Former Commissioner Speaks About SEC’s Role in Rapidly Changing Market

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Troy A. Paredes offers his views on recent regulatory developments at a Penn seminar.

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The past five years were the busiest in the history of the Securities and Exchange Commission (SEC) according to Troy A. Paredes, former Commissioner of the SEC, who reflected on his term during a recent seminar hosted by the Penn Wharton Public Policy Initiative.

Parades lived through these busy and tumultuous years, serving as a Commissioner from August 2008—just before the outbreak of the financial crisis—until August 2013.  Not only did the financial crisis make the SEC busy, but it also revealed issues and risks previously overlooked in the financial sector.  As a response, the SEC’s role continued to grow during and after the financial crisis according to Paredes.  Furthermore, the Dodd-Frank Wall Street Reform and Consumer Protection Act, which became effective in July 2010, expanded government’s power and gave the SEC a new set of rulemaking, supervisory, and enforcement responsibilities.

The SEC is an independent agency, more isolated from political pressure than agencies in the executive branch.  It is headed by five Commissioners, of which “no more than three … may belong to the same political party.” Not only do Commissioners come from different philosophical and political backgrounds, but each Commissioner is independent and non-chair Commissioners can, and often do, challenge the Chair.

The key role of the SEC lies in the enforcement of law.  Before being appointed to his position as a Commissioner, Paredes was a practicing lawyer and an academic.  He described it as a “very sobering” responsibility to determine whether to charge someone with violating a law, since doing so is a powerful assertion of government authority and even a mere allegation that a person or entity engaged in unlawful activity can be disruptive and detrimental.

Despite Parades’ acknowledgment of the gravity associated with making charging decisions, he emphasized that robust enforcement is key to achieving the SEC’s mission.  In particular, when the financial sector lost public trust due to the financial crisis and other alleged misconduct, the SEC needed to be tough in enforcement to improve business ethics and regain public trust.

At the same time, enforcement requires clear evidence of legal violations and strict adherence to due process.  Paredes acknowledged this clear enforcement boundary: although public sentiment understandably supports increasing prosecutions of and sanctions against the individuals and entities that were possibly responsible for the crisis or are engaged in other unethical conduct, there can be no sanction unless the facts and law justify liability.  Unfortunate outcomes do not by themselves justify enforcement actions.

Paredes further explained his view on deterrent effects of law enforcement.  Law enforcement claims to have deterrent effects, warding off future misconduct.  Yet claims about deterrence are based on empirical assumptions that people make rational decisions to engage in misconduct after weighing the possibility of detection, magnitude of sanctions, and expected payoff.  Research demonstrates that human behavior in making decisions is more complicated and less rational.  Therefore, even a robust law enforcement effort supported by stringent investigation might not be sufficient to prevent misconduct.

With regard to preventing misconduct, Parades further noted that many fraud cases suggest that individuals invest in opportunities that are “too good to be true.” Thus, increasing investor education and financial literacy might be as effective for deterring public harm resulting from financial misconduct as increasing enforcement activity, Paredes suggested.

Paredes shared concern about the possibility of overregulation—in his view, regulatory burdens under the Dodd-Frank Act are too high, with recent regulatory changes having created thousands of pages of new rules.  These new requirements also cause practical challenges to people engaging in business.  First, it is unrealistic to expect that the users, particularly those who make business decisions such as traders and investment bankers, can understand all the applicable rules.  Second, multiple regulators involved in the new framework might have conflicting views.  Excessively restrictive and complicated regulations will lead to loss of business opportunities, and could harm competitiveness and reduce economic growth.

Paredes expressed skepticism about the effectiveness of the new regulations in preventing another crisis.  In his view, rather than micro-managing business activities of financial institutions, laws and regulations should focus on capital and leverage ratio requirements to ensure financial institutions maintain sufficient liquidity to cover risks associated with their business.

Finally, answering questions from the audience, Paredes touched upon the post-Madoff SEC reforms.  In the aftermath of the Madoff case, it has been reported that the SEC did not properly respond to the multiple substantive complaints regarding Madoff’s conduct prior to the public scandal, in addition to overlooking red flags in the few examinations it did conduct.  The SEC, in response, improved its complaints handling system and implemented a risk-based examination system.

In addition, Paredes emphasized that attracting and retaining talent is always in the SEC’s interest.  Traditionally, the SEC has been lawyer-dominated agency.  Recent innovations in the financial market as well as issues identified during and after the financial crisis, most notably the Madoff case, have affirmed the need for industry and market knowledge to detect and investigate issues effectively.  Therefore, as a part of the post-Madoff reforms, the SEC has acquired more staff with industry-specific expertise.  The turmoil in the financial sector during the recent crisis encouraged some industry experts to move to the SEC, and their knowledge, Paredes said, has contributed to improving the Commission’s regulatory capacity.