SEC IG Kotz Responds to Rep. Kanjorski With Legislative Suggestions to Improve SEC

Congressman Paul E. Kanjorski, the Chairman of the House Financial Services Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises, released a letter today from the SEC’s Inspector General, H. David Kotz, in which the inspector general responds to Chairman Kanjorski’s requests for suggestions for modifying the federal securities laws based on the Madoff investigations.  As previously discussed here, Kanjorski advised Kotz on June 16 that he needed information from him by June 30, not August/September as Kotz planned, to have time to “use the Madoff fraud as a case study for determining how to improve oversight of and investor protection in our securities markets.”

According to Kanjorski, Kotz was able to met his expedited deadline:

“I thank Mr. Kotz for his swift reply and his preliminary legislative recommendations for improving enforcement and closing legal loopholes based on his investigation into the $65 billion Madoff Ponzi scheme,” said Chairman Kanjorski. “The recommendations provide some valuable insight that could help the House Financial Services Committee as we work to develop legislation for financial regulatory reform.”

The text of SEC Inspector General Kotz’s letter to Chairman Kanjorski from June 30 follows:

Dear Chairman Kanjorski:

Thank you for your June 16, 2009 letter regarding the Securities and Exchange Commission (SEC) Office of Inspector General’s (OIG) investigation into allegations regarding Bernard L. Madoff (Madoff) and Bernard L. Madoff Investment Securities, LLP and for meeting with me on June 23, 2009 at your offices to discuss our ongoing investigation.

I am glad that you are generally pleased with our progress in connection with our investigations and audits of these important and complex matters. As I indicated to you during our meeting, we are committed to producing, in an expeditious manner, thorough and comprehensive investigative and audit reports analyzing the reasons that the SEC did not uncover the Madoff Ponzi scheme notwithstanding examinations and investigations conducted over a period of nearly 20 years, as well as providing recommendations to improve the operations of the pertinent SEC divisions and offices. I appreciated the opportunity to brief you on developments in our investigation at your offices last week and am happy that you felt the meeting was productive.

While we have not yet completed the investigation, we are able to provide to you, at your request, several legislative suggestions that have arisen out of our Madoff investigatory work, which we believe will strengthen the ability of investors and the regulatory agencies to uncover frauds such as Ponzi schemes in the future. We understand that the SEC is also recommending to the Subcommittee the legislative suggestions numbered 1 and 4 below. These suggestions are as follows:

(1) Extend the regulatory jurisdiction of the Public Company Accounting Oversight Board (PCAOB) to audit reports prepared by a domestic registered or foreign public accounting firm regarding issuers, broker-dealers, investment advisers and any companies subject to U.S. securities laws. The PCAOB’s current responsibilities include the following: (a) registering public accounting firms; (b) establishing auditing, quality control, ethics, independence, and other standards relating to public company audits; (c) conducting inspections, investigations, and disciplinary proceedings of registered accounting firms; and (d) enforcing compliance with the Sarbanes-Oxley Act of 2002. The PCAOB is able to address many auditing problems through a combination of inspections and standards-setting. The PCAOB’s supervisory model uses several tools to improve audit quality, correct audit deficiencies, and promote compliance with applicable standards and laws. Where necessary, the PCAOB exercises its enforcement authority.

Extending the regulatory jurisdiction of the PCAOB would allow for increased oversight of these accounting firms and reduce the risks associated with unknown accounting firms that have been able to avoid scrutiny. We believe that H.R. 1212, as currently introduced, accomplishes many of these same goals, except that we would recommend that the legislation clarify that the PCAOB oversight be extended to audit reports prepared by a registered accounting firm which provides reports for investment advisers, investment companies and other registered entities, as well as registered broker dealers.

(2) Amending the Investment Advisers Act of 1940 (Investment Advisers Act) to require the use of independent custodians in a manner similar to Section 17(f) of the Investment Company Act of 1940 (Investment Company Act), which requires the use of an independent custodian by mutual funds. Section 17(f) of the Investment Company Act requires a registered management company to “place and maintain its securities and similar investments in the custody of” a bank or a dealer admitted to a national securities exchange, subject to such rules and regulations as the Commission may from time to time prescribe for the protection of investors. See 15 U.S.c. § 80a-17(f)(1). In addition, Rule 17f-2(b) of the Rules and Regulations promulgated under the Investment Company Act requires that all such securities and similar investments be deposited in the safekeeping of, or in a vault or other depository maintained by, a bank or other company whose functions and physical facilities are supervised by Federal or State authority. The Rule further provides that investments so deposited shall be physically segregated at all times from those of any other person and shall be withdrawn only in connection with transactions of the character described in the Rule. This custodian requirement essentially removes the ability of an investment adviser to fraudulently use the proceeds invested by new investors to make payments to old investors.

Hedge funds are currently exempt from the Investment Company Act and are not subject to the independent custodian requirement. In addition, investment advisers who are also registered broker-dealers are currently permitted to clear their trades through their own broker-dealer firm. Thus, both investment advisers and hedge funds should be required to use an independent custodian.

We are aware that the SEC is currently proposing amendments to its custody rule under the Investment Advisers Act to require a written report from an independent public accountant that includes an opinion regarding the custodian’s controls relating to custody of client assets if the client accounts are not maintained by an independent qualified custodian. However, we believe that a more direct way to remedy this statutory loophole would be to amend the Investment Advisers Act in conformity with the Investment Company Act.

(3) The Sarbanes-Oxley Act of 2002 requires ongoing certifications of certain reports by chief executive officers and chief financial officers of public reporting companies. Executives who knowingly file noncompliant reports face possible criminal prosecution including substantial fines and imprisonment.

Certifications have been determined to be effective controls to ensure compliance with particular requirements or guidelines. We would recommend imposing a requirement of certification by senior officers of registered investment advisers that shows they conducted adequate due diligence in connection with investments. This certification requirement should apply to all funds of hedge funds. The adequate level of due diligence required in accordance with the certification may be defined pursuant to a particular model of best practices, such as the Managed Fund Association (“MFA”) model or the Alternative Investment Management Association (AlMA) model, or could be developed by the SEC. Enforcing an adequate level of due diligence would ensure that investors have adequate information when investing through intermediaries.

(4) Bounty programs are an effective tool to encourage whistleblowers to come forward and would provide necessary incentives for outside entities to bring complaints about possible illegal activity. There is some evidence that the bounty program implemented by the Department of Justice (DOJ) has played a role in the increase of civil recoveries obtained by the DOJ over a 10-year period. The Internal Revenue Service (“IRS”) also has a system in place where it provides a bounty to individuals who present the IRS with information leading to the collection of federal taxes.

Although the bounty system has been in place at the SEC for more than 20 years, there have been relatively few awards made. The SEC program is limited to insider trading cases, and the stated criteria for judging bounty applications are broad, somewhat vague and not subject to judicial review.

Currently, Section 21A(e) of the Securities Exchange Act of 1934 (Exchange Act) [15 U.S.C. 78u-l(e)] authorizes the SEC to award a bounty to a person who provides information leading to the recovery of a civil penalty from an insider trader, from a person who “tipped” information to an insider trader, or from a person who directly or indirectly controlled an insider trader. All bounty determinations, including whether, to whom, or in what amount to make payments, are within the sole discretion of the SEC, however, the total bounty may not currently exceed 10% of the amount “actually recovered” from a civil penalty pursuant to a court order.

We would recommend that the Exchange Act be amended to authorize the SEC to award a bounty for information leading to the recovery of a civil penalty from any violator of the federal securities laws, not simply insider trading violations. We would also suggest that the Exchange Act be amended to provide specific criteria for awarding bounties, including a provision that where a whistleblower relies upon public information, such reliance does not constitute an absolute bar to recovering a bounty. The statute should also require that the whistleblower be provided with status reports at certain milestones during the investigation or examination that was based on the tip.

We would be happy to discuss any of the above legislative suggestions with you or the Subcommittee at your convenience. If, as we conclude our investigation, we determine that there are any further legislative recommendations that would be appropriate for your Subcommittee, we will share them with you at that time.

Thank you again for your continued interest in our work.


H. David Kotz

Inspector General

cc: The Honorable Mary L. Schapiro

Chairman, Securities and Exchange Commission

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