The Whistleblower From the Madoff Scandal Tells How to Reform the SEC

Harry Markopolos is an American hero for trying to warn the Security and Exchange Commission (SEC) about the infamous Bernie Madoff, who, for years, pulled off the largest Ponzi investment scheme in history. In 1999, while an investment officer for an investment firm in Boston, Markopolos was

asked by his boss to find out why Madoff's wealth management company consistently did better than other financial firms. After about four hours of investigating and running Madoff's numbers, he realized that Madoff could not legitimately have made that high a return for his investors. However, with the help of three other coworkers, he spent the next nine years peeling back the layers on Madoff's scheme and trying to get the SEC to investigate.

While he did find a sympathetic ear from a few SEC investigators during that period, the agency on the whole ignored him and ducked his calls and emails. Undaunted, he kept investigating and finding more information showing that the Madoff fund was just a large Ponzi scheme only to have the SEC continue to ignore his information. In April of 2008, he filed his last report to them and had decided to give up trying to get the government to do the right thing. It was only because of the stock market crash that fall that caused Madoff to turn himself in, after defrauding $18 billion of his customers' money.

After the dust settled on the Madoff's case and he was sentenced to life in prison, Markopolos testified to Congress and wrote a book on his unsuccessful disclosures to the SEC. After trying for nine years to get the SEC to do their job, he had unique knowledge on what was wrong with the SEC in routing out fraud. He made hard-hitting suggestions on how to reform the SEC or abolish it and set up a new agency to oversee all corporate and financial markets. Here are the some of the suggestions from his February 4, 2009, testimony to Congress and his book, “No One Would Listen: A True Financial Thriller,” on what to do to make sure that the Madoff nightmare never happens again or persists for nine years.

From his testimony:

[A]s is typical for the SEC, too many of the staff lawyers lack any financial industry experience or training in how to conduct investigations. In my experience, once a case is turned into the SEC, the SEC claims ownership of it and will no longer involve the investigator. The SEC never called me. I had to call the SEC repeatedly in order to try to move the case forward and with little to no response. This may go a long way in explaining the SEC's long and consistent history of regulatory failures.

And, I wish to clear the air on a very important matter about ethics, public trust, civic duty and what this all says about self-regulation in the capital markets. The four of us did our best to do our duty as private citizens and industry experts to stop what we knew to be the most complex and sinister fraud in American history. We were probably a lot more foolish than brave to keep up our pursuit in the face of such long odds. What troubles us is that hundreds of highly knowledgeable men and women also knew that BM [Bernie Madoff] was a fraud and walked away silently, saying nothing and doing nothing. They avoided investing time, energy and money to disclose what they also felt was certain fraud. How can we go forward without assurance that others will not shirk their civic duty? We can ask ourselves would the result have been different if those others had raised their voices and what does that say about self-regulated markets?

To the victims, words cannot express our sorrow at your loss. Let this be a lesson to us all. White collar crime is a cancer on this nation's soul and our tolerance of it speaks volumes about where we need to go as a nation if we are to survive the current economic troubles we find ourselves facing; because these troubles were of our own making and due solely to unchecked, unregulated greed. We get the government and the regulators that we deserve, so let us be sure to hold not only our government and our regulators accountable, but also ourselves for permitting these situations to occur.

… I believe the one over-arching deficiency is that the SEC is a group of 3,500 chickens tasked to chase down and catch foxes which are faster, stronger and smarter than they are. It's painfully apparent that few foxes are being caught and that Bernie Madoff, like too many other securities fraudsters, had to turn himself in because the chickens couldn't catch him even when told exactly where to look. As currently staffed, the SEC would have trouble finding first base at Fenway Park if seated in the Red Sox dugout and given an afternoon to find it. Taxpayers have not gotten their money's worth from the SEC and this agency's failures to regulate may end up costing taxpayers trillions in government bailouts.

Amazingly, the SEC does not give its employees a simple entrance exam to test their knowledge of the capital markets! Therefore is it any wonder when SEC staffers don't know a put option from a call option, a convertible arbitrage strategy from a long/short strategy, the left side of the balance sheet from the right side, or an interest only security from a principle only security. By failing to hire industry savvy people, the SEC immediately sets their employees up for failure and so it should not be surprising that the SEC has become a failed regulator.

A good way for Congress to find out exactly what I mean when I say the SEC doesn't have enough staff with industry credentials is to query the SEC senior staff that come before your Committee. Ask them – “Do you have any financial industry professional certifications?” “Have you ever worked on a trading desk?” “What accounting, business or finance degrees do you hold?” “What financial instruments have you traded in a professional capacity?”

If Congress decides to keep the SEC in existence, then upgrading its staff, increasing its resources and wholly revamping its compensation model is in order. In order to attract competent staff, a test of financial industry knowledge equivalent to the Chartered Financial Analysts Level I exam should be administered to each prospective employee to ensure that new employees have a thorough understanding of both sides of a balance sheet, an income statement, the capital markets, the instruments that are traded and the formulas incorporated within these instruments. Talented Certified Public Accountants (CPA's), Chartered Financial Analysts (CFA's), Certified Financial Planners (CFP's), Certified Fraud Examiners (CFE's), Certified Internal Auditors (CIA's), Chartered Alternative Investment Analysts (CAIA's), MBA's, finance Ph.D.'s and others with industry backgrounds need to be recruited to replace current staffers. One thing the incoming SEC Chair should do right away is order a skills inventory of the current SEC staff to measure the exact skills shortfalls with which she is now faced. My bet is that Ms. Shapiro [the new SEC chair] will find that she has too many attorneys and too few professionals with any sort of relevant financial background.

I recommend that the Chair ask the SEC senior staff to provide her with a complete skills listing of the current SEC staff. Knowing how many SEC employees hold accounting, business and finance degrees versus how many hold law degrees would be a useful first step in quantifying the mismatches between skills on hand versus skills required to properly regulate. Determining how many SEC employees have ever worked on a trading desk would be particularly illuminating for the new Chair. Ditto for how many SEC employees are CAIA's, CIA's, CPA's, CFA's, CFE's, CFP's and FRM's. My bet is that the SEC staff is critically short of employees with credible industry experience.

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Besides upgrading its staff at the junior and mid-levels, the SEC needs to recruit foxes to join the SEC staff in senior, very high paying positions that offer lucrative incentive pay for catching foxes and bringing them to justice. The revolving door between industry and regulators can be precluded if the SEC recruits highly successful industry practitioners who have succeeded financially during their long careers and now want to serve the American Public by fighting securities abuses. The ideal candidates would all have gray hair (or no hair at all) and the SEC would be the capstone on their already illustrious careers. The main hiring criteria would be that each candidate would have to submit a written list of securities frauds that he/she would attack and list the estimated dollar recoveries for each of these frauds. These “foxes” would then be brought on board specifically to lead mission-oriented task forces dedicated to closing down these previously undiscovered frauds, restoring trust in the marketplace, thereby lowering the cost of capital and minimizing the regulatory burdens for honest American businesses.

My theory is that it's better to target your enforcement efforts at known fraudsters while leaving honest American businesses alone other than for occasional but thorough spot inspection visits. The fraudsters would be terrified but most businesses would be relieved if the SEC adopted the proposed regulatory scheme.

In summary, the SEC needs to stop hiring more of the same people it's already been hiring. What the SEC needs to do is test its staff, identify who to retain, get rid of those who either don't have the proper skills sets for their specific mandates at a 21st century level or don't want to obtain those skills, hire foxes from industry to lead the enforcement and examination teams, increase the pay levels and expand its educational budgets to ensure that the SEC becomes a forward leaning, learning organization that is more than a match for the industry it regulates.

… The SEC's main focus is to mindlessly check to see if registered firms paperwork is in order and complies with the law as written. If a firm happens to be a financial predator and is engaged in market-timing or selling auction rate securities, the SEC's lawyers will not be concerned because market-timing and auction rate securities aren't illegal, merely unethical. If that firm's paperwork meets legal requirements, the SEC will give these financial predators a free pass just like it has always done. You will note that the SEC has said that the market-timing of mutual funds was not illegal, which may explain why the SEC turned away the Putnam whistleblower, Peter Scannell, in 2003. The long-term, buy and hold mutual fund investors who lost that billions in returns to market-timers as a result of these actions and omissions, certainly would agree that this activity was unethical and they deserved to have this money returned to their retirement accounts. Auction rate securities issuers and investors ended up similarly disappointed thanks to the SEC's willingness to foster an “anything goes” climate on Wall Street. Enough of the securities' lawyers robotic simple compliance audits, let's shift the 21st century's capital markets to a higher plane and start to insist on ethical capital markets that give all investors a fair deal with full transparency.

… Unless everybody at a particular firm is dishonest, if fraud is present, at least these standard internal auditing techniques will result in a materially significant number of new enforcement cases. These are internal auditing techniques that well trained accountants, internal auditors and fraud examiners use when conducting audits or investigations. But at present, the SEC staff is so untrained, it's almost as if this concept of talking to a firm's employees is advanced rocket science. It is my belief that SEC examiners are so inexperienced and unfamiliar with financial concepts that they are literally afraid to interact with real finance industry professionals and choose to remain isolated in conference rooms inspecting pieces of paper.

… The goal should never be how many pieces of paper were inspected, but rather how much fraud was caught or prevented.

… Whistleblowers are the single largest source for fraud detection according to the Association of Certified Fraud Examiner's (ACFE) 2008 Report to the Nation (Chapter 3, page 22, www.acfe.com). According to the ACFE, whistleblower tips were responsible for detecting 54.1% of fraud schemes at public companies whereas external audits account for a meager 4.1% of fraud cases detected (note: the SEC would be considered an external auditor). Therefore whistleblowers are a full thirteen (13) times more effective than the SEC's external audits yet there is no Office of the Whistleblower. Who wouldn't want the SEC to become thirteen (13) times more effective?

Markopolos also suggested that a new and improved whistleblower bounty program be instituted so that whistleblowers have a place to bring their knowledge of fraud. That program has been set up as explained in two past Solutions columns. Here and here.

If the SEC is unable to be reformed because of entrenched bureaucratic ways, Markopolos suggests that it be abolished and a new overarching agency be created to oversee all financial markets. He outlines what this agency should look like in his 2010 book, “No One Would Listen: A True Financial Thriller”:

It seems logical to me that one super-regulatory agency be formed, perhaps called the Financial Supervisory Authority (FSA). It should have all of the security and capital markets and financial regulators underneath it. To simply command and control, to ensure unity of effort and eliminate expensive duplication, I would place under its command the Fed, the SEC, a national insurance industry regulator and some form of Treasury or Department of Justice law enforcement entity with a staff of dedicated litigators responsible for carrying out both civil and criminal enforcement for those three combined agencies.

All banking regulators should be merged into the Fed, so that only a single national banking regulator exists. Pension fund regulation should be moved from the Department of Labor to the SEC. The Commodity Futures Trading Commission should be brought into the SEC, which would then become the sole capital markets regulator. To ensure the highest degree of coordination, this super-agency would maintain a centralized database, a super-duper CALL center so that the details of any enforcement action by one agency would be online for all the other agencies to see and utilize. Spread the knowledge, share the experience, be bigger than the biggest bad guys. Bernie Madoff got caught for the first time in 1992, but apparently none of the investigators after the turn of the century knew about it. Cross-functional teams of regulators from the SEC, the Fed, a national insurance regulator and the Treasury or Department of Justice should be sent together on audits whenever possible to prevent regulatory arbitrage.

The SEC, the Fed and the national insurance regulator would be responsible for the inspections, while the Treasury or Department of Justice would be responsible for taking legal action against offenders. American businesses need and deserve a simple, easy-to-follow set of rules and regulations and they deserve to have competent regulation. Financial institutions currently pay high fees to support regulation, but neither they nor the public are getting their money's worth.

… If self-regulation is ever going to work, we need to find ways to advertise it, reward it and measure it. Currently, the SEC is doing none of the above. Every tool, every resource and every person has to be brought to bear in the fight against white-collar crime. Government has coddled, accepted and ignored white-collar crime for too long. It is time the nation woke up and recognized that it's not the armed robbers or drug dealers who cause us the most economic harm, it's the white-collar criminals living in the most expensive homes and who have the most impressive resumes who harm us the most. They steal our pensions, bankrupt our companies and destroy thousands of jobs, ruining countless lives. No agency is better situated than the SEC to attack high-level white-collar crime. Therefore, the SEC is too important to allow to continue to fail.

So far, Markopolos has not been too impressed with current SEC Chair Mary Shapiro, who was appointed to clean up the SEC in the wake of the Madoff fraud. Markopolos is a tough and persistent fraud investigator with a hard edge. I would suggest another reform for the SEC would be for Chairwoman Shapiro to hire Markopolos as a special assistant with the sole charge of making the necessary investigative reforms to the SEC. He has exactly the type of knowledge of the industry and of the failures of the SEC along with the edginess to truly make it happen if she is serious about reform.

At the very least, Markopolos' brave whistleblowing may inspire other whistleblowers to go through the new SEC whistleblower program and continue to expose fraud at a much higher level than the SEC internal fraud investigators. Markopolos has set the standard of how you can, with an understanding of the industry, unearth and expose the fraud that has robbed so many Americans.