Just how was Bernard Madoff able to elude the Securities and Exchange Commission with his confessed Ponzi scheme? What about those tough auditing rules imposed after the Enron and WorldCom scandals? Surely, such a massive fraud would light up enforcers' radar screens.

Of course, we know that the radar screens were dim, perhaps intentionally. But of the many regulatory failures that contributed to Madoff's ability to remain undetected, one in particular, a rule that exempted the tiny accounting firm used by Bernard L. Madoff Investment Securities LLC from new oversight rules, stands out as emblematic of the SEC's failure.

Madoff's auditing firm was Friehling & Horowitz, a three-person accounting firm. Because it didn't audit public companies, it wasn't required to register with the Public Company Accounting Oversight Board, created under the Sarbanes-Oxley Act in 2002 to help prevent fraud. But brokerage firms such as Madoff Securities are required to be audited by firms registered with the PCAOB. Yet the SEC provided a temporary reprieve to the rule for privately held brokerage firms and extended it several times.

Friehling is so tiny that industry experts say it was preposterous it was allowed to audit an operation the size of Madoff's. The accountants clearly missed warnings that might have tipped off a more capable firm to the largest Ponzi scheme in history. But because of the exemptions, it was able to continue auditing the Madoff firm without registering with the board. As a result, the PCAOB had no idea Madoff's accountant wasn't up to the task.

Waiving the rule was "consistent with the public interest and the protection of investors," the commission determined in 2006, the last time it extended the exemption.

The rationale for the SEC's position is unconvincing. Although a privately held firm may have few shareholders who need audited financial statements, it may have many customers who have an interest in knowing that appropriate auditing procedures have been followed. So with little fanfare, and in the wake of the Madoff scandal, the SEC quietly let the exemption expire at the end of 2008.

As a result, the oversight board announced in early January that accounting firms now must register with the board if they are auditing broker-­dealers whose fiscal years end this year.

But that dictate might not be as tough as it sounds. According to its mandate, the board only has jurisdiction over public companies and their auditors. "As a result," the board explained in its statement last month, "audits of nonpublic broker-dealers, like other private company audits, are not, under current law, subject to board inspection and cannot be the basis for board disciplinary action."

So even if a firm is registered, if it does no audits of public companies, the statement added, "the board cannot inspect it."

Congress must now rewrite the law to beef up regulators' authority. House Financial Services Committee member Paul Kanjorski, D-Pa., is already making plans to close the "loophole" that keeps the PCAOB from inspecting all auditors of broker-dealers. Kanjorski, who leads a subcommittee overseeing capital markets, says he is working on legislation to let the Public Company Accounting Oversight Board inspect and take enforcement action against auditors of closely held broker-dealers.

The PCAOB "has advised me that it needs statutory authority" to conduct the inspections, Kanjorski said in a letter to the SEC. "I would also like an explanation as to why the commission has not publicly called on Congress to take this action," he says.

The PCAOB is funded by fees paid by the registrants and is endowed with subpoena power and the authority to discipline accountants. The SEC, which oversees the board, oversees its five-member panel. The SEC should have spotted red flags from a December 2007 audit report filed by Madoff Securities, Kanjorski said in the letter. The report, publicly available at the SEC's Washington headquarters, "appears to offer several red flags that could have helped the commission to find this sizable investor problem earlier" and prevented losses for people who invested with Madoff in 2008, the lawmaker wrote.

New SEC Chairwoman Mary Schapiro then told the Senate Banking Committee during her confirmation hearing that she believes the agency may "need a legislative fix to the PCAOB's authority" over the audits of nonpublic broker-dealers. She added that she "would absolutely support" it.

Some states also demand that accounting firms should face a "peer review" by another accounting firm, but a loophole in the New York rules enabled Friehling & Horowitz to dodge that oversight as well.

The American Institute of Certified Public Accountants says David Friehling, who is a member, enrolled in the AICPA's peer review program, but the firm last completed a review in 1993. Since then, he has regularly checked off a box on a required AICPA form indicating his firm does not perform audits. The institute is now investigating whether Friehling lied.

That loophole is also closing. New York's state Senate passed legislation last month requiring peer review as a licensing requirement. Gov. David Paterson signed the bill Jan. 30.