Ponzi Scheme Detection: How the SEC Can Catch the Next Thief

03 August 2009
By Dr. Marcia Kramer Mayer

The SEC has been taking enormous heat for failing to detect Bernard Madoff's massive and long-running Ponzi scheme. The official report has yet to be issued on how the watchdog agency was itself fooled by Mr. Madoff's machinations despite the many "red flags" brought to its attention by whistle-blowers. In this NERA paper, Senior Vice President Dr. Marcia Kramer Mayer contends that, whether the explanation proves to be insufficient resources, inadequate systems, insufficiently savvy staff, misplaced priorities, or willful blindness, the SEC can be equipped to cost-effectively deter and detect Ponzi schemes if asset verification is made an automated feature of its regulation of investment advisers.

Dr. Mayer proposes a simple set of clever legal and regulatory reforms to do just that. Her approach is modeled on the IRS' practice of systematically cross-checking the income items on taxpayers' Forms 1040 against the W-2s, 1099s, and K-1s filed by employers, financial institutions, and other income payers. Along with requiring investment advisers who manage at least $30 million in client assets to use an independent custodian and to register under the Investment Advisers Act of 1940 (recommendations recently advanced by the SEC and the Obama Administration, respectively), Dr. Mayer's plan would entail multiple-source reporting and systematic cross-checking of assets under management: by adviser, by account, and by position. Investment advisers, custodians, the IRS, Omgeo (the entity that handles post-trade processing for investment managers), and investors would each have a role to play -- optional for the last group, mandatory for the others. Because advisers would be required to tell the SEC their assets under management by account, one who overreported to investors but reported truthfully to the SEC (so as not to be done in by its custodian) would risk detection if just a single customer with an inflated account statement reported its purported asset value to the SEC.

Ultimately, Ponzi scheme prevention means keeping close watch on the assets that investors are told they own. Because custodians may be deceived or complicit, it should not be assumed that they can carry the full burden alone. By bringing other parties who possess relevant data into the reporting process and funding the program through account- and asset-based fees on registered investment advisers, the SEC can address the Ponzi problem quickly, effectively, and at minimal cost to taxpayers.

An excerpt from this paper was published in the 2009/2010 Annual Edition of Kroll's Global Fraud Report.