Monday, July 27, 2009

SEC Whistleblowers?

"Regulators should pay whistleblowers for information about frauds, according to an official investigating the US [SEC's] failure to uncover Bernard Madoff's $65bn scam. David Kotz, SEC inspector-general, said 'bounty' schemes, would provide 'necessary incentives' for individuals to bring complaints about possible illegal activity. There was evidence that similar programmes by the [DOJ] and the [IRS] had been effective, he said. ... The current system applied only to insider trading cases and criteria for judging awards were 'vague'. ... Since missing the Madoff fraud, the SEC has been hit by an avalanche of criticism. Credible allegations about the scam were brought to its attention by Harry Markopolos, a whistleblower, for at least a decade. ... His recommendations reinforce proposals by the US Treasury and the SEC for making better use of whistleblowers and the thousands of complaints and tips that flood into regulators' offices every year", Joanna Chung at the FT, 2 July 2009.

"Sir, While the inspector general of the [SEC] is right to propose a new bounty programme to encourage whistleblowers (July 2), such a programme would be pointless without a requirement that the SEC actually investigate reports of investor fraud and pursue the ones deemed worthwhile. The SEC already receives plenty of whistleblower and investor complaints--more than 700,000 annually. The problem is that important information about significant cases of investor fraud--such as Bernard Madofff's scheme--get buried in with crackpot complaints. There's no question the [DOJ's] bounty programme created under the False Claims Act [FCA] to stop fraud against the government has been successful, with recoveries from whistleblower cases totalling more than $14bn", my emphasis Erika Kelton (EK), letter to the FT, 6 July 2009.

Is Kotz serious? The DOJ's whistleblower program is a sick joke. The SEC's will be no better.

EK is an attorney at Phillips & Cohen. EK, I disagree. Requiring the SEC to do anything will give miscreants an incentive to drown the SEC in bogus complaints. The SEC should adopt my "Blankfein Test". I doubt Markopolos' information was buried. The SEC works this way in my experience: whoever read the information noted Markopolos was a nobody; Madoff a somebody. Stop. That the DOJ recovered $14 billion from whistleblower cases proves nothing. The DOJ intervenes in about 14% of FCA cases. We don't know how many billions, or tens of billions, the DOJ "left on the table". EK, you commited a Type One Error. Back to statistics class.


Anonymous said...


I wonder that if programming guy at Goldman Sachs who took off with the proprietary Goldman code that manipulated markets would have been tempted to go the SEC and talk about what the program does trading ahead of the markets.

If that tech guy could have got a small percentage of a settlement against his employer I think that might work pretty well. It probably would have been a lot more than the ex-Citadel guys were gonna pay him.

Most of Wall Street is so complex that the only way to know what is happening is to have someone on the inside create a roadmap.

And truly people on the inside know when they've crossed over the legal boundaries... they know...

In the end it's a question of someone understanding the markets, writing good rules and enforcing them.

We'll see if Mary Shapiro hires anyone who understands the markets and ends regulatory capture.

Peripheral Visionary said...

I saw this post after Naked Capitalism linked to it; I'm leaving much the same response at NC.

The idea that the tip was dropped because Madoff was a "somebody" and Markopolos a "nobody" is exactly incorrect, at least from my experience. In reviewing SARs (Suspicious Action Reports) in particular, a SAR related to a "somebody" goes right to the top of the list. As Mark Cuban and Eliot Spitzer can attest, the authorities love going after "somebody"s, and make an extra effort to do so, and those efforts more often than not start with a tip. Again, being a "somebody" means any allegations of wrongdoing go right to the top of the list and get special review.

The problem with the Madoff tip was of a different nature. You're absolutely correct in that the SEC has to wade through an incredible number of spurious "tips", which is a huge part of the problem (alleging fraud is the easiest way of being in denial of having made a poor investment.) But the real problem is that the tips were being reviewed by attorneys, not accountants or examiners. Attorneys look for cases worth pursuing, which means that they look primarily for legal proof--not the statistical arguments that Markopolos was making, but hard proof in the form of incriminating testimony and/or documents. The problem with Markopolos' otherwise well-formed argument was that it was aimed at a financial professional, not a lawyer looking for a slam-dunk case. That, and it fit too easily into the mold of "jealous competitor trying to compensate for failure by alleging fraud" (which, of course, was exactly what it was--but, in this one case out of who knows how many, he was actually correct.)

In comparing the two systems, and I have some familiarity with both, the SAR system works much better than the SEC's tips system. The reason for that is not just because of who is reviewing the tips, but also because of who is submitting them. SARs are submitted by trained professionals who are simply doing their duty (and they do an excellent job of it), as opposed to the tip system, where many are from people with no special expertise, and many from people with hidden agendas. The SARs are reviewed at multiple layers by financial and criminal professionals, while the tips are reviewed at only one level by attorneys, although that is set to change.

One concrete suggestion for the SEC would be to separate out tips from professionals from those from the general public. I know that sounds condescending, but look at it from this perspective: when it comes to money laundering, there's a huge difference between a bank teller and a guy with a checking account. A teller has been there for years handling uncounted thousands of transactions, and knows when something is amiss; the guy with a checking account wouldn't know a money laundering transaction if it had "Money Laundering" stamped in red ink on it. Complaints from professionals, like Markopolos, deserve a higher level of attention and review; not that the general public should be ignored, but that complaints from stronger sources and with more substantiation deserve a more thorough, multi-level review process.

P.S. A big thanks to our SARs submitters; you do a great job, and it makes a big difference.

Independent Accountant said...

Your experience AT the SEC is not mine WITH the SEC. I have been a CPA over 30 years. For my money, SEC case selection stinks. I think the SEC erred in going after Cuban. So did a judge. The SEC was looking for some cheap headlines. It got them. The DOJ going after Spitzer proves my point, i.e., the DOJ was protecting Wall Street FROM Spitzer.
I am sympathetic to your post to this extent: most attorneys don't understand evidence. Very few can make cases except using eye witness testimony. The SEC wastes time on insigificant insider trading cases. Why? To look busy. The SEC settles big cases with no admissions of wrongdoing. Why? Hidden agendas? SEC and DOJ personnel looking for post government jobs, is not a hidden agenda?
You and I inhabit different worlds. Look at our "ping-pong ball Fed" Mary Jo White and John Mack. That's my world.
SEC attorneys look for cases they can get easy settlements from, "slam dunks" as you say. These cases should be ignored by and large. I await the SEC making a case against Citigroup for having cooked its books. Or AIG. Why was Gary Aguirre fired?

Peripheral Visionary said...


I won't disagree that case selection is less than optimal; I've been in meetings where it was admitted that the focus is on high-profile cases where there is a good chance of a conviction. And there's a reason for that: shortage of resources. Since every potential case can't be pursued, the ones that are selected are those that will "send a message" to the rest of the financial community.

Attorneys don't always understand evidence, but that's not the primary problem: the primary problem is that judges and juries don't always understand the evidence. That's why there's so much focus on high-profile cases, especially those with sensational testimony or damning documents. There initially were worries that Enron wouldn't be a successful prosecution because it was so arcane; but what saved the case was that the defendants were tried in the media and found guilty before they ever set foot in a courtroom.

The "revolving door" issue factors into it, but not in the way most people think. Contrary to what is widely believed, regulators have little incentive to go easy on big players. Financial institutions may appreciate a clueless regulator, but nobody's going to hire one. The quid pro quo argument is nonsense; does anyone seriously think a major bulge bracket firm will pay good money to hire a regulator who didn't do their job? On the contrary, regulators build their resumes through landing big cases and getting their name in the news next to a pithy statement about protecting investors from the predators, etc. You don't get to be a highly-paid defense attorney through being a lousy public prosecutor who couldn't so much as make a parking ticket stick.

That only reinforces the incentives to go after high-profile cases, but at the same time, creates a high level of risk aversion. Nobody wants to put years into a potential prosecution only to have it fall apart in court--and then face a backlash as phones start to ring on the 10th floor with politicians asking questions about fishing expeditions going on at the regulator. So what the attorneys look for is the perfect win: an easy to understand case with clearcut evidence. Hence the emphasis on Ponzi schemes and insider trading.

On settlements, the SEC settles cases for the same reasons public prosecutors do: because it's much faster and it requires fewer resources. The offending action can be stopped, a penalty can be extracted, and the whole thing can be over with in a fraction of the time a full prosecution takes. It's not always the right decision, but in a world of limited resources, it's easy to see how that decision can be made.

But Citi is a perfect example of everything above. Anybody who knows anything about accounting knows about the potential issues there. But that group of people does not, unfortunately, include a great many judges and juries. So the reward of successfully prosecuting bad behavior runs head-on into the risk of investing huge amounts of time for no payout, or, worse, a political backlash from the White House and from the Fed, who have their own agendas. That's just not a risk many people will take, even if it's the right thing to do. Much easier to go after local Ponzi artists stealing old peoples' money.

There are fixes to this, but they essentially boil down to: far more resources and even more autonomy and insulation from the political process. Unfortunately, the current movement is in the opposite direction: fewer resources, and under the all-wise control of the Fed (or, worse, the Treasury.)

Robert said...

But back to the point....studies have shown that whistleblowers are not more statistically likely to "tattle" if induced by monetary incentives. This type of incentive tends to work better with "blue-collar" criminal acts rather than white-collar. Even if the SEC's experience differed, they would still have to wade through additional frivolous allegations. Take the money and throw more resources at improving the funnel and screening mechanisms....