Opinion: Why Didn't FINRA Catch Madoff?
Traders Magazine Online News, January 8, 2009
Press reports have raked the SEC over the coals because of the Madoff scandal. Much has been made over the fact that Shana Madoff is married to a former SEC official, a private matter of no relevance to the issues involved.
I submit that this focus is misplaced. Instead, we should be asking, why didn't FINRA catch up to Madoff? A few days ago, after weeks of tireless reporting, the Wall Street Journal finally tried to probe Mary Schapiro on this question. Mary has been in charge of FINRA and its regulatory predecessor, NASD Regulation, for many years. She did not respond to the Wall Street Journal's inquiries.
Equity traders rarely are a focus of attention during a financial crisis. They accept and execute orders; they don't make investment decisions. Occasionally a trader "goes rogue" and wildly exceeds his or her trading authority, but the business ordinarily doesn't provide much opportunity for fraud of a magnitude sufficient to bring a financial institution to its knees. For that reason, the Madoff scandal is unique. A trader well-known in equity trading circles apparently has engineered a fraud sufficient to make him front page news in the financial press for weeks.
That said, there is no evidence that the Madoff scandal involved its trading operations. After all, the Madoff firm was famous for executing lots of small orders in listed securities. These are orders that by their nature tell us little or nothing about market direction. The various frauds that typically occur on a trading desk - front-running, marking the close, manipulation of thinly traded securities - are difficult to accomplish at a firm that handles small orders from other broker-dealers for extremely liquid, listed equities. Moreover, institutional trading firms like Madoff typically do not hold client funds, but trade delivery versus payment. So that rules out frauds that involve stealing from customer accounts. While the magnitude of the Madoff fraud is truly staggering, it is difficult to see how the Madoff trading operation was involved in any significant way, except perhaps as a front for what was really going on.
The Madoff firm,however, was a broker-dealer, and therefore it was entitled to do more than merely make markets in stocks, provided that it received permission from FINRA to engage in other activities. It seems that FINRA granted Madoff permission to hold funds and securities for clients, and to manage those accounts as a discretionary broker.
The financial press is very confused about all of this. I still see news reports calling Madoff a hedge fund. It was not. It was, besides making a market in equities, a broker-dealer holding customer funds and securities in discretionary accounts. This is a traditional brokerage activity.
Of course, to those who are not used to the fine distinctions that exist in the financial services industry, discretionary brokerage looks a lot like investment management. But discretionary brokerage was a traditional brokerage activity in 1934, when our current system of regulation was enacted, and continues to be part of the business of many broker-dealers to this day. In 2003, about 70 years after the Securities Exchange Act of 1934 was enacted, the SEC finally came around to the notion that discretionary brokers ought to register as investment advisers under the Investment Advisers Act of 1940, as well as being registered as broker-dealers. When this regulation became effective, the Madoff firm registered as an investment adviser, while retaining its registration as a broker-dealer.
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