SEC Should Focus on Prevention

The Obama administration supports a Securities and Exchange Commission (SEC) request for a budget increase of $245 million. The SEC argues that it needs more money to carry out the wider responsibilities of implementing the 2010 Dodd-Frank law, as well as to "achieve multiple, high-priority initiatives," including conducting "essential activities to protect investors."

The budget would fund 1,190 positions in the Office of Compliance Inspections and Examinations, an increase of 222 from the current level. About 90% of the new jobs would be in the exam program, where the SEC says it needs to oversee "an expanding universe of entities," including 10,000 registered investment advisory firms.

The SEC needs more examiners, but I find President Obama's timing a little suspect. Is he really worried about protecting investors, or is he simply engaging in election-year posturing, so voters see him as tough on Wall Street greed and corruption?

The budget recommendation has to make its way past the politicians who support Wall Street's goal of less scrutiny. But here is the reality: Even if the funding hike survives, additional examiners will not help investors all that much.

Investors need services that prevent fraud, not examinations that detect schemes and scams after the fact. Just ask Bernie Madoff's clients what would have helped them most -- prevention or detection.

Auditing licensed firms more frequently, as the SEC suggests it will do if it gets its budget increase, may detect some fraudulent activities. But those activities are only the tip of the iceberg. Even more investment fraud is perpetrated by unlicensed, unregistered firms that operate outside the sphere of regulatory oversight.

Regulators typically don't even know these firms exist until they receive a complaint from an investor. At that point, it is usually too late. All or most of the investor's money is already gone.

Very few investors ask individuals and firms to prove they hold current licenses. Even fewer validate the licensing with regulatory agencies. I guess you could say investors are at fault for not conducting a minimal amount of due diligence that would protect their financial interests, but many investors fall victim to illogical thinking. They convince themselves that fraud only happens to the other guy.

If the SEC focused on prevention, maybe it would uncover more of these questionable firms before it was too late for investors.

Why do Wall Street firms spend $300 million per year on lobbyists who fight regulations that could prevent fraud? I think the reason is clear. Preventive regulations would reduce the bonuses of Wall Street executives. For example, consider what would have happened if Goldman Sachs had been required to disclose its bets against the investments it sold its clients. No one would have bought the investments, and Goldman Sachs' executives would have received smaller bonuses.

It's in Wall Street's best interests to make investors responsible to protect themselves from bad financial advice, bad investment products, and scams. This means investors have to know the right questions to ask, conduct their own due diligence, and know good answers from bad ones. Wall Street knows fewer than 5% of investors have developed processes to gather and evaluate the information that financial advisers provide. And even fewer validate the accuracy of the information with third parties.

Investors need services that will help them avoid scams before they lose all or most of their assets. Regulators could create these services tomorrow, but politicians on Wall Street's payola list will not let this happen. If there is going to be a solution for investors, it will come from private companies, not agencies that are controlled by politicians, like the SEC, or agencies controlled by Wall Street executives, like the Financial Industry Regulatory Authority.

I'm adding tools and services on my own Website that investors can use to gather data about financial advisers, firms, and products before they invest. The tools provide the information investors need to detect unlicensed advisers and firms, bad investment products, excessive expenses, and poor performance. More importantly, the tools do the work for investors, who just have to spend a few minutes reading the reports the tools produce and send to their user accounts. These free services will be available by mid-month.