Many consider the SEC’s nadir was their failure to detect the Madoff and Stanford frauds. Jonathan Katz, the former Secretary of the SEC, admits that the investment advisory division has always been “the Achilles heel of the Commission.” He said, “The SEC does not have the resources to adequately monitor investment advisors and Congress refuses to allocate additional money. State regulators can’t be relied on to do the SEC’s work because there is too much variation in the law state by state.”
Robert M. Fusfeld, , who worked at the SEC for 31 years, said, “The system is clearly broken. The SEC needs to do a major rethinking.”
Barbara Roper, director of investor protection at the Consumer Federation of America, believes that an increase in funding would solve many of the SEC's problems. The case of Spencer Barasch, the former head of enforcement at the SEC’s Fort Worth office, is illustrative that the SEC is a Gordian knot that money alone can unravel. Barasch, now in private practice, is expected to settle charges that he improperly represented Stanford before the commission. A scathing report by SEC Inspector General David Kotz, who is not your typical mealy mouthed SEC employee, found that Barasch was involved in repeated attempts to quash investigations into Stanford while in the employ of the SEC. After leaving the SEC, he then represented Stanford despite this being a violation of SEC ethics rules and being explicitly denied permission three times.
Barasch explained his egregious behavior this way- “Every lawyer in Texas and beyond is going to get rich over this case. Okay? And I hated being on the sidelines.” His greed illustrates that the revolving door between the SEC and Wall Street is one of the major causes of the SEC’s ineffectuality. The SEC lawyers, many of whom intend to eventually move to the more lucrative private sector, avoid launching investigations that will antagonize potential well-heeled clients.
Fraud examiner Harry Markopolos warned the SEC in great detail about the likelihood of something wrong in Madoff's operation. In addition, the SEC conducted several onsite inspections and audits. The vast majority of fraud by investment advisers escapes exposure simply because there has been no audit.
Buddy Doyle, a founder of regulatory and compliance consulting practice Oyster LLC, said, “The SEC only audits 9% of all investment advisers each year. In practical terms that means that investment advisers are audited, at the most every ten years. I have clients that have never been audited.”
Even if an investment adviser is audited, the fraud could still go undiscovered. “Examiners are under pressure to finish their audits quickly. The SEC likes to issue press releases trumpeting their record number of enforcement actions and fines, said Fusfeld. “This discourages investigators and examiners from doing complex investigations that take time and money.”
Katz, who recently wrote a 130 page report on reforming the SEC for the Chamber of Commerce, thinks the best way to combat investment adviser fraud is to mandate private regulatory audits. Compulsory regulatory audits would be analogous to the current requirement for public companies of an annual accounting audit.
Privatization of SEC functions may not be as radical as it seems. The SEC already outsources some of its oversight to the Financial Industry Regulatory Authority (FINRA), the self-regulatory organization (SRO) of the financial industry. Possibly due to its reliance on the financial industry for funding, FINRA was inefficacious in its supervision during the financial crisis.
Privatization of law enforcement duties has a long history. Abraham Lincoln probably regrets not being guarded by his regular Pinkerton detectives the night that John Wilkes Booth entered the theater. Municipalities regularly use private security officers to guard government buildings, the care of prisoners is often privatized, and bounty hunters are rewarded for catching fugitives. While the city provides a minimal level of police service, San Francisco is divided into patrol areas and licenses were auctioned off to private security firms. The private contractors, who can make arrests, write tickets, and conduct investigations, customize their patrol services to the individual needs of the resident. The independent companies answer to both a government body and the individual consumer.
Lawrence Reed, president emeritus of the Mackinac Center for Public Policy, said, “Communities that have experimented with alternative and private-sector police services introduce market principles such as accountability to the customer, cost consciousness, and competition into what is regarded as strictly a government function. The possibilities for privatization are limited only by the ingenuity and political courage of local leaders.”
“Privatization of some SEC functions is what my firm has been doing for 30 years,” said Todd Collins, a partner at Berger Montague. “The plaintiff’s securities bar is demonized for doing too much, just as the SEC is criticized for doing too little.”
The state of Indiana has been utilizing private contractors to audit broker-dealers since the 1990’s. With only a staff of 30, Chris Naylor, the zealous Indiana Securities Commissioner, has no choice but to use private firms to supplement his regulatory monitoring of more than 1800 broker-dealers and 132,000 brokers registered with the state. “In 2011, we sent out letters to 181 broker-dealers mandating that they undergo a compliance audit within 45 days,” said Naylor.
This program has allowed Indiana to earn a stellar record in prosecuting fraud. “During my term in my office, we have sent more than 50 people to jail. Vaughn Reeves, the family patriarch, was sentenced to 54 years in prison after being convicted of selling millions of dollars of fake church bonds in the name of the holding company Alanar,” he said.
Naylor credits the successful prosecutions to the close coordination between his Prosecution Assistance Unit with local prosecutors. “We don’t just send over fifteen boxes to prosecutors. We work complementary, hand to hand with them.”
It is doubtful that the SEC will implement a program using private contractors in the near future. The Occupy Wall Street movement has railed against Goldman Sachs, the Supreme Court, and the Fed, but has largely stayed silent about the SEC. It was not an outcry from the public but a cri du couer from Federal Judge Jed Rakoff that forced the SEC to modify their decades old "neither admit nor deny" policy.
CLSA bank analyst Mike Mayo, author of the revealing “Exile on Wall Street” wants investors to become more militant in their repudiation of bad behavior by withholding business from the offending banks. When he tried to raise the alarm that Citigroup violated Sarbanes Oxley by not disclosing a letter from the Office of the Comptroller of the Currency in their 2008 10-k, the public and media yawned.
“Despite several securities law violations, Citigroup has not seen a mass exodus of clients. I would like to see the day come when customers award their business to the brokerage houses that provide the best research, even if it is critical of the company,” said a clearly frustrated Mayo.
The research for this article was sponsored by the community reporting site Spot.us