SEC not alone in missing the Madoff debacle

The Securities and Exchange Commission’s inspector general, David Kotz, rightfully excoriated the agency for its failure to expose the Madoff scheme during its investigations of the firm.

The lack of curiosity displayed by SEC examiners is inconceivable and inexcusable, given that there were many occasions when the commission received hints that something wasn’t right at Bernard L. Madoff Investment Securities LLC.

Top SEC officials allowed Mr. Madoff to disarm the commission by letting him infiltrate it through his role in the founding of The Nasdaq Stock Market Inc. and as a director of what is now the Securities Industry and Financial Markets Association.

No doubt, reforms have been made at the SEC, and hopefully, its examiners will be more on their toes as they look for fraud.

Perhaps the financial reforms that will be debated in Congress this fall will produce ideas that will help hold the SEC’s feet to the fire so that the fervor doesn’t fade.

In one reform effort, Sen. Charles E. Schumer, D-N.Y., will introduce a bill to make the SEC self-funded by allowing it to keep the fines it levies against wrongdoers and the fees it collects from financial institutions for transactions, mergers and registrations. Currently, it has to turn over all fines and fees to the Department of the Treasury and is then funded by congressional appropriations.

In 2007, the SEC collected $1.54 billion in fees but received just $881.6 million through appropriations.

The SEC, however, can never be big enough, can never be smart enough, can never have enough resources to catch all the crooks attracted to the financial markets. The bad guys go where the money is, and these days, the real money is in the financial markets, not in the banks.

The SEC will need the help of financial planners, investment advisers and brokers. They, too, must be more alert to possible fraud and be more willing to alert the SEC or the Financial Industry Regulatory Authority Inc. when they suspect that something is amiss.

The SEC wasn’t alone in missing warning signs about Mr. Madoff’s firm. The failure to detect the fraud was a widespread industry failure.

Third-party marketing firms, often masquerading as investment consulting firms, failed to do even reasonable due diligence on the firm. They never questioned Mr. Madoff’s claimed investment returns, though those big boasts struck at least a few observers as too good to be true.

So-called industry experts allowed themselves to be reassured by his powerful connections and seduced by the rich finder’s fees he paid. So they didn’t examine too closely the documents that Mr. Madoff provided, and never checked with third parties to make sure that those documents were real.

Many advisers also were incurious about the steady returns Mr. Madoff claimed, when their years of training should have told them such consistency was unlikely. These advisers were thrilled when some of their clients were allowed into his fund.

All these groups, and their clients, forgot the old truth: If it seems too good to be true, it probably is.

Financial fraud is unlikely ever to be eliminated from the financial markets, but if it is to be reduced, all honest investment advisers and brokers must be on the alert for signs of it and be willing to blow the whistle to the SEC.

The industry’s anti-fraud antennae must be tuned to higher frequencies to catch the faintest signals.