01/09/2007: Among some current and former co-workers, I have been involved in a quite lengthy debate over the merits of socialism versus free markets. A few of them are in favor of more government control–in some cases absolute control–of economic assets, while my position is that markets, while far from perfect, are far and away more efficient than government enterprise.
As an example, I pointed out the SEC versus the free market. In the case of the SEC–which serves a useful purpose, which I shall point out later–we have an entire federal agency staffed by brilliant analysts, programmers, and technicians–that aims to ensure the integrity of our capital markets. They focus on insider trading, corporate financial reporting, stock, commodity, and options markets.
The question is, who notices corporate fraud first: the market or the SEC?
Clearly, the SEC is the last link in the chain on that front.
Take the fraud cases of the late 1990s through 2004: Enron, Tyco, Global Crossing, Adelphia Communications, K-Mart, Computer Associates, Dynegy, HealthSouth, and WorldCom.
The investers clearly understood that there was a problem before the SEC did. After all, the SEC didn’t start going after Enron until after their stock had tanked. What caused Enron’s stock price to fall? Investors understood that the stock price was not justified by the lack of return on invested capital (ROIC).
Ditto for Worldcom and Tyco. While Dennis Kozlowski (Tyco) and Bernie Ebbers (WorldCom) were flying high, the SEC took a three-monkey approach. It was only after their stocks headed for the dunghill that the SEC decided that something might be wrong.
In other words, from a pure regulatory standpoint, the SEC is perfect at locking the barn door after the horses are stolen.
With that said, does the SEC serve a useful purpose?
Toward that end, I answer in the affirmative: the SEC is a nice conduit of information through which investors can access financial reports of public companies. All public companies must file official reports with the SEC–annual (10-K) reports, quarterly (10-Q) reports, and other (8-K) filings of importance. These are all available–for free–online.
Through this wonderful tool, investors can evaluate companies against their competitors, against the markets in which they are traded, against current economic conditions, with respect to any number of financial performance metrics.
In addition, an investor can check the footnotes to determine if there are outstanding issues–litigation, special purpose entities, stock option grants–that could impact the company’s future performance.
Ergo, the SEC is helpful in that it provides a function that allows the market to perform more rationally and efficiently.
However, as for its regulatory function, the SEC is very limited in its effectiveness.
They have excellent 20/20 hindsight after the damage is done, and–while they can refer guilty parties for prosecution by the Department of Justice–they have only the power to pursue civil cases. Typically, those are useless because the businesses in question are either financially crippled if not bankrupt.
But as an information repository, they are useful to the savvy investor.