[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
U.S. GOVERNMENT PRINTING OFFICE
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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?
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\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
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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.
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\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\
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\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).
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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\
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\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\
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\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.
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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\
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\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\
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\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.
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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.
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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\
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\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).
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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.