SEC Inspector General Raises Red Flags in New Report

By Zachary A. Goldfarb
The Washington Post
March 23, 2010

About two miles separate the Securities and Exchange Commission's headquarters in Washington from the offices of Allied Capital, a District-based private-equity company. 

But over the course of an 18-month government probe into whether Allied Capital overstated the value of its holdings, nobody from the regulator ever visited the firm to ask questions, according to a new, internal SEC review that raises questions about the agency's oversight of the financial industry. 

The SEC's watchdog found that the agency failed to properly pursue serious allegations made against Allied Capital, a public company that invests in small to midsize businesses. But after heavy lobbying by Allied Capital, the agency aggressively pursued the hedge fund manager who had challenged the value of Allied's investments. 

The SEC has been under intense scrutiny for failures in its regulation of financial firms, and the report by Inspector General H. David Kotz casts doubt about whether the SEC has the proper procedures in place for effectively policing the actions of public companies and Wall Street firms. 

Among other things, Kotz questions how SEC officials decide to open investigations and whether they are unduly influenced by outside lawyers -- particularly former SEC officials -- in conducting the probes. 

"The SEC needs to open investigations based on evidence, rather than unsupported allegations, so as not to waste the agency resources and focus needed for investors and market integrity," said Charles E. Grassley (Iowa), the ranking Republican on the Senate Finance Committee. "The revolving door is turning at the SEC, and the problems we've seen before with former senior SEC employees influencing enforcement decisions has been highlighted in this report." 

The agency's leadership has been replaced with the new administration, and the new officials have pledged to fix the problems. 

"We agree with each of the report's recommendations, have already implemented several of them and expect to complete the process in June," said John Nester, an SEC spokesman. 

Allied Capital did not return two calls seeking comment. The firm has struggled amid the financial crisis, defaulting on debt and credt agreements. Its shares have lost most of their value in recent years, and the firm has accepted a buyout offer from New York-based Ares Capital. 

Straw-man strategy

The case explored by the inspector general began in 2002, when a hedge fund manager named David Einhorn explained in a speech that he bet against Allied Capital's stock by short-selling it because he thought Allied overvalued its holdings. 

Other investors proceeded to short Allied's stock, which declined sharply in value. 

About the same time, Einhorn began contacting the SEC by phone and letter to explain his skepticism about Allied Capital's accounting techniques. 

Allied responded by waging a public relations campaign against Einhorn, questioning his motives. The war between Einhorn and Allied became well known in legal and financial circles. 

Allied also worked behind the scenes to urge the SEC to investigate whether Einhorn was engaging in illegal behavior to undermine the company's shares, according to the inspector general's report. 

Without any specific evidence of wrongdoing, Allied met with SEC investigators in June 2002 to urge them to investigate Einhorn. Shortly thereafter, the SEC opened a probe, questioning Einhorn about his trading activities, subpoenaing documents, and seeking his telephone records and a list of clients. 

Soon after investigators started looking at Einhorn, they concluded that he had done nothing wrong. Investigators finished their review by mid-2003, but they refused to tell Einhorn the case was closed. 

The probe was supervised by an enforcement bureau chief named Mark Braswell; he soon left the agency and went to work a Washington law firm, where he landed Allied Capital as a client. 

Braswell said Monday that he couldn't comment on the inspector general's report without reviewing it. 

Reaching out

While Einhorn was the subject of an SEC investigation into his activities, he tried to persuade agency officials to look into Allied Capital's practices. Einhorn's spokesman declined to comment. 

The inspector general confirmed what Einhorn later wrote in a book, that he wrote a dozen letters to the SEC with detailed information alleging that Allied overvalued its portfolio. 

Two separate agency offices -- unaware of each other's activities -- opened probes into Allied Capital based on Einhorn's letters. 

The inspector general wrote that the first probe, conducted by the Office of Compliance Inspections and Examinations (OCIE), was prolonged by delays and involved just two officials. 

One OCIE official overseeing the review told the inspector general that he trusted an Allied officer contacted because that person formerly worked for the SEC and was "not going to be doing anything illegal." 

However, OCIE ultimately referred concerns to the SEC's enforcement division, which could take legal action against Allied. That division had already been investigating on its own. 

Two years later, investigators determined that "more than a dozen of Allied's investments had significant problems with the calculation of their value and that Allied had materially overstated its" finances, according to the inspector general's report. 

Allied's lawyers, which included a former SEC enforcement director, set up a meeting with SEC enforcement staff. 

A year later, the SEC was persuaded not to pursue fraud charges against Allied, according to the report. Allied instead faced a more modest charge that allowed the company to settle without paying any penalties.

[ RGM Short Selling Home page ]