The Commission’s New Chairwoman And The Madoff Scandal

Mary Schapiro was sworn in as the new SEC Chairwoman. Ms. Schapiro has previously served as the CEO of the Financial Industry Regulatory Authority, the Chairwoman of the CFTC and as an SEC Commissioner.

Ms. Schapiro assumes the position of Chairwoman at a pivotal time in the history of the agency. The market crisis which continues to transform Wall Street and the financial markets is on-going and seems to be never ending. Many have questioned whether the agency is an effective market regulator and up to the task of policing the securities markets, a key part of its historic mission. Others have suggested that the SEC should be merged with the CFTC and perhaps the Fed.

During confirmation hearing testimony, Ms. Schapiro stated that she would reinvigorate the Commission’s troubled enforcement program which many claim is ineffective and that has been the subject of adverse publicity in light of the Madoff scandal. Retooling the enforcement division and restoring the program and investor confidence in it will no doubt be a difficult task in the current environment.

While Ms. Schapiro was being sworn in Lori Richards, Director, Office of Compliance and Inspections and Examinations, and Linda Thomsen, Director Division of Enforcement, were on Capital Hill testifying before the Senate Committee on Banking, Housing and Urban Affairs. The focus of the testimony was the Madoff scandal and the Commission’s prior investigations.

Ms. Richards’ testimony consisted largely of a review of the Commission’s examination program. With respect to Mr. Madoff, Ms. Richards noted that he first registered his investment advisory business in 2006. That business was never inspected. In contrast, the Madoff broker-dealer operation was subject to routine examination oversight by the firm’s SRO and “was also subject to several limited-scope …” exams by the staff. No fraud was found. Ms. Richards noted however, that she was “not authorized to provide specific information about past regulatory oversight …” of Mr. Madoff.

Ms. Thomsen also did not discuss the allegations regarding the prior investigations of Mr. Madoff. After noting that there are on-going law enforcement investigations that might be compromised, Ms. Thomsen provided the Committee with an overview of three actions related to Mr. Madoff which have been brought by the Commission. The first is the current enforcement action, filed after the Ponzi scheme was revealed. SEC v. Madoff, Case No. 08 Civ. 10791 (S.D.N.Y. Dec. 11, 2008).

The second is a 1992 action captioned SEC v. Avellino & Bienes, Lit. Rel. No. 13443 (Nov. 27, 1992). The defendants there raised $441 million from 3,200 investors through unregistered securities offerings. The investors received notes with interest rates of between 13.5 and 20%. The funds were invested in discretionary brokerage accounts with Mr. Madoff’s broker-dealer firm. The case was settled with the return of investor funds, an accounting at Avellino & Bienes and the payment of penalties by the defendants.

A third case is SEC v. Telfran Associates, Ltd., Lit. Rel. No. 13463 (Dec. 9, 1992). This case involved the creation of a feeder fund to Avellino & Bienes. About $88 million was raised from 800 investors through unregistered securities offerings over a three-year period. Investors were promised a return of 15%. This action was settled on terms similar to the Avellino & Bienes case.

Ms. Thomsen’s only reference to the 2006 initial inquiry conducted by the New York Regional Office and discussed here noted that the matter was opened and closed: “As widely reported in the press, the SEC’s New York Regional Office commenced another investigation of Mr. Madoff in early 2006. Two years later, in January 2008, that investigation was closed without any recommendation of enforcement action.” In that inquiry, the Commission’s internal documents state that the investigation began based on allegations that Mr. Madoff was conducting a Ponzi scheme. At the time the case was opened, the Commission had received a detailed letter about the possible fraud from a source the staff found to be credible. Little was done in the two years the investigation was open and there is no indication the Ponzi scheme allegation was investigated.

The enforcement director went on to review how the division handles complaints, tips and referrals and the care with which this material is reviewed. Ms. Thomsen concluded her testimony with three suggestions to prevent future frauds: 1) certain regulatory reforms focused on “harmonizing the regulatory regimes that apply to these similar products and businesses …”; 2) more staff for the Commission; and 3) investor education. There was no mention of reforming the enforcement program.

The SEC Concludes A Financial Fraud Case; PCOB Staff Guidance For Small Companies

The SEC: On Friday the SEC announced the conclusion of a case arising out of the financial fraud at Hayes Lemmerz International, Inc. The court entered judgments against Ranko Cucuz, the former CEO, and William D. Shovers, the former CFO of the company.

The action centered on a financial fraud which took place at Hayes from 1999 through 2001. According to the Commission’s complaint, senior officers of the company engaged in a scheme to meet earnings targets and disguise the declining operating results at the company. Key elements of the scheme included: 1) inappropriately deferring operating expenses to balance sheet accounts; 2) failing to process vendor invoices; 3) understating employee fringe benefits; and 4) improperly recording certain customer discounts to balance sheet accounts. As a result, Hayes made materially false filings with the Commission for the fiscal years 1999 and 2000 and the first quarter of 2001.

On April 25, 2006, the Commission brought an enforcement action against the company and four former senior officers. In addition to Messrs. Cucuz and Shovers, the SEC named as defendants Ronald Kolakowski, former President of the North American Wheel Group, and Jesus Bonilla-Valdez, former Vice President of the Aluminum Wheel Group. SEC v. Cucuz, Civil Action No. 2:06-CV-11935 (E.D. Mich. Filed April 25, 2006)

The company settled at the time the complaint was filed, consenting to the entry of a permanent injunction prohibiting future violations of the antifraud, reporting and internal control provisions of the federal securities laws. Mr. Kolakowski also settled at that time, consenting to the entry of a permanent injunction prohibiting future violations of the same statutory sections as the company. In addition, Mr. Kolakowski consented to the entry of an order baring him from being an officer or director for ten years and requiring him to the pay a $75,000 civil penalty. Defendant Jesus Bonilla-Valdez settled with the Commission on January 14, 2007. He consented to the entry of a permanent injunction containing the same provisions as the earlier settlements. In addition, he consented to the entry of an order requiring him to pay a $30,000 civil penalty. Four other employees settled with the Commission in administrative proceedings. These actions are listed in Release No. 20864.

Messrs. Cucuz and Shovers were found liable by a jury on August 20, 2008. Based on the verdict of the jury, the court entered final judgments against each defendant. The judgment against Mr. Shovers imposed a permanent injunction prohibiting future violations of the antifraud and reporting provisions of the federal securities laws, barred him from acting as an officer or director for a period of five years and imposed a civil penalty of $50,000. The judgment against Mr. Cucuz also contained a permanent injunction which barred him from future violations but only of the antifraud provision of the Securities Act. The judgment also imposed a $10,000 civil penalty. The Commission’s complaint had charged Mr. Cucuz with violations of a the antifraud and reporting provisions of the Securities Exchange Act including Sections 10(b), 13(a), 13(b)(2)(A) and 13(b)(2)(B) as well as Rule 13b2-2, lying to auditors.

PCAOB: The Public Company Accounting Oversight Board on Friday published “An Audit of Internal Control Over Financial Reporting That is Integrated with An Audit of Financial Statements: Guidance for Auditors of Smaller Public Companies.” This staff guidance explains how auditors can apply the principles of Auditing Standard No. 5 to audits of smaller public companies.