The distorting incentives facing the U.S. Securities and Exchange Commission.

• Author: Macey, Jonathan R.

INTRODUCTION

This Article is about the incentives that motivate the Securities and Exchange Commission (SEC) and the ways in which those incentives influence the SEC's policies. Unlike most other treatments of bureaucratic incentives, (1) this analysis begins with the assumption that the SEC is populated by honest, professional, and skilled personnel who work hard and are motivated to succeed. Despite the high quality of its staff, the SEC has not been successful in recent years. This Article argues that the SEC's lack of success results from the way that staff members respond to three sets of endogenous incentives.

First, of course, the SEC wants approval from its congressional overseers and from the general public. Unfortunately, however, these constituencies have short attention spans and are not particularly sophisticated observers. Consequently, the SEC tends to pursue high profile matters, to change its priorities frequently in accordance with public opinion, and perhaps most significantly, to pursue readily observable objectives, often at the expense of more important but less observable objectives. In particular, the SEC's performance is measured by Congress and in the court of public opinion on the simplistic basis of how many cases it brings and on the size of the fines it collects. This inclination to value only what can be easily measured has not served the SEC well. For example, the SEC's narrow focus on such measurable indicia of success as the raw number of cases brought explains, among other things, the SEC's complete lack of interest in exposing the fraud at Bernard L. Madoff Investment Securities, LLC.

A second major factor that influences the SEC's conduct is the metamorphosis of the SEC from an administrative agency dominated by a combination of industry experts, economists and lawyers into an agency dominated exclusively by lawyers. (2) This metamorphosis has affected the culture of the SEC profoundly. In particular, the glacial speed at which the SEC operates is largely attributable to the Commission's lawyer-dominated culture. The culture has also exacerbated the problems associated with the revolving door connecting the SEC with Wall Street. SEC staffers are now focused narrowly on maximizing their reputations within the legal community rather than within economics and business as well as law.

Thirdly, the SEC has strong incentives to promote the appearance that the capital markets are in crisis and to eschew the development of market mechanisms that might solve the very problems that the SEC is tasked with solving. So long as people believe that the SEC is needed in times of crisis and that there are no superior substitutes for the SEC's style of crisis intervention, then there will be a need for the Commission. Ironically, the more financial crises there are, the more the SEC can claim a need for greater resources to meet such crises.

Nonetheless, the SEC is virtually untouched by scandal. This fact is in keeping with the argument, advanced in this Article, that the SEC as an institution, and its staff as individuals, are both professionally ambitious and ethically honest. Because corruption weakens the future mobility of SEC personnel, it is highly costly and studiously avoided. In this narrow context, at least, the SEC's response to incentives has produced positive social results.

At the same time, there have been significant, ongoing, and valid criticisms of the SEC's performance over the past decade. These criticisms became very loud when the SEC failed to recognize the fraud and attendant abuses at Enron in 2001, shortly followed by similar problems at Adelphia, WorldCom, Global Crossings, Tyco, and a host of other companies. Only months later, Eliot Spitzer issued scathing attacks on the SEC's dismal performance in regulating mutual fund abuses. (3) This was followed by the SEC's failure to respond to, or even to comprehend, the excessive risk-taking at Bear Stearns, Lehman Brothers, and other broker-dealer firms. The parade of shortcomings ended most recently with the SEC's failure to respond to glaring warnings about the massive fraud of Bernie Madoff. (4)

Part I of this Article develops several arguments about the factors that motivate the SEC. Part II attempts to link the incentives facing the SEC to particular failures in the agency over the past decade.

1. WHAT MOTIVATES THE SEC?

   Bureaucrats are people, too. They respond to incentives just like everybody else. Strangely, however, the theories about precisely what incentives bureaucrats respond to are sketchy. Of course bureaucrats care about their professional futures and their reputations, and perhaps even the amount of 'regulatory turf' they control. Bureaucrats at the SEC and elsewhere also seem to be concerned with congressional oversight, because Congress controls the budgets of the bureaucrats' administrative agencies. They also care about public opinion because public opinion deeply affects most of the other concerns (reputation, professional advancement, and budgets) that matter to bureaucrats.

   At the same time, the SEC is staffed by highly capable, extremely well-qualified professionals, most of whom are lawyers, (5) and many of whom come from or move on to extremely successful careers in the most rigorously competitive parts of the private sector (primarily law, but also investment banking). Finally, but by no means least of all, there is little corruption at the SEC. Although potential future employers of top SEC personnel appear to have considerable clout, few SEC employees have been seriously accused of generating bad public policies or enforcement decisions for corrupt motives. (6) The lawyers and other professionals want to be successful and have rewarding careers. They want to be viewed as successful by their professional peers outside of the SEC.

   In light of these facts, it is puzzling why the honest, competent people at the SEC appear to perform so poorly at their appointed tasks. Another question is why their behavior never seems to improve from crisis to crisis. This Article argues that the fault lies not with the bureaucrats, but rather with the incentives that motivate them. To understand the failures of the SEC, one has to look at precisely how the personnel are motivated to do their work.

   First, it is clear that the SEC is largely evaluated on the basis of how well its Division of Enforcement performs. The SEC is divided into five divisions. Four are rather obscure and have not attracted much controversy, including: the Division of Corporate Finance, which reviews SEC registration statements; the Division of Trading and Markets, which pursues the SEC's mandate for maintaining fair, orderly, and efficient markets; the Division of Investment Management, which is supposed to protect individual investors by overseeing and regulating the $26 trillion investment management industry; and the Division of Risk, Strategy, and Financial Innovation, which was established in 2009 "to help further identify developing risks and trends in the financial markets" by "providing the Commission with sophisticated analysis that integrates economic financial and legal disciplines." (7)

   The principal SEC division is the Division of Enforcement. The SEC describes itself as: "first and foremost.., a law enforcement agency." (8) The Division of Enforcement exists to enable the Commission to investigate possible securities law violations, and, where appropriate, it recommends to the Commission that a civil action be brought against individuals and companies that have violated such laws. Upon obtaining the necessary approval from the Commission, the Division of Enforcement then prosecutes on behalf of the Commission the cases it has investigated. (9) An additional component of the Division of Enforcement mandate is to work closely with law enforcement agencies in the United States and around the world to file criminal charges. In the United States, this task is done through a referral process in which the SEC refers cases to the Criminal Division of the U.S. Department of Justice and then works with the Assistant U.S. Attorneys to bring criminal actions.

   At the SEC, "enforcement actions have traditionally defined the mission of the agency." (10) In fact, economic sociologist William Bealing has posited correctly that it is the activities of the Enforcement Division of the SEC that legitimize the Commission's existence and its federal budget allocation to Congress. (11) It certainly appears that "the SEC is carrying out its (enforcement) duties so as to maintain a base of support within the Congressional budget process." (12)

   Assuming that the SEC is deeply concerned with its budget and that the performance of the Enforcement Division is critical to the SEC's success, the strategy that the SEC employs to maximize its appeal to Congress, and more generally to maximize the overall notion that it is effectively using the resources that Congress has allocated to it, is to focus on available, salient criteria. In particular, the SEC focuses on the raw number of cases that it brings and on the sheer size of the fines that it collects. For example, when criticized recently for failing to respond to numerous tips from whistle-blowers and red flags in the case of Bernard Madoff's massive fraud, the SEC noted in congressional testimony that:

   [C]omparing the period from late January to the present to the same period in 2008, Enforcement has:

   * opened more investigations (1377 compared to 1290);

   * issued more than twice as many formal orders of investigation (335 compared to 143);

   * filed more than twice as many emergency temporary restraining orders (57 compared to 25); and

   * filed more actions overall (458 compared to 359). (13)

   The SEC's 2008 Annual Report is similarly clear in its emphasis on the easily measurable criteria of number of enforcement actions brought and the amount of fines assessed:

   During FY 2008, the...