The Bernie Madoff Law: A Closer Look

The House Banking Committee has just finished drafting a bill intended to stop anyone in the future from putting together another Bernie Madoff scam. It’s a worthy aim that I wholly endorse, but I worry that passing the current draft will introduce more arbitrariness and cost into the regulatory system without solving the problems revealed by the Madoff debacle. Let’s look at some of the bill’s main features:

Higher fiduciary standards for financial professionals. Historically, brokerage reps providing incidental investment advice to retail customers have only been required to make “suitable” recommendations to their customers. The bill proposes replacing this requirement with a stricter “fiduciary” standard. This sounds promising, but the draft does little to tell us what the new fiduciary-type standard will be. Moreover, the bill does not address the practical challenge of how the SEC can inspect a larger group of financial “fiduciaries” — it has only 400 staffers to inspect 11,000 financial advisers. (Of course, there are ways to address that problem: we could extend the jurisdiction of the current self-regulatory organization for broker-dealers to include all investment advisers or at least those affiliated with broker-dealers. Alternatively, we could create a new self-regulatory organization for investment advisers.)

Expanded SEC powers. The bill would vest the SEC with broad new powers to “promulgate rules prohibiting sales practices, conflicts of interest, and compensation schemes for financial intermediaries (including brokers, dealers and investment advisers) that it deems contrary to the public interest and the interest of investors.” The scope of this remit is alarmingly vague. For instance, I could imagine the SEC setting maximum commission rates or sales loads on the distribution of certain financial products. It could adopt a general prohibition on paying cash bonuses to brokers or advisers unless a substantial portion is deferred for a few years. These new powers could get the SEC mired in the micro-management of compensation. These decisions are better left to a firm’s independent directors, who know the specific context of each firm

Court-based arbitration. As drafted, the bill would allow the SEC to prohibit mandatory arbitration clauses in the customer contracts of brokers and advisers. But the arbitration process is clearly faster and less expensive than court cases. And while consumer advocates have criticized certain arbitration procedures, most of these have been changed over the last few years. If this draft bill were adopted, then many customer complaints would be put together in class action suits against market professionals instead of being resolved through arbitration.

Larger bounties for whistleblowers. The bill would authorize the SEC to pay cash bounties to whistle blowers who supply information leading to SEC enforcement cases and these bounties could go as high as 30% of the monetary sanctions in the relevant cases. But the Madoff case did not show the need for cash incentives to whistle blowers. What we need is a more disciplined process for following up on complaints from whistleblowers.

Do you believe that the House Banking Committee’s draft bill is an appropriate response to the problems revealed by the Madoff scandal or an over-reaction?

Bob Pozen is a senior lecturer at Harvard Business School and the author of “Too Big to Save? How to Fix the US Financial System” (John Wiley, forthcoming November 9, 2009)