Financial Regulation and Compliance. Kotz H. David

on almost identical principles. That is why fraud works.

      The author of this book is the former Inspector General of the SEC and has been fortunate to see firsthand how regulations are supposed to work, and how they are often perceived by the regulated community. I have been an admirer of his work at the SEC for quite some time, as he was able to conduct meaningful oversight of a very important financial regulator during a very significant time period in our nation's financial history. In this book, he draws on his own vast experience to provide cogent hands-on advice to compliance professionals in a myriad of important areas. He also brings together a very unique collection of expertise from many individuals, including several former senior-level governmental officials which only add to the comprehensiveness and value of this book. It is a must-read for compliance professionals in the financial arena, and, as supervisory principles are applied in financial market regulation, the present manuscript will be all the more important to manage the new regulatory and administrative law burdens that will be imposed on the industry.

Joseph R. Mason, the Hermann Moyse, Jr./ Louisiana Bankers Association Endowed Chair of Banking and Professor of Finance at Louisiana State University and Senior Fellow at the Wharton School.

      Preface

      During the week of March 10, 2008, I was in the first few months of my new position as Inspector General of the Securities and Exchange Commission (“SEC”). I had come over to the SEC after serving as Inspector General of the Peace Corps. At the Peace Corps, I dealt with many very significant issues, some involving life and death, as I tried to put into place procedures for ensuring Peace Corps Volunteer safety and security. Much of my time was spent working with foreign governments to assist in the prosecution of individuals who committed heinous crimes against Peace Corps Volunteers, such as assault, rape, and even murder. I found my job very rewarding and many of the protections we put into place for Volunteers remain in existence today. The Peace Corps position was, however, generally low profile, and while I testified before Congress on one or two occasions during my tenure as Inspector General of the Peace Corps, for the most part, we were able to operate out of the public eye. I recall when I interviewed for the SEC position that former Chairman Christopher Cox told me, at the end of my interview, words to the effect of “one thing you will realize if you work here, this is not going to be like working at the Peace Corps.” Chairman Cox certainly turned out to be right about that statement.

      I was the second ever Inspector General in the SEC's history. The previous Inspector General had been in his position for approximately 18 years, and had recently retired among some rumblings from Capitol Hill that his office could have been more aggressive in certain investigations. Shortly after I arrived at the SEC at the very end of 2007, I received a letter from Senator Charles E. Grassley (R-Iowa), who was then the Ranking Member of the United States Senate Committee on Finance, referencing the previous Inspector General's tenure and pointing out that he expected my office to engage in aggressive oversight. I understood that I was being watched carefully and expectations were high regarding my tenure as Inspector General.

      I very clearly recall the extreme concern at the SEC during the week of March 10, 2008, when word spread about liquidity problems at Bear Stearns. There was also, of course, a flurry of activity surrounding the March 16, 2008 Bear Stearns' sale to JP Morgan with financing support from the Federal Reserve Bank of New York (“FRBNY”). Little did I realize at that time how significant these events would be not only in my own life, but with respect to its role in the eventual global financial crisis.

      On April 2, 2008, my office received another letter from Ranking Member Grassley, requesting that my office analyze the SEC's oversight of firms under its Consolidated Supervised Entity (“CSE”) program and broker-dealers subject to the SEC's Risk Assessment Program. The letter requested a review of the SEC's oversight of the investment banks that it supervised, with a special emphasis on Bear Stearns. The letter requested that we analyze the adequacy of the SEC's monitoring of Bear Stearns, and that we make recommendations to improve the SEC programs.

      The CSE program was a voluntary program created by the SEC in 2004, to allow the SEC to supervise certain broker-dealer holding companies on a consolidated basis. These entities included Bear Stearns, Lehman Brothers, Goldman Sachs, Morgan Stanley, Merrill Lynch, Citigroup Inc., and JP Morgan. The CSE program was designed to allow the SEC to monitor for financial or operational weakness in a CSE holding company or its unregulated affiliates that might place regulated broker-dealers and other regulated entities at risk. The CSE program's mission was, in pertinent part as follows:

       The regime is intended to allow the Commission to monitor for, and act quickly in response to, financial or operational weakness in a CSE holding company or its unregulated affiliates that might place regulated entities, including US and foreign-registered banks and.. broker-dealers, or the broader financial system at risk. (emphasis added.) 1

      I understood at that point in time how important it was for there to be a thorough and comprehensive assessment of the circumstances that led to Bear Stearns' collapse and the effectiveness of the CSE program, and I was very aware that my office was being given an opportunity to demonstrate that we could engage in aggressive oversight of the SEC and its programs. Accordingly, I decided that I would not “pull any punches” with respect to this assessment and audit, and determined that one of my initial conclusions in my assessment would be that “it is undisputable that the CSE program failed to carry out its mission in its oversight of Bear Stearns because under the Commission and the CSE program's watch, Bear Stearns suffered significant financial weaknesses and the FRBNY needed to intervene during the week of March 10, 2008, to prevent significant harm to the broader financial system.”2

      In the audit, we also found numerous specific concerns with the SEC's oversight of the CSE program, including the fact that, although the SEC was aware, prior to Bear Stearns becoming a CSE firm, that Bear Stearns' concentration of mortgage securities had been increasing for several years and was beyond its internal limits, and that a portion of Bear Stearns' mortgage securities (e.g., adjustable rate mortgages) represented a significant concentration of market risk, the SEC did not make any efforts to limit Bear Stearns' mortgage securities concentration. We also did not “pull any punches” with respect to Bear Stearns, as we concluded that there was evidence of significant shortcomings in the area of risk management at Bear Stearns, including a proximity of Bear Stearns' risk managers to traders suggesting a lack of independence.

      There was a strong reaction within the SEC as a result of our findings, and concerns were expressed about the impact of the report on the SEC's reputation and credibility, which could negatively affect its ability to engage in regulatory oversight. There were even comments made that a weakened SEC as a result of my office's report would make it more difficult for the government to manage what was increasingly being viewed as the beginning of a serious financial crisis, and suggestions about whether the entire report should be publicly disclosed. Notwithstanding these concerns, I decided that it was more important for Congress and the public to understand what had occurred with respect to Bear Stearns' collapse and the SEC's oversight, and I declined to substantially edit the report and released it with minimal redactions.

      Congressional officials appreciated my willingness to accurately report what I had found in my assessment even during this difficult time. Eventually, my report was utilized extensively by the Financial Crisis Inquiry Commission (“FCIC”) in their work in attempting to understand the causes of the financial crisis. I met with FCIC officials on numerous occasions over a period of months, and eventually testified before the FCIC with regard to my findings in 2008.

      Chairman Cox was prescient in telling me that life as Inspector General of the SEC was going to very different than at the Peace Corps. My tenure as Inspector General at the SEC later included several other high-profile investigations, including my investigation of the SEC's failure to uncover Bernie Madoff's $50 billion Ponzi scheme. Operating in the glare of the public eye, while attempting to conduct oversight of the very people with which I was working side-by-side on a daily basis, was tremendously challenging.

      Yet, my four-plus years as Inspector General at the SEC were also incredibly rewarding. Moreover, my experiences being in the center of the regulatory storm during the global

1

See SEC's Oversight of Bear Stearns and Related Entities: The Consolidated Supervised Entity Program, SEC Office of Inspector General, Report No. 446-A, September 25, 2008, at http://www.sec.gov/about/oig/audit/2008/446-a.pdf.

2

Ibid. at p. viii.