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Why Are the Financial Watchdogs Still Sleeping?

David Callahan

Earlier this summer, after Peregrine Financial collapsed -- and its customers found themselves out $215 million -- it was revealed that the firm's auditor was a one-person shop run out of a home in suburban Chicago. Even as Peregrine's CEO forged key records and ripped off customers, the auditor vouched for the company's soundness year after year.

Sound familiar?

Bernie Madoff built a multi-billion dollar global Ponzi scheme as a one-person auditing shop in Rockland County looked the other way. Allen Sanford's huge swindle was facilitated by a shady auditor based on the Caribbean Island of Antigua.

What's striking is that these scandals occurred years after the meltdown at Enron, which showed the bad things that can happen when watchdogs are sleeping -- or have been lulled to sleep through conflicts of interest.

Sarbanes-Oxley sought to bolster auditor independence with new rules governing accounting firms, but it didn't extend those rules to firms that audit brokerages like Madoff. Dodd-Frank closed this gaping loophole in 2010, giving regulators the power to, in effect, audit the auditors tasked with keeping brokerages honest.

And what regulators are finding is pretty shocking, according to a report released yesterday by the Public Company Accounting Oversight Board (PCAOB). Most of the auditors PCAOB looked at were not doing an adequate job of sniffing out possible fraud and ensuring that customers of brokerages were protected. Some also had flagrant conflicts of interest -- namely, that they were supposed to audit books that they themselves prepared. Meanwhile, many of these auditors claimed they were exempt from the new regulations governing how they operated.

None of this is stopping the accounting industry from trying to weaken the new rules. The New York Times reports that:

The board said that about 800 accounting firms perform audits of brokerage firms, and that about 500 of those were previously exempt from board inspection. Most of them could continue to escape board oversight if the board decides against reviewing audits of smaller brokerage firms, as many auditors have urged.

Which makes exactly no sense. The Madoff and Peregrine frauds both involved tiny auditing firms that were supposed to be keeping an eye on large brokerages. It seems especially important to be monitoring such small-time operators -- who are either easily corruptible or just not up to the job.

Financial regulation is like a game of Whack-a-Mole: New villains keep popping up, coming faster than regulators can smash them down. But a decade after Enron, the biggest scandal is that regulators still don't have the hammers they need to go after the bad guys.