Monday, September 6, 2010

The SEC Needs To Fix Its Structural Problems Before It Gets More Funds

The SEC has structural, cultural and incentive problems, which lead the commission and its staff to focus on the wrong aspects of the securities and investment industry. These problems also make the SEC look understaffed and insufficiently funded. In medicine, the best medical care is preventive care, which stops an illness from starting. At the SEC, prevention is secondary to the number of enforcement actions and the amount of fines and penalties imposed on wrongdoers. Actions and fines against wrongdoers is the primary measure of the SEC's success. The SEC does not have any incentive to look at its fraud cases and develop any efficient algorithmic type of analysis that would prevent future fraud.

Congress rewards the SEC for the quantity of frauds it finds in a year, but not for preventive measures that deter the occurrence of fraud. Bernie Madoff is a good example of the structural problems at the commission that prevent the most effective use of SEC's resources to prevent fraud.

Madoff was an affinity fraud. An affinity investment fraud occurs when the duped investors are part of a cohesive group, such as members of a particular church, a local religious group, a charity, a social club, an immigrant group, a union local, a specific country or golf club, etc., and another member of the group refers them to the fraudster.

The referral by other members of the group to a specific investment adviser or investment vehicle allows the fraud to grow because new investors trust the referring members' judgment and that trust overcomes any incredulity, inhibitions and qualms that may exist.

Affinity fraud did not begin with Madoff and it will continue as a common fraud problem for the SEC. The SEC has prosecuted, fined and ended affinity frauds years before Madoff came along.

In all the years of affinity frauds prior to Madoff, the SEC did not implement procedures as part of its examinations of investment firms and advisers to detect affinity fraud. Simple questions could act as warning flags for affinity fraud, such as how do you get new clients? Do you rely on referrals? Where do most of referrals come from? Making these questions and verifying the answers as part of an SEC examination would deter numerous cases of affinity fraud because swindlers would understand that affinity group referral would create a warning sign to the SEC of potential fraud and open that adviser up to intensive scrutiny.

Similarly, in any year, about 80 percent of professional investors do not beat their investment vehicle benchmark index, such as S&P 500, etc. The odds of a professional investor beating the relevant investment index in multiple consecutive years are even lower. A string of several years of better than comparison returns should indicate to the SEC that things are too good to be true and that the SEC needs to conduct an in depth examination of that investment adviser. Advisers showing unbelievable returns would trigger intensive SEC scrutiny. Yet, the SEC does not compare the historical adviser's returns with a comparable index or even ask the adviser to report the comparison.

The SEC as currently structured will always need more resources and there will always be undetected large investment frauds because the SEC has little if any incentive to prevent fraud or to become efficient in its methods to detect fraud.

I also posted the above as a comment on Econlog, "Technocratic Fundamentalism" by Arnold Kling.

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