Under Chris Cox’s weak chairmanship, critics characterized the SEC as a combination pro-management training camp, graduate school and employment agency. Why? Most of their alumni go directly to work as fund and securities industry insiders, directors, ICI staffers, legal counsel and lobbyists. So it‘s no wonder they all have close working relationships, before and after. This regulatory agency operates like the classic three monkeys who ‘see no evil, hear no evil and speak no evil,’ especially when it comes to acting in an oversight capacity of mutual fund managers exercising controls over Washington politicians, Congressional committees and also staff regulators at the Securities and Exchange Commission.
“The fund industry’s moral compass is broken” said John P. Freeman in his Senate testimony. Freeman, a former SEC staff attorney, professor of law at the University of South Carolina, and along with Eliot Spitzer and Jack Bogle, is one of the SEC’s loudest critics. Freeman was echoing an indictment similar to one made a year earlier by Don Phillips, managing director of the highly respected Morningstar fund data trackers.
“Broken moral compass!” What great imagery and a powerful indictment of the fund industry and a great headline journalists love quoting. But what happened? Why was the industry’s “moral compass broken?” Reading Freeman’s testimony before Congress made it painfully obvious why the fund industry’s moral compass is broken. The $10 trillion fund industry’s moral compass is broken … because the SEC’s moral compass is broken.
The SEC is responsible for regulating the fund industry. But unfortunately, the SEC is like a weak parent with no backbone, no sense of discipline, and no moral values. They let their children get away with murder. And then, lacking any moral training, these kids graduate, leave home and go to work in the real world, for their friends in the fund industry—the very people the SEC was supposed to be regulating in order to protect investors.
The SEC fails, self-regulation fails—Wall Street loves it!
Instead, the SEC are so pro-management, they consistently relegate their responsibilities to the very people they should be regulating. As SEC spokesman John Nester put it in early 2007, “The SEC can’t be in all places, so the fastest way to stop illicit behavior is for the company to take the first steps.” Fastest? What a joke! He was referring to the practice of backdating of options, which had been going on for as long as twelve years. And in the case of fund industry “illicit practices,” in 2004 we learned they had been going on for decades. The truth is, this kind of implied self-policing doesn’t work with a weak regulator like the SEC—but Wall Street loves it. From an ethical point-of-view the picture Freeman paints of the SEC is extremely disturbing. We see the SEC as a combination training camp, graduate school and employment agency working closely with the mutual fund industry—protecting management from investors rather than the other way around.
Training camp for cushy insider jobs
So many of the SEC’s alumni graduate with brilliant minds but no moral training or compass. Indeed, all too many SEC employees spend their years working with but one goal in mind—to get the experience necessary for a high-paid job working inside the fund industry where they will continue helping wealthy fund owners and managers secretly skim money from their fund investors.
Professor Freeman’s testimony revealed some of these dirty little secrets inside the SEC’s Division of Investment Management (DIM), the group within the SEC that oversees the mutual fund industry. Listen as Freeman tells us about the SEC’s lack of a moral compass: “Bluntly stated, over time, DIM has become far too deferential to the industry.” The situation reminds us of what criminologists call the “Stockholm Syndrome,” a bizarre psychological phenomenon where hostages sympathize with and even protect their captors. “The SEC’s Division of Investment Management represents a Chihuahua watchdog, not the Doberman that shareholders need. And then there are the DIM alums. What we almost always find when SEC staffers move on are SEC-honed skills being put to work protecting the wealth of fund managers, not fund shareholders.”
So while the SEC was originally created in 1940 as an advocate for investor, over time, the SEC has morphed into a training camp, a graduate school and an employment agency for industry insiders. As Freeman puts it: “My analysis of SEC personnel movements, using data I obtained from the SEC under the Freedom of Information Act, shows that most of the SEC’s senior personal who leave the DIM go to work for mutual funds as officers or directors, or for the ICI [the Investment Company Institute, the industry’s lobbying organization], or for service suppliers (law firms or accounting firms) who advise fund sponsors.”
Incest between SEC and fund industry
In other words, thanks to the industry’s policy of hiring SEC staffers, over the years the fund industry has evolved into an incestuous secret society of professionals with its own self-serving code of ethics, most of whom graduate from the same “school,” where their “major” is learning the nuances of manipulating fund companies and investors, in order to help industry insiders get rich and richer: “These professionals are dedicated to protecting the industry’s managers, and the industry’s managers have an agenda that does not place the fund shareholders first,” says the good professor. “When I was working with the SEC in DIM years ago, I was told by a fellow staff lawyer: ‘Let’s face it, in five years we’ll all be working for those guys.’ Then and now, that staff lawyer’s observation holds true. I tell you bluntly the SEC has failed mutual fund investors.”
Then in one incredibly succinct summary of today’s problems with the SEC, Freeman quotes Nobel Laureate Paul Samuelson’s warning on fund reforms made at another Senate hearing back in the late sixties:”There is a danger that government commissions, set up.…originally to regulate an industry, will in fact end up as a tool of that industry, becoming more concerned to protect it from competition than to protect the consumer.”
And exactly as Samuelson predicted, that has indeed come to pass at the SEC. Freeman’s testimony has forced me to shift my view of the SEC dramatically, as one simple conclusion became obvious: Today it is clear that the primary reason the fund industry’s moral compass is broken is very simple—because the SEC’s moral compass is broken.
Weak parents lack values, raise kids without moral values
The SEC is indeed like a parent with no morals, no discipline and no backbone. They are letting their kids get away with murder. And when these “kids” graduate and go to work in the fund industry, they carry with them the same broken moral compass—so it’s no wonder both the SEC and also the fund industry have “broken moral compasses.” You may argue that the SEC is not supposed to take on the responsibilities of moral leadership. You may defend the SEC, arguing that their sole responsibility is simple to make regulations and enforce the law. But they fail there because of the lack of moral integrity.
Aside from the fact that the SEC is doing a miserable job setting up regulations and enforcing the law, such arguments reveal a shallow understanding of America’s legal system, at least the system drummed in me at the University of Virginia Law School. In fact, the legal system of every society is always grounded in the society’s moral values. And when those morals are compromised, the legal system is weakened.
SEC lost its moral compass long ago … and corruption spread
Bottom line: The reason the SEC has failed at its job enforcing the law is simply because SEC is at the core a miserable failure as a moral leader—the system is biased, weak, undisciplined, ineffective and ethically corrupt, which is widely obvious since Chris Cox stepped down as SEC chairman. And because of the SEC’s failure as a moral leader, the mutual fund industry has also deteriorated into a culture with no morals, no ethics, no integrity and no sense of what it means to have a primary fiduciary duty to first to protect the investors who entrust it with $10 trillion, a duty that should come ahead of the interests of the fund owners and managers.
So the next time you wonder how the hell things got so far out-of-whack prior to the scandals of 2002-2004, remember, it was a very long time coming, going back to the 1940’s Act. Corruption on such a massive, widespread scale—involving such name brands as Putnam, Alliance, Strong, Franklin Templeton, PBHG, Merrill Lynch, Bank of America, Smith Barney, MFS, Federated, Bank One, Schwab, Alger, and Wilshire—is clear evidence of a conspiracy-in-fact. And the SEC charged with regulating this industry was looking the other way for a long time too ignoring that funds were illegally taking advantage of millions of their own investors. Unfortunately, today, the SEC is in total denial and incapable of seeing the problem or changing their behavior.
Instead, the SEC are so pro-management, they consistently relegate their responsibilities to the very people they should be regulating. As SEC spokesman John Nester put it in early 2007, “The SEC can’t be in all places, so the fastest way to stop illicit behavior is for the company to take the first steps.” Fastest? What a joke! He was referring to the practice of backdating of options, which had been going on for as long as twelve years. And in the case of fund industry “illicit practices,” in 2004 we learned they had been going on for decades. The truth is, this kind of implied self-policing doesn’t work with a weak regulator like the SEC—but Wall Street loves it.
From an ethical point-of-view the picture Freeman paints of the SEC is extremely disturbing. We see the SEC as a combination training camp, graduate school and employment agency working closely with the mutual fund industry—protecting management from investors rather than the other way around.