The WSJ reports on the sad history of miscues by the SEC in the Madoff case.
An enforcement case 16 years ago gave the Securities and Exchange Commission its first shot at figuring out how Bernard Madoff could rack up favorable returns with such uncanny consistency. After that, it received repeated warnings from outside whistle-blowers and at least twice looked into Mr. Madoff's brokerage itself. Each time, it blew its chance.
The WSJ observes that the case "will likely fuel calls for more regulation of areas that have fallen outside the scope of oversight."
But as I've said, the case actually adds to the argument against regulation. As a WSJ editorial says:
We are now supposed to believe that the same SEC lawyers who couldn't detect a fraud at a firm for which they were directly responsible would somehow have done so if only they had been able to examine other hedge funds that invested in Madoff Securities. Thus does every enforcement failure become an excuse for more enforcement, especially among law-school professors and journalists who specialize in hindsight. * * * The reality is that it is impossible for the SEC or any regulator to prevent every financial fraud, just as it is impossible for city police to prevent every burglary. If even Mr. Madoff's two sons claim not to have known about the scheme, despite working at the firm for decades, how can we expect outside regulators to do better?
* * *The real lesson here is about men, not markets. Human nature doesn't change, and crooks will always be with us. For investors the lessons are the eternal ones of diversification and diligence. Don't trust your life savings with any single money manager or investment. Don't assume that passing some new federal law will banish financial fraud, any more than "campaign finance reform" will stop the likes of Rod Blagojevich from trading political favors for money.
But, the advocates of regulation will persist, even if we can't eliminate fraud, we can at least do a better job. However, this path leads to two real dangers.
First, it can make investors over-confident or over-trusting. I have repeatedly (e.g.,here and here) referred to this excerpt from Market v. Regulatory Responses to Corporate Fraud, 28 J. Corp. L. 1 (2002) at 53, draft here:
Corporate frauds arguably were facilitated because there was too much investor confidence, as indicated by investors' willingness to ignore what the market knew about questionable accounting and to not question firms' extravagant claims about unproven business plans. Overselling regulation might perpetuate this misjudgment and mislead investors back into the same complacency that contributed to the recent frauds.
This quote applies well to what happened in Madoff. Fraud regulation and financial supervision are supposed to increase investor confidence. But given regulators' inherent defects, there's a real problem of investor over-confidence. What you want is healthy investor skepticism.
The second danger comes from fixing the first. A determined regulation advocate will insist that at some level we can really make investors safe. But even if that's true, the necessary regulation would seriously constrain the kind of risky activity that is necessary to grow the economy. We'd have to distrust all innovation, particularly financial innovation, and turn business people into bureaucrats. Just what we don't need right now.
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