SEC Commissioner Mary Schapiro has begun making the necessary changes. The agency is trying to get better and, for a government agency, it is moving at an enviable pace. But you have to crawl before you can walk, and you have to walk before you can run. The SEC has to learn how to crawl again. It has suffered through decades of sloth, abysmal leadership, underfunding, and benign neglect, and realistically it will take several years for it to begin functioning as the effective, efficient cop on the financial beat that both investors and industry professionals expect.
As I told Congressman Kanjorski’s House subcommittee, the Senate Banking Committee, David Kotz, Mary Schapiro, and reporters for several newspapers and magazines, there are numerous concrete steps that need to be taken as soon as possible if the SEC is to be transformed into a respected agency.
First, banish the lawyers from the land. Currently the SEC, like most Washington agencies, is dominated by lawyers. In 2009 all five SEC Commissioners were lawyers. Now, I have nothing against lawyers. I’m sure they are good to their children, and many of them contribute to charities. But putting them in charge of supervising our capital markets has been an unmitigated disaster. It would be like putting a political appointee in charge of the Federal Emergency Management Agency and expecting him to handle a flood. Very few SEC lawyers understand the complex financial instruments of the twenty-first century, and almost none have ever sat on a trading desk or worked in the industry other than doing legal work. A primary reason the SEC has reached this point is that historically the SEC Commissioners have been lawyers who may know where to find the best power lunches in Washington, D.C., but don’t have a clue as to how the financial industry actually operates on a day-to-day basis.
Maybe lawyers know the difference between a tort and a tortilla, but there is a reason that most firms in the industry are run by businesspeople with capital markets or banking expertise—it’s because they’re experts. Obviously that didn’t prevent the industry from barely surviving the 2008 crisis, but just about anything would be an improvement over lawyers attempting to lead an industry whose complexities they don’t understand.
Of course there is a place for lawyers inside the SEC. They should be in charge of making sure the rules and regulations promulgated by financial experts are followed, and that those people who don’t follow them get penalized. The director of enforcement should be a lawyer, but the other departments should be led by people knowledgeable about what they actually do in those departments. Lawyers need to be removed from most positions of senior leadership and replaced with people who understand the markets and institutions being regulated.
Anyone who doubts this should simply read David Kotz’s report for evidence that the SEC’s enforcement lawyers did not have a clue as to what Bernie Madoff was telling them about his trading strategy. As a basketball coach once scolded a poor shooting guard, “You couldn’t hit the ocean if you were standing in it.” Most lawyers couldn’t recognize a Ponzi scheme if they were having dinner with Charles Ponzi. They couldn’t recognize Madoff’s obvious lies because none of them had the financial expertise to understand the capital markets. The typical SEC attorney would have trouble finding fireworks on the Fourth of July, so asking them to uncover financial frauds was well beyond their pay grade. There were a lot of financial experts who knew that Madoff was doing something illegal—even if they didn’t publicly expose him. But at least we should put those people in position to stop these scams—and then make it worth it for them to do it.
The purpose of laws is to define the lowest form of acceptable behavior between people, but ethics are the higher standard that the SEC’s securities lawyers have successfully ignored. For example, mutual fund market timing isn’t illegal, so the SEC ignored it while individual investors lost billions of dollars to market timers and hedge funds engaged in the practice. But within the industry the professionals with a moral compass knew this activity was unethical, that it cheated investors and needed to be stopped. Lawyers are trained to follow the black-letter law and regulation the way Hansel and Gretel tried to follow the bread crumbs home from the forest. But the SEC has to do more than just follow the technical bar set by the rules; it has to lead in regulating industry behavior so that it embodies the highest standards of transparency and fairness for all.
There certainly is an important role for lawyers to play in the SEC, just not the part they’ve been playing. Securities laws are outdated almost as soon as they go into effect, because new financial instruments are created to skirt these new laws. Lawyers should focus on using regulations to establish a standard of behavior for the industry that is substantially higher than now exists. But it would be tough to do a worse job running the show than they’ve done, so we really should put professionals in charge. The lawyers should have a separate enforcement unit in which they can prosecute both civil and criminal cases of securities and capital markets fraud. Let lawyers prosecute, not investigate.
Second, smart is as smart does. The people who should fill the positions created when we clean up the SEC should have industry experience, not resemble a clown car filled with college degrees. These college greenhorns couldn’t find a steer in a stampede. This is actually a great place for reverse age discrimination. For the broker-dealer exam teams, the people who actually go into an office to conduct an investigation, we should be hiring experienced brokers with as many years of experience as can be found. These people know the tricks and the hiding places; they may even have used some of them themselves when they were on the other side of the investigation. So put veteran traders and veteran back-office personnel on these investigative teams to conduct trading floor exams. For the money management and hedge fund teams, hire experienced portfolio managers, analysts, and buy-side back-office personnel to conduct asset manager examinations. Hire experienced accounting professionals to examine required corporate filings.
Hire experienced leaders. Most people in the industry considered William Donaldson a capable chairman—and he came from the industry. He knew where the skeletons were buried, and he allowed his staff to dig them up.
There is a theme here: Hire people who know what they’re doing, not college kids who know what they want to do—which is get a better-paying job at the companies they’re investigating!
This is a true story: A woman I know with an undergraduate degree in economics and math, an MBA, and a CFA, with more than 10 years’ experience in the industry, wanted to leave her job as a senior analyst at a large mutual fund in order to have a second child. She wanted out of the 70-hour-a-week rat race, so she applied for a job at the SEC. If she were hired, she would almost immediately become one of the most experience people on their staff. But during her interview she was told that she was overqualified with too much industry experience, that she was overeducated, and that it was clear she wouldn’t be happy inspecting paperwork and would probably just quit anyway, so it made no sense to hire her.
Instead, the SEC hires unqualified, sometimes undereducated people without financial industry experience, apparently because those people won’t get bored doing the boring work. All they want these people to do is check pieces of paper to make sure that a company’s paperwork is in compliance with the outmoded securities laws that have to be followed. So is it any surprise, given the current quality of the SEC’s staff, that major felonies go undiscovered and unpunished while paperwork violators are cited and fined? This is the regulatory equivalent of death by a thousand paper cuts!
No Child Left Behind tests students to determine if they’re learning, yet we don’t test those people given power to regulate our financial industry. So maybe we should hire the fifth graders who passed the test? Because it’s clear that a significant portion of the SEC’s professional staff—my guess is at least half and maybe more—need to be let go because they are not qualified to hold their positions. Certainly based on their performance in the Madoff investigation, quite a few employees of the New York regional office staff should be fired—unless th
ey’ve had the good sense to resign. Fortunately, given the layoffs that have swept Wall Street, there are many extremely qualified industry professionals with a clear understanding of the capital markets who are currently at liberty and would be delighted to start tomorrow morning. The quality of the SEC’s staff needs to be dramatically upgraded, and the people who are capable of doing that are incredibly available and ready to jump into that particular pool.
Before hiring an employee, the SEC should give applicants a simple entrance exam to test their knowledge of the capital markets. To me, it doesn’t seem unreasonable that someone joining the agency that regulates the financial industry should have some knowledge of the industry he or she is being hired to regulate. Many SEC staffers, particularly the staff attorneys, don’t know a put from a call, a convertible arbitrage strategy from a municipal bond, or an interest-only from a principle-only fixed income instrument. The Chartered Financial Analysts Level I exam covers the material that I would expect all of the SEC’s professional staff to have mastered before being hired. But that’s just me being Harry. I seriously doubt that 20 percent of the SEC’s current staff would be able to pass this important exam.
There are several other tests that could be used to determine the proficiency of potential or active employees. SEC employees should be tested regularly, and if they perform poorly on those tests they should be required to attend classes until they prove their ability to conduct professional inspections.
Third, examine the SEC’s examination process. I have survived an SEC inspection, although I didn’t get the official T-shirt. I was a portfolio manager, then the chief investment officer at a multibillion-dollar equity derivatives asset management firm. My firm, Rampart, was considered high-risk only because we managed derivatives; therefore, we received SEC inspection visits every three years, so I know from my own experience how flawed these examinations are. Incredibly, the SEC never sent in a single examiner with any knowledge of derivatives. These examiners had no idea what they were looking at. Rampart was always honest, but we easily could have pulled a Madoff and they never would have caught us. These examiners were very young and had little or no industry experience. These examiners would come in with a typed list of the documents and records they wished to examine. They handed this list to our compliance officer, who escorted the examiners to a conference room where they could diligently inspect the piles of documents and records we provided to them. If we were corrupt—if any firm is corrupt—we easily could have kept a second set of falsified but pristine records, committing the equivalent of mass financial murder, and gotten away with it, just as long as the documents and records shown to the inspection team were in compliance.
Yes, it is that simple.
That particular inspection team wouldn’t have been able to find a batter in the batter’s box. First, it interacted only with the firm’s compliance team, not the traders, not the portfolio managers, and not the client service officers; they didn’t even speak to the people who ran the place, top management. The examiners sat there looking at papers, rather than taking advantage of the tremendous human intelligence—gathering opportunities who happened to be sitting a few feet away. They’re called people, and you can’t make a good pile of them, but they have a lot of information about those papers. The SEC examination teams should send their so-called experts onto the trading floors and into the portfolio manager’s office to ask leading, probing questions. Here’s an example of one of those questions: Is there anything going on here that is suspicious, unethical, or even illegal that I should know about? Are you personally aware of any suspicious, unethical, or even illegal activity at any competing firms that we should know about?
The SEC examiner should point out that it is a felony to lie to an official of the federal government—even without taking an oath—and then hand them a business card, making it easy to call an examiner if they should see any illegal activity. This isn’t rocket science, it isn’t brain surgery, and it isn’t even supermarket bagging; these are basic internal auditing techniques. But the SEC staff is so untrained that for them it is rocket science, because these examiners are so inexperienced and unfamiliar with financial concepts that they clearly are either afraid or embarrassed to interact with industry professionals; instead, they choose to remain isolated in conference rooms looking at paperwork.
The current examination process is an insult to common sense—as well as a waste of taxpayer dollars. It is essential that examiners interact with industry professionals and talk to them about what’s going on inside their firm and what they know about their competitors.
The examination teams should be made up of people with various types of expertise. You certainly need a subject matter expert on each team, at least one person who is familiar with the area being investigated. Then you need an investment professional, someone from the industry who knows precisely what to look for. And you also need an accountant on the team capable of combing financial statements until every flea shakes out.
Currently the SEC measures the performance of a regional office by the number of exams it conducts annually, a totally worthless statistic. The SEC’s stated mission is to protect investors and to find or prevent fraud. As David Kotz’s report has shown, conducting poorly planned and executed exams and then promoting staff based on the completion of those exams is not a deterrent to fraud. Incredibly, people involved in the Madoff examination were promoted. The goal should never be how many pieces of paper were inspected, but rather how much fraud was caught or prevented.
The success metrics the SEC should use to determine the value of its examination teams are income from fines, dollar damages recovered for investors, dollar damages prevented, and the number of complaints received from Congress complaining about the severity of those fines or the thoroughness of the agency’s investigation. The way exams are currently conducted, they catch so little major fraud as to be worthless, unless someone actually believes that compiling minor technical violations stops fraud.
Until the SEC puts professionals on these examination teams and allows them to conduct thorough examinations, the odds of uncovering the next Bernie Madoff—and Bernie was not out there alone—are minuscule at best.
Fourth, money talks business. The only way the SEC is going to attract those qualified industry professionals it needs is to increase its pay scale and offer incentive compensation tied to how much in enforcement revenue each office collects. Make it financially worthwhile to do this job right. The SEC pays peanuts and then wonders how it ended up with so many monkeys. Firms in the financial industry pay a salary plus a bonus and to attract the best talent; the SEC needs to be competitive. Obviously SEC Commissioners would be setting the levels of fines for enforcement actions, but each SEC regional office should keep some percentage—I recommend 10 percent to start—which would form an office bonus pool.
If you want to motivate enforcement officers, a pile of bonus money will light that fire. Staff members should be given a proper incentive; believe me, if there is a bonus at stake and someone tries to stop a staff member from bringing a big case, the staffer will roll over the obstacle with a bulldozer to get that case in the door.
Regional enforcement teams that uncover a $100 million case should be compensated for that. And to prevent taxpayers from having to pay these multimillion-dollar bonuses, I would insist that the fines be triple the amount of actual damages and that the guilty firms pay the cost of the government investigation—so the SEC staff bonuses given out for uncovering fraud are paid by the people and companies committing those frauds.
In the financial centers like New York and Boston, where the cost of living is high, I believe base compensation should be $200,000. That’s a salary level sufficient to attract the brightest and most experienced industry professionals. Compensation above that would need to come from each regional office’s bonus pool and be tied directly to revenues from fines each office generates. People who don’t bring in quality cases that settle eventually
will be asked to leave to make room for other people who can produce solid cases and generate bonus revenue.
Fifth, relocate the SEC headquarters to New York City. New York, New York, it’s a wonderful town. I love Boston, but the single thing the SEC can do to quickly upgrade the agency’s talent pool is move its headquarters to New York City. Currently the SEC headquarters are in Washington, D.C., and Washington, D.C., is the place where you’ll find a lot of politicians, but not very many qualified finance professionals. As New York is the world’s largest financial center and Boston is the world’s fourth largest financial center, moving the SEC to New York City or elsewhere in the New York-New England corridor makes a lot of sense. Put the SEC headquarters in the center of the financial industry, a place with easy access to New York and Boston. Go where the best people are instead of trying to lure the best people to where the politicians are.
Sixth, book ‘em. If you walk into any substantial investment industry firm, you’ll find a library stocked with professional publications for its staff to use as an important resource. Among those publications would be the Journal of Accounting, Journal of Portfolio Management, Financial Analysts Journal, Journal of Investing, Journal of Indexing, Journal of Financial Economics, even the Wall Street Journal. But if you walk into an SEC office, you probably won’t see any of these publications—and you won’t find an investment library. So where do SEC staffers actually go to research an investment strategy, or find out which formulas to use to calculate investment performance, or even figure out what a CDO-squared is? Apparently the SEC staff uses Google and Wikipedia—because both of them are free. Good luck to a man or woman attempting to figure out a complex financial instrument using free Web resources. The SEC makes sure its staff will remain uneducated—by not providing the educational tools they need.
No One Would Listen: A True Financial Thriller Page 34
