Securities Law Prof Blog

Editor: Eric C. Chaffee
Univ. of Toledo College of Law

Tuesday, January 27, 2009

FINRA's Interim CEO Testifies on Madoff

Stephen Luparello, Finra's Interim CEO, also testified at the Senate hearing on the Madoff scandal.  In his remarks, he emphasized that Finra only regulated Madoff's broker-dealer firm and has no regulatory authority over investment advisors.  He also stated they received no tips or complaints about fraud.  Some excerpts from his testimony:

It certainly appears that Madoff knew well the seams in that system that separated functional lines of regulation, and perhaps that knowledge assisted him in avoiding detection and defrauding so many unsuspecting individuals and institutions. By all accounts, it appears that Mr. Madoff engaged in deceptive and manipulative conduct for an extended period of time during which he defrauded the customers who invested with him and misled those who had the responsibility to regulate him.

Even so, Mr. Madoff's alleged fraud highlights how our current fragmented regulatory system can allow bad actors to engage in misconduct outside the view and reach of some regulators. It is undeniable that, in this instance, the system failed to protect investors. ...

In its regulatory filings and FINRA examinations, the Madoff broker-dealer has consistently held itself out as a wholesale market-making firm; that means it was a firm that was in the business of executing, as a market maker, order flow that other broker-dealers directed to it for execution and otherwise trading securities for the risk of its own proprietary accounts. These relationships with other broker-dealers are treated under regulatory rules as counter-party rather than customer relationships. The Madoff broker-dealer consistently reported that 90 percent of its revenue was generated by market making and 10 percent by proprietary trading. The broker-dealer consistently represented to FINRA that it had no retail or institutional customer accounts, a position that would be consistent with the business model of a wholesale market-maker.

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During the last 20 years, FINRA (or its predecessor, NASD) conducted regular exams of Madoff's broker-dealer operations at least every other year. Madoff's broker-dealer was on a two-year examination cycle because it engaged in market making and was self-clearing. Based on this business mo
In the course of FINRA's broker-dealer exams, we found no evidence of the fraud that Bernard Madoff carried out through its investment advisory business. While there have been some reports that victims of the fraud received statements from the Madoff broker-dealer, our examinations did not reveal the existence of customer relationships that the broker-dealer would have had in providing execution or custody of advisory assets, and they did not reveal that the Madoff broker-dealer in fact held client assets other than in a small number of inactive employee accounts. Also, FINRA did not receive customer complaints that might have alerted us to the existence of the alleged accounts.

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The absence of FINRA-type oversight of the investment adviser industry leaves their customers without an important layer of protection inherent in a vigorous examination and enforcement program and the imposition of specific rules and requirements. It simply makes no sense to deprive investment adviser customers of the same level of oversight that broker-dealer customers receive.

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