Jan. 27 (Bloomberg) -- The Securities and Exchange Commission’s top investigator, facing congressional ire for failing to detect Bernard Madoff’s alleged $50 billion Ponzi scheme, said the agency lacks resources to pursue all leads.

“The amount of resources available to the SEC has not kept pace with the rapid expansion in the securities market over the past few years,” SEC Enforcement Director Linda Thomsen said today in written testimony for a Senate Banking Committee hearing. There has been an “explosion” in new and complex financial instruments, “some of which were expressly designed to avoid SEC regulation and oversight.”

U.S. lawmakers are grilling securities watchdogs for the first time since Madoff’s Dec. 11 arrest. The proceeding may shed light on the SEC’s fate, as Congress debates whether investigators are overtaxed or ineffectual. After the arrest, then-Chairman Christopher Cox faulted the staff for failing to act for at least a decade on “credible and specific allegations” about Madoff.

“We’re a far cry from the SEC that was established by Joe Kennedy and Franklin Roosevelt in the 1930s,” said Banking Committee member Charles Schumer, a New York Democrat. The SEC now seems “stagnant and behind the times” and should have “professionals in place who understand how markets work.”

Other witnesses include Lori Richards, who heads the SEC’s office inspecting brokerages and investment advisers, and Stephen Luparello, interim chief executive officer of the Financial Industry Regulatory Authority, an industry self- regulator that examined the Madoff brokerage business. Cox stepped down Jan. 20 and the Senate has confirmed his replacement, Mary Schapiro.

‘Triage’ for Tips

In her prepared remarks, Thomsen said SEC investigators receive hundreds of thousands of tips every year, and the enforcement division’s 1,000 employees use “triage” to pursue the most promising leads. In an earlier draft obtained by Bloomberg, Thomsen said the SEC uses “virtually all our resources to pursue fires,” and that more resources would enable it to find “smoke.” The sentence was omitted from the testimony released today.

The agency’s staff opened an investigation of Madoff’s investment-advisory business in 2006 and closed the probe two years later without filing a claim. In his statement last month, Cox said Madoff kept several sets of books and provided misinformation to regulators. The money-management business was audited by Friehling & Horowitz, a three-person firm in New City, New York.

Suggesting an Overhaul

To better detect misconduct, the U.S. should consider overhauling “balkanized” oversight of brokerages and investment advisers, Thomsen said today. It should also consider forcing investment advisers to assign custody of customer assets to third parties, and requiring that auditing firms are large enough to oversee money-management clients.

The SEC’s inspections unit never examined Madoff’s money- management business after it registered with the regulator in September 2006. It inspected his brokerage operations in 1999, 2004 and 2005.

“The SEC in this case seemed to be color blind,” said Senator Robert Menendez, a New Jersey Democrat. Congress shouldn’t just “provide a new paint job and assume everything is OK.”

Senate Banking Committee members Schumer and Richard Shelby, a Alabama Republican, want to provide $110 million to boost the investigative staffs at the SEC, Federal Bureau of Investigation and Justice Department. Legislation proposed by the lawmakers Jan. 22 would allow the SEC to hire 100 new employees in its enforcement division.

Congress

Congress already doubled the SEC budget this decade by approving the Sarbanes-Oxley Act in 2002. The law, a response to accounting scandals at Enron Corp. and WorldCom Inc., allowed the SEC to hire more enforcement attorneys, examiners and accountants. The SEC has an annual budget of about $900 million and about 3,500 full-time employees.

On Jan. 5, as the House subcommittee overseeing capital markets heard from one of Madoff’s alleged victims, panel members including Texas Republican Ron Paul said the SEC’s performance shows it should be scaled back or eliminated.

Banking Committee Chairman Christopher Dodd, a Connecticut Democrat, and Shelby, the panel’s top Republican, have asked the SEC for all complaints it received about Madoff, reports on its investigations and internal agency e-mails that mentioned his firm. The lawmakers are also scrutinizing Finra.

To contact the reporter on this story: Jesse Westbrook in Washington at jwestbrook1@bloomberg.net; David Scheer in New York at dscheer@bloomberg.net.

Last Updated: January 27, 2009 11:39 EST