Thursday, March 10, 2011

Finally The SEC Gets Smart About Enforcement

From "SEC Looks Into Hedge Funds With Repeated, Above-Market Returns" by By Siobhan Hughes:
The U.S. Securities and Exchange Commission is scrutinizing hedge funds that consistently offer above-market returns amid a concern about whether outsized returns are a result of malfeasance, but budget constraints could hamper the agency.

"We're now doing things like canvassing all hedge funds for aberrational performance," SEC enforcement director Robert Khuzami told a House Financial Services Committee subcommittee Thursday. He said the focus was on "anybody who is beating market indexes by 3% and doing it on a steady basis."
As I wrote a year ago in my March 16, 2010 blog, "Madoff Is A Case Of SEC Dysfunction":
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?
If the SEC continues along the path of using heuristics, looking for commonality among investors and fraudsters and uses other experienced based warning signals to detect investment malfeasance, the Commission will find it can accomplish more to effectively deter fraud with fewer dollars and personnel.

As I said the above mentioned 2010 post:
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.
Hopefully, using market benchmarks to highlight excessive returns is only the beginning of the SEC's use of behavioral, statistical and market indicators to detect fraud. If the SEC continues to use and expands its use of its experience and knowledge base, a lot of investor fraud will be deterred for fear of discovery at minimal expense to the taxpayer.

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