The news has been full of commentary excoriating the Securities and Exchange Commission for its failure over many years to detect and stop the enormous fraud by Bernard Madoff. How could the SEC fail to discover this vast fraud carried out virtually in its lap?
It is true that the SEC, like most government agencies, is sometimes dysfunctional. It is not true that it is inept and staffed by incompetents. As a former SEC enforcement attorney myself, I would like to point out a few factors that help explain, if not excuse, how this could have happened.
1. It is easier to get away with a big lie than a small one. The enormity of Madoff's fraud is itself a key factor. That a man of such stature in the securities industry, who participated in its structuring and governance in many ways over the years, would have betrayed his clients and colleagues on such a massive scale seems beyond belief even now. As author Malcolm Gladwell pointed out in the bestseller "Blink," all of us employ, and cannot help employing, certain basic, bedrock assumptions as we go about our daily lives. One basic and usually correct assumption is that wealthy, prominent, successful people who have everything to lose do not, in general, want to go to jail and will not risk it by engaging in outright fraud.
The SEC staff, although it conducts its work with appropriate skepticism, is no more free of bedrock assumptions about how the world works than the rest of us. To question the very existence of Madoff's advisory business required either the kind of long study engaged in by whistleblower Harry Markopolos or perhaps a level of extreme skepticism that would (and likely will, in the coming years) make SEC examinations, inspections and investigations much longer and less productive than they are now.
2. The "simple step" of verifying facts with third parties is not so simple. Wouldn't the SEC have caught Madoff easily if it had simply reached out to third parties to verify that he made the trades that he claimed? Even if the answer is yes, there are good reasons why the SEC examination staff has historically been reluctant to contact third parties and customers. The mere act of doing so runs the risk of damaging the reputation of a legitimate adviser and, in the process, harming the adviser's investors. If investors get spooked by word that the SEC is looking at an adviser, the adviser can quickly be put out of business by the withdrawal of customer assets.
3. The SEC's limited resources have been rightly focused on protecting small investors, not sophisticated ones. The number of investment advisers in the United States, registered with the SEC and unregistered, greatly exceeds the SEC's ability to examine them. There are more than 11,000 investment advisers currently registered with the SEC and many more that are not. One estimate in 1998 put the time between examinations for certain SEC-registered advisers considered to be low-risk at 40 years.
Further, the Investment Advisers Act and the Investment Company Act embody in statute the idea that investors of large sums, such as those who invested with Bernard Madoff, have more ability to protect themselves and conduct their own inquiries into their advisers than small investors. Those who invest in standard mass-market products such as mutual funds have the protection of a set of extremely detailed regulatory requirements. Wealthy investors are free to take more risk by using alternative investments that do not have such requirements.
Given these realities, and the fact that the SEC's attempts to further regulate alternative providers such as hedge funds through rulemaking have been rebuffed by the courts, it should come as a surprise to no one that the SEC was not well-positioned to police an unregistered adviser running (supposedly) a private fund.
With regard to such advisers, the SEC is in a regulator's nightmare -- it has fraud jurisdiction and therefore, responsibility, without the resources to do the job.
Julie Smith is a leading securities litigation lawyer at Willkie Farr & Gallagher LLP and a former SEC staff attorney.