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When You Allow Regulators to Issue Rules, They Often Don’t

Anyone who has seen the seminal Schoolhouse Rock video “How a Bill Becomes a Law” likely thinks that, when a bill is signed into law, the government can begin enforcing it. Anyone who’s worked in Washington, including former Fed chairman and Obama economic adviser Paul Volcker, knows that after the law comes the rule-making process — and another bite at the regulatory apple for industry lobbyists.

This week’s ruling that the SEC must– against its objections — continue to enforce rules set forth by a 2003 legal settlement that separates market analysts from investment bankers looking to profit off market reports also contained another great nugget: A portion of the 2003 settlement obligated the SEC to issue rules, and it just decided not to. The decision not to promulgate a single rule in five years was what led to the lawsuit and to the partial win for financial services companies.

According to the Wall Street Journal:

It illustrates that the agency didn’t put in place broader rules to cover some key parts of the enforcement settlement, much of which was open to review after five years. It was that review process that led to the ruling by Judge Pauley.

The SEC argues that the binding lawsuit wasn’t meant to force the agency to issue rules covering all banks engaging in behavior everyone agreed was a conflict of interest; instead, they think the rules were only meant to apply to companies that we caught behaving that way in 2003. Of course, by not applying the rules to the entire industry, the SEC — by its own admission — opened the door to allowing companies who did engage in illegal behavior to get out from under those rules dictated by the settlement.

SEC spokesman John Nester said, “The settlement did not contemplate that all of its provisions would be applied industrywide to parties that had not engaged in alleged wrongdoing. In fact, the 2003 settlement explicitly states that it was the expectation of all the regulators that, after five years, the settling firms could seek modification of those provisions that were not applied industrywide.”

In other words, the settlement was intended to force the SEC to issue rules to regulate the overly cozy relationships between investment bankers and market analysts who work for the same company. But all the parties agreed that if the SEC didn’t issue any rules, the companies caught engaging in the behavior would not have to abide by the terms of the settlement. The SEC refuses to write the rules, the companies head into court and all the restrictions on corporate behavior that led to the tech bubble and caused massive economic losses to individuals investors and the economy are now legal again.

As a reminder, Paul Volcker argued to the House Financial Services Committee this week that it should codify in law the so-called Volcker rule, which would prohibit depository banks from investing depositors’ money for the banks’ own profit (one of the contributing causes of the widespread damage done by mortgage-backed derivatives). It would also prohibit banks from owning or investing in hedge funds and private equity firms, rather than waiting for an agency to go through the rule making process. Volcker’s reasoning: regulatory agencies aren’t keen to make rules.

For regulators, “there’s a lot of pressure not to do it,” Volcker told reporters during a break in the hearing. That’s why it needs to be in the legislation, specifically directing regulators to take action, he said. In a mocking tone, Volcker said the banks would tell regulators, “‘Don’t touch us’…’What did we do wrong?’… You know, ‘Leave us alone.’”

From the looks of the SEC, this is exactly what has been happening all along.

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