“The SEC: Designed for Failure”

Thank you to a loyal Sense on Cents reader for providing a recently released report by the U. S. House of Representatives Committee on Oversight and Government Reform entitled The SEC: Designed for Failure.

Much of what the American public has been fed about the SEC has been produced by the SEC itself. With all due respect to SEC Office of Inspector General David Kotz, who is widely respected, the other internal reports produced by the SEC have the stamp of career regulator Mary Schapiro. Regular readers of Sense on Cents know I have little regard for Mary.

This Congressional committee is led by Darrell Issa (R-CA). The report highlights that amongst the SEC’s issues, a lack of funding was not one of them. What else did the report find? What does it recommend?

Executive Summary

• FINDING: Spanning nearly two decades, five Commission investigations of allegations against Bernard Madoff failed to discover that his purported trading activity was fabricated. After pulling the wool over the Commission’s eyes for years, Madoff finally decided to blow the whistle on himself. Following this stunning episode, a report by the Commission’s Inspector General found that Commission investigators did not understand Madoff’s business; separate investigation teams did not coordinate or communicate with one another; simple, blatant project-management and follow-up failures were constant; and available information technology was not properly used.

• FINDING: The Commission’s failed and cancelled Consolidated Supervised Entity (CSE) program, which had voluntary supervisory authority over Bear Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch, and Morgan Stanley, showcased many of the Commission’s wider systemic problems. Without the necessary expertise, or even a mandate from Congress, the Commission sought to expand its bureaucratic fiefdom while many festering problems at its core were left unaddressed.

• FINDING: The Commission’s securities disclosure processes are technologically backward. It reviews corporate filings manually, using printouts, pencils, and calculators. It has never developed the ability to perform large-scale quantitative analysis to find fraud. Commission staff use Google Finance, Yahoo! Finance, and other commercially-available resources to analyze corporate filings. If the Commission had a robust database of the financial information filed by its registrants, it could automatically prioritize the thousands of tips and complaints it receives. But no such database has ever been constructed.

• FINDING: Auditors, journalists, and academics – not Commission investigators – have led the pursuit of the highest-profile frauds, including Enron and Worldcom. In addition to problems detecting fraud and reporting failures in the companies it regulates, the Commission has struggled to govern itself, and failed to implement reforms recommended by the GAO and its own Inspector General.

• FINDING: From 1997 to 2004, the Commission conducted four staff investigations of Texas financier R. Allen Stanford, but failed to pursue him seriously until 2005. A report by the Commission’s Inspector General reveals that Commission examiners concluded four times between 1997 and 2004 that Mr. Stanford’s businesses were fraudulent, but each time decided not to go further. Stanford was running a Ponzi scheme that bilked investors out of $7 billion.

• FINDING: Despite a budget that nearly tripled between 2000 and 2010, the Commission’s current Chairman and senior staff have argued that its recent failures can be addressed by increasing the agency’s funding. The Commission’s regulatory and management failures, however, are caused by systemic structural and cultural problems, not lack of funding.

• FINDING: The Commission suffers from an acute “silo problem,” which has been admitted by former Chairmen, current and former commissioners, senior staff, and the SEC Inspector General. The Commission is divided into five operating divisions and sixteen independent offices – all but three reporting directly to the Chairman. The Commission’s fragmentation into operational silos has devastating effects on collaboration, encourages uninformed rulemaking, prevents effective IT investment, and generates bureaucratic rivalries.

• FINDING: The Commission’s lawyer-heavy approach to regulation and enforcement has discouraged creativity, devalued management skills, and damaged its expertise in the financial products and industry that it regulates.

• FINDING: The Commission’s work force of attorneys, accountants, and analysts was unionized in the 1990s, rendering the Commission effectively incapable of firing poorly-performing employees. A combination of untouchable job security, toothless performance reviews, recruiting cronyism, powerful and self-interested permanent staff, and incentives that discourage knowledge-sharing and innovation have had a predictable impact on the agency’s effectiveness.

• FINDING: The complexity of the Commission’s securities disclosure rules and forms drains resources, prevents technological innovation, and overloads the staff with lawyers. Worse, disclosures that investors cannot understand, and do not read, violate the Commission’s basic philosophy of protecting investors through transparency.

• Recommendation:Congress should pass legislation to simplify the Commission’s structure.

• Recommendation: Congress should insist that Chairman Schapiro fulfill her promise to appoint a Chief Operating Officer with sufficient power to change longstanding practices.

• Recommendation: Congress should aggressively investigate the Commission’s employee hiring, firing, and review processes; internal culture; and staff incentives.

• Recommendation: Congress should require the Commission to overhaul, update, and simplify its securities disclosure rules and forms.

• Recommendation: Congress should require a detailed, independent study of the Commission’s mission, organization, and work force.

If the SEC were half as bad as reported by Congressman Issa’s committee, we could make a good case to blow it up and merely start over. Do we now appreciate why Harry Markopolos impugned the SEC as being incompetent? What about FINRA? Who is reviewing them? What are the recommendations for this Wall Street self-regulator?

Congressman Issa, please take up that cross and expose the failings, if not worse the conflicts of interest, inside FINRA. America deserves to know just how FINRA was ‘in bed’ with the industry as defined by Mr. Markopolos.

LD

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