Skepticism about the high regulatory priority placed on insider trading is rising in both the media and in academia. Matt Levine of DealBreaker recently posted a great blog questioning the SEC’s fixation on insider trading investigations which was echoed by Felix Salmon of Reuters and other thought leaders. Academics are also questioning whether the level of effort is appropriate. An article published earlier this month in the Hofstra Law Review argues that the prosecution of insider trading under both criminal and civil codes creates a large burden on an already under-resourced SEC, and distracts the SEC from pursuing more deserving cases.
Levine’s Challenge
From the very beginning there have been questions why insider trading is more important than investigations into actions which triggered the financial crisis. This argument was taken to a new level by Matt Levine’s blog, which was triggered by Bloomberg BusinessWeek’s cover story on the SEC’s painstaking pursuit of Steve Cohen.
“If you don’t believe that insider trading is the most important financial regulatory problem, then you might worry about the sheer person-hours devoted to this case; the millions of documents and thousands of phone calls that consumed all of several skilled SEC lawyers’ time for basically three years. Surely that time and money could be spent elsewhere.”
Levine’s concern isn’t just the time spent on insider trading investigations. He argues that looking for needles in haystacks is the wrong mindset for a financial regulator. A more critical skill is being able to move from the particular to the general, such as using the information about the London whale’s positions — which regulators had — to challenge Dimon: “hey you gotta cut back risk in your whalery, not in a bullshit RWA-and-VaR-model-manipulation way but by actually paring down positions.”
“The financial regulators you’d really want would start from specific facts and look for the general pattern. They’d spend years looking for broad problems with systems, not phone records to prove a single instance of wrongdoing by a single person. These SEC lawyers – the ones held up as models of SEC enforcement, the ones responsible for the SEC’s one post-crisis success story – should have been finding Bin Laden, not overseeing a financial system.”
Other Media Pushback
Another attack on the SEC was made by Yves Smith (pen name for Susan Webber of Aurora Advisors, Inc.) in Naked Capitalism. Reviewing Robert Khuzami’s track record as head of the SEC’s Enforcement Division, Smith argues that the SEC largely failed in its prosecution of actions that precipitated the financial crisis. For example, it botched its case against the two Bear Stearns’ hedge funds that imploded with subprime mortgages:
The SEC and DoJ conceptualized the case along the lines of an insider trading case…But the effort botched basic case development, as in doing sufficient discovery. Turns out the dubious-looking sale was part of a program; the timing was not market-driven.
More importantly, the SEC did not use its best weapon, Sarbanes-Oxley, in prosecuting financial firms which precipitated the crisis. Sarbox’s requirement for senior management to certify the adequacy of internal controls gave the SEC a perfect weapon to attack poor risk controls, off balance sheet shenanigans, and other damaging behavior. When the SEC did bring action against financial firms, it settled the cases with no fault, rather than bringing them to trial. Although Jed Rakoff challenged this practice, the SEC appealed the action rather than amending its practice.
Smith also criticizes the SEC’s policy of suing on only one Collateralized Debt Obligation (CDO) per major firm and settling: “This [practice was] heinous, since each and every one of these firms sold more than one CDO and the bad practices were pervasive.” Khuzami should have resigned when it became clear that CDOs would be a major part of SEC’s enforcement actions post-crisis. Khuzami had been General Counsel for the Americas for Deutsche Bank from 2004 to 2009, when the majority of Deutsche’s CDOs were issued.
Any serious investigation of CDO bad practices would implicate Deutsche Bank, and presumably, Khuzami. Why was a Goldman Abacus trade probed, and not deals from Deutsche Bank’s similar CDO program, Start? Khuzami simply can’t afford to dig too deeply in this toxic terrain; questions would correctly be raised as to why Deutsche was not being scrutinized similarly.
So, having failed in its prosecution of bad actors in the financial crisis, the SEC has fallen back on pursuing insider trading as a way to restore its enforcement mojo.
Academics Chime In
In an article published earlier this month, “Wall Street as Yossarian: The Other Effects of the Rajaratnam Insider Trading Conviction“, Scott Colesanti of Hofstra University’s Maurice A. Deane School of Law argues that the SEC’s practice of following criminal prosecutions of insider trading with duplicate civil cases is a waste of resources, and detracts from more deserving cases, such as wrong doing during the financial crisis.
“Accepting the blatant illegality of Rajaratnam’s tactics, the more harrowing result still is that the promised complement of criminal and civil investigative efforts has arguably led primarily to more work for the under-resourced SEC. Stated bluntly, rather than supplement or lessen Commission efforts, the criminal pleas, trial, and battles over Galleon have led to more SEC complaints and duplicative penalties…In terms of the public’s clamor for accountability for the ongoing financial crisis, such double-dipping in the insider trader pool seems misplaced; in terms of the desire for a prohibition that provides clarity and deterrence, the fighting on two fronts seems outright hazardous.”
Conclusion
Will the increasing criticism of insider trading prosecutions deter prosecutors? As Matt Levine points out, insider trading prosecution is well suited to the SEC skill set. It is something the SEC knows how to do, and it does it well. Unlike prosecuting CDOs or other crisis-related wrong doing, if Yves Smith is believed. So if the SEC excels at pursuing insider trading, why stop? It can point to its successful track record, and vigilance in protecting markets. The appointment of former prosecutor Mary Jo White as head of the SEC is not likely to change the SEC’s orientation.
Yes, media is getting bored with the topic, but the media despite itself is drawn into the drama of ‘Will they nail Steve Cohen?’ The media will go along for the SAC ride at least.
In a recent interview, Preet Bharara boasted “Our budget is about $50 million. We brought back $3 billion. That’s about 60 times our budget which is better than a lot of the companies and a lot of the hedge funds who trade in companies around this exchange get.” The bottom line is that insider trading prosecution is successful and lucrative, and that is why it will not go away.