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House Committee Questions SEC Inspector General About Madoff Scandal

The House Financial Services Committee yesterday questioned the SEC's inspector general and the president/CEO of the Securities Investor Protection Corp. about the Bernard Madoff Ponzi scheme. David Kotz, the SEC's inspector general, outlined the steps that his office will take in response to a request by Chairman Christopher Cox to investigate the Madoff matter, including the reasons that allegations about Madoff, dating back to 1999, were not found to be credible by the staff.

Cox asked the inspector general to look at the internal policies that dictate when allegations of fraudulent activity should be brought to the Commission. The inspector general's office will also look into any staff contacts or relationships with the Madoff family and whether they affected staff decisions. The inspector general's investigation was opened on December 17 and included a document preservation notice to the entire Commission. The office has requested documents from the Division of Enforcement and the Office of Compliance Inspections and Examinations.

Kotz advised that his office has been given additional resources to assist in the investigation, including office space, administrative assistance and new investigators. Witnesses have been identified and interviews will begin shortly. The office has scheduled a meeting with Harry Markopoulos who years ago tipped the SEC to what he had concluded was a Ponzi scheme conducted by Madoff. Kotz added that the investigation may go beyond the specific issues that Cox asked his office to examine.

Kotz explained that his office will look at the broader issues affecting the operations of the Division of Enforcement and OCIE. His office will trace the complaints to the SEC from their inception and the staff's response, including whether the complaints were handled in accordance with the SEC's policies and procedures. The investigation will include a review of the allegations of conflicts of interest with respect to relationships between SEC staff and the Madoff family. Kotz said his office will also determine whether any red flags were overlooked by examiners and inspectors.

The inspector general will review the complaint handling procedures by the Division of Enforcement, OCIE's examination and inspection procedures and the extent of the intra-agency collaboration and communication. At the end of the investigation, Kotz said his office should be able to identify any individuals who engaged in inappropriate behavior and make recommendations to ensure the SEC's systems enable it to respond effectively to complaints. Kotz said he understands the need to conduct the investigation promptly and conclude it swiftly.

Kotz is considering the preparation of reports on a rolling basis as discrete issues are identified and resolved. He also assured the committee that the investigation will be independent. If criticism is warranted, Kotz said his staff will not hesitate to report the facts and the conclusions it reaches.

SIPC president and CEO Stephen P. Harbeck said that 2008 was unlike any other year in SIPC's history, including the liquidation proceedings involving Lehman Brothers Inc. and now the liquidation of Bernard L. Madoff Investment Securities LLC. Lehman Brothers' failure was linked to the systemic failure of the subprime mortgage market, he said, but Madoff's liquidation is the result of the theft of customer assets on an unprecedented scale.

In the Lehman case, the customer records were accurate, Harbeck noted, but in the Madoff case, the statements that were sent to customers bore little relation to reality. That made it impossible to transfer assets to another solvent brokerage firm. Instead, notices were sent to 8,000 customers and creditors along with claim forms. The trustee has requested information from customers about the amount they gave to or withdrew from the firm to help determine what each is owed. The extended period of the deception may make it difficult to reconstruct the correct amounts.

Harbeck noted that the $50 billion that reportedly was stolen may include the annual "profits" Madoff reported to investors. The maximum amount that the SIPC may advance to any one claimant is $500,000. The trustee has obtained a court order authorizing the release of $29 million of debtor assets to him, according to Harbeck, and another $830 million in liquid assets has been identified. Depending on the potential cost of customer claims, SIPC may have to adjust the target balance of the SIPC fund. He said the SIPC's $1 billion line of credit with the Treasury has not changed since the passage of the Securities Investor Protection Act in 1970. Harbeck added that SIPC has never used the line of credit.

Several committee members asked Kotz whether he will look into the accounting firm that was employed by Madoff, suggesting that a fraud of this size could not be implemented without the involvement of the auditors. Kotz said his initial investigation will focus on the SEC, but his office will look at whether the size of the audit firm should have been a red flag.

Spencer Bachus (R-AL) noted that Madoff claimed to do something no one else was able to do and that the market did not support his claimed strategy. Bachus asked if the SEC has staff with the expertise to recognize that what Madoff was claiming was impossible. Kotz said the staff should have the necessary expertise, but his office would look into that.

A number of committee members also raised concerns about SEC exemptions that permitted broker-dealers to use audit firms that were not registered with the PCAOB. Paul Kanjorski (D-PA) noted that the exemptions have been extended for three years and suggested that the fraud may not have occurred if Madoff was required to use a registered auditing firm. Carolyn Maloney (D-NY) echoed those concerns and said she has lost confidence in the SEC. Madoff relied on a model that no one understood and used an auditor that no one had heard of, she said.

Harbeck advised that his office is meeting this week with the SEC's Division of Trading and Markets to determine the best way to handle the distribution of funds to investors. Those with the shortest trail will have the best records, he said. He emphasized the importance of investors submitting whatever documentation they have about their accounts with Madoff.