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Regulatory Capture of the SEC

Which master does the SEC serve? Congress or the Great Vampire Squid?

The SEC is the Three Stooges of regulation. It can’t manage the simple problem of creating a rule comparing the compensation of CEOs with the median compensation of employees. When it does propose a regulation, it looks like the universally derided regulatory structure to enforce the Volcker Rule. It can’t supervise Wall Street, which sold securities fraudulently to investors around the globe. It’s gotten so bad that Judge Rakoff insists that it prove it represents the public interest on a weak settlement.

The anecdotal evidence is now complemented by an academic paper examining SEC enforcement actions, The SEC And The Financial Industry: Evidence From Enforcement Against Broker-Dealers by Stavros Gadinis, a professor at the Berkeley Law School. Gadinis looked at all SEC actions against brokerage firms from 2005 through the first four months of 2007, under a Republican administration, and in 1998 under a Democratic administration. Gadinis concludes:

The analysis shows that big firm defendants fare better in three ways. First, when big firms and their staff are engaged in misconduct, the SEC often brings actions based exclusively on corporate liability, without naming any specific individuals as defendants. Second, for the same violation and comparable levels of harm to investors, a big-firm defendant is less likely than a small-firm defendant to end up in court rather than in an administrative proceeding, facing a higher likelihood of being banned from the industry as a result. Third, among cases that the SEC assigns to administrative proceedings, big-firm defendants are more likely than small-firm defendants to receive no industry ban, controlling for violation type and harm to investors. The gap between big and small firms persists when the analysis is limited to the individual employees of such firms.

P.53. Nothing has happened in the wake of the Great Crash to suggest that things have improved. Look at the Goldman Sachs Abacus case: Goldman has to give back the money it leeched up through one of its tenacles, and suffers no serious sanction. There is only one individual named, the flunky salesman Fabrice Tourré. There isn’t any reason to believe this was the only similar case at Goldman Sachs. The SEC has taken no action on the Senate investigation of Senators Carl Levin and Tom Coburn, or the Final Report of the Financial Crisis Inquiry Commission.

Gadinis raises but does not opine on the question of whether the SEC is a captured agency. The term does not have an exact definition, but generally it means that the regulated entities have a substantial degree of influence over the actions of the agency. The motivation for capture is obvious. The purpose of regulation is to protect a large group of people from damage by regulated entities. For example, we all benefit from clean air. That is a concern for the average person, but the rules themselves are crucial to car-makers and coal-fired utilities. That imbalance means that the agency hears from them in all sorts of ways, louder and clearer than the diffuse concerns of the average citizen.

Tools for capture include bribery, job offers direct and indirect, campaign contributions, socialization, biased advisers, and threats, such as negative publicity or complaints to political superiors. Gadinis provides several facts supporting the theory of the revolving door at the SEC. There is very high turnover at the SEC; half of all agency personnel plan to stay fewer than five years. The pay is terrible: the private sector pays twice as much for comparable employees.

To me, the best evidence for regulatory capture is the actions of the agency. Does it give greater weight to the concerns of the regulated entities than to the direction from Congress? Take the rule on CEO compensation. This isn’t hard, but the corporations that have to do the calculation obviously have more weight with the SEC than the instructions of Congress to report the ratio.

The Volcker Rule says that banks can’t trade securities for their own accounts, taking risks with depositor money at the expense of stability of the financial system. The proposed regulations are full of provisions to define trading as not proprietary. The insistence of giant banks that they be allowed hang on to this source of revenue obviously weigh more than Congress’ direction to end it.

Congress made securities fraud a crime. The SEC can’t find anyone to prosecute in the Great Crash. They say it’s hard to prove intent, there isn’t a smoking gun, and we don’t have tapes of Wall Street execs saying they intend to cheat people. The evidence and the theory say they are captured by an industry they plan to join at the first offer to double their salaries.

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