Friday, March 19, 2010

Give the SEC the teeth to stop fraud

That Lehman Brothers had hidden its dire financial situation with the aid of accounting tricks is no surprise. Banks, trading companies and even Big Oil and Big Car have been doing this for years. Lehman was special in this, however, as the size of the losses was of such a magnitude that they nearly wiped out several other banks and helped to take down the global economy. Enron looks pale in comparison (and its execs went to jail). That Merrill Lynch staffers had spotted Lehman's trickery and grassed them out to the SEC is a surprise. Most banks tend to collude, or at least ignore others' peccadilloes with a nod and a wink, when it comes to the little tricks that keep them cozy with their shareholders. That the SEC somehow failed to grasp the significance of the so-called Repo 105 accounting practice is the biggest surprise of all. After the Bernie Madoff scandal, the SEC had a lot of explaining to do to the American public, and to the government. It went hat in hand for a bigger budget in order to hire experts to help sniff out and nail financial fraudsters. And got it. The task at hand now is to figure out how to hire people who actually understand the very things the SEC is supposed to be nailing people for. One idea is to hire outside firms with the expertise.
Last year in an article for Financial News, I wrote about the possibility of regulators cracking down on hedge funds and making them more transparent. At the time I spoke to former Securities Exchange Commission chairman Harvey Pitt, who is now CEO of business consulting firm Kalorama Partners. Pitt said that what needs to be done about hedge funds had already been laid out in an SEC request for comment in 2003: Data about hedge funds' activities should be available to regulators, and the SEC's concept of examination and inspections needs to be changed. Pitt said: "It is not structured to succeed."
Further, Pitt believes that all portfolio managers should be required to allow (and to pay for) a regular independent examination by a company that it has no relationship with. These independent examiners would then give their report to the audited entity as well as the SEC.
This tactic would work well for the whole of the TBTF businesses in America. There are independent firms out there including one run by ex-FBI agent Ken Springer - Corporate Resolutions. (Inexplicably, Financial News cut this part of my story - and I think it was the most important angle.)
Springer said: "Investors need to re-claim confidence and more regulation alone will not necessarily do it. Often, things fall through the cracks and investors need to take more pro-active steps." He advises conducting independent onsite financial due diligence with comprehensive background checks, and implementing an ethics hotline where employees, accountants, prime brokers, fund administrators can anonymously report wrongdoing to an independent third party.
Springer said: "Managers can hide trades or have brokers eat fees to boost the fund's performance. Up to now fund managers have resisted this enhanced transparency. Now they may have to do this as a condition of investment. The bigger funds won't want to, but the smaller ones will jump through hoops to get investors. Investors bring us in as part of due diligence."
The answer to a Lehman- or Enron-like conspiracy to bury bad news is twofold. Give the regulators the power to hire outside experts, and the power to insist on their use. Having the staff, the money and the will to investigate and find fraud is one thing. The SEC needs to have the power and the authority to go into these companies and actually do it.

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