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The False Security of the SEC

Founded in the aftermath of the Great Depression, the stated mission of the Securities and Exchange Commission (SEC) is “to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.” While this seems like a laudable goal, like all forms of government intervention, the actual results are considerably different from the stated intentions.

Consider the following:

  • In 2007, Lou Pearlman was indicted for operating a Ponzi scheme that defrauded investors of more than $300 million over a twenty year period.
  • Tom Petters operated a Ponzi scheme for thirteen years, resulting in losses of $3.65 billion for investors.
  • Allen Stanford operated his Ponzi scheme for nearly fifteen years before he was indicted in 2009.
  • Bernie Madoff, who defrauded investors of more than $65 billion, eluded detection for more than two decades.

These are but a few examples of the fraudulent enterprises that operated for years, and sometimes decades, without discovery by the SEC. In each of these cases, the SEC failed to protect investors. The results were massive financial losses and destroyed lives.

And how long did it take to discover Charles Ponzi’s (for whom “Ponzi Scheme” is named)  fraud in 1920? Operating in an unregulated market prior to the SEC, Ponzi was exposed in about eight months. In a free market, the truth was exposed in less than a year, and countless victims were saved. In contrast, Pearlman, Petters, Stanford, Madoff, and their ilk hid behind the skirt of the SEC to gain legitimacy and thereby more easily defraud a greater number of investors.

What accounts for this difference? Why was Ponzi’s fraud exposed so quickly while more recent frauds take years for the SEC to uncover?

Some have argued the market is too free, that more regulations are required. Indeed, this viewpoint led to the Sarbanes–Oxley Act of 2002 and the Dodd–Frank Wall Street Reform and Consumer Protection Act in 2010. Yet, prior to these statutes, in addition to the SEC, the Financial Industry Regulatory Authority, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, the National Credit Union Administration, Office of Thrift Supervision, and the Federal Reserve all had regulatory authority over financial institutions. In truth, there was no shortage of laws, regulations, and bureaucrats reigning over the financial industry.

Despite this mountain of controls and regulations, Pearlman, Petters, Stanford, Madoff, and their ilk were able to perpetrate massive frauds under the “watchful” eyes of the SEC and other regulators. Even though these fraudsters had to regularly submit piles of reports to regulators, the bureaucrats were unable to detect a fraud. Yet, Charles Ponzi—who had no such requirements—was discovered within months. What accounts for this difference? Why was Ponzi’s fraud exposed so quickly while more recent frauds take years for the SEC to uncover?

It would be easy to claim that regulators are simply incompetent, and there is certainly some evidence to support such a claim. For example, eight SEC employees were disciplined for their handling of the Bernie Madoff case. But incompetence does fully explain the differences between a regulated market and a free market.

It is generally recognized that government interventions distort markets by forcing producers to act differently than they would freely choose. These interventions also motivate consumers to act differently, whether it is through incentives to buy a Chevy Volt, deductions for the interest on home mortgages, or low interest rates. The same is true of regulations intended to protect consumers.

In a regulated market, consumers often trust the government’s stamp of approval on a product. They assume that if a medicine or investment product has met the government’s standards, then it must be safe. Rather than conduct their own due diligence, consumers often suspend judgment in deference to government bureaucrats. As a result, Pearlman, Petters, Stanford, Madoff, and their ilk can hide behind the skirt of the SEC to gain legitimacy and thereby more easily defraud a greater number of investors.

Relying on government regulation for consumer protection is a double-edged sword. Not only does it restrict the freedom of both producers and consumers, it inculcates a false sense of security. It encourages consumers to trust bureaucrats rather than their own independent judgment. When consumers did not rely on the SEC for protection, fraudsters were exposed more quickly and fewer lives were destroyed.