One year ago today, Bernard Madoff was arrested and charged with securities fraud in a $50 billion Ponzi scheme that affected thousands of investors. It was an investment scandal that rocked Wall Street and raised concerns and awareness on all levels. As a result, stricter regulations and much needed reforms and due diligence on how the Securities and Exchange Commission intends to respond to and review allegations of fraud have been implemented.
Briefly stated those reforms include:
- Revitalizing the Enforcement Division: Specialized units enabling staff to concentrate their expertise in focused areas and help detect patterns, links, trends and motives.
- Revamping the Handling of Complaints and Tips: Creating a centralized system for managing complaints and tips and working on a system which will help to reveal links, trends, and patterns that might not be visible when each complaint is examined one at a time.
- Encouraging Greater Cooperation by ‘Insiders’: Crafting agreements to secure the cooperation of individuals who are on the “inside” of companies engaged in fraudulent activity (i.e. insiders who offer truthful evidence and agree to cooperate and testify would be eligible for a possible reduction in sanctions).
- Enhancing Safeguards for Investors’ Assets: Proposed rules that would encourage investment advisers to place their clients’ assets in the custody of an independent firm.
- Surprise Exams: Requiring investment advisers who control or have custody of their clients’ assets to hire an independent public accountant to conduct an annual “surprise exam” to verify those assets actually exist.
- Third Party Reviews: Applicable to investment advisers who do not use independent firms to maintain their clients’ assets, such advisers would be required to obtain a third party written report assessing the safeguards protecting clients’ assets. The report would, among other things, describe the controls that are in place to protect the assets, the tests performed on the controls, and the results of those tests.
- Improving Risk Assessment Capabilities: Increasing collaboration with third parties and other government agencies. Creating a new Division of Risk, Strategy and Financial Innovation which will provide new expertise in risk assessment, financial products and financial engineering.
- Conducting Risk-Based Examinations of Financial Firms: Dispatching examiners to conduct a “sweep” of firms that present certain risk characteristics to ensure that the clients’ assets in fact exist (i.e. risks include advisers whose clients’ assets are held with an affiliate; hedge funds that seem to have “smooth” or outlier returns; firms that use an unknown auditor or no auditor at all; firms with a disciplinary history; and broker-dealers that sell an affiliate’s hedge fund or limited partnership).
- Improving Fraud Detection Procedures for Examiners: Examiners reaching out to third parties such as custodians, counter-parties and customers during exams to verify the existence and integrity of client assets managed by the firm.
- Recruiting Staff with Specialized Experience: Bringing in new staff with diverse skill sets to expand knowledge base and improve the ability to assess risk, conduct examinations, detect and investigate wrongdoing, and focus our priorities.
- Senior Specialized Examiners: Hiring new staffers who have specialized experience in areas such as trading, operations, portfolio management, options, compliance, valuation, new instruments and portfolio strategies, and forensic accounting.
- Additional Staff with Capital Markets Expertise: Hiring staff with expertise in modern financial products and techniques — such as derivatives and hedge fund activities.
- Expanding and Targeting Training: Staff training related to hedge funds and specialized products; derivatives and options; the verification of trades and custody arrangement; and the use of databases maintained by exchanges and clearinghouses, among other things.
- Improving Internal Controls: Quarterly review program where managers will meet to review and discuss all open exams and investigations and address whether additional expertise is needed to resolve issues, finalize exams and bring investigations to conclusion.
- Advocating for a Whistleblower Program: In proposed legislation that the Chairman sent to Congress, a fund would be established to pay whistleblowers using money collected from wrongdoers that is not otherwise distributed to investors.
- Seeking More Resources: The SEC has been seeking additional funding to hire more examiners who can go into more financial firms to see whether they are in compliance with the law, as well as for more enforcement staff who can bring more enforcement cases when fraud and other violations of the law are found.
- Integrating Broker-Dealer and Investment Adviser Examinations: The SEC has instituted several measures to integrate the broker-dealer and investment adviser examination programs. In addition, the examination program has expanded opportunities for examiners to cross-train and increase coordination between broker-dealer and investment management staff on their examination plans.
- Enhancing the Licensing, Education and Oversight Regime for “Back-Office” Personnel: Working with senior SEC staff, FINRA has committed to establish a new system to enhance the oversight and professional requirements of personnel performing back-office functions at broker-dealer firms.
While this year has been a difficult one for the investment community, the reforms outlined above present an opportunity to prevent another “Madoff” catastophe from occuring. We are living in a culture of accountability where due diligence is no longer an after thought but a preemptive step required by all investors and the financial industry as a whole.
