Hey, Obama, the SEC And CFTC Are Ripe for Consolidation

This week, Obama asked Congress for the power to consolidate several federal agencies such as the Small Business Administration and the Commerce Department because they were performing overlapping functions. Oddly, he did not mention the financial regulatory space, which is even riper for combination. Perhaps, he was mindful of the copious contributions to his campaign from Wall Street. 

Having two regulators, the SEC and the CFTC, did not prevent MF Global from failing. In fact, it might have hastened its decline. Professor Cornelius Hurley, director of Boston University’s Center for Finance, Law, & Policy, advocates combining the SEC and CFTC into one agency. He asserts that a merged agency would save money by eliminating the duplication of oversight and allow for a more efficient deployment of a staff and other resources.

“The collapse of MF Global suggests that we are paying a price for not combining the CFTC and SEC, which was suggested in a white paper about financial reform developed by the Treasury Department soon after Obama arrived in town,” he said. “Anyone can see that an organizational chart where two regulators are regulating the same space is absurd.”

He inveighs against the greed of members of Congress killed the unification efforts. “The House and Senate Financial Services Committees oversee the SEC while the Agriculture Committee administers the CFTC.  Members of the agricultural committee did not want to lose the tremendous contributions to their campaigns from the commodities firms,” explained Hurley.

Jonathan Katz, the former Secretary of the SEC, observed that SEC Chairmen from both political parties have supported merging the two regulatory agencies since 1980. “The United States is the only country in the world where the regulations of securities and derivatives is separated,” he said.

Mike Koehler, a professor of business law at Butler University, challenges the current practice of  the SEC and the Department of Justice (DOJ) to announce concurrent settlements with the same violating entity. With limited enforcement budgets, Koehler doesn't understand why the SEC is still prosecuting cases once the DOJ became involved. He thinks “the SEC step down after a case is referred to the DOJ”.

 He asks, “What purpose does it serve to have two separate enforcement actions of the same course of conduct?  Basking in the klieg lights, while holding a press conference to take credit for the enforcement action, sadly appears to the only purpose of dual prosecutions.

Federal Judge Jed Rakoff’s rejection of the SEC’s punishment in the Citigroup cast has caused many to reassess the types of penalties that should be levied against serial violators of securities laws. Low fines and SEC settlements have become a cost of doing business not a deterrent. "Companies will think twice about committing fraud if they can’t settle for chump change,” said Hurley.

Robert Fusfeld, a former SEC employee of 31 years and manager of litigation in the Denver office of the SEC for 15 years, suggests that current settlements include the potential punishment of the company if they break the law again. “If you violate again, the SEC will bring an administrative proceeding. We will pull your ticket (license), close you down for 6 months, or deny your right to bring in new business for a period of time,” he said. “If corporations knew that they could be barred from soliciting new customers or could potentially be closed for a period of time, they might think twice about violating the law.”

Although the SEC has rarely rescinded the license of a major New York firm, he emphasized that that the pulling of a license is standard procedure in law enforcement.  He noted, “When a business is caught serving someone under aged alcohol, they lose their license immediately. The SEC bars mom and pop, no name firms in the Midwest all the time. Yet, they do not use this weapon in their arsenal against major New York firms.”

Katz, who described his position at the SEC as the last set of eyes before an enforcement action was voted on, wants to see more SEC enforcement actions end in criminal prosecutions.

“Ponzi schemes are criminal activity. Injunctive relief, which is the sole weapon of the SEC, is not effective. There should be a criminal prosecution,” said Katz. “While the SEC routinely cooperates with the DOJ, I would propose that it become standard practice that they refer cases to local law enforcement if the DOJ declines to prosecute.”

It was shocking too many that Citigroup’s recent settlement was their fifth violation of the nation’s securities laws. Former NY Governor Spitzer, known as the “Sheriff on Wall Street during his tenure as NY State Attorney General, believes the first step in tackling the problem of corporate recidivism is to establish a career criminals unit that would be modeled after similar unit at the Manhattan District’s office.  He recalled, “When I was assistant district attorney in the career criminal’s unit, those that had committed more than two felonies were punished more severely. They were sent away for a long time,” he said. “For corporations that repeatedly offend, we need to increase exponentially the financial penalties and insist on structural changes such as compensation.”

“Right now, the SEC now uses restitution as a proxy,” said Spitzer. Under that current system, it is the shareholders, not the corporate executives that committed the wrongdoing, that bear much of the financial pain of a corporation’s malfeasance. Spitzer wants to change that. “There must be individual responsibility. Executives of violating corporations must be held responsible."

If the SEC is going to effectively change, Katz opines that it must be restructured from the top down. “The commissioners are overburdened,” he said.  “The problem is that too many decisions are being made at the staff level.”

 In his opinion, the number of commissioners needs to expand from five to seven. Currently, all five commissioners must vote on an enforcement action. Katz proposes that number be reduced to rotating working groups of three.

Barbara Roper, director of investor protection at the Consumer Federation of America, recommends changing the way the commissioners are chosen. She laments, “SEC commissioners can’t be straight up and down consumer advocates, which is the job that they are appointed to do. They must be acceptable to the financial industry, the very industry that they have been appointed to regulate.”

Most financial regulation experts are in consensus that no additional regulations are needed. “The collapse of MF Global violated long existing securities laws about customer account segregation not newer regulations like Dodd Frank, said Hurley. “Regulation is about individuals, culture.  Former Federal Reserve Chairman Alan Greenspan could have protected the mortgage borrower with powers given to him in the Home Owners Equity Protection Act had he been a different person – not a free market champion and devotee of Ayn Rand.”


The research for this article was supported by the community report site spot.us

Outsourcing the SEC's Oversight Function Could Strengthen the Agency

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

MF Global Bankruptcy Proves Need for Privatization of Financial Regulation

Here we go again. After all of the public outcry to rein in Wall Street, the eighth largest commodities trading firm in the United States has declared bankruptcy, three short years after the Lehman Bankruptcy.  This bankruptcy comes with a twist - $593 million of customer money is missing. The FBI, as well as the securities regulators, is now camped out the firm's headquarters. Will we ever learn?

I have been arguing for privatization of financial regulation for some time. This bankruptcy proves that we need to find a new paradigm for regulation. The regulations and regulators that we have now in place are not working. After the last financial crisis, it seems incredible that there were no rules in place to limit the leverage and concentration of trades done with firm's money. Once again, one trader has bankrupted an entire firm by taking outsized risks without any fear of a clawback of his earning.

My new paradigm for securities regulations is to empower outside lawyers, with a vote by the commissioners, with the ability to investigate securities and commodities firm, prosecute violators and pocket the fines imposed. I am working on this with the community reporting news site, Spot. us. More details here. 

Regulators are always Johnny Come Lately if they arrive at all. The CFTC did not detect the lack of controls over the segregation of client money. Exactly when MF Global clients  need his insight and wisdom the most, the head of the CFTC, Gary Gensler, has withdrawn from any involvement in the case due to his close relationship with the firm's former CEO Jon Corzine, his former boss at Goldman Sachs.  Funny, that close relationship never seemed to be a problem when Corzine was lobbying for what he wanted.

MF Global clients may lose as much as 40% of the capital in their personal accounts. Some of these losses could have prevented if regulators were paying attention,  Many institutional investors, having their ear to the ground, rushed to withdraw their money last week. A money manager in Chicago told the New York Times that his firm, hearing the rumors, pulled out $5 million last week. The CTFC gave sophisticated investors an advantage by not blocking last week's hastily arranged withdrawals. Maybe, the withdrawals can be clawed back like they are in a Ponzi scheme.

Corzine, who should have known better, was using the commodities firm, which was also a registered broker-dealer, as his own private casino. He was making huge bets, leveraged 40 to 1, on European sovereign debt with the firm's money.  If he won, he would become richer. If he lost, he would walk away as he has done.

The Financial Industry Regulatory Authority, a private organization, first raised the alarm about MF Global's risky bet. Then the panic spread. MF Global tried to sell itself to Interactive Brokers but the missing client money precluded a deal. The firm may not have been properly segregating customer money.; It  may have been using the money to shore up their under the water positions.

We might be able to write this off this speculative use of firm money as a one time incident except that Corzine and the CEOs of other commodity firms were lobbying the CTFC  to even further relax the rules surrounding commodity firms' uses of customers' money. Gensler wanted to tighten the rules, but apparently was unable to stand up to the bulldozer that is Corzine. The Republican commissioners were also against more regulation. Gensler isn't perfect. When he served in the Clinton White House, he was against additional regulation of derivatives.

The coziness of Gensler and Corzine may be unseemly but probably had very little effect on the final result. When I was at Wharton, Gensler and his twin brother were the most intelligent and best prepared students in every class I attended. If Gensler was blindsided by Corzine's actions, then probably no one could have seen it. When traders leave Wall Street and become Washington regulators, something appears to happen to them. It must be the brand of cool aid they serve in Washington.

While many treat Elizabeth Warren as a hero for dreaming up the Consumer Financial Protection Bureau, this bureau also would not have prevented the MF Global disaster.  More regulations and regulators are not the answer. Smart people in the private sector must be given tools by which they can protect the consumer. Regulators are not up to the job.

There may be one good thing to come out of the MF Global bankruptcy. While it is a commodity firm and not a bank, the bankruptcy should shore up support for the Volcker Rule, which is meant to curtail speculative investments by the banks.

Saving the SEC by Outsourcing Its Investigations

With the SEC admitting defeat and announcing a change strategy to target negligence instead of  the harder to prove fraud, I thought it was a good time to discuss my idea of saving the SEC by outsourcing its work. I am developing  my idea with the help of the community reporting site, Spot.us.

Private lawyers would be allowed to present a SEC staffed tribunal with customer complaints or credible allegations of violations of securities law. The tribunal would then put it to a vote to decide if the investigation by the private lawyers should proceed.. Once the investigation is authorized, the lawyers would be armed with full investigative powers of the government including subpoena. Upon the finding of wrong doing,  the staff tribunal would impose punishment. The lawyers would be paid from the fines imposed.

Everyone knows about the failure of the SEC to detect the Madoff fraud. More recently, SEC attorney Darcy Flynn blew the whistle and revealed that the SEC has hindered investigations and broken National Archive rules by destroying documents that are required to be kept for 25 years.

 My personal experience of  trying to inform the SEC about a potential fraud might be more illustrative of the reasons that government oversight of the securities markets is not enough. When I discovered several years that serial con man Glenn Manterfield of England had registered the hedge fund Lydia Capital that he co-founded with Evan Andersen with the SEC, I immediately contacted and alerted them that he had stolen money from me and clients of mine.

I also informed them that he lied about his criminal history on the SEC  form ADV. The form asks about the applicant's criminal history and requires registrants to update the SEC about any developments. He had checked that he had no criminal history and had not informed him of his latest arrest, which occurred after his registration. The SEC indictment later said he lied about his extensive criminal record.

Although we regularly throw around the term international financial markets, the SEC has not adjusted to the globalization,. The SEC can only access American fingerprint databases so there was no way to discover Manterfield's British criminal history. A SEC lawyer told me that they had to get special  permission to make a transatlantic call so they have no regular ability to check on international applicants for registration. It is negligent to register international applicants if you can not run the proper background checks.

Requiring hedge funds to register was one of the knee jerk responses of Congress to the Wall Street bailouts, but it is not the right answer. No one contemplated the pitfalls of registration. Manterfield's bone chilling retort to why he registered shows the downfall of this lack of foresight - "We were just two guys with an idea. The SEC registration gave us credibility."

When the SEC did not proceed with an investigation, I contacted the office of William Galvin, the Secretary of the Commonwealth of Massachusetts. After Galvin's office started the prosecution, a light finally went on at the SEC and they took over the prosecution. They later apologized to me for ignoring my tip.

The SEC closed Lydia and appointed a receiver to recover assets. They imposed a lifetime ban and a $2.91 million fine on Manterfield for defrauding 60 investors of $34 million. 

Unfortunately, this was not the end of the story. Even though I warned the SEC that Manterfield could be running multiple cons at once, they didn't check. I complained again to Galvin's office. They issued a cease and desist order for his second entity, Osiris FX.  The US Attorney of Massachusetts, which rarely prosecutes securities violations, declined to prosecute even though they had the cooperation of the British police.

Without my intervention and a little luck, Lydia Capital could have defrauded investors for years. Lydia Capital happened to be headquartered in Boston. Massachusetts' Galvin is one of the few state law enforcement officials aggressive about prosecuting securities crimes. Anywhere else in the country, my warnings would have also been ignored by the state authorities.

Galvin stepping in might have saved the day for Lydia's investors but it is not a permanent solution. We need cops patrolling the securities beat. From my varied interactions with the SEC, I do not think that they are up to the job. After SEC investigator Gary Aguirre was fired after he vigorously pursued Morgan Stanley CEO John Mack too aggressively, they may no longer feel safe challenging big names on Wall Street. The revolving door between the SEC and Wall Street may also play a role in their lackadaisical attitude.

Outside lawyers need to step in and supplement the investigative staff of the SEC, We already outsource some aspects of  law enforcement such as bounty hunting and allow private contractors like Blackwater defend our country.  Private SEC investigations would be the next logical step.

If you have any doubts, remember "Inside Job" direct Charles Ferguson's Oscar acceptance speech. He said, "Forgive me, I must start by pointing out that three years after a horrific financial crisis caused by fraud, not a single financial executive has gone to jail - and that's wrong."

Matt Taibbi's Must-Read Hatchet Job on the SEC

I think Matt Taibbi of Rolling Stone is the second greatest financial journalist of our generation after Michael Lewis. I did not see his latest piece, "Is the SEC Covering Up Wall Street Crimes?" on businessinsider so I decided to post it.

Against National Archive rules, the SEC has been destroying documents from MUI (investigations that did not result in prosecutions) that they should have been keeping for 25 years. This has the effect of whitewashing suspicious but legally unprovable activity. It also eliminates the possibility of investigators seeing a pattern.

I came away from the article with the realization that the culture of the SEC has not changed even after the Madoff fraud and a financial crisis that almost brought the country to its knees. The current director of enforcement at the SEC, Robert Khuzami, was hostile to the whistleblower Darcy Flynn when he brought the improper destruction of documents to his attention. Khuzami also refused to cooperate with a recent inquiry from Senator Grassley about the infamous hedge fund SAC.

I am scared for investors. Read Taibbi's article. Just not before bed or it will give you nightmares.