For recently retired SEC Enforcement Director Linda Thomsen, however, I’ll make an exception. (As Mr. Buffett says, “There are times when a man has to rise above his principles.”)

The first story I would like to tell about this Enforcement Director concerns an investigation that the SEC’s San Francisco office was conducting a few years into collusion among short-sellers and crooked journalists who shilled for them using ammunition provided by “research shops” which were fed their material by those same hedge funds, in a kind of “serpent-eating-its-tail” of financial hooliganism. It was a hard scheme to miss: any company shorted by Stevie Cohen (SAC), David Einhorn (Greenlight), Dan Loeb (Third Point), David Rocker, or a handful of others, could count on coming under the “where-there’s-smoke-there’s-fire” journalistic scrutiny of such worthies as Jim Cramer and Dave Kansas, Gary “Scaramouche” Weiss, Bethany “Long, Slow Thing” McLean and Roddy Boyd (both of Fortune Magazine), Carol Remond and Karen Richardson (both of DowJones), Floyd Norris and Joe Nocera, (both of the New York Times), and Herb Greenberg (MarketWatch), that “smoke” often being supplied by research shops of which those same hedge funds were clients. Invariably they’d be naked shorted as well, and show up on the Reg SHO Threshold List, and anyone noticing this constellation of facts occurring over and over with complete regularity could be counted on to be declared “wacky” by these same journalists.

I learned about this investigation because I was invited to a meeting by the SEC investigators conducting it. I’m pretty sure that “invitation” came in the form of a federal subpoena, but I am not completely clear on that, having over the last few years received enough such paperwork to wallpaper my bedroom. In any case, I arrived at the appointed hour, and was sworn in. My deposition was conducted by a man named “Mark” and overseen by his boss, Tracy, both of whose last names I see no reason to reveal. They both were the kind of federal employees that make one swell with pride: They displayed neither favor nor enmity, but simply, white collar professionalism such as has largely been lost in Corporate America. They were prompt, prepared, and business-like, and, without being rude, challenged me fairly aggressively while revealing to me as little as they could.

That said, try as they did, it was impossible for them to be as blank to me as they wished. After all, if someone asks, “What do you know about the possibility that Colonel  Mustard killed his victim in the library with a rope?”, then it is resonable to infor that the utterer suspects that Colonel Mustard may have indeed killed someone in the library with a rope. In this fashion, I became reasonably confident that while the New York financial press was bleating about how wacky I must be to notice patterns that many sane observers had noticed, those same patterns had been noticed by others better placed to do something about them than I. (Incidentally, normally I would be loathe to reveal the contents of such a deposition, but given that this is all moot now, yet tied to today’s news, and the bad guys are using FOIA requests to get this stuff anyway, it seems like the right thing to do.)

Somewhere around this time, Jim Cramer and others of the journalists mentioned above  received their own subpoenas. All hell broke loose, because they made it break loose (see for example “Herb Greenberg, The Worst Business Journalist in America, on the Conspiracy“). Of course, in a world where editors still had integrity, it would have been considered somewhat unseamly to have journalists reporting on an investigation of which they, themselves, had become the targets (I’m not sure why I mention that: I suppose it seems like it should be germane or something). But as a result, that investigation was promptly shit-canned. There’s no other way to describe it: the investigators were summoned to Washington, publicly crapped upon from a great height by SEC Chairman Chris Cox, the Enforcement Director who signed those subpoenas stood by idly while this happened to her staff, and we returned to our regularly scheduled programming of Muzak and bromide business reporting interrupted occasionally by B-list actors pitching Grandmother-Safe financial products and narcissistic hustlers promising that this time they really wanted to make you money, Mad Money!

Interestingly, not all the press backed up their brethren: editorials by Loren Steffy of the Houston Chronicle spring to mind in this regard. But by and large, the profession of business journalism stood mute while the reporting on a federal investigation was dominated by folks who were themselves the targets of that investigation.

The second story I would like to tell about this SEC Enforcement Director concerns some comments she made in 2008 in a keynote address before the United States Chamber of Commerce. In a pattern that observers of this issue have seen before, when asked about naked short selling, the Enforcement Director avoided the question by simply talking about the virtues of short selling, an issue which is not in contention. This pattern of avoiding the subject of naked short selling has been used time and time again by apologists for the practice (imagine someone being asked about sexual harassment, and answering with a response about the virtues of sex). Unfortunately for the Enforcement Director, her interlocutor, who was standing in the front row, directly in front of her podium, using a microphone that broadcast his voice loudly to the whole room (and you will see in a moment why that is relevant) pressed her on the distinction in a way that we would never see happen in any of the captured business media such as CNBC, New York Times, or Fortune.  The Enforcement Director’s subsequent answer (she blamed the victim companies and excused the crime) is instructive because it confirmed, as though further confirmation were necessary, that there are in fact two and only two plays in the apologists’ playbook: first, conflate naked short selling with short selling and discuss the benefits of short selling; second, blame the victim companies and excuse the crime.

3:00 p.m. – 3:30 p.m.
Regulatory Keynote Address: A View from the Division of Enforcement: Perspectives and Priorities
Linda C. Thomsen, Director of the Division of Enforcement, U.S. Securities and Exchange Commission
Introduced and moderated by: Michael J. Ryan, Senior Vice President and Executive Director, Center for Capital Markets Competitiveness

AUDIENCE MEMBER: “You spent a lot of time talking about insider trading and penny stock fraud, but you failed to mention an issue that’s of great concern to the Chamber, and that is naked short selling and the unsettled trades that can result from that. How can the Commission claim that it is serious about enforcement when millions of trades fail to settle every day and companies remain on Reg SHO Threshold Lists for years and years? And, second part of the question, why is the new rule 10b-21 necessary when, as Commissioner Casey pointed out, it makes illegal activity that is already illegal?;

SEC ENFORCEMENT DIRECTOR: “Um… I didn’t hear all of it, unfortunately, but as to the issue of short selling, we recognize that short selling is -”

AUDIENCE MEMBER: “My question was not about short selling. We all know that short selling is legal, and a necessary and efficient part of the market process. I’m talking about naked short selling-the selling of shares one does not have in inventory and probably has no intention of locating or borrowing.”

SEC ENFORCEMENT DIRECTOR: “As to naked short selling, and more generally market manipulation generally (sic), it is an area we are focused on. We have seen fewer cases in that arena because, often times, this is not necessarily with respect to naked shorts, but shorting or market manipulation more generally, because often the components of something that might look to be manipulative are all legal trades as you point out. So it’s a hard case to bring, which is not to say that it isn’t something that we don’t investigate, because we do. So I .. hear and understand the frustration of many on the subject of short selling generally. When we hear complaints about short selling-and, frankly, it is both short and naked short, it is a combination of both-we routinely hear from companies who’ve come in, who worry that they’re being shorted in an illegal way. We routinely take all that information in and look into it. And often times, as I think many defense counsel would be happy to tell you, when we dig in, what we find is that some of the information that has caused people to be shorting is actually true as to the company, and we may very well be confronted with two issues, one on the company and its disclosure side as well as on the trading side. But they’re very difficult cases, which is not to say that we aren’t focused on them and interested in them and indeed this new focus that we have on some smaller companies and smaller issuers will wrap some of those concerns into their focus as well.”

As you may have gathered, that SEC Enforcement Director was Linda Thomsen.

That would be the same Linda Thomsen who, for the entire 14 year duration of her service in the Enforcement Division of the SEC (the last four as Director), missed the $67-billion-and-counting walking Ponzi scheme/human brown stain known as Bernie Madoff, though concerned citizen Harry Markopolis not only did the work for the Enforcement Division, he all but spray-painted his findings on the lovely Italian marble of the SEC’s posh new DC headquarters.

That would also be the Linda Thomsen who, regarding Mr. Markopolis, acquitted herself so handily in this now-famous exchange with New York Democratic Congressman Gary Ackerman.

That would be the same Linda Thomsen against whom the SEC’s Office of the Inspector General recommended disciplanary action for her role in hanging out to dry SEC Senior Investigator Gary Aguirre, due to his impertinence in trying to subpoena Morgan Stanley CEO John Mack simply because a trail of clues in “the most important insider trading case in 30 years” led directly to him.  Aguirre had failed to regonize that the law of the land does not apply to Mr. Mack because he has too much “juice“, as Aguirre’s boss Robert Hanson put it while shutting down the investigation. According to a subsequent report of the United State Senate Judiciary Comittee, by “juice” Hanson meant, “meaning they could directly contact the Director or an Associate Director of Enforcement. That Director was, again, Linda Thomsen, and the Associate Director was Paul Berger, who was, at the time of these events, negotiating for a job with Mr. Mack’s law firm, Debevoise Plimpton, a job which Mr. Berger ultimately took. That report by the US Senate Judiciary Committee summarized the culture of Enforcement Division under Director Linda Thomsen:

“Staff Attorney Gary Aguirre said that his supervisor warned him that it would be difficult to obtain approval for a subpoena of John Mack due to his ‘very powerful political connections.’ Aguirre’s claim is corroborated by internal SEC emails, including one from his supervisor, Robert Hanson. Hanson also told Aguirre that Mack’s counsel would have ‘juice,’ meaning they could directly contact the Director or an Associate Director of Enforcement.

“SEC management delayed Mack’s testimony for over a year, until days after the statute of limitations expired. After Aguirre complained about his supervisor’s reference to Mack’s ‘political clout,’ SEC management offered conflicting and shifting explanations.

“The SEC fired Gary Aguirre after he reported his supervisor’s comments about Mack’s ‘political connections,’ despite positive performance reviews and a merit pay raise.

“After being contacted by a friend in early September 2005, Associate Director Paul Berger authorized the friend to mention his interest in a job with Debevoise & Plimpton. Although that was the same firm that contacted the SEC for information about John Mack’s exposure in the Pequot investigation, Berger did not immediately recuse himself from the Pequot probe. Berger ultimately left the SEC to join Debevoise & Plimpton. When initially questioned, Berger’s answers concerning his employment search were less than forthcoming.

“The SEC’s Office of Inspector General failed to conduct a serious, credible investigation of Aguirre’s claims.”

That would be the same Enforcement Director to whom the SEC’s new Inspector General was obliquely referring, in page after page, for 55 pages, in a report explaining how three well-organized  6th graders could have handled the nation’s naked shorting complaints better than did the SEC Director Linda Thomsen’s Enforcement Division.

That Linda Thomsen is the same one whose resumption of employment with white-shoe law firm Davis Polk & Wardwell (I say “resumption” because Ms. Thomsen worked at Davis Polk until she joined the SEC in 1995) was announced today in this gem (”SEC Enforcement Chief Joins Davis Polk“) from the Blog of Legal Times (”Law and Lobbying in the Nation’s Capital”).

The announcement reads, with no detectable irony:

Linda Thomsen, who headed the SEC’s enforcement division until February, is starting as a partner in the firm’s white-collar defense and government investigations and enforcement practices in June. She will be joining former SEC commissioner Annette Nazareth, who started at Davis Polk last year, and Robert Colby, who joined the D.C. office this year after serving as deputy director of the SEC’s trading and markets division…

Thomsen practiced in Davis Polk’s New York office before joining the SEC in 1995. She started at the commission as assistant chief litigation counsel and went on to become head of enforcement in 2005. After leaving the SEC earlier this year, Thomsen says, “I had no preconceived ideas about where I was going to go, or what I was going to do.” – Translation: “I swear, it never occurred to me to go work for the law firm defending wealthy clients against whom I was overseeing cases until weeks ago.”

At the firm, Thomsen will advise clients on internal investigations and defend them against SEC probes. – Comment: Probes such as those ones she was overseeing weeks ago.

After serving at the agency for 14 years, Thomsen says she understands the kind of questions clients should be asking themselves to stay out of trouble with the commission. “I think I know and can see the kind of issues that get people into trouble, and the kinds of processes that cause them to, perhaps, ignore warning signs,” says Thomsen. - Comment: Yes, I am sure Ms. Thomsen is one of the world’s most recognized experts on the subject of processes that cause people to ignore warning signs.

Thomsen headed the enforcement division as it came under fire for failing to catch Bernard Madoff’s Ponzi scheme, as well as problems that contributed to the meltdown on Wall Street. In response to critics, Thomsen vehemently defends her former division. “I think the professionalism in the division of enforcement is really unparalleled,” she says. ‘If you look at the totality of the enforcement efforts…it’s really a record that I know I’m proud of.”

Considering the world-historic implosion of the US capital market occurring to vamp-til-ready accompaniment of Ms. Thomsen’s blind-piano-player-in-the-cathouse Enforcement Division,  I’m at something of a loss for words with which to comment upon Ms. Thomsen’s “pride”.

But it is nice she landed on her feet.

Aguirre places particular blame upon the “revolving door” culture that hangs over the SEC’s workforce, with its attendant promise of a lucrative move to the private sector in store for those whose approach to regulation is deemed acceptable to the regulated.

As Aguirre puts it:

The system maintains itself, because those that stay know their turn will come if they play the game. They see a director or associate director move onto a $2 million job with a Wall Street law firm. Then, the departed employee calls back to his former colleagues and says, “you know I really don’t think there is much of a case against so-and-so, I’d like for you to take a look at it.” And the case goes away; the system goes on in perpetuity … [There's a] culture of ‘don’t rock the boat,’ the industry does not want ‘boy scouts,’ and if you can be effective with the SEC through your contacts, that is a very valuable asset you can bring to the table.

To summarize, Gary Aguirre says that a large part of the SEC’s widely-acknowledged (though not as yet fully comprehended) dysfunction results from the self-reinforcing cycle of:

1. High level SEC staffers accepting positions with powerful institutional market participants, in order that they might…
2. Pressure their former associates to take regulatory action beneficial to their employers, and in the process…
3. Impressing upon former associates the value of regulating selectively – as the former staffer had done – in order to ensure their own eventual move to the private sector.

This revolving door dynamic is at the heart of the high degree of “regulatory capture” observed at the SEC and a central focus of this blog.

But enough of the theory of the SEC’s revolving door…let’s look at it in practice (as Mark Mitchell did in a superb item last month) through the example of Richard Sauer, former assistant director of the SEC’s Division of Enforcement.

First, a little background.

In June of 2003, after 13 years with the Commission – including seven as assistant director – Richard Sauer left the SEC for the law firm of Vinson & Elkins. There, among his clients, Sauer counted Rocker Partners hedge fund.

On October 6, 2006, the New York Times published Bring on the Bears, a rather lengthy opinion-editorial authored by Sauer, which argues, on the surface, that short sellers are as vital to healthy markets as predators are to healthy ecosystems.

Fair enough.

But set in the shadow of that well-worn market truism are some disconcerting clues as to Sauer’s mindset, both present and past.

For one, Sauer is dismissive of the uptick rule (a provision created to prevent bear raids intended to drive a company’s stock down) as an unfair vestige of a by-gone era, calling for its elimination.

For another, Sauer reveals that while at the SEC, he initiated many investigations into public companies based on the tips from short sellers betting on a drop in those companies’ stock prices. Indeed, he says short sellers were his only source for these kinds of investigations.

And for yet another, Sauer defends the relationship short-biased hedge funds have with journalists such as Herb Greenberg, Roddy Boyd, Carol Remond and Bethany McLean, while calling on the SEC to initiate enforcement actions against companies that “attribute their woes to conspiracies by short sellers,” and “retaliate against critics through defamation campaigns and manipulative short squeezes.”

As unsound as his logic is, on one point we can be certain: Sauer is at least telling the truth. A former co-worker confirms that while he and Sauer worked together at the SEC, Sauer had been involved, at least tangentially, in most of the investigations instigated by short-selling hedge fund Rocker Partners.

But the most telling sentence in Sauer’s op-ed piece is the one he didn’t even write, but which appears a the end, as an editor’s note. It reads:

Richard Sauer, a former administrator in the Securities and Exchange Commission’s enforcement division, joined the management at a short-biased hedge fund this week.

Of course, that short-biased hedge fund turned out to be Rocker Partners (which had recently changed its name to Copper River Partners).

In December of 2006 Institutional Investor Magazine published a small story on Sauer’s new gig, noting that “[hedge] funds regularly brought [Sauer] complaints of possible wrongdoing at companies they were betting against.”

When asked whether his job description at Rocker Partners might include getting future SEC investigations launched, Sauer responded, “it remains to be seen.”

In point of fact, thanks to emails produced through discovery in the Fairfax Financial (NYSE:FFH) vs. SAC Capital, et al, lawsuit, we know that there was nothing at all remaining to be seen, for by mid-November of 2006, Sauer had already emailed keyesr@sec.gov (someone he apparently knew well enough to address only as “Rob”), pointing him to one of the anti-Fairfax sites set up by Spyro Contogouris, and attempting to spin Contogouris’ then-recent arrest on embezzlement charges as a Fairfax-motivated act of retribution.

In light of what we’ve just learned, let’s revisit Gary Aguirre’s theory of regulatory capture at the SEC:

1. Former Associate Director of Enforcement Richard Sauer accepts a position with Copper River Partners, a short-biased hedge fund known to be heavily shorting Fairfax Financial.
2. Sauer pressures former SEC colleague Robert Keyes to take regulatory action likely to negatively impact the share price of Fairfax.
3. Keyes is impressed by the need to regulate selectively – as Sauer had most likely done while at the SEC – in order to ensure his own eventual move to the private sector.

And the cycle continues.

Of Aguirre’s three requirements, we can state with certainty that in the case of Richard Sauer, the first two are satisfied. It is my opinion that the third requirement has been, as well.

What all this means is not that Richard Sauer is a bad person, for I don’t know a thing about his character. What I do know is that he has spent most of his professional career enabling bad people, first from within a fatally flawed regulatory agency, and later from without.

Mr. Sauer, if you’re reading this, given your recent unemployment following Copper River’s collapse, I sincerely hope you’ll hold out for a job that breaks the cycle of regulatory capture and actually makes the world a better place in the process.

If this article concerns you, and you wish to help, then:

1) email it to a dozen friends;

2) go here for additional suggestions: “So You Say You Want a Revolution?“

But it’s a start. Given that the CNS system is the one place the SEC can look, and might be able to do something about, it is instructive to see how well they are cleaning up unsettled trades there.  Towards that end, DeepCapture has analyzed the data that the SEC released last week. These graphs show their fine progress in that regard.

============================================================================
Any questions?

If this article concerns you, and you wish to help, then:

1) email it to a dozen friends;

2) go here for additional suggestions: “So You Say You Want a Revolution?“

This graph registers the daily total of companies appearing on the Reg SHO list.

=================================================================

I have maintained all along that naked short selling was not a hard problem to solve: it was just a hard problem to solve without seeing about 20 rich guys get their asses handed to them. And because they were rich and well-connected, efforts to persuade the federal government to enforce the law were stopped dead in their tracks.

Somewhere in the middle of 2008, after the horses bolted from the barn, the barn collapsed, the barn burned, and the barn’s ashes scattered to the four winds, the federal government decided to close the barn door. They enacted a subset of the reforms which Deep Capture and a handful of other activists had been suggesting for a few years. The data suggests those reforms are working. I would not stake money on the likelihood that this means much, but hope springs eternal….

Shortly after I started raising the possibility of the SEC’s capture, an SEC Senior Investigator named Gary Aguirre began echoing it, first in a September, 2005 letter to SEC Chairman Christopher Cox, and then in May 2006 in asecond letter to the United States Senate. Mr. Aguirre has informed me that he wrote that first letter to Chairman Cox without knowledge of my own public statements, which preceded his by a month only.

The proximate cause of Aguirre’s complaint was that an insider trading investigation he had been conducting into the activities of Pequot Capital, a powerful Connecticut hedge fund, was derailed (he claimed) once the trail led towards John Mack, the influential boss of Morgan Stanley. Mr. Aguirre claimed that his SEC bosses had maneuvered to kill his investigation while warning Aguirre that Mr. Mack had too much “juice” to pursue.

The more general theme of Mr. Aguirre’s letter, however, was the capture of the SEC by lawbreakers to the detriment of law-followers. As former SEC Senior Investigator Aguirre wrote to the United States Senate:

“…is the SEC adequately protecting the nation’s capital markets and their participants from the risk of manipulation and fraud by the nation’s 11,500 hedge funds? The answer is no.

“And the answer is no whatever facts you consider. It is no when the SEC fails to recognize any hedge fund fraud or manipulation against other market participants for a quarter century: from 1979 to 2004. It is no when the SEC fails to protect mutual fund investors when billions of dollars are siphoned from their accounts by hedge funds. It is no when you compare what the SEC is doing and saying about hedge funds with what its counterparts in Europe are doing and saying….It is a deafening no when the SEC halts an insider trading investigation of one of the nation’s largest hedge funds because the suspected tipper has powerful political connections, as they did with the investigation assigned to me…

“I believe our capital markets face growing risk from lightly or unregulated hedge funds just as our markets did in the 1920s from unregulated pools of money – then called syndicates, trusts or pools. Those unregulated pools were instrumental in delivering the 1929 Crash…. There is growing evidence that today’s pools-hedge funds-have advanced and refined the practice of manipulating and cheating other market participants…

“Fixing the SEC so it can protect investors and capital markets from hedge fund abuse will not be an easy task. Powerful interests want the SEC to stay just the way it is or, better yet, to become even weaker. Those interests are not just the hedge funds. They include the financial industries that are receiving tens of billions of dollars in revenues for helping hedge funds cheat other market participants or close their eyes to the carnage. At the top of that list are the big investment banks, e.g., Goldman Sachs, Morgan Stanley, Merrill Lynch and Bear Stearns. Those interests know how to reward friends and punish perceived enemies. Their tentacles reach far. They stopped the hedge fund investigation I was assigned to conduct. They cost me my job.”

It would be difficult to devise a more eloquent statement of regulatory capture, or one more informed by experience, than this letter from SEC Senior-Investigator-turned-whistle-blower Gary Aguirre.

In June 2006, Mr. Aguirre was asked to testify before the U.S. Senate Judiciary Committee, to which he had delivered boxes of evidence (which he apparently carried out of the SEC). The U.S. Senate Judiciary Committee began demanding answers of the SEC. The SEC stalled while threatening criminal charges against Aguirre for his whistle-blowing, prompting U.S. Senator Charles Grassley to write in August a remarkable letter lecturing the SEC on congressional oversight and the U.S. Constitution.

In September 2006, the Senate wrote two letters pressing the General Accounting Office to conduct a formal investigation into Aguirre’s allegations of regulatory capture and the overall regulatory framework of our country’s capital markets (see here and here).

In October 2006, Gretchen Morgenson and Walter Bodganich of The New York Times began to report on the serious implications of this story. Their reporting was able, and took Mr. Aguirre’s allegations seriously.

On December 5, 2006, however, New York Times reporter Floyd Norris wrote a story that was dismissive of Mr. Aguirre’s allegations and derisive towards his motives (“Get a Job, then Sue Because You Were Not Hired Earlier”). Reporter Norris included no quote from Mr. Aguirre and precisely one sentence (”He contends that the S.E.C. was unwilling to go after John Mack, now the chief executive of Morgan Stanley, because of his political clout”) that reflected Aguirre’s position. Norris made no mention of Aguirre’s deeper claims about the capture of the SEC by “Powerful interests [which] want the SEC to stay just the way it is or, better yet, to become even weaker,” nor about its failure “to recognize any hedge fund fraud or manipulation against other market participants for a quarter century,” nor about the systemic risk thereby engendered (we will see that such omissions occur with remarkable consistency in our mainstream financial press).

However, Norris did find space to give liberal coverage to the SEC’s position , including an SEC statement denying Aguirre’s claims, the SEC’s reasons for that denial, the position of SEC Enforcement Director Linda Thomsen reaffirming the SEC’s position, the same from an EEOC judge, two rhetorical questions aimed at deriding Mr. Aguirre’s actions, and a quote from an SEC lawyer attacking Aguirre. Mr. Norris closed by saying of that attack by the SEC’s own lawyer, “It certainly sounds as if that opinion was (sic) correct.”

Such was the impartial approach taken by “our newspaper of record.”

This mocking and derisive piece appeared on The New York Times on the day that Gary Aguirre testified at a US Senate hearing. The U.S. Senate Judiciary Committee took Mr. Aguirre’s testimony (see parts 1 and 2). Several SEC officials appeared to refute Mr. Aguirre’s claims (click here). Giving testimony that drew sharp replies from the U.S. Senate Judiciary Committee members, these SEC officials contradicted each other and their own email records. The Inspector General of the SEC refused to answer questions on the advice, he said, of the U.S. Department of Justice.

Read that again: our capital markets are regulated by the SEC, and the Inspector General of the SEC, in effect, its “Internal Affairs” department, invoked the 5th Amendment’s protection against self-incrimination.

Is that bad?

When The Wall Street Journal played its normal and customary role of downplaying these events on the behalf of Wall Street, it drew a public letter from Senator Grassley rebuking them for outright misdirection.

In January 2007, the Senate released a preliminary report. Marcy Gordon of AP News summarized it:

“an official review raises serious questions about the Securities and Exchange Commission’s handling of an insider-trading investigation and the possibility of a cover-up amid allegations of political interference….After taking testimony and reviewing thousands of documents, many of them provided by the SEC, the judiciary panel’s preliminary findings show ‘extraordinarily lax enforcement by the SEC and … may even indicate a cover-up by the SEC,’ [Senator Arlen] Specter said. The SEC’s handling of the matter, including a review of the attorney’s allegations by the agency’s inspector general, ‘has all of the earmarks of the obstruction of justice’, he said.”

Again, when a United States senator, highly respected by both parties, suggests that the regulator of the capital markets has taken part in a cover-up and the obstruction of justice, is that bad?

In March 2007, Mr. Aguirre’s allegations were covered sympathetically in a PBS news story which was later nominated for an Emmy for investigative journalism.

In August 2007, the final report was released under the imprimatur of the Committee on Finance of the U. S. Senate. A good summary of the report can be found in this Reuters story.

The Senate’s report stated the following conclusions (emphases in the original):

“Staff Attorney Gary Aguirre said that his supervisor warned him that it would be difficult to obtain approval for a subpoena of John Mack due to his ‘very powerful political connections.’ Aguirre’s claim is corroborated by internal SEC emails, including one from his supervisor, Robert Hanson. Hanson also told Aguirre that Mack’s counsel would have ‘juice,’ meaning they could directly contact the Director or an Associate Director of Enforcement.

“SEC management delayed Mack’s testimony for over a year, until days after the statute of limitations expired. After Aguirre complained about his supervisor’s reference to Mack’s ‘political clout,’ SEC management offered conflicting and shifting explanations.

“The SEC fired Gary Aguirre after he reported his supervisor’s comments about Mack’s ‘political connections,’ despite positive performance reviews and a merit pay raise.

“After being contacted by a friend in early September 2005, Associate Director Paul Berger authorized the friend to mention his interest in a job with Debevoise & Plimpton. Although that was the same firm that contacted the SEC for information about John Mack’s exposure in the Pequot investigation, Berger did not immediately recuse himself from the Pequot probe. Berger ultimately left the SEC to join Debevoise & Plimpton. When initially questioned, Berger’s answers concerning his employment search were less than forthcoming.

“The SEC’s Office of Inspector General failed to conduct a serious, credible investigation of Aguirre’s claims.”

The conclusion of the Senate report (page 104) expands on this point regarding the Office of the Inspector General, that part of the SEC tasked with preventing precisely the regulatory capture implicated in these events:

“The OIG investigation into Aguirre’s allegations was flawed from the beginning and hindered by missteps during the entire process. Every step seems to have been based on a desire to go through the motions and close the case. How the OIG could assess Aguirre’s credibility without ever speaking to him remains a mystery. One of the major problems with the OIG seems to be the perception within the SEC regarding the independence of the office and whether or not employees who approach the OIG are treated fairly. We interviewed a number of current and former SEC employees who indicated that the OIG is not well respected and that there is a general reluctance to approach the OIG with concerns. Aguirre was no exception…. Based on our review, the OIG at the SEC seems to have failed in its mission. Other SEC employees perceive it as a tool of management, used for retaliatory investigations against disfavored staff.”

The New York Times summarized all of this in a story with the tepid headline, “S. E. C. Erred on Pequot.” Indeed, if derailing investigations into wealthy elites with “juice” while negotiating high-flying jobs with their white shoe law firms as an Inspector General conducts a half-hearted investigation before whitewashing the cover-up-firing of an investigator too recalcitrant to go along for the ride all count as “erring”, then yes, The New York Times is correct, the SEC “erred” here.

In late July, 2007, SEC Chief Economist Chester Spatt resigned suddenly.

The U.S. Senate report was released on August 3, 2007. That afternoon, Walter Stachnik, Inspector General of the SEC, also resigned (according to this Forbes story, he had held that position since its creation in 1989).

The following Thursday, August 9, 2007, SEC Commission Roel Campos resigned as well.

That same day news leaked of the impending resignation of a second commissioner, Annette Nazareth (who, as we shall see later, is via marriage directly linked to the issue whose exposure is the ultimate purpose of this blog: unsettled trades in our settlement system).

The SEC is overseen by seven people: a Chief Economist, an Inspector General, and five commissioners. Of them, the Chief Economist, the Inspector General, and two of the five commissioners resigned within a three week period surrounding the August 3, 2007 publication of a report by the Senate Judiciary Committee of its investigation into the political capture of the SEC. I do not know the degree to which that constellation of facts is meaningful, nor do I wish to disparage any individual’s record of public service. Yet I trust that at this point my statement, “The SEC, regulator of our nation’s capital markets, has been at least partially captured by financial elites,” is a claim the merit of which the reader will now consider.

Because Mr. Aguirre was thoroughly vindicated by an investigation of the United States Senate, I thought it would be interesting to know how Floyd Norris of The New York Times felt about the hatchet job he had written on Mr. Aguirre. Given that by blowing the whistle on his former employer Aguirre had risked fortune, reputation, and perhaps even his freedom, surely a thoughtful, fair-minded journalist at “our newspaper of record” would welcome the opportunity to reflect on his mocking and derisive attack on Aguirre. So I wrote Mr. Norris a short note that contained a link to his December 5, 2006 story, and the simple question, “How do you feel about this piece now?”

The response I received from Mr. Norris was instructive:

“I have read our story on the Senate report, but not the report itself, and that does not change my opinion on Mr. Aguirre. I did not conclude in the blog that he was or was not fired for illegitimate reasons. The Senate thinks he was, judging by the article. The blog item remains accurate, to the best of my knowledge.”

Another New York Times reader emailed Mr. Norris a similar question, and forwarded to me the short response Mr. Norris sent him:

“And what, precisely did I write about Aguirre that was wrong?”

That is, concerning his own piece lambasting a tiny section of Mr. Aguirre’s position while ignoring all of its crucial elements, and which confined itself to parroting criticisms of him by the SEC, its director of enforcement, and its lawyer, and asking derisive rhetorical questions about Aguirre, and which then ended with Mr. Norris opining that, “It certainly sounds as if [such criticism] was correct,” now, in the face of a Senate report vindicating Aguirre and triggering the disintegration of the highest echelon of the SEC, New York Times senior reporter Floyd Norris can bring himself to express neither remorse nor contrition. Please stick another pin in this as an expression of the standards of journalism evinced by our financial media in general and “our newspaper of record” in particular, for it is a topic to which I shall have cause to return.

In any case, if I may assume that the reader judges my claim regarding the regulatory capture of the SEC to be worthy of at least modest consideration, then I may in good conscience turn to another aspect of that alarm raised to the United States Senate by erstwhile SEC Senior Investigator Aguirre:

“I believe our capital markets face growing risk from lightly or unregulated hedge funds just as our markets did in the 1920s from unregulated pools of money – then called syndicates, trusts or pools. Those unregulated pools were instrumental in delivering the 1929 Crash…. There is growing evidence that today’s pools-hedge funds-have advanced and refined the practice of manipulating and cheating other market participants …”

Of this process Milton Friedman wrote:

“It took about a decade to get the commission in full operation. By that time the reformers had moved on to their next crusade. The railroads were only one of their concerns…. For the railroad men the situation was entirely different. The railroads were their business, their overriding concern… And who else had the staff and expertise to run the ICC? They soon learned how to use the commission to their own advantage.

“The first commissioner was Thomas Cooley, a lawyer who had represented the railroads for many years. He and his associates sought greater regulatory power from Congress, and that power was granted. As President Cleveland’s Attorney General, Richard J. Olney, put it in a letter to railroad tycoon Charles E. Perkins… only a half-dozen years after the establishment of the ICC:

“‘The Commission, as its functions have now been limited by the courts, is, or can be made, of great use to the railroads. It satisfies the popular clamor for a Government supervision of the railroads, at the same time that the supervision is almost entirely nominal. Further, the older such a commission gets to be, the more inclined it will be found to take the business and railroad view of things. It thus becomes a sort of barrier between the railroad corporations and the people and a sort of protection against hasty and crude legislation hostile to railroad interests… the part of wisdom is not to destroy the Commission, but to utilize it.’” (Free to Choose, pages 196-197)

This idea, that a body that was set up to protect society from certain agents could be captured by those agents and turned against society, is the essence of the concept of “capture” (when it concerns regulators specifically, it is referred to as “regulatory capture”). Its pedigree spans the political spectrum from Montesquieu and the Founding Fathers to Karl Marx, and from economists such as Stigler and Friedman (who are generally – if somewhat inaccurately – associated with the Right), to Harvard Law School’s Jon Hanson. I will review the evolution of this idea before turning to recent events involving the Securities & Exchange Commission, the regulatory body overseeing the US capital markets.

The Federalist was a series of 85 essays written by James Madison, Alexander Hamilton, and John Jay (all sharing the nom de plume, “Publius”) published over the second half of 1787 in an effort to convince New Yorkers to ratify the recently drafted US Constitution (click here for all references to The Federalist). The most famous of these essays is Federalist #10, written by James Madison, which took up the subject of special interests, or what he called “factions”:

“By a faction, I understand a number of citizens, whether amounting to a majority or a minority of the whole, who are united and actuated by some common impulse of passion, or of interest, adversed to the rights of other citizens, or to the permanent and aggregate interests of the community.”

Madison recognized that in a free society special interests are unavoidable (”Liberty is to faction what air is to fire, an aliment without which it instantly expires.”) Interestingly, he located the source of factions in the competition among rich and poor, landed, manufacturing, merchant, and financial classes:

“But the most common and durable source of factions has been the various and unequal distribution of property. Those who hold and those who are without property have ever formed distinct interests in society. Those who are creditors, and those who are debtors, fall under a like discrimination. A landed interest, a manufacturing interest, a mercantile interest, a moneyed interest, with many lesser interests, grow up of necessity in civilized nations, and divide them into different classes, actuated by different sentiments and views. The regulation of these various and interfering interests forms the principal task of modern legislation…”

Madison foresaw that these factions represented the greatest threat to the democratic experiment:

“The friend of popular governments never finds himself so much alarmed for their character and fate, as when he contemplates their propensity to this dangerous vice… The instability, injustice, and confusion introduced into the public councils have… been the mortal diseases under which popular governments have everywhere perished.”

So much weight did Madison assign to the problem of special interests that he held the greatest virtue of the proposed Constitution its ability to check them (”Among the numerous advantages promised by a well constructed Union, none deserves to be more accurately developed than its tendency to break and control the violence of faction.”) It was Madison’s hope that the proposed Constitution would accomplish this by creating a republic so large and containing such a multiplicity of special interests that they would cancel each other out (”…the society itself will be broken into so many parts, interests, and classes of citizens, that the rights of individuals, or of the minority, will be in little danger from interested combinations of the majority.”)

Yet Madison’s argument in Federalist #10, that in the republic for which he was advocating special interests would be checked by their mere number, is strikingly half-hearted. Madison himself seems to have guessed that on the subject of controlling “the violence of faction” he was writing a check that might not cash:

“The valuable improvements made by the American constitutions on the popular models, both ancient and modern, cannot certainly be too much admired; but it would be an unwarrantable partiality, to contend that they have as effectually obviated the danger on this side, as was wished and expected.”

We shall see that Madison was correct, to a depth he could not have fathomed.

Next, I ask the reader to consider Karl Marx. That may seem an odd request, but it should not be. As the highly-regarded conservative economist Thomas Sowell has written, “…[Marx's] intellectual legacy, especially his insights concerning history, are now part of the general intellectual equipment of modern man” (Marxism, page 187). A significant part of that legacy was Marx’s view that what we experience as law, culture, and civil society are actually cloaks for powerful economic interests wrestling to determine social outcomes. Thus the Marxian sense of “capture” runs deeper than mere influence with politicians or regulators. For Marx, civil society was the public face of an occupation by a hostile ruling class. As Marx & Engels put it in The German Ideology (1846):

“The ideas of the ruling class are in every epoch the ruling ideas.”

This Marxian tradition lives on, somewhat notoriously, at our universities, in courses and departments using the word “critical” in their name. For example, a generation ago the Critical Legal Studies tide came in at Harvard Law School. Its main figure, Roberto Mangabeira Unger, explored law as a discourse shielding from public view the reality of power politics, that reality being White, male, wealthy “elites” cloaking their control of society in the rule of law’s false neutrality.

The CLS tide went out by the 1990’s. However, the recent work of Harvard Law Professor Jon Hanson (a self-defined “Critical Realist,”) moves past legal analysis to postulate a fuller concept of “deep capture” that resembles Marx’s original critique of civil society. Hanson has raised the possibility that powerful economic interests have captured not only regulators and legislatures but journalism, universities, and popular culture (see “The Situation: An Introduction to the Situational Character, Critical Realism, Power Economics, and Deep Capture”). By way of example, Hanson argues with respect to a certain school of legal thought (”Law and Economics”) that over the course of the last generation has come to dominate American jurisprudence, that its triumph has been engineered by powerful groups with an interest in its success. If Hanson is right, the success of the Law & Economics movement in US law schools is less a function of its theoretical strength than it is a function of the fact that it favors elites, a number of whom have funded conferences, journals, professorships, and even law school buildings, in order to allow a shoddy theory to emerge as though it were the winner in a neutral marketplace of ideas.

“But neither considers that such profound effects might well have been the precise ambition of powerful individuals, entities, and groups in our society with the means to influence those important institutions through the situation…
“As we have been arguing, the situation is often as significant as it is invisible. Where Posner, Ulen, and most legal scholars tend to see a marketplace of ideas in which supply-side participants determine the winners, we see a marketplace of ideas in which demand-side actors are wielding an immense, unseen influence over the playing field and, in turn, the winners.”

I believe Hanson pushes on this idea too hard: that is, I believe that Law & Economics is a consistent, satisfying theory which produces good results for society, and its success cannot be dismissed as having been bought-and-paid-for. However, our disagreement on that point is not relevant here. I bring up Hanson because I think it worth considering the manner in which Hanson asks us to imagine our social world. Could it be possible for some agents to capture not only regulators and politicians but the institutions of our civil society, such as the universities, the press, and the intellectual class? Could the capture run so deep that it would become nearly impossible to reason one’s way out of it? In other words, could it be possible that our social world resembles the world depicted in the movie The Matrix, dominated by a machine that taps us for its energy while deluding us about our situation, until we heed rare glimpses of evidence that might wake us to our fate?

Please put a pin in this notion of “deep capture.” I will return to it in due course.

The reader who wishes to explore the concept of “capture” should see George Stigler’s seminal 1971 paper, “The Theory of Economic Regulation” (one of the works for which he won his Bank of Sweden Prize in Memory of Alfred Nobel), and Laffont & Tirole’s 1991 paper, “The Politics of Government Decision Making: A Theory of Regulatory Capture.” For information on regulatory capture in developing countries, see Columbian researcher Frédéric Boehm’s “Regulatory Capture Revisited – Lessons from Economics of Corruption”, along with World Bank economist Anwar Shah’s “Corruption and Decentralized Public Governance”. Please note that throughout this literature there exists a theme of staff moving back and forth between a regulator and the industry it oversees, and the pathological incentives thus created.

For our purposes, however, we need go no further. I wished only that the reader would come to see “capture” not as a fringe idea of paranoids. Capture threatens governments in every country. It was a primary concern for our republic’s founders, and it is a current concern of World Bank “institution building” programs. It happens in market and socialist economies. In this country it happens under Democrats and Republicans. It happens to regulators often enough that economists created a term (”captured regulator”) to describe it.

So when I claim that our financial regulator (the SEC) has been captured by the industry it regulates (Wall Street), I do so not from a desire to abuse or insult fine people engaged in public service. I wish merely to raise in a clinical and dispassionate way the possibility that what Madison saw as “the mortal disease[] under which popular governments have everywhere perished,” and what economists spanning the spectrum from Marx to Stigler to Friedman saw as a normal tendency of government, is also a possibility with regard to our own situation, and in particular, our own financial regulator. In fact, given that anybody trying to regulate Wall Street is trying to regulate some of the deepest pools of money in the world, would it not be extraordinary if it were not the target of regulatory capture?

All of which leads us to the curious case of Mr. Gary Aguirre, formerly of the SEC.