No One Would Listen: A True Financial Thriller (48 page)
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Authors: Harry Markopolos
BOOK: No One Would Listen: A True Financial Thriller
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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 they’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.
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.
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.
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.
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.
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.
Seventh, card ’em.
Perhaps the easiest change the SEC can make is to supply every employee with business cards. If SEC employees want their own business cards, they have to pay for the cards themselves. It’s very difficult to get a call back from someone you’ve met at an industry conference—assuming you are permitted to attend an industry conference—or from an employee of a firm who you’ve just suggested should “Call me if you run across a securities fraud” if you can’t hand the employee your business card. If private industry provides business cards for its employees, then so should the SEC. It’s common sense.
Perhaps the easiest change the SEC can make is to supply every employee with business cards. If SEC employees want their own business cards, they have to pay for the cards themselves. It’s very difficult to get a call back from someone you’ve met at an industry conference—assuming you are permitted to attend an industry conference—or from an employee of a firm who you’ve just suggested should “Call me if you run across a securities fraud” if you can’t hand the employee your business card. If private industry provides business cards for its employees, then so should the SEC. It’s common sense.
These business cards should include the list of professional credentials each SEC staffer has obtained. Credentials such as CAIA, CFA, CFE, CFP, CIA, CISA, CPA, FRM, JD, PhD, and any other initials earned should appear prominently on all business cards. And maybe at the bottom of each card the words “To report a securities fraud, call me” could appear. This would send the message that each SEC staff member is a fraud fighter first. And business cards should be given to secretaries and clerks, too, as a way of building internal pride in the agency as well as advertising that the SEC is in the fraud-fighting business.
When these staffers do receive that call reporting a potential fraud, they should immediately forward it to the proper person under the SEC’s new standard operating procedure for handling whistleblower tips.
Eighth, go to events.
The SEC should encourage its staff to participate in industry events. The thinking in not encouraging this, I assume, is to keep the staff away from the people they regulate. I believe the most important thing the SEC can do to increase the opportunities for uncovering fraud is to encourage staff members to socialize with industry professionals wherever and whenever possible. Interacting with industry professionals before and after industry functions is a great way to keep up to date with what’s happening in the industry and obtain tips on possible frauds—especially when they are just beginning.
The SEC should encourage its staff to participate in industry events. The thinking in not encouraging this, I assume, is to keep the staff away from the people they regulate. I believe the most important thing the SEC can do to increase the opportunities for uncovering fraud is to encourage staff members to socialize with industry professionals wherever and whenever possible. Interacting with industry professionals before and after industry functions is a great way to keep up to date with what’s happening in the industry and obtain tips on possible frauds—especially when they are just beginning.
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