Investors Need Private Enforcement of Securities Laws

Institutional investors often ask why they should become involved in private securities litigation. After all, “Isn’t the SEC protecting us?” Yes and no. The SEC is tasked with protecting investors, maintaining fair, orderly and efficient markets and facilitating capital formation. Faced with that mission, the SEC is a dramatically underfunded and understaffed agency. A March 10, 2011 report by the Boston Consulting Group highlights that the SEC also faces other significant barriers that prevent it from carrying out its mandate. Boston Consulting Group estimates that the SEC is short staffed by 400.

The SEC’s lack of staff and funding create a void allowing frauds to go uncontested and leaving investors unprotected. Thus, the role of the institutional investor as a watchdog is pivotal to maintaining the integrity of our financial systems and protecting investors’ assets.

In addition to being underfunded and understaffed, a recent report released by the Project on Government Oversight (POGO) questions the SEC’s ability to remain independent in light of a “revolving door” through which SEC staffers leave the agency for jobs at law and accounting firms that advise the public companies they once regulated.

“The financial meltdown of 2008 brought renewed focus to the integrity and aggressiveness of federal government oversight of the financial system,” the report’s executive summary states. “One of the most important agencies overseeing financial markets and investor protection is the [SEC].”

The report is based on the group’s analyses of hundreds of SEC documents obtained under the Freedom of Information Act – mainly statements that former employees file if they plan to represent a client before the Commission within two years of leaving the SEC. According to the report:

  • Between 2006 and 2010, 219 former SEC employees filed 789 post-employment statements indicating their intent to represent an outside client before the Commission, with half coming from the Division of Enforcement. Some statements were filed within days of leaving the Commission.
    • There are 131 entities providing legal, accounting, consulting and other services that were identified as new employers in the statements. Some entities recruited numerous SEC employees within the five year period after the employee left the SEC.
  • One recent empirical study uncovered several significant and systematic biases in the SEC’s enforcement patterns and found indirect evidence to support the contention that, “Post-agency employment at higher salaries may operate as a quid pro quo in return for favorable regulatory treatment.”
  • POGO says that its findings lend credence to the concerns of SEC critics wary of the commission’s ability to remain independent. It also notes that the troubling traffic moves two ways. “The revolving door also operates in the opposite direction, where individuals come from entities regulated by the SEC to work for the Commission,” states the report. “The general concern is that a conflict of interest could bias SEC oversight and undermine public confidence in the SEC’s work, as acknowledged by the current SEC chairman.”

What does this mean for your portfolio? It means that you cannot rely on the SEC alone to police the market. Why rely on an underfunded and understaffed regulatory body?