Fixing the Regulatory System: Geithner and Schapiro Ignore the Need for Mutual Fund Reform

Fixing the Financial Regulatory System: Geithner and Schapiro Ignore the Need for Mutual Fund Reform  I waited for March 26, 2009, in great anticipation that we might see meaningful change in protecting investors. I pray that my retirement years are not stolen from me as they have been from those who we represent - those who trusted Charles Schwab, OppenheimerFunds, MassMutual and Madoff. However, March 26 came and went with little recognition of why and how this happened by those our new President entrusted to help steer these changes. Both Timothy Geithner (Secretary of Treasury) and Mary L. Schapiro (SEC Chair) testified today on improving our financial regulatory system. Geithner spoke to Barney Frank and his House Committee on Financial Services, and Schapiro spoke to Christopher Dodd's Senate Committee on Banking, Housing and Urban Affairs. Geithner's testimony can be found here, and Schapiro's here.

Before I start in on my criticism, let me say that I understand that both Geithner and Schapiro are long time industry/regulatory insiders. Change comes slow to those who have been part of the system and failed to step forward early. Certainly, it is better to talk about "failures" than to admit that they were asleep at the switch. It is better to talk in the abstract with little criticism that might incite a lynch mob.

Reading both testimonies, I am dumbfounded at how little attention is paid to the mutual fund industry that took investors' money and started pouring it into any asset available regardless of its objectives.

Geithner gives a strong statement recognizing the need for investor protection:

"[W]eaknesses in our consumer and investor protections harm individuals, undermine trust in our financial system, and can contribute to systemic crises that shake the very foundations of our financial system."

 Hear hear! Geithner then swiftly moves on to talk about mortgage lending, not investor protection. Try to sort out the following statement:

"Innovation and complexity overwhelmed the checks and balances in the system. Compensation practices rewarded short-term profits over long-term return. We saw huge gains in increased access to credit for large parts of the American economy, but those gains were overshadowed by pervasive failures in consumer protection, leaving many Americans with obligations they did not understand and could not sustain. The huge apparent returns to financial activity attracted fraud on a dramatic scale. Large amounts of leverage and risk were created both within and outside the regulated part of the financial system."

It's almost like the financial services industry wrote his words: "Tim, throw in words that make it look like 'things' caused us to commit fraud, and then put the blame on the 'many Americans with obligations they did not understand...'"

Let's pretend our mess was caused by poor consumers who did not know what they were buying, instead of the greed; greed of financiers who "created" packages of garbage loans, and dumped them on retirees for huge fees, profits and commissions. This slight of hand makes my blood boil.

Geithner completely leaves out the crimes of our mutual fund industry. Instead, he focuses on Money Market Funds that broke the buck. Big deal. This cost the American people a tad of what was lost in mutual funds by companies that sold "conservative," "stable" investments to retirees following the models that touted moving to bonds in your retirement years to preserve capital and earn income. The Reserves money market fund, when all is said and done, lost about three percent. Oppenheimer's Champion Income Fund lost 79 percent. Schwab's Ultra Short Term Bond Fund lost more than 50 percent.

Schapiro jumps on the fraud bandwagon too. She deplores penny stock frauds and insider selling, she touts the SEC's recent (mostly pre-Schapiro) enforcement activity, but she appears oblivious to reality, and the following statement is laughable:

"Our capital requirements go a long way to ensuring that customer funds entrusted with a broker-dealer are safe in the event the broker-dealer gets in financial trouble. Again, our focus is not to insulate broker-dealers from competition and the risks of failure, but to protect investors in the event that failures do occur. We conduct examinations of these firms to assess their compliance with laws and regulations. And when we find violations or deficiencies, we direct that corrective action be taken."

Think Bernie Madoff Investment Service (a broker dealer regulated by the SEC). Ahhhhh! Capital requirements? Protect? Examinations? Compliance? Of course note the disclaimer; "And WHEN we find..."

Schapiro does however have a solution for making sure Madoff's don't occur:

"I expect the staff to recommend that the Commission consider requiring a senior officer from each firm to attest to the sufficiency of the controls they have in place to protect client assets. The list of certifying firms would be publicly available on the SEC's Web site so that investors can check on their own financial intermediary. In addition, the name of any auditor of the firm would be listed, which would provide both investors and regulators with information to then evaluate the auditors."

"As part of this effort, I expect to come to you in the near term with a request for authority to compensate whistleblowers who bring us well-documented evidence of fraudulent activity."

 Ok. Let me get this straight...

  1. Madoff would be required to sign a certification - big help.
  2. The auditors name would be public - oh, this helped the Oppenheimer Tremont Rye fund investors who received audit reports from KPMG and Ernst & Young who believe that they are isolated from liability because they can rely on certifications by Madoff's audit or shoeshine man.
  3. The SEC could now pay whistleblowers who present "well documented evidence...because when Madoff's whistleblower Harry Markopolos came to the SEC for free the SEC could not believe that anyone would blow the whistle for free!

As for mutual funds: NADA, Nothing, Zip! Certainly, Schapiro recognizes the importance of mutual funds:

"Ultimately, capital comes from investors - people who invest directly in companies; people who invest in financial institutions that lend capital; people who invest in mutual funds and other pooled vehicles that in turn invest in America's businesses; people who buy municipal securities to help fund the operations of state and local governments; and people who look to the capital markets to save, put away money for their kids' education, and prepare for retirement. Markets that attract this capital are critical to America's economic future."

But Schaprio talks only about the past enforcement efforts and current regulations. As for future change, she talks only about money market funds. She apparently does not recognize that current regulations do not work for mutual funds.

The Courts have recently thrown out the private rights of action under the Investment Company  Act, which regulates the fund industry. Because of the structure of the funds, purported independent trustees ( who often sit on the boards of 10, 20 and even 40 funds offered by the same investment adviser), and trust agreements, even state law claims are impossible to bring. That leaves the paltry resources of the SEC to enforce those laws for an industry with more than $9 trillion in assets.

Mutual Funds are sold primairly over the phone or with glossy web pages and/or brochures containing smiley faces, impressive graphics and a sales pitch. To the extent that disclosures can be found, they  are impossible to read, dispursed in a staggering array of documents with indecipherable names, never actually delivered until after the purchase, and even then rarely. The funds' advisers retain near unlimited power to change their focus overnight...if it brings in more profits. The industry is driven by a need to do what it takes to attract capital, not the interests of the investor.

Neither Geithner nor Schapiro seem to recognize these issues, nor seem to care.

Dear, dear. The more things change the more they stay the same.


Famous Madoff Qoutes: "I Suppose You Could Program a Computer To Violate A Regulation, But We Haven't Gotten There Yet"

Famous Madoff Qoutes: "I Suppose You Could Program a Computer To Violate A Regulation, But We Haven't Gotten There Yet", 60 million people retire next ten years? "Good Luck " and "I'm very close to the Regulators...my niece married one."
And More
As we proceed to work our way through the Madoff litigation, we tend to focus on those cases where we believe we can best find a scource of recovery for our clients. to date that has been principally the Tremont Rye Funds which were controlled by Oppenheimer and Massacusetts Mutual, audited by the Big Four accounting firms and supposedly had a cusodial bank, Bank of New York Mellon. We have focused also on the feeder funds to the Tremont Rye Funds, such as Spectrum, Future Select, Austin and Meridian. Others crop up every day. Nevertheless, these stories at this point are rather dry and our minds still drift over to how did Madoff pull this off. A video of Bernie Madoff discussing his business has surfaced onthe internet, and helps led us there.
When I watched this video of Bernie Madoff ( and his computer guru, Josh Stampfli) participating in a round table discussion, on the future of the stock market, I expected to find a hint of irrationality or slick behavior. The link to the video, audio and transcripts can be found here. Instead we hear a very rational human being, thoughfully discussing fraud, human behavior and profits. Download Madoff Transcript But we also see tremendous irony in Bernie's statements. I highly recommend anyone impacted by this scandal to watch, especially around the the 43 minute mark. An index to Bernies more ironic statements are as follows:
At minute 26 Bernie Madoff states:
"Now, no one is going to run a benefit for Wall Street, so whenever I go down to Washington and meet with the SEC and complain to them that the industry is either over-regulated or the burdens are too great, they all start to roll their eyes, just like all of our children do whenever we talk about the good old days."
At minute 28 Bernie Madoff states:

Today, basically the big money on Wall Street is made by taking risks. Firms were driven into that business, including us, because you couldn’t make money charging commissions, primarily because the rates were lowered and because of the regulatory infrastructure you had to have dealing with clients.

At minute 30 Bernie says:
"There are so-called Chinese Walls that are required to be established at every brokerage firm. They’re called Information Barriers—a term most people would understand—to sort of wall off a brokerage firm from taking advantage of information that he has as to what clients are basically going to trade or not going to trade. There are separate divisions within the firms and it is very carefully enforced and surveilled. It doesn’t mean there are not abuses, for sure, but by and large in today’s regulatory environment, it’s virtually impossible to violate rules. This is something that the public really doesn’t understand. If you read things in the newspaper and you see somebody violate a rule, you say well, they’re always doing this. But it’s impossible for a violation to go undetected, certainly not for a considerable period of time.  And when you consider the volumes of trading, the trillions of dollars of trading that go on today in Wall Street—I mean, our firm, for example, we trade an excess of $1 trillion dollars a year and that’s one firm—and you look at what we would consider to be the infractions, they’re relatively small, primarily because of all the regulation. Most firms do try to comply with that."
At minute 43 Bernie states:

So we determined that the best thing for us to do was basically to take the human being out of the equation. That had two advantages in our industry. Number one, when you take the human being out of the equation, you solve your regulatory problems because the nature of any human being, certainly anyone on Wall Street, is the better deal you give the customer, the worse deal it is for you. You’re on the other side of the transaction. It’s like going into any store—the store sells you a television at a higher price, they’re going to make more money. They sell you the lower price, their profit goes down accordingly. As honest as you try and get people to be, there’s this normal, natural pole that you have to deal with. By taking the human being out of the equation to a great extent and turning it over to a computer to make your decision—I guess you could also program the computer to violate the regulations, but we haven’t gotten there yet.

At minute 69 Bernie states:
"The future is silence. I don’t see a lot changing in the marketplaces. It’s hard to of course say that because everything always changes, but I cannot imagine what else we’d do, from an automation standpoint..."
At minute 71 Bernis states:
"You know, this is a psychoanalytical group, I guess, right?... I’m sort of curious—maybe because no one got a chance to ask any questions about it yet—what are human beings contributing to the marketplace?  Is there any change in their actions?
At minute 111: Bernie states:
"This is SEC’s concern today because they call us all the time and ask us: should we be concerned about the fact that certain firms have left certain areas of the industry and are not serving the public, or not serving even other parts of the industry itself? The answer is it’s too late, because you’ve done it. So there’s always this friction that goes on between the regulation side of the industry and the practitioners that say okay, where do you draw the line? I’m very close with the regulators so I’m not trying to say that what they do is bad. As a matter of fact, my niece just married one.  (Speaker:  My condolences) (Speaker; Did the SEC approve?) Madoff:  He’s an attorney. (Speaker:  Okay.)

Madoff:  The issue is, the way they tend to look at the industry if you’re making a profit there’s something wrong, even though intellectually they know that shouldn’t be.

At minute 118, Bernie states:
"You know, my theory—and I’ve always said this even though we were one of the ones that started all this automated algorithmic trading—was that I never wanted to get into a cockpit of a plane and see there wasn’t a pilot sitting there...But more importantly, in our firm—and I don’t know that we’re unique, but I know there are other firms that do not operate this way—we  have a group of traders that are watching the systems work and the results of the systems to make sure that from their sense of trading things look right. With all due respect to Josh and a lot of other people that we have with similar backgrounds, programmers—not that he’s a programmer—but people of his ilk can tend to believe too much in the math and in the model. They fall in love with it sometimes. Not so much Josh, which is why he’s with us, but we have a lot of people like Josh that we employ and deal with. They’re different. The thing that separates somebody that is a good algorithmic trader from somebody that is dangerous is somebody that just always believes the machine is right. There are people like that. It goes back to what Bob said about the joke of the dog. It’s supposed to make sure that nobody touches the machine. You always want to have the human factor involved in the process because that makes it better. At least that’s been our experience.


And most disturbing at minute 125:


Audience:  "My question is a little basic. It’s open for the whole audience. How do you feel that the baby-boomers retiring, starting this year, will affect the future of the stock market, considering there were probably about 60 million people who are going to retire in the next ten years?"


Madoff:  "Good luck."

What is the take from this...its hard to tell. Here we have a man who created the NASDAQ, and took the human element out of the trading, and yet clearly likes to spend time with people. Maybe he was bored and needed the human touch. By playing the big man on campus, and spreading largess, he was the center of attention. As he states in minute 69...."The reason why is it’s quiet. When you went up to our firm you said, “Well, I’m surprised at how quiet it is.” I find it difficult to get used to that because I’m used to a lot of noise and screaming."


Clearly worst punishment for Bernie Madoff will be silence.


Bernie Madoff...We Trusted You So Long

One of the best movies of the year is a french movie, starring Kristen Scott Thomas, entitled, "I Loved You So Long." It is a sad and tragic movie, about a love so deep for a child...and how that love, and the mother's assisting her son die peacefully from cancer, haunts her upon her release from prison. Why it reminds me of Bernard L. Madoff is hard to say...but clearly their are parallels. The investors who have approached us have told us of decades old trust...a love so long...and now they are facing a death of their own...and they too are haunted, and some may be for the rest of their lives. And of course there is prison....

Often times securities fraud class actions felt like aiding a gambler who got cheated at the pool table. No tears were felt, but their were rules to be enforced and money returned. Today....it is not the same...in the Madoff matter and others. Today those who fled the tough and tumble of the public markets, and sought safety and security...investing in money market funds, cash, and trusted advisors, are telling us of having lost their entire savings and in too many cases, the funds needed to pay their medical bills and retirement. It is hard not to want to cry.

One of our clients had invested with a partnership pool almost 40 years ago, and that is where his money stayed and grew. Today he got the call where the caller revealed the "worst nightmare" ...all of the money had been invested with Madoff. 75% or his retirement gone! Shock does not describe his feelings...if any are left.

The SEC has now shut down Madoff's operations, including Bernard L Maddoff Investment Securities LLC, or BMIS. The freeze order can be found here. The SEC's complaint used to obtain the order can be found here.

But who else was involved, and where will investors be able to seek recovery?

Our investigation...in its early stages...leads use to believe that many were involved...and many knew or suspected. The investors we know invested in partnerships who invested with partnerships... who invested with Bernie M. And Bernie M. and some of the General Partners of these partnerships seem to have close relationships. We are trying to learn more about those partnerships and relationships...many of the partnerships seem to have less of a real presence than the 3 auditors of Bernie M's fund. At least they had a 12 by 18 foot office and showed up for 15 minutes a day in their tie dye T-shirts. We know that there was a group of funds or partnerships funneling money to Bernie M. But the pciture needs paint.

You can help us with our investigation. Help us define the web that allowed this Ponzi scheme to hurt so many. A description of our investigation is available here.


SEC Settlements Compared to Settlements in Private Shareholder Class Actions

NERA Economic Consulting has just published a report on SEC Civil Enforcement Settlements over the past few years. The study, SEC Settlements: A New Era Post-SOX, provides an overview of trends NERA has identified in the number of settlements and settlement values in the six years since the enactment of SOX. The data stems from a database of litigation releases and administrative proceedings  published from 31 July 2002 through 30 September 2008.
Of interest is a comparison of some of the SEC settlements with those achieved by private securities fraud class actions. While the comparison is not made in the report, NERA also published a report entitled   2008 Trends: Subprime and Auction-Rate Cases Continue to Drive Filings, and Large Settlements Keep Averages High .
Each report contains a chart of top 10 settlements, which is set out below. The first is a chart of  the top 10 settlements for SEC settlements for the period of July 2002 - September 2008. The second  is for the top ten private class action settlements. Interestingly, the lowest of the  top ten settlements in private shareholder class actions covers starts out higher than the highest SEC settlement ($895 million versus $800 million).
The settling companies are not the same either, except for a few. For example, the SEC disgorged no funds for investors in Worldcom. While it accessed a $750 million civil penalty, civil penalties do not necessarily go to investors. Since enactment of  the Sarbanes-Oxley Act of 2002, penalties may be added to disgorgement funds for the benefit of investors. Section 308 of Sarbanes-Oxley (the Fair Funds provision) allows the Commission to take penalties paid by individuals and entities in enforcement actions and add them to disgorgement funds for the benefit of victims. Penalty moneys no longer always go to the Treasury, but there is no hard and fast rule. By way of contrast, the private shareholder class action against Worldcom recovered over $6 billion for investors, not including institutional investors who opt-outed out of the securities fraud class action and received their own substantial recoveries.
Similarly, the SEC accessed penalties of $300 million from Time Warner, and received no disgorgement for investors. By way of contrast, the private shareholder class action against AOL Time Warner recovered over $2.6 billion for investors. This recovery does not include the recoveries of institutions that opted-out of the class action and pursued their own suits.
The SEC Settlement report also states that the number of SEC enforcement actions  with recoveries relating to misrepresentation claims for the 6 - year period totals 197 settlements. The Private Shareholder Class Action report, by way of contrast reveals that over 200 class actions are filed per year with a 60% settlement rate---or over 1200 suits with 720 settlements.
Our comparisons, here, are rough. Hopefully, NERA will do a more in depth statistical and case by case comparison that would stand up to expert review. But even based on this rough comparison, what do we conclude?
  • Private class actions remain the most important vehicle for investor recovery, and dollar-wise provide the biggest deterrent to securities fraud in the area of public company misstatements or omissions. 
  • The SEC report, however, remains the primary watch dog for actions involving boiler room operations, pump. and dump schemes, Ponzi schemes, financial services (brokers) misappropriation fo funds and misrepresentations to clients, and insider selling, and recoveries against individuals. NERA's report has statistics covering each of these area too. 
This first chart is from the SEC Settlements: A New Era Post-SOX :
SEC Top Ten

The following is a list of top settlements in Private Securities Class Actions from the NERA Shareholder Class Action Report:
Top ten private



Is Cadence's Restatement Likely the Result of Fraud?

Meaningful Disclosure.

Is Cadence's Restatement Likely the Result of Fraud? Posted by Reed Kathrein 11/04/08 1:38 AM On October 15, 2008, Cadence (NASDAQ: CDNS) of San Jose, California, was supposed to announce its third quarter results for 2008. Instead it announced the resignation, "by mutual agreement" of its CEO, Mike Fister and four other executives: Kevin Bushby, executive vice president, worldwide sales operations; James S. Miller Jr., executive vice president of products and technologies; William Porter, executive vice president and chief administrative officer; and R.L. Smith McKeithen, executive vice president, corporate affairs. Porter had also served as CFO between 1999 and April 2008. Then on October 23, 2008, Cadence announced that it has improperly recognized $24 million in revenue in the first quarter, which should have been recognized over the duration of the contracts beginning in the second quarter. While a restatement of $24 million is only about 10 percent of the revenue, the impact on the income/loss would have been tremendous, as the first quarter was already a loss of $27 million. Hence, if the executives were scrambling to close the gap on the loss, a little revenue recognition shenanigans might have helped:

PERIOD ENDING 28-Jun-08 29-Mar-08 29-Dec-07 29-Sep-07
Total Revene 329,478 287,189 457,943 400,924
Cost of Revenue   59,670 51,734 56,150 52,404
Gross Profit 269,808 235,455 401,793 348,520
Operating Expenses
Research Development 120,087 125,356 297,611 125,391
Selling General and Admin 124,870 130,742 (13,942) 137,910
Non Recurring (355) 600 (102) (4,388)
Others 5,820 5,760 5,760 4,739
Total Operating Expenses 250,422 262,458 289,327 263,652
Operating Income or Loss 19,386 (27,003) 112,466 84,868

Even then, however, the stock took a hit over the next two quarters. Results:

But often a good indicator of fraud is insider selling. However, insider sales have been very small over the last year, though James Miller, one of the executives who resigned, sold about $120,000 in September and an executive who did not resign, sold about $631,000 in February. Much more was sold in the last two quarters of 2007, before the revenue recognition problems, but it is always possible that the executives foresaw the upcoming income declines and sold before they needed to play revenue games.

Of course another incentive could be the need to raise cash for acquisitions such as the failed attempt to acquire Mentor Graphics announced in May 2008.

We will keep monitoring this story, and if you have any information, let us know. See our post on Meaningfuldisclosure.com.

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