Required versus Probable Reform and the Madoff Distraction
posted by Lawrence Cunningham
The press, politicians and reformers are devoting extraordinary attention to a Ponzi scheme whose only peculiarities are scale and duration. Compared to ongoing global financial devastation, this is trivial. Yet this attention may lead politicians to distract focus from their role in the deeper problems that matter far more.
Recriminations against the Securities and Exchange Commission arise from allegations it has made (complaint here) that Mr. Madoff operated a large-scale Ponzi scheme involving tens of billions of dollars over perhaps decades and bilking scores of sophisticated parties. SEC critics include prominent securities law professors Jim Cox (Duke) (SEC may “have a hell of a lot to answer for”) and Joel Seligman (Rochester) (“a debacle for the SEC”).
Critics express concern that the SEC may have failed to investigate investor tips (see Wall Street Journal story here); failed to regulate sufficiently Madoff’s investment advisory services or fund vehicles; or failed to enforce existing regulations. Calls are for both investigation and greater regulation, many pinning hope on the incoming Obama administration to institute such searching and effect requisite change.
The SEC itself, and some backers, including today’s Wall Street Journal opinion page (subscription required), assert that nothing the agency could have done, under existing regulations or any imaginable regulatory framework it might have developed, could have prevented the fraud or led to its earlier detection. Furthermore, those suffering losses from the alleged fraud appear to be highly sophisticated investors whose own acuity could have detected red flags as well as any capacity the SEC might have had or be capable of developing.
Both sides make good points. No doubt, episodes like this one require review and drawing lessons—from both regulatory and investor perspectives. Discussion and resulting pressure may lead to studies and reforms worth undertaking. But it is not obvious that there has been any preventable regulatory failure.
And this scam, despite reportedly reaching perhaps $50 billion, remains small change compared to the far vaster, deeper and systemic devastation being wreaked on ordinary people by the proliferation of financial devices that have cascaded to put the world economy on the brink of collapse.
Among leading culprits in the larger problem are credit default swaps and related financial instruments that Congress put outside of regulatory reach in its 2000 legislation “modernizing” financial regulation. Thanks to Congress, neither the SEC nor its cousin, the Commodity Futures Trading Commission, has jurisdiction over many of the devices or markets that proliferated since that legislation passed.
Moreover, there always have been regulatory gaps, as well as turf skirmishes, between the SEC and CFTC, concerning which agency is responsible for what products, markets and firms. The two agencies from time to time reach formal understandings, including one in response to the current crisis, but neither appears eager to cede existing power allocations in any significant way.
Yet nearly all serious students of financial regulation know that the most obvious and sensible step to reduce problems arising from these gaps and fights is to merge the two agencies into one with extensive consolidated authority over financial products, markets and firms.
Alas, nearly all of these also agree that this obvious solution is exceedingly unlikely to occur because of political power structures in Washington that even an administration dedicated to hope and change will find essentially impossible to surmount. Different congressional committees exercise oversight of the SEC and CFTC and Members have deeply vested interests in maintaining the existing allocation of supervisory power.
The alleged Madoff fraud is a spectacle warranting reporting and revulsion, but it is not a serious systemic problem. The politics that prevent sensible financial regulatory systems in this country are very serious indeed. It would be a shame if the upshot of the two episodes is creativity in the prevention and detection of old-fashioned fraud and insufficient attention to how power brokering in Congress and among regulators contributes to global financial calamity.
December 15, 2008 at 2:37 pm
Posted in: Securities Regulation
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Responses (3)
A.W. - December 15, 2008 at 5:12 pm
Argh, here we are once again. Someone does something illegal. then congress discovers that despite having made it illegal, someone did it. So congress says, “well, maybe now we can 100% prevent bad behavior with another rushed, ill-concieved law.”
Why is it that every time some breaks a law in the corporate law, there is a rush to put in a new law? It would be one thing if someone did something deeply wrong but not technically illegal, but that isn’t what we have here. Just someone breaking the law. And maybe it is even an occasion to recalibrate punishment, as in make them even higher.
But if the bad behavior is itself illegal, then I don’t see the argument to change the substantive law itself (as opposed to new punishment). of course we all know what this is really about: looking like you are doing something of value. As in Congress wants to be able to claim they did something about the problem.
This is how the administrative state runs amuck.
Quidpro - December 15, 2008 at 8:02 pm
Correct AW. But you forget the statist drive for perfection. If only a new law is passed, or better enforcment mechanisms were in place, so the thinking goes, then we could have prevented the Madoff scandal.
As Professor Cunningham observes, “nearly all serious students of financial regulation” favor merging the SEC and the CFTC as if creating one large bureaucratic agency in place of two imperfect agencies would be better. And thus Leviathon grows.
ohwilleke - December 17, 2008 at 2:53 pm
One reform that recommends itself is the public disclosure of tips which the SEC decides to not actively pursue (perhaps with a period of delay) along with a brief statement of a reason for not pursuing it (e.g. lack of resources, insufficient coroboration, etc.).
Presumably, someone in the market would monitor such disclosures and engage in a little detective work to see if smoke means fire.
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