Capitol Report: Speed of revolving door between SEC and private sector is shocking, says expert on regulatory capture

The revolving door at the Securities and Exchange Commission is making it difficult for an already embattled regulator to fight the excesses of Corporate America, a leading scholar on the subject says.

Luigi Zingales is an economist, a professor of entrepreneurship and finance at the University of Chicago’s Booth School of Business and the director of the Stigler Center for the Study of the Economy and the State whose mission is “to promote and disseminate research on regulatory capture, crony capitalism, and the various distortions that special interest groups impose on capitalism.”

Zingales’ book, Saving Capitalism from Capitalists, was coauthored with Raghuram Rajan, the former head of India’s central bank and a fellow professor at Booth. His latest book, “A Capitalism for the People: Recapturing the Lost Genius of American Prosperity,” promotes intellectual and economic freedom and encourages business schools and academics to increase the common good by encouraging true competition and truly free markets.

In a wide-ranging interview, MarketWatch spoke to Zingales about the SEC’s enforcement record in light of the core values promoted by the Stigler Center.

MarketWatch: The SEC says its mission is to “protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.” Enforcement standalone actions numbers improved for 2017 but are still much lower than 2016 when 548 individual matters were filed and 2015 when 508 new cases were filed.

Officials said we should focus on the impact of the actions not metrics. Why this message now?

See: Key SEC official: Judge enforcement by impact, not stats

Zingales: I’ve been surprised by the intensity of their pursuit of crypto-related fraud. Not that there is not a lot of fraud in that area. For example, I was surprised by promotions of crypto funds for IRAs. But it is a bit disproportionate vis a vis the modest enforcement activity in other sectors. They have a lot of Foreign Corrupt Practices Act cases that they don’t seem to be particularly active on. Why is crypto the first priority? It surprises me.

MarketWatch: The day to day enforcement action I see is focused on retail fraud – elder abuse, small Ponzi schemes, broker-dealer rule-breaking, etc. And yet there’s Elon Musk getting a slap on the wrist for his “going private” tweet that substantially jacked up the Tesla TSLA, +2.15%  stock price.

Zingales: I’d like the SEC to do both if possible. I would not underestimate the importance of stamping out fraud of retail investors. Just look at Amit Seru’s forthcoming paper on financial advisor misconduct. He found 7% percent of advisers have misconduct records, and in some of the largest advisory firms that number is more than 15%. Roughly one third of advisers with misconduct are repeat offenders.

Going after those guys is not a bad idea.

But yes, there is very little attention in situations that could be described as market manipulation. Maybe the SEC sends private warnings we are not aware of but, publicly, there is not much reaction to that.

Read: SEC targets proxy and short selling rules, compensation disclosures for possible changes

MarketWatch: The SEC is generating a lot of activity in support of capital formation. Anything that gets the U.S. more IPOs is on the table including relaxing rules about disclosure or regulatory costs related to audits activities. There is discussion of allowing some companies to report on an annual basis only other than quarterly.

Read also: Behind the push at the SEC to make it easier for IPOs to be launched

See also: SEC looking at reducing auditor reviews at smaller companies

How do you think the prior Silicon Valley IPO experience of SEC chair Jay Clayton and his deputy Bill Hinman predict this focus?

Zingales: One interpretation is that if you have a hammer, everything looks like a nail. If you spend most of your professional life helping IPOs you think this is a very important process and you’ll favor them. It is surprising that at the same time the SEC is so negative about ICOs.

Maybe the SEC realizes there is too much of a gap between the money ICOs are raising and IPO activity and they are trying to reduce this gap by enforcing rules a bit more on the ICOs.

Reducing the cost of IPOs is not necessarily a bad thing because public corporations are disappearing in the U.S. In 2006 I wrote a report for the Committee on Capital Market Regulation on the disappearance of IPOs. The U.S. equity market share of world IPOs dropped dramatically from 2000 to 2005. We concentrated on the issue of the increase of cross-listings during the dot-com bubble and I found the drop could not be explained by changes in the geographical or the sectoral composition of IPOs. I concluded that the most likely cause was a combination of an improvement in the competitors (mostly European equity markets) and an increase in the compliance costs for publicly traded companies.

I am concerned with a world where much of the capital gains happen early on in private markets. Then when the companies are mature they are dumped in the public markets. It means you and I can only invest in the bad stuff and the good stuff is reserved for the private investors.

MarketWatch: That’s a refrain we are hearing from Clayton and some former SEC commissioners. They say “mom and pop 401k” are missing out on investing in the high growth companies because they are staying private longer and are reserved for accredited investors. The concern is that the “unicorn” companies are only going public to provide an exit to wealthy investors at the expense of the unwitting retail investor.

Zingales: I understand the balance.

But the gap between the cost of being private and public is too big. One way to close the gap is to work on both margins–reduce a bit the burden of regulation on public companies and increase it a bit on private companies. I have a paper in 2009 published in the Journal of Accounting Research that “this migration should be stopped not only by deregulating the public market but also by introducing some disclosure standards in the private one.”

For example, many private firms are owned by private equity firms or other investors who are investing our pension money and there is very little visibility on their true metrics.The private equity industry has become so big that adding a bit more transparency there will help. One way to encourage more companies to go public is to shed some light on private equity ownership.

MarketWatch: Many companies go in and out of private equity ownership now. Toys “R” Us, Inc. which recently filed bankruptcy was in and out of private equity ownership. Dell is now talking about going public again via a reverse merger with a publicly traded tracking stock, VMWare VMW, -1.97%  , which would result in Dell going public without having to file and S-1 with the SEC for IPO.

Companies that we thought might never go public like Palantir, the secret data analytics firm co-founded by Peter Thiel, are now talking about it and there’s a rush of unicorns like Uber and Lyft that are talking IPO early next year. Have we reached a top where they can’t stay private anymore or it’s just too enticing?

Zingales: In recent history we have experienced too few companies willing to go public and it is a question the SEC is right to address.

MarketWatch: To go back to enforcement, one company I have been talking to accounting students about is Theranos. Theranos went fifteen years as a private company with sophisticated investors who did not insist on audited financial statements. The SEC charges against founder Elizabeth Holmes and her COO were not about fake technology but about making up the information they sent to investors. Now there are also criminal charges for fraud by the Department of Justice.

Zingales: Not only the technology was made up but the numbers were made up!

More info: The last days of Theranos — the financials were as overhyped as the blood tests

MarketWatch: What is the state of private investing when these accredited investors are not doing even basic due diligence anymore?

Zinglaes: Due diligence is boring but very useful. When investors get excited they might be willing to cut some corners. Eventually, these shortcuts end up being very costly.

MarketWatch: Has the impact of lobbying on the SEC changed from the Obama administration to this administration? It seems like there are industry participants writing more comment letters, meeting more with officials and more active participation in the rule making process than I saw before. Is it the normal cycle or something more?

Zingales: There has been a change in who are the top lobbyists because friends of this administration tend to be different than friends of the prior administration. So, big technology firms are out of favor, and big oil is in favor, just the opposite during the Obama administration. There is clientele effect, but lobbying is bipartisan. I recently read about Facebook hiring Republicans to push a particular issue, for example. What we can certainly say is there is no sign that Trump is “draining the swamp.”

MarketWatch: Is there less or more transparency in that arena?

Zingales: It has clearly become less transparent. President Trump, for example, reversed the decision to release the list of everyone who visits the White House. (Note: The White House finally released some logs in April after the settlement of several lawsuits forced the issue.)

That is clearly a sign of less transparency.

It looks like personal contacts are more important than organized lobbying in the Trump administration. I am not sure that’s much better, maybe it’s even worse. There is less of a formal component, which is more transparent, and more of the informal component.

MarketWatch: People take for granted they can exert personal, professional or financial influence and that activity is not going to show up in the formal tracking mechanisms.

Zingales: Lobbyists know where the soft spots, weak points are and they use them. In this administration the weak points are different. Being considered a friend of Jared Kushner gives you an advantage and lobbyists happily exploit that opportunity since it is more difficult to monitor.

MarketWatch: The Stigler Center highlights the problem of the revolving door and regulatory capture, in particular intellectual capture—when regulators hold back because they admire and aspire to be like their regulatory targets. The average SEC attorney does not aspire to be a shady microcap operator but may aspire to be a compliance officer in a major bank.

Can SEC professionals ever escape these traps given the expertise that is needed to do the job?

Zingales: They can. One option, not very popular, is to pay SEC attorneys more in exchange for a longer period of “cooling off” before taking a job in the private sector. Even though there is an SEC rule that prevents lawyers from taking on a case on the outside that they were involved in as SEC attorneys, the speed at which the doors revolve is quite shocking.

This fast process contributes to an aura of impunity for big companies. Even without a revolving door system it’s very difficult to go after big companies since they have very good lawyers and the SEC may end up losing even if it is right. If on top of all this you add the revolving door problem, it becomes excessive.

One approach to reducing this form of regulatory capture is to mix different sets of expertise at the SEC. One interesting restriction put on the PCAOB, the accounting regulator created by the Sarbanes-Oxley law, is that no more than two of the five board members may be public accountants. The SEC is run by lawyers, so a few more economists, especially in fraud enforcement, may help. This may seem self-serving, since I am an economist, but it is not. I am not saying that economists are less prone to capture than lawyers n general. I am simply saying that economists play less of a role in securities litigation, so more economists would help the SEC be more independent. (Disclosure: Zingales has advised the PCAOB.)

MarketWatch: Lately the SEC commissioners are almost always lawyers but also ex- Congressional staffers, also typically lawyers.

Zingales: I can see why senators and congressmen want to place their people. You are not paid particularly well as a congressional staffer so promising an SEC or other agency commissioner position down the road is a way to attract talented people.

I think it does undermine the independence that this agency should have. At the Fed we don’t see that. Unfortunately the people who would enforce the idea to diversify the choice of commissioners are the senators and congressmen who have a vested interest in doing the opposite.

MarketWatch: Latest initiative by Chamber and the National Association of Manufacturers is to potentially put proxy advisors under the jurisdiction of the SEC.

See also: Bipartisan bill proposes putting proxy firms under SEC’s authority

Zingales: It’s funny, I thought this administration was against more regulation. What I am concerned about, just like with credit rating agencies, is that regulation will lead to barriers to entry, make the services mandatory, and result in lack of competition.

There is need for new entry in the proxy advisory business, particularly since investors are interested in more issues such as environmental and social impact issues. The Chamber has always been very active in trying to prevent shareholders from expressing their opinions in proxy voting. I fear that their demand for regulation is aimed at controlling the influence of these proxy firms.

It is surprising that the Chamber doesn’t seem to be concerned about the conflict of interest of audit firms, even if audit is mandatory, yet it is concerned about the perceived conflicts of proxy advisors when their services are not mandated by law and when new entry and competition can still play a role.

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