Regulation in theory and reality

It seems to me that a perception exists among much of the public that the solution to various ills in the economy, particularly the financial sector, is expanded regulation. By applying close scrutiny regulators can identify and head off problems before they start, thus protecting consumers. The calm, neutral view of regulators can exert a calming influence on the sturm und drang of the marketplace.

It's with this in mind that I read this Washington Post story this morning about the failure of the Securities and Exchange Commission to uncover the financial mismanagement of Bernard Madoff and halt arguably the most significant financial misconduct since Enron. Perhaps the saddest part of the whole episode is that it isn't as though the SEC turned a blind eye to Madoff or exhibited a lack of awareness -- they actually investigated him five times:

At least five times over nearly 20 years, the SEC has investigated Madoff's business, but it never discovered the tremendous fraud. In 2007, for instance, the agency reviewed his activities after warnings from a one-time rival, Harry Markopolos, that Madoff was probably running a Ponzi scheme.

This inability to detect Madoff's shenanigans is not a product of incompetence. In fact, looking over documents produced by Madoff one SEC staffer immediately saw that something was amiss and tried to raise a red flag:

The agency asked Madoff to turn over reams of information -- accounting statements, trade confirmations and other documents -- and told him to detail his strategy, called "split-strike conversion." Madoff told the SEC that he used sophisticated trading practices to buy and sell stocks, employing stock options as hedges to limit losses. He told investors he never lost money.

Walker-Lightfoot, a staff lawyer, had previously worked at the American Stock Exchange, where she developed an expertise in specialized trading strategies. When she reviewed the paper documents and electronic data supplied by Madoff, she found it full of inconsistencies, according to documents, a former SEC official and another person knowledgeable about the 2004 investigation.

For example, the standard industry practice was that a firm buying a security must pay for it -- or "settle" -- within three days. But Madoff's settlements were erratic. Sometimes he settled only a day later after the purchase, sometimes seven days later.

She was also focused on his claim that he was using the same strategy for all his investors, which would involve trading stocks and hedges at the same time. On review, he seemed to be following different approaches on different accounts.

The staffer's concerns, however, were essentially ignored. Rather than delving deeper the staffer was told to devote her energies to a project that regulators were under pressure to pursue:

One month after Walker-Lightfoot raised her concerns, Donohue told her to focus on a separate probe into mutual funds, documents show. At the time, there was intense pressure to investigate this industry. The press and other regulators, such as then-New York Attorney General Eliot L. Spitzer, were challenging industry practices. About a dozen of her colleagues were already assigned to pursue the issue.

Walker-Lightfoot e-mailed Donohue, saying she was "not sure what you want [J]acqui [Wood] and I to do concerning Madoff, but I'm focusing on the mutual fund project, as requested." She asked, "Should we just focus on mutual funds and return to Madoff when we're done?"

The next morning, Donohue responded: "Concentrate on mutual funds for the time being."

A few weeks later, Donohue told Walker-Lightfoot to turn over her work on Madoff to Wood, according to a person familiar with the matter. Not long after that, the material was boxed by Wood for transfer, this person said.

To top it all off, there are suggestions that Madoff may have actually enjoyed a close relationship with the very people that were in charge of monitoring him:

[SEC Inspector General H. David] Kotz said earlier this year that he was looking into "allegations of conflicts of interest regarding relationships between any SEC officials and members of the Madoff family and whether such relationships in any way affected the manner in which the SEC conducted its regulatory oversight of Bernard Madoff."

Swanson married Shana Madoff in 2007. The SEC has said he worked on reviews related to Madoff in 1999 and 2004 but he never did while he was involved with his future wife. SEC officials are not permitted to work on matters that involve people with whom they're romantically linked.

Madoff boasted at a business roundtable discussion about his close relationship with SEC regulators, saying "my niece just married one."

A few lessons that can perhaps be drawn from this episode:

• Regulators, lacking skin in the game, might not be well attuned to uncovering problems in the area they are tasked with monitoring. Calm and neutral isn't far removed from simple disinterest.

• To the extent that regulators are motivated, it may be to serve a political agenda. Politics and government are not easily separated.

• Those being regulated may try to influence those that are tasked with monitoring them. The public sector may be captured by private interests for their own ends.