After the Madoff case, the SEC instituted a number of reforms to its operations.

Question

After the Madoff case, the SEC instituted a number of reforms to its operations. Please visit the SEC's website (www.sec.gov) and search for Post-Madoff reforms. Next, please identify the two reforms that you believe will have the best chance of catching a criminal like Madoff. Make sure you provide justification for your choices.

Bernard L. Madoff: The Fraud of the Century Bernard L. Madoff: The Fraud of the Cen On December 11, 2008, Bernie Madoff was arrested on one count of securities came one day after Madoff admitted to his fraud The arrest two sons that his entire investment advisory busine was just one big Ponzi scheme. In the early part of 2009, Madoff pled guilty to 11 counts i did perjury, and money laundering. As a result, Madoff was sentenced to 150 years in pronHw of fraud Madoff defraud investors out of as much as $65 billion? This case provide Madoff was able to commit the Fraud of the Century. s an overvie PONZI SCHEME A Ponzi scheme is any fraudulent investment plar investor's own principal or principal paid by future investors, not from legitimate investment returns To carry out his plan, Bernie Madoff represented to clients and potential clients that he used an inno- vative "split-strike conversion strategy" to invest their money. In so doing, he claimed to invest thenr money in "shares of common stock, options and other securities of well-known corporations, an upon request, would return to them their profits and principal."2 In fact, Madoff never invested the funds in the securities that had been promised. Rather, the funds were deposited into a bank account at Chase Manhattan Bank, based in New York City. If clients requested to receive "profits earned or redeem their investment principal, Madoff merely used the money in the bank account at Chase Manhattan Bank that had belonged to either that client or other clients to pay off the requested sum that pays its returns to an investor from either that SPLIT-STRIKE CONVERSION STRATEGY Madoff created Madoff Investme installing refrigeration systems and working as a lifeguard. By the late nt Securities in the 1960s with $5,000 that he had earned from 80s, Madoff had hired number of family members and had earned a sterling reputation on Wall Street. By the early 0s, Madoff began to receive investment commitments from key institutional investors. While he did not promise specific rates of return to clients, Madoff knew that the investors expected that their investment would perform at a level higher than the market average. To meet their expecta tions, Madoff claimed to have mastered a "split-strike conversion strategy." Under his split-strike conversion strategy, Madoff promised clients and prospective clients that their funds would be invested in a "basket of stocks that would closely mimic the price movements of the Standard & Poor's 100 Index." He further promised to "opportunistically time these purchases and would be out of the market intermittently, investing client funds during these periods in United d States Treasury bills." Madoff also promised o hedge the investments in common stocks "by using client funds to buy and sell option contracts hose stocks, thereby limiting potential client losses caused by unpredictable changes in States Government-issued securities such as Unit lated to t stock prices." Madoff, in reality, never made the investments that he promised to clients S To help conceal the Ponzi scheme from investors, Madoff created "false trading confirma- s and client account statements that reflected the bogus transactions and positions" and then estment clients. According to Madoff, "The clients receiving trade ing by reviewing these documents that I had never and account statements had no engaged in the transactions repres nted on the statements and confirmati ns SECURITIES AND EXCHANGE COMMISSION stingly, between June 1992 and December 2008, the SEC received several complaint ing Madoff s hedge fund, including those from Harry Markopolos, a portfolio manager at Ram part This case contains excerpts from three different cases published b of this textbook's authors, Jay Thibodeau (with Deborah Freier McGraw-Hill Education and written by one ission to excerpt this material was granted bore lay Thibodeau The complete version of each case can

Explanation / Answer

In the wake of the Madoff fraud, the SEC’s Office of the Inspector General launched an internal investigation in December 2008 to determine why the agency did not detect the scheme. While awaiting the report, the SEC has been taking decisive and comprehensive steps to reduce the chances that such frauds will occur or be undetected in the future.

In my opinion these two reforms have the best chance of catching a criminal like Madoff :

1. Enhancing Safeguards for Investors' Assets: In December 2009, the SEC adopted rules to better protect clients of investment advisers from theft and abuse. The rules provide greater assurance to investors that their accounts contain the funds that their investment adviser and account statements say they contain. Among other things, the new rules encourage registered investment advisers to place their clients' assets in the custody of an independent firm, unlike Bernard Madoff did. In situations where an independent custodian is not used or an adviser has control of client assets, surprise exams and third party reviews are required to protect investors’ assets.

(a). Surprise Exams: The new custody rules require registered investment advisers who control or have custody of their clients' assets to hire an independent public accountant to conduct an annual "surprise exam" to verify those assets actually exist. This surprise examination provides another set of eyes on the clients' assets, thereby offering additional protection against the theft or misuse of funds. The Commission expects to take up a complementary proposal with respect to the custody of customer assets by broker-dealers in the near future.

         (b). Third Party Reviews: Under the new custody rules, registered investment advisers whose client assets are not maintained with independent firms must obtain a third-party written report assessing the safeguards that protect the clients' assets. The report — prepared by an accountant registered and inspected by the Public Company Accounting Oversight Board — among other things, must describe the controls that are in place to protect the assets, the tests performed on the controls, and the results of those tests. The old rules made no distinction between an investment adviser whose affiliate holds its clients' funds and an investment adviser that uses a truly independent custodian. In addition, the SEC adopted changes in July 2010 to the principal disclosure document that SEC-registered investment advisers provide to clients and prospective clients. The changes substantially improve the quality of disclosure clients receive and allow them to better evaluate the risks associated with a particular investment adviser.

2. Improving Internal Controls: The examination program and Enforcement Division each have implemented a quarterly review program to help ensure that important issues are resolved in a thorough and timely manner and that no examination or investigation falls through the cracks. As part of the quarterly review programs, examination and enforcement managers meet with their respective staffs to review and discuss all open examinations and investigations and address whether additional expertise is needed to resolve issues, finalize exams, and bring investigations to conclusion. In addition, the examination program has enhanced its management controls and decision-making through a new governance structure that includes a National Leadership Team composed of both headquarters and regional office managers.

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