A Fresh View of the Madoff Scandal

The news of the crimes by Bernie Madoff has dominated the headlines since his arrest in December. As the lynch mob mentality has now run it’s course, it is appropriate to re-examine the method that he used to commit his crimes and the regulatory environment that allowed him to get away with it for so long.

We know that Madoff chose to utilize a “secret” firm located on a separate floor to run his Ponzi scheme. We know that he registered this firm, on advice of counsel, in 2006. The firm was not new and had been managing, or in Madoff’s case stealing, money for years. However, prior to 2006, there was no requirement to register this particular type of advisor as it was considered exempt from the Investors Act of 1940. This act required the registration of firms that provided investment management as defined by the Act and the Madoff firm fell under the exemption because it was an advisor to hedge funds. Neither hedge funds, or their advisors, were required to register with any self-regulatory or governmental agency.

The Act exempts these funds and advisors because of the limited number of clients that invest in them and because their investors had to be “accredited”. Accredited investors must have a minimum net worth of $1,500,000 or an annual income for the previous two years of at least $200,000. Basically, congress decided many years ago that wealthy investors would be willing to give up some regulatory protection in exchange for the ability to invest in products that were limited in distribution. Consider it a privilege of wealth! In 2005, the SEC adopted new rules requiring “advisers to certain private investment pools (“hedge funds”)” to register their firms with the SEC by February 1, 2006. They decided to require the registration because they redefined the definition of investor. In most of these funds, the investors are institutional hedge funds with numerous clients. Prior to the new rule, each one of these funds was considered to be one investor and the SEC did not “look through” the fund to find the actual number of investors that the fund represented. With the new rule in place, Madoff was advised to register his fund and he registered prior to the deadline of February 1, 2006.

In justifying the new rule, the SEC stated that they ”are concerned that individuals have targeted hedge fund investors and chosen hedge funds as a vehicle for fraud because these individuals could operate their funds without regulatory scrutiny of their activities”. Hedge funds offered, and continue to offer, an unregulated environment that provided generous compensation and the ability to manage money without oversight!

Phillip Goldstein, co-founder of Bulldog Investors, hedge fund advisor, director, and a well-known hedge fund activist filed suit to block the SEC rule. Mr. Goldstein has worked vigorously to prevent regulation of hedge funds and has portrayed the ability of hedge funds to operate in secret as a “first amendment issue”. In a unanimous decision on June 23, 2006, the US Court of Appeals for the District of Columbia agreed with him and struck down the rule. As a result of this decision, advisors to hedge funds could continue to operate with minimal regulation and without registering!

In his testimony to congress on July 25, 2006, then SEC Chairman Christopher Cox responded saying, “given the recent invalidation of the SEC’s hedge fund rule by the United States Court of Appeals, we have been forced back to the drawing board to devise a workable means of acquiring even basic census data that would be necessary to monitor hedge fund activity in a way that could mitigate systemic risk.
The current lack of such basic data requires me to hedge when I say that the SEC’s best estimate is that there are now approximately 8,800 hedge funds, with approximately $1.2 trillion of assets. If this estimate is accurate, it implies a remarkable growth in hedge fund assets of almost 3,000% in the last 16 years.” If the Chairman of the SEC doesn’t know how many hedge funds exists, how can we expect the SEC to successfully prevent criminal activity within them?
Congress needs to remove the hedge fund exemption in its entirety. Allow the SEC to examine the books and records, just as they do for investment advisors. The SEC cannot be expected to investigate operations that can simply turn them away at the door. Blame Madoff, not the SEC.

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