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Madoff and Sarbanes Oxley
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lekatis
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PostPosted: Sat Feb 07, 2009 5:18 am    Post subject: Madoff and Sarbanes Oxley Reply with quote

I have a couple of emails every week: Why Sarbanes Oxley could not stop Madoff?

We don't need another law. We do need gatekeepers with knowledge and experience in risk management. All gatekeepers failed, because they trusted Madoff. There is an assumption - some VIPs are too famous, too intelligent to fail. But they continue to fail.

Do you remember what happened with the near collapse of the Long-Term Capital Management (LTCM), the hedge fund which used trading strategies such as fixed income arbitrage, statistical arbitrage, and pairs trading, combined with high leverage?

LTCM was founded by John Meriwether, the former vice-chairman and head of bond trading at Salomon Brothers. I admired two board members of the fund, Myron Scholes and Robert C. Merton. They shared the 1997 Nobel Memorial Prize in Economic Sciences. Could they fail?

If you admire somebody, do you really audit or challenge him, or you try to learn from him?

Some years before somebody told me that Air Force Intelligence is using a motto: "In God we trust, all others we monitor." I had a good laugh out of it, looked funny, but today I do believe that they are right. I prefer the commercial version: "In God we trust, all others pay cash"

Auditors and gatekeepers should not admire or trust anybody. If somebody is very genius, it is likely he will use his intelligence to harm rather than help.
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Denis
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PostPosted: Mon Feb 09, 2009 4:01 am    Post subject: Reply with quote

What bothers me the most about Madoff is the serious financial institutions that invested in a Ponzi scheme becuase they didn't do their due diligence, or even worse didn't recognise it as a Ponzi scheme even though they did due diligence because of it's complexity. In either case they shouldn't have invested.


As with all of these things someone pointed things out well ahead of time icon_rolleyes.gif

This paper, from Harry Markopolos, submitted to the SEC in 2005 makes interesting reading:

Code:
http : // online.wsj.com/documents/Madoff_SECdocs_20081217.pdf


It identifies 29 red flags about Madoff Securities with the conclusion that:

Quote:
Madoff Securities is the world's largest Ponzi Scheme
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harrywaldron
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PostPosted: Tue Feb 10, 2009 10:41 am    Post subject: Reply with quote

Hi George - That is an excellent question icon_idea.gif

I see the Madoff scandal as a failure of the SEC itself, rather than being SOX related icon_sad.gif Also, I'm not certain if Madoff's trust holding company had to even comply with SOX? There are also mini-Madoff scams surfacing, so he was not alone in these Ponzi schemes.

SOX is a regulatory compliance tool for monitoring the internal fiscal soundness and controls for a single company. Collectively for all companies participating in the stock exchange, it's supposed to provide investors with assurances that company annual statement reporting and financial valuations are sound.

However, SOX will NOT STOP ALL CRIMINAL ACTS. Even if Madoff's company had to comply with SOX, everything related to this Ponzi scheme could still be faked, esp. given his prominence as a former NASDAQ head. Prior to discovery, he was highly trusted by everyone and unfortunately SOX 302 and SOX 404 could be faked with some possible collusion - esp. if proper detailed audits and actual checking didn't take place.

The SEC failed to thoroughly investigate complaints before the scam was discovered or to research detailed transactions. Personally, I'm disappointed that regulators failed to find this $50B. Some thoughts expressed here related to the difficult and sad times (e.g., friends and family being laid off) we are in with respect to the Financial crisis we are experiencing world-wide:

http://www.sarbanes-oxley-forum.com/modules.php?name=Forums&file=viewtopic&p=9442#9442

In light of the banking crisis, the SEC probably needs to improve valuation rules to ensure non-regulated investments now are part of the SOX evaulation process, (e.g., CDOs, etc). However for the Madoff scandal, the "lessons learned" are more related to the need for better examination, evaluating complaints/concerns (as there was an early whistleblower), and improving regulations on these types of investment firms.
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WrightLot
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PostPosted: Thu Feb 19, 2009 6:33 am    Post subject: Reply with quote

OK so SOX could not stop this because this was a private company (as I guess is the alleged fraud involving Stanford).

But, if SOX is the assurance that any reasonable risk of a material fraud/error has been mitigated wrt the financial statements then how, my friends in the financial services sector, did all the big banks pass SOX?

Is it because this is such a complicated area no one had the inclination to try and understand it and took senior management's word for it?

Is it because, regardless of the intention of SOX, the external auditors still have a cozy relationship with their employers thanks to the sizeable audit fees which they don't want to lose?

Is it because SOX really lacks independence and for all the talk about protecting whistleblowers this is just proving to be hot air?

It can't be because the risk was unreasonable as it had been reported on and discussed in the financial press for a few years before it all happened. It can't be because the assumptions were wrong because these had to be audited as part of SOX to ensure reasonableness. It can't be because everyone was doing it because that is no excuse.

So if the BS can be so mistated because of assets that were clearly bad, then what is the point of SOX in the first place!?
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Denis
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PostPosted: Thu Feb 19, 2009 8:19 am    Post subject: Reply with quote

A trite answer perhaps, but when things are complicated nobody wants to admit that they don't understand, whether that be the people doing the deal, the management approving it or the auditors auditing it.

Not an acceptable explanation I know, but potentially a large part of the psychology around it.
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gmerkl
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PostPosted: Mon Feb 23, 2009 5:06 am    Post subject: US securities laws Reply with quote

The Sarbanes-Oxley Act generally only applies to companies that use the public capital markets of the USA. This means:
- companies whose securities are listed on a national securities exchange in the USA
- companies whose equity securities are traded over-the-counter in the USA
- companies whose securities have been publicly offered in the USA

Madoff's funds were not listed on a stock exchange and did not meet the minimum number of shareholder threshold for over-the-counter trading and were not publicly offered (private placements only).

Apart from that section 404 does not apply to investment companies (only section 302 does).

Madoff structured his activities in such a way, that he was not even a fund in the classical sense because he wanted to avoid having to register his fund or his investment advisory activities with the SEC and to avoid to be subject to inspections by the SEC's Office of Compliance Inspections. Madoff only had contractual arrangements that he would invest money on behalf of third-party feeder funds. The SEC actually did inspect the broker/dealer business that was part of the firm that Madoff ran with his sons, but they did not look at his investment advisory business. Eventually the SEC did look at it and determined that he should register as an investment advisor with the SEC.

Even if privately placed funds would be subject to a section 404 audit (section 302 audited by an external auditor would be even better), there could still be fraud if the auditor turns out not to be independent or incompetent or if the fund is able to fake evidence. Read Harry Markopolos' testimony to a US House of Representatives Committee on Financial Services hearing or search for his name on youtube for the videos. It is fund reading and listening.
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harrywaldron
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PostPosted: Mon Feb 23, 2009 1:51 pm    Post subject: Re: US securities laws Reply with quote

gmerkl wrote:
The Sarbanes-Oxley Act generally only applies to companies that use the public capital markets of the USA


Thank you for an EXCELLENT explaination on how he was able to evade SEC scrutiny, as I wasn't familiar with the funds structuring or rules icon_idea.gif

P.S. Unfortunately, we just had another case of $8B in fraud by Allen Stanford in Houston, who also used his high-profile status and lots of trust without verification icon_sad.gif

Code:
http : // www .msnbc.msn.com/id/29334590/
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WrightLot
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PostPosted: Tue Feb 24, 2009 9:34 am    Post subject: Reply with quote

This is all very well. I acknowledge that Madoff and Standford worked outside SOX and SEC and never disputed it.

But the banks are within the scope of SOX and the SEC yet, after all the whistleblowing and media speculation in recent years, we were still taken internationally by surprise! Key banks in the UK were properly presented in 2007 and had addressed all reasonable risk of material error on their accounts yet 1 trillion GBP has had to be made available to prevent some of them from going under and share prices dropped by, in some cases, over 95%.

This causes me to question why were they certified as SOX compliant. Is it because the SOX/external audit were not really that independent? Is it because the measure/definition of shareholder materiality is not good enough (after all whatever led to the changes had a significant impact on the share value)? I suppose we could argue it is because the company made business decisions that are outside the scope of SOX but that still leads me to question whether the accounts were properly stated and whether the definition of materiality was correct.

Perhaps it is just that, as many critics said when it first came out, SOX is a pointless paper pushing exercise that proves nothing and protects noone but lines the pockets of those working in the field of compliance.
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gmerkl
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PostPosted: Wed Feb 25, 2009 2:20 am    Post subject: Bank regulation in the US Reply with quote

OK, let an Austrian living in Switzerland provide a lecture on bank regulation in the US to someone living in the UK.

The U.S. Securities and Exchange Commission (SEC) regulates:
1) full disclosure in securities prospectuses, annual and quarterly reports and ad-hoc reports to investors by companies that use the public capital markets of the US. If a bank does not offer its securities (shares, bonds, etc.) to the public, the SEC does not look at the information.
2) regulation of national securities exchanges and over-the-counter trading in the US
3) regulation of brokers and dealers
4) regulation of investment funds that are offered to the public
5) regulation of investment advisors that provide advice to the public

The prudential regulation of the safety and soundness of banks in the US is fragmented and parallel. It depends whether a bank has a state charter or a federal charter and whether the bank is insured by the federal deposit insurance corporation. Banks with a state charter are supervised by the banking commisioner of the respective state, the ones with a federal charter by the Office of the Comptroller of the Currency. Banks who want their deposits insured by the Federal Deposit Insurance Corporation are also regulated by the FDIC. In addition, the US Federal Reserve also performs some supervision.

In conclusion, the SEC only regulates the broker/dealer, fund and investment advisory parts of banks, but is not responsible for the prudential supervision of banks (minimum capital requirements, investment policy for investments on the banks' balance sheets).

Section 302 and Section 404 are only concerned with assuring the accuracy and reliability of the financial reporting and non-financial disclosure in the annual and quarterly reports. SOX contains no provision to prevent bad investment decision to investment in assets that turn out to be so risky later that the market for them dries up. As long as the valuation of the bad assets in the financial statements is correct, there is no problem. I have not heard of many restatements of historical financial statements of banks due to accounting errors or accounting fraud in conjunction with the banking crisis.
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Denis
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PostPosted: Thu Feb 26, 2009 4:34 am    Post subject: Re: Bank regulation in the US Reply with quote

gmerkl wrote:
OK, let an Austrian living in Switzerland provide a lecture on bank regulation in the US to someone living in the UK.


icon_lol.gif
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gwc5161
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PostPosted: Fri Feb 27, 2009 3:59 pm    Post subject: Reply with quote

The Russian term from the Reagan-Gorbachav days....perestroika? Doesn't that mean (loosely), "trust, but verify"?
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gmerkl
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PostPosted: Sun Mar 01, 2009 5:18 am    Post subject: meaning of perestroika Reply with quote

The literal meaning of perestroika is restructuring, reconstruction or rebuilding. Source: Wikipedia and my girlfriend who has a degree in Russian and used to live there for a while during "perestroika".
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WrightLot
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PostPosted: Fri Mar 06, 2009 4:16 am    Post subject: Reply with quote

I'm sorry gmerkl but this sounds like the emperor's clothes!

I understand all your arguments but it seems to me that because everyone who was interested in making money out of this were happy to accept each others' approach then they were happy bedfellows. Each agreed a box of air was worth something so they accounted for it as such and there cannot be a restatement because how do you revalue something that depends on current market value?

The Execs all said the clothes were fantastic. The independent SOX team said the clothes were fantastic because the Execs said so. The independent auditors all said the clothes were fantastic because they still wanted to line their pockets with the buckets of silver they were making from saying so. And the shareholders were happy because they couldn't see what the emporer was wearing but trusted all these independent parties. So when the little boy cried out the emperor was naked everyone was astonished, pocketed the money they had been making and cried it was a business risk and the shareholders went home empty handed.

I disagree that this was just a business risk. There were serious consequences in investing in some of these lines of business and this was not being properly recognised in the accounts. Insufficient provision was being made, for example, in the mortgage market for defaulters based on assumptions that were not being properly questioned. Assumptions that were material to the shareholders but I guess not important to the auditors as long as everyone knew what the assumptions were and then calculated their accounts correctly.

You see I would argue that assumptions are key to SOX because they are highly sensitive and have material impacts on the accounts. Yet it would appear that assumptions are not touched by SOX, or touched only lightly because either the auditors do not understand them, they accept managements explanation without question because they are their paymasters and bosses or in the case of an external auditor 'never look a gift horse in the mouth' because you wouldn't want to be the one to lose the account!

This is not just SOX's fault, there were many regulators who could have stepped in but most were also enjoying their booming bank accounts. What it does show is that for all the industry that has been built up around SOX it is an impotent piece of legislation where individual experts line their pockets with increased fees and when found out shrug their sholders and say it was a business decision, outside the scope of SOX and, after all, everyone else was doing it so that makes it OK!
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PostPosted: Sat Mar 07, 2009 5:01 am    Post subject: Supprime and SOX Reply with quote

The point of my explanation was to demonstrate that it is unfair to blame the SEC, because the US securities laws do not put the SEC in charge of regulating the investment decisions or the minimum capital requirements to support the investment risk of banks. One can blame congress to leave certain gaps in the regulation of securities and banks.

Most external auditors are not experts in the valuation of companies or securities, especially not complex funds or structured products. The less knowledge you have, the more you will accept management's assumptions and just verify the calculations or compare assumptions/input factors to publicly available sources. In the case of investments in funds, an auditor will often rely on the auditor who audited the fund. The longer the chain from the real asset (or real debtor) to the end investor, the more information is lost due to the intermediation. Auditors or bank regulators also relied on the ratings of securities provided by rating agencies.

The valuation of securities or funds is based on assumptions of future events (such as future default rates). If the historical default rates at the time of the rating/valuation were low, they were used as an input to arrive at the assumptions for the future. One of the problems was that there were only short track records of experience for some new products (e.g. subprime loans) and that the credit quality documents (income or assets of the borrower) were sometimes forged by the agent who knew he would sell the mortgage (and the corresponding credit risk) anyhow.

In conclusion, there were a lot of people involved in a very long chain and it is hard to determine whose fault is was in lawsuits.
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harrywaldron
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PostPosted: Thu Mar 12, 2009 12:56 pm    Post subject: Reply with quote

Some links from today's trial. Judge Chin revoked bail and he now has to start immediately serving his sentence in jail

Trial of Bernie Madoff held on March 12, 2009
Code:
http://www.msnbc.msn.com/id/29651773/


Quote:
QUOTE: He told the judge that he believed the fraud would be short-term and that he could extricate himself.

Authorities said he confessed to his family that he had carried out a $50 billion fraud. In court documents filed Tuesday, prosecutors raised the size of the fraud to $64.8 billion


Exhibit A - Madoff's List of Customers (Victims) - 167 pages
Code:
http://msnbcmedia.msn.com/i/msnbc/sections/business/madofflist.pdf
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