Securities and Exchange Commission: Overview

The U.S. Securities and Exchange Commission (“SEC”) was created by Congress through the Securities Exchange Act of 1934 (the “Exchange Act”). The Exchange Act was passed as a result of the stock market crash in October 1929 and the following years of market turmoil.

On October 28, 1929, later dubbed “Black Monday”, the Dow Jones Industrial Average fell roughly 13%. The next day, the Dow fell almost another 12%, totaling an approximate 25% drop in the market in 2 days. The market continued to fall for almost three years, finally hitting rock bottom in 1932 when the market was down almost 90% from its high in 1929.

At that time, the stock market in the United States was not federally regulated and, as a result, many scams had been perpetrated on the investing public. In response, Congress passed the Exchange Act with the intention of protecting investors and restoring investor confidence. The Exchange Act generally held two main goals:

• To require companies offering securities for sale to the general public to tell the truth about information important to an investor in making investment decisions, and
• To require people selling and trading securities to treat their customers fairly and honestly.

The Securities and Exchange Commission was created both to establish rule systems designed to help achieve those goals, as well as to enforce the laws and rules against bad actors and make sure that all broker-dealers, brokers and financial advisors were playing by the rules.

The Securities and Exchange Commission has a number of divisions with different focuses and functions. These include:

• 1. Corporation finance
• 2. Enforcement
• 3. Investment management
• 4. Economic and risk analysis
• 5. Trading and markets
• 6. The office of administrative law judges
• 7. The office of compliance inspections and examinations.

The SEC’s Division of Trading and Markets “establishes and maintains standards for fair, orderly, and efficient markets”, making it the division most relevant to the investing public.

There are many institutional players in the securities trading markets, including the stock exchanges themselves, broker-dealers who buy and sell securities on behalf of other people, as well as self-regulatory organizations such as FINRA who all operate under SEC oversight.

The Division of Trading and Markets is the section of the SEC that directly oversees these participants. That oversight includes several different functions such as reviewing and approving (or disapproving) rule changes for FINRA or various exchanges, developing and implementing SEC rules and regulations, and processing required broker-dealer filings.

Even though Trading and Markets is more directly involved in issues important to investors, the SEC’s Enforcement Division is the one that gets the most publicity and public awareness.

The Enforcement Division of the SEC investigates violations of the federal securities laws and brings claims against the violators in both federal courts and administrative proceedings. SEC enforcement actions are public record once they are filed, and the SEC makes some information about those proceedings available on their website.

According to those records, the Securities and Exchange Commission’s Enforcement Division instituted approximately 266 civil lawsuits in the year 2020 to enforce claimed violations of the federal securities laws.

One of the most well-known investment frauds in modern times was the one orchestrated by Bernard (“Bernie”) Madoff.

Madoff had been running his Ponzi scheme for years which allowed him to amass billions of dollars from investors. A Ponzi scheme in simple terms is a fraudulent enterprise where the “investment” is not actually generating the return for investors. Instead, the purported returns are typically just earlier investors being paid with the money from new investors.

In these schemes, the perpetrator needs to continually find ever-larger investments from new victims in order to keep up with payments owed to earlier investors. As soon as the Ponzi scheme operator cannot find enough new funds to pay the earlier investors, the scheme falls apart as the earlier investors are no longer being given payments they were promised, exposing the fraud.

Madoff was arguably the most successful Ponzi schemes in history in terms of its size and the length of time it existed. According to the SEC’s complaint against Madoff, he lost approximately $50 billion of investor funds over several decades.

Madoff’s scheme was also notable in terms of the types of investors affected. Most investment fraud schemes primarily affect and target individual investors and unsophisticated parties. Madoff’s scheme was perpetrated on a number of large institutional investors, including several international banks. This largely occurred because Madoff had a substantial system of other investment companies, including a number of hedge funds, which “invested” funds into Madoff’s enterprise and passed on those investments to their own investors (these are often called “feeder funds”).

When Madoff’s scheme collapsed in 2008, the SEC stepped in and appointed a receiver whose job function was to take control of whatever assets were remaining and then use any legal means to try to obtain additional money back for the benefit of the scheme’s victims. The receiver has, to date, recovered over $14 billion of funds which have been used to partially pay back victims.

The Department of Justice’s criminal prosecution of Madoff resulted in a prison sentence of 150 years.

Another major Ponzi scheme that involved the SEC was one run by Robert Allen Stanford in Texas. Stanford’s company sold investors “certificates of deposit” which were supposed to pay high-interest rates that Stanford managed to obtain through a large portfolio of investments.

These certificates of deposit were actually held through foreign banks and, allegedly invested in real estate and other safe assets. Ultimately, it was uncovered that most of the alleged investments were fraudulent and the money was largely stolen.

Stanford raised $8 billion from investors before being caught. As a result of his fraud, Stanford was sentenced to 110 years in prison in 2012. However, unlike the substantial payouts that the SEC receiver in Madoff’s case was able to obtain, the receivership that was established for Stanford’s Ponzi scheme has not been nearly as successful.

By 2018, the receiver had only managed to recover $500 million of the many billions that were lost in Stanford’s Ponzi scheme. More tragically, roughly half of that money recovered has been used to pay expenses and to pay the lawyers for the receiver. That leaves only roughly 5 cents on the dollar to pay back to investors.

More recently, the SEC shut down an investment company called the Woodbridge, which involved a large group of companies generally referred to as “the Woodbridge group of companies.”

This scheme sold investors promissory notes which were supposedly backed by real estate as collateral for the loans. The reality was that, while there was some real estate supporting the notes, the amount borrowed against that real estate far exceeded the value of the assets, and the security interests were never filed correctly to perfect the liens.

Instead, many of the notes were to various Woodbridge group companies that had no actual interest in real estate. In total, Woodbridge and its founder Robert Shapiro used this scheme to raise approximately $1.3 billion from unsuspecting investors before it was shut down.

There were substantial orders for restitution and disgorgement to be paid back from the Woodbridge companies and Shapiro himself, including almost $900 million from the companies and another ~$120 million from Shapiro. However, these large numbers have little correlation with the assets that are really available to pay back investors.

The receiver in the Woodbridge case has to date made several distributions to affected investors which total approximately 30 cents on the dollar of the losses. There are still assets to be sold and legal claims outstanding which, if successful, could substantially increase the size of the overall recovery for investors. However, victims of this scheme will undoubtedly lose the majority of the funds they invested with Woodbridge.