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The reputation of the US Securities Exchange Commission as the defender of investors’ interests was severely damaged in the Crash of 2008.

First, there was the Bernard Madoff Ponzi scheme where the SEC completely dropped the ball.

Then there was the safe harbor granted by SEC Rule 10b-18 to corporate stock manipulators in the buyback scheme that spanned a generation — a major factor in the fall in the price of equities.

Next, there was an overly lenient policy with regard to financial leverage of broker-dealers and investment banks.

Who is really “protected” by the SEC?

When the Securities and Exchange Commission was established under President Roosevelt during the Great Depression, the mission was to protect investors against market manipulation and securities fraud, bucket shops, and lack of disclosure.

The legislation provided the SEC with sharp teeth and ample powers to do its job. And for a generation or so, the SEC did its job well. It was arguably the best market regulator in the world — and the US was the world premier capital market, by a large margin

Following World War II, the SEC began to crack down on “insider trading”, an infraction not even mentioned in the basic law.

Nevertheless an activist SEC found legal theories and ways to protect investors against what they considered unfair use of information by insiders.

In olden times, brokers had unlimited personal liability ...

The critical event in Wall Street history occurred in 1953 when the New York Stock Exchange allowed member firms to incorporate. No longer were exchange members subject to unlimited personal liability. The morality based on threat of personal bankruptcy was gone.

“My word is my bond” became just another quaint saying. By 2008, Lehman Brothers was able to go bankrupt, while the “partners” walked away, unscathed!

In the 1960s and 70s, the SEC was still on the side of investors, cracking down on front-end load fees of mutual funds, by which fund marketers were extracting unfair advantage from naive investors.

However, from the 1980s on, the SEC became progressively less interested in protecting investors and more interested in supporting issuers, fund managers, and investment bankers.

Free from personal liability and able to earn fortunes, even when their firms went under, investment bankers slipped the traces of rational behavior. Bigger, riskier, was definitely better.

The argument of “keeping Wall Street competitive” in international financial markets trumped interests of domestic investors.

Design flaws turn the SEC from investors

The SEC had plenty of legal power and ample resources to do its job. But the organization has a design error that eventually turned it away from its basic mission.

The problem is with how the organization is governed.

The SEC is a commission, a collegiate board of five political appointees, chosen on the basis of party affiliation for staggered periods of five years.

One of the commissioners is designated as the Chairman and has authority over the staff of civil servants the handle the daily routine of the agency.

Founding SEC commissioners

Two commissioners are chosen by the Republican Party and two by the Democrat Party, and the fifth, the Chairman, is chosen by the President.

All nominations are subject to the advice and consent of the US Senate and commissioners are regularly called to Capitol Hill to testify on this or that matter.

Commissioners are usually lawyers, although sometimes there is an accountant or an economist.

They are usually nominated by members of the relevant committee in Congress, with preference going to Congressional staffers, securities lawyers, law professors, and civil servants of financial regulatory agencies.

After serving their term, commissioners often go back to what they were doing, working at a law firm, teaching law, arranging an assignment with another agency, or serving as directors on corporate boards.

A commissioner that has a reputation for being tough on issuers or market intermediaries, in the defense of the interests of investors, is likely to find him or herself in bad odor on returning to the private sector.

Stock buybacks cloaked regulatory laxity

Throughout the 1980s, largely as a result of stock buybacks sanctioned by SEC Rule 10b-18, equity prices move steadily upwards.

The Crash of 1987 was seen as a temporary technical glitch.

The Crash of 2000 was excused as a problem resulting from unwise speculation in dot.com stocks.

As a result, the fact that the SEC was turning its attention away from investors towards supporting Wall Street institutions was hardly noticed by Congress.

The market is up! Why spoil the fun?

This changed suddenly in the fall of 2008.

Now, with Bernard Madoff, and several mini-Madoff’s, plus the collapse of major investment houses, and the destruction of the savings of a large portion of the population, congressmen and women were screaming at SEC staffers and commissioners, like Captain Renault in the movie Casablanca, claiming to be “shocked, shocked” at the lack of investor protection provided by the agency.

Commissioners are only human

Almost every day, an SEC Commissioner is giving a speech somewhere — in an open hearing in Washington, at a conference in New York, Boston, San Francisco, London, Tokyo, Sydney, at a university, at a “think tank” — usually before an audience of issuers, lawyers, accountants, investment bankers, or policy wonks.

Rarely does a commissioner speak to an audience of ordinary investors.

In fact, most “ordinary investors” don’t even know what an SEC commissioner is or what he or she does. A commissioner’s world is made up of the regulated (issuers, investment bankers, accountants), not those who he or she is sworn to protect and defend.

When one speaks to a group, there is a natural tendency to seek approval and applause from the audience.

One wants to be liked and appreciated. If you are speaking to issuers, investment bankers, and market professionals — any one of whom might be in a position to give you a job, or be your client in a year or so, when you get out of office — you don’t want to say something unpleasant.

The title “SEC commissioner” is a wonderful credential to have on your resume. Unless you make enemies when in office, a “former commissioner”, especially with a law degree, is set for a life of economic comfort.

So it is not surprising that gradually, over the years, inexorably, the SEC moves towards regulations that are more likely to please the regulated than investors — especially when investors are not even paying attention.

Quis custodiet ipsos custodes?

The problem with the SEC is the same problem posed by Plato in The Republic, his work on government and morality, “Who will guard the guardians?”

Tell them a 'noble lie'?

If SEC commissioners are only human and are surrounded, influenced, and subtlety suborned by issuers, investment bankers, and market professionals, how can we find men and women who will be able to act out of character and their own interests, to defend distant “ordinary investors” who do not even appreciate what they do?

Plato’s solution to this problem was to tell the guardians the “noble lie” that they were better than those they serve and that it is their responsibility to guard and protect those lesser than themselves. Plato would have SEC commissioners instilled with a distaste for power or privilege so that they would rule in the interest of their subjects because they believe it was their duty — and in the nature of who they were and what they do.

Well, it’s not clear whether that worked in ancient Greece or whether it would work today in Washington, DC.

Sure, SEC commissioners all have mothers, fathers, sisters, brothers, aunts and uncles who are “ordinary investors”. Most of them actually believe that they are “protecting investors”.

But they are also, usually, lawyers … there are many other factors to be considered … one must see the “big picture” … and then there is Congress and its lobbyists to appease, and the threat of unpleasant hearings that may ruin their careers.

Reforming the SEC … a proposal

First of all, I don’t believe that the SEC needs greater powers, or more rules. Nor are larger staffs called for.

A regulatory agency, like the SEC achieves its ends mainly by making examples of those that behave improperly.   It is not necessary to catch every tiny infraction.

The market will police itself, if the players think there is a cop on the beat that is a serious threat to their well-being.

So here is what I would propose:

Personal bonds:

Every director and officer of an investment bank, broker-dealer, or fund manager should put up a personal bond of his or her entire net worth as a guarantee for investors that deal with his or her firm. This might seem to be cruel and unusual punishment, but it is not much different from the situation on Wall Street prior to 1953.

I, myself, as an executive of an investment bank in Brazil had to do precisely this.

This practice allows investment banks to still be large (because of the limited liability of shareholders), while putting the fear of God into financial executives. If it worked for J. P. Morgan (the real one), it should work today.

New criteria for commissioners:

Commissioners should be appointed by the President for a single term of 15 years, without consideration of political party.

The minimum age for commissioners should be 50 years and they should be expected to retire at the end of their term on a fat pension.

There should be 15 commissioners, with staggered terms, so that it would take three presidents to name the entire board.

The commissions should each have one vote and would choose among themselves a Chairman, yearly.

Not more than one-third of the commissioners could be lawyers. Commissioners should be chosen on the basis of their demonstrated reputation for serving the interests of investors.

New oath of office:

The oath of office of a commissioner of the SEC should be reworded to emphasize the commissioners duty to protect and serve the interests of investors, with special emphasis on the interests of small investors.

The oath should place emphasis on the stability of the capital markets and the utility of investment instruments to as a store of value for modest investors.

A degree of “merit-regulation” should be introduced, in the form of better disclosure, without going to the extreme of approving each new issue.

Of course, there is not much chance of anything like this happening.

So it will be up to each investor to look out for his or her own interests — as always has been the case.

Photo credit: Block party by “sing me a song”, flickr