Wednesday, January 7, 2009

Inspector General to Ask SEC Some Tough Questions

On January 5, the SEC's Inspector General, H. David Kotz, testified before the House Committee on Financial Services regarding the Office of the Inspector General's (OIG's) activities and plans to investigate the SEC's handling of matters related to Bernard Madoff and affiliated entities.  The OIG has been asked to undertake an investigation into:
  • allegations made to the SEC regarding Mr. Madoff, going back to at least 1999, and the reasons that these allegations were deemed not to be credible;

  • the SEC's internal policies that govern when allegations of fraudulent activity should be brought to the Commission;

  • whether those policies were followed; and

  • whether improvements to those policies are necessary.
In addition, Mr. Kotz testified that the OIG's investigation will look into all staff contact and relationships with the Madoff family and firm, and any effect such relationships had on staff decisions regarding the firm.

More specifically, Mr. Kotz testified that his office intends to investigate the following issues:

  • The SEC's response to complaints it received regarding the activities of Bernard Madoff, including any complaints sent to the Division of Enforcement, OCIE, the Office of Risk Assessment and/or the Office of Investor Education and Advocacy. We plan to trace the path of these complaints through the Commission from inception, reviewing what, if any, investigative or other work was conducted with respect to these allegations, and analyze whether the complaints were handled in accordance with Commission policies and procedures and whether further work should have been conducted;

  • Allegations of conflicts of interest regarding relationships between any SEC officials or staff and members of the Madoff family, including examining the role a former SEC official who allegedly had a personal relationship with a Madoff family member may have played in the examination or other work conducted by the SEC with respect to Bernard Madoff or related entities, and whether such role or such relationship in any way affected the manner in which the SEC conducted its regulatory oversight of Bernard Madoff and any related entities;

  • The conduct of examinations and/or inspections of Bernard Madoff Investment Securities LLC by the SEC and an analysis of whether there were "red flags" that were overlooked by SEC examiners and inspectors (which may have been identified by other entities conducting due diligence), that could have led to a more comprehensive examination and inspection, including a review of whether the SEC violated its own policies and procedures by not conducting timely reviews or examinations of Bernard Madoff's activities and filings; and

  • The extent to which the reputation and status of Bernard Madoff and the fact that he served on SEC Advisory Committees, participated on securities industry boards and panels, and had social and professional relationships with SEC officials, may have affected Commission decisions regarding investigations, examinations and inspections of his firm.
Depending on what the OIG's investigation into the SEC's handling of Bernard Madoff turns up, Mr. Kotz testified that the OIG may expand its activities to a more ambitious investigative agenda addressing the effectiveness of the SEC's inspection and enforcement structures and procedures.  As appropriate, the OIG intends to take a serious look at:
  • The complaint handling procedures of the Division of Enforcement, including a review of how complaints are processed, internal incentives that may affect the decision whether to take action with respect to a complaint, an analysis of which complaints are brought to the Commissioners' and Chairman's attention, and whether tangible and specific complaints are being reviewed and followed-up on appropriately;

  • The OCIE examination and inspection procedures, including an analysis of what policies and procedures were then and are currently in place, whether these policies and procedures are being followed and/or whether there are gaps in these policies and procedures relating to operations involving voluntary private investment pools, such as hedge funds, because they are subject to limited oversight by the SEC, and whether any such gaps may lead to fraudulent activities not being detected; and

  • The relationships between different divisions and offices within the Commission and whether there is sufficient intra-agency collaboration and communication between the Agency components to ensure comprehensive oversight of regulated entities.
Mr. Kotz promised an independent and expeditious investigation resulting in "more than just the potential identification of individuals who may have engaged in inappropriate behavior or potentially failed to follow-up appropriately on complaints, but rather an attempt to provide the Commission with concrete and specific recommendations as appropriate to ensure that the SEC has sufficient systems and resources to enable it to respond appropriately and effectively to complaints and detect fraud through its examinations and inspections."

The complete text of Mr. Kotz's January 5, 2008 testimony is available at: