SEC dilemma: Protect investors or taxpayers?

As troubled financial institutions get into hot water with SEC regulators, the federal agency has found itself facing a tricky problem: given that taxpayers often have partial ownership in these companies because of bailouts, is it ethical to use more taxpayer money to protect investors?

When the issue came to a head this week, the investors won and the taxpayers lost. Even though Bank of America (BAC) has gotten TARP bailout money, it managed to settle a $33 million civil suit with the SEC. The case hinged on the fact that BOA violated securities laws when it concealed its decision to pay billions of dollars of bonuses to employees of Merrill Lynch. What makes this even more convoluted is that the Treasury Department and Federal Reserve may also have been culpable.
The Bank of America dilemma is one of many that the SEC is facing. Just last week, the agency thought twice about whether or not to file a suit against Regions Bank (RF) for selling nearly $1 billion in troubled investments. The bank got $3.5 billion in taxpayer aid. If it is forced to buy back its toxic assets, it could be in trouble; on the other hand, the sale was not in the best interest of the shareholders. So, even though it could hurt the struggling bank, the SEC went ahead with the suit.

As the SEC steps up enforcement action, it will be faced with many more of these painful decisions. The big problem is that it seems to have dual (and often conflicting) goals: punishing wrongdoers and keeping financial firms healthy. It must not only look at a firm's wrongdoing, but also any impact the fines or other actions may have on the specific firms, the financial system and TARP rescue efforts.

Some major investigations that could result in cases later in this year include:

* The sale of derivatives by AIG (AIG), which has received more than $100 billion in government aid. The investigation is looking at whether or not investors received proper disclosures.

* Disclosures by mortgage giants Fannie Mae and Freddie Mac, which together have gotten $85 billion.

* Additional infractions by two top TARP bailout banks - Citigroup (C) and Bank of America, both of which have gotten tens of billions of dollars in federal aid.

The SEC also doesn't have any legal authority to investigate government officials for actions taken. That means that, even if some of the investigations of AIG, Bank of America, Citigroup or others uncover wrongdoing by government officials, the SEC still can't perform its primary responsibility, namely acting to protect investors.

This story offers an interesting window into Congress' deliberations over Obama's proposed overhaul of financial regulators. The Wall Street Journal reports today that Treasury Secretary Timothy Geithner blasted top financial regulators for their opposition to Obama's plans, particularly the idea of handing even more power over to the Federal Reserve. However, watching the SEC's dilemmas unfold, it becomes clear that regulators are right in their assertion that a council of regulators which can bring various viewpoints to the table makes much more sense than placing all the power in the hands of the Federal Reserve.

The Federal Reserve has already shown that it can't handle its power well. When it had the dual responsibility of protecting financial institutions and consumers during the current mortgage mess, it failed consumers completely. Clearly any overhaul of the financial system must look at these conflicting responsibilities and correct for them.

Lita Epstein has written more than 25 books including Reading Financial Reports for Dummies and Trading for Dummies.
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