Madoff Is A Case Of SEC Dysfunction

Below is a comment I posted on "Regulators are from Mars, Investors are from Venus?" by Lisa Fairfax on the Conglomerate Blog.

Madoff is a case of SEC dysfunction.

Madoff's crime is a simple form of affinity fraud. A gullible group with some cohesion, similarities and member trust is targeted, such as church groups, religious groups, ethnic groups, immigrant groups, country club members, etc. The fraudster relies on members of the group to introduce other members to the fraud. The referral and implicit trust among members of the group makes the job of the fraudster easier than if he targeted strangers.

The SEC has prosecuted affinity frauds for years. Yet, it does not ask questions during an exam to determine if the investors have any commonality that would suggest the possibility of an affinity fraud. A simple question such as how did you find the investor would have indicated to the SEC that most of Madoff's investors were referrals from a few small social circles and indicated the extremely high likelihood of affinity fraud.

Similarly, standard audit procedures include selectively confirming transactions with third parties, such as vendors, banks, customers, etc. Only in the last year, after Madoff, has the SEC adopted these well-established audit procedures. A true audit process would have found that the assets did not exist. The SEC at the time of Madoff's fraud did not even have standards for outside audit firms or standards to determine if there were possibilities of conflict and collusion between the auditors and the firms.

Furthermore, Madoff's reported long run of positive returns to investors should have been a signal to the SEC. The returns were too good to be true and unlike the returns of other investment managers. Several banks and brokerage firms did not do business with Madoff because his returns were suspicious. Why is the SEC isolated from the information available to other investment firms on the street?

We have an SEC that does not incorporate its own knowledge of fraud into its examinations, does not use standard business practices and audit procedures and has isolated itself from common industry knowledge. It is not due to a lack of staff or funding. It is an SEC internal cultural problem. The SEC had enough funds to investigate and examine Madoff. The SEC did a poor job and did not find any problems.

The Madoff case shows that the SEC is ill prepared to protect investors. The Commission needs to develop heuristics based on its history with investor fraud and act more wisely with the funds and tools it has. It needs to improve communication between itself and firms on the street. It needs to rid itself of most of its lawyers and remove the adversarial process that is part and parcel of its culture.

If one actually reviewed the SEC's ability to prevent investor fraud since its founding, I think one would probably find that the SEC does a poor job of preventing investor fraud.