SEC Drops the Ball – Madoff Investment Securities and Consolidated Supervised Entities

On December 11, 2008 former NASDAQ Chairman, Bernard L. Madoff, was arrested for securities fraud relating to his firm Bernard L. Madoff Investment Securities LLC. Madoff admitted to his senior employees that he was effectively running a giant ponzi scheme and the fraudulent losses may total $50 billion. Madoff’s business included investment advisory ($17.1B AUM), a NASDAQ market maker ($700mm in capital), and a broker dealer.

As a broker dealer and market maker where was the SEC? Perhaps the SEC was turning a blind eye, or simply trusting their own. Bernie Madoff has been in the securities business since the 1960’s and was the former Chairman of the NASDAQ. The SEC’s basic mission is to protect investors:

“The mission of the U.S. Securities and Exchange Commission is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation”

“The SEC oversees the key participants in the securities world, including securities exchanges, securities brokers and dealers, investment advisors, and mutual funds.”

Madoff’s firm was not taking capital from naive retail investors; Madoff’s investors included the $7.3B Fairfield Sentry Ltd and the $2.8B Kingate Global Fund Ltd. These sophisticated, qualified investors likely did not complete all of the necessary diligence on the firm. Madoff utilized a split strike conversion strategy which is an option arbitrage strategy trading equity and at-the-money puts verse out-of-the-money calls. Despite this complicated, volatile, esoteric strategy, Madoff generated consistent high single-digit returns with limited volatility. Furthermore, CNBC reports the hedge fund due diligence firm Aksia found a 2005 letter to the SEC stating that Madoff was running a “ponzi scheme”.

The Madoff disaster highlights the continued lack of oversight from the SEC. The SEC allowed investment banks to have voluntary supervision which has no doubt fueled the problems facing Wall Street today. In August 2004, the SEC past Consolidated Supervision of Broker-Dealer Holding Companies, allowing large investment banks, labeled consolidated supervised entities (CSE) to be regulated at the holding company level as opposed to regulating the banks individual business lines. The goal was to reduce the amount of duplicate oversight from the regulatory body. The SEC required Require that CSE holding companies maintain regulatory capital commensurate with the risk of their activities. The SEC state “the amendments should help the Commission to protect investors and maintain the integrity of the securities markets by improving oversight of broker-dealers and providing an incentive for broker-dealers to implement strong risk management practices.” The Basel Standards established three Basel “Pillars” to assess the CSEs, minimum regulatory capital, supervisory review, and disclosure of the capital, risk exposures, and risk assessment processes of the institution.

While the SEC may be stretched too thin, the self-governing system was not adequate to regulate the banks. The banks appeared not to have understood the amount of risk exposure in the credit markets or the potential counter party risk of the credit default swap market. Only a few institutions saw the credit crisis coming, but perhaps with greater oversight of the broker dealers, alternative asset management firms, and market markers, the SEC could have pooled this knowledge to require larger capital requirements for the CSEs. On the heals (hopefully no the toes) of this financial crisis, the US Government should reassess the role of the SEC and potentially even increase the resources available to the regulatory body.