Madoff lesson: More investor protections needed

Introduction

Bernard Madoff’s $65 billion Ponzi scheme holds many painful lessons for regulators and investors.

Among them: It’s time for the Securities and Exchange Commission to crack down on registered investment advisers who use their own affiliated companies to act as custodian of clients’ money.

That’s what John Coffee, a respected securities law professor at Columbia University, told a House Financial Services subcommittee hearing today. The panel is trying to decide if more tinkering is needed with the Securities Investor Protection Corp. – a quasi-governmental entity that repays investors when a rogue broker steals their money.

“The clearest lesson from the Madoff scandal is one that the SEC will simply not listen to because it is inconvenient,” Coffee said in his testimony. “Once Madoff became a registered investment adviser, he continued to use his own brokerage firm as his custodian. But no one can be his own watchdog, and the continued toleration of self-custodians by the SEC invites future scandals.”

Last year, an SEC official told lawmakers that out of about 11,300 investment advisers registered with the SEC, as many as 1,500 may be doing what Madoff did – using a company affiliate as custodian for clients’ money instead of a bank or independent company.

Some lawmakers from New York, where a court-appointed trustee is trying to recover Madoff assets to divide among thousands of bilked investors, have demanded an overhaul of SIPC.

The Dodd-Frank financial reform law took a few tentative steps in that direction. It more than doubled SIPC’s government line of credit to $2.5 billion, and boosted the annual fee brokerages must pay into SIPC’s fund to 0.02 percent of their gross revenues, up from the previous fee of just $150 each year.

That isn’t enough, says Rep. Paul Kanjorski, a Pennsylvania Democrat who held today’s hearing.

Kanjorski and other critics say SIPC didn’t do enough to help investors who lost money in the Madoff scam. Victims have complained about the slow pace of payouts and SIPC’s insistence on basing claim payments on how much money a customer invested, not the amount Madoff told each customer he had made from the fictitious investments.

But a “several hundred-billion dollar fund” would have to be created if Congress decides to expand SIPC to protect investors from failed investment advisers as well as failed brokerages, said Ira Hammerman, general counsel of the Securities Industry and Financial Markets Assn. And that, he added, means “we need to do it for all Americans and all frauds, not just for a Stanford fraud or a Madoff fraud.”

Created by Congress in 1970, SIPC is an odd hybrid, even by Washington standards.

It’s not a government agency but five of SIPC’s seven board members are presidential appointees who must be confirmed by the Senate. The remaining two are from the Treasury Department and Fed. By law, SIPC can pay a single investor up to $500,000 when a brokerage firm fails and customer money is missing.