Category | Our Captured Federal Regulator the SEC

“Capture” Explained

In the late 19th century the work of governing the United States began its partial shift from legislatures to regulators. In 1887 the U.S. Interstate Commerce Commission was founded, and has served as a cautionary tale ever since. The ICC was established to regulate the railroads but was quickly subverted by the industry it was supposed to oversee. That happened because its staff learned that if they “regulated” the railroad industry (and later, the trucking industry) by fixing prices artificially high and restricting new entrants, so that the industries they regulated made super-profits, then cushy jobs and directorships would await them upon their retirement.

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.

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Wall Street Captures the SEC

For reasons that will eventually become clear, in early 2005 I began to believe that the SEC was behaving oddly, that is, in a manner inconsistent with its duties as a regulator. By the summer of 2005 I began publicly stating two hypotheses for this behavior. The first was that the SEC had been captured; I will explain the second in Deep Capture’s Chapter 7, “Unsettled Trades and Systemic Risk“.

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 …”

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There. Was That So Hard?

In mid-2004 the Securities & Exchange Commission (itself a kind of a joint venture of the US federal government and Wall Street) adopted Regulation SHO. Among other things, “Reg SHO” insisted that exchanges publish the names of firms being victimized by naked short selling. They left plenty of loopholes (grandfathering, offshore failures, option market making abuse) and used lots of weasel-words to say it, and courteously stipulated no penalties for failing to follow the rules, and gave everybody until January 2005 to figure out new ways around them, but tepid though these measures were, curtailing naked short selling was their basic thrust.

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

Reg SHO Threshold List Membership Since January, 2005


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….

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Regulators Spring Into Action Against Naked Short Sellers. Or not.

As is explained in numerous pieces in DeepCapture, there are many cracks in the settlement system, one of them being the DTCC’s Continuous Net Settlement system, or CNS. I am highly confident that the federales (at least, the SEC) are not permitted to explore the other cracks, that the failures to deliver that they see within the CNS are thus but a small fraction of all that exist, and that, therefore, trying to gauge the depth of the naked short selling problem from the level of FTD’s in the CNS is like trying to guess the condition of an automobile from the level of water in its radiator.

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?

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A hedge fund suite for Richard Sauer

In a recent interview, SEC whistleblower Gary Aguirre offered his insights into the regulatory failings that allowed the Bernie Madoff scheme to reach such enormous proportions for so long.

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 (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?

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SEC Enforcement Chief Linda Thomsen Joins Davis Polk. Somebody Call Kreskin.

SEC Enforcement Chief Linda Thomsen Joins Davis Polk. Somebody Call Kreskin.

As a rule, I avoid criticizing individual public servants. Elected officials are fair game, in my view, but not public servants. They do not wake up and go into work wanting to do a bad job, I know, and I have had too many tailwinds in life to criticize wantonly people who devote themselves to public service of any kind, simply as a matter of principle.

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, BethanyLong, Slow ThingMcLean 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.

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The SEC and its culture of regulatory capture

The SEC and its culture of regulatory capture

Perspective is a funny thing. The full taxpayer cost of the S&L bailout came to an enormous, inflation-adjusted tab of around $255-billion; and yet, in the shadow of the latest spate of bank bailout checks written by Congress, that doesn’t seem like much. Similarly, the $60-billion Madoff fiasco tends to make the many Ponzi scheme busts that followed seem quaint by comparison, including the $7-billion scam allegedly carried out by Robert Allen Stanford’s firm.

Just to make sure everybody agrees that $7-billion is a lot of money – keep in mind it exceeds the GNP of 40% of the nations on earth. Imagine putting a match to all the goods and services produced in one year by the people of Laos or Mongolia. Stanford is accused of doing that, and more. But because it’s just a tenth of the wealth destroyed by Madoff, Stanford may forever be regarded a Ponzi also-ran.

But dig a little deeper and you’ll find the Stanford case is the bigger outrage by far, not so much for the scam itself, but for the shocking behavior of the regulators tasked with preventing it. Where Madoff was enabled by SEC bureaucratic incompetence, Stanford was empowered by overt SEC indifference.

That’s right – indifference. Unlike Meghan Cheung, the former head of enforcement at the SEC’s New York branch, who didn’t know how to determine whether Madoff was running a Ponzi scheme, her counterpart in Fort Worth spent years swimming in evidence of Stanford’s scam, but simply preferred not to do anything about it.

The evidence, if you can stomach it, is oozing out of the report recently submitted by SEC Inspector General extraordinaire David Kotz. In it, we learn that SEC examiners spotted the red flags as early as 1997, and spent eight years lobbying then-chief of Fort Worth’s enforcement division, Spencer Barasch, to investigate. Barasch repeatedly declined, even as evidence of the Stanford scam – together with the size of the scam itself – grew exponentially.

The first referral by SEC examiners was sent to Barasch in 1998. According to the testimony of Julie Preuitt, who helped author the request, Barasch declined to investigate after discussing the matter with Stanford’s legal counsel at the time, former SEC Fort Worth District Administrator Wayne Secore.

According to the report:

Barasch told Preuitt “he asked Wayne Secore if there was a case there and Wayne Secore said that there wasn’t. So he was satisfied with that and decided not to pursue it further.”

Obviously, Barasch denies this, and such a claim would be difficult to believe were it not for the well-documented facts that follow.

Barasch finally left the SEC for a spot as partner in the law firm of Andrews Kurth in 2005, shortly after putting the kibosh on a third attempt by SEC examiners to investigate Stanford. Barasch’s replacement accepted a similar recommendation later that year, but the resulting inquiry was mismanaged and did not produce an enforcement case until February 2009, after the Commission’s hand was forced by Madoff’s admission two months earlier.

But it was what happened after Barasch’s departure from the SEC that casts his earlier actions in a much harsher light. As the investigation discovered:

[Barasch], who played a significant role in multiple decisions over the years to quash investigations of Stanford, sought to represent Stanford on three separate occasions after he left the Commission, and in fact represented Stanford briefly in 2006 before he was informed by the SEC Ethics Office that it was improper to do so.

The final of Barasch’s three attempts to represent Stanford was by far the most brazen, not to mention instructive. It happened in February 2009, immediately after the SEC filed suit against Stanford. Like the two before it, the third was also denied. When asked to justify the renewed request, Barasch replied,

“Every lawyer in Texas and beyond is going to get rich over this case. Okay? And I hated being on the sidelines.”

In email, veritas.

Not only was Barasch apparently numb to the definition of “ethical conflict,” he seems to have used it as a business development tool, at least that’s the impression left by an email not included in the Kotz report but acquired by the Dallas Morning News. According to the email, after Mark Cuban was sued by the SEC’s Fort Worth office for insider trading in 2008, Barasch told an associate of Cuban’s,

“I am friends with and helped promote two of the guys who signed the Complaint against Mark. Someone should tell Mark to look at my profile on my firm website, my SEC press releases, and advise Mark to add me to his defense team.”

It’s safe to say that Barasch plays the heavy in the IG’s report, but read it carefully, and you’ll find that he’s not the real villain. Instead, that role is played subtly but consistently by the broader SEC Enforcement Division’s flawed culture.

As the report stated,

We found that the Fort Worth Enforcement program’s decisions not to undertake a full and thorough investigation of Stanford were due, at least in part, to Enforcement’s perception that the Stanford case was difficult, novel and not the type favored by the Commission. The former head of the Fort Worth office told the OIG that regional offices were “heavily judged” by the number of cases they brought and that it was very important for the Fort Worth office to bring a high number of cases…The former head of the Examination program in Fort Worth testified that Enforcement leadership in Fort Worth “was pretty upfront” with the Enforcement staff about the pressure to produce numbers and communicated to the Enforcement staff, “I want numbers. I want these things done quick.” He also testified that this pressure for numbers incentivized the Enforcement staff to focus on “easier cases” – “quick hits.”

And these instructions were predictably manifest in the handling of the Stanford case, as evidenced by the reaction to an anonymous Stanford insider’s letter, first sent to the NASD, denouncing Stanford as a Ponzi scheme. The letter was forwarded to the SEC where Barasch saw and ignored it, saying,

“Rather than spend a lot of resources on something that could end up being something that we could not bring, the decision was made to not go forward at that time, or at least to not spend the significant resources and wait and see if something else would come up.”

The report also cites a former Fort Worth office administrator who says Barasch and others in his group had been subjected to criticism from high-level SEC staff in Washington DC for “bringing too many Temporary Restraining Order, Ponzi, and prime bank cases.”

Accordingly, Fort Worth was admonished to avoid investigating “mainstream” cases in favor of simple accounting fraud.

Now, let’s take a step back to see what insights into the SEC’s enforcement paradigm might be gleaned from what we’ve learned so far.

  1. Given his actions both prior to and after leaving the Commission, I suspect Spencer Barasch’s approach to regulating Stanford – and presumably other entities – was heavily influenced by a desire to maximize his eventual private sector opportunities. This is further evidence that the significance of regulatory capture and the revolving door ethic in the minds of SEC enforcement officials cannot be overstated.
  2. Whereas “Ponzi and prime bank cases” most often apply to investing institutions, while accounting fraud charges are most often leveled against public companies, I suspect the high-level mandate to prefer the latter over the former to be the root of the SEC’s long-suspected anti-issuer/pro-institutional investor bias – or at the very least, further evidence of it.
  3. This apparent anti-issuer bias, paired with the report’s well-documented evidence of the SEC’s preference of case quantity over quality, offers additional support for the widely-held belief that cases against public companies are seen as low-hanging (and career-protecting) fruit in the eyes of Enforcement Division staffers.

If my conclusions are correct, then the Stanford outrage is not really about Spencer Barasch, but the SEC’s flawed enforcement culture, from Washington DC on down. I further suspect this culture to be a key factor in explaining the SEC’s role as enabler of the stock manipulation schemes extensively documented here on Deep Capture.

But don’t take my word for it. Instead, consider the words of then-Director of the SEC’s Division of Enforcement, Linda Chatman Thomsen, responding to a question posed by a member of the audience following her keynote address at the US Chamber of Commerce’s 2008 Capital Markets Summit.

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?”

Thomsen: “As to naked short selling, and more generally market manipulation generally, 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.”

Thomsen’s answer needs to be examined from two angles: what she said and what she (meaning, her division) actually did.

What Thomsen said, was that when it comes to illegal, manipulative naked short selling, “it’s a hard case to bring,” and that it often it turns out the targeted company deserved to have its stock manipulated. But don’t worry…the SEC Division of Enforcement cares and regularly investigates complaints of illegal, manipulative short selling.

What Thomsen’s division actually did was quite different. We know this thanks to another outstanding report by SEC Inspector General David Kotz relating to the Commission’s handling of complaints of illegal, manipulative naked short selling between January 2007 and June 2008. What Kotz discovered was that of the more than 5,000 complaints received by the Division of Enforcement during that time, not one resulted in an investigation.

Kotz further found that while robust methods exist for dealing with complaints relating to “spam driven manipulations, unregistered online offerings and insider trading” (again, infractions typically committed by issuers), no written policies existed for dealing with complaints of illegal naked short selling. This “[has] the effect of naked short selling complaints being treated differently than other types of complaints.”

And in this case, “differently” meant “not at all.” This attitude closely mirrors that of the SEC’s Division of Enforcement as described in the Stanford report.

In my opinion, the best thing to happen to the SEC in many years is the arrival of Inspector General David Kotz. The second best thing is the February 2009 departure of Linda Thomsen. In the months following the arrival of Thomsen’s successor, Robert Khuzami, many encouraging developments have been observed, including two enforcement cases brought against manipulative naked short sellers, the permanent adoption of regulations greatly reducing instances of such manipulation, and the recent case brought against Goldman Sachs (NYSE:GS). Each of these represents an important departure from the SEC’s long-standing anti-issuer/pro-bank approach to regulation.

These positive developments notwithstanding, the dysfunctional culture at the SEC’s Division of Enforcement was undoubtedly a long time in the making. As a result, it will require a long time to root out. Unfortunately, we don’t have a long time. Investor confidence in the fundamental fairness of our capital markets must be restored now, not as long as it takes the old guard’s institutional memory to fade away. Having read the Stanford report, the only practical solution I see is a new beginning. Congress needs to sunset the SEC on an immovable — and ideally not too distant — date certain and instruct the Department of Justice to have a replacement ready to begin work the next day.

The next best solution would be to disband the SEC entirely, and send big, red warning letters to all potential market participants, giving them fair warning that they’re on their own.

These may seem like desperate measures, but I suspect you’ll agree these are becoming increasingly desperate times.

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Goldman’s gold has lost its luster

Goldman’s gold has lost its luster

The most clichéd, yet satisfying, moment in any movie comes when the brutally bullying antagonist discovers he’s lost that which had empowered his abusive nature. Wait…I take that back. Seeing that fear in the bad guy’s eyes is the second most satisfying movie moment, the first being the inevitable administration of long-overdue justice that follows.

Though evidence has mounted for a while, today it became official: Goldman Sachs (NYSE:GS) is now on its own, as the guardian angel/demon that once enabled the firm’s assault on our capital markets has clearly severed that relationship. At least that’s the conclusion I draw from the news that Goldman was censured and fined by NYSE and the SEC for specific faults in “execution and clearing” (another way of saying “naked short selling”).

What changed? After all, Goldman is still rich, right?

Well…sort of. Goldman may be flush with cash, but with pressure mounting on politicians to reject any of it in the form of campaign contributions, suddenly that cash doesn’t spend nearly as well as it used to.  At the same time, it’s probably safe to assume Goldman’s allure as a future client has been severely degraded in the eyes of private sector career-minded regulators.

In other words, Goldman’s gold has lost its luster, and with it, the firm’s political ‘juice’. I can only imagine the look on their faces when Goldman brass first realized why their calls were not being returned: their power was gone. And folks with badges were knocking on the door.

Goldman’s role as a facilitator of illegal, short-side market manipulation will never come to symbolize its villainy in the mind of the public the way knowingly selling its clients garbage CDOs on behalf of John Paulson will. But that’s what makes this latest development even more significant: it suggests a sort of “piling on” mentality that was inconceivable just one month ago (keep in mind this is the company that, evidence suggests, successfully lobbied to have even legitimate short selling banned once the practice began to impact its share price). This, in turn, may be an inadvertent signal from regulatory “insiders” that Goldman’s prospects of emerging intact from this storm are slim.

Do not mistake the tone of this post for contentment, for this particular action doesn’t come close to addressing what I suspect is the true breadth and depth of Goldman’s role in short-side market manipulations. Indeed, the bulk of this particular complaint focuses on a few infractions observed over a few weeks in late 2008. Goldman, for its part, attributes the problem to an inconsequential bookkeeping error. If that’s true, a half-million dollar fine for an accounting mistake makes Goldman’s plight seem even more dire.

In the end, what’s most significant about this complaint is the insight it provides into how the system works when inappropriate influence ceases to be a factor in the regulatory process (something we’ve grown accustomed to not seeing): investigators investigate, infractions are cited, penalties applied, juice ignored.

I’m not convinced it’s within human nature to develop a financial markets regulatory paradigm able to consistently achieve this ideal (though I’m certain we can do better than what we’ve got). The alternative is to focus on the other side of the equation by limiting the capacity of any market participant to become so influential the rules cease to apply.

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Moral Hazard at the SEC

Moral Hazard at the SEC

Moments after first mention of the word “bailout” came the first of many references to the inevitable outcome: moral hazard, which is the term used to describe the direct correlation between the irresponsibility of one’s behavior and the degree to which one is insulated from responsibility for said behavior.

Moral hazard is observed in any decision-making entity – including individuals, corporations and even government regulatory agencies – and in extreme cases helps to explain many of their otherwise inexplicable actions. Indeed, when attempting to understand much of what happens at the Securities and Exchange Commission (SEC), I believe moral hazard is nearly as important a factor as the much more frequently-discussed matter of regulatory capture.

The following case illustrates this quite aptly.

In his most recent report to Congress, David Kotz, Inspector General of the SEC, summarized an internal report prepared by his office in which two unnamed enforcement attorneys were found to have provided information on non-public SEC investigations to an unnamed short-seller and an FBI agent. It’s apparent that the short-seller and FBI agent are the infamous Anthony Elgindy and Jeffrey Royer, respectively. The identities of the two SEC investigators who enabled them, on the other hand, are not clear.

Hoping to learn more, longtime SEC critic Dave Patch requested and received the IG’s full report on the matter (get your copy here!). Months later, the report arrived, though redacted by SEC censors (not affiliated with the IG’s office) to the point of near incomprehensibility. None the less, thanks to a single missed redaction and extensive cross-referencing of facts mentioned in the report, we’ve established the identities of both SEC employees.

They are: Douglas Gordimer and Robert Long, both senior investigators at the SEC’s Fort Worth regional office. Knowing this, it’s possible to fill in almost all of the holes left by SEC censors, and better understand the enabling role that organization played in the Elgindy/Royer scams.

It all began in March of 2000, when Royer, then a special agent with the FBI’s White Collar Crime Unit, contacted Gordimer about Broadband Wireless (BBAN), a public company Royer was investigating. We know from other sources that Royer would later inform Elgindy associate Derrick Cleveland of the subsequent SEC investigation into BBAN, and that both Cleveland and Elgindy illegally (and profitably) used that information to short the company’s stock ahead of the investigation’s disclosure.

The BBAN situation apparently gave Elgindy a really bad idea: to use Royer as a conduit for acquiring negative, confidential information about potential shorting targets, and as a catalyst for launching SEC investigations into companies Elgindy was already shorting.
According to the IG report:

During the course of the BBAN investigation, Royer began to contact Gordimer to “try to get the Commission to investigate” various other companies and individuals based on information that Royer provided to Gordimer. Royer would tell Gordimer that “he had some information about [alleged securities laws violations by public companies] that he wanted to pass along” and would ask “who at the SEC might have an open investigation about the company.” (OIG-512 report p.4)

In response to Royer’s requests, Gordimer acknowledged that he would perform a search in the NRSI database, which he described as “an internal SEC database that shows all the open investigations and closed investigations and filings of different entities,” to determine if the SEC currently had an open investigation for the company or individual. (OIG-512 report p.5)

In addition to providing this information, according to Gordimer if there was an existing investigation of the company or individual about which Royer had inquired, Gordimer would refer Royer to the SEC staff attorney conducting the investigation. If the SEC did not currently have an open investigation of the company or individual about which Royer inquired, Gordimer would take the information from Royer and look into it himself. (OIG-512 report p.5)

Gordimer testified that he knew Royer lacked the proper authorization to request such confidential information, but that he freely provided it anyway.

In September 2000, Royer’s involvement in the FBI’s White Collar Fraud unit ceased as he was transferred to Gallup, NM, tasked with investigating crimes on an area Indian reservation. And yet, Royer’s calls to the SEC continued, and in January 2001, Royer also began calling Robert Long, probing for information on confidential investigations and lobbying to get others started.

During this period, Gordimer and Long also began to deal directly with Elgindy, and both became frequent readers of his website,

Later in 2001, Gordimer acknowledged that he became aware of a correlation between the stocks that Royer asked him to investigate and the stocks that Elgindy discussed on Despite knowing about this correlation and Elgindy’s background, Gordimer insisted that Royer “wasn’t just fishing” for information by continuing to bring information to him, particularly as some of this information had resulted in the opening of a few “legitimate investigations.” (OIG-512 report p.7)

Royer informed Gordimer in January 2002 that “he was leaving the Bureau to go work for some investigative agency which…was associated [with] Elgindy. Gordimer later learned that Royer had received a job offer from Elgindy directly and that Royer would be working with…the company running Elgindy’s (OIG-512 report p.7)

Meanwhile, Royer’s requests for information about investigations into public companies slowed but did not stop, though Gordimer felt it prudent to no longer tell Royer exactly who was handling any active investigations, opting instead to provide the relevant SEC staffer with Royer’s number and instructions to get in touch with him. Either way, the outcome is the same: disclosure of confidential, highly material information to a business partner of known short seller Elgindy, despite past evidence of a correlation between such disclosures and shorting activity by Elgindy.

But wait, there’s more.

Despite the fact that Royer left the FBI altogether, Gordimer contacted Royer about an alleged false press release issued in March 2002. Gordimer said he needed information about the company “quickly” in order to determine whether the SEC should suspend trading of its stock.

The IG’s report summarizes the situation nicely as follows:

Therefore, by disclosing information to Royer about whether certain companies and individuals were under investigation, Gordimer released non-public information to Royer. Royer would then provide this information to Elgindy and his associates, and they would sell short the companies’ stock in order to earn illegal profits…By discussing non-public information with Royer without appropriate agency authorization on numerous occasions, the OIG finds that Gordimer repeatedly violated SEC policy. (OIG-512 report p.9)

Normally, such an overt pronouncement of culpability would equate to an explicit demand for one’s resignation, if not one’s termination. But lacking such authority, Kotz was forced to pass the baton to just about every one of Gordimer’s and Long’s superiors.

In light of the foregoing, these matters are being referred to the Director of Enforcement…the Associate Executive Director for Human Resources, the Associate General Counsel for Litigation and Administrative Practice, and the Ethics Counsel for consideration of disciplinary action against Gordimer and Long. (OIG-512 report p.13)

The outcome?

According to Kotz, “[Gordimer and Long] were issued written counseling memoranda and were required to attend training.” (OIG Semi-annual report, April 2010 p.67)

In other words, neither was held responsible for their deeply irresponsible behavior. And, in such a setting, the principle of moral hazard dictates that behavior will become increasingly irresponsible.

And it’s about to get much worse.

The only reason we know what little we do about the SEC’s culture of irresponsibility is the Freedom of Information Act (FOIA), which imposes much transparency on government by empowering citizens seeking access to official records. It was through FOIA that we were finally able to grasp of the true depth of the illegal naked shorting problem. FOIA also helped to identify the motives behind the illegal firing of SEC investigator Gary Aguirre and the extent of the Commission’s failures in stopping the Madoff and Stanford Ponzi schemes. And not least, FOIA made it possible for Dave Patch to acquire the above-cited internal report detailing the SEC’s role in supporting Anthony Elgindy’s illegal trading racket.

In each of these cases, the SEC was held responsible for its screw-ups only after documentary evidence was revealed – and that was only possible through FOIA requests submitted by the public and news organizations.

Today, Fox Business reports that the SEC is claiming Section 929I of the recently-signed financial reform bill exempts it from complying with FOIA. In other words, the SEC currently finds itself in a regulator’s wonderland: all of the authority and none of the accountability. If ever there was a reason to urgently contact your representative in Congress, this is it. That body must be made aware of the disaster of unintended consequences buried in the legislation they just passed. Please contact yours immediately (you can find their contact information here).

Postscript: to learn more about the Elgindy/Royer case, check out his excellent report from the series American Greed.

Posted in Featured Stories, Our Captured Federal Regulator the SEC, The Deep Capture CampaignComments (75)

Professor William Black Flunks Bethany McLean for Giving Hall Passes to Goldman Sachs and Wall Street

I first heard of William K. Black over 20 years ago as the regulator who had stood up to the “Keating 5” and come out the hero of the S&L crisis (in which I gained some early experience: hence my awareness of him). Later, as a professor of law and economics at University of Missouri in 2005, Black wrote a book about control fraud,  “The Best Way to Rob a Bank is to Own One,” available here. You should read it.

Yet I had never heard Black speak until one night in April, 2009, when he appeared on Bill Moyers. How refreshing it was to see the tabloid analyses be at last replaced with discourse about the system itself (and remember that while the following claims now seem barely controversial, in 2009 most were still heretical):  Banksters. Fraud versus trust. Moral hazard and pathological incentives in the financial system (e.g., lending firms’ Ninja Loans + investment bankers pooling mortgages + captured ratings agencies = toxic waste = systemic risk).  FBI warned on mortgage fraud in 2004, but the Machine failed to react. Bank lobbyists. Glass Steagall. Brooksley Born and Credit Default Swaps. Bailout of the elites. Bank CEOs. Cover-up. Strategy to keep the public from understanding how bad the problem is. Prompt Corrective Action Law: Nationalize zombie banks. WHERE IS OUR PECORA COMMISSION? Scared of insolvent banks being revealed. Mimicking the strategies of Japan’s Lost Decade.  AIG-to-Goldman bailout.  Increasingly horrific give-aways of taxpayer money. Stop hiding the losses.  The current bleak numbers still vastly underestimate the fraud problem.

Black had me at “control fraud.”  I leave it to the community of readers to judge the familiarity of the other claims he made:


Alas, Bethany McLean and I are not so sympatico, and in fact have had a challenging relationship. Her side of the story is told  here:

Is Overstock the new Amazon?


DeepCaptures’ side, here:

Bethany McLean: your benefit of the doubt is hereby revoked

Rocker Partners and Bethany McLean: the smarmiest guys in the room

David Einhorn, Cheryl Strauss, and the “Unavailable” Bethany McLean

One interesting aside: in the last year I have had numerous journalists bring up to me Bethany’s emails wherein she schemes with a hedge fund (emails obtained by DeepCapture from a New Jersey courthouse and published in Bethany McLean: your benefit of the doubt is hereby revoked). These journalists have told me that they know about it and see it as a tremendous breach of journalistic ethics. So there it sits, an open secret, although not, apparently, a secret anymore, but just something about which one whispers.  In a similar fashion, Jim Cramer’s video sat on DeepCapture for a couple of years drawing no comment, until Comedy Central confronted Cramer with it.

In any case, this week on CNBC Maria Bartiromo invited William Black and Bethany McLean on as guests to discuss the Justice Department’s decision not to pursue criminal charges against Goldman Sachs for its role in the financial crisis in general, and for selling financial products from whose specific failure Goldman profited. Truly remarkable performances were delivered by all, albeit in different ways.

Black responds to Maria’s opening by stating the obvious: Generating liar loans and packaging them for resale is fraud. There is no evidence that there was a significant federal investigation, or that a grand jury was convened. There is an absence of  accountability.  Goldman has been given a pass by Obama and Bush.

Bethany responds with bromides delivered with a dulcet confidence intended to suggest that she knows what she is talking about. Her analysis: I don’t think anybody is giving  Goldman Sachs a pass to be honest. I think this is a tough case to make. I do think integrity needs to be restored to the financial system, but you don’t do that by bringing a case that shouldn’t be made. Goldman Sachs didn’t make liars’ loans –  they actually among the Wall Street firms were not on the ground making mortgages. So if you can’t bring a case against Countrywide how can you possibly bring a case against Goldman Sachs?  … From an overall perspective Goldman Sachs as a firm lost money in the mortgage business. Awfully tough to bring that case to a jury and win, I think… I’m not giving Goldman a pass or any of Wall Street a pass. I think I’m with Bill on that. But I don’t think this was a criminal case.  I think Goldman’s customers should make the call: Do we want to do business with this firm? …

These vapid apologetics draw Maria Bartiromo’s stammering, nodding approval: As you said earlier, stupidity does not mean criminality.

Bethany: Greed and venality do not make a criminal case.

There are two remarkable items about Bethany’s performance. First, note the air of confidence she exudes when in fact (as will become clear) she has essentially no idea of what she is talking about (hence the expression “a journalistic understanding”). Second, note that Bethany is apparently unaware that the man she is debating on-air, Professor William K. Black, knows a lot about what she is talking about. In fact, he is perhaps the nation’s foremost expert on precisely the issue she and Maria are trying to spin to Goldman’s behalf: the federal prosecution of white collar crime at financial institutions.

Professor Black continues like a gentle professor with two weak students: Critical area here…. First, I’m the type of person that was involved in training the FBI agents, the assistant US attorneys, serving as the expert witness in these successful prosecutions where we had a 90% successful rate. Um, clearly people are not understanding fraud mechanisms. In accounting control fraud, the firm – loses – money. Indeed that is one of the defining elements because the way you maximize it is by making bad loans. And Goldman did make liar’s loans, it did it through subsidiaries, and Goldman purchased loans that it knew to be fraudulent, and it packaged them and sold them as if they were good loans. This belief that this is the first virgin crisis in which fraud was not driving it is amazing. Nobody believes it about the savings and loan debacle. No one believes it about the Enron era fraud. And given what you’ve seen in the last three weeks, how can you believe it out of the current…”

Bethany appears to panic slightly then, unable to respond substantively to a single one of Black’s arguments, simply locks into a repetitive, droning regurgitation of the talking points she just delivered a moment earlier (which amplifies my suspicion that some Goldman PR flack gave them to her to memorize). Behold Bethany McLean’s verbatim analysis of legal culpability in the greatest financial collapse of our lifetime (so far):

Maria, I think there was a hue and a cry and a lot of political pressure to bring charges in this case. And I think that if they could have, they would have. And I don’t think that any of our interests are served… I think it’s just as dangerous to bring a case that shouldn’t be made as to not bring a case that should be made. Neither one helps with the integrity of the financial system. I agree – peoples’ behavior during this crisis was unethical, it was abhorrent, it was every word you can come up with for ‘wrong.’ But if you are going to bring a case against Goldman Sachs you have to bring a case against every single other Wall Street firm as well as every mortgage originator as well as every home owner who lied on his or her mortgage application. You cannot single out one firm and say we are going to charge Goldman and we’re not bringing charges against everybody else. That’s wrong.

Maria Bartiromo: That’s a great point.

William Black (like a professor exasperated with dull students he can no longer humor): No, it’s not a great point. It’s a terrible point. You’ve got to start with somebody. Your first prosecution is always your first prosecution. And you can always say where there’s been an epidemic of fraud…”

Goldman Sachs Avoids Prosecution from CNBC.

Bethany’s nails-on-a-chalkboard apologetics have received a fair bit of shocked attention this week:

Columbia Journalism Review: “Bill Black goes on CNBC and shreds Maria Bartiromo and Bethany McLean on whether Goldman Sachs (and others) could and should have been prosecuted for fraud related to the financial crisis…”

Bill Black vs Goldman Sachs Apologists

WATCH: Bill Black On CNBC Debates Wall Street Fraud-Deniers Maria Bartiromo, Bethany McLean

Bethany McLean Demonstrates her Profound Lack of Understanding of Control Fraud, Gresham’s Dynamics, and Justice: “In this painful CNBC segment, former Goldman Sachs employee Bethany McLean provides a heartfelt apologia for her much-maligned former employer. Bethany says it is time for us all to move on for the good of confidence in the economy…In the process of prostrating herself for GS, she demonstrates her complete lack of understanding of control fraud, Gresham’s Dynamics, and how white collar crime can be pursued.”

I think this interview was unusual in that her panic drew Bethany into baring her biases incautiously (though frankly, the first sentence she uttered the first time she called me in 2004 conveyed to me that she is a shill and a Mean Girl). Asserting without argument that  political pressure supported bringing charges against Goldman, Bethany appears literally incapable of considering the possibility that net political pressure ran in the opposite direction, and that in fact were it not for “political pressure” Goldman Sachs would have been prosecuted years ago.

But personally, I think Bethany is not really incapable of considering such a possibility, and that her adamancy thus has other motive.

Daily headlines disappoint with lack of prosecution, making clear that this will go down as history’s “first virgin financial crisis” (in Professor Black’s phrase) in which fraud played no role.  When you read these headlines, imagine Bethany McLean, or someone very much like her, standing in an oak-paneled room in Washington, DC, droning through the same set of talking points to some senior decision-maker, and that decision-maker slowly getting snowed in under the same dulcet non sequiturs as appear in this remarkable exchange.

Posted in Our Captured Federal Regulator the SEC, The Deep Capture CampaignComments (320)

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At the time much of the content on was written, the Great Financial Crisis of 2008 was either on the verge of happening or had just occurred. In those days, emotions among this publication’s contributors were raw and, in an effort to get their warnings noticed and appropriate blame placed, occasionally hyperbolic language and shocking imagery were employed.

Were we to write these entries today, a different tone would most certainly prevail.

Yet, being a record of a pivotal time in our global economic history, we’ve decided to leave the rawness unedited, with the proviso that readers take the context of the creation of certain posts into account, and that those easily offended re-consider the decision to read them.