WHY THE SEC MISSED MADOFF / THE WALL STREET JOURNAL OP EDITORIAL ( RECOMMENDED READING )

OPINION

JULY 17, 2010

Why the SEC Missed Madoff

Its enforcers are rewarded for the number of cases brought and for following political fashion

By RICHARD C. SAUER

The Securities and Exchange Commission is experiencing a crisis of public esteem, particularly for failing for more than a decade to bust confessed Ponzi-schemer Bernie Madoff and alleged Ponzi-schemer Alan Stanford. This week's $550 million settlement with Goldman Sachs over fraud charges notwithstanding, "Where was the SEC?" has a familiar ring.

The Milken-Boesky follies of the 1980s, the turn-of-the-century parade of financial frauds led by Enron, and the mutual-fund market timing scandal, all resulted in much hand-wringing over how the agency might be more proactive and generally faster off the dime.

The SEC's current chair, Mary Shapiro, is pursing a well-publicized effort to reform its enforcement program. The question is whether anything can realistically be done to keep history from repeating itself. The answer is a qualified yes.

Reports from the SEC's Office of Inspector General describe in detail the many missteps and missed opportunities in the Madoff and Stanford inquiries. Its Madoff report, issued in August 2009, portrays a slick market professional glibly throwing sand in the eyes of novice government investigators, over-awed by his expertise and industry stature and confused by the complexities (real or fictional) of his operation.

But shuffling around the more experienced staffers to deal with tough cases becomes a losing game of whack-a-mole. They simply can't be everywhere. A current SEC initiative creates specialized groups to handle certain important case categories. This sounds reasonable and merits a try. Still, that alone won't do the trick. Government attorneys can never fully close the knowledge gap between them and sophisticated financial players.

The IG's March 2010 report on the Alan Stanford matter highlights other endemic problems that bring us closer to what's gone wrong. As early as 1992, the staff of the SEC's Fort Worth, Texas, office strongly suspected Mr. Stanford of running a Ponzi scheme. Yet Ponzi and pyramid schemes, according to the report—and my own experience in the agency—held low priority with SEC top management, who saw them as having little press appeal and afflicting only small investors looking to make a quick buck. Due to the uncooperative stance of the company and the offshore location of important documents, the regional office also feared that pursuing that matter would eat too many staff hours and so reduce the number of its filed cases ("stats," in agency lingo).

The "stat system" creates perverse incentives. To impress congressional appropriators, the SEC touts year-over-year increases in filed actions. This leads to a bias in favor of quick-hit cases and against pursuing anything novel or speculative. But all cases are not created equal and the easy cases are rarely the most significant.

A staff chained to the stat treadmill, moreover, has meant ever-growing administrative burdens that make it more difficult to open new cases or close old ones that haven't panned out. Frequent reports were demanded to permit management to satisfy itself that matters were not being mishandled or allowed to languish. Every hour the staff spends reporting on what it is or isn't doing is one less spent enforcing the securities laws.

The agency also sometimes becomes a slave to public perceptions, responding to the scandal du jour (and accusations of how it was allowed to occur) by launching a raft of investigations of varying degrees of promise. Examples include the blowups over mutual-fund market timing and options backdating in 2003 and 2006, respectively. These behaviors all but vanished the moment the SEC took public notice of them—yet they occupied much of the agency's enforcement agenda for years.

Under Ms. Shapiro the agency in recent months has reduced the procedural obstacles and supervisory bottlenecks facing its staff, apparently accepting the occasional screw-up in exchange for more aggressive enforcement. The management hierarchy has been somewhat flattened, and the number of approvals required for certain staff actions reduced. These are sensible reforms, but will they make it easier to foil future Madoffs?

I would suggest cautious optimism. The agency has taken some solid steps toward fostering a more agile and aggressive internal culture. But strong improvements in performance will actually arise from a hundred small decisions, never seen by the public, that reward effort and initiative, rekindle a sense of shared mission—and above all emphasize quality of cases over quantity or fashionability. And these decisions are not without a political cost.

Put bluntly, the press and the public simply have to recognize that the SEC will often—maybe inevitably—be a step behind in attacking truly novel forms of market abuse. Rather the agency should be held to the goal of dealing reliably, day in and day out, with the meat-and-potatoes of market abuse: financial fraud, insider trading and, of course, that perennial favorite the Ponzi scheme. Its commitment to pursuing that goal, without expectation of immediate public appreciation is, or should be, the standard by which the agency's reform efforts should be judged.

Mr. Sauer, an attorney and assistant director with the SEC's Division of Enforcement from 1990 to 2003, is the author of "Selling America Short: The SEC and Market Contrarians in the Age of Absurdity" (J. Wiley & Sons, 2010).

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