(Bloomberg News) The former top lawyer of the U.S. Securities and Exchange Commission should be investigated by federal prosecutors for improperly working on policy related to Bernard Madoff's fraud when he had a financial interest in the outcome, the SEC's internal watchdog said.

David Becker, the SEC general counsel who inherited profits from a family Madoff account, became the agency's point person on questions of how to compensate investors who were bilked in the Ponzi scheme, inspector general H. David Kotz said in a report sent to Congress today. The decisions Becker made "could have directly impacted his financial position," Kotz wrote.

Kotz said he is referring the conflict-of-interest case to the Justice Department. He also noted in his 119-page report that SEC Chairman Mary Schapiro didn't tell other commissioners about Becker's ties to Madoff. At least six other people at the agency were aware of the investment, including the chief ethics lawyer who gave Becker clearance to work on Madoff policy. None of them suggested Becker recuse himself, Kotz wrote.

William Baker III, a lawyer for Becker, said the report "contains a number of critical factual and legal errors that lead to erroneous conclusions." He said Becker, who left the agency in February, is looking forward to explaining his actions at a House of Representatives hearing on Sept. 22, where Kotz and Schapiro also are scheduled to appear.

Laura Sweeney, a Justice Department spokeswoman, declined to comment except to say the agency has received the referral.

Culture

Kotz's report also urged the SEC to overhaul its procedures for providing advice on conflicts to officials, saying there have been "concerns about the role and culture" of the agency's ethics office.

The findings are another setback for the securities regulator, which has been trying to bolster its standing after being castigated for failing to uncover Madoff's decades-long fraud. More recently, the commission has been under fire for destroying some enforcement documents and bungling a $557 million lease for new office space.

The troubles have been magnified as the agency grapples with writing dozens of new rules for Wall Street under the 2010 Dodd-Frank financial-regulatory overhaul.

"Clearly, Chairman Schapiro assumed that she and her management team were above any possible reproach and needn't worry about the federal conflict-of-interest law," said Representative Patrick McHenry, a North Carolina Republican who will help lead the hearing later this week. "That is an assumption no regulator should ever be allowed to make."

'Dedicated'

Schapiro, in a statement, said she takes the report "very seriously." She added that it would be "inappropriate" to comment on the Justice Department referral.

"I've known David for many years to be a talented, highly skilled lawyer," Schapiro said.

Kotz began his probe in March after Becker and his brothers were sued by the court-appointed trustee in the Madoff bankruptcy case to recover $1.5 million in what he termed fictitious profits from the inherited account.

When he joined the agency in 2009, Becker told Schapiro and William Lenox, then the agency's ethics counsel, about his family's Madoff investment. Lenox told Becker in May 2009 that he didn't have a financial conflict of interest and could work on the policy for compensating the victims.

Adjusted For Inflation

As general counsel, Becker advocated that Madoff investors be compensated for losses from an SEC-overseen insurance fund using a formula that adjusted for inflation. The argument, which was approved by the commission, could have made it less likely that the trustee would seek to reclaim profits from Becker.

The SEC said today that it would take a new vote on the issue in light of the report's findings, a step Kotz recommended. The inflation-adjusted formula hasn't been adopted in the Madoff bankruptcy case.

If the method were used, the amount of money that the trustee would be able to seek from Becker and his brothers would have been reduced by about $140,000, Kotz said in the report.

Becker may also have violated the law by offering an opinion on proposed legislation that would have limited a trustee's ability to bring so-called clawback suits like the one filed against him, Kotz wrote. In testimony to the inspector general, Becker defended his participation, saying the measure he weighed in on was "political noise" rather than a serious proposal.

Schapiro Testimony

In her testimony to Kotz, Schapiro said she would have asked Becker not to participate in Madoff policy if she had known he was potentially subject to a lawsuit or if she "understood that he had any financial interest."

The report also focused on a late 2009 congressional hearing where Becker, on Schapiro's recommendation, was slated to testify about the SEC's decisions on compensating Madoff victims.

Ultimately, another SEC official appeared at the hearing, in large part because of a determination that Becker's Madoff connection would have to be revealed if he were to appear as a witness in the matter, Kotz said.

While Schapiro said that she recalled telling Becker he would need to disclose the Madoff interest if he testified, Becker told the inspector general he was certain "it was I who told the chairman that I would disclose this rather than her telling me I would have to disclose it."

'Very Surprising'

Before news of the lawsuit against Becker came out earlier this year, none of the commissioners other than Schapiro was aware of Becker's Madoff connection. Commissioner Troy Paredes said "not to have been apprised of this potential conflict of interest was very surprising," according to the report. Commissioner Luis Aguilar said that Becker's ties "absolutely" gave him concern as to whether the information he received was completely unbiased.

Schapiro said she told the commissioners she was "deeply sorry that this had happened and that I never connected the dots," according to the report.

The inspector general recommended that the agency change its procedures for vetting potential conflicts, noting that Becker, as the agency's top lawyer, was Lenox's boss. In the future, Kotz said, the ethics counsel should report to the SEC chairman, not the general counsel.

The report noted that Lenox based some of his advice on an "incorrect understanding" of the SEC's role in the Madoff case and that he never "took any further steps to better understand the extent and nature of Becker's involvement" in the matter.

'Blame Me'

When questions arose in February 2011 concerning Becker's participation in the Madoff liquidation, Lenox told Becker in an e-mail: "Please just blame me; you did what you were supposed to do," according to the report.

Lenox's lawyer, Harvey Pitt, didn't immediately respond to a request for comment. Pitt has said that Lenox's advice "was thoughtful, correct and has been mischaracterized repeatedly."

Kotz has referred other matters to criminal authorities, including allegations that SEC officials backdated leasing documents to hide a missed deadline and that two employees engaged in insider trading. The Justice Department doesn't necessarily have to open a case based on the referral.

Representative Darrell Issa, a California Republican who is chairman of the Oversight and Government Reform Committee, and Representative Randy Neugebauer, a Texas Republican who heads a Financial Services subcommittee on investigations, have spearheaded a congressional review of the matter. Neugebauer's panel and an Oversight subcommittee have scheduled the joint hearing for Sept. 22.

Becker, 64, worked as a clerk for former U.S. Supreme Court Justice Stanley Reed after graduating from Columbia University School of Law, where he was editor-in-chief of the law review. He was the SEC's general counsel from 1999 to 2002 before rejoining the agency in 2009. After leaving the SEC in February, he returned to law firm Cleary Gottlieb Steen & Hamilton LLP as a partner.