Avoiding More Madoffs: The IRS Model May Be the Key
27 August 2009
27 August/New York -- Proven systems already in use by the US Internal Revenue Service (IRS) should be adopted by the Securities and Exchange Commission (SEC) to deter and detect Ponzi schemes of the sort perpetrated by Bernard Madoff, according to a new white paper by NERA Senior Vice President Marcia Kramer Mayer.
Under Dr. Mayer's proposal, the asset data would feed into computers programmed to routinely perform comparisons and report disparities; if any disparities were large, numerous, or persistent for a particular adviser, an SEC inquiry would result.
"While the reforms proposed by the Obama administration are an excellent start, they don't go far enough in ensuring that we won't see another Madoff-type fraud in the future," said Dr. Mayer, a financial economist. "A common feature of Ponzi schemes is that investment advisers overstate the account assets that they report to clients. The IRS's simple, proven approach of routinely cross-checking reported data would be ideal for the SEC to adopt in its regulation of investment advisers, and such a system could be implemented at no cost to taxpayers."
Dr. Mayer's paper, Ponzi Scheme Detection: How the SEC Can Catch the Next Thief, notes that the IRS does not simply accept at face value the income amounts submitted to it by taxpayers. Instead, Dr. Mayer writes, it systematically compares those items to submissions by income payers (employers, financial institutions, the Social Security Administration, trustees, etc.) to identify discrepancies. Dr. Mayer proposes a similar multiple-source reporting and cross-checking system for the SEC in its regulation of investment advisers, whereby:
"The involvement of individual investors is the linchpin of this plan, and even a modest level of participation would be effective," according to Dr. Mayer. Requiring advisers to use an independent custodian is the single most important step the SEC could take to thwart Ponzi schemes, but additional measures are needed because custodians could be deceived or complicit. "A scheming adviser would risk exposure from random clients reporting their presumed account assets to the SEC. Unless the adviser had reported the same account-level assets and the custodian corroborated the total, any one investor report could trip him up," said Dr. Mayer.
"The massive and sustained over-reporting of client assets by Madoff and others of his ilk demands better detection systems on the part of regulators," said Dr. Mayer. "Instead of taking half-way measures, the Obama administration and the SEC should look to the tried and true approach to data verification that the IRS has been successfully using for decades."
The views expressed by Dr. Mayer in this release and in her paper, Ponzi Scheme Detection: How the SEC Can Catch the Next Thief, are her own opinions and do not necessarily represent the views of NERA Economic Consulting or any other NERA consultant. To view the full paper, please visit www.nera.com.
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