You might think that an agency that missed the Madoff fraud for years even after being told about it would have some sympathy for people who are, not bad guys necessarily, just a little sloppy on the whole looking-out-for-investors front. But you would be wrong:

Securities and Exchange Commission officials are trying to make it easier on themselves to hold more individuals responsible for wrongdoing during the financial crisis.

The good news, though, is that the way they’re going to make life easier for them is by reducing the stakes, pursuing negligence cases where they only have to show that someone acted “without reasonable care, even if there was no intent to harm investors." The tradeoff for the SEC is:



The penalties for negligence typically are much less harsh than for intentional fraud, with smaller fines and less risk of a ban from working in the financial industry. A charge of negligence also can result in less reputational damage for a defendant than outright fraud.

This is a change because the US model of financial regulation has long been a sort of lottery of corporate criminalization, where various not-quite-Ponzi forms of screwing around have a pretty small chance of being punished but, if they are punished, are punished with ludicrous severity.

So, for example, let's say that your business is running into trouble, and someone asks you in public something like: "is your business in trouble?" Being an optimist/not smart, you say "nah, we're doing great." Turns out you don't do so great. What happens: (a) nothing; (b) investors sue you to get back some of the money you got paid while maybe slightly overstating the goodness of your business; (c) you get arrested, but avoid jail because a jury isn't sure whether you intended to screw investors or were just a little misguided; or (d) you get arrested and sent to prison for the rest of your life? Or, another one - you quit your job and maybe swipe some business secrets on the way out. Is that (a) NBD, and by the way you might be entitled to some back pay, or (b) a crime for which you go to jail for eight years?

Right now the answer seems to be "one of the above, but you can't know in advance which one." Reasonable people can disagree on which answer is right, but there's good reason to want it to be predictable. And there's also good reason for the answer not to depend on subtle nuances of email tone. (When you emailed your boss saying "these securities are dogshit" and he wrote back "LDL," did he follow up with a meeting in which he explained with careful reasoning and compelling models why those securities were actually undervalued, or did he just tell you to shut up and mind your own business if you wanted a bonus this year? Should a jury really have to figure that out?)

The best way to prevent garden-variety, negligent, looks-pretty-shitty-but-isn't-obviously-a-crime financial shenanigans isn't to pick one poor sucker out of every hundred and send him to jail for a decade. It's to seek reasonable penalties, based on clearly proven negligence rather than tenuous criminality, in more cases. It's to lower the severity but increase the certainty, so that the threat of SEC enforcement is something for individuals to take into account in their personal cost-benefit models rather than a terrible but random and exogenous lightning strike.

It's not hard to find someone who disagrees, since there are lots of people who just want the SEC to walk through the halls of Goldman Sachs with a flamethrower:

"The problem is: I don't think the people calling for that accountability have negligence in mind," said Mark Schonfeld, a former director of the SEC's office in New York who now is a partner at law firm Gibson, Dunn & Crutcher LLP. "They want heads to roll for outright fraud, or at least recklessness, not simple mistakes."

That's only half true. People who want to "throw all the banksters in jail" want two conflicting things. They want to punish everyone who was in any way involved in the financial crisis - and they want to punish them for "outright fraud" and, if possible, child murder and puppy-stomping. But there's still no reason to believe that a lot of people were actually committing intentional fraud, and a whole lot of reason to believe that careless and not especially brilliant things were done from time to time with investors' money. If we're going to have a rule of law, then people who want heads to roll are going to have to live with disappointment: either too few heads will roll, or those heads won't roll far enough and in a deep enough pool of gore to satisfy their blood lust.

The Journal has recently been running a great and alarming series of articles on the alarming proliferation of federal criminal laws, which often don't require criminal intent and which can land you in jail for things like "importing the wrong kinds of lobsters and bulk packaging them in plastic" (really). The takeaway from this series is that if overzealous legislators and prosecutors make a federal crime out of everything that anyone doesn't like, the consequences are both incoherent and tragic. If the SEC is actually focusing on negligence suits as a way to deter financial shenanigans - and to address public anger at Wall Street without just tossing a few scapegoats in jail for decades - then that seems like a welcome corrective.

At SEC, Strategy Changes Course [WSJ]