Why did the SEC fail to spot the Madoff case?

By Mark Williams
January 6, 2009

mark_williams– Mark T. Williams, a finance professor at the Boston University School of Management, is a risk-management expert and former Federal Reserve Bank examiner. The views expressed are his own. –

With Congress now probing the Bernard Madoff case, some claim the SEC missed the risk because of under staffing. Even if that’s an issue, one SEC enforcement officer using basic risk-management skills, asking probing questions, searching for clear answers, and exercising timely follow up could have helped in detecting this fraud before it grew to such a staggering size.

The central flaw at the SEC is that its current oversight approach is not sufficiently risk focused. Moreover, any changes in approach have tended to be in response to a specific event instead of incorporating an overall risk-based approach across all areas under their regulatory purview.

The SEC is responsible for overseeing registered broker-dealers, transfer agents, clearing agencies, investment companies and investment advisers, yet there is not a consistent risk approach used in all of these examinations. For example, in 2003, after widespread unlawful trading practices surfaced in the mutual fund industry, the SEC took steps to take a more risk-based approach.

Yet these higher examination standards were not viewed important enough to be applied to investment advisers such as Bernard Madoff. The weakness in the SEC’s existing examination approach can be best highlighted by the fact that, in the last 16 years, while Madoff’s firm was investigated 8 times, no fraudulent activities were ever uncovered.

As part of their broad regulatory mandate, the SEC is responsible for overseeing over 10,000 investment advisers. This agency needs to adopt a “where there is smoke there is fire” approach. The SEC must become risk focused in the scope and frequency of its monitoring and surveillance operations. Given the significant number of investment advisers, even if we assume that 99 percent are low risk, that still leaves 100 that need to be closely monitored and scrutinized.

The SEC should keep a detailed list of the top risky investment advisers and use it to prioritize and set review frequency. Currently, there is no clear indication that the SEC links review frequency or scope of exam with level of perceived riskiness. Former SEC Chairman Arthur Levitt recently indicated that only 10 percent of investment advisers are examined every three years. A wealth of new fraud can be dreamed up, hatched, and perpetrated at such firms in the interim.

Instead, the SEC must develop a stronger risk filter that will quickly flag investment advisers which exhibit higher risk characteristics. Such red flags should center on corporate governance issues such as level of independence and checks and balances. For example, does the investment adviser clear its own trades or do they use an independent third-party? Who is this third-party? Are they well known and do they have a good reputation? Who is the accountant for the investment adviser and what is their reputation and size?

Other warning indicators can come in the form of formal as well as informal complaints. What is the nature and frequency of such complaints and is a particular firm being consistently implicated?

Importantly, the SEC needs to develop a better “whistleblower” framework so it can quickly identify and respond to such complaints. If managed properly, the thousands of e-mails the SEC gets annually can be a powerful risk management tool to identify and respond to potential risk.

The SEC maintains a website to collect complaints and tips. However, the fact that whistleblower tips about Mr. Madoff’s firm were received as far back as 1999 and yet they were never fully vetted speaks to the weakness in the SEC’s risk filtering and response system. The SEC must be able to quickly sort through creditable allegations. Once such allegations have been identified, they must be prioritized, investigated and resolution reached in a timely manner.

Internally, the SEC should revise policy and include a clear action plan, process, and timeframe to address whistleblower complaints and tips. This would establish immediate accountability. To further encourage SEC investigators to comply with new response policy, standards must be directly linked to annual employee performance reviews.

In 1920, long before the SEC was established, Charles Ponzi was able to keep his scam running and undetected for only eight months. Fortunately, this fraud quickly unraveled when local media began to raise and followed up on some basic risk-related questions. The Madoff case and the failure of early detections is a further indication that the SEC should move to a more risk-focused approach.

Doing so, when coupled with timely follow up and consistent risk-based examination practices will help restore market confidence that the SEC can and will protect us against investment fraud.

29 comments

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All broker transactions that I do in my IRA and individual accounts have an SEC fee. If all investors read the statements from their broker or mutual fund the SEC fee’s indicate how much trading is going on.

It would be a self check if there were no fee’s paid to the SEC but the mutual fund said they traded successfully to beat the market the SEC payment would show immediately the facts don’t match the hype.

In addition it would allow the SEC to quickly register a complaint % based on paid fees for brokers. IE = Broker A has 5 complains / million SEC fee paid, vs Broker B with 12 complaints / million SEC fees paid.

No new regulation but applying statistics and common sense to existing regulation.

From what I gather a MadeUP fund will show a fraudulent amount of SEC payments and that can put a spotlight on fraud before it gets to the billions.

Posted by Chris Hamilton | Report as abusive

I’ll bet my bottom dollar the SEC was well aware of Mr. Madoff. He seems like small fish compared to the derivatives scandal that is being covered up. Madoff seems like the patsy in this. Now the fed’s are going to claim need for more control and regulation and the public is buying it. Sounds just like what we need here in the land of the free.

Posted by jason | Report as abusive

I am not so surprised when I hear about these “scandals” anymore. I don’t blame any one political party more than the other. I can’t even really blame the regulatory agencies that were otherwise stripped of their authority by those “in power.” (Who are invested in making money too ex. see corporate/banking/insurance lobbyist) How long are we going to pretend that the US hasn’t been on a crash course? We can’t just let corporations and lending institutions go unregulated and trust they are looking out for whats the best practice, they are looking out for maximum profit. And when they fail we (taxpayers) bail them out- which by the way is the antithesis of a free market economy!! And average American consumers are fine just so long as they can keep buying stuff they don’t really need because it makes them feel as though they’re keeping up with that family on the TV. But when they fail they can go hungry and homeless. As a citizen of the United Corporations of America, the “oh my! oh no!” just rings so hollow. I am not so surprised anymore.

Posted by KAS | Report as abusive

I agree with the column, but I think the SEC’s biggest failing came with the failure to properly regulate trading itself in the markets. The unbelievable leverage being applied, both short and long, had to have set off some warning bells.

The markets have become one big casino, where insiders are the house, and everyone outside became unwitting gamblers–that would be pension funds, 401ks, mutual funds and just about everyone else who’s seen their life savings halved.

Even today, the SEC hasn’t re-instituted common sense trading rules that worked for decades.

Mr. Jason above, complains about the mess, and then makes remarks to the effect that more effective oversight is not warranted in the land of the free.
He is being inconsistant. “Land of the free”, does not mean “We trust you not to be a thief”. Madoff a patsy?
I’ll use that excuse in the future.

Mr SRk,
I didn’t complain just stated a fact that I believe. Mr. Madoff is being used as a patsy. I think the derivatives scam is the beast they want to cover up as soon as they can. If they can focus the public attention on one thing they can get away with another. I absolutely believe that honest enforcement of the rules we already have will be sufficient. More regulation and consolidation is not the answer. Here in the land of the free we should be alot less friendly to federal government centralization of our financial laws. A very consistent statement Mr. SRK. We need to obey the laws we have not to create more.

Posted by jason | Report as abusive

50 billion and he never executed one trade. The SEC was paid to look the other way through political contributions. Madoff was a big dollar donor. 50 billion is a drop in the bucket compared to the real organised crime (AIG Merrill Countrywide etc) that has crippled the world economies. I agree with others this is a smoke screen for the real theft which is in the multi trillions. Repackaging worthless subprime paper into vehicles that were sold to inocent investors eclipses this scheme by a landslide and no one is going to jail or even being investigated. Credit default swap Translation ponzi scheme. Risk managment? What managment? These are the same firms we are giving bonuses/bailouts to. The SEC is corrupot dont fool yourselves into thinking otherwise if it looks like a duck quacks like a duck its a corrupt duck. An 8 year old could have figured out Madoff was a theif. Now we are hearing he acted alone come on people people wake up. Brokers were supplying extensive documentation detailing the ponzi scheme and the SEC ignored them. Repeatedly. Does this sound like regulation to you? I believe the last estimate on the sub prime debackle was 4 trillion dollars this make 50 billion look like a bad joke. Dont get me wrong Madoff should be in jail for the rest of his life but the real crime isnt even being looked at because as I said earlier the SEC is corrupt and all of wall street was involved.

Posted by RICH | Report as abusive

Prof Williams seems to equate size with quality: “Who is the accountant for the investment adviser and what is their reputation and size”.
Can he cite any research correlating size of accounting firm and reduction in risk of loss?
According to the anecdotal evidence at my disposal, more has been lost in undetected frauds committed by clients of the Big Five – oops, post-Enron, make that four – than to clients of their smaller competitors.

Posted by Colin | Report as abusive

I sympathize with all of you guys.Just few remarks.
SEC or any other regulation will not/would not/can not save your money from fraudsters.Only you can. Dont trust blindly to any adviser, diversify your investments, invest in ETFs, dont trust in high return funds.What comes up must come down sooner or later.
Educate yourself, there are huge collection if good books in the USA. Best wishes to you all from Croatia