Strengthening Oversight of Broker-Dealers to Prevent Another Madoff

Posted by Luis A. Aguilar, Commissioner, U.S. Securities and Exchange Commission, on Thursday August 1, 2013 at 9:23 am
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Editor’s Note: Luis A. Aguilar is a Commissioner at the U.S. Securities and Exchange Commission. This post is based on Commissioner Aguilar’s statement regarding the SEC’s final rule concerning broker-dealer custody practices; the full text, including footnotes, is available here. The views expressed in the post are those of Commissioner Aguilar and do not necessarily reflect those of the Securities and Exchange Commission, the other Commissioners, or the Staff.

The facts surrounding Bernie Madoff’s unprecedented fraud are well-known. Through a Ponzi scheme, he stole untold billions over decades. What is not as well-appreciated is that during the vast majority of this time, he operated solely as a registered broker-dealer. This led to the inevitable conclusion that the regulatory framework for broker-dealer custody required urgent strengthening.

The U.S. Securities and Exchange Commission (“Commission” or “SEC”) has finally adopted amendments to strengthen the framework governing broker-dealer custody practices to prevent another Madoff. The adoption of these amendments comes more than four and a half years after Madoff’s scheme came to light in December, 2008, and more than two years after they were proposed. As a Commissioner, I have often been asked about steps the Commission has taken to prevent another Madoff, and it has concerned me that these issues have not been addressed.

For example, when the Commission adopted rules regarding investment adviser custody practices over three and a half years ago, it was clear that it was not the Madoff fix. At the time, I highlighted the urgent need for the Commission to take steps to strengthen the framework governing the custody practices of broker-dealers. Because Madoff was registered solely as a broker-dealer for most of the time he conducted his Ponzi scheme, the investment adviser custody rules would not have prevented much of the harm he caused. In addition, unlike broker-dealers and banks, investment advisers typically do not maintain physical custody of client assets. Thus, while I supported the adoption of the investment adviser custody rules, it was clear that more was needed.

Accordingly I am pleased to support the adoption of the amendments regarding broker-dealer custody. These amendments, in conjunction with the 2009 rules regarding the custody practices of investment advisers, are designed to create a framework to ensure that investor assets are safely held. This framework is critical to cultivating early detection and to preventing the type of fraud Madoff perpetuated.

This framework has several components, of which I will highlight just a few:

  • First, broker-dealers that carry customer assets must file with the Commission a compliance report stating that they are in compliance with certain of the financial responsibility rules. The report must also certify that the broker-dealer has effective internal controls to ensure compliance with those rules. This will enhance early detection of misappropriated or lost assets, and identify weaknesses in a broker-dealer’s internal controls that could jeopardize the safety of customer assets.
  • Second, broker-dealers must identify in the compliance report any instances of non-compliance with certain of the financial responsibility rules and any material weaknesses in their internal controls. Importantly, the compliance report must be examined by independent public accountants registered with the Public Company Accounting Oversight Board (“PCAOB”).

Of course, for these rules to be meaningful, it is important to highlight the roles played by accountants and broker-dealers in implementing these amendments. First, it will be critical for broker-dealers to promptly notify the Commission of non-compliance, as required under the rules. Second, accountants must notify the Commission of a broker-dealer’s non-compliance if the broker-dealer is required but fails to do so, and accountants should enact measures to confirm that a broker-dealer has notified the Commission of such non-compliance.

I also want to acknowledge the role of the PCAOB. Under the Dodd-Frank Act, the PCAOB has oversight authority over the audits of broker-dealers and has the authority to establish an inspection program for auditors of broker-dealers. I note that the PCAOB is in the process of finalizing its standards for broker-dealer audits and its inspection program. I encourage the PCAOB to act with appropriate haste. The PCAOB’s oversight will help to ensure that accountants diligently perform their duties in examining broker-dealers. This is critical to the implementation of the framework.

Finally, I note that the SEC’s rules regarding broker-dealer and accountant notification of non-compliance with certain of the financial responsibility rules still require such notification to be made by telegraph or facsimile transmissions. I urge the staff to modernize the notification process to allow broker-dealers and their accountants to provide notification to the Commission using more modern electronic methods, such as emails, which would be both faster and cheaper.

In conclusion, I support these long-awaited amendments. To that end, I want to commend the staff’s efforts to address the weaknesses in the broker-dealer custody framework illustrated by the Madoff fraud.

 

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