We all know that the SEC proved entirely incompetent when it came to catching Bernie Madoff. But until something better comes along, don’t we still need the SEC’s fraud enforcement? Wouldn’t fraud run rampant without a “cop on the beat,” even one as ineffective as the SEC?
Maybe not. A new study suggests that the securities market is a better regulator than the SEC.
The authors of the study look at a number of companies whose options grant timing looked suspiciously like they were backdated. And although these companies were never the subjects of a formal investigation, their stock prices experienced significant declines. And this wasn’t just due to rocky markets pushing down all stocks—firms not predicted to have backdating problems had normal stock performance.
From the study:
Using a large sample of option granting firms, some of which were investigated for option grant backdating, we develop a predictive model for such investigations and examine how the capital market responded as the backdating scandal unfolded. Firms that were investigated experienced significant stock price declines from the beginning of the Wall Street Journal’s Perfect Payday series through the end of 2006. Firms predicted to have backdating problems, but not the subject of publicly revealed investigations, experienced stock price performance during the same period that was remarkably similar to that of firms with publicly revealed investigations. In contrast, firms not predicted to have backdating problems experienced normal stock price performance. Our results suggest that capital markets disciplined companies with suspicious option grant histories, often prior to, and irrespective of, any public revelation of an investigation into the matter.
As law professor Larry Ribstein points out, two of the study’s authors were the finance professors who originally uncovered the backdating problem and inspired the big Wall Street Journal expose.
“In other words, finance professors spotted the problem, and journalists and the market publicized it and punished the companies that needed punishment,” Ribstein writes.
It’s possible that the stock market punished these companies in the expectation of a future investigation and SEC fine. But that’s highly speculative—it requires us to believe that shareholders wrongly anticipated further investigations even while many of us were writing that the legal consequences of the crisis would likely be minor and passing.
This indicates—although doesn’t decisively prove—that the market might do very well without the SEC. Indeed, it calls into question whether the SEC’s anti-fraud activities are really doing very much good at all. That’s important because the perception of the SEC as policing the market has real costs—investors can become overconfident that the market is safer than it actually is. Without the SEC, Madoff may never have been possible since its lack of interest in him was taken by many to be a tacit endorsement of his firm.
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