Regulation & Bernie Madoff

Today's Wall Street Journal contained yet another Madoff article. This one described, in detail, the various examinations and investigations of Madoff's investment activities over the past years by the SEC and other agencies.

The tone of the piece was one of shock and disappointment that so many exams had missed the ongoing fraud.

Once again, however, I find myself at odds with the Journal on this topic, as I was in its recent piece by the clueless James Stewart.

Today's piece seems to chide the various Federal agencies for having sniffed so close to the massive fraud, but never have discovered it. Great pains are taken to describe the minor infractions uncovered, the refrain from actually punishing Madoff for various minor trading or record-keeping violations.

What seems to be missing from these pieces, and general expectations of regulation and regulators by Congress, the media and populace, is individual responsibility and prudence.

So long as investment management is a cottage industry, there will be the potential for Madoff-like abuses. People who choose to deal with managers other than those running publicly-followed, large mutual funds should know they are taking excessive risks beyond simply that of the management's investment judgment.

There is simply no way that the SEC will visit and catch every registered, let alone unregistered investment manager.

As an example, the state in which I reside has a law requiring every driver to carry insurance. But this is often honored in the breach. Drivers who can't afford insurance simply void the check, fail to pay the second six-month installment, or never write a good check in the first place. If one of these drivers hits you, you pay for your own damages.

Despite the state's massive regulatory infrastructure, there is simply no way it can identify and remove these scofflaws.

Madoff and his ilk are no different. If we want to allow individual initiative in business, this sort of crime is a certainty. Only individual common sense can really prevent it.

Even now, my business partner and I are reluctant to manage anyone else's money, due to regulatory requirements. But, in reality, we could structure it so that there was no regulatory overhead. Or footprint. And it's likely nobody would ever know otherwise.

We cannot expect large, unwieldy regulatory staffs and agencies to smoke out every single violator. Especially not when people will seek excess returns, heedless of the risks. For a better, longer treatment of this facet of human behavior, see the Journal's excellent weekend story by Stephen Greenspan.

Simply put, though, if the SEC doesn't have evidence that you run a Ponzi scheme across dozens of individual accounts, there's no way they will stumble upon it until it is way, way too late.

Despite what I just heard Jim Cramer allege on CNBC, I doubt anyone would have been in a position early on to learn what was really going on with Madoff, if they were outside the scheme.

As to those who were victims, they did, indeed, consciously throw various cautions to the wind, such as separate custody accounts, too-perfect returns, and an explicit agreement to remain totally ignorant of how such stupendously-invariant returns could be earned.

It's unnerving to see the Madoff affair used to promote more regulation, when what is required is more self-reliance, less denial, and more effective enforcement of existing regulation.