More Funding And Staffing At The SEC Will Not Reduce Fraud

The following is a comment I posted on the Conglomerate Blog, "Funding the SEC: Dependent on the Kindness of the Regulated?" by Erik Gerding.

What indications are there that more funding and staffing at the SEC will reduce fraud? The failure to stop Madoff was not due to a shortage of staff or inadequate funding. Dysfunction at the SEC is the core issue. For example, the IRS has statistical profiles of IRS returns to identify likely tax evaders. In all its existence, the SEC has failed to develop a manageable, efficient system to identify fraud at the corporate level, at the investment level, or to evaluate the likelihood that an investor complaint to the SEC is true.

SEC staff investigated Madoff and fundamental procedures that have been in existence in auditing for decades, such as verifying payments, receipts and funds at other institutions, were not part of SEC investigations until after Madoff.

Madoff is a form of affinity fraud, which is a type of fraud the SEC has known about for years. It is based on investor commonalities to form referrals based on unfounded trust. Immigration groups based on country of origin, religious groups, country club membership, etc and other forms of referrals allow affinity fraud to succeed. Does the SEC even attempt to determine if the investors are part of an affinity group that would alert the SEC that there is a high likelihood of affinity fraud? It did not at Madoff. Does anyone remember ever seeing an ad or other outreach informing the public of this kind of fraud? The SEC has a 2009 pamphlet (after Madoff) and a 2006 press release, but what is the best preventative measure at the investor level and at the SEC to limit affinity fraud?

Option backdating was discovered because a professor published a statistical study showing its likely existence. Shouldn't a SEC priority be finding and funding research in important areas of potential fraud to help it efficiently identify corporate fraud? More staff would not have found backdating.

The SEC today is like a ship lost at sea that keeps asking for more stargazers to help identify its position instead of asking for a GPS navigation system. It is a 1930s organization with a 1930s culture that does not know how to function in the modern world. It is heavily staffed with lawyers whose culture is to avenge a fraud instead of prevent a fraud.

More money and staff are not the answer. A complete rethinking and restructuring is in order.

Furthermore, contractual legal rights are a powerful mechanism for protecting the rights of parties to commercial transactions. In fact, most transactions are based on contractual protections as opposed to regulatory protections. Shareholders and other interested private parties, and not the SEC, often sue to enforce their legal rights in securities transactions, when courts have recognized their right to sue to protect themselves.

While the counterfactual of life without 75 years of an SEC is difficult to envision, the existence of the SEC did not prevent major securities and investor fraud. Additionally, the SEC is always requesting more funding and staffing to investigate and litigate fraud. It is unclear that the 33 and 34 Acts have decreased fraudulent activities.