Meltdown 101: Risks of another Madoff-style scam

WASHINGTON — Monday brought some closure to Bernard Madoff’s victims, who were swindled out of $65 billion in the largest recorded financial fraud — a scheme that was exposed in part because the plummeting stock market led investors to demand repayment of money that was long gone.

With Madoff on his way to jail, attention is shifting to the next fraud — and to the agency responsible for preventing it.

The Securities and Exchange Commission lost credibility when it emerged that a tipster had been trying to blow the whistle on Madoff for years but had been brushed off repeatedly. Since Madoff’s case came to light, the agency has announced a series of changes it hopes will improve enforcement, making it easier to detect and root out fraud before it approaches this massive scale.

But obstacles remain, including the finding in a recent oversight report that agency lawyers lack necessary support staff and resources. And even with the benefit of hindsight, experts say, eliminating fraud is about as likely as eliminating greed.

Here are some questions and answers about what the SEC is doing to shore up its examination and enforcement actions, and how far these changes will go to prevent the next Madoff-style scandal.

Q: Could a Madoff-style fraud happen again?

A: Of course it could. Enforcement is by definition a backward-looking process, with officials exposing and punishing wrongdoing only after it’s been committed. As far as the SEC knows, there are more Madoffs starting up right now.

But officials say fraud on Madoff’s scale is unlikely because he was an uncommonly talented crook, quietly gaining the trust of investors, regulators and power brokers over decades in the financial world.

Q: Does that mean they’re not doing anything to stop the next Madoff?

A: Regulators are doing quite a bit to prevent similar Ponzi schemes from bilking more investors.

The examinations division, which is responsible for day-to-day oversight, will be improving examiners’ expertise in fraud detection and in complex financial products, looking more closely at firms deemed more likely to commit fraud and improving handling of tips and complaints. That’s according to a speech this month by Lori Richards, who directs the SEC’s Office of Inspections and Examinations.

SEC Chairman Mary Schapiro has installed a new director of the Division of Enforcement: Robert Khuzami, a former federal prosecutor. He has launched efforts to improve the SEC’s enforcement capabilities, including streamlining key processes, and advocates pouring vast resources into hiring new staff.

Testifying before Congress in May, Khuzami said, “Not a day goes by that I don’t think about how we can stop the next big fraud.”

The agency also will introduce a new computer system intended to track and sift through the complaints that come in, which number between 750,000 and 1.5 million a year.

Q: That all sounds nice, but aren’t there some concrete loopholes the SEC needs to close to prevent future scams?

A: Madoff exploited the opportunity to act as both investment adviser and custodian of his clients’ assets. That meant there was no one to verify whether the assets existed, or whether he was making the trades he claimed.

The SEC proposed a new rule that would require third-party verification of the assets, effectively closing that loophole.

But closing loopholes doesn’t prevent future abuses, warns Laura Unger, a former commissioner and acting chairman of the SEC.

“Disclosure and rules are always changed after the crisis,” she says. “You’re hard-pressed to prevent the next thing before it happens because it’s always going to be something different.”

Q: With so many attempts at reform going on all at once, how can we be sure the SEC even understands where the problems were?

A: In August, SEC Inspector General David Kotz is expected to release a long-awaited investigation of the breakdowns that allowed Madoff to pull off his scam undetected. It will examine information sharing between the examination and enforcement divisions, and attempt to explain why a tipster with information on Madoff’s fraud was unable to attract the agency’s attention for over a decade.

Even before the formal recommendations come out, Schapiro has said she will address any weaknesses that come to her attention.

Q: Now that the SEC is stepping up its game, can investors rest easy?

A: Never.

Investors who want to feel safe misunderstand the agency’s role, says Unger, the former SEC commissioner. As more people have investments, “there’s this increasing sense that there’s no longer any risk in investing, that it’s like putting money in a bank,” she says.

But investments earn higher returns than savings accounts precisely because they carry risks — and fraud is one of those risks, Unger says.

“We can’t end fraud because we can’t end greed and stupidity,” she says. “But you can make an impact in reducing it and make other people sensitive and thoughtful about it.”