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Heidi Pickman Headshot

Can the SEC Change?

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How's this for investment advice?

Invest in fountain pens. Buy gold and borrow money to do it. Put your retirement money in a collateralized mortgage obligation - a risky, illiquid and complex investment vehicle that most people would say has no business being in your 401K.

These aren't imaginary examples, but cases that have crossed regulators' desks at the Security and Exchange Commission and other agencies. The latter example is from the SEC versus Brookstreet in which in 2009, the SEC charged Brookstreet with fraud because the company allegedly "sold risky, illiquid CMO's to retail customers with conservative investment goals." More than 1000 customers lost $300 million dollars, when the price of the CMO's bottomed out and the company went under. The case is still active.

And now comes the big daddy of them all, last week, the S.E.C. filed fraud charges against Goldman Sachs on the grounds that the company sold mortgages that bet on the housing market to fail

One mildly heartening result of the financial meltdown and discovery of immense Ponzi schemes like that scam run by Bernie Madoff is that the S.E.C. has done a little self-analysis and decided to grow claws, sharp ones.

Carlo di Florio is the new Director of Compliance Inspections and Examinations; that is, he's the guy who oversees all of the audits and examination of company books to make sure they are in compliance with what ever financial regulations still exists. Di Florio's been on the job for about three months and has a more comprehensive approach to regulatory compliance.

Roz Taylor, the S.E.C. regional director of the Los Angeles Regional Office says, "With Carlo DiFlorio, we're taking a more top-to-bottom approach to compliance so that we can use our resources more effectively and efficiently."

At a recent breakfast in San Francisco, Ms. Taylor explained to a roomful of financial company compliance officers that from now on the S.E.C. is going to concentrate on a few key areas.

1. Asset verification, do assets on the books actually exist. In Ponzi schemes, they often don't.
2. Custody rules http://www.bpmllp.com/display.asp?catid=6&pageid=634 that among other things are going to require background checks on personnel who have access to client information and ensure that the person giving the investment advice doesn't have access to the client's assets.
3. New products: how effective are they and do they have controls in place.

This all seems like common sense and makes one wonder why these issues weren't considered best practices in the first place, but they weren't. For example, with regard to new products, before this year the S.E.C. would check to see if a firm had procedures for regulatory compliance in place and stop there. Now, the S.E.C. will determine whether the procedures are effective. For example, many firms release a new product that makes sense under certain market conditions, but don't make sense under other conditions. In many cases, firms don't re-evaluate the appropriateness of a new product when the market conditions change and keep selling the product. Regulators will be looking for a review process of new products to make sure.

Another regulator who spoke at the breakfast, Don Lopezi, the Examination Director for FINRA or the Financial Industry Regulatory Authority, said that with some of these new products the sales reps don't even understand the products.

"The regulator asks the sales rep what is the product, what do you tell the customer the product does. Sometimes the rep says 'I don't know.' So then the regulator asks the compliance officer and the compliance officer says 'I don't know.' If the sales rep doesn't know what the product is and the compliance officer doesn't know what the product is, how can the customer understand?"

The fact is that many customers don't understand and they invest in risky assets or assets that don't exist. And they lose.

Due diligence on the part of investors, or lack there of, is another red flag. Roz Taylor recalled the case of Norman Hsu, who bilked investors out of $600 million in a Ponzi scheme. Investors would be shown pictures of Norman Hsu with high profile politicians and when they would ask for details about the asset Hsu was trying to get them to invest in, the answer would be "Norman Hsu is a very private person." And the investors would invest anyway.

The temptation of high returns mixed with more than a decade of deregulation means that the SEC, to its credit, certainly has its work cut out for it. The agency certainly will have to do more than check off whether or not a financial firm has the proper procedures in place. A top-to-bottom approach to compliance and enforcement is a good one in theory In practice, the question remains to be answered whether or not the regulatory efforts are enough of a deterrence to deter fraud cases like Madoff (and the alleged Goldman Sachs case) and shady accounting practices like at Lehman Brothers. The SEC has a lot to prove. The Goldman Sachs case will be the test of whether or not the SEC's claws are sharp enough to draw blood.