Reforming the SEC: Looking Around the Corner

The truth is that the most far reaching reforms apparently ongoing inside the SEC have been disclosed in only small snippets.  Rather than pick up the pieces once a fraud has self-imploded, the Division of Enforcement will be most effective if it can learn to intervene while the fraud is still in progress.  It would mean a proactive rather than reactive approach. To do so means developing techniques for spotting fraud as they occur.  It also means amassing the data that will allow the SEC to uncover this activity. 

In describing one of the specialty areas, Robert Khuzami, in his speech before the New York City Bar, called for the creation of The Market Abuse Unit.  In describing the unit, he noted that the Commission was developing tools for uncovering the complex frauds.

• We expect to build some of our own technological tools and screening programs to ferret out suspicious trading activity. We expect to use these tools to analyze trading and other activity across markets, including equities, debt securities and derivatives, and across different corporate announcements and other market events. This will allow us to see patterns, connections and relationships that might otherwise not be apparent if one were focused on a single security or single announcement.

Likewise, the Commission plans to apply risk and other criteria to the hundreds of thousands of tips provided to the Agency each year.  As Khuzami described in his speech: 

• It is this Office that will be responsible for the collection, analysis, risk-weighing, triage, referral and monitoring of the hundreds of thousands of tips, complaints and referrals that the Agency receives each year. By analyzing each tip according to our internally-developed risk criteria, as well as our priorities, and by making connections between and among tips from different sources, we will be better able to focus our resources on those tips with the greatest potential for uncovering wrongdoing. This Office of Market Intelligence will also utilize the expertise of the Agency's other Divisions and of our Specialized Units to help analyze the tips and identify wrongdoing.

In other words, the Commission plans to use tools designed to spot fraud as it occurs.  Moreover, in a speech given back in March, Commissioner Aguilar called on the SEC to get into the business of market surveillance.  While noting that it was a task normally undertaken by the stock exchange, he emphasized that the SEC had broader responsibilities and could not simply outsource its responsibilities in this area.  Moreover, once collected, the "information should feed into state-of-the-art surveillance and analysis programs, manned by appropriately trained staff, to monitor for quantitative signals of possible misconduct."

In short, the emphasis is on detection while the fraud is underway.  There were times when Madoff indicated that his profits came from options trading, something that could probably have been verified by any surveillance system connected to a robust analysis program.  Whether Madoff or Enron, these frauds were of massive proportion and were spotted by some in the market.  Commission surveillance and analysis ought to be able to do just as well.

To the extent the Commission moves in this proactive direction, however, it will need to shear off its dependency on stats.  Investigations started because anomalous activity popped out of a monitoring program will often prove fruitless.  Yet even if accurate by one out of ten, the benefits will likely dwarf the costs.  But such an approach will make the stats go down, not up.