The SEC, Inspections, and Bernard Madoff

The WSJ noted that the SEC had looked into the activities of Bernard Madoff on a number of occasions without spotting the alleged fraud that public sources are describing as a $50 billion ponzi scheme.  The article noted that Madoff's market making business had been inspected by the SEC in 2005.  This was almost certainly the Office of Compliance Inspections and Examinations (which has responsibility for the inspection of investment advisors and broker-dealers).  The failure highlights a structural problem within the SEC.

OCIE was created back in 1995 under Chairman Levitt.  While any number of reasons have been offered for the creation of the office, the removal of inspection authority (primarily from the Division of Investment Management and Market Regulation) and its insertion into a separate, independent office created a system of inspections less beholden to an operating division and, presumably, less likely to be subject to industry influence and capture.

But independence came with costs.  For one thing, it separated the inspectors from the operating divisions in the SEC with the expertise over the relevant industries.  The result was likely some loss of understanding of the business by OCIE which in turn made the inspections less effective. 

For another, the Office has been something of a step child within the agency.  Most division directors stay a few years in the agency then parlay the post into a lucrative private practice.  It provides both an incentive to attract the best and an opportunity for turn over that can be both dislocating but also a way to introduce new ideas and energy.  Lori Richards, the head of the office, is the first and only director of the office, having been appointed back in 1995.

The office also, in many ways, has an impossible task.  On the one hand, it can be criticized if it allows most brokers/advisors to remain uninspected (there are 6700 brokers alone in the US).  As a result, the office produces a high volume of inspections.  As Chairman Cox recently described:

• In FY 2007, SEC examiners in our Office of Compliance, Inspections and Examinations conducted more than 2,400 examinations of investment advisers and investment companies, broker-dealers, transfer agents, and self-regulatory organizations. Overall, 75 percent of investment adviser and investment company examinations and almost 82 percent of broker-dealer examinations revealed some type of deficiency or control weakness. Importantly, most examinations resulted in improvements in the firms' compliance programs.

While large firms are given "enhanced focus," the reality is that much of the inspection process focuses on technical compliance, a relatively easy thing to monitor through checklists and other objective measures. 

To drill down far enough to uncover frauds like the one apparently perpetrated by Madoff (and, presumably, one that was actively concealed), OCIE would need enhanced resources and increased expertise.  Among other things, this would require a staff that had the time, the understanding of industry and, ultimately, a thorough knowledge of the business that was subject to the inspection.  It might even require enhanced credentials.  A law degree is not required to become a compliance examiner.  Without legal training, recognizing signs of illegality, including fraud is likely more difficult.

Unlike Enforcement, this is a pro-active office.  It inspects with or without evidence of violations.  It is therefore in a position to uncover significant problems before they occur.  But to do so means that the office must have the resources and the staff necessary to accomplish the task.  As with so many things at the Commission these days, this type of reform will need to await regime change.