or other inappropriate connection with Madoff or the 
Madoff family that influenced the conduct of the examination or 
investigatory work. We also did not find that former SEC Assistant 
Director Eric Swanson's romantic relationship with Bernard Madoff's 
niece, Shana Madoff, influenced the conduct of the SEC examinations of 
Madoff and his firm. We further did not find that senior officials at 
the SEC directly attempted to influence examinations or investigations 
of Madoff or the Madoff firm, nor was there evidence any senior SEC 
official interfered with the staff's ability to perform its work.
    As I discussed earlier, we did find that despite numerous credible 
and detailed complaints, the SEC never properly examined or 
investigated Madoff's trading and never took the necessary, but basic, 
steps to determine if Madoff was operating a Ponzi scheme. Had these 
efforts been made with appropriate follow-up at any time beginning in 
June 1992 until December 2008, the SEC could have uncovered the Ponzi 
scheme before Madoff confessed.
    As a result of our findings, we have recommended that the Chairman 
carefully review our report and share with OCIE and Enforcement 
management the portions of this report that relate to performance 
failures by those employees who still work at the SEC, so that 
appropriate action (which may include performance-based action) is 
taken, on an employee-by-employee basis, to ensure that future 
examinations and investigations are conducted in a more appropriate 
manner and the mistakes and failures outlined in this report are not 
repeated.
Additional OIG Reports
    While the report we issued to the Chairman on August 31st describes 
in detail the factual circumstances surrounding the Madoff-related 
complaints received by the SEC and the SEC's examinations and 
investigations of Madoff over the years, my Office plans to issue three 
additional reports relating to these matters. Because our investigation 
identified systematic breakdowns in the manner in which the SEC 
conducted its examinations and investigations, we plan to issue two 
separate audit reports providing the SEC with specific and concrete 
recommendations to improve the operations of both OCIE and Enforcement.
    With respect to recommendations concerning OCIE, our expert, FTI, 
has conducted extensive fieldwork to analyze further the adequacy of 
OCIE's examinations of Madoff. The FTI engagement team reviewed our 
August 31, 2009 Report of Investigation, as well as related findings, 
exhibits, witness testimony and other supporting documentation (i.e., 
OCIE examination staff work papers), and interviewed over a dozen key 
personnel representing OCIE's broker-dealer, investment adviser and 
risk assessment programs. In addition, the FTI Engagement Team reviewed 
OCIE's policies and procedures with regard to its examination processes 
and other third party records, including FINRA order and execution data 
and DTC and NSCC records.
    The FTI Engagement Team also was granted access to OCIE's various 
Intranet sites, including the Broker-Dealer, Investment Adviser/
Investment Company, Office of Market Oversight, and Training Branch 
sites, in order to view its examination policies and procedures. The 
FTI engagement team is currently finalizing a report that will describe 
its analysis of OCIE's examination process and provide numerous 
``lessons learned'' arising from its analysis, with specific 
recommendations to improve OCIE's operations. While these 
recommendations are currently in draft status, I can report that the 
recommendations we are considering include the following:

    Establishing a protocol for SEC examiners to identify 
        relevant information from industry news articles and other 
        sources outside of the agency;

    Establishing a protocol that explains how to identify red 
        flags and potential violations of securities law based on an 
        evaluation of information found in industry news articles and 
        other relevant industry sources;

    The implementation of an OCIE-related collection system 
        that adequately captures information relating to the nature and 
        source of each tip or complaint and also chronicles the vetting 
        process to document why each tip or complaint was or was not 
        acted upon and who made that determination;

    Mandating procedures for review of credible and compelling 
        tips and complaints;

    Mandating timelines for the vetting of tips and complaints, 
        as well as for the commencement of cause examinations;

    Requiring proper procedures for the use of scope memoranda 
        to ensure that examinations conducted in response to tips and 
        complaints that are received are not too narrowly focused;

    Establishing procedures for the timely modification of 
        scope memoranda when significant new facts and issues emerge;

    Ensuring the appropriate review and analysis of planning 
        memoranda for cause examinations to ensure that cause 
        examinations are thoroughly planned based upon the tip or 
        complaint that triggered the examination;

    Creating procedures to ensure that all steps of the 
        examination methodology, as stated in the planning memorandum, 
        are completed before the examination is closed;

    Requiring the documentation of all substantive interviews 
        conducted by OCIE of registrants and third parties during 
        OCIE's pre-examination activities and during the course of an 
        examination;

    Prescribing procedures for the preparation of workpapers 
        for an OCIE examination to ensure sufficient detail to provide 
        a clear understanding of its purpose, source, and the 
        conclusions reached;

    Establishing, reviewing and testing procedures for logging 
        all OCIE examinations into an examination tracking system;

    Ensuring that the focus of an examination is determined in 
        an appropriate and thoughtful manner, and not simply based upon 
        on the availability or the skills of a particular group of 
        examiners;

    Ensuring that personnel with the appropriate skills and 
        expertise are assigned to cause examinations with unique or 
        discrete needs;

    Requiring that a Branch Chief, or a similarly designated 
        lead manager, be assigned to every substantive project 
        including all cause examinations;

    Requiring the development of a formal plan within OCIE to 
        ensure that OCIE staff and managers are obtaining and 
        maintaining professional designations and/or licenses by 
        industry certification programs that are relevant to their 
        examination activities;

    Recommending the development and implementation of 
        interactive exercises to be administered by OCIE training staff 
        or an independent third party and reviewed prior to hiring new 
        OCIE employees in order to evaluate the relevant skills 
        necessary to perform examinations;

    The training of OCIE examiners in the mechanics of 
        securities settlement, both in the United States and in major 
        foreign markets;

    The training of OCIE examiners in methods to access the 
        expertise of foreign regulators, such as the United Kingdom's 
        Financial Services Authority, as well as foreign securities 
        exchanges and foreign clearing and settlement entities;

    Requiring OCIE examination staff to verify a test sample of 
        trading or balance data with counterparties and other 
        independent third parties such as FINRA, DTC, or NSCC whenever 
        there are specific allegations of fraud involved in an 
        examination;

    Recommending the training of OCIE examiners jointly with 
        the Office of Economic Analysis economists by FINRA, other 
        self-regulatory organizations (SROs) and exchange staff in 
        understanding trading data bases, regional exchanges, option 
        exchanges, and DTC/NSCC, etc.;

    Ensuring that OCIE staff have direct access to certain data 
        bases maintained by SROs or other similar entities in order to 
        allow examiners to access necessary data for verification or 
        analysis of registrant data;

    Mandating procedures to ensure that when an examination 
        team is pulled off an examination for a project of higher 
        priority, the examination team return to the previous 
        examination upon completion of the other project and bring the 
        prior examination to a conclusion;

    Implementing procedures for tracking the progress of all 
        cause examinations, including the number of cause examinations 
        opened, the number ongoing and the number closed for each 
        month; and

    Requesting OCIE management provide express support to their 
        examiners regarding the examiners' pursuit of evidence in the 
        course of an examination, even if pursuing that evidence 
        requires contacting customers or clients of the target of that 
        examination.

    We are also finalizing a report that analyzes ``lessons learned'' 
from the investigations conducted by the SEC's Enforcement Division of 
Madoff and prescribes concrete recommendations for improvement within 
Enforcement. For this analysis, we launched an extensive survey 
questionnaire to Enforcement staff and management in both headquarters 
and the regional offices. This survey was designed to obtain feedback 
from Enforcement staff on numerous topics, such as allocation of 
resources, performance measurement, case management procedures, 
communication, adequacy of policies and procedures, employee morale, 
and management efficiency and effectiveness.
    The Enforcement-related recommendations that we are currently 
considering include the following:

    Establishing formal guidance for evaluating various types 
        of complaints (e.g., Ponzi schemes) and training of appropriate 
        staff on the use of such guidance;

    Ensuring that the SEC's tip and complaint handling system 
        provides for data capture of relevant information relating to 
        the vetting process to document why a complaint was or was not 
        acted upon and who made that determination;

    Requiring tips and complaints to be reviewed by individuals 
        experienced in the subject matter to which the complaint or tip 
        relates, prior to a decision not to take further action;

    Establishing guidance to require that all complaints that 
        appear on the surface to be credible and compelling be probed 
        further by in-depth interviews with the sources to assess the 
        complaints' validity and to determine what issues need to be 
        investigated;

    The training of staff to ensure they are aware of the 
        guidelines contained in Section 3 of the Enforcement Manual and 
        Title 17 of the Code of Federal Regulations, Section 202.10, 
        for obtaining information from outside sources;

    Requiring annual review and testing of the effectiveness of 
        Enforcement's policies and procedures with regard to its tip 
        and complaint handling system;

    Implementing procedures to ensure that investigations are 
        assigned to teams comprised of individuals who have sufficient 
        knowledge of the pertinent subject matter (e.g. Ponzi schemes);

    The training of staff on what resources and information are 
        available within the Commission, including how and when 
        assistance from internal units should be requested;

    Mandating that planning memoranda be prepared at the 
        beginning of an investigation and that the plan include a 
        section identifying what type of expertise or assistance is 
        needed from others within and outside the Commission;

    Requiring that after the planning memorandum is drafted, it 
        be circulated to all team members assigned to the 
        investigation, and all team members then meet to discuss the 
        investigation approach, methodology and any concerns team 
        members wish to raise;

    Conducting periodic internal reviews of any newly 
        implemented policies and procedures related to information 
        sharing with divisions and offices outside of Enforcement to 
        ensure they are operating efficiently and effectively and 
        necessary changes are made;

    Requiring that the planning memoranda and associated scope, 
        methodology and timeframes be routinely reviewed by an 
        investigator's immediate supervisor to ensure investigations 
        remain on track and to determine whether adjustments in scope, 
        etc., are necessary;

    Ensuring that sufficient resources, both supervisory and 
        support, are dedicated to investigations up front to provide 
        for adequate and thorough supervision of cases and effective 
        handling of administrative tasks;

    Establishing policies and procedures to ensure staff have 
        an understanding of what types of information should be 
        validated during investigations with independent parties such 
        as FINRA, DTC and the Chicago Board Options Exchange;

    Updating Enforcement's complaint handling procedures to 
        ensure complaints received are properly vetted even if an 
        investigation is pending closure; and

    Conducting periodic internal reviews to ensure that Matters 
        Under Inquiry (MUIs) are opened in accordance with any newly 
        developed Commission guidance and examining ways to streamline 
        the case closing process.

    Both of these reports containing recommendations to OCIE and 
Enforcement will be finalized and issued within the next few weeks. We 
also plan to issue an additional report analyzing the reasons that 
OCIE's investment adviser unit did not conduct an examination of Madoff 
after he was forced to register as an investment adviser in 2006, and 
prescribing recommendations as appropriate to improve this process. We 
plan to issue this report by the end of November 2009.
    My Office is committed to following up with respect to all the 
recommendations that we will be making to ensure that significant 
changes and improvements are made in the SEC's operations as a result 
of our findings in the Madoff investigation. We are aware that 
improvements have already been begun under the direction of Chairman 
Schapiro even prior to our report being issued. We are confident that 
under Chairman Schapiro's leadership, the SEC will carefully review our 
analyses and reports and take the appropriate steps to implement our 
recommendations and ensure that fundamental changes are made in the 
SEC's operations so that the errors and failings we found in our 
investigation are properly remedied and not repeated in the future.
Conclusion
    In conclusion, we appreciate the Chairman's and the Committee's 
interest in the SEC and our Office and, in particular, in the facts and 
circumstances pertinent to the Madoff Ponzi scheme. I believe that the 
Committee's and Congress's continued involvement with the SEC is 
helpful in strengthening the accountability and effectiveness of the 
Commission. Thank you.
                                 ______
                                 
                 PREPARED STATEMENT OF HARRY MARKOPOLOS
   CFA, CFE, Chartered Financial Analyst and Certified Fraud Examiner
                           September 10, 2009
Introduction
    I would like to thank Chairman Dodd and Ranking Member Shelby for 
inviting me to submit written and oral testimony to the Senate Banking, 
Housing and Urban Affairs Committee today. I appreciate your invitation 
to testify on my experiences with the SEC with regard to the Bernard 
Madoff scandal, the SEC Inspector General's Report and recommendations, 
along with my own recommendations on regulatory reform.
The Current Situation
    The current situation is dire. The cost to this nation's capital 
markets due to criminal acts by white-collar fraudsters is still being 
totaled up but easily runs into the trillions of dollars. The only 
question is: how many trillions will be required to clean up the 
banking system, the insurance companies, and the shadow financial 
institutions and rid their balance sheets of toxic debt? We still don't 
know and won't know for several more years.
    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. These troubles were of our own making and due solely to 
unchecked, unregulated greed. We, as a nation, get the government and 
regulators that we deserve, so let us be sure to hold not only our 
government and our regulators accountable, but also ourselves, as 
citizens, for permitting these situations to occur.
    Far too much attention and money has been paid to violent crime and 
drug offenses while white-collar fraudsters have been allowed to roam 
freely and openly without fear of getting caught. For example, too many 
FBI agents were assigned to chase down bank robbers who dared hold-up 
bank tellers at bank branches and steal small amounts of money in the 
mere thousands. Bank robberies are better left to state and local 
police while Federal resources are targeted to attack the high-level 
white collar frauds originating in the C-level suite. Meanwhile the 
true banksters were the top officials of our nation's largest financial 
institutions who looted millions and hundreds of millions in unmerited 
bonus payments from these financial institutions while apparently no 
FBI agents were investigating the white-collar frauds these fraudsters 
were perpetrating.
    White-collar criminals cause far more economic harm to this nation 
than armed robbers, drug dealers, car thieves, and other assorted 
miscreants put together. These fraudsters steal approximately 5 percent 
of business revenues annually, dwarfing the economic losses due to 
violent crime, yet not nearly enough Federal law enforcement resources 
are devoted to catching them. White-collar criminals have the best 
resumes, have attended good universities and many of them hold graduate 
degrees. They live in the nicest neighborhoods and have the best 
reputations--until they get caught. But the worst whitecollar criminals 
cause far more damage to the Nation than common criminals because they 
wipe out pensions, bankrupt companies, throw thousands of out work, and 
destroy investor confidence.
    Sub-prime loans, liar loans, option-arms, collateralized debt 
obligations (CDO's), credit default swaps (CDS's), collateralized loan 
obligations (CLO's), and other toxic structured products were the 
evidence of their crimes but so far, all too few have been brought to 
justice. An entire criminal class consisting of corrupt real estate 
agents, property appraisers, mortgage lenders, ratings agencies, and 
Wall Street investment banks openly colluded to originate, package and 
sell toxic debt securities to pension funds, individuals and other 
unsuspecting victims. And all of these crimes occurred right under the 
noses of our nation's incompetent financial regulators who saw nothing, 
said nothing and did nothing, in effect they stole their government 
paychecks. So here we are today with a regulatory system that is beyond 
broken.
    Bernard Madoff is merely the poster child for what went so horribly 
wrong with our financial system. His fraud destroyed the lives of 
thousands of direct investors. Entire generations of families went from 
riches to rags literally overnight. Some victims cannot pay for medical 
care while others have seen their children's college education funds 
wiped out. Charities, schools and endowments have shut down or seen 
their operations curtailed. The millions of indirect victims of the 
Madoff fraud are those individuals and organizations that received 
services, scholarships or grants from the direct victims.
    The reputation of the U.S. capital markets as a desirable place to 
invest is also a victim. No foreign government or investor holding U.S. 
securities thinks our capital markets are properly regulated. Some 
foreign investors will be adding an ``American Fraud Risk Premium'' to 
their expected rates of return which increases the cost to American 
businesses which need access to affordable capital. This raises the 
cost to all Americans. Each one of us will be paying higher fees and 
higher interest rates to our foreign creditors as a result of our 
failure to properly regulate our markets.
    The mess in which we find ourselves took decades to manifest itself 
and it will take a considerable number of years to repair the damage to 
our nation's balance sheet and to our nation's reputation as a safe 
place to invest.
My Comments on the SEC IG's Madoff Report
    I realize that the Committee invited me here today to verify that 
the SEC IG Madoff Report was both truthful and accurate. The 477-page 
IG Report contains an accurate depiction of what transpired during my 
dealings with the SEC. I have seen no discrepancies between what I saw 
and heard and what the SEC IG has reported. If there was a cover-up or 
a white-wash, I would have spotted it and vehemently refuted all 
discrepancies in my testimony today.
    I am impressed beyond my ability to express myself by how open, 
honest, transparent and how exceptionally well researched and well 
written the SEC Inspector General's report is. As a key figure who 
probably accounts for approximately a third of the report's length 
either directly or indirectly, I was at ground zero of the Madoff fraud 
investigation for 8 1/2 years. Tragically, what the SEC IG depicts in 
his report fits with my experiences with the SEC during the time period 
2000 to the present.
    I have to thank H. David Kotz, the SEC's Inspector General (the 
``IG'') for his team's tireless efforts while under great stress to 
write this report. My counsel, Dr. Gaytri Kachroo, Esq. (LL.L, LL.B, 
LLM, SJD) and I have worked closely in assisting the IG's team with the 
portions of the report that are relevant to my team's investigation and 
others. Thanks also to my investigative team members, Frank Casey, Neil 
Chelo, and Michael Ocrant for cooperating with the IG team.
    I have read many government inspector generals' reports and, all 
too often, they have been nothing but white-washed, cover-up jobs. This 
IG report is different because this IG is different. If you go back and 
read the SEC's IG reports since Mr. Kotz became the IG, you'll see that 
all of his reports are hard-hitting and very embarrassing to the 
agency. They also contain coherent and constructive recommendations on 
fixing the problems. The Madoff IG Report is consistent with the high 
quality of work that I have seen from his office. With these kinds of 
reports the SEC cannot help but get better faster and Lord knows we 
need them to get better faster.
    I would be remiss if I didn't also thank the key individual who 
allowed this report to be written in an open and transparent manner. 
Mary Shapiro, the SEC Chairman, supported her IG office's writing and 
release of this report. I'm sure there are many within the SEC who 
wished she had scuttled this report or at least heavily censored it. I 
admire her dedication to the truth, to openness and to transparency. I 
am sure the internal pressures to censor this report were tremendous 
but Chairman Shapiro demonstrated superior leadership in allowing the 
IG write and deliver this hard-hitting report to the American public. 
This report defines her courage and her leadership of the SEC as it 
rebuilds itself.
    To all Americans who are thinking that the level of incompetence, 
inexperience and laziness depicted in the full 477-page report just 
can't be true, sadly, I can assure you it is all true. My February 4, 
2009 testimony before the House Capital Markets Sub-Committee details 
the low regard I held this agency in pre-Madoff and pre-Mary Shapiro. 
Unfortunately, this IG report is frighteningly accurate. Even a great 
fiction-writer like Stephen King couldn't have made up the nightmare 
that the SEC was pre-December 11, 2008. The SEC's actions and inactions 
during the Madoff investigation were a comedy of horrors.
    No doubt it would have been far better for the agency if it turned 
out that Mr. Madoff had bribed one or more of the SEC staff to waylay 
investigations of his criminal enterprise. Catching an SEC employee or 
employees who were paid to look the other way would have resulted in 
far less embarrassment and turmoil for this agency. It is my opinion 
that if there was an internal corruption case to be made, the SEC 
appeared to me to be pulling out all of the stops to make corruption 
cases against its own employees which I will cover in some detail 
below. But it wasn't corruption that led to Madoff operating a multi-
decade long Ponzi scheme that went unchecked for so long--it was 
systemic and structural incompetence.
    At no time did I notice criminal activity by SEC staff examiners or 
enforcement personnel. Clearly, I feared that if the SEC staff were 
corrupt then one or more of them would have taken money from Bernard 
Madoff, handed him copies of my SEC submissions and Madoff would have 
attempted to silence me soon thereafter. That did not happen. My being 
here refutes the conspiracy theorists who mistakenly think that anyone 
connected to the SEC's 2006-2008 Madoff investigation related to my 
November 2005 SEC submission must have been corrupt.
    It was clear to me during my first call with the SEC IG in late 
December 2008 that he was conducting a thorough and wide-ranging 
investigation of the SEC staff. My first call with him told me a lot 
about him both as a person and as a professional. He asked me if I 
would be willing to make a full production of Madoff case documents 
because he wanted to double-check the document production he was 
getting internally from the SEC. In other words, he wasn't going to 
meekly accept whatever documents his own agency was giving him, he 
wanted an independent third party, namely myself and my counsel, to 
provide our documents and emails as a check on his own agency's 
veracity.
    When I first met him in person on February 5, 2009, it was also 
clear that his investigation did encompass possible criminal acts by 
SEC staffers at all levels. He read my 2005 SEC Submission and must 
have thought to himself,  ``there's no possible way that an SEC 
enforcement team could miss the Madoff Ponzi scheme with this kind of 
detailed road map in their hands. It's just not possible, there must be 
internal corruption involved somewhere.'' He asked me pointed questions 
about high level employees bowing to outside political pressures. He 
also asked pointed questions about possible corruption at lower levels 
involving team, branch and regional staff. I can assure you that the IG 
went down all the proper paths in his questioning of me to thoroughly 
explore any and all possible criminal acts that might have occurred 
involving SEC employees. Given my knowledge of what transpired, I never 
felt any SEC staffers were corrupt and the fact that the IG's 
investigation asked plenty of questions that were corruption related 
suggests a proper investigation was conducted.
    I am a certified fraud examiner (CFE) and I have been investigating 
large, half billion dollar and up, white collar fraud cases full-time 
for over 5 years now. I could tell from Mr. Kotz's questions where his 
investigation had gone and where it was going. It was as thorough and 
wide-ranging as it could be. Like all investigations, you are forced to 
go down every possible path you can identify, most of which turn out to 
be dead ends, in order to finally arrive at a fair interpretation of 
the truth. No one is capable of conducting the perfect investigation 
nor does any report contain a full 100 percent of what transpired--
humans and memories are way too fragile for that. Investigators, no 
matter how good they might be, are incapable of perfectly recreating 
the past. I am a pretty fair investigator myself and I know for a fact 
that I could not have done nearly as good a job as Mr. Kotz and his 
team did. This IG Report is the absolute best inspector general's 
report I have come across.
    In my opinion this IG Report is a fair and accurate depiction of 
what I experienced. My hat is off to the SEC for conducting a proper 
and thorough investigation and delivering such a detailed and powerful 
report. I also commend this agency's leadership for having the moral 
courage to release it to the American public. If a harder hitting IG 
Report than this has ever been written, please let me know so that I 
can obtain a copy and read it.
Where are the other Financial Regulator's Inspector Generals' Reports?
    It is a breath of fresh air that the SEC has stepped forward and 
delivered a comprehensive and transparent report about what transpired 
during the Madoff crime spree for the sixteen year time period 1992-
2008. Now where are the IG Reports for the other financial regulators, 
namely the Federal Reserve (FED), the Office of the Comptroller of the 
Currency (OCC), the Federal Deposit Insurance Corporation (FDIC), and 
the Office of Thrift Supervision (OTS)? These regulators were far more 
incompetent than the SEC yet they seem intent on lying low in the weeds 
and avoiding blame.
    One can argue that the banking regulators' lapses were far more 
egregious than the SEC's and that their examiners were even less 
competent--and that's quite a feat! If the entire SEC staff were seated 
in Fenway Park for the afternoon and couldn't find 1st base, then I'm 
not too sure that banking regulators could even find Boston, much less 
Fenway Park. And at the top levels of these non-functional banking 
regulators, there are more than a few who I doubt could even find the 
east coast.
    I urge the Committee to task each banking regulator to prepare its 
own inspector general's report for their agency and to make their 
reports at least as hard-hitting as the SEC IG's. The bank regulators' 
failures to regulate have cost the American taxpayers a lot more money 
and lost reputation than the SEC's failures and it is past time they be 
taken to the woodshed too. They need to be exposed and held accountable 
just like the SEC has been exposed in this report and held accountable.
Comments on the SEC's Reforms to Date
    Plainly put I have never seen a government agency embrace reforms 
as rapidly as the SEC has. Of course, I've never seen an agency do such 
a bad job first-hand like this either. For the SEC it's definitely a 
case of sink or swim. If this agency fails to right itself and quickly, 
it is doubtful that they would get included in the new regulatory 
structure due to be enacted by this Congress. The SEC's very survival 
depends upon embracing change at a rapid pace in a bid to show they 
deserve to survive and not have their enforcement powers parceled out 
to other agencies after they were disbanded.
    The Madoff Ponzi scheme exposed this non-functional agency's every 
wart and took it to its lowest point in its 75-year history. The 
scandal was so big and all encompassing and took place over such a long 
timeframe that it called into question the entire agency's structure, 
staffing, willingness and ability to protect investors and to ensure 
the safety, soundness and transparency of our nation's capital markets.
    When a scandal of these epic proportions hits it is like a 100-year 
flood--it occurs every century or so. If the Stock Market Crash of 1929 
and subsequent Great Depression was last century's 100-year financial 
flood, then Bernard Madoff and the Panic of 2008 are this century's 
version of that. The regulatory structures put into place in the wake 
of the Great Depression are now over three-quarters of a century old 
and inadequate to police our financial markets. Madoff brought this 
point home to the SEC and they seem to have gotten religion after their 
multi-decade long slumber.
    By now you've seen the SEC's list of Proposed Post-Madoff Reforms 
dated June 29, 2009. I support each of these recommendations without 
exception. There are other much smaller, less newsworthy reforms that 
are not on this list of which even Mary Shapiro may not be aware 
because the SEC's regional offices adopted them on their own. They saw 
a need for change and took the initiative to make the changes within 
their power to make. I happen to have found out about them either from 
SEC staffers who are personal friends of mine or professional 
acquaintances of mine. I would like to share two of these instances 
with you.
    First, one regional office held its own series of internal meetings 
to discuss changing the way exams are performed. They just knew the 
current methodology wasn't effective and discussed new methods on their 
own without being told to do so by their Washington headquarters. 
Second, another regional office was reviewing a company's restated 
earnings and discovered an old internal auditor's report that bluntly 
stated that the company's CEO and CFO were cooking the books. The 
internal auditor was fired on the spot when he refused to withdraw the 
report and then mailed it to the Audit Committee Chairman. The SEC went 
in, found the report in the company's files, and then, several years 
after the report was written, flew a team out to meet the fired 
internal auditor to conduct a follow-up investigation. These are only 
two examples of how the SEC is changing rapidly and for the better. 
Before Madoff turned himself in, the SEC staff didn't seem to care 
about anything other than showing up and collecting their paychecks. 
Nowadays it does seem that the agency is operating with a speed and 
vigor which it hasn't exhibited in many years.
    I would rate the SEC in its current state as still being non-
functional but at least they are trying to get better and they are 
trying at an enviable pace. As they say, you have to crawl before you 
can walk, and you have to walk before you can run. Right now the SEC is 
learning to crawl again. It took decades of sloth, abysmal leadership, 
under-funding and benign neglect to get this bad and realistically it 
will take them at least a few years to become the effective, efficient 
cop on the beat that investors expect.
    My biggest worry is that the SEC will backslide once their agency 
is out from under public scrutiny. It is up to Congress to ensure that 
they keep close watch over the SEC and perform close oversight to 
ensure that the pace of reform continues and that these reforms are 
funded. I encourage Congress to write enabling legislation where 
required to enact and fund the SEC's proposed reforms.
Recommendations for Regulatory Reform
Recommendation # 1: Combine all of the Nation's Financial Regulators 
        under one Umbrella
    The SEC IG report details how the Boston, New York, and Washington 
offices of the SEC were incapable of coordinating the Madoff 
investigation amongst themselves. Worse, within the New York Regional 
Office, the Examination team (OCIE) that had just finished an exam of 
the Madoff operation in 2005 did not coordinate effectively with the 
Enforcement team (DOE) that started investigating Madoff shortly 
thereafter. If regional offices from a single agency could not 
coordinate with each other and if teams within one regional office 
could not coordinate with each other, what sense does it make to keep 
FED, OCC, FDIC, SEC and the CFTC as stand alone regulators? Worse, each 
of the five regulators would have its own computer system and none of 
them would know what the other regulators were doing with respect to a 
particular company.
    Regulators are facing off against financial institutions magnitudes 
larger than those that existed back in the 1930s when the current 
regulatory system was formed. Today, unfortunately we still have 
gigantic ``too big to fail--too big to succeed--too big to regulate'' 
companies like Citigroup, Bank of America, American International Group 
and others. These ultra-large companies may have subsidiaries operating 
banks, insurance companies, mortgage lenders, credit card companies, 
investment-banks and securities broker-dealers not only domestically 
but also internationally. Sending in several separate regulators to 
spot problems is akin to tackling the problem peace-meal. If the SEC 
can't coordinate within its own agency, what hope is there that 
separate agencies can coordinate effectively? Is it any wonder the 
three financial institutions I've listed above collapsed last year and 
needed government rescues to survive?
    Our nation has too many financial regulators and this leaves too 
many gaping holes for financial predators to engage in ``regulatory 
arbitrage'' and exploit these regulatory gaps where no regulator is 
looking or the regulator that may be investigating is trumped by 
another. I have seen one institution where individuals 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. But let's assume that both the 
SEC and FED were to come in and inspect fraud in the company's pension 
accounts under management, well then the company might say, ``Oh but 
these are ERISA accounts and they fall under the Department of Labor, 
so you don't have jurisdiction.'' Clearly this situation has to be 
corrected so firms can't play one regulator off against the others or 
worse, choose to be regulated by the most incompetent regulator 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 whom American 
businesses must respond.
    I recommend that one super-regulatory department be formed and that 
it be called the Financial Supervisory Authority (FSA). Under it's 
command should be the SEC, the FED, a national insurance regulator and 
some sort of Treasury / DOJ law enforcement function with staffs of 
dedicated litigators carrying out both criminal and civil enforcement 
for the SEC, national insurance regulator, and the FED. All banking 
regulators should be merged into the FED so that only one national 
banking regulator exists. Pension fund regulation should be moved from 
the Department of Labor to the SEC. The CFTC should be merged into the 
SEC so there exists only one capital markets regulator. 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. Right now financial institutions 
pay a lot in fees for regulation but they certainly aren't getting 
their money's worth.
Recommendation # 2: Pass a Sarbannes-Oxley (SOX) Equivalent Law for 
        Government to Hold Agency Heads Accountable to Taxpayers
    In the wake of the accounting scandals that felled Enron, WorldCom, 
Global Crossing, Adelphia and others, Congress passed very strict laws 
that held corporate CEO's and CFO's accountable for their company's 
financial reporting. CEO's and CFO's suddenly became accountable for 
everything that happened or failed to happen with their company's 
financial reporting. No longer could they claim ``they didn't know what 
was happening'' under their watch. If a CEO and CFO signed off on a 
company's books and it turned out that for whatever reason the books 
were materially inaccurate, it was a 10-year prison sentence. If the 
CEO and CFO were willfully cooking the books, it meant a 20-year prison 
sentence.
    I propose that Congress pass similar legislation that holds agency 
heads just as responsible as we currently hold corporate CEO's and 
CFO's for their financial reporting. If an agency fails to enforce this 
nation's laws, as passed by Congress, then a criminal referral to the 
Justice Department seems in order.
    Right now there is no accountability in government. All of this 
nation's financial regulators failed to regulate the industries they 
were charged with regulating and they've gotten away scot-free without 
any punishment. At the SEC a few high-level department heads were 
allowed to resign ``to pursue other growth opportunities'' called 
``pogo-ing out'' but how fair is that to taxpayers? It sure would be 
nice to see a few agency heads sent to prison for their willful 
blindness in letting our nation's financial system collapse but, 
unfortunately, there are no laws on the books to help in this regard.
    If Congress passes a law, we as taxpayers should want to see it 
enforced fairly for all. Currently it seems that entire government 
agencies can remain comatose and let the industries they are charged 
with regulating commit whatever crimes they wish with impunity. Putting 
agency heads in prison for willful blindness, malfeasance, and 
corruption seems like it's long overdue.
    SOX for government would also go a long ways toward eliminating 
``regulatory capture'' whereby regulators stop protecting the public 
because they become beholden to the industries they are charged with 
regulating. Government is supposed to be representing the public's 
interests but all too often these government agencies become captive 
and start representing their industry's interests over those of the 
citizenry. For instance, the overall goal of the SEC investigation and 
examinations, as the IG's report iterates time and again, is and was to 
protect investors, current and future, not deep pocketed and 
influential industry firms.
Recommendation # 3: Use Congressional Public Censure to Punish 
        Incompetent Government Agencies
    One way to light a fire under under-performing or non-performing 
government agencies that are non-responsive to Congressional oversight 
is to publicly censure these wayward agencies. For example, Congress 
could censure an agency by voting into law that for the next X number 
of months or years, that offending agency be termed ``A national 
disgrace by Act of Congress dating from today--Month Y.'' The censured 
agency would then have to include this censure in every email sent out 
by its employees during the time period the censure was in force for. 
This shaming mechanism is a low-cost but effective means for Congress 
to express its displeasure over the lack of regulatory zeal by certain 
agencies, some of whom are repeat offenders. The road toward gaining 
respect would then be earned through every successful effort by 
employees, who would in turn be incentivized to work together to 
improve the entire organization through their individual and team 
efforts.
Recommendation # 4: Regulate all Over-the-Counter Products, Mandate 
        Centralized Clearing and Wherever Possible Put Them on 
        Exchanges
    Over-the-Counter (OTC) is unregulated space. It's where the 
financial industry's cockroaches congregate because there is no light, 
only darkness. This is also where the industry's highest margins exist 
so they will fight like the dickens to protect their profit margins.
    Laws should be passed that dictate that U.S. investors cannot trade 
OTC products offshore and receive government protection in the form of 
bailouts. In other words, no more trading through unregulated entities 
such as AIG's London-based Financial Products unit where the risk ends 
up getting transferred back on-shore domestically and U.S. taxpayers 
end up footing the bill. If U.S. regulators don't have visibility into 
an OTC product that's traded off-shore, then strict risk and capital 
limits should be placed on U.S.-based traded counter-parties in order 
to avoid systemic risk.
    You cannot regulate common sense but some sort of guidelines should 
be available to investors on the SEC's website that if you don't know 
how to model an OTC derivative yourself, then you, your company or your 
municipality should not be trading them. The SEC should closely 
investigate all disclosures in the OTC municipal derivatives market 
because this sector of the marketplace is rife with fraud. In many 
instances it is still a pay-to-play market with opaque disclosure 
documents and even more opaque pricing mechanisms which only serve to 
defraud government entities.
    In my own state, Massachusetts, our Turnpike Authority ended upside 
down on a series of interest rate swaptions they did not understand. 
The last press account I saw in late 2008 put the amount of fiscal 
carnage in Massachusetts at $450 million. I can assure you that no one 
in our state's government knows how to price interest rate swaptions. 
Our Turnpike Authority was ``picked off'' by several Wall Street firms 
because they were lured into these OTC transactions and did not 
understand either the pricing or the risks. But since you cannot 
regulate common sense, at least regulate the OTC markets so they don't 
remain lawless like the Wild Wild West of the late 19th century.
Recommendations for the SEC
Recommendation # 1: A Maximum of One Lawyer on the SEC Commission 
        Itself
    Currently the SEC is dominated by lawyers, in fact all five of the 
current SEC Commissioners are lawyers so is it any wonder the SEC is 
ineffectual? I have nothing against lawyers but putting them in charge 
of supervising our capital markets has been an unmitigated disaster. 
Very few SEC lawyers understand the complex financial instruments of 
the 21st century and almost none of them have ever sat on a trading 
desk or worked in the industry other than in a legal capacity. If you 
want to know how things became so bad at the SEC it's because 
predominantly most or all of the five SEC Commissioners have been 
lawyers who haven't a clue as to how the industry really operates.
    Putting lawyers in charge of regulating the capital markets makes 
no sense, something the financial services industry recognizes. Most 
financial firms are run by businessmen with capital markets or banking 
expertise--not that this prevented the industry from a near-death 
experience in 2008 but just about anything is better than being led by 
lawyers who have no understanding of the finance industry they are 
governing.
    Lawyers within the SEC need to be relegated to back-seat roles and 
removed from most positions of senior leadership within the agency and 
replaced by people with the proper backgrounds to understand the 
markets and institutions being regulated. Yes, the Director of 
Enforcement should be a lawyer but as for the other departments, very 
few should be led by lawyers.
    Read the SEC IG's report for how the SEC's enforcement lawyers did 
not have a clue as to what Bernard Madoff was telling them about his 
trading strategy. They couldn't recognize the obvious lies because none 
of them had any financial expertise to understand the capital markets. 
The typical SEC attorney would have trouble finding ice cream at a 
Dairy Queen so tasking them to uncover financial frauds would be about 
as fruitful.
    The law is the lowest form of acceptable behavior but ethics are a 
higher standard that the SEC's securities lawyers seem to ignore time 
and again. For instance, mutual fund market-timing wasn't illegal so 
the SEC's lawyers ignored it while individual investors lost tens of 
billions to market-timers and hedge funds engaged in the practice. 
However, any industry professional with a moral compass could have told 
you this activity was unethical and needed to be stopped. SEC lawyers 
are not trained within the industry, and so they have little idea of 
the ethical dilemmas industry professionals face everyday. Lawyers are 
trained in the black letter law and regulation instead. This, in a 
nutshell is why it is better to have industry professionals running the 
show and not lawyers because securities laws are a very low behavioral 
bar. Securities laws are outdated as soon as they are passed because 
new financial instruments are invented to skirt these laws, which is 
another reason that lawyers shouldn't be running the SEC. We need to 
raise the bar and insist upon transparent and fair dealings for all 
which is a standard of behavior that is leaps and bounds higher than 
merely following existing securities laws. Therefore having lawyers run 
the show allows too much bad behavior to occur since they have blinders 
on and can only distinguish between lawful and unlawful behavior. Only 
finance professionals can keep up with the modern financial instruments 
of the 21st century. Therefore they should be in positions of 
authority. It would be very difficult to do a worse job than the 
securities lawyers have already.
Recommendation # 2: Conduct a Skills Inventory of the Professional 
        Staff and Terminate Those Not Qualified to Hold Their Positions
    It's clear that a significant portion of the SEC's professional 
staff, perhaps 50 percent or more of them, need to be let go because 
they are not qualified to hold their positions. For example, quite a 
few of the New York Regional Staff depicted in the SEC IG report should 
be immediately fired if they haven't already resigned. Fortunately, 
given the layoffs on Wall Street, plenty of vastly more qualified 
industry professionals who do understand the capital markets, are 
available and could be brought on board quickly. The SEC's staff needs 
to be dramatically upgraded and there's no better economic environment 
to be in than today's from a hiring standpoint.
Recommendation # 3: Hire Qualified Industry Professionals with Over 10 
        Years of Experience
    Hiring kids right out of college is not the way to detect financial 
fraud. These greenhorn twenty-something's couldn't find steak at an 
Outback. For the broker-dealer exam teams, hire experienced brokers 
with as many years of experience as you can. Send veteran traders and 
veteran back office personnel in to conduct trading floor exams. For 
the money management and hedge fund teams, hire experienced portfolio 
managers, analysts and buy-side back office personnel to conduct asset 
manager exams. The same goes for hiring experienced accounting 
professionals to examine required corporate filings. Let me tell you 
about the following story from Boston. A person I know rather well with 
over 10 years of industry experience, an under-graduate degree in 
economics and math, an MBA and a Chartered Financial Analyst 
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 70 hour work weeks were 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. And that's the problem. Since the SEC only hires unqualified, 
uneducated people without financial industry experience, all they want 
to do is check pieces of paper to make sure all the paperwork that 
existing (outdated) securities law requires is being complied with. Is 
it any wonder, given the current SEC staff, how major financial 
felonies go unpunished while minor paperwork transgressions are flagged 
for attention?
    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. We were 
considered ``high risk'' because we managed derivatives and received 
SEC inspection visits every 3 years like clockwork, so 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. A good thing my firm was honest because if 
we weren't we could have pulled a Madoff on them and they would have 
never been the wiser. Second, the teams are very, very young and they 
don't 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 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's books and records were in compliance.
    Now let's examine what went wrong with the examination process 
described above. First, the team only interacted with the inspected 
firm's compliance team, not the traders, not the portfolio managers, 
not the client service officers, and not top management. The problem 
with this process is that the SEC examiners only examined paperwork but 
neglected the tremendous human intelligence gathering opportunities 
that were 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 if they ever run across anything the 
SEC should be looking into either at their firm or any other firm. 
These are basic internal auditing techniques that every accountant, 
internal auditor, and fraud examiner uses when conducting audits. But 
the SEC staff is so untrained, it's almost as if this is advanced 
rocket science, because the SEC examiners are so inexperienced and 
unfamiliar with financial concepts they are afraid to interact with 
real finance industry professionals and choose to remain isolated in 
conference rooms inspecting pieces of paper.
    Right off the bat, the incoming SEC Chair needs to get these 
examiners to focus on interacting with the industry professionals and 
querying them on what's going on in their firms and their competitors' 
firms. Sitting like ducks getting fed controlled bits of paper by 
inspected firms isn't getting the job done and the current examination 
process is an insult to common sense. It also seems like a waste of 
taxpayers' or investors' money. This also reinforces the need to 
increase the pay scale and add in 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 are miniscule at best.
Recommendation # 4: Adopt the Industry's Compensation Model
    The problem is that the SEC pays peanuts and then wonders how it 
ended up with so many monkeys. Industry pays salary plus bonus and the 
SEC needs to be competitive in order to attract the best talent. 
Compensation at the SEC needs to be both increased and shifted to 
include incentive compensation tied to how much in enforcement revenues 
each office collects. Of course, the SEC Commissioners would be setting 
the levels of fines for enforcement actions, but each SEC Regional 
Office should get back some percentage, and I recommend a 10 percent 
level initially, toward that office's bonus pool.
    Regional enforcement teams that bring in a $100 million case 
deserve to be compensated for that. And, to prevent taxpayers from 
having to pony up these multimillion dollar bonuses, I would insist 
that the fines be triple the amount of actual damages, that the guilty 
transgressors pay the actual costs of the government's investigation, 
so that SEC staff bonuses end up being paid for by the guilty 
transgressors.
    In expensive financial centers' like New York and Boston, cost of 
living adjustments bringing base compensation to the $200,000 level 
make sense. This would be enough to attract the nation's best, 
brightest and most experienced industry practitioners. All compensation 
over and above this amount would need to 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 settle will get asked to leave and make room for 
people who can come in and produce solid cases.
Recommendation # 5: Move the SEC's Headquarters to New York
    This might be the single best way to quickly upgrade the SEC's 
talent pool at the highest levels. Move the SEC's headquarters out of 
Washington because Washington is a political center not a financial 
center, so you won't find very many qualified finance professionals 
there. 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 New York City, West Chester County, New York or Fairfield 
County, Connecticut makes a lot of sense. This puts the SEC's 
headquarters right in the center of the financial industry and offers 
easy access to both Boston and Washington. If the SEC wants to attract 
the top talent, relocating its headquarters to somewhere between New 
York City and Stamford, CT is where this agency will best attract the 
foxes with industry experience it so desperately needs to be on the 
right side of the fence.
Recommendation # 6: Administer Competency Exams for Professional Staff 
        Before Hiring
    Amazingly, the SEC does not give its employees a simple entrance 
exam to test their knowledge of the capital markets! Is it any wonder 
that most SEC staffers, particularly the Staff Attorneys don't know a 
put from a call, a convertible arbitrage strategy from a municipal 
bond, or an interest-only from a principle-only fixed income 
instrument? The Chartered Financial Analysts Level I exam covers the 
material that I would expect all of the SEC's professional staff to 
have mastered before being hired. I doubt that even 20 percent of the 
SEC's current staff would be able to pass this exam. For SEC Staff 
Attorneys that number would likely be less than 5 percent.
Recommendation # 7: Fund Subscription Budgets
    If you walk into any sizable investment industry firm, they'll have 
a library of professional publications for their staff to use as a 
resource. Typical journals on hand would be the Journal of Accounting, 
Journal of Portfolio Management, Financial Anaylsts Journal, Journal of 
Investing, Journal of Indexing, Journal of Financial Economics, and the 
list goes on and on. If you walk into an SEC office, you won't see any 
of these journals nor will you see an investment library. 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 makes 
sure its staff remains uneducated.
Recommendation # 8: Mandate and Fund Business Cards for All SEC Staff
    The SEC doesn't provide its staff with business cards. I know, it's 
hard to believe but it's true. It's sort of hard to get a call back 
from someone you've met at an industry conference or an employee of a 
firm that you just asked, ``please give me a call if you ever spot a 
securities fraud,'' if you haven't handed them a business card. Some 
SEC staff pay for their own business cards but if private industry 
provides business cards for its employees then the SEC should also. 
It's only common sense.
    All business cards should also tell what professional credentials 
each SEC staffer has obtained. Credentials such as CFA, CFE, CFP, CIA, 
CISA, CPA, JD, Ph.D., and others should appear prominently on all staff 
business cards. Printed at the bottom of each card should be something 
like, ``To report a securities fraud please call me.'' This would send 
a message that each SEC staff member is a fraud-fighter first and 
foremost. Upon receiving calls to report a fraud, each SEC employee 
will immediately forward the call to competent authority per the SEC's 
standard operating procedure for handling whistleblower tips. 
Secretaries and clerks should also have business cards since this is a 
low cost means of advertising that your employer is in the securities 
fraud-fighting business.
Recommendation # 9: Change Performance Metrics Away From the Number of 
        Exams Undertaken
    Measuring performance by the number of exams a Regional Office 
conducts each year totally misses the point. The SEC's mission is to 
protect investors and to find or prevent fraud. As the SEC IG's report 
has shown, conducting poorly planned and executed exams and then 
promoting staff based upon the completion of shoddy exams is not a 
deterrent to fraud. The goal should never be how many pieces of paper 
were inspected, it must become how much fraud did we catch?
    Obvious success metrics which the SEC should start measuring are 
fine income, dollar damages recovered for investors, dollar damages 
prevented, 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. Exams catch so little major fraud that 
they are the least important metric to follow unless one actually 
believes that catching minor technical violations is a felony 
deterrent.
Recommendation # 10: Increase the Risk of Fraud Detection by Funding 
        SEC Attendance at Industry Events
    The most important thing the SEC can do is increase the risk of 
detection for securities fraudsters. To do that the SEC needs to put 
its staff out among the industry's employees wherever and whenever 
possible. Interacting with industry professionals before and after 
industry functions is a great way to obtain tips on nascent fraud 
schemes and stop them before they become Madoff-sized or sub-prime 
sized.
    Large cities with robust financial centers have financial analyst 
societies, CPA societies, securities traders associations and economic 
clubs which hold educational meetings of just the sort the SEC staff 
needs, but the SEC typically doesn't allow its staff time off to attend 
these meetings nor does it reimburse its staff for attending industry 
meetings of this nature. Rarely does anyone see SEC staff attending 
these educational events and we all know it isn't because the SEC has 
no need for industry knowledge.
Recommendation # 11: Fund Development of an SEC Knowledge Base
    Think of how different it would have turned out if the SEC exam and 
enforcement teams in New York could have turned on their PC's, typed in 
the word ``Ponzi'' to an on-line SEC knowledge base and have appear on 
the screen diagnoses of past Ponzi schemes and a list of checklists on 
how to most efficiently solve such cases. Unfortunately, the SEC staff 
did not have such a system and as a result SEC exam and enforcement 
teams were not able to solve one of the easiest fraud schemes there is, 
the simple Ponzi scheme. Ponzi schemes are not that hard to figure out 
because there is no underlying investment product, there is no trading 
and the assets are being diverted to pay off old investors.
    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 collate and sort through every fraud that the SEC finds. These 
frauds would be diagnosed for both common and unique elements that each 
had so that the odds of future frauds going unchecked are further 
reduced.
    CALL would be a password protected, on-line 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 to this knowledge base.
Recommendation # 12: Properly Arm SEC Exam & Enforcement Teams
    If the SEC staff in New York had Bloomberg machines and if they 
knew how to use them, they could have quickly analyzed actual OEX 
Standard & Poor's 100 index options trades that Bernard Madoff 
purported to trade on certain dates and proven that no such trades 
actually occurred. The case would have been cracked open quickly but, 
of course, the SEC staff doesn't have easy access to Bloomberg machines 
nor are they trained in how to operate them.
    The Bloomberg machine is the key knowledge tool used in the finance 
industry but it is expensive, costing over $20,000 per machine per 
year. Industry allocates one Bloomberg machine per trader, analyst and 
portfolio manager so that they can conduct the business of finance. The 
SEC is lucky to have one Bloomberg machine per Regional Office! Sending 
SEC teams into exams and enforcement actions without a Bloomberg is 
akin to sending unarmed teams to a gunfight and then wondering why they 
come back to the office hanging their heads in defeat each time.
    When a financial analyst is about to analyze 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, 
its financial statements, financial ratios, look up the firm's weighted 
cost of capital, and start running a horizontal and vertical analysis 
of the firm's financial statements. The trained analyst will also use 
the Bloomberg to read all news stories out on a company, look at the 
firm's SEC filings, and use all of the information collected to build a 
set of questions he/she needs to answer before investing. The trained 
analyst will also obtain Wall Street's research reports on the company 
to see how those analysts approached their analysis to see if there 
might be something they missed.
    Unfortunately, the SEC staff examiner rarely can do this because 
either they can't get access to a Bloomberg or they are not trained in 
how to use one. For SEC compliance purposes I don't see how their staff 
can function effectively without having at least one Bloomberg assigned 
per exam and enforcement team. Their work, in brief, cannot be done 
without it. Those Bloomberg machines are the lifeblood of the industry 
and they contain must of the data that an SEC staffer would need for a 
basic fraud analysis of a company. Not funding these machines is penny-
wise but pound-foolish.
Recommendation # 13: Establish an SEC Office of the Whistleblower
    According to the Association of Certified Fraud Examiner's 2008 
Report to the Nation (please refer to the attached Appendix II for the 
relevant portions of this report or you can find it a www.acfe.com) 
whistleblower tips detected 54.1 percent of uncovered fraud schemes in 
public companies. External auditors, and the SEC exam teams would 
certainly be considered external auditors, detected a mere 4.1 percent 
of uncovered fraud schemes. Whistleblower tips were 13 times more 
effective than external audits, hence my recommendation to the SEC to 
encourage the submission of whistleblower tips.
    Other interesting statistics from the ACFE Report are that employee 
tips are 57.7 percent of all whistleblower tips received. How easy 
would it be for SEC enforcement teams if an internal whistleblower came 
in and presented them with hidden books and records? Customers provided 
17.6 percent of whistleblower tips followed by vendors (12.3 percent) 
and shareholders (9.2 percent).
Recommendation # 14: Authorize an SEC Whistleblower Bounty Program 
        Similar to Those of the Department of Justice and the IRS
    The Internal Revenue Service (IRS) started its Office of the 
Whistleblower in December 2006 and in less than 3 years has grown this 
office to a staff of 18. The IRS now receives the largest cases with 
the absolute best quality of evidence in its history. Consider the cost 
of 18 IRS employees versus the billions in additional tax revenues they 
will be responsible for bringing into the U.S. Treasury.
    The IRS offers bounty payments of 15 percent-30 percent to 
whistleblowers for cases that lead to successful recoveries for 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 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  
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, then my bet is that hundreds of 
cases would walk in the door each year, and that several dozen 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 USC 
Sections 3729-3733) already provides each year.
    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, the issue of self-regulation 
and whistle-blowing. 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 and identified themselves? Unfortunately, I may 
have been the only one.
    Getting rid of the shysters, fraudsters and banksters 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.
APPENDIX I
NOTICE OF MISINFORMATION IN THE PRESS AND MEDIA FROM HARRY MARKOPOLOS, 
        CFA, CFE, SEPTEMBER 10, 2009
1. Per a recently released Madoff book, I am not an accountant nor do I 
hold a B.S. degree in Accounting from Loyola College (now called Loyola 
University) of Maryland. I do hold a Bachelor of Arts degree in 
Business Administration from Loyola.

2. Per several news agencies reporting, I am not a Certified Public 
Accountant (CPA) nor am I an accountant. I am a Chartered Financial 
Analyst (CFA) and a Certified Fraud Examiner (CFE).

3. Per a major news service's reporting, I am not writing a book 
entitled, ``An Army of One,'' due for release this fall. First, ``An 
Army of One,'' is a U.S. Army recruiting slogan. Second, this title 
would be wholly inappropriate because I led a team of four. Together, 
we are writing a book but we have not selected a title yet and our 
anticipated publication date has always been March 2010.

4. Per a major news service's reporting, I did not pay my way through 
college, my parents did. I did pay my way through graduate school.

5. Per an Internet-only newspaper's reporting, I never commanded a 
civil affairs unit on active duty for 7 years in Western Europe and 
Africa. I was a part-time reservist for 17 years, having served first 
in the Maryland Army National Guard (MDARNG) and then in the U.S. Army 
Civil Affairs and Psychological Operations Command (USACAPOC). I also 
never served as a commando of any sort nor did I ever hold a top-secret 
clearance nor was I ever an Army Intelligence Officer. I have held a 
secret clearance and I left the reserves in April 1995 so that I could 
apply for and enter graduate business school at Boston College in 
September 1995.

6. Per a major news service's reporting, I never said, ``The SEC roars 
like a lion and bites like a flea.'' I did say, ``The SEC roars like a 
mouse and bites like a flea.''

7. Per a major newspaper's gossip column that reportedly quoted me as 
saying larger fraud schemes than Madoff's were out there, I never said 
that. An audience member said that during the question & answer period 
at one of my presentations. I did say that someday way into the future 
there would be someone who will break Madoff's record for fraud because 
white collar fraudsters are always getting smarter.
APPENDIX II
2008 ACFE Report to the Nation Excerpts
APPENDIX III
June 2009 Fraud Magazine Interview with Harry Markopolos




                                 ______
                                 
                  PREPARED STATEMENT OF ROBERT KHUZAMI
                   Director, Division of Enforcement
                   Securities and Exchange Commission
                    PREPARED STATEMENT OF JOHN WALSH
   Acting Director, Office of Compliance Inspections and Examinations
                   Securities and Exchange Commission
                           September 10, 2009
I. Introduction
    Chairman Dodd, Ranking Member Shelby, and Members of the Committee, 
thank you for the opportunity to testify today on behalf of the 
Securities and Exchange Commission (SEC) regarding the agency's failure 
to detect the massive fraud perpetrated by Bernard Madoff. We share the 
Committee's desire to identify and remedy the causes of this failure 
and appreciate your support for improving the agency's enforcement and 
examination roles. We are committed to making every change necessary to 
fulfill our mission.
    Before we begin, the Commission would like to recognize the work of 
the Inspector General and his staff investigating this matter and 
drafting the report, Investigation of Failure of the SEC to Uncover 
Bernard Madoff's Ponzi Scheme (OIG-509) (``IG Report''). We and others 
at the Commission are closely studying the report and will continue to 
analyze and learn from its findings and conclusions.
    Having read the IG Report and its litany of missed opportunities, 
it is clear that no one can or should defend, excuse, or deflect 
responsibility for the SEC's handling of the Madoff matter. Stated 
simply, in this case we failed in our fundamental mission to protect 
investors, and we must continue vigorously to reform the way we 
operate. We have read letters from harmed investors that were filed 
with the court in connection with Madoff's sentencing. It is a sobering 
and humbling experience.
    The IG Report traces the SEC's failure with Madoff to shortcomings 
in a number of areas, including insufficient expertise, training, 
experience and supervision by management; inadequate internal 
communication and coordination among and within various SEC divisions; 
deficiencies in investigative planning and prioritization; lack of 
follow-through on leads; and insufficient resources.
    We deeply regret our failure to detect the Madoff fraud and pledge 
to continue to fix the problems that contributed to this failure. Today 
we commit to you, investors across the country and the public 
generally, that we will carefully study the content and findings of the 
IG Report and any forthcoming audit reports and continue to implement 
the changes necessary to strengthen our enforcement and examination 
programs. We also each personally pledge our unwavering commitment to 
establish heightened levels of expertise and tenacity within both the 
Office of Compliance Inspections and Examinations (``OCIE'') and the 
Division of Enforcement (``Enforcement'') in an effort to restore the 
trust of the investors we are charged to protect.
    In this testimony, we would like to describe in detail some current 
initiatives and future programmatic commitments of Enforcement, OCIE 
and the Commission overall to address the issues raised in the IG 
Report.
    Even before the report was issued, the agency already had begun 
instituting extensive reforms, including vastly expanding our training 
programs, hiring staff with new skill sets, streamlining management, 
putting seasoned investigators on the front lines, revising our 
enforcement and examination procedures, restructuring processes to 
ensure better sharing of information, leveraging the knowledge of third 
parties, revamping the way we handle the hundreds of thousands of tips 
we receive annually, and improving our risk-assessment techniques so 
that examiners are knocking on the right doors and delving into the 
right issues.
    Despite the many changes we recently have initiated, we 
nevertheless recognize that much more needs to be done. This will 
require commitment and creativity. In addition, while we sincerely 
appreciate the support that Congress has provided the Commission, it is 
clear that addressing key problems identified by the IG's Report will 
also ultimately require additional resources. The acquisition of 
specialized skill sets and needed technology will require the agency 
and Congress to work together to make these priorities a reality.
    In the coming weeks, we will continue to review the full report 
closely in order to learn every lesson we can, and to help buildupon 
the many reforms that we have already begun to put into place.
II. Current Initiatives
    While the Commission has awaited the results of the IG 
investigation and audits, we have not waited to implement changes 
needed in our structure and process. Prior to the release of the IG 
Report, Enforcement, OCIE and the Commission as a whole have taken 
decisive and comprehensive steps to address self-identified 
deficiencies, in addition to filling gaps in our rules, which we will 
address later.
The Enforcement Division:
    With respect to Enforcement, since Mr. Khuzami joined the 
Commission as Director of Enforcement in March of this year, he has 
been undertaking what has been referred to as ``the unit's biggest 
reorganization in at least three decades.''\1\ Upon his arrival, his 
first mission was to establish nine working groups comprised of 
Enforcement Division staff and charge them with a top-to-bottom self-
assessment of Enforcement's operations. Phase One of this self-
assessment is now complete, and the resulting recommendations are now 
in the implementation phase. The recommendations, which will begin to 
address many of the issues identified in the IG Report, include:
---------------------------------------------------------------------------
    \1\ David Scheer, SEC Never Did `Competent' Madoff Probe, Report 
Finds (Update 2), Bloomberg.com, Sep. 2, 2009, http://
www.bloomberg.com/apps/news?pid=20603037&sid=
aBHQkUqCQppk.

    creating five national specialized investigative groups 
        comprised both of in-house experts and newly hired staff with 
---------------------------------------------------------------------------
        practical trading, market, and other specialized skills;

    adopting a flatter organizational structure by reducing 
        current management by 40 percent and deploying those personnel 
        to the mission-critical work of conducting front-line 
        investigations;

    establishing structures and procedures to enhance training 
        and supervision;

    eliminating needless bureaucratic approvals and process;

    hiring the Division's first-ever chief operating officer 
        and beginning the task of transferring administrative and 
        infrastructure tasks from investigative personnel to 
        centralized operations personnel;

    establishing an improved structure to gather, analyze, 
        assign and monitor the hundreds of thousands of complaints, 
        tips and referrals received by the SEC annually; and

    seeking more resources to help achieve these goals.
Office of Compliance Inspections and Examinations:
    With respect to OCIE, Mr. Walsh became Acting Director last month 
and will continue to serve in that capacity while we are conducting a 
search for permanent leadership. The first task for any new leader will 
be to conduct the same kind of top-to-bottom review of OCIE that was 
conducted by Enforcement in order to fundamentally rethink how it 
conducts business. Since his appointment, Mr. Walsh's most important 
goal has been to push forward several significant reforms that are 
reshaping the examination program. These include: placing an emphasis 
on fraud detection in addition to the program's overall goal of 
identifying potential violations of specific securities laws and rules; 
strengthening procedures and internal controls to better ensure we are 
maximizing limited resources, staffing examinations with the right 
skill sets, and improving oversight and communication throughout OCIE; 
recruiting examiners with specialized skills; increasing expertise 
through enhanced training and widespread participation in certified 
training programs such as the Certified Fraud Examiner credential; and 
ensuring that examiners know that they have management's full support 
as they follow the facts wherever they lead.
A. Expertise, Experience and Supervision
    Across the SEC, there is significant focus on hiring staff with 
specialized expertise, greater experience and new skill sets within the 
confines of our current budget. These efforts should address some of 
the issues identified in the IG Report.
The Enforcement Division:
    The Division of Enforcement is undergoing a fundamental 
restructuring. We are creating five national specialized units that 
will be dedicated to high-priority areas of securities enforcement, 
with a particular emphasis on complex products, markets, transactions 
or practices. In order to help the agency keep pace with the complexity 
of the markets and market practices, staff assigned to these 
specialized units will receive advanced training, including training 
customized to reflect market developments and particular investigative 
challenges in those subject areas.
    With the help of Congress, Enforcement is assigning to these units 
and seeking to hire specialists with practical market experience and 
expert skills. Approximately 7 positions of the 23 allocated from 
reprogrammed 2009 funds are being used for specialists to be assigned 
to the specialized units. Of course, current market conditions make 
this an opportune time to recruit staff with this expertise, and 
additional funding would allow us to hire more quickly specialists with 
significant market experience.
    Unit members will acquire the expertise and investigative insights 
that can only be developed by conducting investigations in the same 
subject area, combined with ready access to others with specialized 
skills. With increased focus, training, and access to specialized 
expertise, investigative staff will make better investigative decisions 
and be less likely to be misled by those using complexity to conceal 
their misconduct.
    Below is a description of the five specialized units. Future units 
may be added as experience and priorities dictate.

    The Asset Management Unit will focus on investment 
        advisers, investment companies, hedge funds and private equity 
        funds. Asset managers are responsible for an ever-growing 
        percentage of invested assets, and the lines between different 
        entities involved in these markets are blurring and 
        overlapping. We anticipate that this unit will work closely 
        with colleagues in OCIE and in the Division of Investment 
        Management who also have substantial expertise in investment 
        adviser and investment company issues.

    The Market Abuse Unit will focus on large-scale market 
        abuses and complex manipulation schemes by institutional 
        traders, market professionals, and others. We expect to build 
        some of our own technological tools and screening programs to 
        ferret out suspicious trading activity as well as working with 
        others within the Commission who have expertise with the firms 
        and products we investigate. Using these tools, our staff will 
        analyze trading and other activity across markets, including 
        equities, debt securities, and derivatives, and across 
        different corporate announcements and other market events. This 
        should allow us to detect patterns, connections and 
        relationships that might otherwise remain hidden if we simply 
        analyzed a single security or announcement.

    The Structured and New Products Unit will focus on complex 
        derivatives and financial products, including credit default 
        swaps, collateralized debt obligations and securitized 
        products. These are huge, opaque markets. Staying current with 
        these markets, and whatever new products are next devised, 
        requires specialized knowledge and commitment. This unit will 
        benefit from the hiring of staff with new skill sets as well as 
        working closely with our colleagues in the Division of Trading 
        and Markets who have significant expertise in these areas.

    The Foreign Corrupt Practices Act Unit will focus on new 
        and proactive approaches to identifying violations of the 
        Foreign Corrupt Practices Act, which prohibits U.S. companies 
        from bribing foreign officials for government contracts and 
        other business. Although the SEC has been quite active in this 
        area, more needs to be done, including working more closely 
        with foreign counterparts, and taking a more global and 
        proactive approach to investigating violations.

    The Municipal Securities and Public Pensions Unit will 
        focus on problems in the municipal securities market including 
        offering and disclosure issues, tax and arbitrage-driven 
        activity, unfunded or underfunded liabilities, and ``pay-to-
        play'' schemes in which money managers pay kickbacks and 
        provide other favors in return for being selected to advise 
        funds.

    Of course, there are investigations that will cut across a number 
of these specialized areas such as insider trading, financial fraud, 
and Ponzi schemes. Each specialized unit and its personnel will be 
available as a source of expertise to the extent the unit is not 
handling the investigation. Specialization will therefore better enable 
the entire Enforcement staff to develop and benefit from particular 
subject-matter expertise within the agency.
    In addition, the Enforcement Division is creating a searchable data 
base listing staff members with particular securities industry 
background, professional experience, academic degrees, certifications, 
specialized investigative expertise, and other relevant credentials. 
Staff will be able to use this resource--in addition to the specialized 
units--to identify those with the relevant skills and experience to 
answer questions and provide advice. This information sharing occurs 
now, but on a more informal and less comprehensive basis. This data 
base also will be used to identify potential gaps in expertise and to 
develop both an enhanced initial core training program for new hires, 
as well as an expanded range of advanced training for more senior staff 
members.
    In addition, Enforcement is planning to implement a new and more 
rigorous performance evaluation process for staff and supervisors 
alike. In contrast to the current system, this new approach will 
incorporate a five-level measure of performance, with objective 
performance goals established at the front end of the performance 
cycle. These goals will be oriented to results and not simply the 
accomplishment of tasks, and will identify the knowledge, skills and 
behaviors that need to be demonstrated to achieve those results. 
Individual professional development plans will also be incorporated 
into the new system. Further, supervisors in the Enforcement division 
will be required to review regularly caseload reports generated by the 
Division's newly enhanced case management data base (discussed below in 
more detail under the heading ``Examination and Investigative Planning 
and Follow-Through'').
    Additionally, Enforcement is focused on improving training. While 
there already is formal training consisting of a program for new hires 
supplemented by sessions for experienced staff on substantive topics 
offered by SEC or outside experts, a systematic approach to training 
has not been a sufficiently high priority. This is changing. 
Enforcement is creating a formal training unit and will prioritize 
training by including in the evaluation of staff and supervisors the 
extent of their participation in formal training programs.
    Our new hire training, which will be expanded, already includes 
sessions on, among other things, the use of forensic technology; 
investigating financial fraud, market manipulation, Ponzi schemes and 
offering frauds; and coordination among SEC offices. Since April, our 
sessions for experienced staff have included, among other things, 
forensic and investigative accounting; investigating offering frauds 
and market manipulation; Ponzi scheme investigative techniques; 
understanding and investigating certain insurance products; and hedge 
fund investigation issues. In the last 3 months, an increasing number 
of Enforcement staff has signed up to participate in Certified Fraud 
Examiner Training. In addition, substantial training resources are 
available to staff on shared internal websites. Training comes from a 
variety of sources, including seminars led by senior SEC staff, other 
government agencies (e.g., Federal Law Enforcement Training Center) and 
private industry experts, interactive offerings, and courses directed 
to regulatory (Series 7) and other certifications (Certified Fraud 
Examiner).
    Enforcement's forward focus will be to establish and implement a 
comprehensive training strategy to ensure that staff members receive 
regular training, have access to thorough and timely training materials 
and effectively apply training resources to their enforcement 
responsibilities. Upcoming training will emphasize current financial 
services topics as well as investigative techniques. Specialized 
training for managers also will include a focus on leadership and 
managing investigations.
The Office of Compliance Inspections and Examinations:
    OCIE, which leads the Commission's examination program, will 
support Enforcement's specialization initiative, primarily through 
risk-targeted or ``sweep'' examinations. In an examination sweep, 
multi-disciplinary teams of examiners draw on their specialized 
experience to take a focused look at a single compliance issue. 
Recently, for example, examiners have been vigorously reviewing custody 
practices and the safety of client assets generally at a number of 
firms, including both advisers and broker-dealers.
    Generally, in a sweep, the examiners review several firms according 
to a single examination plan, which has been developed with the 
cooperation of other offices and divisions within the SEC. Now, working 
with Enforcement's specialized units, OCIE is forming multi-
disciplinary sweep teams to provide focused examination expertise that 
would support the Enforcement units.
    OCIE also has begun to increase the expertise and skills of its 
examination staff. Chairman Schapiro has authorized a new type of 
position--a Senior Specialized Examiner--to attract experienced 
industry professionals with specialized experience in trading, 
portfolio management, valuation, complex products, sales, compliance, 
and forensic accounting. As vacancies arise, OCIE also is recruiting 
other staff with similar skills. Current market conditions make this an 
opportune time to recruit staff with this expertise. We received to 
date over 380 applications for only six Senior Specialized Examiner 
positions advertised. Thus, additional resources would allow us to 
bring on more specialists without waiting for attrition. These new 
skills should enhance OCIE's ability to detect sophisticated and well-
hidden frauds.
    Further, OCIE is strengthening the expertise of its staff through 
enhanced training, including:

    providing training by internal and external industry 
        experts on complex issues such as hedge funds, options trading, 
        and credit default swaps;

    enrolling its examiners in other certification programs 
        such as the Certified Fraud Examiner (in which one-third of 
        examiners are participating), Chartered Financial Analyst, and 
        Chartered Alternative Investment Analyst certification 
        programs;

    conducting joint training programs with other regulators, 
        such as a recent specialized program designed to permit 
        examiners to better identify red flags and uncover potential 
        fraud; and

    establishing an internal training program focusing on 
        establishing third-party verification of customer assets.

    In addition, supervisors in the examination program will be 
required to review regularly the status of examinations (discussed in 
more detail under the heading ``Examination and Investigative Planning 
and Follow-Through'').
Agency-wide:
    On an agency-wide basis, the SEC is also working to enhance its 
risk assessment capabilities. As part of that effort, the agency has 
recently created the Industry and Market Fellows Program, through which 
it is hiring highly seasoned financial experts to help it keep pace 
with the practices of Wall Street and protect investors. These experts 
should provide staffers with the information and perspectives necessary 
to identify emerging issues and understand ways the industry is 
changing.
B. Communication and Coordination
    The IG Report described weaknesses in coordination among 
Enforcement, OCIE, and other SEC offices and divisions, as well as 
among and within divisions or regional offices, and with third parties. 
In the Madoff matter, this lack of effective coordination resulted in 
missed opportunities, miscommunications, and a failure to share 
knowledge and evidence. Over the past year, we have been addressing 
this weakness.
Office of Compliance Inspections and Examinations:
    Traditionally, the OCIE examination program has been divided along 
the lines of registrants, with some examiners focusing on broker-
dealers and others focusing on investment advisers and investment 
companies. This organization is a legacy of the program's origins in 
two different operating divisions. While this structure allowed 
examiners to develop particular expertise, the IG Report illustrates 
how there has not been enough interaction between the two operational 
groups, especially since many entities that are examined operate as 
both a broker-dealer and an investment adviser.
    We are moving to address this issue. For example, the New York 
Regional Office already has adopted a protocol under which a single 
team of examiners, drawn from the broker-dealer and investment 
management units, will jointly examine selected firms to ensure that 
the examination team includes those most expert in the subject of the 
examination. The examination program in other regional offices has been 
consolidated under the leadership of a single senior manager to ensure 
consistent supervision on their coordination, collaboration and 
communication. In addition, regional offices are evaluating additional 
initiatives--like the initiative underway in New York--to better 
integrate the broker-dealer and investment adviser examiners as 
necessary.
    OCIE also is emphasizing enhanced planning of examinations that 
involve firms jointly registered as broker-dealers and advisers to 
ensure they have staff with the right skill sets and adequate 
information to understand the firms' businesses. OCIE has prepared new 
guidance to assist examiners in their review of broker-dealers with 
advisory affiliates or operations. The guidance includes detailed 
procedures for examiners to follow when reviewing such firms, including 
lines of inquiry regarding supervision, referral arrangements, 
advertising and trading. This new guidance already has been used in 
selected examinations to field-test its effectiveness and will soon be 
deployed to the entire examination program. Also, OCIE recently held a 
variety of training programs to cross-train examiners and examination 
managers in each others' specializations.
The Enforcement Division:
    Similarly, the Enforcement initiatives described above will improve 
coordination and communication. National specialized units will 
discourage the existence of separate regional ``silos'' that could 
develop based solely on a regional organization. National specialized 
units, as opposed to exclusively geographically defined units, will 
foster a more comprehensive and coherent national program that 
encourages communication and collaboration. Effective communications 
with other SEC offices or divisions is essential to ensure that 
Enforcement is benefiting from our collective agency resources.
    In addition, Enforcement senior management has re-emphasized to 
Enforcement staff the importance of consulting with other SEC offices 
and divisions early and often to identify and resolve issues. 
Enforcement also has a formal process by which it seeks review and 
comment from other offices and divisions before it submits an 
enforcement recommendation to the Commission, and it will continue to 
use this important resource.
    Further, Enforcement is creating an Office of Market Intelligence 
to improve the Division's handling of tips and complaints. This new 
office dovetails with the agency-wide effort to revamp the way in which 
it handles the hundreds of thousands of tips and complaints the SEC 
receives each year. (This is described below in further detail under 
the heading ``Additional Initiatives to Protect Investors.'') The 
Office of Market Intelligence will be responsible for the collection, 
analysis, risk-weighing, triage, referral and monitoring of the 
hundreds of thousands of tips, complaints, and referrals the SEC 
receives each year. The office also will draw on the expertise of the 
agency's various offices to help analyze the tips and identify 
wrongdoing while greatly increasing our communication with other 
divisions and offices about how to respond to tips and complaints. 
Through this effort, we hope to have a unified, coherent, coordinated 
agency-wide response to the huge volume of information we receive every 
day.
C. Examination and Investigative Planning and Follow-Through
    The IG Report also found that the Madoff investigation suffered 
from poor examination and investigative planning and follow-through. 
The Commission has been working on these very issues over the past 
year. Where they can be addressed by new procedures, we are adopting 
them. Beyond procedures, however, the leadership of enforcement and 
examination programs at all levels are enhancing planning and follow-
through as a management priority.
    For example, the Commission is deeply concerned about the IG's 
findings that Madoff attempted to intimidate investigators and 
examiners. We are addressing this unacceptable tactic by sending a 
consistent internal and external message. When junior investigators or 
examiners believe they are being subjected to intimidation tactics, 
they should immediately notify their supervisors. OCIE, for example, 
has created a new internal Hotline for examiners to immediately reach a 
senior attorney in headquarters when a firm is being uncooperative, 
unreasonable, or otherwise resisting appropriate oversight. Supervisors 
at all levels will back up more junior personnel. We will not be 
successful if we tolerate intimidation tactics directed against our 
staff. Indeed, we will train our staff to view these tactics as a red 
flag, and instruct to dig deeper, and look harder, at the firms that 
try to use them.
Office of Compliance Inspections and Examinations:
    OCIE is reviewing its written procedures and internal guidance to 
make sure it provides clear and consistent practices across the 
examination program. The guidance concerns pre-examination planning, 
document requests, responses to red flags, tracking managing findings, 
organizing and retaining work papers, preparing closing reports, and 
making enforcement referrals. OCIE is paying particular attention to 
procedures governing the scope of for-cause examinations, including 
procedures for more careful (and documented) examination planning and 
supervisory involvement. Specifically, the procedures help ensure that 
complaints and tips are appropriately examined.
    OCIE also has implemented new procedures for obtaining third-party 
verification of information obtained in examinations. As the IG Report 
notes, third-party verification is a critical examination technique. 
OCIE now requires examiners to utilize third-party verification 
techniques routinely to ensure that asset and account information is 
accurate. As appropriate, examiners contact counter-parties, custodians 
and customers.
    As noted earlier, we are also implementing mandatory Quarterly 
Reviews in which supervisors will formally review progress on 
examinations with assigned staff. The Quarterly Reviews will enable 
supervisors to assess each new matter and its examination scope and 
plan, to identify and address roadblocks to achieving the scope and 
plan, as well as new issues that could require a modification to the 
scope and plan, and with respect to an aged examination, to assess the 
examination work to date and develop a plan for resolving the open 
issues and bringing the examination to an appropriate conclusion. The 
Quarterly Reviews will provide direct supervision at regular intervals 
of all examinations open in an office or supervisory unit. Supervisors 
will be instructed, in all such reviews, to consider whether an 
examination could benefit from the deployment of new or different 
expertise or assistance from other offices, divisions, or functional 
units within the SEC.
The Enforcement Division:
    The Enforcement Division's efforts toward specialization and 
reducing process and administrative burdens will improve investigative 
planning and execution. Enforcement's initiative to streamline its 
structure through a 40 percent reduction in management will result in a 
redeployment of highly experienced staff to front-line investigations, 
the heart-and-soul function of the division. It should be emphasized, 
however, that this streamlining will not come at the cost of 
appropriate levels of investigative supervision. At the same time 
Enforcement is redeploying its branch chiefs to the front lines, it is 
expanding the number of Assistant Directors in order to maintain staff 
to manager ratios that allow for close substantive consultation and 
collaboration.
    As noted earlier, we also are implementing mandatory Quarterly 
Reviews in which senior supervisors will formally review progress on 
investigations with assigned staff. The Quarterly Reviews will enable 
supervisors to assess all new matters and their investigation plans; to 
devise strategies to overcome investigative roadblocks and challenges; 
and, with respect to aged investigations, to assess our findings and 
develop plans to obtain the proper and sufficient evidence to either 
proceed to an enforcement recommendation or close the matter. The 
Quarterly Reviews will provide senior direct supervision at regular 
intervals throughout an investigation to ensure comprehensive oversight 
and the swiftest possible completion. In conducting these reviews, 
supervisors will benefit from the use of our newly updated case 
management data base that shows at a glance key progress milestones in 
the matters under review.
D. Resources
    The IG Report identifies a number of shortcomings that will require 
additional resources. Nevertheless, we are aggressively reallocating 
existing resources into areas that maximize our ability to achieve our 
mission.
The Enforcement Division:
    A number of initiatives underway in the Division of Enforcement 
seek to address, directly or indirectly, serious resource-constraint 
issues. Specialization and a flatter management structure will increase 
Enforcement's investigative capacity and permit a greater focus on 
programmatic priorities. Eliminating or streamlining internal processes 
will give staff more time to dedicate to core investigative work, as 
will improved training and information technology capability. Creating 
incentives for witnesses to cooperate in investigations, or for 
whistleblowers to provide information on ongoing frauds, should also 
increase efficiency by permitting Enforcement to obtain high-quality 
evidence from insiders. Each of these is a current initiative within 
the Division of Enforcement.
    In addition, Enforcement is seeking to deploy newly available 
resources as thoughtfully as possible. Enforcement allocated recent 
headcount increases among market specialists, trial attorneys, 
paralegals and paraprofessional support, and training personnel.
    Enforcement also is committed to reducing administrative burdens on 
our attorneys so they can spend more time on the front lines. In fact, 
just last week, Enforcement hired the division's first-ever chief 
operating officer, who will oversee improved coordination and 
centralization of various infrastructure and administrative tasks. Many 
of these tasks currently are handled by lawyers in Enforcement. 
Similarly, future resources have been committed to more than tripling 
the number of full-time paralegals and support personnel in Enforcement 
and to dedicating significantly greater resources to ongoing technology 
initiatives. Leveraging resources is critical given the breadth of the 
agency's responsibility to enforce the securities laws as to more than 
35,000 registrants and monitor for fraud involving all categories of 
investors.
Office of Compliance Inspections and Examinations:
    Over recent years, recognizing the need to best use its limited 
inspection resources in contrast to the vast number of regulated 
entities, OCIE has developed risk-based processes for selecting firms 
and activities for examination in order to ensure that it is deploying 
its resources most effectively. One process currently relies on 
registration information that firms must file with the SEC or self-
regulatory organizations (SROs), information from past examinations, 
and information OCIE can obtain from public sources. OCIE has also 
developed a second process that identifies key risks observed by staff 
and assesses each risk's probability of occurrence and potential 
impact. We focus on risks such as fraud, abuse, misappropriation, 
manipulation and unregistered firms and offerings. OCIE is exploring a 
variety of ways to enhance these processes, and we look forward to 
working with this Committee on any necessary legislative foundations.
    Risk-based processes are critical because the number of entities 
subject to SEC examination has grown much faster than the number of 
staff available to examine them. The SEC's examination program has 
approximately 790 staff dedicated to examining approximately 11,300 
investment advisers, approximately 8,000 mutual funds, approximately 
5,000 broker-dealers (with more than 170,000 branch offices), as well 
as hundreds of other entities such as SROs, transfer agents, credit 
rating agencies, and clearing agencies.
E. Additional Initiatives To Protect Investors
    In the wake of the Madoff fraud, the SEC also has embarked on a 
number of initiatives in addition to those discussed above aimed to 
enhance its capacity to detect and prevent similar frauds. For example:

    The SEC has contracted with Mitre, a federally funded 
        research and development center, to help the agency revamp its 
        processes to improve the handling of hundreds of thousands of 
        complaints, tips, and referrals it receives each year. After 
        reviewing and analyzing its intake procedures, the SEC is now 
        beginning to improve upon its processes for collecting, 
        recording, investigating, referring and tracking this 
        information. Among other things, the agency is creating a 
        centralized system for handling this information. Once the 
        information and processes are centralized, the agency will 
        apply risk analytics to better enable it to reveal links, 
        trends, statistical deviations and patterns that might not be 
        observable when each complaint is examined one at a time and 
        provide a platform for greater communication about tips and 
        complaints throughout the agency.

    The SEC has advocated for expanded authority from Congress 
        to reward whistleblowers who bring forward substantial evidence 
        to the agency about significant Federal securities violations. 
        Under proposed legislation, money collected from wrongdoers 
        that is not otherwise distributed to investors would be used to 
        establish a fund to reward whistleblowers whose contributions 
        lead to successful enforcement actions. We welcome the 
        opportunity to work with Congress as it considers this 
        important legislation.

    In May the Commission proposed two rules that are designed 
        to better protect clients of investment advisers from theft and 
        abuse. The rules are designed to provide assurance to these 
        clients that their accounts contain the funds as represented by 
        their investment adviser and account statements. Among other 
        things, these rules are designed to encourage investment 
        advisers to place their clients' assets in the custody of an 
        independent firm, or obtain an independent custody controls 
        review, commonly referred to as a SAS-70 review, by a PCAOB-
        registered and examined independent accounting firm. In 
        addition, the rules would require investment advisers with 
        custody of their clients' assets to undergo an unannounced exam 
        by an independent accounting firm in order to verify clients' 
        assets. These asset-verification exams would occur on an annual 
        basis at the time of the accountant's choosing. As with all our 
        rule proposals, the Commission looks forward to reviewing and 
        evaluating the comments on these rule proposals. The proposed 
        rules provide for:

        Surprise Exams: One proposal would require all 
investment advisers who control or have custody of their clients' 
assets to hire an independent public accountant to conduct an annual 
``surprise exam'' to verify those assets actually exist. This surprise 
examination would provide another set of eyes on the clients' assets, 
thereby offering additional protection against the theft or misuse of 
funds.

        Third Party Reviews: A second proposal would apply to 
investment advisers who do not use independent firms to maintain their 
clients' assets. Such advisers would be required to obtain a third 
party written report assessing the safeguards that protect the clients' 
assets. The report--prepared by an accountant registered and inspected 
by the Public Company Accounting Oversight Board--would, among other 
things, describe the controls that are in place to protect the assets, 
the tests performed on the controls, and the results of those tests. 
Existing rules make no distinction between an investment adviser whose 
affiliate holds its clients' funds and an investment adviser that uses 
a truly independent custodian.

    Finally, working with senior SEC staff, FINRA has committed 
        to establish a new system to enhance the oversight and 
        professional requirements of personnel performing back-office 
        functions at broker-dealer firms. ``Back-office'' personnel 
        typically perform critical custody, accounting, transfer 
        agency, and account maintenance functions. Under the new 
        regime, certain back-office personnel would be subject to 
        licensing and education requirements as well as enhanced 
        oversight. The new regime will further promote the 
        qualifications and professionalism of those performing back 
        office functions so that client accounts are better protected.
III. Recent Enforcement Efforts
    As Chairman Schapiro previously observed before this Committee, the 
SEC is the only agency focused primarily on the protection of 
investors. As the agency's most public face, a strong Division of 
Enforcement is critical to the investing public's confidence in the 
integrity of our markets. Over the past year, while the criticism 
surrounding the Madoff fraud has been sharp and steady, our 
organizational response in light of these acknowledged errors is 
exactly what taxpayers and the public have every right to expect. We 
have taken the lessons to heart and implemented a far-reaching program 
of change and improvement. Our investigators have not been complacent 
or hesitant to take on the most difficult and challenging 
investigations aggressively and intelligently.
    Although numbers do not tell the whole story, the metrics 
demonstrate the hard work of our staff. Comparing the period from late 
January to the present to the same period in 2008, Enforcement has:

    opened more investigations (1,377 compared to 1,290);

    issued more than twice as many formal orders of 
        investigation (335 compared to 143);

    filed more than twice as many emergency temporary 
        restraining orders (57 compared to 25); and

    filed more actions overall (458 compared to 359).

    The justified criticism of the SEC arising from the Madoff fraud 
should not obscure the 75-year tradition of vigorous enforcement 
resulting from the dedicated efforts of public servants who work 
tirelessly and with impressive results to protect the investing public. 
Here is a small sample of Enforcement's recent actions:

    Credit Crisis-Related Cases: The SEC charged the former CEO 
        of Countrywide Financial and two other former executives with 
        fraud for allegedly deliberately misleading investors about the 
        significant risks it was undertaking.\2\ The SEC's charges 
        allege that Countrywide portrayed itself as underwriting mainly 
        prime quality mortgages, while privately describing as 
        ``toxic'' certain of the loans it was extending. The SEC's 
        complaint also charged the former CEO with insider trading.
---------------------------------------------------------------------------
    \2\ SEC v. Angelo Mozilo, David Sambol, and Eric Sieracki, Lit. 
Rel. No. 21068A (June 4, 2009).

    In other mortgage-related cases, the SEC brought actions against 
former mortgage-lending company executives for accounting fraud and 
allegedly making false and misleading disclosures relating to the risk 
of the mortgages originated and held by the company as the credit 
crisis began to unfold.\3\ The SEC sued registered representatives of a 
broker-dealer firm for allegedly making false statements in marketing 
investments in mortgage backed securities as safe and suitable for 
retirees and others with conservative investment goals.\4\ The SEC also 
charged a registered investment adviser and its affiliate with 
allegedly overstating the value of a mutual fund that invested 
primarily in mortgage-backed securities and for selectively disclosing 
problems with the fund to favored investors, allowing them to bail out 
early to avoid losses.\5\
---------------------------------------------------------------------------
    \3\ SEC v. Michael Strauss, Stephen Hozie and Robert Bernstein, 
Lit. Rel. No. 21014 (April 28, 2009).
    \4\ SEC v. William Betta, Jr., et al., Lit. Rel. No. 21061 (May 28, 
2009).
    \5\ In the Matter of Evergreen Investment Management Company, LLC 
and Evergreen Investment Services, Inc., AP File No. 3-13507 (June 8, 
2009).
---------------------------------------------------------------------------
    And in the Reserve Fund matter, the SEC charged the managers of a 
$62 billion money market fund whose net asset value fell below $1.00, 
or ``broke the buck'' based in part on investments in Lehman-backed 
paper, for their alleged failure to properly disclose to the fund board 
all material facts relating to the value of the Lehman-backed paper.\6\
---------------------------------------------------------------------------
    \6\ SEC v. Reserve Management Company, Inc., Resrv Partners, Inc., 
Bruce Bent Sr. and Bruce Bent II, Lit. Rel. No. 21025 (May 5, 2009).

    Ponzi Schemes: The SEC investigates and prosecutes many 
        Ponzi schemes cases each year, the majority of which are 
        brought as emergency actions--seeking a temporary restraining 
        order and an asset freeze--both to prevent new victims from 
        being harmed and to maximize the recovery of assets to 
        investors. Since January, the SEC already has filed 45 
        enforcement actions involving Ponzi schemes or Ponzi-like 
        payments, a significant increase over the same period last 
---------------------------------------------------------------------------
        year.

    Public Trust: Working with the New York State Attorney 
        General, the SEC pursued placement agents and others for 
        allegedly extracting kickbacks from investment management firms 
        seeking to manage the assets of New York's largest pension 
        fund, the New York State Common Retirement Fund.\7\
---------------------------------------------------------------------------
    \7\ SEC v. Henry Morris, et al., Lit. Rel. No. 20963 (March 19, 
2009), Lit. Rel. No. 21001 (April 15, 2009), Lit. Rel. No. 21018 (April 
30, 2009).

    Derivatives and Structured Products: We have been looking 
        aggressively at fraudulent schemes involving structured 
        products. In May, the SEC charged a former portfolio manager at 
        hedge fund investment adviser Millennium Partners and a 
        salesman at Deutsche Bank for alleged insider trading in credit 
        default swaps on international holding company VNU. In this 
        case, bank employees allegedly tipped the portfolio manager 
        about an anticipated change in VNU's underlying bond structure 
        that substantially increased the price of the credit default 
        swap, which allowed the defendants allegedly to profit from 
        their purchase of credit default swaps when the restructuring 
        was announced \8\ In addition, the SEC filed a civil injunctive 
        action late last year against four individuals for allegedly 
        engaging in a fraudulent scheme to overvalue the commodity 
        derivatives trading portfolio at Bank of Montreal (BOM) and 
        thereby inflate BOM's publicly reported financial results.\9\
---------------------------------------------------------------------------
    \8\ SEC v. Jon-Paul Rorech, et al., Lit. Rel. No. 21023 (May 5, 
2009).
    \9\ SEC v. David Lee, et al., Lit. Rel. No. 20811 (Nov. 18, 2008).

    Accounting Fraud: The SEC charged General Electric with 
        using improper derivative accounting methods to increase its 
        reported earnings and revenues and avoid reporting negative 
        financial results.\10\ The SEC also charged Terex Corporation 
        with accounting fraud for allegedly making material 
        misstatements in its financial reports to investors, as well as 
        allegedly aiding and abetting a fraudulent accounting scheme at 
        United Rentals, another public company.\11\
---------------------------------------------------------------------------
    \10\ SEC v. General Electric Company, Lit. Rel. No. 21166 (August 
4, 2009).
    \11\ SEC v. Terex Corporation, Lit. Rel. No. 21177 (August 12, 
2009).

    Abusive Short Selling: In two separate actions, the SEC 
        charged two broker-dealers and two options traders for alleged 
        ``naked'' short sale rule violations.\12\ In these actions, the 
        SEC alleged that the respondents improperly claimed that they 
        were entitled to an exception to the Regulation SHO 
        requirements that broker-dealers must locate a source of 
        borrowable shares prior to selling short and circumvented the 
        requirement to deliver securities sold short by a specified 
        closeout date.
---------------------------------------------------------------------------
    \12\ In the Matter of TJM Proprietary Trading, LLC, Michael R. 
Benson and John T. Burke, AP File No. 3-13569 (August 5, 2009) and In 
the Matter of Hazan Capital Management, LLC and Steven M. Hazan, AP 
File No. 3-13570 (August 5, 2009).

    Foreign Corrupt Practices Act:Late last year, the SEC filed 
        a civil injunctive action charging Siemens Aktiengesellschaft 
        (Siemens), a Munich, Germany-based manufacturer of industrial 
        and consumer products, with violations of the anti-bribery, 
        books and records, and internal controls provisions of the 
        Foreign Corrupt Practices Act. In this settled action, Siemens 
        offered to pay a total of $1.6 billion in disgorgement and 
        fines, which is the largest amount a company has ever paid to 
        resolve corruption-related charges.\13\
---------------------------------------------------------------------------
    \13\ Siemens agreed to pay $350 million in disgorgement to the SEC. 
In related actions, Siemens agreed to pay a $450 million criminal fine 
to the U.S. Department of Justice and a fine of =395 million 
(approximately $569 million) to the Office of the Prosecutor General in 
Munich, Germany. Siemens previously paid a fine of =201 million 
(approximately $285 million) to the Munich Prosecutor in October 2007. 
SEC v. Siemens Aktiengesellschaft, Lit. Rel. No. 20829 (Dec. 15, 2008).
---------------------------------------------------------------------------
    Enforcement is continuing to investigate rigorously cases in all of 
these areas and more: misconduct relating to the credit crisis, 
accounting and financial fraud, structured product fraud, suspected 
Ponzi schemes, hedge fund and investment adviser fraud, insider 
trading, market abuse, and market manipulation based on complex use of 
technology and advanced trading systems.
IV. Conclusion
    Our mission is critical. We are thus committed to using all of our 
energies, efforts, experience, expertise, and a sincere dedication to 
investor protection to continue to revitalize and improve our programs. 
These are challenging times, but we believe they are also times of 
great opportunity for improvement. We are aggressively pursuing long-
term changes in our structure and processes, while at the same time 
working hard to continue our vigorous enforcement and examination 
efforts. We can say without reservation that we are proud to be part of 
this institution, and we are confident of our future success.
    We appreciate the opportunity to appear before you today. We would 
be happy to answer your questions.

  RESPONSE TO WRITTEN QUESTION OF CHAIRMAN DODD FROM H. DAVID 
                              KOTZ

Effect of Madoff's Stature in the Investment Community
Q.1. How many of the current or former SEC staff who you 
interviewed for your study were aware that Madoff was 
influential in the securities community at the time of the 
investigation or examination with which they were involved? 
What was their reaction to this knowledge and how did it 
influence their judgment?

A.1. The OIG investigation found that most of the current and 
former SEC staff who worked on Bernard Madoff-related 
examinations and investigations were aware, or became aware, of 
Madoff's prominence in the industry, and that Madoff used his 
stature and perceived connections to try to influence 
examinations and investigations. We also found Madoff 
participated in SEC panels and events and communicated with SEC 
Chairmen, and that SEC Officials participated in conferences 
arranged by Bernard Madoff's niece, Shana. We further found 
that there were several instances in which the SEC staff 
visited Bernard Madoffs offices in New York City as part of 
official SEC events.
    However, we did not find evidence that SEC examiners or 
investigators failed to aggressively follow-up on their 
suspicions of fraudulent activity because of concerns that they 
were targeting such an influential figure in the securities 
industry. We did find that the SEC examiners' and 
investigators' awareness of Madoff's stature played an 
ancillary role in the conduct of their examination and 
investigatory work in that they had difficulty believing that 
Madoff, who had an established and well-known reputation in the 
industry, would be operating a Ponzi scheme.
    The following provides the specific level of knowledge on 
the part of current or former SEC staff and its impact for each 
major investigation and examination of Madoff. In connection 
with the 1992 SEC investigation of Avellino & Bienes, an SEC 
examiner acknowledged that Madoff's stature and reputation in 
the industry may have influenced their decision not to further 
examine Madoff's operations while investigating Avellino & 
Bienes for a possible Ponzi scheme. Former SEC Branch Chief 
John Gentile (Gentile) stated that he was aware that Madoff's 
firm ``was very prominent in developing third market particular 
automated trading.'' Similarly, former SEC examiner Demetrios 
Vasilakis (Vasilakis) stated that during the 1992 examination, 
he was ``made aware'' by Bernard Madoff himself that Madoff 
served in various industry committees, was a well respected 
individual and noted that the SEC examiners used an NASD manual 
with Bernard Madoff's name on it. In fact, when asked for his 
recollections of Bernard Madoff at the time of the examination, 
Vasilakis stated as follows:

        My personal conclusions [from the examination] were that 
        [Bernard Madoff] was a pioneer in the industry, to use the term 
        that's been thrown around now, but that he really used, you 
        know, technology to bring trading to the next level. It was 
        strictly--when I walked out of there it was more along the 
        lines of wow, this guy is a third market guy that does X 
        percent of the volume on the exchange. This is where I actually 
        learned about third market. I didn't even know the so-called 
        term that that's what it was called [prior to the examination.]

    Gentile stated that it was fair to say that because of 
Bernard Madoff's reputation at that time as a large broker-
dealer, there may not have been any thought to look into 
Madoff's operation any further because of their disbelief that 
Madoff would be operating a Ponzi scheme.
    With respect to the 2003 SEC examination of Madoff, former 
SEC Associate Director John McCarthy (McCarthy) stated he 
became aware of Madoff when he conducted an examination in the 
mid-90s. McCarthy said he subsequently learned that Madoff's 
firm was one of the largest third market maker firms and that 
they had a very good reputation in terms of their execution 
quality of retail customer orders. Former SEC Assistant 
Director Eric Swanson (Swanson) also stated that in the later 
1990s he became aware of Madoff Securities as a large market 
maker in over-the-counter space. SEC Branch Chief Mark Donohue 
(Donohue) stated that he was also aware of Madoff's firm as a 
market maker prior to the 2003 examination.
    Although McCarthy, Swanson, and Donohue were aware of 
Madoff's stature, there is no evidence that Madoff's prominence 
impacted their examination, and they denied that their 
examination was influenced by Madoff's reputation. However, 
there is evidence that when McCarthy, Swanson, and Donohue 
discussed their examination with other SEC examiners, they made 
a point to inform the SEC examiners of Madoff's stature in the 
industry.
    According to SEC examiner William Ostrow (Ostrow), during a 
conference call on May 31, 2005 with Swanson, McCarthy, and 
Donohue, he and fellow SEC examiner Peter Lamore (Lamore) were 
informed that Madoff was a powerful and well-connected 
individual, stating:

        I don't know who said it, someone from [the SEC's Office of 
        Compliance Inspections and Examinations (OClE)] basically, 
        `[Madoff's] a very powerful person, Bernie, and you know, just 
        remember that.' . . . But basically just, `He is a very well-
        connected, powerful person.'

    Ostrow interpreted the statement to raise a concern for 
them about pushing Madoff too hard without having substantial 
evidence. Lamore had a similar recollection, stating ``I'm not 
sure if those were the exact words, but it struck me as odd at 
the time.'' Assistant Director on the SEC examination John Nee 
(Nee) also recalled the statement, although he did not 
interpret it to mean they should ``tread lightly.'' He thought 
the comment indicated ``they might get a phone call from 
someone but we never did.''
    The OIG investigation uncovered further evidence that 
Ostrow and Lamore were well aware of Madoff's stature in the 
industry, that Madoff attempted to intimidate and impress them 
with his perceived connections, and that the junior examiners 
were overmatched in their interactions with Madoff making them 
unable to aggressively conduct the 2005 SEC examination.
    Prior to beginning the examination, Ostrow stated he knew 
the name Bernie Madoff because Madoff was ``a large market 
maker.'' We also found that around the time of the examination, 
Ostrow and Lamore exchanged articles describing Madoff's 
significant achievements, including ``serv[ing] as chairman of 
the board of directors of the Nasdaq Stock Market as well as a 
member of the board of Governors of the NASD . . . [and] of the 
Securities Industry Association . . . [and] a founding member 
of the board of directors of the International Securities 
Clearing Corporation in London.'' Another article exchanged by 
the examiners was entitled, ``The Madoff Dynasty'' and 
described Madoff's family members.
    Lamore also testified that the name Madoff was familiar to 
him when he began the examination, stating he was aware that 
Madoff was ``a pretty prominent maker.'' Lamore acknowledged 
that after researching Madoff prior to the examination, he 
concluded that Madoff was an impressive and influential figure 
in the industry. Nee and SEC Associate Director Robert Sollazzo 
(Sollazzo) also recalled being aware of Madoff as a big market-
maker when they began the cause examination. Lamore said Madoff 
made efforts to emphasize his role in the securities industry 
during the examination. Lamore said he found it ``interesting'' 
but also ``distracting'' because they were there ``to conduct 
business.''
    Ostrow indicated that there were efforts made by Madoff to 
impress and even intimidate the examiners. Ostrow stated that 
``[all throughout the examination, Bernard Madoff would drop 
the names of high-up people in the SEC.'' Ostrow reported that 
Madoff told him and Peter Lamore that former SEC Chairman 
Christopher Cox (Cox) was going to be the next Chairman of the 
SEC a few weeks prior to Cox being officially named. Ostrow 
stated they ``were pretty amazed'' that Madoff knew this 
information and he felt that Madoff's intention was to both 
impress and intimidate them. Ostrow said Madoff made clear that 
``he knew everybody in OCIE,'' and referenced his relationship 
with Lori Richards, then-Director of OCIE.
    Ostrow also reported that Madoff told them that Madoff 
himself ``was on the short list'' to be the next Chairman of 
the SEC. Ostrow said they believed it was a possibility since 
he was very well known in the industry. However, Ostrow also 
stated that Madoff's name-dropping ``didn't really impress 
us.'' Lamore also recalled that Madoff would drop the names of 
senior SEC officials, including referencing a meeting or 
rulemaking relating to then-Commissioner Annette Nazareth. 
Lamore stated that Madoff was trying to impress him with all 
his connections, and noted that dropping the name of a 
Commissioner of the SEC, ``was a pretty big name to mention.'' 
Lamore also recalled Madoff saying that he was on the short 
list to be the next Chairman of the SEC. In fact after the 
examiners received an email from the Director of the SEC's New 
York office announcing that Chairman William Donaldson would be 
resigning, Lamore sent an email to Nee stating, ``Bernie told 
us he was on the short list when Chairman Donaldson was 
selected. Maybe this time.'' Nee responded to Lamore's email, 
stating, ``Maybe you and William can be his aides.'' Nee stated 
that in his response on the email about Lamore and Ostrow being 
Madoff's aides, he ``was trying to be facetious.''
    While Nee stated he did not believe that Ostrow was ``star 
struck'' when meeting Madoff, he did note that he later found 
out that Ostrow had his wife take pictures of Madoff when he 
was being arraigned. Nee acknowledged that Madoff's intent was 
to impress and intimidate the examiners, but he thought these 
efforts were unsuccessful and the examiners found Madoff to be 
a ``bit of a blowhard.'' Sollazzo also acknowledged that given 
the frequent interaction between Madoff and the examiners, 
there was a possibility that Madoff's ``reputation and supposed 
world of knowledge'' that he could ``overcome'' or ``stonewall 
examiners.'' He stated that they may have been ``overwhelmed'' 
by Madoff and ``outmatched a bit.'' Elaine Solomon, who worked 
as Peter Madoff's secretary from March 1997 until December 
2008, stated that the SEC examiners who met with Madoff looked 
like they were ``in awe'' of him.
    In connection with the 2005-2006 SEC Enforcement 
investigation, the OIG found that the Enforcement investigators 
were not aware of Madoff's stature before they began the 
investigation. Former SEC Assistant Director Doria Bachenheimer 
stated that when she first learned of Markopolos' complaint, 
she had not heard the name Bernie Madoff or Madoff Securities. 
Former SEC Branch Chief Meaghan Cheung (Cheung) stated that she 
had ``embarrassingly'' not heard of Madoff or his firm before 
the Madoff case. SEC Staff attorney Simona Suh (Suh) similarly 
stated that prior to being assigned the case, she had never 
heard of Madoff or his firm.
    In addition, while the Enforcement investigators 
acknowledged becoming aware of Madoff's stature during the 
investigation, they denied that his prominence impacted the 
investigation, except to the extent that they were less likely 
to believe that Bernie Madoff had engaged in a Ponzi scheme. 
Cheung acknowledged that during the investigation, she learned 
that Madoff was an influential figure in the securities 
industry, and had a high-level position with the NASDAQ. 
Moreover, when asked if once she learned of Madoff's 
reputation, she thought that the staff treated him differently, 
Cheung stated as follows:

        I don't think there was ever a conscious desire to make 
        something go away or to ignore an allegation about Bernie 
        Madoff. Do I think that there's an inherent bias toward the 
        sort of people who are seen as reputable members of society, 
        there may be an inherent bias in that way. I think that we did 
        not forego investigative steps because of who he was, and I 
        don't think we were easier on him. I have personally 
        interviewed, requested documents, gotten tolling agreements, 
        pushed from people who I view as--as sort of more powerful than 
        Bernie Madoff without, I think, pulling a punch.

    Suh stated in testimony, ``Madoff [did] sort of try to play 
up his prominence to some degree. He talked about, you know, 
being on panels of, I believe, NASD or something like that.'' 
However, Suh stated, ``[i]t did not really matter much to me.'' 
Suh, did, however, acknowledge, ``[i]t's certainly true that he 
didn't fit the profile of a Ponzi schemer, at least as we--in 
the world that we knew then,'' however, ``I never had a concern 
in terms of, you know, stepping on the wrong toe or anything 
like that, and I had no impression that anybody else did.''
    Cheung, however, denied that in her mind, it was ``just 
inconceivable'' that someone like Bernie Madoff would have run 
a Ponzi scheme, stating that the investigators significantly 
looked at and considered the issue of a potential Ponzi scheme 
even though he was Bernie Madoff.
    For further information about this topic, please see the 
OIG's August 31, 2009 Report of Investigation entitled 
``Investigation of the SEC's Failure to Uncover Bernard 
Madoff's Ponzi Scheme'' at Section VI(E)(2).
    Thank you for your continued interest in our work.
                                ------                                


RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN DODD FROM JOHN WALSH

Resources and Examinations
Q.1. 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.1. Our examination staff is primarily comprised of 
accountants, lawyers, and former industry professionals. At the 
beginning of 2009, approximately 63 percent of our examination 
staff were accountants, 18 percent were CPAs, approximately 13 
percent were attorneys, approximately 7 percent were 
examination support staff, including information technology 
staff, and approximately 1 percent were financial analysts. We 
have continued to recruit experienced industry professionals, 
and more than 70 percent of the examination staff hired during 
the past few years had securities experience prior to joining 
the SEC.
Oversight of FINRA Examinations
Q.2. 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. Also, please 
describe the scope and frequency of the SEC's review of FINRA's 
exams and exam process during the past 25 years.

A.2. Section 19(g)(1) of the Exchange Act requires each SRO to 
comply with, and enforce compliance with, the provisions of the 
Exchange Act, the rules and regulations thereunder, and the 
SRO's own rules. The SEC oversees FINRA's compliance with these 
obligations through its inspections of FINRA and through its 
oversight examinations of broker-dealers. OCIE conducts 
inspections of FINRA to assess the adequacy of FINRA's 
regulatory programs, generally focusing on select regulatory 
programs in each inspection. Such inspections periodically 
include a review of FINRA 's regulatory programs for examining 
its member firms, including its financial responsibility 
examinations program.
OCIE also conducts oversight examinations of broker-dealers 
pursuant to its examination authority under Section 17 of the 
Exchange Act. During such examinations, SEC examination staff 
analyze and sample a broker-dealer's records from the same time 
period and focus areas that FINRA reviewed during its 
examination. These examinations serve the dual purposes of 
evaluating the quality and effectiveness of FINRA's 
examinations of its member firms, as well as detecting 
violations or compliance risks at broker-dealers. Such 
examinations generally include a review of the firm's financial 
responsibility and net capital assessments if FINRA had focused 
on these issues. In fiscal year 2008, the examination program 
conducted 720 broker-dealers examinations, representing 
approximately 13 percent of registered broker-dealers. When 
taking into account both SEC and SRO examinations, 
approximately 57 percent of registered broker-dealers were 
examined in fiscal year 2008.
The Problem of ``Silos''
Q.3. A recent column in The New York Times stated, 
``Bureaucratic rivalries are nothing new, and the S.E.C. is 
certainly not one big happy family. But when an agency's goal 
is to protect investors, it needs to ensure that everyone is 
working toward that end. Opening up the lines of communication 
both within and between divisions, and encouraging them to work 
with one another and share all information rather than view 
others as potential rivals, is a much better way to operate.''
    Over the years, I have heard many complaints from industry 
about stovepipes, or ``silos,'' within the SEC--Divisions or 
Offices that do not communicate or cooperate with each other. 
The Report identifies several instances where this contributed 
to the failure of the SEC to find the Madoff fraud.
    Are you concerned about the problem caused by silos? What 
are you doing to promote cooperation among the units in your 
Office and between them and other SEC offices?

A.3. The Inspector General's report described how a lack of 
effective coordination both among staff within OCIE as well as 
with other offices and divisions resulted in missed 
opportunities, miscommunications, and a failure to share 
information. I agree that opening the lines of communication 
within the examination program and with staff in other SEC 
offices and divisions is crucial to the agency's ability to 
successfully detect fraud going forward.
    Over the past year, the SEC has taken many steps to address 
this weakness. Chairman Schapiro has repeatedly stressed the 
fact that we are one agency that can only succeed if we fully 
cooperate with each other, share information and rely on the 
expertise throughout the agency. She specifically brought 
together her senior managers to convey this message. She also 
began a program in which she and her senior managers are 
visiting every regional office to discuss the importance of 
learning lessons from the Madoff fraud, the importance of 
having a ``culture of cooperation,'' and to begin an ongoing 
dialog throughout the agency about how different divisions and 
offices can better help each other as we work to protect 
investors.
    With respect to the examination program, OCIE has 
traditionally been divided along the lines of registrants, with 
different groups focusing on different types of entities such 
as investment advisers, broker-dealers, and SROs. We have 
focused our efforts on breaking down these silos in many 
different ways over the past several months. For example, we 
have provided cross-training to examiners and have strongly 
emphasized the necessity for joint planning of examinations 
that involve firms jointly registered as broker-dealers and 
advisers. Further, we have formed a task force to assess how we 
can best improve collaboration among the various groups within 
the examination program. The task force has assessed, among 
other things, how the cross-training and coordinated planning 
has impacted examinations involving the need for joint onsite 
reviews. Ultimately, the task force will recommend solutions to 
enhance our internal communication, promote cross-staffing from 
the various examination groups on certain examinations where 
specific expertise is necessary, and to encourage staff to 
reach out to other staff across the examination program that 
might have specialized knowledge.
    In addition, we have initiated a quarterly review program 
to foster communications among examination program managers and 
enhance our internal controls. As previously mentioned, this 
review involves quarterly meetings at which a team of managers 
review and discuss all open examinations and assess whether 
additional expertise is necessary to resolve issues and 
finalize those examinations. This review process will help 
ensure that examinations do not ``fall through the cracks,'' 
and that important issues get timely resolved, and will provide 
an opportunity for managers to obtain fresh perspectives on the 
issues under review. The review process will include managers 
that are not the line supervisors of the examinations under 
review.
    Finally, OCIE has worked to improve communication and 
collaboration with other SEC offices and divisions. For 
example, OCIE holds regularly scheduled meetings and training 
programs in which examiners have the opportunity to interact 
with staff from other offices and divisions within the SEC. In 
particular, these sessions enable examiners to discuss current 
trends and issues they have recently identified during 
examinations with staff in other offices and divisions that may 
have specialized knowledge of such issues. Further, OCIE 
consistently seeks input from other offices and divisions when 
planning our goals for each fiscal year, and when planning and 
conducting sweep examinations. Within the examination program, 
we will continue to proactively identify ways in which we can 
encourage examiners to reach out to staff in other offices and 
divisions for ideas and expertise.
Custodial Funds
Q.4. At this Committee's hearing on January 27, 2009, we heard 
testimony about the need for independent verification of 
custody of client funds and securities. I am glad that the 
SEC's Division of Investment Management has proposed a rule 
that would strengthen the regulation of the custodial practices 
of registered investment advisers. What is the timetable for 
further action on this proposal?

A.4. I fully agree with the need to conduct independent, third-
party verification of information obtained during examinations. 
I am not able to specify the timetable in which the SEC intends 
to further act on the rule proposal. I am pleased to report, 
however, that OCIE has implemented a program for verifying 
custody of client funds and securities. We have incorporated 
verification techniques into the examination program and 
require examiners to verify certain information with third-
parties as a routine part of examinations. Further, we have 
required all examiners to attend training sessions on third-
party asset verification techniques and procedures. Using these 
third-party verification techniques will enable examiners to 
(1) verify the existence and integrity of client/customer 
assets managed by the firm; and (2) confirm that the 
information provided to examiners by the firm represents a 
full, true, and accurate record of the firm's investment, 
brokerage, and other business activities.
SEC Examination of Newly Registered Investment Advisors
Q.5. At this Committee's January hearing on Madoff, the SEC 
staff testified that ``the Commission's staff did not examine 
[Madoff's] advisory operations, which first became registered 
with the Commission in late 2006.''
    Post-Madoff, what is the policy for the SEC staff examining 
newly registered investment advisors?

A.5. In light of the number of examiners in comparison to the 
number of registered investment advisers and mutual fund 
companies subject to SEC examination, OCIE continues to use a 
risk-based scoring process to select investment advisers for 
priority, cyclical examination. To assess the relative risks 
and thereby prioritize advisory firms for examination, all 
investment advisers' filings with the SEC on Form ADV, Part I, 
as well as results of any past examinations, are analyzed each 
year. Advisers that are designated ``higher risk'' are placed 
on a 3-year examination cycle. Approximately 10 percent of 
advisers are in this ``higher risk'' category. Finally, OCIE 
selects a sample of advisers for examination each year using 
random selection techniques. Among other things, the randomly 
selected examinations allow the staff to monitor and assess the 
effectiveness of the risk-based scoring process.
    In addition, as resources allow, examination staff conducts 
limited-scope reviews of recently registered advisers not 
classified as ``high risk'' in order to assess their risk-
rating. In these reviews, the examination staff seeks to obtain 
an initial assessment of the recently registered adviser's 
compliance culture, conflicts of interest, the compliance 
policies and procedures used to mitigate or manage those risks, 
and the capabilities of the firm's compliance and other 
personnel. These limited-scope visits assist offices in 
determining whether a recently registered adviser's risk rating 
is appropriate, and if not, to facilitate the assignment of a 
more accurate risk rating. In addition, these reviews allow 
field offices to become more familiar with the business 
activities of recently registered investment advisers, which 
may identify emerging trends or unique issues. In many 
instances, such information is useful to the examination 
program as a whole. Finally, these visits may correct clearly 
problematic compliance practices early on in the registrants' 
existence.
Markopolos Recommendations
Q.6. Mr. Markopolos has recommended ideas to improve the SEC's 
capability to detect financial frauds. These include 
recommendations for the Commission to: administer competency 
exams for applicants for professional staff positions before 
hire; change performance metrics from the number of exams 
undertaken; conduct a skills inventory of the professional 
staff; and develop an SEC knowledge base. Will you consider 
these ideas from Mr. Markopolos?

A.6. In the examination program, we reviewed Mr. Markopolos' 
recommendations and noted many good ideas. We have already 
taken action to implement certain recommendations. In 
particular, we have sponsored training with other regulators 
designed to enhance examiner skills in identifying potential 
fraud, including financial fraud, and following up on red 
flags. We have assessed the skills of current examination staff 
and have increased and diversified training opportunities for 
examiners to increase their skills and expertise. For example, 
we have offered training programs by industry professionals on 
complex products, buy-side trading strategies, and options 
trading, among others. In addition, we have offered training in 
certain FINRA professional series, such as Series 7 training. 
Further, we have actively encouraged and obtained broad 
examiner participation in certain certification programs such 
as the Certified Fraud Examiner program and have made other 
programs available, such as the Chartered Financial Analyst 
program. We will certainly consider other of Mr. Markopolos' 
recommendations as we continue to improve our examination 
program.
Supervisors Who Lack A Particular Expertise
Q.7. The Report states that an SEC staff accountant and Mr. 
Markopolos both testified that when Mr. Markopolos presented 
his analysis to SEC staff ``it was clear that the BDO's 
Assistant District Administrator did not understanding the 
information presented. Our investigation found that this was 
likely the reason that the reason that the BDO decided not to 
pursue Markopolos' complaint or even refer it to the SEC's 
Northeast Regional Office (NERO).'' The Report refers to other 
similar situations.
    Does this concern you? What is OCIE's policy about what 
ADAs or other supervisors in similar situations should have 
done?

A.7. I believe that we made mistakes with respect to handling 
Mr. Markopolos' tips and we all share responsibility for 
failing to detect the Madoff fraud. I believe it is extremely 
important that we are receptive to information regarding 
potential misconduct and possible investor harm. Every tip, 
complaint and referral should be thoroughly analyzed and each 
should be presumed to have merit until there is a reasonable 
basis for concluding otherwise. Examination supervisors should 
seek expertise and assistance from other SEC offices or 
divisions as necessary to accurately and thoroughly analyze a 
tip, referral or complaint as to its merits and the appropriate 
actions to be taken, if any. In addition, we are determined to 
give individual staff the training, tools, and resources they 
need to thoroughly perform their duties. Finally, in this 
regard, we look forward to full deployment of the new tips, 
complaints, and referrals system that is being developed under 
Chairman Schapiro's leadership.
Human Resources Actions
Q.8-A. The Report identifies some SEC employees who 
demonstrated good professional judgment, such as the two 
employees of the Boston Office who ``had substantial experience 
and knowledge of investment funds'' and recommended that Mr. 
Markopolos' allegations be investigated.
    Do you feel that the SEC should recognize or reward 
employees who the Report documents to have demonstrated good 
judgment and recognized the gravity of Madoff's conduct? Will 
they be put into appropriate positions of responsibility, so 
that the SEC and investors can benefit from their good 
judgment?

Q.8-B. The Report describes supervisory staff that appears to 
have lacked the expertise or judgment to successfully discharge 
their duties. Has the SEC reviewed their performance and 
considered moving them to positions more suited to their 
abilities and where they will not cause harm to investors? Are 
you reviewing and revising your criteria for promotion to avoid 
future types of problems?

A.8. We all take very seriously our failure to detect the 
Madoff fraud. As recommended by the Inspector General, we are 
carefully considering what, if any, action is necessary with 
respect to employees mentioned in the report. As an initial 
measure, we placed certain individuals named in the report 
under heightened supervision pending a thorough review and 
evaluation of the matters set forth in the Inspector General's 
report. We have now received the underlying documentation 
relied on by the Inspector General during his investigation. We 
will assess this information to evaluate what steps should be 
taken to increase specific individual's expertise or impose 
disciplinary action as necessary.
    As a Federal agency, the Commission must follow an 
established process in all personnel decisions. We are 
committed to rewarding good performance and addressing any poor 
performance identified during this review process. We will act 
as quickly as reasonably possible in a manner consistent with 
the law.
Enforcing the Laws Against ``Well-connected, Powerful'' 
        People
Q.9. The Report states that on a conference call about two 
Madoff exams, ``a senior-level Washington D.C. examiner 
remind[ed] the junior NERO [New York Regional Office] examiners 
that Madoff `was a very well-connected, powerful person,' which 
one of the NERO examiners interpreted to raise a concern for 
them about pushing Madoff too hard.''
    What is the OCIE policy about investigating compliance with 
the laws by ``well-connected, powerful'' people? How does OCIE 
protect its staff from people under investigation who might 
seek to intimidate or threaten to blackball staff from a future 
job in the industry?

A.9. OCIE's policy has always been to fairly and consistently 
pursue examination goals, regardless of the size of the firm or 
the perceived stature of the firm's personnel. Examiners are 
bright, dedicated, and professional individuals who 
consistently look for ways to protect investors. In my 
experience, examiners are not easily intimidated by tactics a 
registrant may use to avoid examination.
    I was deeply concerned about the Inspector General's 
findings that Madoff attempted to intimidate investigators and 
examiners. To address this unacceptable tactic, OCIE has 
created a new internal Hotline by which examiners can 
immediately contact senior managers and attorneys in 
headquarters when a firm is being uncooperative, unreasonable, 
or otherwise resisting appropriate oversight by the examination 
team. Supervisors at all levels will back up more junior 
personnel. We will train our staff to view these tactics as a 
red flag, and instruct to dig deeper, and look harder, at the 
firms that try to use them. We all recognize that, in order to 
ensure the examination program is successful we must not 
tolerate such intimidation tactics directed against our staff.
Measuring the Effectiveness of Reforms
Q.10. The SEC is undertaking various reforms, but it will take 
time to see whether these will improve the situation. Former 
SEC Chief Accountant Lynn Turner has said, ``Will it fix the 
problem? I don't think we'll know the answer . . . until we see 
what comes out of the agency for the next couple of years.'' 
[``Madoff's Lies Weren't Scrutinized,'' The Los Angeles Times, 
Sept. 3, 2009]
    What steps are you taking to measure whether the changes 
that you are making will solve the apparent problems?

A.10. OCIE now measures the success of its program through 
various metrics that focus on the results we achieve. In 
examinations, for example, we now track ``significant 
findings.''\1\ Such findings include those that could cause 
significant investor harm, those that give rise to a referral 
to another regulator or to the Division of Enforcement and 
those that involve willful conduct, among others. For fiscal 
year 2008, OCIE published in the SEC's annual Performance and 
Accountability Report the percentage of examinations that 
resulted in significant findings. In addition, as another 
example, we now also track the number of registrants that take 
corrective action in response to our findings.
---------------------------------------------------------------------------
    \1\ OCIE has issued guidance to all examiners on the different 
findings that would constitute a ``significant finding'' for purposes 
of our measurement process. Such findings include those that could 
cause significant investor harm, those that give rise to a referral to 
another regulator or to the Division of Enforcement, deficiencies that 
involve willful conduct, among others.
---------------------------------------------------------------------------
SEC Culture
Q.11. A column in The New York Times stated ``The issues at the 
commission are not so much ones of personnel or training, but 
instead the S.E.C.'s culture.'' [``Lessons for the S.E.C. From 
the Madoff Debacle,'' September 8, 2009]
    What change to the culture are you making so that OCIE will 
be more efficient, professional and effective?

A.11. OCIE is working to improve communication and 
collaboration both within OCIE and with other SEC offices and 
divisions. For example, the SEC has formed working groups, such 
as a hedge fund working group and a life settlement working 
group, comprised of individuals from various offices and 
divisions in order to promote collaboration and enhance 
opportunities for sharing ideas. OCIE has formed similar groups 
within the examination program in order to bring together staff 
from various groups within the examination program. As 
mentioned above, one specific task force formed by OCIE is 
focused on breaking down silos within OCIE, enhancing internal 
communication, promoting cross-staffing from the various 
examination groups on examinations where diverse expertise is 
necessary, and encouraging staff to reach out to other staff 
across the examination program that might have specialized 
knowledge.
    In addition, OCIE holds regularly scheduled meetings and 
training programs in which examiners have the opportunity to 
interact with staff from other offices and divisions within the 
SEC. In particular, these sessions enable examiners to discuss 
current trends and issues they recently identified during 
examinations with staff in other offices and divisions that may 
have specialized knowledge of such issues.
    As the Chairman has stated, we should never stop 
questioning and should not worry about appearing foolish by our 
questions.\2\ As an agency, we should encourage questions and 
be open to ideas from all of our colleagues. I believe that 
encouraging examination staff to regularly reach out to others 
both within the examination program and in other offices and 
divisions will foster an environment in which examiners are not 
hesitant to ask questions and learn from others.
---------------------------------------------------------------------------
    \2\ Speech by SEC Chairman: Applying the Lessons, Chairman Mary L. 
Schapiro, Harvard University John F. Kennedy School of Government, 
Institute of Politics (Nov. 5, 2009).
---------------------------------------------------------------------------
                                ------                                


RESPONSES TO WRITTEN QUESTIONS OF SENATOR BROWN FROM JOHN WALSH

Q.1. To what specific set of reasons do you attribute the 
previous failure of the SEC to thoroughly investigate Bernie 
Madoff and bring him to justice? How does the SEC plan to 
operate differently in the future?

A.1. The Inspector General's report noted shortcomings in areas 
including insufficient expertise; inadequate internal 
communication and coordination within the Office of Compliance 
Inspections and Examinations (``OCIE'') and with other SEC 
offices and divisions; deficiencies in planning examinations 
and investigations; and lack of follow-through on tips and 
complaints. Even before the report was issued, the SEC had 
begun to institute extensive reforms. With respect to the 
examination program, these reforms include enhancing and 
strengthening our internal controls, initiating a quarterly 
review program for all open examinations, and developing the 
expertise and skills of the examination staff.
    OCIE has focused on enhancing and strengthening our 
internal procedures. In particular, we have fully incorporated 
third-party asset verification as a routine component of the 
examination program. We have implemented procedures for 
examiners to follow when verifying information with third 
parties, and generally require third-party verification of 
information in all examinations. We have also emphasized fraud 
detection through examinations, and sponsored a conference with 
other regulators to train examiners in methods of identifying 
potential fraud and following up on red flags during 
examinations. I believe that this increased emphasis on fraud 
detection and third-party verification of information has 
already strengthened the examination program.
    Further, we have initiated a quarterly review program to 
enhance our internal controls. As part of the quarterly review 
program, a team of managers will meet to review and discuss all 
open examinations and assess whether additional expertise is 
necessary to resolve issues and finalize those examinations. 
This review process helps ensure that examinations do not 
``fall through the cracks'' and important issues get timely 
resolved. This quarterly review also provides an opportunity 
for fresh perspectives on project issues, as the review process 
includes managers that are not involved in the examinations. 
Most recently, we have begun recruiting a compliance specialist 
to perform annual testing of our policies and procedures and to 
recommend changes to these procedures as necessary and 
appropriate given the results of the testing. This specialist 
will also be responsible for testing compliance across the 
examination program with internal procedures and guidelines. 
Overall, we believe that this will further enhance our internal 
controls and quality assurance.
    Finally, OCIE has focused on developing the expertise and 
skills of the examination staff. We recognize that training is 
key to the success of the examination program and have 
implemented new trainings to improve examiner skills and 
expertise on complex issues. This has included widespread 
participation in certified training programs such as the 
Certified Fraud Examiner credential; and ensuring that 
examiners know that they have management's full support as they 
follow the facts wherever they lead. In addition, we conducted 
a mandatory training for all examiners on third-party 
verification techniques, which included a refresher course on 
the trade settlement process. We also now hold cross-training 
sessions for examiners from the broker-dealer and investment 
adviser programs to enhance examiners' ability to identify 
complex broker-dealer and adviser issues during examinations 
and enable examination managers and staff to timely seek 
expertise from other parts of the examination program. Further, 
we have continued to actively recruit examination staff with 
practical, ``hands on'' expertise, most recently through our 
new Senior Specialized Examiner positions. These new positions 
have enabled us to attract industry professionals with 
expertise in areas such as portfolio management, derivatives 
and other complex products, and options and equities trading 
strategies. Enhancing staff expertise provides more flexibility 
to examination managers in selecting the appropriate expertise 
or skill set necessary for staffing examinations.

Q.2. What is the current regulatory capacity of the SEC, i.e., 
how many agents, examiners, investigators, etc., does the SEC 
have for all the individuals and businesses that must be 
overseen? Does the SEC need more resources to do its job 
effectively? Are there any additional enforcement powers that 
the SEC needs Congress to enact?

A.2. As of the end of 2008, the SEC-registered examination 
population consisted of approximately 11,300 investment 
advisers; 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. It also included eleven exchanges, five 
clearing agencies, ten NRSROs, FINRA, the Municipal Securities 
Rulemaking Board and the PCAOB.\1\ Currently, the SEC has 
approximately 425 examination staff for oversight of all 
registered investment advisers (including registered hedge fund 
managers) and the entire mutual fund industry, and 
approximately 300 examination Staff for examinations of broker-
dealers, transfer agents, SROs, trading markets, clearing 
agencies, credit rating agencies, and other types of firms.
---------------------------------------------------------------------------
    \1\ The SEC has oversight and enforcement authority over the PCAOB, 
which is treated like a registered securities association for SEC 
examination and recordkeeping purposes.
---------------------------------------------------------------------------
    While we sincerely appreciate the support that Congress has 
provided, it is clear that addressing key problems identified 
by the Inspector General's Report will ultimately require 
additional resources. As Chairman Schapiro has noted, the SEC's 
staff size and investments in new technology are below where 
they were in 2005.\2\ At the same time, there has been 
significant growth in the market and the registered population 
that the agency oversees. New technology could significantly 
enhance the SEC's ability to carry out its mission of 
protecting investors.
---------------------------------------------------------------------------
    \2\ Speech by SEC Chairman: Applying the Lessons, Chairman Mary L. 
Schapiro, Harvard University John F. Kennedy School of Government, 
Institute of Politics (Nov. 5, 2009).
---------------------------------------------------------------------------
    In addition, we continue to invest in our current resources 
through training and other initiatives. As we continue our work 
to strengthen the examination program, we must ensure that we 
give individual staff members the training, tools, and other 
resources that they may need to thoroughly perform their jobs.
    There are several legislative measures currently under 
consideration that would enhance investor protection and 
improve the examination program by:

   enhancing the SEC's authority to review the books 
        and records of registered investment companies in order 
        to align this authority with the SEC's books and 
        records authority with respect to registered investment 
        advisers, self-regulatory organizations, transfer 
        agents, and other SEC-registered entities;

   authorizing the SEC to obtain information for 
        surveillance and risk assessment purposes and to 
        protect the confidentiality of that information, which 
        will enable the examination program to more effectively 
        target examinations and allocate resources; and

   authorizing the SEC to review certain books and 
        records of custodians, which will enable examiners to 
        more readily confirm that investor assets are not being 
        misappropriated.

Q.3. Compare the current culture of the SEC to that of the 
previous administration. What are the differences in attitude, 
approach to regulation, and management?

A.3. Under the current administration, the Commission has 
reinvigorated the agency's mission of investor protection. 
Recognizing the importance of tips, complaints and other 
information to the Commission's efforts, the agency hired an 
outside consultant to recommend an effective system for 
tracking and reviewing all such information submitted to the 
agency, and to enable staff to research a central source of 
information during the course of planning and carrying out 
their investigations and examinations.
    The Commission has fully supported the examination 
program's mission to protect investors, detect wrongdoing and 
foster compliance. Specifically, the Commission has supported 
OCIE's efforts to increase expertise within the examination 
program through trainings and certification programs, such as 
the Certified Fraud Examiners and Chartered Financial Analyst 
certification programs. In addition, the Chairman supported 
OCIE's creation of a new position entitled Senior Specialized 
Examiner to attract industry professionals with expertise in 
areas such as portfolio management, valuation, complex 
products, and trading. The examination program has further been 
supported through the creation of a new branch of examiners 
dedicated to the oversight of nationally recognized statistical 
rating organizations.

Q.4. What in your view should be the non-negotiable issues in 
financial regulatory reform? In other words, if Congress does 
nothing else, what should they include in any reform proposal?

A.4. Chairman Schapiro has emphasized that we must close gaps 
in regulation, improve transparency, strengthen enforcement and 
establish a workable, macroprudential regulatory framework. She 
also has indicated that any legislation should improve consumer 
and investor protection, as well as address systemic risk--both 
the risk of sudden failures of the financial system and the 
longer-term risk that large, ``too big to fail'' institutions 
will be unintentionally favored at the cost of smaller, more 
nimble innovators. I agree with the importance of these 
measures.
    In addition, there are several legislative measures 
currently under consideration that would enhance investor 
protection and improve the examination program by:

   enhancing the SEC's authority to review the books 
        and records of registered investment companies in order 
        to align this authority with the SEC's books and 
        records authority with respect to registered investment 
        advisers, self-regulatory organizations, transfer 
        agents, and other SEC-registered entities;

   authorizing the SEC to obtain information for 
        surveillance and risk assessment purposes and to 
        protect the confidentiality of that information, which 
        will enable the examination program to more effectively 
        target examinations and allocate resources;

   authorizing the SEC to review certain books and 
        records of custodians, which will enable examiners to 
        more readily confirm that investor assets are not being 
        misappropriated; and

   expanding the SEC's authority to oversee credit 
        rating agencies.
                                ------                                


  RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN DODD FROM ROBERT 
                            KHUZAMI

Tone at the Top
Q.1. Mr. Khuzami, in your testimony, you referred to ``tone at 
the top'' as being important for promoting change at the SEC.
    Later, you testified that the failure of the SEC to find 
the Madoff fraud after receiving what the Inspector General 
said was ``ample information in detailed and substantive 
complaints'' from 1992 to 2008 through three exams and two 
investigations, which the SEC Inspector General characterized 
as ``not being thorough or competent,'' was ``the perfect 
storm.'' You described this ``perfect storm,'' as a 
``confluence of events, including a lack of experience by the 
individuals, a lack of going to sources of competence to get 
advice, perhaps some personality conflicts, a lack of rigorous 
supervision, and a number of other factors meant that--and 
perhaps Mr. Madoff himself, who, while there was a finding that 
there was not undue influence, you know, it takes a little 
while for your mind to get around the fact, I suspect, if you 
are not careful, that someone like Mr. Madoff may be running a 
$50 billion Ponzi scheme. There are lots of indicia of 
legitimacy that he had, from the nature of his institutional 
investors to his stature to other factors. So I think, 
unfortunately--and this was the terrible result--all these 
factors came together to lead to the conclusion that we missed 
this.''
    What tone at the top do you believe is set by attributing 
the Commission's response to a ``perfect storm''?

A.1. I believe that as Director of Enforcement, I have set 
exactly the right ``tone at the top'' in the Division of 
Enforcement. I believe that there may be some misunderstanding 
as to the meaning of my reference to the Madoff investigation 
representing a ``perfect storm.''
    First, I have acknowledged unambiguously in multiple 
speeches, on national television, and in testimony before 
Congress, that the Madoff investigation was a tragic failure 
with tragic consequences. As I said in my testimony, ``no one 
can defend, excuse or deflect responsibility for the SEC's 
handling of the Madoff matter. Simply stated, in this case we 
failed in our fundamental mission to protect investors . . . 
[w]e have read letters from harmed investors that were filed 
with the court in connection with Madoff's sentencing. It is a 
sobering and humbling experience.'' I have also held a number 
of Town Hall meetings with Enforcement Division personnel, and 
have visited eight of the 11 regional offices since my 
appointment as Division Director. In those occasions, I have 
emphasized the twin themes of the grave consequences of our 
failure to uncover the Madoff scheme, and the critical need to 
implement the aggressive program of change that we have 
embraced.
    The unvarnished acknowledgement that we failed in the 
Madoff investigation is at the core of my ``tone at the top'' 
message to Division personnel. I have been clear and 
definitive--because investor protection is our mission, all of 
our operations, processes, and structures must be reevaluated 
in light of that mission, and there are no ``sacred cows'' that 
are immune from this scrutiny. As I have said publicly, 
``[t]here's no denying the fact that the Madoff tragedy was a 
terrible event, a situation where we should have performed 
better . . . We did not, and the best way to put meaning into 
our failure is to study the case and the outcome and determine 
how we can do better.''\1\
---------------------------------------------------------------------------
    \1\ Jenna Greene, New Enforcement Chief Aims to Restore Confidence 
in SEC, Nat'l L.J. (Oct. 20, 2009).
---------------------------------------------------------------------------
    This ``tone at the top''--an acknowledgement of our 
previous shortcomings combined with an unwavering commitment to 
strengthen the Division and its ability to protect investors--
has translated into action. We initiated a rigorous top-to-
bottom self-assessment of our entire operations. Phase one of 
that self-assessment is now complete, and we have implemented 
or are in the process of implementing a number of significant 
and far-reaching reforms. These changes have been described as 
the ``the unit's biggest reorganization in at least three 
decades.''\2\ Highlights of the current changes include the 
following:
---------------------------------------------------------------------------
    \2\ David Scheer, SEC Never Did `Competent' Madoff Probe, Report 
Finds (Update 2), Bloomberg.com, Sep. 2, 2009, http://
www.bloomberg.com/apps/news?pid=20603037&sid=
aBHQkUqCQppk.

   We are creating five new national specialized 
        investigative groups that will be dedicated to high-
        priority areas of enforcement, with a particular 
        emphasis on complex products, markets, transactions, or 
        practices. Members of the specialized units will 
        acquire the expertise and investigative insights that 
        can only be developed by conducting investigations in 
        the same subject area, combined with ready access to 
        others with specialized skills. With increased focus, 
        training, and access to specialized expertise, 
        investigative staff will make better investigative 
        decisions and be less likely to be misled by those 
        using complexity to conceal their misconduct. With a 
        national focus, these specialized groups will also help 
        to break down silos that inevitably develop when an 
        organization, such as the Enforcement Division, is 
        organized along regional lines, and will help to 
        cultivate a sense of common mission and mutual support 
        among Division personnel in different offices. We are 
        currently conducting final interviews for National Unit 
---------------------------------------------------------------------------
        Chief positions to lead these specialized units.

   We are adopting a flatter, more streamlined 
        organizational structure under which we will eliminate 
        the Branch Chief position, which constituted an entire 
        layer of management. Our self-assessment revealed that 
        we had a management structure that was too top-heavy, 
        and which resulted in too much process and rework, slow 
        decisionmaking, and a stifling of creativity, autonomy, 
        and accountability. This is not to say that the Branch 
        Chiefs are not highly valued employees--indeed, they 
        were some of our strongest performers. But their 
        talents are better employed by reallocating them back 
        to the mission-critical work of conducting front-line 
        investigations. As a corollary, those who are currently 
        serving at the next level of management (Assistant 
        Directors) will become first line managers, in turn 
        bringing their experience and expertise to the 
        forefront. As part of this effort, the number of 
        Assistant Directors will be expanded in order to 
        maintain staff to manager ratios that allow for close 
        substantive consultation and collaboration--the goal is 
        to have a management structure that facilitates cases, 
        ensures quality control, and provide for the growth and 
        development of the staff--ultimately enhancing the 
        Division's ability to fulfill its investor protection 
        mission. We are currently in the process of filling the 
        additional Assistant Director positions.

   We are implementing a number of structures and 
        procedures further to enhance training and supervision. 
        With respect to training, we are creating a formal 
        training unit and including in the evaluation of staff 
        and supervisors the extent of their participation in 
        formal training programs. We are also creating a 
        searchable data base listing staff members with 
        particular background and experience. In addition, we 
        will be making available model templates and checklists 
        to guide various types of investigations. With respect 
        to supervision, we are implementing a new and more 
        rigorous performance evaluation process for staff and 
        supervisors alike and requiring the regular review by 
        supervisors of caseload reports generated by the 
        Division's newly enhanced case management data base. 
        These initiatives will ensure that the staff will be 
        better trained, and will know where to go to get 
        answers to investigative questions, as well as be 
        subject to closer and more informed supervision. 
        Together, these efforts will hopefully decrease the 
        chances of missed opportunities such as occurred in the 
        Madoff investigation.

   We are streamlining a number of internal processes 
        and procedures. This streamlining includes the recent 
        delegation of formal order authority (which enables the 
        staff to issue subpoenas for testimony and documents) 
        by the Commission to me, and which I in turn have sub-
        delegated to senior Enforcement staff. In addition, 
        Chairman Schapiro has abolished the prior Commission's 
        ``penalty pilot program'' (which required Enforcement 
        staff to obtain full Commission approval before 
        beginning settlement negotiations regarding civil 
        penalty amounts with public issuer defendants).

   We are developing, for use by the SEC, agreements, 
        similar to those used by criminal law enforcement 
        authorities, to secure the cooperation of persons who 
        are on the ``inside'' or otherwise aware of 
        organizations or associations engaged in fraudulent 
        activity. These agreements, the most important of which 
        is a so-called ``cooperation agreement,'' provide that 
        such persons must agree to provide truthful evidence 
        and testify against the organizers, leaders and 
        managers of such wrongful activity, in exchange for a 
        possible reduction in sanctions imposed on them. Such 
        cooperation agreements have the capacity to secure the 
        availability of witnesses and information for the 
        Enforcement Division early on in investigations, and 
        thus minimize the number of harmed investors and 
        enhance access to persons with strong first-hand 
        evidence of wrongdoing. This will allow us to build 
        stronger cases and to file them sooner than would 
        otherwise be possible, thus preventing more investor 
        harm.

   We have hired the Division's first-ever ``Managing 
        Executive,'' who is focused on the Division's 
        operations. Previously, many administrative, 
        operational and infrastructure tasks were handled by 
        investigative personnel, who did not necessarily have 
        the training or expertise to handle such matters, and 
        for whom these tasks amounted to distractions from 
        their investigation-related functions. By hiring 
        someone with workflow, information technology and 
        process skills, these tasks can be centralized and more 
        efficiently handled, which will better support the 
        investigative functions.

   We are establishing an Office of Market 
        Intelligence, which will (1) oversee, coordinate, and 
        implement a system for the handling of complaints, 
        tips, and referrals that come to the attention of the 
        Division; (2) coordinate the Division's risk assessment 
        activities and act as a liaison for risk management 
        issues with other SEC divisions and offices, as well as 
        with Federal, state, and foreign regulators; and (3) 
        support the Division's strategic planning activities by 
        providing analysis and information and making 
        recommendations to my office. We are in the process of 
        hiring a Senior Officer to head this new office.

    In addition to these changes, we have hired experienced 
former Federal prosecutors to serve as Deputy Director of 
Enforcement and Director of the New York Regional Office, two 
of the most significant positions in the Division.
    Consequently, I believe there is no ambiguity in the 
Division that the Madoff case reflected a failure of our 
investor protection mission, and we are doing all that we can 
to address the root causes of that failure. There is no 
``business as usual'' in the Division.
    Second, my testimony describing the Madoff matter as a 
``perfect storm'' simply reflects the multiple failures that 
occurred and how aspects of our operations that normally would 
have caught or compensated for such failures failed themselves. 
To take a step back, organizations and processes have built-in 
redundancies that permit effective operations to continue 
despite the fact that one or more aspects of the operation may 
fail. The Enforcement Division is no different. Thus, there is 
a natural preference, when possible, to assign cases to persons 
with expertise in the particular area under investigation. 
Where that is not possible, we look to team investigators up 
with others who possess such expertise. In addition, 
supervisors often have experience in many types of 
investigations and can provide the necessary advice and 
guidance, or know where to get it. Other guidance and advice 
can be obtained through other members of the Enforcement 
Division who have relevant experience, or by reaching out to 
members of other SEC offices or divisions or third parties, 
including whistleblowers and other complainants. Training can 
be helpful, as can investigative ``how to'' checklists and 
other materials. In the Madoff case, however, none of these 
``redundancies'' operated to prevent our failure to detect 
Madoff's fraud (even though many were utilized). Aggravating 
the situation in my view was poor communication with our Office 
of Compliance Inspections and Examinations and Madoff's 
stature, which I speculated may have presented a psychological 
barrier to concluding that he was operating a massive Ponzi 
scheme. That is what I meant by the reference to a ``perfect 
storm''--that the various means utilized by Enforcement to 
ensure that we conduct informed investigations did not function 
as intended in this case. That is not an excuse and it is not 
to suggest that we don't need to fix these problems, or that 
the situation was a ``one-off'' or beyond anyone's control, and 
thus there is no risk of repetition that needs to be addressed. 
To the contrary, we are taking a series of ambitious steps, as 
outlined above, to address the deficiencies revealed by the 
episode and as set forth in the OIG Report.
Handling Tips
Q.2. 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 appropriately on 
tips it had received 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 each of the policies since 2003 that the 
Commission has observed governing how the Commission reviews 
unsolicited allegations of violations of the Federal securities 
laws or ``tips'' that it receives.

A.2. The SEC has strived to improve its handling of complaints, 
tips and referrals while leveraging available resources. By way 
of background, for example, prior to 2003 Enforcement 
established the Enforcement Complaint Center (ECC). The ECC 
implemented procedures to ensure review of complaints, tips and 
referrals by the members of the professional staff. Although 
the ECC was an important step forward in modernizing 
Enforcement's capacity for processing information received 
about potential wrong-doing in the industry, it was not 
designed to handle information received outside the channels of 
the ECC. The allegations surrounding market timing and late 
trading were reported directly to regional staff and not to the 
ECC. To close this gap in handling information about possible 
wrongdoing, Enforcement instituted a new Complaints, Tips and 
Referrals (CTR) policy in 2003. The CTR policy applied 
specifically to information that was received directly by 
Enforcement staff without first passing through the ECC. This 
policy required that complainants receive a prompt response, 
and that staff submit the information received for entry into a 
CTR electronic data base. The CTR data base served as an 
additional ``backstop'' system to prevent key leads from being 
lost or overlooked. Information required to be transmitted by 
the staff under the CTR policy included the actual disposition 
of the tip. At this time, the CTR data base includes 
information on nearly 12,000 investigative tips.
    Enforcement continued to review and refine its complaint 
handling capabilities beyond the CTR policy of 2003 to the 
extent that resources permitted. In 2008, the SEC developed a 
more comprehensive electronic data base, CTR-2009. CTR-2009 
built upon the information gathered in the prior data base by 
importing all of the complaints previously entered and enhanced 
the search capacity, reporting capability, and ``user 
friendliness'' of the prior data base. CTR-2009 served to 
further consolidate multiple complaint tracking data bases and 
systems utilized throughout the SEC and reduce administrative 
duplication. Under CTR-2009, all complaints, tips, and 
referrals received by Enforcement through the ECC, directly to 
staff or by other offices and divisions within the SEC, were 
required to be entered into CTR-2009 for tracking. CTR-2009 was 
intended to be a crucial interim resource for Enforcement while 
the SEC-wide complaint center was in development.
    Of course, the most wide-ranging reinvention of the 
complaints, tips, and referral handling process involves our 
recent work with the MITRE Corporation and the Division's 
establishment of the Office of Market Intelligence (OMI) within 
Enforcement. OMI will be responsible for the collection, 
analysis, triage, prioritization, referral, and monitoring of 
the huge numbers of complaints, tips and, referrals that the 
Division of Enforcement receives. This new office, headed by a 
senior officer, who will report to Enforcement's new and first-
ever ``Managing Executive'' and the Deputy Director, dovetails 
with agency-wide efforts to upgrade and modernize its capacity 
for handling information it receives. Our goal is to have a 
unified, coherent, coordinated agency-wide process for 
understanding and managing every complaint, tip, or referral.
Markopolos Recommendations
Q.3. Mr. Markopolos has recommended ideas to improve the SEC's 
capability to detect financial frauds. These include 
recommendations for the Commission to: administer competency 
exams about the capital markets to applicants for professional 
staff positions before hiring; change evaluation criteria from 
the number of exams undertaken; conduct a skills inventory of 
the SEC staff; and hire qualified industry professionals. Do 
you plan to examine these ideas from Mr. Markopolos?

A.3. The SEC has not only examined Mr. Markopolos's 
recommendations but has already implemented many of them to the 
extent practicable and legally permissible. In other instances, 
the SEC has taken steps that are consistent with the purpose 
and spirit of Mr. Markopolos's recommendations.
    As described above, the Enforcement Division has undertaken 
a comprehensive self-evaluation and devised a broad range of 
new initiatives designed to improve the Division's operations, 
efficiency, and ability to detect fraud. These initiatives 
include the creation of five specialized units to be staffed in 
part by experienced market professionals; the elimination of a 
layer of management to free up some of the Division's most 
talented and experienced staff for front line investigative 
work; the creation of an Office of Market Intelligence to 
address all complaints, tips and referrals received by the 
Division, as well as risk management and proactive strategic 
planning; and substantial expansion of the Division's training 
programs and personnel.
    With respect to the specific recommendations mentioned 
above, the Division is actively seeking to hire applicants with 
extensive industry experience, including those with industry 
certifications. As part of its self-assessment, the Division 
recently completed a skills inventory of staff and the results 
are presently being compiled. While competency examinations are 
presently not within the scope of the hiring criteria for 
Federal employment at the SEC, the SEC already has numerous 
staff members who have industry certifications and indisputable 
expertise in many complex subject matter areas. The 
Commission's efforts to attract and hire additional industry 
professionals with extensive practical experience in various 
market areas will further ensure the competency of the SEC 
staff.
Supervisors Who Lack A Particular Expertise
Q.4. The Report states that an SEC staff accountant and Mr. 
Markopolos both testified that when Mr. Markopolos presented 
his analysis to SEC staff ``it was clear that the BDO's 
Assistant District Administrator did not understand the 
information presented. Our investigation found that this was 
likely the reason that the reason that the BDO decided not to 
pursue Markopolos' complaint or even refer it to the SEC's 
Northeast Regional Office (NERO).'' The Report refers to other 
similar situations.
    Does this concern you? What is Enforcement's policy about 
what ADAs or other supervisors should have done in similar 
situations? In what ways has the SEC made this policy known to 
supervisors?
A.4. We take the findings of the OIG Report very seriously. To 
ensure the proper handling of tips, complaints, and referrals, 
as previously described, the Division is creating an Office of 
Market Intelligence that will coordinate and consolidate the 
intake, triage and resolution of the huge number of tips, 
complaints, and referrals that we receive each year. In 
addition, the SEC hired the MITRE Group, a non-profit, 
federally funded research firm, to conduct a comprehensive 
review of the agency's systems and procedures for evaluating 
and tracking complaints, tips, and referrals. Finally, the 
Division formed a Risk Focus/Advisory Group in December 2008 to 
look for ways to improve the Division's tip-handling process.
    In addition, our own top-to-bottom self-assessment earlier 
this year also found that training and expertise had not been 
appropriately prioritized. We have begun to address the issue 
through several initiatives. This past year, the Division 
formed the Training and Resources Working Group. The Group 
assessed the training needs of the staff and is now determining 
which types of training should be mandatory for all staff. To 
further strengthen our training program, we are committed to 
creating a formal training unit to operate a comprehensive 
training program, including an expanded new hire training 
program. To provide incentives to supervisors to encourage the 
staff to complete training, we plan to make staff training one 
of the factors considered under the new performance evaluation 
for managers.
    As noted above, we have also begun the process of 
restructuring the Division to take advantage of staff 
expertise. We will be rolling out five new units that will 
focus on highly specialized and complex issues (asset 
management, market abuses, structured and new products, Foreign 
Corrupt Practices Act, and municipal securities and public 
pensions). Staff in these units will receive specialized 
training. Further, we are compiling a skills inventory of all 
Enforcement staff. Once completed, investigators in the 
Enforcement Division will have a searchable data base listing 
staff members with particular expertise, such as securities 
industry experience, academic degrees, certifications, 
specialized investigative experience, and other relevant 
credentials. Staff will be able to use this resource--in 
addition to the specialized units--to identify those with the 
relevant skills and experience to answer questions and provide 
advice.
Human Resources Actions
Q.5-A. The Report identifies some SEC employees who 
demonstrated good professional judgment, such as the two 
employees of the Boston Office who the SEC Inspector General 
found ``had substantial experience and knowledge of investment 
funds'' and recommended that Mr. Markopolos' allegations be 
investigated.
    What has been done or what will the SEC do to recognize or 
reward employees who the Report documents have demonstrated 
good professional judgment and issue recognition? Will they be 
put into appropriate positions of responsibility so that the 
SEC and investors can benefit from their good judgment?

Q.5-B. The Report describes some supervisory staff who appear 
to have lacked the expertise or judgment to successfully 
discharge their responsibilities in critical situations. Have 
you reviewed the performance of such employees under your 
supervision and considered moving them to positions more suited 
to their abilities and where they will not cause harm to 
investors? Are you reviewing and considering revisions to the 
criteria for promotion to avoid future types of problems?

A.5. As recommended in the OIG Report, we are closely 
considering the issue of whether any action--positive or 
negative--is appropriate with respect to current employees in 
light of the massive failures to detect Madoff's fraud. Our 
evaluation will include what, if any, retraining, mentoring, or 
disciplinary action should be taken. There is an established 
process in place that we are required to follow for personnel 
actions, as we would in any employment issue involving Federal 
Government workers. We will act as quickly as reasonably 
possible in a manner consistent with the law.
    Our first step has been to ensure that the employees who 
remain at the SEC are appropriately supervised, including 
heightened supervision if necessary, while we determine whether 
and what personnel actions should be taken. Our second step has 
been to review the record and evidence. We had deferred to the 
OIG during its investigation into this matter. We have now 
received the OIG's collected evidence, including source 
documents and testimony transcripts, and we are in the process 
of reviewing the evidence and determining whether and what 
actions are appropriate.
    Under the law, a proposing official will review the record 
and determine whether and what action to propose. The official 
notifies the employee of the proposed action and the employee 
then has the right to add a reply to the record. After 
considering the employee's reply, a deciding official 
determines the final action. The employee may appeal that 
action.
    To the extent that there is public information that we can 
provide about any actions taken, we will provide that 
information at an appropriate time. We will remain mindful that 
we are legally obligated to respect SEC employees' rights to 
privacy and procedural due process.
The Problem of ``Silos''
Q.6. A recent column in The New York Times stated:

        Bureaucratic rivalries are nothing new, and the S.E.C. 
        is certainly not one big happy family. But when an 
        agency's goal is to protect investors, it needs to 
        ensure that everyone is working toward that end. 
        Opening up the lines of communication both within and 
        between divisions, and encouraging them to work with 
        one another and share all information rather than view 
        others as potential rivals, is a much better way to 
        operate.

    Over the years, I have heard many complaints from industry 
about stovepipes, or ``silos,'' within the SEC--Divisions or 
Offices that do not communicate or cooperate with each other. 
The Report identifies several instances where this contributed 
to the failure of the SEC to find the Madoff fraud.
    Are you concerned about the problem caused by stovepipes or 
silos? What are you doing to promote cooperation among the 
units in your Division and between them and other SEC offices?

A.6. I am deeply concerned about the problems caused by 
stovepipes or silos. The Enforcement Division's self-assessment 
and the OIG Report noted important gaps in communication, and I 
consider the need to close these gaps one of our top 
priorities.
    In the wake of the Madoff IG Report, Chairman Schapiro 
repeatedly has stressed the fact that we are one agency that 
can only succeed if we fully cooperate with each other, share 
information and rely on the expertise that exists throughout 
the agency. She specifically brought together her senior 
managers to convey this message. She also began a program in 
which she and her senior managers are visiting every regional 
office to discuss the importance of learning lessons from the 
Madoff fraud, the importance of having a ``culture of 
cooperation,'' and to begin an ongoing dialog throughout the 
agency about how different divisions and offices can better 
help each other as we work to protect investors.
    Within the Division, we are taking a number of steps toward 
creating a solid framework for increasing lines of open and 
efficient communication, including the establishment of a 
unified, coherent, and coordinated response to the massive 
amount of complaints, tips, and referrals that we receive on a 
daily basis.
    The steps we have taken to improve communication and 
coordination include:

   Specialization and restructuring. National 
        specialized units will discourage the existence of 
        separate regional ``silos'' that could develop based 
        solely on a regional organization. Units defined by 
        specialization, as opposed solely to geography, will 
        create a natural structure for better communication and 
        collaboration across geographic lines, and ultimately a 
        more comprehensive and coherent national program. We 
        may also assign staff from other SEC offices and 
        divisions with relevant expertise to serve as liaisons 
        to these newly formed Specialized Units within the 
        Enforcement Division, such that there exists a point-
        of-contact that Enforcement staff can consult with 
        questions related to the activity of other SEC offices 
        and divisions. Moreover, the flattening of the 
        management structure will streamline and improve 
        communications between staff and management.

   Emphasis of current policies regarding consultation 
        with other SEC divisions and offices. Enforcement 
        senior management has emphasized to the staff the 
        importance of consulting with other SEC divisions and 
        offices early and often. In addition to informal 
        consultation, there is a formal process by which 
        Enforcement staff seeks review and comment from other 
        divisions and offices before it submits an enforcement 
        recommendation to the Commission. We view other SEC 
        offices and divisions as an important resource and will 
        continue to strive to keep the lines of communications 
        open and effective.\3\
---------------------------------------------------------------------------
    \3\ Enforcement also highlights the importance of consultation with 
other SEC divisions and offices, and communication generally, in the 
Enforcement Manual. Section 1.4.3. of the Enforcement Manual, entitled 
``Consultation,'' states:

    ``Although this Manual is intended to be a reference for the staff 
in the Division who are responsible for investigations, no set of 
procedures or policies can replace the need for active and ongoing 
consultation with colleagues, other Divisions and Offices at the SEC, 
and internal experts. Investigations often require careful legal and 
technical analysis of complicated issues, culminating in difficult 
judgment calls that may affect market participants, individuals, and 
issuers. Therefore, any time an issue arises for which colleagues or 
other Divisions or Offices may hold particular expertise, the staff 
should consider consultation. In addition, staff should keep other 
Divisions and Offices informed regarding issues of interest that arise 
during investigations, and consult with interested Divisions and 
Offices before making recommendations for action to the Commission at 
the conclusion of an investigation.''

    See SEC Division of Enforcement, Enforcement Manual, Oct. 6, 2008, 
http://www.sec.gov/divisions/enforce/enforcementmanual.pdf (Enforcement 
Manual).

   The SEC's MITRE Initiative. The SEC has contracted 
        with MITRE, a federally funded research and development 
        center, to help the agency revamp and improve its 
        processes for handling the high volume of complaints, 
        tips, and referrals (CTRs) it receives each year. This 
        project focuses on the central role that tips and 
        complaints may play in uncovering fraud and protecting 
---------------------------------------------------------------------------
        investors.

   Creation of an Office of Market Intelligence. 
        Dovetailing with the MITRE initiative, we are 
        establishing a new Office of Market Intelligence. This 
        Office will be responsible for the collection, 
        analysis, risk-weighing, triage, referral, and 
        monitoring of CTRs. This Office will have open lines of 
        communication with the agency's various divisions and 
        offices and draw on their expertise to analyze and 
        respond to CTRs. Through this effort, we hope to have a 
        unified, coherent, coordinated agency-wide response to 
        the huge volume of information we receive every day.

    We take very seriously the criticisms of silos and 
stovepiping. Continual communication on issues concerning an 
investigation is of the utmost importance. We are determined to 
put into practice the lessons learned from the Madoff failures 
and from our Division's self-assessment about the central 
importance that communication and collaboration play in shaping 
an investigation and bringing wrongdoers to justice.
Enforcing the Laws Against ``Well-connected, Powerful''
        People
Q.7. The Report states that on a conference call about two 
Madoff exams, ``a senior-level Washington D.C. examiner 
remind[ed] the junior NERO [New York Regional Office] examiners 
that Madoff `was a very well-connected, powerful person,' which 
one of the NERO examiners interpreted to raise a concern for 
them about pushing Madoff too hard.'' What is the Division of 
Enforcement policy about investigating compliance with the laws 
by ``well-connected, powerful'' people? How does the SEC 
protect its staff from people under investigation who might 
seek to intimidate or threaten to blackball staff from a future 
job in the industry?

A.7. The Division's Mission Statement states that integrity and 
fairness are integral to the Division's mission of protecting 
investors, and fairness compels treatment ``without regard to 
wealth, social standing, publicity, politics, or personal 
characteristics.''\4\ Thus, well-connected persons are given no 
special treatment. The same is true with respect to the 
opposite concern--that staff will pursue the well-connected 
more vigorously than others simply because of who they are. In 
short, staff is expected to act honestly, forthrightly, and 
impartially in every aspect of work.\5\
---------------------------------------------------------------------------
    \4\ See Enforcement Manual at Section 1.4.1.
    \5\ See id.
---------------------------------------------------------------------------
    The integrity of the staff is of central importance to the 
success of our mission to protect investors. Thus, supervisors 
are sensitive to situations where the well-connected or 
influential may seek to bully or intimidate staff, or utilize 
other more subtle ways to deflect an investigation. I also 
believe that the ``tone at the top'' is crucial in empowering 
employees to conduct investigations in a way that is fair and 
impartial, without regard to a person's status or wealth. 
Fostering a culture of integrity and professionalism is one of 
the Division's priorities. To that end, staff is encouraged to 
communicate openly to management if they encounter roadblocks 
in investigations. If staff does not feel comfortable speaking 
directly to a manager, there is an anonymous email box 
available to Enforcement staff. Contents of the box are 
regularly reviewed and considered by senior members of the 
Division's staff.
    In addition, as the enforcement arm of the agency, 
communications between my staff and persons involved in 
investigations are generally through legal counsel. Face-to-
face interactions usually occur only in formal settings. For 
example, if a person has been subpoenaed to testify in an 
investigation, that testimony is sworn and on-the-record. These 
settings lend inherent protections for Enforcement staff 
against intimidation and threats.
Measuring the Effectiveness of Reforms
Q.8. The SEC is undertaking various reforms, but it will take 
time to see whether these will improve the situation. Former 
SEC Chief Accountant Lynn Turner has said, ``Will it fix the 
problem? I don't think we'll know the answer . . . until we see 
what comes out of the agency for the next couple of years.'' 
[``Madoff's Lies Weren't Scrutinized,'' The Los Angeles Times, 
Sept. 3, 2009]
    What steps are you taking to measure whether the changes 
that you are making will solve the apparent problems?

A.8. With respect to Enforcement, the Division has already 
begun a process of developing additional metrics to gauge how 
it is accomplishing its mission. These new metrics are designed 
to reflect better the relative significance of our 
investigations and enforcement actions and our concomitant use 
of resources. Over time, the new measures should help us 
evaluate whether reforms now being implemented are achieving 
the desired results.
    In the past, the metric most commonly used as a shorthand 
measure of the Division's success has been the number of 
enforcement actions filed or instituted during a fiscal year. 
There is a valid concern that such an approach could have the 
unintended effect of discouraging the staff from investigating 
more complex matters that may take longer to complete or have a 
lower likelihood of actually resulting in filed cases. 
Certainly, an internal and external focus on the number of 
enforcement actions alone as a standard for success creates too 
great of a risk that other important information will be 
ignored or put on the back burner. We need to consider and 
evaluate other important information about each of our matters 
which can help give us a complete picture of what we are doing 
right and where we can improve.
    Accordingly, we are moving to a system of both qualitative 
and quantitative metrics that will align incentives with 
programmatic goals. Among other things, Enforcement is looking 
to measure the programmatic importance of enforcement actions, 
the timeliness of filed or instituted actions, monetary 
sanctions imposed (disgorgement and penalties), the 
productivity of our staff's work on each action (including 
productivity by office or other relevant unit), and the use of 
litigation resources. As another means of gauging whether we 
are maximizing our efficacy and resources, we also intend to 
measure regularly the number of priority investigations and 
actions as compared to our total caseload. We are also seeking 
to develop a metric that captures important investigative 
efforts where the evidence does not warrant enforcement 
actions.
    We are developing reporting tools for these and other 
measures that will provide updated information on a rolling 
basis. Many of these metrics are being compiled into a readily 
useable Enforcement ``dashboard'' report. Examples of the types 
of measurements that we are considering for inclusion in the 
monthly dashboard are:

   New investigations opened by Regional Office, Home 
        Office group, or Specialized Unit in particular 
        priority areas of emphasis (e.g., Ponzi schemes);

   Length of investigation from opening of 
        investigation to first action taken, broken down by 
        subject matter, for each Regional Office, Home Office 
        group, or Specialized Unit; and

   Emergency court actions sought to preserve investor 
        assets or halt ongoing frauds.

    We have already implemented some of these initiatives 
designed to improve the management and effectiveness of the 
Enforcement program. For instance, a report detailing the 
highest priority investigations being conducted nationwide is 
now prepared bi-monthly and circulated to senior officers 
within the Division. The report breaks down the investigations 
by subject matter and stage of investigation. Thus, among other 
information, senior managers can see what percent of priority 
investigations involve, for example, subprime mortgage fraud, 
what the key facts of each investigation are, and what progress 
the staff has made toward completing the investigation since 
the prior report.
    Among the changes that I have already initiated are: the 
streamlining of internal processes for review of proposed 
enforcement actions, the subdelegation of authority to senior 
officers in Enforcement to approve formal orders of 
investigation, and the streamlining of other internal processes 
for the issuance of Wells notices and the review of settlement 
parameters. We are conducting final interviews for the hiring 
of chiefs of the Specialized Units. We anticipate that the 
implementation of streamlined procedures and the establishment 
of meaningful ``dashboard'' metrics as described above will 
help us monitor the effectiveness of the changes to 
Enforcement's operation and program.
SEC Culture
Q.9. A column in The New York Times stated ``The issues at the 
Commission are not so much ones of personnel or training, but 
instead the S.E.C.'s culture.'' [``Lessons for the S.E.C. From 
the Madoff Debacle,'' September 8, 2009]
    What changes to the culture are you making in order to 
enhance the effectiveness of the Division of Enforcement?

A.9. The ambitious self-assessment and restructuring that we 
have undertaken can only be successful if there is an 
accompanying change in culture. It is my view that human 
capital--the brains and experience of people--is the most 
critical asset of most organizations. The SEC is no exception. 
Not only must we as an organization capture, nurture, and 
optimally utilize our skill sets, we need to ensure that our 
assumptions, values, and norms--that is, our culture--are 
conducive to our success.
    Maintaining and fostering a culture of integrity and 
professionalism is one of the Division's top priorities. It is 
my belief that the current changes we are making in structure 
and organization will engender a shift in culture: one in which 
the staff feels more empowered because it has better training, 
better access to expertise, and overall better tools to tackle 
an investigation; one in which the staff has the time--because 
resources are better leveraged--to push, probe, and follow 
through when it needs to find verified answers to its 
questions; one in which management--in part because of a 
tighter staff to supervisor ratio--invites open communications 
and responds with encouragement when staff come forward with 
questions, suspicions, or ideas for investigations; one in 
which the staff feels more personally and professionally 
responsible because the Commission has supported and shown 
deference where appropriate to staff assessments; and 
ultimately, one in which the staff is held to the highest 
standards. Finally, to further guard against the possibility 
that an issue is missed because a staffer does not feel 
comfortable approaching a supervisor, there is now an anonymous 
email suggestion box available to Enforcement staff. Contents 
of the box are regularly reviewed and considered by senior 
members of the Division's staff.
    My first day on the job as the Director of the Division of 
Enforcement, I asked the staff to approach the critically 
important work of enforcement by embracing four key principles:

   First, I asked the staff to be as strategic as 
        possible. We must use our resources as efficiently as 
        possible and in a manner that achieves the greatest 
        impact. This means a focus on cases involving the 
        greatest and most immediate harm and on cases that send 
        an outsized message of deterrence.

   Second, I asked the staff to be as swift as 
        possible. A sense of urgency is critical. If cases are 
        unreasonably delayed, if there is a wide gap between 
        conduct and accountability, then the message is 
        diluted. Timeliness is paramount. Corporate 
        institutions are dynamic and ever-changing. When a case 
        is brought years after the conduct, the sanctions still 
        hurt but the opportunity to achieve a permanent change 
        in behavior and culture is greatly reduced.

   Third, I asked the staff to be as smart as 
        possible. Our resources are finite and critically 
        limited. We must better determine on an informed basis 
        whether to continue an investigation, who to continue 
        it against, how to shape it, and how to charge it. This 
        means a constant focus on investigative plans and 
        regular decision point during the life-cycle of a case.

   And last, I asked the staff to be as successful as 
        possible. We need to win. This means building strong 
        cases so that defendants settle quickly on the 
        Commission's terms or face a trial unit armed with 
        compelling evidence.

    With these principles as a backdrop and the reorganization 
and other changes currently being implemented, I am hopeful 
that our organization will rise to the challenge. The mission 
of investor protection is too important for us to do anything 
less.
Restacking Project
Q.10. In March, the Inspector General reported on the SEC's 
``restacking'' project, in which many staff offices were 
relocated to segregate an office or division in a separate 
floor area at a cost of almost $4 million. The original space 
assignments were designed to improve communication and 
consultation among divisions and reduce the ``silo mentality.''
    Is the SEC now evaluating the effects of restacking on 
issues of communication between divisions and the ``silo'' 
effect?
A.10. The Division's ongoing reorganization effort is aimed at, 
among other concerns, the ``silo'' mentality or effect. 
National specialized units, as opposed to geographically 
defined units, will foster a more comprehensive and coherent 
national program, both within the Division and with respect to 
staff in other SEC divisions and offices. We anticipate that 
the staff of the specialized units will foster and develop 
ongoing relationships with their counterparts in the other SEC 
divisions and offices with the relevant expertise. Ideally, 
such ongoing relationships will further encourage the free flow 
of information and dialog that can only serve to enhance the 
Division's investigative abilities.
    In addition, our Division senior management continues to 
emphasize to Enforcement staff the importance of consulting 
with other SEC divisions and offices early and often to 
identify and resolve issues. There is also a formal process in 
place by which Enforcement staff seeks review and comment from 
other SEC divisions and offices before it submits an 
Enforcement recommendation to the Commission.
    With respect to the specific effects of restacking, it is 
my belief that the current configuration--where divisions and 
offices are located together--discourages siloization. When 
staff in the same division or office sit in close proximity, 
the group is more cohesive and unified. There is naturally more 
communication and consultation. It is also my belief that 
morale is raised when no subgroups are left to feel isolated or 
disconnected from the main body of the Division.
    As described in the SEC Office of Inspector General's 
report, Review of the Commission's Restacking Project, Report 
No. 461 (March 31, 2009), senior managers at the Commission 
believed that the original configuration impeded effective 
communication and collaboration among staff within divisions 
and offices.\6\ More specifically, the Management Comments to 
the report noted that the original configuration made no 
attempt to keep offices and divisions together. Instead, 
operating units were intentionally broken up and spread across 
multiple floors and both buildings, scattering offices and 
working groups for no discernible benefit. Divisional and 
office leadership across large and small operating units agreed 
that this configuration created significant management 
difficulties and operational inefficiencies, discouraged 
effective communication and collaboration, and adversely 
affected staff morale. Accordingly, over the course of 2007, 
agency management engaged in extensive deliberations and 
consultation with staff on whether to undertake a 
reconfiguration--or stacking--of the then-existing layout.\7\
---------------------------------------------------------------------------
    \6\ See SEC Office of Inspector General, Review of the Commission's 
Restacking Project, Report No. 461 (March 31, 2009), Executive Summary, 
pp. i-iv.
    \7\ See id. at Appendix V, Management Comments, pp. 32-41.
---------------------------------------------------------------------------
    The benefits of Division cohesiveness and improved morale, 
in my mind, outweigh any potential detriment that may occur 
when different divisions or offices are not physically 
commingled. Moreover, different divisions and offices are not 
segregated from one another--we still sit in the same buildings 
\8\ and often sit on the same floors. We often attend the same 
meetings or participate in joint training. In addition to the 
formal and informal processes described above for inter-
divisional communication and consultation, staff can still get 
up and walk down the hall or up the stairs to discuss relevant 
matters or to form professional relationships.
---------------------------------------------------------------------------
    \8\ Headquarters consists of two interconnected buildings.
---------------------------------------------------------------------------
    I am deeply concerned with any potential siloization, and I 
know Chairman Schapiro shares that concern. Chairman Schapiro 
has repeatedly stressed the fact that we are one agency that 
can only succeed if we fully cooperate with each other, share 
information and rely on the expertise throughout the agency. 
She specifically brought together her senior managers to convey 
this message. She also began a program in which she and her 
senior managers are visiting every regional office to discuss 
the importance of learning lessons from the Madoff fraud, the 
importance of having a ``culture of cooperation,'' and to begin 
an ongoing dialog throughout the agency about how different 
divisions and offices can better help each other as we work to 
protect investors.
    I will continue to monitor and evaluate the effects of 
restacking on communication and collaboration. Similarly, the 
restacking project is still under evaluation by the agency. One 
of the OIG's recommendations was that the Office of 
Administrative Services conduct another survey of staff after 
the restacking process has been completed to understand the 
effects and impacts of the project better and determine what, 
if any, changes should be implemented. The Commission's 
response was to concur with the recommendation, stating that it 
intended ``to conduct a full review of the restacking project, 
including a survey of affected staff, after its completion in 
order to better understand the impact of the project and apply 
lessons learned to future comparable projects.''\9\
---------------------------------------------------------------------------
    \9\ Id. at p. 40.
---------------------------------------------------------------------------
Dealing with Staff Biases
Q.11. The Report states that the New York Regional Office 
Enforcement staff, unlike the Boston District Office, ``failed 
to appreciate the significance of the evidence in the 2005 
Markopolos complaint and almost immediately expressed 
skepticism and disbelief about the information.'' It states 
that the branch chief ``took an instant dislike to Markopolos'' 
and did not even pick up a folder of materials that Mr. 
Markopolos offered.
    Is this a concern to you? What does the SEC do to assist 
staff to separate their personal biases from their professional 
job analysis and performance?

A.11. Several initiatives will help prevent staff bias from 
affecting the treatment of a tip or follow-through during an 
investigation.
    First, we are centralizing the processing of the high 
volume of complaints, tips and referrals that the Division 
receives each year. As previously noted, the new Office of 
Market Intelligence will ensure that tips are triaged by a team 
of experts who can then refer them to the appropriate 
investigative team. The treatment of tips will be tracked to 
ensure appropriate follow-up. In addition, as this new Office 
specializes in handling complaints, they will have a broad 
range of experiences, and will have seen tips and complaints 
from a whole host of sources. Presumably, they will be less 
inclined to dismiss one because of a personal bias.
    Second, restructuring the Division to include five 
specialized units that organize staff around areas of 
specialization will enable the Division to harness the 
expertise of staff more efficiently and effectively. Tips and 
complaints will be routed to staff who have the experience and 
skills to understand and act on the information.
    Third, we are prioritizing training for both new and 
seasoned staff. As part of our self-assessment, we are 
determining which types of training should be mandatory for all 
staff and we are committed to creating a formal training unit 
to operate a comprehensive training program. Supervisors will 
be evaluated on staff training as part of our new performance 
evaluation for managers.
    Finally, new hires are required to attend new hire training 
at which the importance of integrity and professionalism are 
highlighted as central to the SEC's mission. Professionalism 
and fairness mean that staff are expected to treat persons 
without regard to wealth, social standing, publicity, politics, 
or personal characteristics.
Bank of America Case
Q.12. On September 14, 2009, in SEC v. Bank of America 
Corporation, a District Court judge issued an opinion rejecting 
the SEC's proposed settlement with Bank of America for $33 
million to settle charges that ``defendant Bank of America 
Corporation materially lied to its shareholders in the proxy 
statement of November 3, 2008 that solicited the shareholders' 
approval of the $50 billion acquisition of Merrill Lynch & 
Co.'' The Court stated that the ``essence of the lie . . . was 
that Bank of America `represented [to shareholders] that 
Merrill had agreed not to pay year-end performance bonuses or 
other discretionary incentive compensation to its executives 
prior to the closing of the merger without Bank of America's 
consent [when] [i]n fact, contrary to the representation . . . 
Bank of America had agreed that Merrill could pay up to $5.8 
billion . . . in discretionary year-end bonuses to Merrill 
executives for 2008.''
    The Court characterized the SEC's proposed settlement as 
``a contrivance designed to provide the S.E.C. with the facade 
of enforcement and the management of the Bank with a quick 
resolution of an embarrassing inquiry--all at the expense of 
the sole alleged victims, the shareholders. Even under the most 
deferential review, this proposed Consent Judgment cannot 
remotely be called fair.'' The Court concluded that the 
proposed settlement was ``neither fair, nor reasonable, nor 
adequate.''
    Please describe the process by which the Enforcement 
Division and the Commission determined the terms of the 
proposed settlement in this case. Was this process 
substantially similar to the process used for arriving at 
proposed settlements in similar types of securities cases? To 
what does the Commission attribute the Court's rejection of its 
proposed settlement? In light of the Court's opinion, will the 
Commission change any aspect of its processes for arriving at 
settlements to proposed to courts?

A.12. In the SEC v. Bank of America matter, the Division of 
Enforcement presented a settlement offer from Bank of America 
to the Commission. The Commission determined whether to accept 
the offer by reviewing a memorandum from the Division of 
Enforcement and consulting with the Office of the General 
Counsel as well as other interested SEC divisions and offices. 
The procedures through which the Commission considered Bank of 
America's settlement offer were the same as the procedures used 
to consider settlement offers generally.
    Contrary to the suggestion of the Court, the Commission 
made no allegation that the Bank ``lied''--i.e., that it 
engaged in intentional misrepresentation. Rather, the 
Commission alleged that the Bank failed to meet its obligation 
to ensure the accuracy and completeness of all statements made 
in a proxy and to disclose in the proxy all material terms of 
the merger agreement with Merrill. The terms of the proposed 
settlement with Bank of America reflected the principle that 
when a corporate issuer has not met its statutory obligations, 
the need for corporate deterrence is paramount. The $33 million 
penalty would have sent a clear message to corporations and 
those who advise them that proxy statements must include the 
substance of a separate nonpublic document that materially 
qualifies or contradicts representations contained in the 
underlying proxy statement. It also would have established an 
incentive for corporations to maintain internal controls for 
preventing and detecting misstatements contained in proxy 
statements.
    Although we believe that the proposed settlement was 
reasonable, appropriate, and in the public interest, we take 
Judge Rakoff's decision very seriously. Judge Rakoff's opinion 
in which he rejected the settlement outlined his reasoning, 
and, as with any court ruling, we will factor his decision into 
our regular ongoing assessment of our activities and 
determinations.
                                ------                                


  RESPONSES TO WRITTEN QUESTIONS OF SENATOR BROWN FROM ROBERT 
                            KHUZAMI

Q.1. To what specific set of reasons do you attribute the 
previous failure of the SEC to thoroughly investigate Bernie 
Madoff and bring him to justice? How does the SEC plan to 
operate differently in the future?

A.1. There were a number of deficiencies in the Madoff 
investigation. These included: (1) the staff attorney and 
immediate supervisor lacked expertise in the alleged trading 
strategies employed by Madoff and in Ponzi scheme 
investigations in general, resulting in the failure to take 
investigative steps that might well have revealed the fraud; 
(2) lack of perseverance and follow-up in obtaining answers to 
questions in the investigation even when that information was 
requested; (3) poor investigative planning and supervision; (4) 
a lack of proper communication with other offices and divisions 
within the SEC, including the Office of Compliance Inspections 
and Examinations; and (5) failure to accumulate and utilize the 
information contained in various tips and complaints received 
over the years that reflected concern about Madoff's 
operations. In addition, there were a number of general 
deficiencies that were revealed, including the lack of training 
and the lack of resources.\1\
---------------------------------------------------------------------------
    \1\ See generally SEC Office of Inspector General, Report of 
Investigation of Failure of the SEC to Uncover Bernard Madoff's Ponzi 
Scheme, Report No. 509 (2009).
---------------------------------------------------------------------------
    To address these problems, the SEC had begun to initiate 
extensive reforms even before the issuance of the OIG 
Report.\2\ With respect to the Division of Enforcement, since I 
became the Director in March of this year, we have been 
undertaking a top-to-bottom self-assessment of our Division's 
operations. We have asked not only the specific question of 
what went wrong and what steps can we take to prevent the same 
terrible failures from reoccurring, but the broader question of 
how can we improve overall: how can we work smarter, swifter, 
be more strategic and more successful? In short, what can we do 
as an organization and as individual public servants to best 
fulfill our critical mission of investor protection?
---------------------------------------------------------------------------
    \2\ See The Securities and Exchange Commission Post-Madoff Reforms, 
http://www.sec.gov/spotlight/secpostmadoffreforms.htm.
---------------------------------------------------------------------------
    Phase One of our Division self-assessment is now complete, 
and we have implemented or are in the process of implementing a 
number of key reforms. These changes have been described as the 
``the unit's biggest reorganization in at least three 
decades.''\3\ Together, these changes are intended to maximize 
our resources, to gather and utilize expertise across the 
Division and the agency, to bring cases more swiftly and more 
efficiently, and to increase strategic analysis and proactive 
investigations. Highlights of the current changes include the 
following:
---------------------------------------------------------------------------
    \3\ David Scheer, SEC Never Did `Competent' Madoff Probe, Report 
Finds (Update 2), Bloomberg.com, Sep. 2, 2009, http://
www.bloomberg.com/apps/news?pid=20603037&sid=
aBHQkUqCQppk.

   We are creating five new national specialized 
        investigative groups that will be dedicated to high-
        priority areas of enforcement, with a particular 
        emphasis on complex products, markets, transactions, or 
        practices. Members of the specialized units will 
        acquire the expertise and investigative insights that 
        can only be developed by conducting investigations in 
        the same subject area, combined with ready access to 
        others with specialized skills. With increased focus, 
        training, and access to specialized expertise, 
        investigative staff will make better investigative 
        decisions and be less likely to be misled by those 
        using complexity to conceal their misconduct. With a 
        national focus, these specialized groups will also help 
        to break down silos that inevitably develop when an 
        organization, such as the Enforcement Division, is 
        organized along regional lines, and will help to 
        cultivate a sense of common mission and mutual support 
        among Division personnel in different offices. We are 
        currently in the process of filling National Unit Chief 
---------------------------------------------------------------------------
        positions to lead these specialized units.

   We are adopting a flatter, more streamlined 
        organizational structure under which we will eliminate 
        the Branch Chief position, which constituted an entire 
        layer of management. Our self-assessment revealed that 
        we had a management structure that was too top-heavy, 
        and which resulted in too much process and rework, slow 
        decisionmaking, and a stifling of creativity, autonomy, 
        and accountability. This is not to say that the Branch 
        Chiefs are not highly valued employees--indeed, they 
        were some of our strongest performers. But their 
        talents are better employed by reallocating them back 
        to the mission-critical work of conducting front-line 
        investigations. As a corollary, those who are currently 
        serving at the next level of management (Assistant 
        Directors) will become first line managers, in turn 
        bringing their experience and expertise to the 
        forefront. As part of this effort, the number of 
        Assistant Directors will be expanded in order to 
        maintain staff to manager ratios that allow for close 
        substantive consultation and collaboration--the goal is 
        to have a management structure that facilitates cases, 
        ensures quality control, and provides for the growth 
        and development of the staff--ultimately enhancing the 
        Division's ability to fulfill its investor protection 
        mission. We are currently in the process of filling the 
        additional Assistant Director positions.

   We are implementing a number of structures and 
        procedures further to enhance training and supervision. 
        With respect to training, we are creating a formal 
        training unit and including in the evaluation of staff 
        and supervisors the extent of their participation in 
        formal training programs. We are also creating a 
        searchable data base listing staff members with 
        particular background and experience. In addition, we 
        will be making available model templates and checklists 
        to guide various types of investigations. With respect 
        to supervision, we are implementing a new and more 
        rigorous performance evaluation process for staff and 
        supervisors alike and requiring the regular review by 
        supervisors of caseload reports generated by the 
        Division's newly enhanced case management data base. 
        These initiatives will ensure that the staff will be 
        better trained and will know where to go to get answers 
        to investigative questions, as well as be subject to 
        closer and more informed supervision. Together, these 
        efforts will hopefully decrease the chances of missed 
        opportunities such as occurred in the Madoff 
        investigation.

   We are streamlining a number of internal processes 
        and procedures. This streamlining includes the recent 
        delegation of formal order authority (which enables the 
        staff to issue subpoenas for testimony and documents) 
        by the Commission to me, and which I, in turn, have 
        sub-delegated to senior Enforcement staff. In addition, 
        Chairman Schapiro has abolished the prior Commission's 
        ``penalty pilot program'' (which required Enforcement 
        staff to obtain full Commission approval before 
        beginning settlement negotiations regarding civil 
        penalty amounts with public issuer defendants).

   We are developing, for use by the SEC, agreements, 
        similar to those used by criminal law enforcement 
        authorities, to secure the cooperation of persons who 
        are on the ``inside'' or otherwise aware of 
        organizations or associations engaged in fraudulent 
        activity. These agreements, the most important of which 
        is a so-called ``cooperation agreement,'' provide that 
        such persons must agree to provide truthful evidence 
        and testify against the organizers, leaders, and 
        managers of such wrongful activity, in exchange for a 
        possible reduction in sanctions imposed on them. Such 
        cooperation agreements have the capacity to secure the 
        availability of witnesses and information for the 
        Enforcement Division early on in investigations, and 
        thus minimize the number of harmed investors and 
        enhance access to persons with strong first-hand 
        evidence of wrongdoing. This will allow us to build 
        stronger cases and to file them sooner than would 
        otherwise be possible, thus preventing more investor 
        harm.

   We have hired the Division's first-ever ``Managing 
        Executive,'' who is focused on the Division's 
        operations. Previously, many administrative, 
        operational, and infrastructure tasks were handled by 
        investigative personnel, who did not necessarily have 
        the training or expertise to handle such matters, and 
        for whom these tasks amounted to distractions from 
        their investigation-related functions. By hiring 
        someone with workflow, information technology, and 
        process skills, these tasks can be centralized and more 
        efficiently handled, which will better support the 
        investigative functions.

   We are establishing an Office of Market 
        Intelligence, which will (1) oversee, coordinate, and 
        implement a system for the handling of complaints, 
        tips, and referrals that come to the attention of the 
        Division; (2) coordinate the Division's risk assessment 
        activities and act as a liaison for risk management 
        issues with other SEC divisions and offices, as well as 
        with Federal, state, and foreign regulators; and (3) 
        support the Division's strategic planning activities by 
        providing analysis and information and making 
        recommendations to my office. We are in the process of 
        hiring a Senior Officer to head this new office.

    I am confident that these significant changes--and others 
we will make along the way as we continue to self-assess and 
evaluate our progress--will reinvigorate our Division, restore 
investor confidence, and enable us to fulfill our mission of 
investor protection.

Q.2. What is the current regulatory capacity of the SEC, i.e., 
how many agents, examiners, investigators, etc., does the SEC 
have for all the individuals and businesses that must be 
overseen? Does the SEC need more resources to do its job 
effectively? Are there any additional enforcement powers that 
the SEC needs Congress to enact?

A.2. The scope and complexity of the financial industry has 
grown significantly over the last decade. Currently, the SEC 
oversees over 30,000 registrants, including 12,000 public 
companies, 11,000 investment advisers, 4,600 mutual fund 
families, 5,500 broker dealers, and 600 transfer agents. The 
SEC oversees the securities industry with a total staff of 
about 3,600 people. Enforcement staff makes up less than one 
third of that total. The entire Enforcement staff nationwide, 
including lawyers, accountants, information technology staff 
and support staff, is just above 1,100. The entire Examination 
staff in the Office of Compliance Inspections and Examinations 
is just over 725.
    Given the size, complexity, cross-border scope of the 
securities industry, and the huge volume of information that 
the agency receives, the SEC needs more resources to improve 
its ability to protect investors. For example, we receive 
hundreds of thousands of emails, letters and phone calls, of 
which tens of thousands are complaints and tips that require 
staff review for possible investigation. To be sure, we 
recognize our obligation to use the resources we have as 
efficiently as possible, which is why we have, for example, 
flattened our management structure to redeploy our Branch 
Chiefs back to being front-line investigators. But even with 
these and other steps to increase our efficiency, our resources 
are inadequate for the task we confront. Thus, we must, among 
other improvements, increase the number of qualified staff in 
the Enforcement program and invest in critical information 
technology initiatives. Because of several years of flat or 
declining SEC budgets, the SEC has faced significant declines 
in resources in recent years. In fact, despite the much 
appreciated budget increase received in 2009, Enforcement will 
still have significantly fewer staff than in it did 4 years 
ago, and its budget for improvements in technology remains 
lower than it was in 2005.
    The SEC has proposed several legislative measures to 
improve its ability to protect investors and deter wrongdoing. 
With respect to enforcement powers, the SEC has requested 
authorization to:

   establish a ``whistleblower'' program, which would 
        permit the SEC to set up a fund to pay significant 
        financial awards for information that leads to 
        enforcement actions.

   establish nationwide service of process in Federal 
        civil actions to streamline costs, avoid the need to 
        obtain duplicative depositions, and improve the 
        effectiveness of litigation by securing the 
        participation of live witnesses.

   impose collateral bars against regulated persons 
        across all segments of the securities industry, not 
        just one segment.

   seek penalties in cease-and-desist proceedings.

   seek penalties against aiders and abettors under 
        the Investment Advisers Act of 1940.

   add aiding and abetting authority to the Securities 
        Act of 1933 and the Investment Company Act of 1940.

   obtain improved access to grand jury materials.

   clarify the application of Section 106 of the 
        Sarbanes-Oxley Act of 2002 to allow the SEC and the 
        PCAOB to review workpapers and other documents of 
        foreign auditors.

Q.3. Compare the current culture of the SEC to that of the 
previous administration. What are the differences in attitude, 
approach to regulation, and management?

A.3. The current administration is fully supportive of--and in 
fact demands from our Division--the vigorous enforcement of the 
Federal securities laws. As noted above, Chairman Schapiro 
paved the way for the Commission to abolish the ``penalty pilot 
program'' and delegated formal order authority to me, which I 
in turn have sub-delegated to senior Enforcement staff. Both of 
these actions have demonstrated to Enforcement staff not only 
that swiftness and timeliness are paramount but that the 
Commission has confidence in the staff's judgment and 
professionalism. In addition, the Commission has removed 
certain other procedural impediments relating to Commission 
approval of enforcement recommendations; shown greater 
deference, where appropriate, to the staff on charging, 
settlement, and other case-related issues; and repeatedly 
emphasized, both publicly and in internal forums, the critical 
nature of the agency's mission and the staff's responsibility 
to fulfill that mission. Finally, the Commission also has been 
fully supportive of the Division's current restructuring 
efforts, including the dramatic changes in management and 
organization that are intended, in part, to promote personal 
and professional responsibility on the part of each and every 
staff member.
    With regard to approach to regulation, the Commission has 
been providing input and support for a variety of regulatory 
reforms, including those included in the Restoring American 
Financial Stability Act of 2009, and similar legislation 
prepared by the House Financial Services Committee. The 
Commission has also been active in rulemaking, including just 
in the last 2 months, rulemaking actions or proposals to 
increase the transparency of dark pools,\4\ prohibit the 
practice of flashing marketable orders,\5\ and bolster the 
oversight of credit ratings agencies by enhancing disclosure 
and improving the quality of credit ratings.\6\
---------------------------------------------------------------------------
    \4\ Dark pools are essentially private trading systems in which 
participants can transact their trades without displaying quotations to 
the public. See SEC Issues Proposals to Shed Greater Light on Dark 
Pools, SEC Press Release 2009-223 (Oct. 21, 2009).
    \5\ A flash order enables a person who has not publicly displayed a 
quote to see orders less than a second before the public is given an 
opportunity to trade with those orders. See SEC Proposes Flash Order 
Ban, SEC Press Release 2009-201 (Sept. 17, 2009).
    \6\ SEC Votes on Measures to Further Strengthen Oversight of Credit 
Rating Agencies,SEC Press Release 2009-200 (Sept. 17, 2009).
---------------------------------------------------------------------------
    The agency's renewed vigor as a whole is reflected in the 
work of the Division. Just in the last 2 weeks, the Commission 
has authorized the Division of Enforcement to charge a former 
CFO of a New York-based hedge fund with securities fraud and 
seek an order to freeze the CFO's assets,\7\ file charges 
against two complex insider trading rings involving hedge funds 
and corporate insiders, among others,\8\ initiate 
administrative and cease-and-desist proceedings against a New 
York-based investment adviser and others in a $24 million 
fraudulent scheme,\9\ file charges against former executives of 
a medical software provider with accounting fraud,\10\ and 
initiate administrative and civil actions against a New York-
based broker-dealer and two of its former managing directors 
for their roles in an unlawful municipal securities pay-to-play 
scheme involving Jefferson County, Alabama.\11\
---------------------------------------------------------------------------
    \7\ SEC v. Levy, Lit. Rel. No. 21289 (Nov. 10, 2009).
    \8\ SEC v. Cutillo, et al., Lit. Rel. No. 21283 (Nov. 5, 2009) and 
SEC v. Galleon Management, LP, et al., Lit. Rel. No. 21284 (Nov. 5, 
2009).
    \9\ In the Matter of Value Line, Inc., et al., AP File No. 3-
0913675 (Nov. 4, 2009).
    \10\ SEC v. Merge Healthcare Incorporated, et al., Lit. Rel. No. 
21282 (Nov. 4, 2009).
    \11\ SEC v. LeCroy and MacFaddin, Lit. Rel. No. 21280 (Nov. 4, 
2009) and In the Matter of J.P. Morgan Securities Inc., AP File No. 3-
13673 (Nov. 4, 2009).
---------------------------------------------------------------------------
Q.4. What in your view should be the non-negotiable issues in 
financial regulatory reform? In other words, if Congress does 
nothing else, what should they include in any reform proposal?

A.4. I share Chairman Schapiro's strong emphasis that we must 
close gaps in regulation, improve transparency, strengthen 
enforcement and establish a workable, macroprudential 
regulatory framework. The legislation also should improve 
consumer and investor protection, as well as address systemic 
risk--both the risk of sudden failures of the financial system 
and the longer-term risk that large, ``too big to fail'' 
institutions will be unintentionally favored at the cost of 
smaller, more nimble innovators.
    Regulatory gaps are exploited by market participants, thus 
heightening systemic risk. For example, major institutions use 
over-the-counter derivatives to engage in enormous, virtually 
unregulated trading in synthetic versions of other financial 
products. I would prioritize legislation to close these gaps by 
ensuring that similar products are regulated similarly.
    Market transparency should be another priority in 
legislation to reduce systemic risk. Increased transparency 
reduces risk by giving regulators and investors better 
information. When investors have better information about 
assets, liabilities, and risks, they can allocate capital away 
from risk or demand higher returns, thus providing a first line 
of defense against systemic risk. Transparency is particularly 
important in the area of ``dark pools'' in which securities are 
traded without oversight or information flow. Also, enormous 
risk resides in off-balance sheet vehicles hidden from 
investors and other market participants. Investors and others 
may allocate capital more efficiently if risks are fully 
disclosed.
    Strengthening enforcement is another important prong that 
addresses systemic risk by anchoring market players to the 
principles that protect consumers, investors, and taxpayers. 
Enforcement actions serve to deter and counterbalance the 
development of questionable business practices that help create 
systemic risk. As noted above, the SEC has identified several 
important tools that would make the SEC a more effective and 
efficient enforcer:

   establish a ``whistleblower'' program, which would 
        permit the SEC to set up a fund to pay significant 
        financial awards for information that leads to 
        enforcement actions.

   establish nationwide service of process in Federal 
        civil actions to streamline costs, avoid the need to 
        obtain duplicative depositions, and improve the 
        effectiveness of litigation by securing the 
        participation of live witnesses.

   impose collateral bars against regulated persons 
        across all segments of the securities industry, not 
        just one segment.

   seek penalties in cease-and-desist proceedings.

   seek penalties against aiders and abettors under 
        the Investment Advisers Act of 1940.

   add aiding and abetting authority to the Securities 
        Act of 1933 and the Investment Company Act of 1940.

   obtain increased access to grand jury materials.

   clarify the application of Section 106 of the 
        Sarbanes-Oxley Act of 2002 to allow the SEC and PCAOB 
        to review workpapers and other documents of foreign 
        auditors.

    Although the roles of regulation, transparency, and 
enforcement are critical in addressing systemic risk, each has 
potential shortcomings. Therefore, any financial regulatory 
reform should include a Financial Stability Oversight Council 
that can identify risks across the system, write rules to 
strengthen existing standards, minimize systemic risk, and help 
ensure that future regulatory gaps--and arbitrage 
opportunities--are minimized or avoided.
