This is a rush transcript from "The Journal Editorial Report," December 20, 2008. This copy may not be in its final form and may be updated.

PAUL GIGOT, HOST: Coming up next on "The Journal Editorial Report," as the Blagojevich story unfolds, some people are wondering if Prosecutor Patrick Fitzgerald's own words could jeopardize his case against the Illinois governor.

And the $50 billion heist. How did Bernie Madoff pull it off? And could he have been stopped?

Plus, Obama's pick to shapeup of the nation's public schools. Is Arne Duncan a true reformer? We'll take a closer look at his Chicago record.

"The Journal Editorial Report" begins right now.

(BEGIN VIDEO CLIP)

PATRICK FITZGERALD, FEDERAL PROSECUTOR: Governor Blagojevich has been arrested in the middle of what we can only describe as a political corruption crime spree.

But the most cynical behavior, the most appalling is the fact that Governor Blagojevich tried to sell the appointment of the Senate seat vacated by President-elect Obama. The conduct would make Lincoln roll over in his grave.

(END VIDEO CLIP)

GIGOT: Welcome to “The Journal Editorial Report." I'm Paul Gigot.

With that announcement almost two weeks ago, U.S. Attorney Patrick Fitzgerald sent the state of Illinois reeling. But did he jeopardize any future prosecution of embattled Governor Rod Blagojevich?

Attorney Victoria Toensing is a former Justice Department official. She joins me now from Washington.

Victoria, good to have you back with us.

VICTORIA TOENSING, FORMER JUSTICE DEPARTMENT OFFICIAL: Good to be here.

GIGOT: You said — recently you wrote for the Wall Street Journal — that although you are a Republican, you take no pleasure in seeing a prosecutor violate his ethical obligations in prosecuting a Democrat. How did Patrick Fitzgerald violate ethical standards?

TOENSING: There's a very strict rule for prosecutors, Paul, and that is you're not supposed to say anything that would heighten public condemnation of the defendant. In other words, you're not supposed to try to taint the jury pool. We, people in criminal law, call it, you're not supposed to talk outside the four corners of the complaint or indictment.

So he can quote from the complaint that he made or he can even introduce other law enforcement officials who were involved in the case. But he is not supposed to say things like "Lincoln would roll over in his grave."

And the FBI agent — he's also the prosecutor, Fitzgerald, is responsible for the FBI Agent's conduct. The FBI agent said the FBI agents who worked the case, were revolted and disgusted. That also is improper.

GIGOT: Once Fitzgerald heard those tapes and figured, well, the governor might actually appoint a U.S. Senator, didn't he have an obligation to go public to prevent the governor to make a play to pay trade in appointing a Senator?

TOENSING: He gives that rational and I don't even understand it. Presumably, if we go along with what Fitzgerald is saying, the only person he's going to appoint is somebody who paid to play. If that's the case, then that person too if corrupt. You've got a twofer. Why not wait until the crime came to fruition. I think perhaps those comments aren't going to — certainly the case isn't going to go away because of those comments. The defense attorney will sure make a lot of hay out of it. But his personality, by stopping this case, is what could jeopardize this case. I call it payment interruptus. He stops before there was a fruition of the crime.

GIGOT: Let's say he hadn't stopped it and the governor appointed a Senator and there had been a pay to play scheme and then four months later or six months later he lays this all out, and the tapes become public. And then you have not only a governor under a cloud, but an appointed serving U.S. Senator under a cloud. How does that serve the people of Illinois?

TOENSING: Are they being served at this moment? Those are the bad things that are handed to somebody who has — a prosecutor, which I've been, who has to make those kinds of decisions. Nobody was all out of sorts when Ted Stevens was indicted and had to go to trial. That's what happens.

But I think he could have jeopardized the case by stopping it right now and I'll tell you why. Because campaign contributions — and that was really what he was talking about — are viewed differently by the courts. Everyone knows that people horse trade campaigns who listen to — we all know that Hillary Clinton I think admitted — Hillary went to Obama and said I'll support you if you help pay off my campaign debt. Everyone accepted that. It wasn't said crudely, perhaps. I don't know. We didn't have phone taps. But how is that too much different than what happened here?

GIGOT: In exchange for campaign contributions for some kind of political favor isn't necessarily, in your view, a crime? Wouldn't be viewed like that under statutes.

TOENSING: The courts view it very differently when it's campaign contributions as opposed to putting the money into your own pocket.

GIGOT: You also said this is not Patrick Fitzgerald's first offense on these ethical grounds, that he also did this when he was prosecuting Scooter Libby, who was Vice President Cheney's former chief of staff. How did he overdo it there?

TOENSING: Well, he held a press conference. Once again, the same kind of conduct. And said — he likened himself to an umpire and said this obstruction of Justice is like you threw sand in my eyes and I couldn't find out who the leaker was. That wasn't the case. We now all know that two years before that he knew that Richard Armitage was the leaker.

Again, he tends to come out there and try to taint a jury pool. Of course, he was a media darling for having gone after Scooter.

GIGOT: He is again here for going after Governor Blagojevich.

TOENSING: I wrote the op-ed piece after I talked to a journalist. I was explaining how he had violated the ethics law and the journalist said, yeah, but he's so quotable.

(LAUGHTER)

GIGOT: In our business it's just what...

TOENSING: That's the attitude out there.

GIGOT: Well, let me — if this is — if Fitzgerald is in fact violating Justice Department guidelines — and you make a persuasive case he is — then why don't his superiors at Justice rein him in? Someone has the obligation to do it. Why don't they? Why doesn't the attorney general or the deputy attorney general rein him in? Are they too afraid of him?

TOENSING: I think by ending this case so soon, he has made himself untouchable as far as not only this administration but the next administration. And maybe that was one of the reasons that he came forward so fast. You know who he reminds me of, and that's Eliot Spitzer, and there were those of us, including the "Wall Street Journal" editorial page, who new how Spitzer was overplaying his power as an attorney general. I didn't care about his sexual peccadilloes. I cared about how he was abusive as an attorney general.

And it's the same thing. He threatens people. Fitzgerald threatened the late John O'Neill when he was in New York because there was a leak to ABC News. Fitzgerald decided O'Neill had done it and told him he was going to indict him. He threatens people. I know numerous instances of that. That's his weapon of choice.

GIGOT: All right, Victoria Toensing, thanks for being here. We'll follow this case closely. Thanks.

When we come back, the $50 billion heist. Why the SEC couldn't catch Bernie Madoff and why they probably won't be able to stop the next big scam either.

(COMMERCIAL BREAK)

(NEWS BREAK)

(BEGIN VIDEO CLIP)

BARACK OBAMA, (D), PRESIDENT-ELECT OF THE UNITED STATES: Charities that invested in Madoff could end up losing savings on which millions depend, a massive fraud that was made possible, in part, because the regulators who were assigned to oversee Wall Street dropped the ball.

(END VIDEO CLIP)

GIGOT: Could the Madoff swindle have been stopped by tougher regulation? Barack Obama seems to think so. Earlier this week, Securities and Exchange Commission Chairman Chris Cox ordered an internal investigation to find out why his staff failed to uncover the scam despite several red flags over the past decade.

Money manager Bernard Madoff was arrested last week in what investigators say was a $50 billion Ponzi scheme that defrauded such high- profile investors like director Steven Spielberg and media magnate Mort Zuckerman.

Joining the panel this week, Wall Street Journal columnist and deputy editor Dan Henninger; columnist Mary Anastasia O'Grady; and assistant editorial page editor, James Freeman, who once worked at the SEC, though we don't hold that against you.

(LAUGHTER)

This is almost a biblical story, sons turning in their father, somebody so close to this community that trusted him and now seemingly betrayed. What's the lesson?

DAN HENNINGER, COLUMNIST & DEPUTY EDITOR: Two words, Paul, due diligence. Everyone sort of feels they understand what that means. They don't. Due diligence is almost a technical requirement that money management firms are supposed to perform when they're putting money in someone else's fund. And that clearly was not done here. When investors who were thinking of putting money into the fund through Peripheral Greenwich Management asked to perform due diligence, Bernard Madoff refused to let them do it. This is like the biggest red flag imaginable.

(LAUGHTER)

GIGOT: That's when you don't write the check.

HENNINGER: Exactly.

(LAUGHTER)

HENNINGER: I think some of these firms and banks probably have some significant legal exposure for not having done that.

GIGOT: James, the SEC is being blamed for not uncovering this. How fair is that?

JAMES FREEMAN, ASSISTANT EDITORIAL BOARD EDITOR: I think people have to understand we've run the experiment and more regulation, more money for enforcers doesn't work. After Enron, the SEC's budget was increased massively.

GIGOT: Almost three times.

FREEMAN: That's right. More enforcement staff, more examinations.

GIGOT: Hundreds of examiners.

FREEMAN: Big increases. And you and look at what happened here and it was not they didn't have enough people. It wasn't that this case got lost in the mail room, but they looked at it, made a bad judgment. I think even the SEC understands that, at some level, regulation cannot stop this kind of thing. They have a name for this type of fraud, affinity fraud, when it's a person of your same religion or cultural ethnic group, it's very common. They try to warn people.

But the point is regulation doesn't work. The best protection for investors is their own skepticism.

GIGOT: Mary, has there been any case you can recall where the Securities and Exchange Commission or any other regulator, in advance, prevented a fraud like this? That blew the whistle on them?

MARY ANASTASIA O'GRADY, COLUMNIST: That generally doesn't happen. One of the problems here, and I think often is that customers have to complain. They usually respond to customer complaints. In fact...

GIGOT: There were competitor complaints though.

O'GRADY: There were no competitor complaints but, in fact, the hedge fund managers giving money to Bernie Madoff I think purposely, because for purposes of greed, did not do their due diligence.

GIGOT: Is that fair though? He was — he ran NASDAQ, the exchange, for Pete's sake. He was a pillar of the financial community.

O'GRADY: No, I disagree, Paul. You can go to the press now and see there were a number of hedge fund managers who did not touch Bernie Madoff. Word was out, don't go near this guy. What is he doing is not possible.

This guy, Harry Markopoulos...

GIGOT: Markopoulos, I think.

O'GRADY: Markopoulos went through the strategy that Bernie Madoff was claiming to use options to deliver these great returns and show it was impossible. But, in fact, one of the things that was appealing about Madoff was that he was not collecting fees for managing the money. He said I'll just take the transaction fees. So the hedge fund managers were able to do their 1-20, their 1 percent management fee and 20 percent of profits. That was very appealing for them. They didn't want to know. They said we'll use them anyway. He's paying us.

GIGOT: This reminds me a little of Enron. The Enron scandal is obviously a different nature, corporate scandal, but the people who blew the whistle on him were short sellers.

FREEMAN: That's right. You see over and over again the people blowing the whistle in these frauds are private people in the markets trading, investment advisors, short sellers. Whatever regulation is coming, it can't impede those people who are the ones who always seeming to be catching these frauds, not the regulators.

GIGOT: What does the SEC do now? Do they say mea culpa?

HENNINGER: You know what they're going to do. They're going to take some companies and take them out and shoot them.

GIGOT: Genuinely, marginal, maybe innocent or...

HENNINGER: Marginal players. And they will make examples of them, monumental examples and life will go on.

GIGOT: Well...

FREEMAN: I'd like to just add. I think if you look at Bernard Madoff's rap sheet, what you saw was a bunch of technical violations. That's what this big regulatory state gives us. It might be hard to spot a real fraud.

O'GRADY: And...

GIGOT: They were so looking for the technical infractions that they missed the bigger picture. All right, thanks, James.

Still ahead, Obama's choice for education secretary. Arne Duncan, is being touted as a reformer, but will he take on the teachers unions? Our panel examines his Chicago record when we come back.

(COMMERCIAL BREAK)

(BEGIN VIDEO CLIP)

OBAMA: When it comes to school reform, Arne is the most hands on of hands-on practitioners. For Arne, school reform isn't just a theory and a book, it's the cause of his life.

(END VIDEO CLIP)

GIGOT: That's Barack Obama nominating Chicago School Chief Arne Duncan to be next secretary of education. But does he have what it takes to fight the nation's teachers unions.

Here with a look at Duncan's reform credentials, Wall Street Journal editorial board member, Jason Riley, and senior editorial page writer, Collin Levy.

Jason, he's described Duncan as a compromise choice. What does that mean in policy terms?

JASON RILEY, EDITORIAL BOARD MEMBER: Well, it means that he's not a product owned, wholly-owned product of the teachers union.

GIGOT: Partially?

(LAUGHTER)

RILEY: Perhaps. He supports reforms that many want, such as merit pay for teacher and charter schools and these sorts of things. That's why he's described as someone that can please both sides of this debate.

GIGOT: But merit pay is more pay for better teachers.

RILEY: Yeah, pay for performance.

GIGOT: But is he willing to take on the flip side of that which is teacher tenure which would allow you to get rid of bad teachers.

RILEY: That's the big question. We don't know.

GIGOT: Do we know?

RILEY: We don't know. But we know he's willing to close bad schools. He's done that. He has a history of doing that in Chicago. That's a step in the right direction.

GIGOT: Collin, let's talk about his Chicago record. You've looked at it. Give us some of the pros and cons of what he's done there.

COLLIN LEVY, SENIOR EDITORIAL PAGE WRITER: I think the record in Chicago is certainly a mixed bag. I think the main thing that people point to is that graduation rates during his tenure improved. And that is something good in Chicago. But the flip side of it was that high school test scores didn't really go up. In particular, Chicago's ranking among other major urban school districts also didn't improve, so it's about status quo.

GIGOT: But the rates probably improved how much, nominally or in a significant way?

LEVY: They're about 55 percent now. They were about 47 percent I think when he took over.

GIGOT: That's not bad. That's pretty good improvement.

LEVY: Yes, that is good.

GIGOT: How extensive — he's a big supporter of charter schools. How extensively did he spread them in Chicago? Are there a lot more now than there used to be?

LEVY: There are a lot more now. One thing he did that was good, Chicago has a cap on the number of charter schools it can actually create. What he did was worked within that cap and said, OK, we're allowed to have 15 charter schools technically so let's let each of those charters operate four or five campuses. That was a way of expanding charters without actually breaking the rules.

GIGOT: So he wouldn't try to bust the cap politically which is what Joel Klein...

LEVY: Exactly.

GIGOT: Joel Klein, the New York City public school superintendent, fought and succeeded breaking that cap, which in this state was a hundred.

I guess my question, Dan, is if Chicago public schools are so great, why didn't Barack Obama and Michelle Obama send their own children there?

HENNINGER: Because they're not great enough. And that's why they're not doing it in Washington D.C. as well.

I think I have to introduce a note of cynicism into this conversation. Maybe he was an effective commissioner in Chicago. What does that have to do with being secretary of education which is mainly about money? The head of the Illinois state union, Ken Swanson, teacher's union, put out a statement saying he was supporting R.A. Duncan. I have it right here. He said why? He said, "Because Duncan said that funding is the civil rights issue of our time." And he quotes Duncan at a big rally in Springfield, the capital of Illinois, saying "Fund our schools, fund our schools!"

GIGOT: But money...

HENNINGER: This is about money! Barack Obama has promised to spend a lot of money through the Department of Education.

RILEY: He's not that much of a reformer in the sense that he still believes that the answer to our educational problems is more money. Dan's right. Most education reform in this country is not done at the federal level which is only responsible for about 8 percent of school spending in the country. It's done at the state and the local level. And it's nice to have someone in Washington who rhetorically backs up the reformers doing the grunt work at the state and local level. Maybe Duncan will do that. He'll give support to people for alternative certification and for school vouchers perhaps, for charter schools and merit pay and so forth. But the hard work is going to be done at the state and local level.

GIGOT: All right, Jason Riley, thanks very much.

We have to take one more break. When we come back, our "Hits and Misses" of the week.

(COMMERCIAL BREAK)

GIGOT: Winners and losers, picks and pans, "Hits and Misses," it's our way of calling attention to the best and the very worst of the week.

Mary, first to you.

O'GRADY: I want to give a hit to Democratic Congressman from California, Xavier Becerra. He, this week, turned down the job of U.S. trade representative in the Obama administration.

You know, the U.S. economy is in one of the worst economic downturns of the past 50 years. And the Obama administration wanted to put one of the most protectionist congressman in the post of U.S. T.R. This is a job that's supposed to promote trade, not block it.

He says he turned it down because it's not a priority for the administration. But whatever the reason, we really dodged a bullet. Let's hope Obama comes up with someone who's a promoter of trade.

GIGOT: Ron Kirk, the mayor of Dallas isn't bad.

All right, Jason?

RILEY: A hit for Barack Obama for choosing the Reverend Rick Warren to give the invocation at his inaugural. Rick Warren is one of the most prominent social conservatives in the country and this could be a sign that Obama isn't interested in pursuing a liberal social agenda. It can be seen as an act of solidarity with religious people in California where Warren is based, who have undergone a lot of backlash over Proposition 8, the ban on gay marriage, which Warren supported. So I think it's a smart political move by Obama.

GIGOT: All right.

Finally, Collin?

LEVY: I'm going to give a hit to Whole Foods Market, which is standing up to the Federal Trades Commission, which is trying to block its merger with Wild Oats, something that already happened but which they're trying to block retroactively. Whole Foods said that the FTC is so prejudice about this merger they basically should be barred from doing anything further on it.

This is a time when you've got markets across the country. Every neighborhood grocer has its own organic food line. The market's more competitive than ever. And it's time for the FTC to step back and let it go.

GIGOT: All right, thanks, Collin.

Remember, if you have your own "Hit or Miss," please send it to us at jer@foxnews.com.

That's it for this week's edition of "The Journal Editorial Report."

Thanks to my panel and to all of you for watching.

I'm Paul Gigot. We hope to see you right here next week.

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