“If government agencies can be said to have peak moments, Nov. 14, 1986, was certainly one for the Securities and Exchange Commission. At 4:40 p.m., SEC Chairman John Shad announced that Ivan Boesky, the most prominent arbitrageur on Wall Street, had agreed to pay a record $100 million fine to settle insider trading charges. Nabbing him fulfilled Mr. Shad’s vow to come down on insider traders with ‘hobnail boots’ and cemented the crusading reputation of the SEC’s Enforcement Division,” writes Mark Maremont in today’s Wall Street Journal.

“Fast forward to a moment the SEC would rather forget. Testifying last month before a Senate committee examining the mutual-fund scandal, current SEC Chairman William Donaldson admitted his agency hadn’t even been looking for the kinds of abuses that were uncovered by today’s crusading Wall Street cop, New York Attorney General Eliot Spitzer. ‘For too long,’ Mr. Donaldson said, ‘the commission has found itself in a position of reacting to market problems rather than anticipating them.’ “

“How did the feared watchdog of the 1980s turn into an agency derided by some as often ineffectual? How did the SEC’s staff of more than 3,000 allow Mr. Spitzer’s investor-protection staff of 84 to grab the enforcement torch? Most important, why did the SEC fail to spot almost every major financial scandal in recent years — from improper fund trading to research analysts’ conflicts of interest to favoritism in doling out coveted shares in initial public offerings?”

“The answer lies both inside and outside the SEC. The agency proved a timid, poorly managed bureaucracy at a time when the markets it polices and frauds it seeks to prevent were increasingly complex. Unraveling Enron Corp.’s circuitous accounting maneuvers was harder than catching 1980s insider traders.”

“Moreover, the same congressional overlords who are now shocked to find the agency wasn’t up to its daunting task were stingy with the resources they gave it. Between 1981 and 2001, the number of filings the SEC’s Corporation Finance Division had to review grew 81% while the staff grew by just 29%.”

“Amid the market euphoria of the 1990s, no one wanted the party to end, and politicians didn’t press for tougher policing. Legislators from both parties often sided with the SEC’s adversaries, from big accounting firms to fans of stock options. ‘The greatest enemy of effective securities regulation and corporate accountability is a sustained bull market,’ says Joel Seligman, an SEC historian who is dean of Washington University Law School. ‘The animal spirits take over, the enthusiasm for deregulation increases as well as the enthusiasm for not increasing the SEC budget.’ “

“Yet even SEC officials acknowledge the agency is due a good measure of criticism. Earlier this year, SEC staffers and McKinsey & Co. consultants produced a 270-page catalog of the agency’s weaknesses, commissioned by ex-chairman Harvey Pitt. The report, whose findings haven’t been publicly disclosed, depicts an overly cautious agency hampered by bureaucratic inefficiencies and problems in monitoring a fast-changing industry.”

“Chief among the flaws is a reactive culture that often fails to identify danger ahead of time, leaving the agency to respond after others expose problems. As the authors put it, the SEC ‘lacks the institutional structure and experience needed to systematically identify risks.’ “

“The report found the SEC generates just 33% of its enforcement cases internally. The rest are spurred by external sources such as tips and referrals from self-regulatory organizations — including 15% of cases the SEC gets by reading the morning papers. In a statement that will resonate with Enron and WorldCom investors, the authors note that ‘enforcement actions usually occur too late to prevent large market losses.’ “

“Today’s SEC isn’t as weak an enforcer as popularly thought, and the 1980s model wasn’t as strong. Even while cracking down on insider trading, Mr. Shad set the SEC on a deregulatory course that some believe set the stage for later market excesses. And in recent years, the agency has won plaudits for policing the penny-stock and municipal-bond markets, and imposing stiffer penalties on miscreants.”