This post was written by Simon van Norden of HEC-Montréal.
The news last week that the SEC was filing charges against Goldman Sachs was a bombshell; it dominated the day's headlines and continues to fill blog-space. As it happens, that announcement came the same day as a report that the SEC would prefer that everyone forget about. The SEC issued a press release about that report which stated (in its entirety)
"This report recounts events that occurred at the Commission between 1997 and 2005. Since that time, much has changed and continues to change regarding the agency's leadership, its internal procedures and its culture of collaboration. The report makes seven recommendations, most of which have been implemented since 2005. We will carefully analyze the report and implement any additional reforms as necessary for effective investor protection."
It was long ago….times have changed….the problem has since been fixed…..and if it hasn't been, we'll be sure to fix it now…..so there's no nothing to discuss…..
But the debate on financial reform is taking centre stage and there's very different visions of what that reform should look like. Many are trying to figure how how to respecify financial regulations (such as the proposed Volcker Rule) to avoid future crises. Others argue that rules cannot keep up with financial regulation, so it is better for the lawmakers to put their faith onto regulators who should have broad discretion in forming and applying regulations. Still others claim that this is a recipe for disaster; the more discretion a regulator has, they argue, the bigger the damage when the regulator does a lousy job. And the report that no one is talking about shows just how lousy a job a regulator can do.
The report is by the SEC's Office of the Inspector General (OIG) Case No. OIG-526 "Investigation of the SEC’s Response to Concerns Regarding Robert Allen Stanford’s Alleged Ponzi Scheme." Sir Stanford (he has a knighthood) is the man behind the Stanford Group Company (SGC) and the alleged Ponzi scheme that was exposed shortly after Bernie Madoff was exposed. In the Madoff case, inquiries showed that the SEC did a spectacularly bad job, including failing to follow up on repeated warnings (notably by Harry Markopolous) that Madoff was running the world's biggest Ponzi scheme. In the Stanford Case, the Ponzi scheme was smaller (still in the billions of dollars), but the failure was worse in some ways.
In 2002 and against in 2003, outsiders warned the SEC that they felt Stanford was running a Ponzi scheme. In 2003, an insider at Stanford Group Company (SGC) warned that Stanford was operating "a Massive Ponzi Scheme." SEC examiners had determined as far back as 1997 that the company was most likely running a large Ponzi scheme. Three follow-up examinations by the SEC confirmed that the operation was almost certainly a fraud and that it was growing. Despite that, no actions were taken to protect investors until February 2009, when SGC was abruptly shut down by regulators.
Here's how the the report summarizes what happened
The OIG investigation found that the SEC’s Fort Worth office was aware since 1997 that Robert Allen Stanford was likely operating a Ponzi scheme, having come to that conclusion a mere two years after Stanford Group Company (“SGC”), Stanford’s investment adviser, registered with the SEC in 1995. We found that over the next 8 years, the SEC’s Fort Worth Examination group conducted four examinations of Stanford’s operations, finding in each examination that the CDs could not have been “legitimate,” and that it was “highly unlikely” that the returns Stanford claimed to generate could have been achieved with the purported conservative investment approach. Fort Worth examiners dutifully conducted examinations of Stanford in 1997, 1998, 2002 and 2004, concluding in each case that Stanford’s CDs were likely a Ponzi scheme or a similar fraudulent scheme. The only significant difference in the Examination group’s findings over the years was that the potential fraud grew exponentially, from $250 million to $1.5 billion.
While the Fort Worth Examination group made multiple efforts after each examination to convince the Fort Worth Enforcement program (“Enforcement”) to open and conduct an investigation of Stanford, no meaningful effort was made by Enforcement to investigate the potential fraud or to bring an action to attempt to stop it until late 2005. In 1998, Enforcement opened a brief inquiry, but then closed it after only 3 months, when Stanford failed to produce documents evidencing the fraud in response to a voluntary document request from the SEC. In 2002, no investigation was opened even after the examiners specifically identified multiple violations of securities laws by Stanford in an examination report. In 2003, after receiving three separate complaint letters about Stanford’s operations, Enforcement decided not to open an investigation or even an inquiry, and did not follow up to obtain more information about the complaints.
It gets worse. The 1998 inquiry was evidently opened not because of the examination group's findings, but because another federal agency was concerned that SGC was involved in money-laundering. It seems that outside counsel for SGC, Wayne Secore, was the former head of the SEC's Fort Worth office. The man at the SEC responsible for shutting down the inquiry, Mr.Barasch, reportedly told colleagues that this was because Mr. Secore assured him that "there was nothing there." Enforcement efforts were consistently avoided until Mr. Barasch left the SEC in 2005. When the successor to Barasch showed interest in pursuing SGC, SGC tried to hire Barasch as legal counsel. Three times Barasch tried to get permission to work for SGC, which could normally be a violation of ethics guidelines for federal employees. He was told three times that he could not, despite the fact that in at least one case he had already begun work.
The report is an accessible mine of more worrying information.
- Frustrated by their inability to get the SEC to take enforcement action, some examiners try to get the Federal Reserve Board to act via its banking supervision responsibilities. The responses from the FRB are among the most heavily redacted parts of the report, but it is clear that, after long delays in responding to SEC concerns, the FRB did nothing.
- One reason advanced for not pursuing enforcement actions against SGC was that the majority of investors were not US citizens. (In 2005, it was estimated that US investors had only invested a bit over $200 million; other investors, particularly Mexicans, had invested over $1 billion.)
- After another worrying report by examiners in 2002, enforcement proceedings were deflected by deciding to refer to the matter to the Texas State Securities Board, but not actually contacting that body.
- Those who were responsible for blocking many of the enforcement actions over the years argued that this was because they understood that they were not to waste resources pursuing Ponzi games.
Meanwhile, Julie Dickson, Canada's Superintendent of Financial Institutions, is arguing that the debate about what rules are required overlooks the important role of supervision in banking. Given that the examiners in the case of SGC seemed to have been so right for so long, I need to read her arguments again and think hard about them.
Worthwhile Canadian Initiative 
Not to try to take things in too different of a direction I found an interesting speech recently by Bill Rice head of the Alberta Securities Commission recently made on his opinions of the causes of the financial crisis. I admit to reading between the lines a little bit but basically he was critical of both the SEC and Sarbanes Oxley and seemed to imply the current Obama regulatory plan was a piece of junk done to keep the populists quiet. He also seemed to imply that the ASC feels no obligation to comply with any G20 agreement the federal government(I actually think this govt will make sure anything they sign applies only to chartered banks under federal jurisdiction although I am not sure the Obama’s and Sarkozy’s will quite understand the difference) makes on hedge funds, derivatives, commodities speculation or executive compensation as Alberta considers all of these issues to be under provincial jurisdiction. The Alberta government also seems to believe that keeping a pro business regulatory enviornment in light of changes elsewhere will help to make Calgary a major financial center in Canada and North America.
Interesting. I believe Flaherty is planning to present draft legislation to the Supreme Court for a constitutionality opinion sometime this spring. I’ve read in various places that their might be an opt out clause to make sure it passes muster.
That raises the interesting scenario: say AB opts out, regulates lightly (or not at all), Calgary’s financial sector booms, but at some point a financial crisis results that threatens the Canadian economy. Will Albertans pay to clean-up the mess? Or what if the crisis is localized like much of the S&L blow-up? Will AB get a bailout from the RoC?
Trivial nitpicking:
“Sir Stanford (he has a knighthood)”
It could be Sir Robert or it could be Sir Allen (as he preferred) but a knighthood is always title then first name, not title then surname.
Peerages work the other way, title (Lord, Baron, Viscount, the Earls and above are title “of”) name. So William Legge, who I worked with, is William, Earl of Dartmouth.
Except when the peerage is a courtesy title for the younger son of a Marquis or Duke, “Lord David Somerset” for example being the (possibly mythical) younger son of the Duke of Somerset.
Feudalism, ain’t it great?
I would love to see Prof Van Norden become a regular contrinutor. Everything I’ve read of regulation has been British or American.
Tim:
“The Alberta government also seems to believe that keeping a pro business regulatory enviornment in light of changes elsewhere will help to make Calgary a major financial center in Canada and North America.”
There’s no shortage of poor places, statelets and islands with “pro business regulatory environments”; SGC structured its deals with Stanford International Bank in Antigua in part to take advantage of Antigua’s favourable regulations. The question is why anyone would think that Alberta has a competitive advantage in that kind of a race to the bottom.
I think junky regulatory plans designed to keep populists quiet come in all shapes and sizes.
Patrick:
Actually, the RoC did bail out failing Alberta financial institutions in 1985, when the Northland Bank of Canada and the Canadian Commercial Bank failed. (Check out http://bankofcanada.ca/en/dingle_book/bank.pdf for a blow-by-blow account from the Bank of Canada.)
Tim Worstall:
What can I say? I was educated in BC public schools, and sometimes it shows!
And clearly not that sort of “public school”, either! 😉
The link by Julie Dixon is indeed a very good read, and your post, Simon, shows why what she’s talking about is so important. But my guess is that economists have little to contribute to the sort of things she is talking about. Which is perhaps why we instead put too much emphasis on the rules. (“If all you have is a hammer, everything looks like a nail”)
Why is it that when personal responsibility and private savings is discussed as the solution to demographic problems or a recipe for macro success, the problem of moral hazard is so rarely discussed?
Private investment for retirement essentially consists of saying “here, take this $300,000 (or $900,000 or $1.5m or whatever) and give it back to me in 20 years time.”
Bit of a risky proposition?
Frances: true. But you might make the same argument about public retirement plans, which are dependent on the choices of future voters, and on government solvency.
I expect the only real alternative is to invest in real assets (houses, land, your own business, consumer durables), but these too have their own problems. I think my grandparents’ generation tended to invest in houses, and rent them out for retirement income. UK rent controls (pre-Thatcher) made sure that worked badly for my grandma.
Meanwhile, Julie Dickson, Canada’s Superintendent of Financial Institutions, is arguing that the debate about what rules are required overlooks the important role of supervision in banking.
You could take it a step further and argue that it is an issue of corporate governance – starting at the top (board of directors). The thought came to mind when you were describing the movement back and forth of key people from regulator to regulated and/or vice versa.
Donald H. Thain, Professor Emeritus, Richard Ivey School of Business has written a lot about corporate governance. This journal article, written in 2004, precedes the final collapse of Nortel by a few years but highlights, at a higher level, similar issues identified by Julie Dixon.
Nick wrote: “But you might make the same argument about public retirement plans”
Absolutely, an excellent reason to be highly skeptical about solving “the demographic crisis” through fully funded government pension plans. Anyone who thinks that the billions of dollars sitting in the Canada Pension Plan account are immune to political influence is simply naive.
There is only one kind of magic bullet that can completely eliminate the risk of suffering in old age. I don’t think Canada is prepared to legalize euthanasia for humans – again I find myself envying the access to quality health care that my dog enjoys.
On a less morbid note: we could all move some place warm and sunny where labour is cheap and outsource the nursing care for our senile years.
(I was going to suggest hoping that your children would care for you in your old age, but this struck me as hopelessly naive as well).
To be fair to Alberta I don’t think its securities regulator is any worse than the other provinces in Canada look at Earl Jones in Montreal. I think though it is perhaps interesting proof of the theoretical argument that economic crisis are caused by poor monetary and banking policy(in Canada under the firm control of the federal govt) than fraud or other problems in the securities markets(under the control of the provinces). In many ways one could argue Canada still has the same type of regulatory structure the US had prior to 1933(when securities where regulated by the states) that has been completely discredited in the US yet Canada has come through this crisis far better than the US.
The securities regulations are actually fairly harmonized are across Canada but don’t tend to cover areas like derivatives or commodities trading which tend to be either competely unregulated or covered by regulation developed solely by a single province. I think interesting real life issue in Alberta could be energy trading/speculation. All of the major Wall Street banks plus the Big Six Canadian banks have energy trading/speculation operations in downtown Calgary that the Alberta Securities Commission has essentially choosen not to regulate. Obama in the US wants to regulate similar types of operations because many his party feel they are pushing energy prices through excessive speculation to unreasonable levels. On the otherhand the Alberta govt has a perversely opposite interest in allowing speculators to push oil prices as high as possible thus increasing economic activity in the province and provincial energy royalties. To be fair other provincial securities commissions have the same perverse incentive on a smaller scale for commodities such as timber, uranium, potash, metals, even Quebec and Manitoba hydro exports indexed to Natural Gas prices.
Frances
There is only one kind of magic bullet that can completely eliminate the risk of suffering in old age. I don’t think Canada is prepared to legalize euthanasia for humans ….
That’s not a magic bullet….that’s an ordinary bullet.
Soylent Green is people!
What a cheery bunch. Dismal science indeed.
Just a crazy thought you can do with as you please: in the past when there has been a persistent failure by the US government to intervene with known criminal operations, there has often been some government entanglement in the operations. There’s the documented history of CIA involvement in drug running, the mafia’s stalemating of J. Edgar Hoover and the Kennedys, and the CIA again with the Bank of Credit and Commerce International, among other examples. I wonder whether there was any covert ops money circulating in SGC?
Is supervision a nice concise way of saying monitoring and enforcement?
In the US financial sector I see monitoring but insufficient enforcement.
Our world is littered with laws and regulations that are rarely if ever or only timidly enforced. For examples, how about tenured profs working for crown-financed universities who smoke tobacco in their offices? Or how about all the materially comfortable, well-educated people that drink alcohol, drive and even sometimes brag about it?
Most municipal by-laws are rarely enforced. Laws against minor toxic environmental spills are rarely enforced.
Paedophilia is another. We have known that Roman Catholic priests have been abusing children for decades.
The nuclear proliferation treaty is another example. Canada, France and the USA seem content that Israel, India and Pakistan all possess nuclear weapons and the vectors to deliver them.
So why are some laws and regulations (financial or otherwise) enforced in some circumstances and not enforced in others?
Well, I can’t speak to the other issues, but I’d imagine that Canada, France and the USA don’t have much to say Israel, India and Pakistan’s nuclear weapons and the nuclear NON-proliferation treaty (the “NPT”), because none of Israel, India or Pakistan are signatories to the NPT and therefore aren’t bound by it.
Bob Smith: Obviously the NPT isn’t very important given how super-power #1 is only paying the treaty occasional lip service.
Perhaps we need to be open-minded about this? The more nations that possess nuclear weapons, the safer the world is. Maybe that is the thinking that is driving western policy?
I look forward to Congress attacking the Proliferation Treaty (sic) after the next regional nuclear war. It promises to be an exciting debate.