A Tale of Shorn Sheep, Slaughtered Pigs and Keystone Cops
No One Would Listen: A True Financial Thriller is Harry Markopolos's own story of a futile eight-year quest to expose the $65 billion Madoff fraud. As an SEC alum myself, I was not looking forward to reading a blow-by-blow description of gross incompetence at my alma mater as it were. I stared at that brown and black book jacket sitting on my desk much as I stared at one memorable dinner plate from my childhood, holding a generous dollop of slimy, similarly colored mushrooms that seemed to dare me to return its limpid gaze.
And, where would the "thrill" come from as the scheme sans apparent motive abruptly came to an end? Madoff himself had effectively written the anticlimax when he turned himself in to the authorities before he would suffer the indignity of being properly caught in the act. I did know that I would be reading about grave mistakes having been made, from which everyone with more than a passing interest in U.S. capital markets would have something to learn. Thusly did I know I would be compelled to read No One Would Listen, much as I knew the two-headed power of our home well enought to predict with absolute certainty that I would be eating those horrible looking mushrooms before TV time.
The mushrooms actually tasted pretty good (my Mom is still a wonderful cook), and much to my surprise, No One Would Listen was might tasty, too. The red meat was, as expected, the SEC's incredible ineptitude; a case of truth stranger than fiction served blood rare. However, the role of "feeder funds" was more complex than simple meat and potatoes aiders and abettors; although to be sure, there was enought of that.
Some feeder funds were managed by third- and fourth-generation rich kids who were as lost as babes in the woods when it came to rigorous financial analysis. All they really cared about was that Madoff had that je ne sais quoi they thought they could trust; to give the blue bloods the excess returns that they were entitled to by their place in the natural order.
A more insidious group of feeder funds portrayed themselves to investors as due diligence mavens, when in actuality they (along with the audit firms involved) did little more than go through the motions. Like the blue bloods, they merely accepted everything Madoff supplied them without any real verification.
All Ponzi schemes raise the ineffable question as to how otherwise intelligent folks turn off their brains when offered the prospect of money without work or risk. But, too little attention seems to be paid to the thinking and actions of those who confidently recognized a true-good-to-be-true offer for what it is. Markopolos writes that for him, one of the most disturbing aspects of the Madoff affair was that hundreds of analysts like him must have been aware of the mass fleecing going on. Yet, only Markopolos and his small group of compatriots apparently tried to do anything about it. I don't know who should feel worse: the suckers who were taken in by Madoff; or those who knew full well what was under foot, yet chose to stand idly by. Ah well, more about that later, when I discuss incentives for whistleblowers.
Can The SEC Do Better?
Markopolos has a number of insightful suggestions for reforming the SEC, and even if you don't care to read the entire book, the lengthy epilogue is worth reading to prime your own pump. I'm going to comment on two of the areas that primed mine: radical restructuring of the SEC staff, and changes to incentives for both staff members and whistleblowers.
With respect to reconfiguring the staff, I agree that there are far too many lawyers, but replacing them with experienced finance professionals, as Markopolos proposes, is a lot harder than it sounds. The problem is that the government can't pay competitive wages to competent and experienced professionals unless it can supplement a paycheck with non-pecuniary benefits, e.g., on-the-job education and 'relationship building.'
SEC lawyers and accountants accept below-market pay sometimes because of lifestyle considerations, but much more often they do so because it creates other options for them. The private sector values the technical and institutional knowledge acquired while at the SEC, and it must be said their tight relationships with SEC staffers doesn't hurt. Such is evidently not the case with financial economists. The best and the brightest are hired straight from school onto Wall Street and soon, if not immediately, command salaries and bonus prospects that are many times greater than SEC staffers of similar vintage. Moreover, SEC experience won't make them any better, brighter or more marketable. The unfortunate reality is that the SEC will have to obtain its financial expertise elsewhere—perhaps through consulting arrangements under which it can pay market rates.
Regarding incentive bonuses to staff, Markopolos suggests that the SEC create compensation bonus pools from collected fines. With all due respect, I think that's an even bigger stretch. If an SEC staffer, who has been working full-time and full-out on a Madoff-size case unexpectedly discovers exculpatory evidence, how will that be handled? If the staffer's family budget depends on getting a bonus out of the case, will she try to bury the evidence? While I would like my government to be highly effective enforcers of the law, I fear much more a government where there is even a slight appearance that law enforcement officers have a personal financial incentive to prosecute and convict the innocent.
Where Markopolos and I agree completely is on the cryingly obvious need to give greater incentives to financial fraud whistleblowers. One of the things I find most pleasing about the securities laws governing financial reporting is that the SEC's enforcement capacity is augmented by private litigants seeking to recover damages and penalties from companies and individuals that violated the securities laws in some fashion or another. Thereby, shareholders and the lawyers who retain them (sometimes in reverse order) are given strong economic incentives to police violations of the securities laws. To be sure, some defendants will be harried by frivolous claims, but that cost seems to pale with the benefits.
So, why not extend this logic to violations by investment advisers and funds? Let's provide an incentive for individuals, be they employees or others, to come forward with direct evidence of financial fraud, and reward them generously when a case is prosecuted successfully. Markopolos points out that a bare bones program is already in place at the SEC for insider trading cases, but somehow the SEC has avoided shelling out much money to its sources. The IRS and other government agencies have much more developed and successful whistleblower programs that the SEC can emulate and/or adapt.
Markopolos also points out that the processes by which whistleblower complaints are vetted needs to be made more efficient, and I would take his suggestions even further. I would require that whistleblowers make their concerns known via a formal, non-public filing process (to be unsealed after a period of time). The instructions to a whistleblower complaint form would set forth the minimum level of specificity of allegations and strength of supporting evidence in order for the SEC to even consider taking further action. The whistleblower could also choose to remain anonymous by engaging a lawyer to handle the filing, and there might be a small filing fee, say $1,000. It would also be specifically established that false filings of whistleblower complaints would themselves be subject to sanctions.
To effectively process the whistleblower allegations and to fairly distribute awards, the SEC would establish and publish its procedures for, among other things, assigning files to teams of enforcement staff members who possess the technical competence to deal with the issues and, if necessary, engage outside consultants. Just as in the Madoff debacle, the inspector general's office would investigate the valid complaints that fell through the cracks, but it would also continuously monitor the handling of all whistleblower filings.