How to Transform the SEC Into a '21st-Century Regulator'
The Right People for the Job
One of the SEC's most glaring inadequacies revolves around staffing. From complaints that there are too many lawyers and not enough industry practitioners to rumblings that the growing number of investment firms is difficult for the SEC to keep up with, staffing has become a major issue for the regulator.
Markopolos was the center of a recent hearing in which he detailed his recommendations for improving the SEC. At the top of his list, Markopolos recommended upgrading SEC employee qualifications and educational budgets to improve the quality of the staff.
In his testimony Markopolos pointed out that there is no entrance exam for or test of prospective SEC employees' knowledge of the capital markets. "By failing to hire industry-savvy people, the SEC immediately sets their employees up for failure, and so it should not be surprising that the SEC has become a failed regulator," he told lawmakers.
The SEC also should seek diverse skill sets and backgrounds in its employees and encourage continuing education, according to Markopolos, who noted like many before him that the SEC is a lawyer-heavy organization.
In addition, Markopolos stressed that SEC staffers should be allowed and encouraged to attend industry conferences, particularly those that feature new securities. In order to properly regulate, Markopolos contended, the SEC must hire staff who know how to "take apart complex financial instruments and put them back together again."
Many in the industry agree. "We would respectfully suggest that the SEC take advantage of the downturn in the market and hire some people that have the intellectual capability to stay up with the market," says Peter Driscoll, chairman of the Security Traders Association (STA) and VP and senior equity trader at The Northern Trust Company, adding that it is a good time to push for a migration from Wall Street to Washington. "There are a lot of smart people at the SEC, but there is also a lot of intellectual capital available to them right now."
Adds Olympian Capital's Levas, "We need practitioners running these types of entities so they can deal with it effectively. The SEC needs a strong budget and people doing what they're supposed to be doing with a knowledge of the business."
Beyond upgrading staff at the junior and middle-management levels, Markopolos also advocated recruiting "foxes" for senior positions to level the playing field. These foxes, he said, ideally would "have gray hair," and a position at the SEC would be a capstone on an already illustrious career. The SEC would need to offer lucrative compensation to attract such foxes, with incentive pay for catching fraudsters and bringing them to justice, Markopolos added.
Compensation in particular needs to be updated to empower a new, effective regulatory body, Markopolos insisted. Compensation, he asserted, should be increased and expanded to include incentives or bonuses tied to enforcement revenues or fines brought in by each office -- whose effectiveness should be quantified through metrics, he added.
Reexamining the Examination Process
But even with the right people in place for the job, the SEC's internal processes and procedures require an overhaul to create an effective regulator, experts agree. Considering that the SEC was presented with highly detailed information by Markopolos on the Madoff Ponzi scheme, it is incredible to most observers that the whistle-blower's information never resulted in the uncovering of Madoff's scheme by the regulatory body.
In fact, the SEC's process for handling whistle-blower complaints and tips is top of mind. In the first of the Congressional hearings in January, the SEC's inspector general, David Kotz, said that the SEC will be conducting an examination to find out what policies and procedures were being followed at the time the Madoff complaints were raised and if there are "gaps in these policies and procedures related to private investment pools such as hedge funds." He also said the SEC would look at the relationships among its offices and divisions.
Markopolos was adamant that the examination process at the SEC should be revamped, describing his personal experience with the SEC's examinations as a portfolio manager and chief investment officer at a multibillion-dollar equity derivatives asset management firm. He noted that even though his firm represented "an area considered high-risk by the SEC," it was inspected only once every three years.
Further, Markopolos pointed to several flaws in the examination process itself. No. 1, he said, the SEC never once sent an examiner with any derivatives knowledge. No. 2, the SEC audit teams are "very young and rarely have any industry experience," Markopolos added.
And third, after coming into the firm with a list of documents and records they need to examine, audit teams go directly to the compliance officer for these records and then hole up in a conference room to pore over the documents, according to Markopolos. "The team only interacts with the inspected firm's compliance team -- not the traders, not the portfolio managers, not the client service officers and not management," he lamented. "They're sitting like ducks in the inspected firm's conference room, and getting fed controlled bits of paper by the firm's compliance staff isn't getting the job done."
Harvey Pitt, former chairman of the SEC and now CEO of Kalorama Partners, a Washington, D.C.-based global business consulting firm, also says improving the SEC hinges on overhauling the regulator's examination process. "The SEC's current examination program, which was put in place in the mid-'90s, is really not well calculated to help the SEC succeed," he says. "It really is almost destined to produce failure."
Pitt explains that a quick review of the numbers -- 17,000 regulated investment advisers and broker-dealers, plus transfer agents, clearing agencies and more, with only a few hundred SEC staff to examine them -- reveals just how overmatched the SEC is. The solution, according to Pitt, would be to require all regulated entities and all portfolio managers to obtain completely independent examinations by an outside firm.
"Then they would have a thorough review done every year or, in the case of smaller firms, perhaps every other year, and effectively prepare a report given to the entity as well as to the SEC," says Pitt. He emphasizes that these examinations would have to be conducted by completely independent firms that have no other association to the securities market and would be subject to strict SEC guidelines and approval. Examinations by outside entities, Pitt contends, not only would increase the SEC's capacity to oversee firms, it also would help ensure that qualified eyes were overseeing the process.
Matt Bienfang, senior research director in TowerGroup's brokerage and wealth management service, points out that the SEC could lessen its burden through collaboration with other regulatory bodies -- FINRA in particular. "Some say Madoff would have been caught earlier if the SEC was sharing the complaints and letters they had received with FINRA, and FINRA may have been able to find the problem through the operational side of the broker-dealer," he relates.
During testimony before the House Financial Services subcommittee, Stephen Luparello, interim CEO of FINRA, specifically outlined the need for greater information sharing and oversight of entities registered with both the SEC and FINRA. "Since the SEC has broad jurisdiction to examine both the broker-dealer and investment adviser lines of business, we would propose a more formalized information-sharing process between the SEC and FINRA to identify potential problems with dually registered firms," he said.
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