TheCorporateCounsel.net

May 18, 2009

Allegations about Insider Trading Within the SEC

Well, the latest thing to tarnish the SEC’s reputation is making the rounds. CBS broke the news on Friday with this report that two SEC Enforcement attorneys are under investigation by the FBI for possible insider trading, based on a 56-page report from the SEC’s Inspector General. The mainstream media (eg. WSJ) blogosphere is humming with the news (eg. Crooks & Liars).

Here are the basics that we know from the IG’s report:

- The IG started to look into this matter in January ’08 after the SEC’s Ethics Office informed it of an Enforcement attorney who pre-cleared voluminous trades.

- The IG reviewed more than two years of email and broker records and broadened the inquiry to two other Enforcement attorneys (one of whom didn’t trade nor respond to emails from the other two, but did communicate with them otherwise about the markets).

- The IG referred its investigation to the FBI and DOJ after it noted that some of the trades by the two Enforcement attorneys occurred around the time that the SEC opened investigations into the related companies.

Here are some interesting tidbits from the report:

- Although the report doesn’t identify the two targeted Enforcement attorneys, we know that the female has been with the SEC since 1981 (and was referred to as a “stock guru” by the others, page 34) and the male is in Enforcement’s Chief Counsel office.

- These two targets – plus the other enforcement lawyer – had a “standing lunch” for Monday where they often discussed stocks and which often lasted 90 minutes (the name of the restaurant was redacted on page 30).

- The two targets frequently emailed about stocks – an average of one per day – and even had folders in their Outlook entitled “Stocks” to archive their emails. Yet, they denied under oath that they used their SEC email accounts to discuss the market and denied knowing the SEC’s policy of limiting personal emails to de minimis use (page 33).

- The colleagues of the targeted attorneys said they thought them to have integrity and character and would be very surprised if either used information for personal purposes and that they were careful, experienced attorneys (page 29).

As if to prove the overreaching by the mainstream media over the IG’s report, the Washington Post ran a top story on the front page in the form of this article on Sunday that honed in on the SEC’s Deputy Secretary and the allegation that she might have wielded her title in a phone fight with a broker whom she believed mishandled her mother’s account. While its arguable whether this might be bad etiquette, it certainly isn’t criminal and definitely shouldn’t be headline news. People use their station in life during their daily routines every day.

In my opinion, I think the Post decided to highlight this story over the suspicious trading because it was able to uncover the identity of the party – potentially ruining her reputation in the process – and because the other media outlets had overlooked this item. Get real.

My Ten Cents: What Does This Alleged Insider Trading Scandal Mean?

In the wake of these insider trading allegations, I’ve had numerous friends and family members contact me to wonder:

- Whether I knew the two people involved? (No, their identities have not been revealed.)

- What type of safeguards exist at the SEC against such conduct? (Not much, as detailed in the IG’s report.)

- How could this happen? (Even with a much sounder compliance program, anything can happen in this world. But note these two haven’t even been charged with insider trading misconduct.)

- Is this type of conduct rampant at the SEC? (I highly doubt it. I’ve worked at the SEC twice – and still network with many of them – and I’ve never had a single conversation with anyone about whether to trade a stock.)

- What took SEC’s Ethics Office so long to refer the matter to the IG? (It’s one of the things that the SEC needs to fix. Since the female attorney was day trading – 247 trades in a two-year period – and properly filing her pre-clearance paperwork with the SEC’s Ethics Office for most of those trades, it should have raised a red flag earlier. I seem to recall a six-month holding period for trades during tours of duty at the SEC – is my memory faulty?)

- Did I know that Enforcement’s Office of Chief Counsel had “bagel” meetings every Friday? (No. But I do now due to page 26.)

Here is my ten cents:

1. Bad Stuff Happens – Putting aside the reality that these two have not even been charged with anything, I point out that if the allegations were true that wouldn’t really mean much in “normal” times because I can pretty safely say that this is an isolated occurrence based on my own personal experience. Trust me, there is no rampant insider trading at the SEC. Those that work there know how simple it is to track it. Nearly all communications these days are digital and easily uncovered – and if someone starts hitting home runs in the markets without a track record of doing so = big red flag.

As those that watch a lot of TV know, just because a cop turns “bad” doesn’t mean the entire department is bad. But these are not normal times and the SEC is under heavy fire, so some serious damage control is required and fast. The SEC’s compliance procedures clearly need an overhaul, just like a number of processes at the SEC.

2. How Did This Information Get Public? – It looks like Senator Grassley forced it out into the open. As noted in this response from the SEC’s Inspector General to Senator Grassley, due to the nonpublic nature of the report, the IG had to go through a process that delayed releasing the report for five weeks.

The IG asked that the report be kept confidential due to the potential harm to the agency. Yet, the Senator choose to release the information. At least that seems to be the way this has happened, since the redacted IG report is not available from the SEC’s IG page.

3. Should This Information Have Been Made Public? – Not until something can be proven. As stated in this letter from Senator Grassley to Chair Schapiro, the Senator himself says that “it’s hard to imagine a more serious violation of the public trust that for the agency responsible for protecting investors to allow its employees to profit from non-public information about its enforcement activities.”

If the Senator recognized the damage that releasing this information could cause to the markets, why did he force this information into the public domain prematurely? There hasn’t even been charges of misconduct yet. At most what we have is that some Staffers lied under oath, took lunches that lasted too long; spent some of their working hours on personal business and violated some of the SEC’s policies regarding trading in the markets (egs. not reporting all trades). It’s pretty clear that the approval process was not used properly, but the more serious suspicions aren’t obvious here.

I imagine that the SEC Chair would have acted on the IG’s recommendations to strengthen the SEC’s compliance procedures without this dirty laundry being aired. But those that follow the SEC know that Grassley has had an axe to grind against the SEC, going back to him pressing the Pequot Capital Management case.

As an aside, did you see how the SEC took action to drum fraudulent securities off Craigslist the day after Craigslist forced prostitutes from its site…

Your Ten Cents: Should the IG’s Report Have Been Made Public So Soon?

Okay, you have my ten cents. Let me know how you feel (all votes are anonymous; you can select more than one answer):

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- Broc Romanek