mary schapiro

Can Fraud Be Immunized by Giving the Defrauder Certain Governmental Powers Over the Victims?

by Hans Bader on October 26, 2011 · 1 comment

in Economy, Legal, Personal Liberty, Property Rights

Can a private organization that has been delegated some government regulatory powers claim absolute government immunity against lawsuits when it engages in fraud against those it regulates — even when the fraud is at most distantly related to its regulatory functions? Amazingly enough, an appeals court said yes — a ruling that conflicted with another appeals court’s ruling — and the Supreme Court is now being asked to reverse that decision.

The Competitive Enterprise Institute joined Cato Institute in filing an amicus brief asking the Supreme Court to review that disturbing ruling shielding wrongdoing. The brief, which cites constitutional safeguards and separation-of-powers principles, can be found here. The case is Standard Investment Chartered v. National Association of Securities Dealers (NASD). NASD converted into an entity called FINRA after deceiving regulated members about the terms of the conversion. (FINRA’s CEO was shortly thereafter appointed by President Obama to head the federal Securities and Exchange Commission.)  Cato Institute’s Ilya Shapiro describes the significance of the case here.

Forbes has an interesting article on the case by Edward Siedle. As he puts it:

Should FINRA, the brokerage industry’s self- regulatory organization, have absolute immunity from lawsuits—even when FINRA issues a false and misleading proxy statement to its membership? As a former SEC attorney and owner of a FINRA-member brokerage for more than 20 years, in 2008 I thought the answer to this question was pretty simple. Almost four years later, I’m still waiting to learn whether FINRA is accountable to anyone.

Back in 2008 I was well aware that the degree of control FINRA had over the investing public was both remarkable and disturbing. . . .self-regulation of the brokerage industry involves an inherent and insurmountable conflict of interest. . . Investors pay a heavy price for conflict ridden self-regulation. . .[NASD boasted that] “The NASD has successfully resisted many proposals inimical to the best interests of . . . its members.” Very revealing—no pretense of concern for the nation’s investors in that boastful line.

Despite this unique history of largely unchecked power over investors, as a former securities regulator I figured there were limits to how far this maniacal monster could go. I was confident that if FINRA, an organization responsible under the law with regulating the truth and adequacy of statements by members of the brokerage industry, lied about the terms of a financial transaction, FINRA, like anyone else, would be held liable.

In 2008, my brokerage firm, Benchmark Financial Services, Inc. filed a class action lawsuit against FINRA on behalf of all FINRA-member firms alleging that FINRA had issued a false and misleading proxy statement to its members in connection with the merger of the NASD and NYSE. Also named as a defendant in the suit was its then Chairman and CEO, Mary Schapiro—the current Chairperson of the Securities and Exchange Commission. . .. The lawsuit focuses chiefly on the truth of statements made about a $35,000 payment that was made by the NASD to induce its members – firms such as Benchmark – to vote in favor of the merger of the NASD and NYSE. The merger closed in July 2007 leading to the creation of FINRA. . .. [NASD falsely] stated in the proxy statement that the tax code and the Internal Revenue Service had imposed a $35,000 ceiling on the payment to NASD members in connection with the merger. Through the course of the litigation, I learned that a much higher payment to NASD member firms was not only possible but feasible. In actuality, the NASD did not even receive an IRS ruling with respect to the payment until months after the proxy statement was issued to NASD members. Documents that the NASD subsequently filed with the SEC made it clear that the NASD’s mantra that the tax code imposed a $35,000 limit on the payments to NASD members was simply untrue. The IRS did not issue a private letter ruling to the NASD concerning the payment to members until March 13, 2007, nearly four months after the proxy was issued and nearly two months after the voting had closed. OK—so NASD fabricated the claim that the IRS limited the payment to a maximum of $35,000 . . .. Here’s the killer: The IRS private letter ruling . . . did not provide any specific limitation on the payment to NASD members. Instead it provided a range of permissible payments that would not affect the self-regulatory organization’s tax exempt status.

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SEC penalty policy change could harm innocent investors

by John Berlau on February 6, 2009 · 2 comments

in Bailout Watch, Politics as Usual, Precaution & Risk, Sanctimony, Zeitgeist

In one of her first actions as SEC chairman, Mary Schapiro announced today that she was getting rid of a policy that required SEC officials to get approval from the commissioners before negotiating corporate penalties. According to the Associated Press, “Schapiro said that practice ‘just sends the wrong message.’”

But Schapiro should perhaps focus a little less on message and a little more on an action’s consequences for investors the SEC is supposed to protect. Because unfortunately, this change will have the effect of further harm to shareholder victims of corporate fraud.

Corporate penalties take money not from individual executives guilty of fraud, but from the corporate treasury that ultimately belong to the ordinary investors in the company. Frequently, these penalties have the effect of harming shareholder victims of corporate fraud twice: once when the corporate executives misuse a company’s money, and a second time when when the corporate penalty further reduces the company’s assets that belong to all shareholders. That’s why it is more just and more effective for the SEC to levy penalties against individual wrongdoers rather than the corporation as a whole.

The 2006 policy Schapiro wants to reverse was prompted by concerns expressed for former Commissioner Paul Atkins and others that the interests of innocent shareholders weren’t being given enough weight in negotiation of corporate penalties. The rule was a sensible change that didn’t outlaw corporate penalties, but ensured that their use was carefully considered by SEC commissioners before enforcement staff could levy an arbitrary fine that could harm shareholder interests.

Moreover, the policy only applied to penalties on corporations, not individuals accused of wrongdoing or private broker-dealers such as the firm of Bernard Madoff.

Schapiro, whom I have praised previously for her regulatory prudence, is correct in wanting the agency go after corporate wrongdoers with full force. But she should seriously rethink instituting this policy change that would have the unintended but predictable effect of punishing innocent shareholders twice.

Madoff: Hiding in Plain Sight, Thanks to SEC

by John Berlau on December 28, 2008 · 18 comments

in Bailout Watch, Features, Nanny State, Personal Liberty, Politics as Usual, Precaution & Risk, Regulation, Zeitgeist

When news broke of Bernard Madoff’s alleged $50 billion worldwide Ponzi scheme, news accounts first protrayed him as a shadowy hedge fund manager outside the scope of regulation by the Securities and Exchange Commission. But as the sheer magnitude of the fraud became clearer, so did the picture of Madoff’s place in the Wall Street-Washington world.

Madoff’s businesses were actually subject to a variety of financial regulations, something Madoff would actually use as a selling point to investors. Last year in a speech, Madoff said, “In today’s regulatory environment, it’s virtually impossible to violate rules.” He registered as an investment adviser in 2006, and had been under the SEC’s extensive regulatory framework for securities broker-dealers since he founded his firm almost 50 years ago.

And far from being a shadowy figure, Madoff was a pillar of the financial establishment. He showered campaign contributions on politicians, mostly Democrats. He was also quite chummy with many of the financial regulators charged with overseeing him.

For instance, Clinton administration SEC Chairman Arthur Levitt, who has championed onerous mandates like the burdensome Sarbanes-Oxley accounting mandates to preserve “market intergrity,” appointed Madoff during his SEC tenure to what the New York Times describes as “a large advisory commission … that explored the rapidly changing structure of the financial markets.”

An even closer connection was SEC assistant inspections director Eric Swanson who, according to CNBC reporter Charles Gasparino, “was part of the team that examined Madoff’s brokerage firm” in 1999 and again in 2004. “During those exams, the SEC team said it found almost nothing wrong,” Gasparino writes in The Daily Beast. In 2007, after leaving the SEC, Swanson married Madoff’s niece Shana, who is the regulatory compliance attorney at her uncle’s firm

While there is no evidence of wrongdoing with regard to Madoff by either Levitt or Swanson, SEC officials, for whatever reason, looked the other way, despite numerous allegations and “red flags,” some received as early as 1992. And since 1999, rival investment manager Harry Markopolos had sent the agency detailed analysis of why he though Madoff consistent postive returns were mathematically impossible without running a Ponzi scheme or insider trading. In a 2005 submission he made to the SEC that was recently made public by the Wall Street Journal, Markopolos charged that it was “highly likely” that “Madoff Securities is the world’s largest Ponzi scheme.”

But despite the SEC’s incompetence in heeding these warnings, many are still arguing that to prevent future Madoff-type frauds, we need more regulations that give more power to the SEC. But it’s hard to see how any additional powers could have made a difference in this case, given that the SEC almost seemed determined to look the other way for violations of the most basic rules against securities fraud that had long been in place.

Since hedge funds were among Madoff’s clients (and biggest victims, as this WSJ editorial points out), calls are again being intensified for further hedge fund regulation to bring them under the cumbersome registration process for investment advisers. (The SEC already has full authority to investigate hedge funds and other unregistered investment entitities if there are suspicions of fraud.) This is what the agency tried to do a few years ago, only to have a three-judge federal appeals court panel throw out the rule in 2006 in a unanimous finding that the agency had stretched the law.

But the SEC can’t argue that this would have helped them prevent Madoff’s fraud, because, as noted above, Madoff had registered as an investment adviser in 2006, and was registered as a broker-dealer for decades.

This broker-dealer registration gave the SEC full power to investigate all affiliated businesses. As MarketWatch commentator David Weidner pointed out (in a column with a curious headline about “lack of regulation” that is the exact opposite of the author’s point — often columnists, unlike bloggers, don’t wite their own headlines), “Broker-dealers are supposed to be the most scrutinized of the investment community. If Madoff was running separate businesses, the SEC and FINRA should have been looking at all of them as a whole.”

In fact, the fact that Madoff was under such heavy regulation probably helped him in constructing the alleged facade. As business reporters Binyamin Appelbaum and David S. Hilzenrath wrote in their perceptive Washington Post article, “the fraud Madoff allegedly constructed was successful in part because it avoided the appearance of risk.” The article quoted an expert as saying that SEC regulators “had to make judgments, and they decided to look at derivatives, short sales, insider trading, all the things that Madoff never had.”

So The SEC was too busy hounding unregistered hedge funds, short-sellers, and entrepreneurial companies for trivial minutiae from Sarbanes-Oxley and other mandates to notice the fraud right in front of them. The regulators didn’t just “drop the ball,” as President-Elect Barack Obama recently asserted. They lost focus on where the most important “ball” was.

Getting that “ball” back by paying attention to warning signs about where the real fraud is, and rolling back the mounds of red tape on honest investors and entrepreneurs that also wastes the time the agency has to go after the real problems, must be the number one priority of newly designated SEC chairman Mary Schapiro.