Bernie Madoff was arrested on December 11, 2008. Many victims were permanently harmed and suffered from the consequences of his fraud. Without diminishing the deleterious effect he had on so many investors, it is worth taking a moment to reflect on the impact his actions had on the regulation of the financial industry. If the $64 billion Ponzi scheme was akin to the 9.1 Tohoku (Japan) earthquake in 2011, the regulatory reaction spurred on by the scale of the event would be the predictable tsunami that followed.
The regulatory reaction can be grouped broadly in two areas: Dodd-Frank and its expansive rule writing and the consequent interpretation of those rules by the people deployed in the regulatory bodies. For a little background, Dodd-Frank was a massive legislative overhaul sponsored by Connecticut Senator Chris Dodd and Massachusetts Representative Barney Frank in part reacting to a need to analyze and assess the rules governing our financial industry. As the most prosperous securities market globally for almost 70 years, regulation in the United States securities markets had been evolutionary, and may have trailed with the pace of change inherent in the markets.
To be clear, Dodd-Frank was not exclusively a reaction to the Ponzi scheme. There were other issues going on in the financial world. But the regulation had unique consequences on smaller firms. For many broker-dealers, such as firms that never touch client assets, it could be argued that the requirement of a PCAOB audit (which is complicated further by tying in reliance on Sarbanes-Oxley) for every firm with no exceptions has had a negligible (if not negative) result on the protection of investors. The cost and drain on resources and the growth of a surrounding cottage industry may be driving broker-dealers out of the market.
As complex and wide-ranging as some of the legislation and commensurate regulation were, the interpretation and enforcement has left many rational, well-intentioned small business owners scratching their heads. From this writer’s experience the amount of shrinking revenues that small firms devote to operations and compliance departments is increasingly out of proportion to the larger firms. This obligation can act as an impediment to innovation by drawing resources (both human and capital) away from other areas of small firms. Furthermore, the expectations of examiners due to the advancement of digital tools and oversight mechanisms more available to larger firms seems to have unbalanced how supervision should be evidenced.
As always, life races ahead and we are left to play catch up. FINRA and the SEC are changing. The waters of the tsunami appear to be receding. Robert Cook, CEO of FINRA, is three years into a program of making the regulator ever more of a collaborative partner, ensuring there is broad understanding of its concerns (protection of investors and promoting well run primary and secondary securities markets) and working with member firms to ensure compliance in a practical manner. The SEC for its part, seems to be revisiting its long-standing guidance on in-person exams.
The industry must be on guard for bad actors: both investors and the regulated firms. Willie Sutton unwittingly promulgated something similar in his retort to the question: Why do you rob banks? (“Because that’s where the money is.”). The pendulum has swung to its amplitudinal limit in this period and is ready for its next cycle. Certainly, Madoff’s will not be the last such heist. Still, as we have seen from regulators and practitioners both, the consequences can have long lasting, unintended, and somewhat predictable consequences that one could argue itself is a case study to ponder when the next tsunami hits.
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