Editor's Note: John C. Coffee Jr. is the Adolf A. Berle professor of law at Columbia University Law School and director of its Center on Corporate Governance. He has been listed by the National Law Journal as among the "100 Most Influential Lawyers in America." Coffee has been a member of the Legal Advisory Boards to the New York Stock Exchange and National Association of Securities Dealers, the Economic Advisory Board to Nasdaq, and the SEC's Advisory Committee on the Capital Formation and Regulatory Processes. He is the author of "Gatekeepers: The Professions and Corporate Governance."
John Coffee says federal regulators were too passive in overseeing Madoff's investment operation.
NEW YORK (CNN) -- Seventy years ago in 1938, Richard Whitney, the chief executive of the New York Stock Exchange (NYSE), was sentenced to 40 months in Sing Sing for embezzling funds from clients, including the widows and orphans benefit fund of the NYSE.
It was the low moment in the history of the NYSE, and public outrage enabled the Securities and Exchange Commission to persuade Congress to pass legislation that created the National Association of Securities Dealers (NASD) as a self-regulatory body that would police Wall Street.
Now, we have come full circle in 2008 with the arrest of Bernie Madoff, a former chairman of the NASD, for perpetrating an alleged $30 billion fraud. But this scandal will only embarrass and possibly weaken the SEC, because considerable evidence suggests it was asleep at the switch.
Red flags were flying all around Madoff Securities. The unvaryingly consistent 10 to 12 percent annual return that it earned for its investors, both in bull markets and bear markets, was simply too good to be true.
Because Madoff managed accounts only as an investment adviser, he was not required to use an independent custodian to hold the investors' funds; similarly, he used an unknown accountant in Upstate New York to certify his financial statements; and he cleared all transactions through his own brokerage firm.
Thus, he evaded all the usual gatekeepers. Although his persistent track record of high annual returns attracted many rich and sophisticated investors, including some easily duped hedge funds, other fund managers investigated and elected to steer clear of an investment strategy that seemed implausible. Some even warned the SEC.
Why did the SEC remain passive? Madoff only registered as an investment adviser in 2006. Traditionally, the SEC would examine the books and records of a new investment adviser during the first year after its registration. But the recent explosive growth in hedge funds and the number of investment advisers left the SEC undermanned and resource-constrained.
Hence, the SEC scheduled investment adviser examinations on a risk-adjusted basis. Here, they made a serious error of judgment, apparently rating Madoff to have only a low risk profile, even though the disclosures that he filed with the SEC showed that he had $17 billion under management as of the beginning of this year.
An examination should have quickly alerted the SEC to the insufficiency of assets in his accounts. Curiously, the SEC did examine Madoff's broker-dealer operations, but these were unrelated to his investment adviser activities, and the SEC's investigation turned up little.
What needs to be done? Ponzi schemes are a recurrent, but relatively low-frequency, phenomenon that occur in all markets and countries. Requiring annual examinations of all investment advisers would be costly and inefficient. But the SEC does need to develop better criteria for judging risk and determining examination priorities.
More importantly, some well-known protections can prevent Ponzi schemes, which are usually the product of desperation. First, investment advisers with significant assets under management could be required to use an independent custodian for investors' funds (as all mutual funds are required to do). Such a custodian would only allow funds to be used to purchase securities and would bar transfers of funds across investor accounts.
Second, Madoff used a small accounting firm that was either inept or complicit. Public companies must use auditing firms that are registered with the Public Company Accounting Oversight Board (PCAOB), and larger investment advisers (certainly those with more than $1 billion under management) should use a similar level accounting firm that would be registered with PCAOB or some similar body.
Finally, one "reform" should clearly be delayed. Recently, the SEC and Congress have been considering whether to grant "mutual recognition" to foreign regulatory authorities, in effect deferring to their regulation of foreign broker-dealers and mutual funds.
In the wake of the Madoff scandal, the last thing that U.S. investors need is for foreign mutual funds and investment advisers that are beyond the reach of the SEC to be allowed to offer their services to U.S. retail investors. This form of deregulation is a bridge too far.
The implications of the Madoff scandal will be debated. Politically, it will probably increase the pressure for registration of hedge funds (even though Madoff did not run such a fund). Critics of regulation will claim that the scandal proves that investors must do their own due diligence. They are right to an extent, but only a specialized agency, and not dispersed investors, can detect fraud. Transparency is usually the lowest cost reform.
Once again, as in 1938, it is time to find a tough cop for the Wall Street beat.
The opinions expressed in this commentary are solely those of John C. Coffee Jr.