Commentary: States vs. the SEC: What's All the Shouting for?

On the surface, it looks like the fragile alliance between state and federal securities cops is crumbling. On July 14, New York State Attorney General Eliot Spitzer challenged Securities & Exchange Commission Chairman William H. Donaldson to oppose a bill in Congress that would curb states' power to police brokerages. Donaldson testily replied that setting rules for markets "is the prerogative of the SEC."

There's more -- and less -- going on here than meets the eye. Yes, Donaldson and Spitzer disagree over states' power to shape rules for Wall Street. But the states and the feds are still working cooperatively. What's brought the SEC chief and Spitzer to swords' point is a clumsy attempt by an influential lawmaker to rein in states' power -- and to embarrass states over their use of fines from securities-fraud settlements.

House capital markets subcommittee Chairman Richard H. Baker (R-La.) triggered the flap on July 10, when his panel passed a bill to beef up the SEC's enforcement powers. At the last minute, Baker inserted a provision saying state enforcers can't impose tougher rules on brokerage firms than the SEC's. It's a sound principle: U.S. securities markets should operate under national rules, a dictum endorsed by Federal Reserve Chairman Alan Greenspan. "The argument that you have national markets and you should have a single regulator is the correct position," the Fed chief told the Senate Banking Committee on July 16.

But Baker's attempt to write that idea into law is doing far more harm than good. State securities cops, along with experts like Columbia University law professor John C. Coffee Jr., say Baker's bill would weaken investigations by barring them from ordering reforms -- like the analyst overhaul that Spitzer won from Merrill Lynch (MER ) & Co. Says Spitzer: "Defense lawyers will use this in every way they can to prevent us from investigating fraud."

Washington is in no position to throw its weight around. The SEC is still living down its reputation, earned under Harvey L. Pitt, for being slow to combat Wall Street's abuses. And state enforcers are widely seen as champions of the little guy -- none more so than Spitzer. "This is not the right time to take on the states," says one SEC insider.

The SEC is caught in the middle. It wants the bill's useful new tools for pursuing miscreants -- an override of state bankruptcy rules, for example, that let fraudsters buy megamansions in Florida or Texas to shield unlimited wealth. But Baker's insistence on reining in the states is diminishing the bill's already slim chance of passing.

SEC officials aren't too pleased with Spitzer, either. He's trying to embarrass the SEC by taking on a case -- complaints against Morgan Stanley (MWD ) over mutual-fund sales practices -- that the SEC has been investigating vigorously for months. Spitzer allies claim the SEC sat on allegations of wrongdoing by Morgan Stanley for years before launching its probe in January. SEC officials say Spitzer is dredging up dirt from the Pitt era.

Then there's the money. Baker first tried to order states to turn over penalties to an SEC-run restitution fund for injured shareholders. That didn't fly, but his latest measure puts a spotlight on states that don't repay investors. While some states have used their share of the analyst settlement to bolster investor protection, others pour the funds into such purposes as building motor vehicle license branches. "I guess if they catch a securities violator they'll take away his driver's license," Baker quipped on CNBC. Forget about states' rights, says one financial lobbyist: "It's all about the money."

That's probably too cynical. Serious issues are at stake. The states must be able to step up enforcement when the SEC is complacent. But the system works best when securities cops from Washington and the state capitals pull together. Under Donaldson, such cooperation was beginning to bloom. Both Baker and Spitzer are acting to protect turf -- when they ought to be more concerned about protecting investors.

By Amy Borrus and Mike McNamee

With Mike France in New York

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