Bill Cohen is right.

It’s time to shut the SEC down and start over.

We should need no further justification then those recent allegations that SEC staffers have been intentionally destroying documents related to initial investigations. Or that the SEC completely missed Bernie Madoff and his $65 billion scheme – despite repeated warnings from this guy. Or maybe our justification to start over should just be that the SEC blessed the rating agency models before the credit crisis. Or perhaps because when markets were collapsing, S.E.C. staffers apparently sat around and watched porn.

Take your pick, I suppose. Regardless of the reason, the need to overhaul the SEC is a bigger issue than politics or ideology. It has nothing to do with free markets or red tape.

I’m all for free markets, but as I’ve said before, don’t confuse them with what goes on on Wall Street. I happen to think it’s ridiculous that I can’t build a shed in my own backyard without getting permission from someone in the local government planning office. But it’s a big mistake to think that the same annoying hassles that we all put up with every day are magnified even more for Wall Street firms. It’s just the opposite. The rules have been written to enable them, really – and in no small way by the SEC.

Wall Street and the NBA

My analogy about regulation on the Street goes something like this:

Wall Street for the past decade has been like the NBA – you’ve got a ton of very motivated, ultra-competitive people banging heads with each other, night after night. And there are literally hundreds of millions of dollars at stake.

Unlike the NBA, though, on Wall Street, it has been expected that the players will call their own fouls – and they won’t get paid unless they win.

I’m of the opinion that you need a referee to have at least some clearly defined boundaries, both in the NBA and on Wall Street, or else things eventually just stop working. And as much as the players in the NBA complain about the refs, I don’t know any who have suggested banning refs and rules outright. I’d bet most of the players also realize the refs help keep their competitors in check, too. The stakes are so high that they need the referees, or else it’s a race to the bottom as soon as the clock starts.

And to make a key distinction here: I think the thing that’s been missing on the Street for too long is just plain old accountability, and that is, by definition, hard to regulate. But we absolutely need to try, because as per the years leading up to the credit crisis, the first effect of not having any real rules is that common sense goes right out the window. The second effect is a weakening in the enforcement of whatever major rules are on the books. And that’s bad for all of us, because as bigger rules get violated, many small dumb ones pop up in their place.

I also don’t believe that Wall Street is so corrupt that it needs more rules – it’s just that no one is wise enough to know how to act without them.

Not to get too grandiose about this, but it’s only after you establish and compel compliance with certain rules that anything resembling freedom is even possible – whether we’re talking about free markets or letting your toddler walk around the kitchen. Good Big Rules don’t have to “restrain” markets anymore than banning double-dribbling slowed down Michael Jordan. But I agree there is a real risk in having too many Bad Little Rules, so all this needs to be done intelligently.

Whose Job Should This Be?

I would submit that the markets work better with a solid referee. And there are certain things a referee needs to be able to do for the players to take him seriously.

I believe it should go without saying to anyone alive in 2008 that the “self-policing” approach to regulation just does not work on Wall Street. And while I’m normally all for doing things smarter/leaner/better, it is also undeniable that when it comes to enforcing laws, the government has a monopoly on the ability to incarcerate. That would seem to mean that this particular role in the markets has to be filled, alas, by government – for the same reasons that you want the cops in your town to be real policemen, not pastry chefs trying to make a few extra bucks at night.

There are also economies of scale to be had in keeping enforcement a role of the government – namely, that investors are too numerous and scattered to either get informed or enforce their own rights without paying through the wazoo. They need an organization to not only represent them, but which is proud of defending them. And finally, a central policing authority solves what would otherwise be a nasty coordination problem. We need someone to standardize and enforce accounting rules among public companies, for instance.

In the case of securities law enforcement, then, I would submit that the best institution to play this role is, like it or not, government. But let’s not confuse that with being expensive, wasteful and bureaucratic. This is the new SEC we’re talking about.

So, in addition to Bill Cohen’s ideas, here are ten ways I would rebuild the SEC:

1. Arm them.

Seriously. As a former Coast Guard officer, I will tell you unequivocally there is nothing as effective as compelling compliance with rules than calmly knocking on someone’s workplace door, stepping inside, and then, after politely exchanging greetings, chambering a round in a shotgun.

Brother, your heart probably skipped a beat just reading that sentence, no? See what I mean?

Relax. I’m not a gun nut, and I was a thoroughly undistinguished boarding officer. My point, though, is that Teddy Roosevelt had it right about that big stick thing. When it comes to visiting the workplace of someone in an industry that you regulate – whether that workplace is a pilothouse or a trading desk – the difference between showing up with a briefcase compared to a Beretta is unmistakable.

You could be stopping by that workplace just to pick up pink princess cupcakes. Doesn’t matter. Once someone recognizes you are a law enforcement agent carrying a weapon, and that you are interested in talking to them – even for the most benign reason – there is no confusion about your relationship. In the law enforcement community it’s called “officer presence,” and among other things, it makes it immediately clear you are not interested in “soliciting feedback.” You’re not there hoping to land a job at that same firm next year. And there certainly is no confusion about being “partners in industry.”

Think I’m nuts? Perhaps. But, quick, answer this – do you think the agents in the FBI who investigate financial crimes pack heat? Should there be a difference between those guys and agents at the SEC? I don’t think so. SEC agents should also be able to conduct surveillance, monitor court-approved wiretaps, review all records, and go undercover. Period.

At the new SEC, agents could not only indict, but they could cuff, Miranda and full-on roundhouse kick the bad guys. Because I’d bet a pretty good way to deter the next Bernie Madoff is to have a dozen YouTube clips of the last Bernie Madoff getting repeatedly pile-driven right into his polar bear skin rug by a former Alabama linebacker – right before agent Chuck Norris shows up and goes Rocky-in-the-meat-locker on him.

How will this not become the next great reality show?

In any case – the only difference in my mind between FBI agents and the new SEC agents would be that only a select few SEC agents would actually get bullets. So, you know, the lawyers and accountants would have to carry guns, but they’d have no ammo.

I’m not a complete idiot, people.

Otherwise, game on. The point is:

Enforcement, enforcement, enforcement.

The SEC is run by lawyers. It should be run by cops.

Plus, cops are far cheaper.

2. No betting against your clients.

I can live with the fact that all financial advisors are not held to a fiduciary standard. Among other things, that helps my firm find clients. But if you’re not going to be a fiduciary, can we agree that at the very least, you should not sell a lousy product to a client – and then immediately turn around and bet against that same product?

Seems like a no-brainer, and once we’ve got a slew of whoop-arse cops at the new SEC, the cost to enforce this rule is next to nothing.

This, by the way, would be known as the Vampire Squid rule. Thank you, Goldman.

Update: Glory be! It appears this rule might actually become law in the asset-backed securities market. Stay tuned.

3. Truly independent leadership.

SEC commissioners should be politically and financially independent. Barring that, commissioners should be appointed based exclusively on merit. This “five political appointees” thing is absolute horse kaka.

I’d actually like to see the SEC be moved under the Department of Justice, too, just to have some semblance of independence from politics, although I concede that it may be naive to think there is any less politics at DoJ. Nonetheless, my point is this: how many lobbyists do you think just stroll on into FBI headquarters every day?

Exactly.

I’d also say SEC employees should be forced to take an oath to protect the small investor, except I have little confidence that politically appointed commissioners would really honor it, anyway. But as Cohen suggests, the SEC cannot be a revolving door to Wall Street – and I think that having politicos running the agency helps create that door.

What sort of career path is there for an SEC staffer, exactly? No matter how hard you work and how committed to the cause you might be, you’ll never be able to reach for the brass ring at the top of your organization. No, my little striver – those chairs are reserved only for people who can bring politicians dumpsters full of money.

No wonder morale is in the dumps at the SEC. Starts at the top.

4. Incentivize them.

The agency’s budget should be as insulated as possible from politics. It could be funded, among other means, for multiple years at a time, or by, say, the cash from SEC victories in court. And in that case, like investment bankers, agent’s earnings could be a percentage of those winnings. Also, there could be lifetime clawbacks – so agents couldn’t chase dumb cases or over-reach in trial without fear of losing some money, too.

Whatever the mechanism ends up being, the means by which these guys have historically been incentivized has been an abject failure. So, get on that, someone.

5. Use qualified shorts as consultants.

Or at the least, have an enforcement hotline.

Any microcap investor worth his salt could have told you five years ago that Chinese reverse merger companies were going to be a real problem, but the system was not set up to in any way acknowledge reports of it, let alone shut it down. There currently is no real mechanism for market participants to raise a red flag to the regulators on anything suspicious. So if I have a problem with the Fruit Loops I just scoffed down at brekkie, I can look at the back of the box to find out who to call…but if I can prove a company is playing fast and loose with that whole “GAAP compliant financial reports” thing, there is nobody at the SEC whose job it is to take my call seriously. This is crazy.

The process I’d like to see would be something like this: Short sellers (or suspicious longs) can send confidential reports about possible corporate and/or market violations privately to the SEC. The agency has 30 days to respond, again in private. If the SEC settles or successfully prosecutes a case based on that work, the referrer gets compensation of some sort – perhaps a healthy a percentage of that settlement, for instance. If shorts waste the agency’s time, though, they will be billed hourly at an exorbitant rate, subject to clawbacks and/or summarily suspended from the program.

The point is that talented shorts are often the catchers in the rye, but the SEC treats them all as if they’re untrustworthy, vindictive cowboys. They good ones deserve to be heard. And the best could be also tasked with privately investigating other leads the SEC has received.

6. Naked shorting and naked credit default swaps should both be banned from the earth.

No exceptions. That is all I have to say about this.

7. No leveraged ETFs.

One of the biggest hypocrisies in enforcing even basic market rules today is that while only supposedly sophisticated investors can invest in hedge funds, anyone with one eye and a thumb can buy inverse, supra-leveraged ETFs in about two seconds online.

Hedge funds, though often wildly speculative, still have an element of adult supervision. ETFs do not, and given the trillions of dollars involved, it strikes me as stunning that ETFs get a complete free pass here.

If not addressed, this will not end well.

8. Encourage the development of some real tools.

The SEC needs a Y Combinator for financial enforcement start-ups. The agency is trying to fight Star Wars battles with Last of the Mohicans tools. Insider trading, for example, is extremely hard to detect when you’ve got multiple portfolio managers running one pool of money. This is a problem, however, that three 25 year olds in Silicon Valley could probably solve if you incentivized them with enough stock options and FourLoko.

Instead of solving these kinds of problems, though, most of those Valley kids seem to be hunkered down coding video games that slingshot fat cartoon birds into grinning green pigs. And I can’t blame them, frankly. As far as I can tell, there is literally no market supporting the development of any sort of technologies to combat financial fraud on Wall Street. And that’s a shame, cuz the right start-ups could make an absolute killing.

I, for one, would pay top dollar for some reasonably cool-looking glasses that would reveal the true identities of posters on Yahoo! message boards to start.

9. Crack down on high frequency trading.

HFT is legalized frontrunning by hackers. It’s also quickly becoming a commodity service, so while I suspect the market is going to reduce profits for almost all of these guys to zero before too long, the ones that will survive should absolutely be regulated more aggressively. That 70% of trades everyday are done by computers right now is, simply, insanity. The only thing more insane is that the SEC has yet to stop it.

For instance, I’d like to see the SEC make it illegal to hold a stock less than 60 seconds. To deal with quote stuffing, all limit orders should be required to stay open for at least one second. And master order numbers should be confidential.

Done. Problem solved with a law that can be promulgated in full on Twitter.

10. Restore the uptick rule.

This would not only put a damper on amateur shorting, but it would have the side effect, as Doug Kass points out, of neutering HFT.

Again, I am in no way against shorting. At least, I am not against shorting by people who know what they’re doing and are doing it for the right reasons. The problem these days is that any idiot can short anything, and many do. I think the resulting volatility makes people question how fair the markets really are – and they may have a point.

In general, I think it is important to offer some minimum sort of base level protection for small investors from powerful stupid people – those who are long or short. When it comes to the shorts, though, I also think it’s important to protect the markets from what over the last five years has seemed to morph into collusion between prideful skeptics who claim they’re relying on reason to short something…but who really just have outsized financial incentives to constantly spread false rumors. And restoring the uptick rule would address this issue satisfactorily to me.

Other Ideas?

I could go on, but too much more and I’ll start to get cynical. I should point out that we do have the best, most mature markets in the history of the world, and up until relatively recently, they did pretty well without much oversight. The problem is, though, that we cannot afford to repeat our more recent mistakes of regulatory omission – many of which were enabled by a feeble, possibly corrupt regulator that has long been captured by the same institutions it’s supposed to be watching.

So while not everyone will agree with the ideas above, I think we can probably agree that it is time for a new approach, no?