Does the SEC Have Your Back?

Facing big challenges and limited resources, the SEC struggles to keep the markets safe for investors.

The Securities and Exchange Commission was born at a time of financial tumult. Ordinary Americans, lured into the stock market bubble of the late 1920s, were livid at losing their savings in the Crash of 1929 and the Great Depression that followed. Senate hearings investigated the causes, but they seemed to get nowhere until a former New York City district attorney named Ferdinand Pecora exposed a range of abusive practices by banks and their Wall Street affiliates, fanning public outrage and calls for financial reform. Sound familiar?

Congress responded by creating the Securities and Exchange Commission, a federal agency charged with protecting the interests of investors. Nearly 80 years later, that same watchdog is tasked with the cleanup of another banking and Wall Street mess. At the same time, the agency is struggling to tame technology that moves markets at lightning speed and in unpredictable ways, to deal with a contentious Congress and challenges from the courts, and to reassure disillusioned investors that the markets are worthy of their trust.

Critics are legion. And the agency has been plagued by internal problems and missteps, ranging from employees at work surfing the Web for porn, to an upscale office-leasing fiasco, to conflict-of-interest questions in the general counsel’s office. Only 24% of Kiplinger readers surveyed think the SEC is effective in policing the stock market. So in 2012 it’s reasonable to ask: Is the SEC up to the task?

Although the question may be reasonable, it hardly seems fair. With a workforce of fewer than 4,000 (smaller, says SEC chairman Mary Schapiro, than the size of the Washington, D.C., police department), the commission oversees 11,700 investment advisers, 9,700 mutual funds and exchange-traded funds, and close to 4,500 brokerage firms -- not to mention a stock market in which more than 8.5 billion shares trade each day. The agency reviews tens of thousands of financial statements and corporate disclosures each year, and says its lawyers go up against companies that spend more on lawyers’ fees than the agency’s entire annual operating budget. Within the context of those constraints, the SEC’s report card is mixed. Below, we grade the SEC on a number of initiatives in three critical areas: making rules, preventing fraud, and maintaining fair and orderly markets.

Putting reform into effect

Start with the Herculean task of implementing the massive and wide-ranging financial-market reform known as Dodd-Frank, enacted in 2010 in response to the financial crisis. The legislation requires the SEC to address everything from the most complex derivative investments to executive compensation to identity theft at brokerage houses. It must even weigh in on such esoterica as corporate disclosures about minerals mined in war-torn Congo.

Reform has taken a huge share of SEC resources. Yet out of almost 100 rules required by Dodd-Frank, the SEC has adopted only 20. Don’t expect a pickup in the pace of reform anytime soon. “I doubt whether 30% of Dodd-Frank mandates will see the light of day until after the election -- and if Republicans win, it’ll be less than that,” says Arthur Levitt, a former SEC chairman.
Grade: Incomplete.

Boosting money funds

Chairman Schapiro (see our interview with Mary Schapiro) says the SEC is working on new rules for the $2.6 trillion money market fund industry. The agency beefed up regulations to make fund holdings more liquid and less risky after one fund “broke the buck” during the financial crisis, redeeming shares for less than $1 each. That triggered a run until Uncle Sam stepped in to insure money market assets. “The American taxpayer should never be on the hook again,” says Schapiro.

Schapiro wants to require that the price of money market fund shares float with the value of the fund’s holdings, so the true value of the shares is crystal clear -- but she must get a majority of commissioners on board. Or the SEC might require fund managers to keep extra capital on hand to meet redemptions and limit how much investors can withdraw right away.

The problem with the SEC’s approach, say both industry insiders and consumer advocates, is that it will kill the industry it’s trying to save. Mercer Bullard, founder of Fund Democracy, a shareholder advocacy group, says the industry’s relatively stable history deserves more credit: “Money market funds are the Rock of Gibraltar in the money-management world -- and yet they’re the ones facing elimination.” Even if new rules are adopted, expect a challenge in court.
Grade: Incomplete

Broker standards

Figuring a way to apply a fiduciary standard to all professionals who give investment advice to individuals was once an SEC priority, but the initiative has stalled. Fiduciaries must put the interests of clients first; the standard for brokers mandates only that they recommend “suitable” products. More than a year after the SEC recommended a reasonable approach to bringing brokers under the fiduciary umbrella, the agency has yet to propose a final rule. Some blame a recent federal court decision that raised the standard for the cost-benefit analysis that goes into SEC rule proposals. The decision could have a chilling effect on SEC rule-making overall, says Barbara Roper, Consumer Federation of America’s director of investor protection.
Grade: B–

Mutual fund fees

Much to the chagrin of fund investors, a proposal to cap 12b-1 fees -- named for the rule that allows managers to use fund assets to pay marketing costs -- has gone nowhere. Adopted in 1980 to support what was then a struggling fund industry, 12b-1 fees have long since outlived their intended purpose, critics say. The fees, which added up to a few million dollars in 1980, totaled $9.5 billion in 2009.
Grade: D

Catching the crooks

The SEC is doing a better job chasing down bad actors. After suffering two black eyes for missing multi-billion-dollar Ponzi schemes perpetrated by Bernard Madoff and Allen Stanford (despite multiple warnings in both cases), the agency has come out swinging. A new whistle-blower program rewards tipsters whose information results in sanctions of more than $1 million. The SEC gets roughly seven tips a day via the program. No rewards have been paid yet, but the kitty contains $453 million. “Five years from now, whistle-blower changes might be as big as any reform within the SEC,” says Georgetown University law professor Donald Langevoort.

A streamlined, reorganized enforcement division -- the SEC’s main crime-fighting unit -- has taken a page from the playbook of the commission’s first chairman, Joseph Kennedy, who staffed the agency with Wall Streeters savvy about industry shenanigans. Today’s SEC is recruiting more non-lawyers, many with expertise in markets. “These folks know where the rocks are and what is buried underneath them,” enforcement chief Robert Khuzami said at a recent conference. Investigators are trolling for fraud in new areas, too, monitoring social media and private markets that trade unregistered stocks. The SEC filed a record 735 enforcement actions in the fiscal year that ended last September, recovering more than $2.8 billion.
Grade: B+

Insider trading

The SEC’s most high-profile successes have been against inside traders. The case against financier Raj Rajaratnam has spawned charges against 30 defendants accused of generating more than $91 million in illicit profits using inside information to trade in more than 15 stocks. (The SEC only has power to bring civil cases, but Rajaratnam was sentenced to 11 years in prison in a companion criminal case.) The SEC brought 57 insider-trading cases last year, nabbing, among others, a Food and Drug Administration chemist trading on drug-approval information and former pro baseball player Doug DeCinces trading ahead of a buyout.

Although insider trading has a negligible effect on individual investors’ portfolios, the misconduct really rankles (56% of Kiplinger readers surveyed think insider trading and other fraud should be the SEC’s top priority). “Insider-trading prosecutions are a way the SEC communicates with retail investors that it doesn’t want the securities markets to segment into the haves and the have-nots,” says Georgetown’s Langevoort. “There’s an emotional reaction that investors get when the SEC nabs someone. It’s healthy, albeit more symbolically than in terms of dollars in anyone’s pocket.”
Grade: A

Financial crisis perps

The SEC hasn’t fared as well bringing to account the companies and executives whose actions brought about the financial crisis. Since 2008, the SEC has filed 27 financial-crisis cases and charged 98 individuals or companies. The agency suffered a setback when U.S. District Court Judge Jed Rakoff refused to accept a settlement negotiated with Citigroup. Rakoff called the $285 million penalty that Citi negotiated “pocket change,” when investors were alleged to have lost more than $700 million on low-grade mortgage investments that Citi itself bet against.

Nor did Rakoff like the wimpy settlement language that let Citi off “without admitting or denying” the allegations -- a catchphrase used commonly at the SEC and other agencies. Settling such serious charges without proving (or making someone admit to) the facts in the case is a disservice to investors, Rakoff said.

The SEC appealed the decision. In March, it won the first round in the appeals process when a panel of judges agreed to postpone a scheduled Citigroup trial. Meanwhile, Schapiro and Khuzami bristle at the suggestion that they’re pushovers. After all, the SEC is limited in the penalties it can assess, and Schapiro has asked Congress to boost sanctions, in particular for repeat offenders. The SEC now compels anyone guilty in a criminal context to admit to as much in an SEC settlement. “If we can get in a settlement about what we’d win in litigation, get that money back to investors sooner, then turn our resources to the next case, that’s a deal I’ll take,” Schapiro says.
Grade: C

Flash-crash fixes

Even before the so-called flash crash that sent stocks yo-yoing crazily on May 6, 2010, the SEC was poking into the more abstruse corners of the markets and the complicated trading strategies executed there. A particular concern is high-frequency trading, employed by pros who use high-speed computer programs to capitalize on minute price changes. The trading accounts for more than half of total trading volume, but has little to do with the prospects of the companies being traded. The SEC might throttle back such trading by instituting fees on the many orders (95%, by some counts) that high-frequency traders cancel before execution.

Long-term stock investors have little to fear from high-frequency traders, says Georgetown University finance professor James Angel. The added market liquidity such trading brings has lowered transaction costs for everyone. And the SEC has already installed a number of stock market safety valves in the wake of the flash crash. Still, the flash crash proved how little is known about some parts of the market. So the SEC has made it a priority to establish a consolidated record of exactly who trades what, when and where. With no such record now, says law professor James Cox at Duke University, “regulators are in the dark.”
Grade: B–

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