The myth of government protection of financial markets

Larry Ribstein —  21 April 2011

With all the calls for more government supervision of financial markets it’s healthy to keep in mind what the public actually gets from this costly supervision.

In many previous posts (e.g., here, here and here) I summarized the SEC’s egregious incompetence in missing the Madoff fraud. When private firms mess up they get sued and punished by the market.  But the SEC is very much still with us and relatively unscathed by this disaster. 

Notably, a court just dismissed a suit under the Federal Tort Claims Act against the SEC by Madoff investors.  The court applied the “discretionary function exception” to liability which excuses any agency misconduct, no matter how egregious, as long as it was discretionary and somehow grounded in public policy.

Here’s some quotes from the opinion that convey a sense of (a) the court’s views of the SEC’s conduct; and (b) the scope of the exception that protects that conduct from judicial scrutiny:

That the conduct in question defied common sense and reeked of incompetency does not indicate that any formal, specific, mandatory policy was “likely” violated. * * *

Plaintiffs’ arguments that the SEC’s conduct defied common sense or violated an unwritten permissible code of conduct do not provide the necessary factual demonstration that the conduct of which they complain is not covered by the DFE. * * *

The boundaries of the DFE are not, however, delineated by best practices or even the absence of logical, responsible practices. Claims escape its scope only where the injury-producing government action was specifically non-discretionary, or where a discretionary action that caused injury was not one that was susceptible to policy analysis. * * *

Note to private firms, which unlike the SEC are subject to market discipline:  don’t expect similar treatment from a court.

Meanwhile the FDIC is arguing that if only Dodd-Frank had been law in 2008 the FDIC could have averted the Lehman crisis.  David Skeel appropriately makes hash of what he calls this “magical thinking”:

[C]laims that regulators will intervene early in a future crisis rather than delaying the inevitable (that “next time will be different,” to paraphrase the title of a recent book on financial crises), and that they’ll foreswear future bailouts because Dodd-Frank says they aren’t supposed to do them, are wildly implausible.

In Oliver Stone’s sorry film on the financial crisis, Money Never Sleeps (reviewed here) the main character defines insanity as “doing things over and over again and expecting a different result.”  The comment was directed at the flaws of financial markets, but seems more apt for our reliance on government regulation of these markets.

Larry Ribstein

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Professor of Law, University of Illinois College of Law

8 responses to The myth of government protection of financial markets

  1. 

    Maybe I’m just a sucker for conventional wisdom, but the SEC (and a large majority of the rest of financial regulation) has been under Chicago Economics influence since way back in the early 1980s with Reagan’s appointees (Shad at SEC, his chief economists, Jarrell was one – can’t remember the other, etc.). My understanding is that all investigations / prosecutions at the SEC go up to a board of political appointees (and the political appointees direct hires – like head of enforcement) where the decision is ultimately made whether to investigate, prosecute, or not. I think the processes at other financial regulatory enforcement offices are similar. That is why I get confused when the Chicago school (clearly I’m using that term generally for simplicity) chastises the enforcement divisions of places like SEC, CFTC, etc. for not operating properly when the divisions’ bosses (or their bosses bosses – Alan Greenspan, Larry Summers, etc.) are the political appointees (and their direct hires) of the Chicago school / faith. Clearly you could make an argument here that the SEC is independent, but is any political appointee really independent? When organizations don’t work the first thing you generally do is change management (put another way – when ships run aground you fire the Captain) – it appears to me the management has been the same, Chicago School, since the early 1980s – under both Republican and Democratic leadership Presidents . . . and in that time we’ve had the S&L crisis, Tech Bubble, and now the Mortgage Crisis. Thus, whenever the discussion turns to the ineffectiveness of regulation and enforcement to prevent these crisis, and thus it should be abolished or curtailed, I always wonder why “who’s in charge?” is never brought up as an issue. Maybe this is well tread soil on the blog and I’ve missed it – if so, apologies.

    • 

      Because I am still a student of corporations and commercial transactions, I want to begin by saying my knowledge of this area is limited, but consider me a sponge. Its rediculous to see how these companies continue to make these decisions in violation of state and federal laws which result in enourmous harm and damage to the markets and families across the country. The previous posts suggest that those who hold positions with the SEC have been appointed by Presidents or political figures. If this is the case and the idea of government protection of financial markets is a myth, how do you suggest we fix the problem as to avoid a third “depression” or economic break down? If the SEC is responsible for regulating activity and persuing civil litigation in an effort to impose liability but they are failing to do the job, what can be done to hold the members of the SEC accountable for “sleeping on the job?” Some may make the argument that we should elect people who will appoint responsible and dependable candidates, but as it has been previously mentioned, both Republicans and Democrats have played a role in deciding who holds the positions. These instances of fraud, insider trading, false statments about financial stability etc. go on for years before someone takes notice perhaps we should further promote whistle blowing and create incentives for aiding in investigations of these white collar crimes.

    • 

      “Chicago School,” the 21st century version of the Bilderbergers. Yeah, right.

      The If-Only-the-Right-People-Were-in-Charge lament of those who are sure the Regulatory State could be made to work ‘if only’ fails. Why? Because no one can name any regulatory successes that foiled a fraud before losses were suffered that is even an order of magnitude smaller than Madoff’s. The Justice Department always had the power to prosecute frauds after the fact. The SEC was created with the promise that its (always growing) powers of regulation and intereference would prevent large frauds in the market.

      The SEC has failed. It’s time for them to go.

  2. 
    north fork investor 21 April 2011 at 6:47 am

    Larry, Larry, Larry,

    You should probably note which administrations and which SEC Chairmen were in charge during the emasculation and demoralization of the SEC staff which resulted in the Madoff investigative incompetency (and other regulatory failures). Or do you want to blame Schapiro and Levitt on this too?

    • 
      Walter Sobchak 21 April 2011 at 12:57 pm

      Ah yes, the last resort of the supporters of a failing bureaucracy. “It was all George Bush’s fault.” Sorry dude the facts do not back you up.

      The SEC Inspector General’s report states that the SEC received complaints about Madoff’s operation from 1992 on, i.e. during Levitt’s entire reign. The famous Markopolous complaint was made in 1999.

      Mary Schapiro, is as responsible as anyone. She was a Commissioner of the SEC from 1988 to 1994, appointed by Reagan and reappointed by Bush Sr., and named Acting Chairman by Clinton in 1993. Clinton appointed her Chairman of the Commodity Futures Trading Commission in 1994, where she served until 1996. Schapiro became President of NASD Regulation in 1996, and Vice Chairman in 2002, Chairman and CEO in 2006. In 2007 NASD Regulation merged with NYSE Member Regulation to form the Financial Industry Regulatory Authority (FINRA) — the largest non-governmental regulator for all securities firms doing business with the U.S. public and Schapiro became CEO where she was until being appointed Chairman of the SEC in 2009 by Obama.

      “the emasculation and demoralization of the SEC staff”

      Must have occurred well before 1992. In my experience, which ran from 1975 through 2000, they were always the same bureaucratic sludge whenever I dealt with them. They thought they were hot stuff, but otherwise, it was like dealing with the BMV.

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