Terra Extraneus

How did Bernie Madoff, the hands-down all-time winner of the title “world’s greatest thief,” get away for so many years with bilking so many investors out of so many billions of dollars?

Madoff awaits sentencing after pleading guilty to 11 felony counts in a Ponzi scheme by which he swindled investors out of $65 billion. Inmate 61727-054 has settled into his new home: a 7½ x 8-foot cinder block cell at the Metropolitan Correction Center in New York City.

How could Madoff get away with such a massive fraud for so long? Don’t we have regulatory mechanisms in place to protect investors against crooked brokers and investment advisors? Yes we do — sort of. If the Bernie Madoff super-con has provoked your ire, how do you react when you learn that one of the people entrusted with preventing such skullduggery was – wait for it – Bernie Madoff. Keep reading.

The Securities and Exchange Commission is the agency charged with enforcing federal securities laws. The SEC was established in 1934 in response to the 1929 crash and the Great Depression that followed. The SEC makes sure that public companies disclose information that investors have a right to know. It also brings enforcement actions against brokers, dealers and advisors who violate securities laws.

However, to a great extent, the SEC allows the securities industry to regulate itself. Come again? That’s right, our first line of defense to protect investors against dishonest brokers and broker-dealers is for the brokers to regulate themselves.

FINRA (the Financial Industry Regulatory Authority) is the self-regulatory organization entrusted by the SEC with making sure that its member brokerage firms and their registered reps follow the law. FINRA can initiate disciplinary actions against its erring members, and also, unhappy customers may file complaints with FINRA against their brokers, which are resolved through arbitration.

By the way, if you have never heard of FINRA, you probably have heard of its predecessor: the National Association of Securities Dealers (NASD). In 2007, the NASD became FINRA and took over enforcement of all major U.S. stock exchanges. So how well does FINRA do at keeping its own members in the financial sector in line? That is, how is FINRA doing besides failing to uncover the biggest swindle in the history of the industry?

According to the Wall Street Journal, in 2008 FINRA levied fines against financial firms totaling $40 million. $40 million? That’s a miniscule sum compared to the trillions being managed by the 5,000 brokerage firms, 173,000 branch offices and 659,000 registered reps that FINRA oversees.

In addition, customers filed about 5,000 arbitration cases with FINRA in 2008. The most common complaints were breach of fiduciary duty, misrepresentation, breach of contract and negligence. However, less than 500 arbitrations in 2008 survived the process all the way to an actual hearing and decision, and less than half of them (42%) resulted in an award for the claimant. About 2,000 more cases were settled or mediated.

To the securities industry, a few million dollars in fines and a couple of hundred arbitration awards is the equivalent of an occasional “traffic ticket.” The industry merely budgets these minor inconveniences as part of the cost of doing business.

And how does Madoff figure into this discussion? Well, believe it or not, Madoff is a former chairman of the NASD’s board of directors, a former member of the NASD board of governors, and a former chairman of Nasdaq, the stock exchange the NASD regulated. In other words, to put it in the simplest possible terms, while Madoff was stealing billions of dollars from unwitting investors, he was also serving as one of the top officials entrusted with making sure brokers didn’t get away with such things. Wall Street, we have a problem.

Dallas money manager Gary D. Halbert writes: “How could regulators have missed this one? Oddly, Madoff appears to have operated below the radar screens of the SEC and various other regulatory agencies for many years. Perhaps this was because of Madoff’s very high Wall Street profile and his service as co-founder, board chairman and governor of the NASDAQ for several years in the late 1980s and early 1990s.”

Halbert continues:

The SEC said it conducted two inquiries [including a 2007 examination] of Madoff in the last several years and did not find major problems. … I find this baffling! My company, Halbert Wealth Management, is a Registered Investment Advisor with the SEC. We have been through a routine examination by the SEC. Our broker-dealer firm, ProFutures Financial Group, has been through multiple routine examinations by the NASD, and more recently FINRA … I can tell you that these routine regulatory examinations – at least among smaller firms like mine – are rigorous. They typically have 2-3 examiners in our offices for up to two weeks at a time looking at all of our books … If my company was running a Ponzi Scheme, or stealing customer monies, I feel confident that the regulators would have caught us upon the next regularly scheduled examination. … Frankly, I have NO CLUE how the SEC failed to discover Madoff’s giant Ponzi Scheme in its various examinations.

Halbert’s observation underscores a frequent criticism of SEC and FINRA enforcement: that the agencies go after small fish to keep up appearances, while failing to uncover large-scale wrongdoing perpetrated by the major players. Madoff was one of the biggest, and he went undetected for years.

As I said, under our current system, our first line of defense to protect investors against dishonest brokers and broker-dealers is for the brokers to regulate themselves. That means that in the case of Bernie Madoff, we have been trusting history’s all-time greatest thief to keep himself honest. That’s not working. New SEC chief Mary Schapiro says a crackdown is coming. “The world has changed dramatically in the last year,” Schapiro recently told Congress. “There will be no sacred cows.”

Given recent headlines, tough talk is to be expected. Tough action is another matter. We’ll believe it when we see it.

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