Strong enforcement of anti-fraud provisions in securities laws is vital to market integrity.
However, a number of successful court challenges to the Securities and Exchange Commission's (SEC) enforcement processes and priorities, including challenges calling into question the former SEC enforcement director's abuse of in-house agency courts to side-step due process rights of defendants, remind us that more enforcement is no substitute for smart enforcement.
It isn't enough to have a heavy missile payload at the SEC; we need to ensure the agency's targeting lasers are pointed in the right direction.
The justice system relies on adversary proceedings as the most objective way to determine guilt. Unfortunately, given the high settlement rate in SEC enforcement cases, that adversary system to search out the truth in a public forum is too often side-stepped.
Companies see high reputation costs in litigating and have strong incentives to settle. As a result, enforcement lawyers at powerful agencies like the SEC have substantial leverage and discretion in how they use that leverage. Empowering a robust and internal deliberation at the SEC can help to alleviate this problem.
The key is ensuring that the economists at the SEC stand on par with the lawyers. Economists and lawyers have different professional norms. Lawyers want to zealously defend a tenable position. Economists are grounded in the scientific method.
Consider the Federal Trade Commission (FTC), which regulates questions of law and economics like merger review that are analogous to many similar questions of law and economics that the SEC regulates in the financial markets. At the FTC, the economists stand on similar footing to the lawyers. Economists are empowered by the commission, they are involved from the beginning of an enforcement action and they set priorities for the enforcement lawyers.
At the SEC, by contrast, economists are an afterthought to the enforcement lawyers. Economists are only called in to enforcement cases at the SEC to justify cases after the fact, and are relegated to serving as technical advisors to the enforcement lawyers. A better approach, modeled on the successful dynamic seen at the FTC, would include economists in setting priorities of the enforcement division, based on which cases could best serve investors using generally accepted economic methods.
A better approach would also draft economists at the SEC to help gauge the effectiveness of the enforcement lawyers. Most press releases from the SEC enforcement division list the benefits of individual settlements using economic concepts. SEC enforcement division press releases note, for instance, how much investors were harmed by an alleged wrongdoing or how much the individual settlement will deter future wrongdoing. All of the above are inherently economic concepts outside the expertise of the enforcement staff.
The SEC needs a performance management system that sets the right incentives to target the enforcement focus in the right direction. Despite the best intentions of the leadership in the enforcement division, the rewards — formal and informal — tend to go to high-dollar and high-profile settlements that capture attention. Frauds that don't promise high recoveries, perhaps because the stolen money has already been spent, can at times slip through the cracks as the agency chases large dollar settlements and headlines.
Every performance rating system needs an outside arbiter — after all, it doesn't make much sense for the same division to both rate its successes and get rewarded for the ratings it provides. Thus, it is important for the economists at the SEC to determine the benefits to investors from a particular enforcement action, and for that division to have oversight authority in calling balls and strikes with respect to the economic impact of the cases they try, the damages they are allowed to seek and in enforcement staff performance assessments at the end of the year.
A related reform to make the five commissioners once again more central to the charging order process, which they were for most of the SEC’s history, would also improve the role of the economists as advisers to the commission.
Someone needs to call balls and strikes and umpire the important work of enforcement lawyers at the SEC. Economists are up to the task if the commission will only empower them.
J.W. Verret is an associate professor at the Antonin Scalia Law School at George Mason University and a senior scholar with the Mercatus Center.
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