By Zachary A. Goldfarb
Washington Post Staff Writer
Saturday, March 7, 2009

In both multi-billion dollar cases, there were common warning signs.

Bernard L. Madoff and R. Allen Stanford promised customers safe, consistent returns that were higher than competitors offered. The men divulged little about how they worked. The auditors they said were in charge of ensuring that everything added up turned out to be inadequate.

Despite the ominous signs, authorities have alleged in recent months, Madoff and Stanford were able to pull off frauds that have devastated people and charities around the world. The Securities and Exchange Commission and other regulators didn't stop the activities until it was too late.

The cases are among a series of recent alleged frauds at financial firms. While they have been handled differently, they have shined a light on loopholes in federal regulations, such as fragmented regulations governing brokers, investment advisers, auditors and other firms. And the cases have underscored obstacles facing authorities, including inadequate resources for detecting wrongdoing and difficulties in gaining access to foreign financial accounts.

"Reform is needed to close the existing regulatory gaps that expose investors to risk," said Richard Ketchum, chief executive of the Financial Industry Regulatory Authority, Wall Street's self-policing agency.

SEC Chairman Mary L. Schapiro is looking to work with lawmakers to overhaul the nation's financial regulatory system. This week, the SEC announced that it would partner with a government-funded research center to study ways to better assess the thousands of tips and complaints that come in each year. The House and Senate plan to consider legislation as early as late spring that would bring all financial activities under federal regulation. The details, however, aren't clear.

At the SEC, Schapiro plans a new focus on spotting fraud and other market manipulation early on. She plans to create a large team to seek out where abuses might be occurring. Then she plans to direct the SEC's limited examination staff toward those places. "We've got to be able to conduct risk assessment that allows us to understand where problems might arise and connect the dots between different problems in different places -- whether they're generated by different products, different firms or different trends in the economy," Schapiro said in a recent interview.

Anti-fraud experts say investment performance that consistently beats the market is one of the most visible red flags. "If there's a 10-year period and the returns are within a narrow window, that's problematic. That's never the way the market works," said Fiona A. Philip, a former SEC enforcement official.

But, as several recent cases have shown, the SEC didn't stop a number of allegedly fraudulent activities until billions of dollars had been compromised.

The SEC largely relies on people coming forward to warn them of unusual patterns of investment returns. Madoff and Stanford, who allegedly conducted their schemes for years, didn't report returns to the SEC because they were not required to make such disclosures.

The SEC received tips that Madoff was running a Ponzi scheme and looked into the charges years ago, but didn't discover the scheme. It is not clear why, but an SEC inspector general's investigation is trying to find the reason. By contrast, federal authorities were probing Stanford's businesses for years, suspicious about his returns, but didn't act because of jurisdiction questions.

Barbara Roper, head of investor protection for the Consumer Federation of America, asserted that part of the problem was that regulators were not aggressive enough. "The quality of oversight that's provided -- in terms of exams, questioning, paying attention to tips -- is not what investors have come to expect," Roper said.

But others say that what tripped up investigators was not a lack of aggressiveness but regulatory barriers and loopholes. For instance, Madoff's firm was split into two parts: a brokerage and an investment advisory, or money management, wing. Under federal law, brokers face scrutiny and oversight, but investment advisers are more lightly regulated. Madoff's advisory business, which was forced to register by the SEC in 2006, was not examined.

The number of investment advisers has nearly doubled in the past decade to 11,300, according to the SEC. While nearly half of all brokers are examined each year by the SEC or another regulator, only one in 10 investment advisory firms is. A fragmented regulatory system also exposed investors to Stanford's certificates of deposits. Stanford operated through a Houston broker that sold CDs offered by a bank in Antigua, which is legal. The SEC does not regulate CDs or foreign banks, and the Federal Deposit Insurance Corp. doesn't protect foreign CDs. The SEC doesn't have the authority to stop a broker from selling a product that's outside its jurisdiction.

"When your Aunt Millie walks into the local financial professional to ask for advice, she has no idea -- nor should she -- which set of laws governs the conduct of the person on the other side of the table," SEC Commissioner Elisse B. Walter said in a recent speech. "What she does need to know is that no matter who it is, or what product they are selling, she will receive a comparable level of protection. I don't think that we can give Aunt Millie that assurance today."

A separate challenge concerns the oversight of auditors for private financial companies, such as those of Madoff and Stanford. Corporate wrongdoing at Enron and other companies in the early 2000s led to new auditing rules and a board to oversee auditors of only public firms. Madoff's firm allowed a three-person storefront operation on Long Island to audit his multi-billion-dollar operation. Stanford's firm had a small accounting firm in Antigua oversee its investments, contrary to what it told investors.

"Inspection and examination of Mr. Madoff's accountant by the [accounting oversight board] could have identified his Ponzi scheme much earlier," said Rep. Paul E. Kanjorski (D-Pa.), chairman of the House capital markets subcommittee, who has introduced legislation to increase regulation of auditors.