Thursday, 29 January 2009

Regulatory loopholes may have helped Madoff

Members of the US Senate Committee on Banking, Housing and Urban Affairs expressed disbelief and amazement at how regulators did not uncover the alleged Madoff Investment Securities Ponzi scheme. On Tuesday the committee listened to witnesses' testimony regarding regulatory and oversight concerns and the need for reform in light of the alleged Ponzi scheme.

Senators expressed disbelief that securities regulators, the Securities & Exchange Commission (SEC) and the Financial Industry Regulatory Authority (Finra), missed numerous "red flags" pertaining to Madoff, including the fact that he did not use a separate custodian for his investment advisory business, and that his accountant was not registered with The Public Company Accounting Oversight Board (PCAOB).
During the hearing one senator remarked: "... it is inexplicable how the SEC missed it (Madoff's alleged Ponzi scheme). It is as if there was a giant elephant standing next to the SEC in a rather small room for 25 years and the SEC never noticed the elephant or even smelt the peanuts on its breath. And it is not as if the SEC were not looking around the room."
The SEC is conducting its own investigation into its handling of the alleged Madoff Ponzi scheme. During Tuesday's testimony senior SEC officials stressed that their past examinations of Madoff were restricted to his broker dealer activities and did not include his investment advisory business which was registered in 2006.

The SEC said 10% of registered investment advisors were examined every three years, and that these examinations were limited in their scope and targeted specific activities. The other regulator in the spotlight regarding the alleged Ponzi scheme, Finra, said its jurisdiction was limited to Madoff's broker dealer operations and that this meant it could not be an "extra set of eyes".

However, during Tuesday's hearing, Professor John Coffee, Professor of Law at Columbia University, said Finra did have jurisdiction over Madoff Investment Securities. He also stated that registered investment advisors are required to use a "qualified" custodian. However, he said Madoff used himself and that he was able to do this because the SEC gave us an "illusory" rule which allows investment advisors, where it has a broker dealer affiliate, to use its own broker dealer to be its custodian.

Following the implementation of Sarbanes-Oxley, Coffee said broker dealers were supposed to use accountants registered with the PCAOB. However, he said on three occasions, the SEC adopted and extended an exemptive rule that said privately-held broker dealers did not have to use such a PCAOB registered accountant.

Coffee said Ponzi schemes were increasing in regulatory and frequency and tended to occur in unregulated hedge funds or alternative investments put together by investment advisors.

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