Drowning in fines

Buttonwood

Dec 6th 2005 NEW YORK
From The Economist Global Agenda

Regulators love to trumpet the big penalties they impose on financial transgressors. How they treat the money is almost a crime in itself

UNTIL 1934, the successors of those who first gathered under the tree that gave this column its name regarded themselves as the free-market regulators of America’s finest businesses (or at least the finest businesses that needed outside capital) and as the foremost advocates of investor interests (meaning their own). Among their proud achievements was the introduction of the annual report, first recommended by the New York Stock Exchange in 1895, to provide “a full report of the operations of the company during its preceding fiscal year”.

Initially, these reports were quite dry, often no more than a financial statement. The penalties for falsehood were simple, as well: a delisting, perhaps, or loss of reputation. The capital markets were known to be populated by sharks; investors participated at their own risk. Life became more complicated following the 1929 market crash with the creation, five years later, of the Securities and Exchange Commission (SEC) and the passage of disclosure laws. Over time, the annual report has swollen into the enormous volumes that today clog our mail, physical and electronic: part legal document, part bold-faced self-congratulation and part place to confess, carefully and unobtrusively, the odd failure. Few better examples of this delicate balance are to be had than the annual report recently released by the SEC itself.

Like most annual reports, the SEC’s begins with a unifying theme written by its leading executive, the chairman, Christopher Cox (“We are a nation of investors”), and a statement of integrity (“Our financial statements were presented fairly”) but then alludes to the kind of issues that, if the SEC were a private company, could send stock prices plunging: weaknesses in internal controls and overspending.

The newest problem to emerge is perhaps the mildest: an audit revealed that an extra $49m was spent on the new SEC headquarters. Mr Cox vows to extract the entire amount from the commission’s operating budget for this fiscal year (which began on October 1st), although this will mean curbs on resources and hiring. Apparently, the enthusiasm for boosting the SEC, born of the scandals of recent years, which convinced Congress to lavish as much money on the commission as it could take, has run its course.

Far more serious is a weakness discovered last year that has yet to be resolved: the inability of the SEC to make sense of all the money coming from various companies and individuals paying fines and “disgorgements” to settle charges from the flood of litigation in recent years. According to the footnotes in the SEC’s report, in the year to September 30th the commission collected $1.6 billion, of which only $302m went back to harmed investors.

Of the rest, $207m was sent to the Treasury and $1.1 billion is being held for future distribution, bringing the total that has yet to be paid out to roughly $2 billion. Another $1.4 billion in announced fines is yet to roll in—though the SEC expects to collect only $96m of it. Where, precisely, all this money came from and where it should go is not clear.

Worse still, after its audit in 2004, the SEC determined that its systems for recording penalties and disgorgements were inadequate, resulting in inaccuracies. In response to this problem, the commission’s staff put a tremendous amount of effort into trying to account manually for fines and disbursements. These efforts do not appear to have been entirely successful. An audit of the results found significant errors. Adding to the mess, there are apparently two SEC departments responsible for disgorgements and penalties, and communication between them is not as effective as it should be. A listed company that was similarly incapable of dealing with its revenues and accurately paying out claims could expect to face shareholder lawsuits. In fact, it might well receive a call from the SEC.

Other failings disclosed in the SEC’s report also look like precisely the sorts of problems the commission exists to prevent in listed companies. There are weaknesses in its information-security controls, resulting in “increased risk of unauthorised individuals being allowed to access, alter or abuse proprietary SEC programs and electronic data and assets.” The commission also admits to being unable to produce reliable and timely financial statements without a lot of manual labour.

As bad as this sounds, the SEC is in better shape than many of the states which in recent years have played prominent roles in prosecuting financial firms and received large settlements. At least the commission is being open about its problems. Numbers, even if they might be wrong, are published and there is clearly pressure from within to make them as accurate as possible. By alluding to the weaknesses on the first page of the annual report, Mr Cox, who is new to the job, is making his priorities plain.

As an example of the record of state regulators, take the office of New York’s attorney-general, Eliot Spitzer. New York received $100m in a settlement with Merrill Lynch, after the equity-research furore, and $40m in another with Canary Capital, over mutual-fund trades. All of it has been funnelled into the state’s general fund. None has yet gone back to the investors who had been ripped off. There is also a large pot of money, derived from the general equity-research settlement between Wall Street firms and federal and state regulators, that was earmarked for investor education and is sitting with something called the Investor Protection Trust. Most of this remains unspent, largely because no one can agree on what should be done with it.

The old system of deterrence run by the traders on the New York Stock Exchange clearly had its limits. Its expectations of behaviour, however, were also modest. If the SEC’s annual report has an underlying message, it is that the transition to a better system is far from complete.

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