Why Madoff Matters, the Value of Quality Regulation - 3 / 12 / 2009

Those of us that are forced by our selected news sources, be they financial or otherwise, to wait for the Madoff hearing results should be warmed by the fact that this matter will actually move us all closer to proper, more consistent regulation. That means the rules governing business in America will move one step closer to equality across the board. And I believe that the greatest value to regulation of business and financial practice is that it brings us closer to a truly free market environment.

Now champions of Adam Smith and his 'invisible hand", Ron Paul and Steve Forbes (both super shrewd guys) as modern day examples, would argue that government regulation and oversight is bad. What they really meant was that the current version of government regulation and oversight is bad.

Let me explain using Wall Street as an example. Most folks think that FINRA and the SEC watch the backs of independent investors. But the truth is the system is designed to protect the big guy first, and small investor second. I won't cover all elements of this statement today, but I will use the subject of standard regulatory review process as the theme.

Madoff Securities was permitted by the SEC and the NASD to fool the system for two reasons. The first is that he was a founder and former head of NASDAQ. Secondly, he had a seperate clearing / trading operation (seperate from Madoff Securities the culprit of the ponzi) and it was compliant with SEC disclosure regulations.

Now in my former capacity of Managing Director of investment banking at a 500 man Broad Street based investment bank, and in my consulting roles for other broker dealers, I have ample experience in the way the SEC and the NASD deal with financial institutions of different sizes and reputation. Here is their standard review process. To put it simply, each group, upon entering the premises for a special or annual review presents the firm's head compliance officer with a list of document requests that include investment banking transactions, trading and sales runs, and research examples. A random sampling is then selected from the information provided, and this sampling becomes the basis for the audit process.

Think about how easy, in the case of Madoff Securities, it would have been to pull one account's trading history and run an audit (trace the trades and monetary flow with the clearing institutions) and immediately see that there was a problem. When SEC and NASD professionals find a problem, they then look for a repetition of that same problem in the account being reviewed and then for the same problem in other accounts as well. This first step is done via the internet and can be effected in 20 minutes. 20 minutes. So the only explanation for the NASD and SEC both missing this simple and required process is that they didn't miss it at all. They made an internal decision to allow Madoff Securities to pay fines for 'inaccurate' or lax reporting standards and moved on. Madoff Securities likely had very few if any customer complaints, so why would these regulators want to openly audit Madoff Securities? Madoff securities would simply pay a fine, which is common practice, and move on.

I will tell you that smaller firms generally keep much better records and abide by rules more stringently because they do not have the spare cash available to pay the fines levied by the regulators as a penalty for findings of lax standards or violations. But it is also true that smaller firms, in my experience, are inevitably going to be fined for lax standards. The larger firms, former bulge bracket firms, are so well capitalized that they have their internal legal team monetarily settle out any violations as quickly as possible without admitting or denying the event ever took place.

Special treatment would be afforded the titans of industry, AIG, Citigroup, and Madoff as examples. They, on the outside, would have appeared to be disclosing accurately. These are highly talented and experienced institutions who are big parts of the financial industry. They know what regulators want and they deliver it, whether accurate or not.

And inevitably, this system which grants passes to industry giants while appearing to actively enforce regulations on small and mid sized financial institutions created an environment which allows for Madoffs, Citibanks, and AIGs to take advantage of institutional and individual market participants for decades without real penalty. The more these implosion events occur, the more the SEC and NASD will be required to treat all participants equally. And that consistency creates a foundation for a level playing field and maybe even a "free" market that Paul and Forbes would be pleased with.

Knowledge is value too - Build Value Every Day.

Brad van Siclen