SEC Will Be Investigated in Probe Sought by Senate's Grassley

By Otis Bilodeau
October 26, 2006

The U.S. Securities and Exchange Commission, already under scrutiny for its handling of a trading probe that entangled Morgan Stanley Chief Executive Officer John Mack, now faces a broad review by government auditors of its management and methods for policing the financial markets.

The Government Accountability Office agreed last week to investigate the SEC's enforcement division and compliance department after requests by Senator Charles Grassley, an Iowa Republican who questioned whether the agency gave Mack special treatment. Grassley asked the GAO to examine the SEC's ``planning, oversight, control and other management processes'' and gauge whether the agency does enough to oversee regulators at the New York Stock Exchange and NASD.

``Based upon allegations I have received over the past few months, I have become increasingly concerned regarding the operations of the SEC, and whether the SEC is faithfully adhering to its mission'' to protect investors, Grassley, the chairman of the Senate Finance Committee, wrote in one of two Sept. 19 letters to GAO Comptroller General David Walker.

The review ratchets up the heaviest political pressure the SEC has faced since Christopher Cox, a California Republican, took over as its chairman in August 2005. Grassley's requests target units run by SEC enforcement chief Linda Thomsen and Lori Richards, head of the Office of Compliance, Inspections and Examinations.

Senators including Grassley are concerned that the SEC shielded Mack from a probe of insider trading at Pequot Capital Management Inc., which runs $7 billion in hedge funds. Gary Aguirre, a former SEC investigator, told the Senate Judiciary Committee in June that he was blocked from questioning Mack because of the Morgan Stanley CEO's political clout. New York- based Morgan Stanley is one of Wall Street's two biggest securities firms.

`Coating of Dirt'

The SEC eventually interviewed Mack in July and notified him and Westport, Connecticut-based Pequot earlier this month that it won't pursue a case against them. The SEC repeatedly has denied Aguirre's claims and Mack and Pequot denied any wrongdoing.

``This Aguirre story will leave a coating of dirt unless it is probed and washed away,'' said Edward Fleischman, a former SEC commissioner now in private practice at Linklaters in New York. ``It will benefit us all, and it will ultimately benefit the SEC, to have the GAO go through all of this as an outside observer.''

Thomsen declined to comment. Walter Ricciardi, a deputy enforcement director at the SEC, said the agency has no objection to the GAO inquiry.

``We welcome the review and look forward to any recommendations that might follow,'' Ricciardi said in an interview.

Donaldson Appointee

Thomsen is the only division director at the SEC not appointed by Cox. She was promoted in May 2005 by Cox's predecessor, William Donaldson, after then-Enforcement Director Stephen Cutler returned to private practice.

Cox said Oct. 18 that members of Congress have ``legitimate concerns and I share those concerns'' when asked about Aguirre's allegations.

Grassley asked the GAO, Congress's investigative arm, to report its findings by June. The GAO said in an Oct. 16 letter to Grassley that it ``accepts these requests as work that is within the scope of its authority.''

The inner workings of the SEC's enforcement division are rarely exposed to public view. As a matter of policy, the agency doesn't say when it opens or closes investigations and officials won't discuss their progress in building a case.

NYSE, NASD Oversight

Grassley asked the GAO to assess how the SEC tracks investigations, the amount of time the agency takes to complete them and its ``reported success rate.'' He also requested that the auditors determine how many referrals of potentially illegal trading activity from U.S. exchanges ``actually become part of a regulatory action.''

SEC enforcers rely on the self-regulatory organizations, or SROs, that police the exchanges, including NYSE Regulation and the NASD, to report signs of suspicious trading for further investigation.

The SEC must ``detect and deter potential abuses of SRO authority arising from inherent conflicts of interest,'' Grassley wrote to the GAO. ``How does the SEC ensure that the SROs vigorously oversee their own members?''

An analysis of stock-trading data by Toronto-based Measuredmarkets Inc. showed in August there may have been insider trading in advance of 41 percent of the largest U.S. takeover announcements in the preceding year. Derivatives traders also made perfectly timed bets before public announcements of recent deals such as the $33 billion leveraged buyout of hospital operator HCA Inc.

Hedge Funds

About 20 percent of the new investigations opened at the SEC in the past year focused on insider trading and slightly less than half of those probes led to enforcement cases, according to Ricciardi.

``We often see suspicious trading, but in some cases it's hard to find the evidence,'' he said in an Aug. 27 interview.

Cox said Oct. 18 that the SEC is ramping up its scrutiny of potential insider trading by hedge funds ahead of company mergers. Thomsen, the enforcement chief, told Congress last month that cases of insider trading by hedge funds have become a ``significant concern.'' Hedge funds are private pools of capital that allow managers to participate substantially in the gains they make for investors.

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