Self-Regulation and Securities Markets: Securities Exchanges Can Police Market Abuses If Government Provides Them the Needed Tools. (Securities & Exchange)

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ENRON, ARTHUR ANDERSEN, TYCO, ImClone, WorldCom, Adeiphia -- as American investors reel from accounting scandals and self-dealing by corporate insiders, the question of trust in the securities markets has taken on a new urgency. Securities markets cannot operate without trust. Markets known for fraud, insider trading, and manipulation risk a downward spiral as investors depart in search of safer investments. Today, many investors are rethinking the wisdom of entrusting their financial futures to the stock market. Absent trust in the integrity of the securities markets, individuals will hoard their money under the proverbial mattress.

Washington has responded to public outrage over corporate shenanigans by proposing a laundry list of new laws and regulations to crack down on corporate abuses. Some of the abuses, however, can be traced back to regulatory laxity. Until recently, Congress had more important uses for the taxes generated from securities transactions than policing the securities markets. An understaffed Securities and Exchange Commission long ago gave up periodic review of company filings because it had other priorities. Accounting fraud ranked low on the enforcement agenda, trailing the vendetta against insider traders and the pursuit of teenagers engaged in Internet stock scams. Justice Department prosecutors had no appetite for explaining complicated accounting transactions to jurors; bank robbery and drug trafficking afforded easier convictions. Only in the late 1990s did the SEC make financial reporting a priority. Once financials were put under the microscope, the agency claimed itself to be shocked to find that chief fina ncial officers were playing fast and loose with the numbers. Once the SEC started looking at the books, the number of restatements skyrocketed and we had a "crisis" on our hands.

Is more regulation the answer to failed regulation? In Washington, the answer usually is yes. So, questionable auditing of public companies is addressed by a raft of restrictions on auditors and a quasi-governmental entity to regulate auditors under SEC control. A lack of SEC oversight is answered by a mandate for periodic review of all public company filings by the SEC. The failure of prosecutors to pursue corporate malfeasance leads to new criminal sanctions for prosecutors to use (or continue to ignore). And, of course, Congress throws more money at the crisis.

Some of the new reforms may help improve the quality of financial reporting. Others, such as longer prison terms for fraud, are election-year posturing and unlikely to add much additional deterrence. The changes have, however, added to the expense and risk of being a public company. Premiums for directors' and officers' insurance have gone up sharply, as have auditors' fees. Those expenses will be passed along to shareholders in the form of a diminished corporate bottom line. And shareholders can expect to pay again when companies are hit by a fresh wave of lawsuits that the new legislation encourages. Finally, by threatening foreign CEOs with jail time, Congress has handed London a great marketing weapon in its competition for listings with New York.

New financial markets Is more government the only answer to shaken investor confidence? Although Congress is unlikely to abandon big government anytime soon, self-regulation remains an option for many developing countries. As developing economies have emerged from the quagmire of socialism and protectionism, financial markets have arisen as well. Those countries must now choose their principal regulator: the government or the market. The stakes are high for the fledgling markets -- countries that fail to establish regulatory structures that instill investor confidence may find stock trading migrates to countries that have done a better job at protecting investor interests.

Investors will be reluctant to invest and trade if they believe that the markets are stacked against them. …