A recent report by Securities and Exchange Commission’s inspector general H. David Kotz shows that the SEC’s investigation of Bernard Madoff was not the only one it botched. The Kotz report also reveals that the SEC’s enforcement division was unduly influenced by former colleagues-turned defense lawyers to drop enforcement matters, according to a New York Times DealBook article by Peter J. Henning called “How Not to Run an S.E.C. Investigation.”
The Kotz report tells how David Einhorn (manager of hedge fund Greenlight Capital), raised questions with the SEC about how Allied Capital was valuing its investments (Einhorn had also criticized the financial reporting of Lehman Brothers before that firm collapsed into bankruptcy in September 2008.) Mr. Einhorn repeatedly asked the SEC to investigate Allied Capital’s financial statements. Allied Capital responded that Einhorn was just trying to undermine it to advance his short position in its stock.
The SEC initially began investigating Einhorn’s hedge fund Greenlight Capital, rather than Allied Capital. The Kotz report notes that this investigation began “without any evidence of wrongdoing.” Less than a year later, it ended without finding any violations, but the SEC did not officially close it until 2006 and never notified Mr. Einhorn of its conclusions.
As the investigation of Greenlight Capital proceeded, two different offices in the SEC also began looking into the valuation issues at Allied Capital. Both the SEC’s office of compliance inspections and examinations, we well as its enforcement division, looked into the Allied Capital’s financial statements, but apparently they were unaware of each other’s efforts ? similar to the various inspections of the Madoff firm.
The compliance office’s investigation was nipped because one of Allied Capital’s representatives was a former SEC staff member, and an associate director of the office said that anyone who had worked at the commission was “not going to be doing anything illegal.” The Kotz report states that the office’s examiner, who was the only staff member assigned to the case, “testified that she received considerable ‘pushback’ from the associate director with regard to her findings about Allied.”
The enforcement division’s investigation was even more questionable. The original supervising attorney on the Greenlight Capital investigation was reportedly pushed out of his job for performance reasons, and then registered as a lobbyist for Allied Capital a year later.
The Kotz report notes that the former supervisor “learned a substantial amount of sensitive, nonpublic information regarding Einhorn and Allied.” When he sought clearance from the SEC’s ethics office to represent Allied, his response regarding prior involvement with the company at the commission was “incomplete.”
When the enforcement staff met with Allied Capital representatives to discuss possible charges against the company, including securities fraud, its staff attorneys faced a former director of the SEC’s enforcement division, who was then representing Allied Capital. After the meeting, the SEC staff agreed to an administrative cease-and-desist order with no penalty imposed on Allied Capital ? the very lightest action that could have been taken, according to Henning, who further points out that Allied Capital did not even have to report back to the SEC about its compliance with the terms of the settlement.
This high-level “revolving door” at the SEC is troubling, as is derailing an investigation because of the perception that former colleagues would not allow anything illegal to occur. According to Henning, the SEC needs to take steps to prevent a former high-level official from pushing it to settle a case for almost nothing.
It will be interesting to see how the SEC deals with the issues raised in the Kotz report as it tries to become more aggressive in investigating possible violations of federal securities laws.