SEC: The Fox Is Guarding the Henhouse

Back in July, an attorney at the Securities and Exchange Commission named Darcy Flynn went public with allegations that the SEC “followed a policy of systematically destroying documents” since at least 1993. In his whistleblower complaint, he claimed that Matters Under Investigation, typically related to possible wrongdoing at Wall Street firms, were often shredded or otherwise destroyed after cases had been dismissed.

If you’re wondering whether some of those MUI files included information on Bernie Madoff, credit default swaps between Goldman Sachs and AIG and other questionable activity related to the 2008 meltdown, the answer is yes.

The SEC is supposed to be the vanguard, the front-line protection for investors who put their hard-earned money into equities markets. But in reality, it’s a $1.19 billion-dollar government program that’s asleep at the switch, run by inept lawyers and careerist regulators who neither understand the regulations nor have the incentive to enforce them.

How did we get to this point?

The SEC was established by Congress in 1934 with the mission to “protect investors, maintain fair, orderly, and efficient markets and facilitate capital formation.” Created under the Franklin D. Roosevelt administration, the SEC was charged with regulating the stock market and preventing corporate abuse in the wake of the Crash of 1929. The SEC is the last surviving New Deal agency, and though it may be hard to believe based on Flynn’s allegations, its mission remains the same to this day.

FDR knew that in order for the SEC to be an effective guardian of the public’s investments, it needed to be run by people who understood the nuances of trading on Wall Street. Rather than appointing a career bureaucrat or white-gloved lawyer to head the agency, he went with a guy who had a little dirt under his nails: Joseph Kennedy.

Kennedy’s past may have been a little checkered, but he understood the Street as well as anyone—how it worked on a functional level and where it was vulnerable to abuse. One of Kennedy’s first actions as chair was to establish the Uptick Rule, which made it almost impossible to ‘plunge’ the market. Kennedy knew that short selling securities on a down tick needed to be banned —after all, he made his money as a market plunger! Well, that and liquor.

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Somewhere between then and now, capable, experienced SEC regulators who possessed a working understanding of the products they regulate have become extinct. They’ve been replaced by bumbling, bureaucratic attorneys who either have no clue about how Wall Street operates or simply choose not to care about abuses. How can the SEC protect investors when it’s been systematically destroying files related to the very investigations it’s supposed to investigate?

And worse, if SEC regulators can’t even enforce regulations already on the books, what’s the point of piling on even more nonsense like Dodd-Frank? The fox is guarding the henhouse. Instead of adding more hens, it might be time to rethink who’s on patrol.

I come from the world of commodities futures, which does not fall under the jurisdiction of the SEC. Futures markets are regulated by the Commodity Futures Trading Commission, which was spun off in 1974. Although it’s the ultimate authority, the CFTC has evolved into more of a guide, providing a system of checks and balances rather than doing the actual policing. Enforcement is handled by the individual exchanges it oversees—the CME, the CBOT, the NYMEX—which are all certified self-regulating organizations.

The system is very effective. The exchanges know that in order to maintain their SRO status, they must remain in strict compliance with regulations handed down from the CFTC. So they take a page out of FDR’s playbook and hire regulators with a little dirt under their nails. Obviously, I’m not talking about crooks like Joe Kennedy—I’m talking about regulators with real-world experience who can think outside the box and have the incentive to eradicate any abuse or wrongdoing.

In the 25+ years I’ve been in the industry, futures have grown from a second-tier asset class to a mainstream vehicle with tremendous popularity. I believe the CFTC/SRO system has a lot to do with that. On around one-fifth of the SEC’s annual budget, the CFTC has been a true guardian of the public interest, lending credibility to and instilling confidence in the futures markets. 

After a tumultuous August that picked the scabs of 2008, today’s equities markets are desperately looking for some of that credibility and confidence. And thanks to Flynn’s whistleblower complaint, it’s pretty clear the SEC is not going to bring these things back. It’s more apparent than ever that a massive budget and a bunch of lawyers cannot protect the public interest.

It’s time for the SEC to go. And whatever is recreated needs to be run by people who understand the markets and products being traded. To paraphrase my old colleague and Nobel Laureate, Merton Miller, it’s never a question of the regulations. It’s a question of the regulators.

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