Close securities law loophole
Bernard Madoff surrendered to authorities in New York last week after telling employees he had been running a giant "Ponzi scheme" and that his investors stood to lose $50 billion. These investors are wealthy individuals or institutions in a number of countries, and the losses may be spread around enough to avoid any major impact on the world economy. But the Madoff scandal should call attention to a loophole in U.S. securities law that needs serious reconsideration.
The loophole is the hands-off regulatory treatment of funds that have fewer than 500 clients, all of whom must be wealthy investors as defined by law. (Among the losers, in this instance, are several large charitable trusts.) Publicly traded companies in which anyone can buy stock have to make regular disclosures to the Securities and Exchange Commission.
But that requirement is mostly waived in the case of funds with a few sophisticated investors. They can borrow money, invest in derivatives, sell stock they don't own and take other risky actions not allowed to widely traded mutual funds.
The hedge fund industry, founded on this loophole, has grown to control trillions of dollars. It fought long and hard in the past decade against federal oversight. That fight should now be all but over.
The Madoff investment operation, while not a classic hedge fund, was like them limited to a small number of very wealthy and very sophisticated investors. Its collapse, and the likely adverse effects on credit markets and by extension on ordinary investors, means Congress must reconsider the special treatment accorded by the securities laws to this class of fund.
Congress should also be aware that even the SEC's normal disclosure requirements appear to have limits when the incentive structure in special investment funds, such as very high management fees, create a heightened risk of fraud. The Financial Times of London reports that Mr. Madoff's operation was in fact registered with the SEC under a recent ruling affecting some, but not all, sophisticated-investor funds.
This fact has spurred criticism of the SEC for not discovering the fraud before it was too late. It is equally, if not more, pertinent to ask why the professional money managers who entrusted funds to Mr. Madoff did not do their homework adequately, as they are legally obliged to do.
Mr. Madoff may have been exceptionally clever at disguising his actions. The New York Times reports that the Fairfield Greenwich Group, an investment firm, sent outside auditors to Mr. Madoff in 2001. They concluded that "everything worked out." Forensic accountants are now pouring through the Madoff books to determine how the fraud developed.
Congress needs to pay close attention.