Madoff Fraud Illustates need for vigorous SEC

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We Need A Strong SEC
Joel Seligman, 12.18.08, 04:45 PM EST
The Madoff debacle underscores the importance of the right kind of regulation.


Now more than ever, we need a Securities and Exchange Commission that will steadfastly perform its historic mission as the investor's advocate.

Few cases better illustrate the need for a vigorous SEC than the Bernard Madoff debacle. Through most of its history, the Commission has been the so-called "cop on Wall Street," whose uncompromising enforcement program has had a major impact on deterring fraud.



The Madoff case has at once tarnished the Commission's reputation and highlighted the need for a revitalized SEC--one with new leadership and an uncompromising commitment to enforce the securities laws without fear or favor.

The Commission was originally created in a crisis even greater than what we are now experiencing. Between Sept. 1, 1929 and July 1, 1932, the value of all stocks listed on the New York Stock Exchange fell from nearly $90 billion to just under $16 billion--a decline of 83%. The value of bonds listed on that exchange declined by 37%, from $49 billion to $31 billion.

"The annals of finance," the Senate Banking Committee memorably wrote, "present no counterpart to this enormous decline in security prices."

Above all else, we learned in the 1932-1934 Stock Exchange Practices Hearing that America could not afford to have a system that placed exclusive reliance on the marketplace.

In seeking to repair a dysfunctional financial system, Congress created a specialized agency with clear enforcement powers to insist on full disclosure of all material information and, most of all, to seal the loopholes that hampered enforcement of rules designed to prevent fraud, market manipulation and insider trading.
For most of its nearly 75-year history, the Commission has been viewed as a success for its role in restoring confidence in our securities markets.


The number of individual investors, for example, has grown from 1.5 million (or 1.2% of our population) in 1930 to 84 million in 1998 (or 44%), with millions more indirectly investing in our securities markets through retirement accounts and mutual funds.

The Commission has helped improve governance of the exchanges and the Nasdaq (which, aptly at times, have been compared to "private clubs"), strengthened accounting and auditing standards and brought enforcement cases against investment banks, private corporations and accounting firms.

Nonetheless, some are posing this question: Has the SEC failed as a regulatory agency and does it need to be supplanted? But I think this question fundamentally misunderstands what has happened in recent years.

To trace one critical line of developments, in 1999 the Gramm-Leach-Bliley Act was adopted to end the separation of commercial and investment banks. But the SEC was not given the power to examine financial holding companies that owned both types of financial institutions and often operated abroad.

This state of affairs created an enormous vacuum of oversight. Commission net capital and liquidity rules were difficult to design or enforce when the agency could address only part of a financial holding company.

In 2004, the five largest independent investment banks implored the SEC to develop a new but entirely voluntary system of regulation called the Consolidated Supervised Entity Program.

As the Commission's Office of Inspector General highlighted in a September report on Bear Stearns and other banks, this system of voluntary regulation failed.

Part of the blame for this failure fairly can be attributed to the SEC--both for providing too small a staff and for that staff's decision, apparently on its own, to permit internal audits to substitute for the Commission's requirement of external audits.

But more of this tragedy can be attributed to a general belief that the world's leading investment banks did not need regulatory rules to assess the risk of novel forms of trading such as credit default swaps, and that those same institutions could tolerate net capital requirements that were much lower than otherwise required.

What we have learned, quite simply, from the last few months is that we now need an SEC once again able to wholly fulfill its historic mandate.

First, this means that the current system of financial regulation--with loopholes for financial holding companies, credit default swaps and hedge funds--must be transformed into one in which all relevant types of financial instruments and actors are subject to similar systems of full and complete disclosure.

Second, we need to make a fundamental distinction between the need for the Department of Treasury or the Federal Reserve, which address issues of systemic liquidity, and the need for a specialized agency, such as the SEC, which addresses the now-urgent needs of millions of American investors.

The Fed has performed well managing crises and regulating commercial banks. But that is a vastly different function than a focus on individual investors and their need for honest and full disclosure. That is the reason a separate SEC was created in the first place.

Third, the key to the most effective protection of the investor is a strong SEC--one that believes in using its Congressionally voted mandate to insist upon full and fair disclosure and pursue enforcement cases that will deter cupidity and irresponsibility.

Capitalism has worked best in this country when regulatory agencies such as the SEC have provided ground rules that ensure transparency and prevent fraud. Our financial success as a nation in part can be traced to the Commission's ability to succeed in this mission.

Joel Seligman is the author of 20 books on securities law and regulation and is the president of the University of Rochester.