We should privatize the SEC. Put a bounty on fraud detection, and then make the following deal: the government puts up a lump sum now, and the recipient must make whole all parties harmed by fraud, but only if the organization approved the fraudulent financial statements.
You probably need to tweak the numbers to avoid some bad incentives, but the general principle is sound: treat it as an insurance problem, rather than a regulatory problem, and the funding you get will approach the point where the marginal utility of more fraud detection falls below the cost.
The bounty system exists: it is called short selling. The SEC just needs to stop demonizing short sellers and start paying attention to who their shorting and why.
The same thing that happens when any insurance company goes bankrupt.
Fraud is a normal, insurable risk. We just have a bizarre, underfunded, overambitious regulatory apparatus bolted on to where insurance is supposed to fit.
Regulators could game this system by taking their lump sum and not
doing the work involved with sniffing out fraud. If there's no fraud,
they win, and didn't have to do any work.
If there is fraud, maybe they can squirrel some of that bounty into an
offshore bank account and sneak out the back door like bernie madoff
was hoping to do.
You'd probably end up with layers of insurance. So one company might give IBM's financial statements a Seal of Approval, stating that any investor can pay the company, say, $1,000 a quarter to insure up to $1 million in restatement-related losses. Then, they double-reinsure this (every $1 million they lose gets them $2 million from a reinsurer) and offer a bounty for anyone who catches fraud.
Or you could just expect people who suspect fraud to short the relevant stock, announce their findings, and make money if they're judged correct.
You're right that it's hard, by the way. I just think it would be easier if we were able to have multiple voluntary levels of insurance against fraud, instead of a single insurer -- especially because, in many cases, the SEC fines a company when management lies to shareholders. So if XYZ Co. overstates earnings by $100 million, investors are poorer -- and then the SEC makes the company give up another $20 million in restitution.
