Can SEC Enforcement Be Revitalized? Lessons From Current Scams

SEC enforcement is widely perceived as ineffective. See, e.g., Gretchen Morgenson, “Following Clues the S.E.C. Didn’t,” New York Times, Business at 1 (Feb. 1, 2009) (available here, registration required). Concerns stem from recent high profile failures. The much talked about Madoff scandal is the most visible example. Of equal concern however, should be the responses from the agency to date: Fraud such Ponzi schemes are very difficult to detect; the Commission needs more resources.

Lack of resources is clearly not the reason the Madoff scheme was not uncovered. There the SEC had multiple chances and simply failed to investigation. Beginning in 1992, the SEC had the opportunity to find the fraud. It did not. In 2006 it had another chance as discussed here. It failed. This is not a lack of resources. It is a lack of investigation.

This is not to say that the SEC does not need more resources. Clearly it does. More resources would help the SEC police the markets more effectively. The reality is however, that no matter how many more resources the SEC it given, those will be small compared to the enormous task the Commission has been assigned. As the cop of the securities markets, the amount of resources the SEC can focus on any given matter has always been small compared to those which can be expended by powerful companies it the markets and their large law firms. That has not stopped the SEC from earning a well deserved reputation for excellence in the past. Resources can help it rebuild that reputation in the future – if they are used effectively.

Fraud is difficult to detect. That does not mean it cannot be found. Insider trading, for example, is notoriously difficult to detect. Yet, last year the SEC filed more insider trading cases that the prior year.

Ponzi schemes, like Madoff, are also difficult to detect. That does not mean that the SEC cannot find them. This is particularly true now that everyone is focused on them. A quick review of headlines from the Litigation Releases issued by the agency in January 2009 illustrates the point:

Release 20842, January 6, 2009: South Florida Investment Adviser Indicted for Multi-Million Dollar Misappropriation and Ponzi Scheme;

Release 20846, January 7, 2009: Mutual Benefits’ Founding Principals and Others Charged in $1 Billion Investor Fraud and Ponzi Scheme;

Release No 20947, January 8, 2009: SEC Charges Joseph S. Forte For Conducting $50 million Ponzi Scheme;

Release No. 20849, January 9, 2009: Temporary Restraining Order Entered in Multi-Million Dollar Offering Fraud and Ponzi Scheme in Western New York;

Release No. 20850, January 12, 2009: Judgments Entered Against Defendants … in Ponzi Scheme in Colorado;

Release No. 20953, January 15, 2009: SEC Sees Temporary Restraining Order To Halt Ponzi Scheme; and

Release No. 20874, January 30, 2009: SEC Obtains Preliminary Injunctive Relief in Case Involving a Ponzi Scheme.

This list does not even include frauds like SEC v. Nadel, Civil Action No. 8:09-CV-00087 (M.D. Fla. Jan. 21, 2009), a claimed fraudulent hedge fund operation or SEC v. Grigg, Civil Action No. 3 09 0087 (M.D. Tenn. Filed Jan. 28, 2009), where the alleged fraudsters were selling investors non-existent shares of a fund that supposedly invested in part in the government’s bail out program, TARP (discussed here) or SEC v.Dreier, Civil Action No. 08 Civ. 10617 (S.D.N.Y. Filed Dec. 8, 2008), where a lawyer sold hedge funds fraudulent securities (discussed here). Clearly these frauds can be uncovered when investigators focus and follow-up on leads as in Dreier, where a potential investor discovered the fraud and reported it.

All of this suggests that uncovering and prosecuting fraud is a function of effective investigation. In part, that requires assistance from investors in the market place as Dreier illustrates. Indeed, investor vigilance is critical. The fraudulent schemes listed above, and others such as Madoff, all hinge on a common element: The promise of returns not usually available from other investments and with little risk.

The scheme conducted by Charles Ponzi in 1920 is typical. Mr. Ponzi promised investors a 50% profit in forty five days. New York Times, July 27, 1920. In hindsight Mr. Ponzi’s promise may seem almost frivolous. A moment of reflection should suggest that the 50% in 45 days Mr. Ponzi promised cannot be done. Yet, that promise differs little from the one made by Mr. Madoff who claimed to make a profit for investors day in and day out year after year regardless of market conditions. Everyone knows that nobody wins all the time, every day, every year as claimed by Mr. Madoff. Yet, investors rushed to give Mr. Ponzi their hard earned cash and flocked to Mr. Madoff.

All this suggests in the end that regulators such as the SEC and investors need to work together. The SEC and other regulators have to encourage investors to provide it with information and then effectively investigate and follow-up on those leads. Investors have to furnish those leads. That begins by realizing that if it the promise is of something others cannot achieve, then it probably cannot be achieved. Stated differently, if it looks to good to be true, then it probably is. If investors report the “to good to be true” opportunities and the SEC effectively investigates, the Bernard Madoff’s of the world will be stopped and prosecuted in a timely fashion before investors are harmed.

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