No One Would Listen: A True Financial Thriller (49 page)
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Authors: Harry Markopolos
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New York, Boston, and other major cities with robust financial centers have numerous financial analyst societies, CPA societies, securities traders associations, and economic clubs, which frequently hold the type of educational meetings the SEC staff needs; but the SEC generally doesn’t allow its staff time off to attend these meetings, nor does it reimburse its staff for attending this type of industry meeting. It’s rare to see SEC staff at these educational events—and we know that isn’t because they already know everything—and they would be welcomed.
Ninth, establish a lessons learned database.
The very first thing the SEC employees who received my submission should have done is gone directly to the SEC database on their computers to see if the red flags I raised were comparable to information learned about other Ponzi schemes. Unfortunately, that would have been impossible because there is no existing SEC database like that. The SEC should build a strong online knowledge center for its staff. In this case when staffers keyed in “Ponzi” they would have been able to find diagnoses of past Ponzi schemes and several checklists teaching them what to look for, what questions to ask, and how to most efficiently solve such cases. A Ponzi scheme is actually one of the easiest fraud schemes to detect because there is no underlying investment product and no trading, while the assets are being diverted to pay offinvestors. Yet this case was assigned to SEC staffers who had absolutely no experience and little knowledge of Ponzi schemes, and they really had no place within the SEC to go to learn about them.
The very first thing the SEC employees who received my submission should have done is gone directly to the SEC database on their computers to see if the red flags I raised were comparable to information learned about other Ponzi schemes. Unfortunately, that would have been impossible because there is no existing SEC database like that. The SEC should build a strong online knowledge center for its staff. In this case when staffers keyed in “Ponzi” they would have been able to find diagnoses of past Ponzi schemes and several checklists teaching them what to look for, what questions to ask, and how to most efficiently solve such cases. A Ponzi scheme is actually one of the easiest fraud schemes to detect because there is no underlying investment product and no trading, while the assets are being diverted to pay offinvestors. Yet this case was assigned to SEC staffers who had absolutely no experience and little knowledge of Ponzi schemes, and they really had no place within the SEC to go to learn about them.
To further increase the SEC’s auditing effectiveness, I would create a Center for All Lessons Learned, a CALL center, similar to a database that has been used with great effectiveness for decades by the U.S. Army. CALL would collate and sort through every fraud uncovered by the SEC. These frauds would be analyzed to find both the common and the unique elements so that the odds of future similar frauds being undetected would be greatly reduced.
CALL would be a password-protected online Web-based resource for all SEC employees to use and, more important, for them to contribute information concerning their own investigations. The SEC needs to be able to learn at a faster pace than the bad guys they are pursuing, and the only way to increase the SEC’s decision-making ability quickly is to demand that all levels of the organization pitch in and contribute to building this database. The traditional top-down, command-from-above approach, the way the agency does business, just doesn’t work anymore and has to be abandoned if the SEC is to achieve greatness. That’s possible. The SEC currently has a staff of more than 3,500, and every single one of those 3,500 brains needs to be turned on and contributing to this core knowledge base.
Ironically, most banks have set up or are establishing risk databases, putting the SEC investigators in the odd position of expecting to find this level of risk management within the organizations they regulate—but not within their own agency.
Tenth, give staff access to the tools of the trade.
Another thing those SEC employees who received my submissions should have done was immediately turn on their Bloomberg terminals and analyze the actual OEX Standard & Poor’s 100 index options trades that Bernie Madoff purported to trade on specific dates. If they had done that, they would have discovered that those trades never took place. But they couldn’t do it, because they don’t have easy access to Bloomberg machines and they have not been trained in how to operate them. That’s like trying to prevent online identity theft without having access to a computer or knowing how to use one. If the staff had had this equipment, this case would have quickly been cracked open.
Another thing those SEC employees who received my submissions should have done was immediately turn on their Bloomberg terminals and analyze the actual OEX Standard & Poor’s 100 index options trades that Bernie Madoff purported to trade on specific dates. If they had done that, they would have discovered that those trades never took place. But they couldn’t do it, because they don’t have easy access to Bloomberg machines and they have not been trained in how to operate them. That’s like trying to prevent online identity theft without having access to a computer or knowing how to use one. If the staff had had this equipment, this case would have quickly been cracked open.
The Bloomberg machine is the key knowledge tool used in the finance industry, but admittedly it is expensive. Each machine costs more than $20,000 a year. Industry allocates one Bloomberg machine per trader, analyst, and portfolio manager so that they can efficiently and professionally conduct the business of finance. The SEC is lucky to have a single Bloomberg terminal in a regional office. Sending SEC teams into exams and enforcement actions without a Bloomberg terminal is like sending unarmed teams to the O.K. Corral and then wondering why they straggle back to the office in defeat each time.
When financial analysts are trying to determine whether to invest in a certain corporate stock, the first thing they do is go to a Bloomberg terminal and analyze the firm’s capital structure, its financial statements, and its financial ratios. They look up the firm’s weighted cost of capital and then start running a horizontal and vertical analysis of that firm’s financial statements. A well-trained analyst will also use the Bloomberg machine to read all the news stories available on that company, look at the firm’s SEC filings, and use the information collected to make a list of questions that have to be answered before committing funds to that company. The analyst will also obtain Wall Street’s research reports on the company to see how those analysts interpreted all this data to make sure there was nothing they might have missed. Doing it correctly is a long process, made possible only by access to a Bloomberg.
The SEC staff examiners can rarely do any of this, either because they don’t have access to a Bloomberg or because they don’t know how to use it. I don’t see how SEC compliance staff can function effectively without at least one Bloomberg available to each exam team for every exam it conducts. They just can’t do a passable job without it. Bloomberg machines have become the lifeblood of the industry, and they make readily available almost all of the data an SEC staffer needs for conducting a basic fraud analysis. Not funding these machines saves money but costs a fortune.
Eleventh, as a policy, encourage whistleblowers.
This is nearest and dearest to my heart and is the bottom line if the SEC intends to recover its reputation from this debacle. It has to open up an active Office of the Whistleblower to provide a central clearinghouse for complaints, which currently are handled ad hoc by 11 regional offices. According to the Association of Certified Fraud Examiners’ 2008 Report to the Nation, whistleblower tips detected 54.1 percent of uncovered fraud schemes in public companies. External auditors (and the SEC exam teams would certainly be considered external auditors) detected a mere 4.1 percent of the uncovered fraud schemes. Let’s examine that: 54.1 percent versus 4.1 percent. Whistleblower tips were 13 times more effective than external audits, which is why I believe the SEC should do more to encourage people to submit tips. There needs to be a single place to which people can submit those tips, anonymously if they choose to for protection.
This is nearest and dearest to my heart and is the bottom line if the SEC intends to recover its reputation from this debacle. It has to open up an active Office of the Whistleblower to provide a central clearinghouse for complaints, which currently are handled ad hoc by 11 regional offices. According to the Association of Certified Fraud Examiners’ 2008 Report to the Nation, whistleblower tips detected 54.1 percent of uncovered fraud schemes in public companies. External auditors (and the SEC exam teams would certainly be considered external auditors) detected a mere 4.1 percent of the uncovered fraud schemes. Let’s examine that: 54.1 percent versus 4.1 percent. Whistleblower tips were 13 times more effective than external audits, which is why I believe the SEC should do more to encourage people to submit tips. There needs to be a single place to which people can submit those tips, anonymously if they choose to for protection.
Another interesting statistic from that ACFE report is that 57.7 percent of all whistleblower tips received come from employees. How easy would it be for the new and more efficient SEC enforcement teams to uncover a fraud after an internal whistleblower presented them with hidden books and records or information as to where they could be found? This would be sort of like informing the SEC that Bernie was keeping a second set on books—and kept the second set on his person! Customers provided 17.6 percent of whistleblower tips, vendors 12.3 percent, and shareholders 9.2 percent.
Whistleblower programs work. Among the most effective market watchdogs is the New York attorney general’s office, which relies on whistleblowers. When a tip comes in they vigorously pursue it, unlike the SEC, which receives a tip and vigorously ignores it.
The best way to encourage people to become whistleblowers is to offer a reward, a bounty. The SEC needs to authorize a viable whistleblower bounty program similar to those at the Department of Justice and the Internal Revenue Service. The IRS opened its Office of the Whistleblower in 2006 and in less than three years the staff grew to include 18 people—and as a result the IRS now receives larger and better-quality cases than ever before in its history. Consider the cost of 18 IRS employees and office equipment against the billions of dollars in additional tax revenue they are responsible for collecting for the U.S. Treasury. Whistleblowers need to be compensated for the risks they are taking; for many people, once it becomes known that they turned in a case, their careers are essentially over. They are blacklisted from the industry.
The key to the success of that program is the fact that the IRS offers bounty payments of between 15 and 30 percent to whistleblowers for cases that lead to successful recoveries for the Treasury. These payments don’t come out of the IRS budget and they don’t come from taxpayer dollars—all bounty payments are made by the defendants. This is a no-cost program that funds itself and allows the IRS to cherry-pick from cases that come in the front door. The investigators have the liberty, and the luxury, of selecting credible cases for immediate investigation.
It seems only logical that the SEC should expand and reinvigorate its almost never used whistleblower program. Section 21A(e) of the 1934 Act allows the SEC to pay a bounty of up to 30 percent to whistleblowers—but only for insider-trading cases. The SEC can fine a person or company found guilty of insider trading triple the amount of its ill-gotten gains or its losses avoided for insider trading, and can award up to 10 percent of the penalty amount to the whistleblower.
Unfortunately, unlike the IRS’s whistleblower program and the False Claims Act, the SEC’s reward payments aren’t mandatory. The SEC can simply refuse to pay these rewards and doesn’t even have to explain why it isn’t paying. If Congress would expand this program to encompass all forms of securities violations and make the reward payments mandatory, hundreds—maybe thousands—of new cases would be brought into the office. That would provide an incentive for the foxes out there in the field to bring cases against their firms with specific and credible allegations and documents—they would be able to provide the smoking e-mails! And this is the financial industry, meaning many of those cases would lead to huge settlements. If cases brought under the False Claims Act now lead to billions of dollars recovered annually, there is good reason to believe the SEC might also recover literally billions of dollars each year.
As each tip is received, it should be logged in and assigned a case number. For tips deemed credible, meaning those that come with real evidence, the whistleblower and the whistleblower’s counsel would be put in direct contact with the SEC unit best able to investigate the complaint. This certainly would prevent anyone from having the same experience I did, in which over the years I kept submitting increasingly detailed complaints but got nowhere. The SEC just wasn’t equipped to handle whistleblower complaints; there was no central processing unit, no one to delegate investigative authority, and no one to track it. Standardizing the treatment of whistleblowers to ensure that they are not ignored or mistreated should be a priority for the SEC. The agency should be required to report annually to a congressional committee all the whistleblower complaints it receives and the agency’s follow-up actions.
Let me add one additional and very important point: the issue of self-regulation and whistle-blowing. I believe that several hundred finance professionals around the world knew or suspected that Bernie Madoff was a fraud—but none of these people contacted the SEC with their suspicions and identified themselves. Nor was there any system in place to encourage these professionals to communicate with the SEC. Unfortunately, my team and I may have been the only ones.
Getting rid of the shysters, fraudsters, and banksters is in every American’s best interest. It is imperative that we do so if we intend to restore worldwide trust in the U.S. capital markets. If I’m the CEO of an honest firm and I hire a new employee who worked at a competing firm and find out from that person that my competitor is dishonest, it’s in my economic self-interest as well as good public policy to turn that firm in to the SEC. If self-regulation is ever going to work, we need to find ways to advertise it, reward it, and measure it. And the SEC has done none of these.
Twelfth, reform the SEC or create a new super-regulatory agency.
There is, of course, another option. If the SEC does not reform itself, it should be disbanded. Just zero out its budget and put every one of those 3,500 staff members on the streets, because right now they do not offer us any real protection. This would be harsh, I know, but anything short of a bottom-to-top reorganization of the SEC will not be sufficient to fight the financial frauds that plague our system.
There is, of course, another option. If the SEC does not reform itself, it should be disbanded. Just zero out its budget and put every one of those 3,500 staff members on the streets, because right now they do not offer us any real protection. This would be harsh, I know, but anything short of a bottom-to-top reorganization of the SEC will not be sufficient to fight the financial frauds that plague our system.
The federal government has to get involved, too. The SEC is an agency of the government and has to abide by the rules and regulations, and the budget, set by Congress. So Congress also has a responsibility to ensure that changes are made to the way we govern our financial markets. That’s why I agreed to testify in front of both House and Senate committees. As I told them, there are several things that Congress can do to guarantee a fair playing field for investors. For example, David Kotz’s report highlights the complete lack of coordination and even communication between the Boston, New York, and Washington SEC offices, which severely hindered the Madoff investigation. It actually was even worse than that. The examination team in the New York regional office that had just finished an investigation of Madoff’s operations in 2005 wasn’t able to coordinate effectively with the enforcement team from the same office that was just starting its own Madoff investigation. If regional offices from a single agency can’t coordinate with each other, and if teams within one regional office don’t coordinate with each other, it makes no sense to maintain all of our financial industry regulatory agencies—the Federal Reserve, the Office of the Comptroller of the Currency (OCC), the Federal Deposit Insurance Corporation (FDIC), the Commodity Futures Trading Commission (CFTC), and the SEC—as independent entities. It gets worse: Each of these five regulators would have its own internal computer system—and none of them would have the slightest idea what any of the other regulators were doing with respect to a specific company.
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