REPORT OF THE 2009 SPECIAL REVIEW COMMITTEE ON FINRA’S EXAMINATION PROGRAM IN LIGHT OF THE STANFORD AND MADOFF SCHEMES SEPTEMBER 2009 SPECIAL REVIEW COMMITTEE Charles A. Bowsher (Chairman) ———————————— Ellyn L. Brown ———————————— Harvey J. Goldschmid ———————————— Joel Seligman ———————————— INDUSTRY GOVERNOR ADVISERS OF COUNSEL Mari Buechner Paul V. Gerlach W. Dennis Ferguson Griffith L. Green G. Donald Steel Dennis C. Hensley Michael A. Nemeroff SIDLEY AUSTIN LLP 1501 K Street, NW Washington, DC 20005 TABLE OF CONTENTS I. EXECUTIVE SUMMARY .............................................................................................. 1 A. The Stanford Case................................................................................................. 2 B. The Madoff Case................................................................................................... 4 C. Recommendations................................................................................................. 6 II. BACKGROUND ON FINRA EXAMINATION PROGRAM...................................... 9 III. EXAMINATIONS OF MEMBER FIRMS INVOLVED IN THE STANFORD AND MADOFF SCANDALS.................................................................. 11 A. The Stanford Case............................................................................................... 12 1. Background............................................................................................... 12 2. Daniel Arbitration and 2003 Cycle Examination...................................... 13 3. 2003 Anonymous Tip Letter..................................................................... 14 4. Basagoitia Arbitration and Notice of SEC Investigation.......................... 17 5. 2005 Cycle Examination........................................................................... 18 6. Meeting with SEC and the SEC Referral Letter ....................................... 23 7. Conclusion of the 2005 Cycle Examination ............................................. 27 8. 2005 Cause Examination .......................................................................... 28 9. 2007 Cycle Examination........................................................................... 38 10. 2007 Miami Branch Examination and 2009 Unannounced Branch Examinations............................................................................................. 39 B. The Madoff Case................................................................................................. 46 1. Background............................................................................................... 46 2. Registration of the Madoff Firm as an Investment Adviser ..................... 50 3. 2007 Cycle Examination........................................................................... 51 4. 2003 and 2005 Cycle Examinations ......................................................... 56 i 5. Assessment of the Madoff Firm Examinations......................................... 57 6. Examinations of Cohmad Securities......................................................... 61 IV. OVERVIEW OF FINRA’S JURISDICTION.............................................................. 65 V. FINRA ACTIONS SINCE THE STANFORD AND MADOFF SCHEMES ............ 69 VI. RECOMMENDATIONS................................................................................................ 71 1. Jurisdiction............................................................................................................ 71 2. Examination Process and Personnel ..................................................................... 73 3. Coordination with the SEC and Other Regulatory Agencies................................ 75 4. Training of FINRA Personnel............................................................................... 76 5. Plan of Action ....................................................................................................... 76 ii I. EXECUTIVE SUMMARY On April 13, 2009, the Board of Governors (“Board”) of the Financial Industry Regulatory Authority, Inc. (“FINRA”) established a Special Review Committee (“Special Committee”)1 to review FINRA’s examination program, with particular emphasis on the examinations of FINRA member firms associated with R. Allen Stanford and Bernard L. Madoff. The Board was particularly concerned by the significant harm to investors caused by Stanford and Madoff. Pursuant to a resolution approved by the Board, the Special Committee was asked to “recommend . changes in the examination program, where appropriate, to improve member oversight and FINRA’s fraud detection capability,” and to consider management’s “monitoring [of] compliance with examination program policies.”2 The Special Committee, acting through outside counsel, reviewed relevant examination files from 2003 to 2009 of the principal member firms associated with Stanford and Madoff. Interviews were conducted with the examiners, supervisors, and managers still employed by FINRA who were involved in the examinations. In addition, outside counsel interviewed numerous headquarters staff and senior management to enable the Special Committee to develop factual findings and recommendations.3 In total, outside counsel conducted 60 interviews of FINRA staff. Because of ongoing civil and criminal actions involving the Stanford and Madoff schemes, counsel did not interview persons other than current FINRA employees or obtain information directly from the implicated firms or from the Securities and Exchange Commission (“SEC”). 1 All members of the Special Committee are public governors of FINRA. 2 The Charter of the Special Committee is attached as Appendix A to this report. In making its recommendations regarding FINRA’s examination program, the Special Committee was not asked to comment on personnel matters. 3 The Special Committee solicited the input of FINRA senior executive staff prior to finalizing the recommendations presented in this report. 1 The Ponzi schemes allegedly perpetrated by Stanford and admitted to by Madoff are striking because of their size and duration.4 Madoff’s scheme spanned decades, defrauded thousands of investors, and caused an estimated $64 billion in investor losses. According to the SEC, Stanford sold numerous investors approximately $7.2 billion of fraudulent products, purported to be certificates of deposit (“CDs”), over at least a decade. FINRA’s examinations of the Madoff and Stanford firms did not uncover these frauds. The histories of the examinations of these firms present distinct lessons for improving FINRA’s examination program. A. The Stanford Case Between 2003 and 2005, the National Association of Securities Dealers—FINRA’s predecessor entity—received credible information from at least five different sources claiming that the Stanford CDs were a potential fraud. The most striking was a July 2005 five-page referral letter from the SEC’s Fort Worth office that explained in detail why the purported investment strategy of the offshore bank could not have produced the consistently high returns being paid by the CDs. The letter stated that the CD program was a “possible fraudulent scheme” and that the returns were “too good to be true.” According to this letter, “as of October 2004, [the Stanford firm’s] customers held approximately $1.5 billion of CDs.” Despite the existence of this “red flag” and others described in the body of this report, FINRA did not launch an investigation of whether the Stanford CD program was a fraud until January 2008.5 By the time the CD program was shut down by the SEC in February 2009, the alleged amount of 4 Bernard Madoff has confessed and pled guilty. As of the publication of this report, Allen Stanford is contesting the charges against him. 5 As discussed in the body of the report, FINRA’s 2005 cause examination did result in a charge against the Stanford firm for advertising violations relating to the CD program and a $10,000 fine. 2 investor funds had grown to approximately $7.2 billion. According to the court appointed receiver in the Stanford matter, the vast majority of these funds will never be recovered. FINRA missed a number of opportunities to investigate the Stanford firm’s role in the CD scheme. First, FINRA’s Dallas office staff curtailed a 2005 investigation prompted by the SEC referral letter because of a concern that the offshore CDs were not “securities” regulated under federal securities laws. Facts surrounding the decision not to pursue the fraud investigation indicate that certain of FINRA’s examination staff were then, and may remain, unsure of the full scope of the organization’s investigative authority, are reluctant to pursue investigations where jurisdiction questions arise, and are not adequately trained to identify alternate bases of jurisdiction. Second, although the CD program involved billions of dollars of investor funds, FINRA procedures, at the time and now, do not set forth criteria for escalation of a matter to senior management or the use of specially-trained investigators based on the gravity and substance of the fraud allegations. The Dallas staff did not provide the SEC referral letter to senior management in Washington, DC, until December 2008. Third, FINRA’s member examination program focuses the majority of member regulation resources on routine “cycle” exams. Although SEC-required cycle exams play a role in ensuring that member firms are adequately capitalized and compliant with regulatory requirements, they are not an effective means for uncovering complex