From the January 2009 issue of Investment Advisor • Subscribe!

January 1, 2009

More Regulation Post-Madoff?

The only thing they are certain of is that his alleged Ponzi scheme--estimated at $50 billion--will prompt fresh calls for regulators to beef up enforcement and possibly adopt new rules for loosely supervised hedge funds. "If this fraud is even a fraction of the magnitude that is alleged, there will be calls for regulation that will mandate some level of auditing, compliance, and monitoring," said Jacob Frenkel, a former Securities and Exchange Commission enforcement lawyer who is now in private practice.

Even before this debacle, lawmakers including Rep. Barney Frank (D-Massachusetts), hinted that hedge funds would face new rules in the next year. They might be asked to have bigger capital reserves and reveal certain positions to the Federal Reserve so central bankers can monitor risk.

Bernard Madoff, a pioneer on Wall Street and former chairman of the Nasdaq Stock Market, was famous for telling clients his name was on the door and that he worked hard to maintain an unblemished record of value, fair dealing, and high ethical standards, his firm's hallmark.

But some people said increased oversight might include giving regulators the right to make spot checks at hedge funds to review auditing practices. If such regulation had been in place, it might have shed some light on Madoff's years of steady returns that many investors said looked too good to be true.

"If you look at his performance, it was a straight line up. That's silly," said a Wall Street professional who at one point worked with a firm that did business with Madoff feeder funds. "He did not have a reputable auditor, which was another giant red flag. He wouldn't talk to you about how he made money. He met with very, very few people, and if you did meet him, you got 20 minutes with him." This Wall Street professional requested anonymity because he was not authorized to speak to the media.

As more details of Madoff's alleged fraud emerge, some people also wondered if the Securities and Exchange Commission, which has been harshly criticized for not having done enough to mitigate this year's financial market meltdown, missed warning signs at Madoff's New York firm, Bernard L. Madoff Investment Securities. (On December 12, the SEC seized the firm and placed it into receivership; Madoff himself was arrested in New York by the FBI on December 11, charged with securities fraud, and released on $10 million bond the same day.)

"I've got to think that regulators will look at this and see that there might have been some way they could have headed this off at the pass," said Peter Turecek, a managing director at Kroll Inc., a risk consultancy owned by Marsh & McLennan Cos. Inc.

But Lynn Turner, the SEC's former chief accountant, said it was too early to tell whether the SEC missed crucial signs.

The scope of the alleged fraud is still unknown, Turner said. While Madoff has pointed to $50 billion, he was supposedly only managing $17 billion in assets. Turner questioned whether the alleged fraud was committed in the portion of Madoff's business that would be within the scope of a regular inspection.

"If it turns out that this occurred at a time when the SEC didn't have the resources to do an inspection, then there may be calls for resources for the SEC to do its job," he said. (For more on what the SEC may need to do its job, and what President-elect Obama's thinking is on the subject, see page 17 in the News section.)--Svea Herbst-Bayliss and Jeff Joseph

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