A Crazy Idea for the SEC

I’ve got a crazy idea for the Securities and Exchange Commission. And when I say crazy I don’t mean in a cool, this is awesome way. I mean in an I could be accused of not knowing what I’m talking about crazy. Here is the idea: we should link the compensation of SEC regulators to the stability of the stock market.

Something like this could probably never happen, but that is the fun of blogging. Here is the logic-ish:

If you consider the research that short sellers (should) conduct before doing a trade, you could make the argument that short sellers do some of the work of the SEC. They dig into companies. They root out failures. And they bet against them. Imagine there were two lists of short selling activities: one for shorts on companies that are honest but just suck, and the other for shorts on companies that are corrupt and are about to blow up. I would place money on the short seller’s ability to detect corruption over the SEC’s ability any day. Why? Because they have a financial incentive to get it right.

Now, what happens to an SEC regulator that misses Bernie Madoff, or Lehman accounting shenanigans? Not much. Some might claim they have a loss of faceā€”but do you know who the individual people at the SEC that missed this were? Pretty much anyone, including a bunch of the people on Wall Street, could probably only name Christopher Cox, the former hands-off head of the SEC. Did anyone get fired for missing Madoff?

Well, what if regulators were paid a base wage, and then a commission for the bad guys they nailed, or some kind of adjusted pay for keeping the market stable. A Lehman bankruptcy because the SEC turned a blind eye to bogus accounting practices would cut into their pay, or fire people all together. You might say it wasn’t the SEC’s fault that Lehman failed, that plenty of people were invested in them, and you’d be right on both counts. Lehman failed because they had a terrible operating model. But there were people who saw the Lehman failure coming. And shorted Lehman. Put that on a specialized short board for the corrupt, and we’ve got a cleaner system.

Okay, there are a million caveats to this. And a million ways this could be done wrong to create more problems in the market. By broader point is that some how aligning the incentives of regulators with the market that they oversee to try and ensure more effective prosecution of fraud wouldn’t be a bad thing.