New approaches to the custody of assets, whistleblowers, and jurisdictional issues are being developed while there is no evidence of any attempt to address the failure of FINRA, the private organization that oversees member broker-dealers, to expose Madoff's Ponzi scheme. Rather, the SEC--under the leadership of former FINRA executives--is poised to reward FINRA for its failure by recommending an expansion of its regulatory turf to include all investment advisers. Unfortunately, the net effect of the Madoff scandal may very well be a reduction in investor protection.
A Question of Custody
The Madoff scandal was a custody scandal. An analogy may be helpful here. When Child Services visits a home to check up on a child's welfare, a necessary predicate to assessing the child's well being is confirming that the child is actually in the home. The assets on Madoff clients' account statements, like children missing from the custody of their guardians, were not there. Regulatory inspections failed to discover that the assets were not there. The SEC accordingly has proposed new custody rules that require registered investment advisers with custody of client assets: 1) to submit to an annual surprise audit and, in certain cases, 2) retain a registered accountant to review their custody procedures.
These rules might marginally improve the safety of client assets, but they will not even apply to brokers like Madoff (although they will apply to registered investment advisers who invested with Madoff). Madoff was not a registered investment adviser until the very end of a fraud that began in the early 1990s.
This is not unusual. The SEC has spent several decades helping brokers avoid regulation as investment advisers, most notably by adopting an exemptive rule that was later declared illegal by a federal court and interpreting a narrow exemption from investment adviser regulation so broadly than any broker could rely on it. The Madoff Custody Rules will not apply to future Madoffs, whose regulation will be left in the hands of FINRA, their "self-regulator."
The Limits of Whistleblowers
Prior to the proposal of the Madoff Custody Rules, the SEC had announced the Madoff Whistleblowing Procedures. Many have blamed the Madoff scandal on the SEC's failure to act on tips provided by Harry Markopolos as early as 1999. The SEC should have investigated Markopolos' claims because they were credible and detailed, and the SEC plans to overhaul the management of whistleblower tips and seek authority to compensate whistleblowers. Again, these procedures may marginally improve investor protection, but they do not attack the root causes of the Madoff scandal.
Whistleblowers are an extremely inefficient means of detecting misconduct. The SEC receives hundreds of thousands of complaints every year, only a tiny fraction of which reflect illegal conduct. If the SEC committed the resources necessary to conduct a thorough investigation of every complaint, it would do nothing else. The potential benefits of the Madoff Whistleblower Procedures may be more than offset by the costs. Overinvesting in whistleblower management may divert resources that could generate greater fraud detection, such as through improved inspections by regulators--the professional
The SEC cannot be faulted here, for such overinvestment is an unavoidable response to the Madoff scandal. The behavioral sciences have long established our strong bias for converting, with the benefit of hindsight, unintelligible background noise in a cacophony of information into a siren that no rational person could have missed. Blaming the scandal on Markopolos' ignored tips also satisfies our bias for precise, simple explanations over accurate, complex ones. Policymakers' rabid focus on Markopolos' whistleblowing to the exclusion of more important regulatory causes of the Madoff scandal evidences both of these biases.
The SEC can
be blamed, however, for failing to inspect Madoff in 2006 after he registered as an investment adviser. A core part of an inspection would have been confirming that client assets were actually there. Never-inspected, new registrants should be inspected promptly. Never-inspected, new registrants that show up at your doorstep with $17 billion in assets under management should be inspected immediately. Click for next page >>