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The SEC and its culture of regulatory capture

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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.

Posted in Featured Stories, Our Captured Federal Regulator the SEC, The Deep Capture CampaignComments (83)

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