Quick, Call Tech Support for the S.E.C.

By Gretchen Morgenson
New York Times
December 16, 2007

It’s no secret that the Securities and Exchange Commission is terrifically understaffed and wildly underfunded compared with the populous and wealthy Wall Street world it is supposed to police. But a report by the Government Accountability Office to be released Monday indicates that in its battles against insider trading and market manipulation, the commission declines to use one of the sharpest tools in its arsenal: the internal audits conducted by the nation’s stock and options exchanges.

Moreover, S.E.C. investigators’ efforts to track questionable trading are hampered by a computer system that does not allow investigative referrals from the major exchanges to be searched easily and efficiently, the report said.

The new report on the S.E.C. focuses on its oversight of the various stock and options exchanges, known as self-regulatory organizations, investors’ first line of defense against market manipulation and insider trading. The study was requested by Senator Charles E. Grassley of Iowa, the ranking Republican on the Senate Finance Committee.

Mr. Grassley asked for a review of the commission’s operations last year after his staff delved into a botched S.E.C. investigation of possible insider trading at Pequot Capital Management, a major hedge fund. The G.A.O.’s report, “Opportunities Exist to Improve Oversight of Self-Regulatory Organizations,” is disturbing, he said.

“They’ve got a computer system that can’t search for the data the securities industry is reporting — that’s like working with one hand tied behind your back,” Mr. Grassley said in an interview. “And it was kind of shocking to know that the S.E.C. doesn’t review the exchanges’ internal audits. That’s inefficiency and there is no excuse for it.”

There is no doubt that market mischief has enriched many players recently, especially during the mergers-and-acquisitions boom, when so much suspicious trading occurred in stocks of companies minutes before they received buyout bids.

Sure enough, the G.A.O. report noted that the exchanges’ referrals of possible trading improprieties have surged. From 2003 to 2006, the number of advisories to the S.E.C. increased to 190 from 5. Of the total during those years, 91 percent were insider trading advisories.

But when referrals come in to the S.E.C. from the exchanges, they enter a digital netherworld where investigators can search by stock ticker, date of the unusual activity and type of trading, but not by the name of someone or some firm who may be under scrutiny.

Information about who is behind suspect trading, which can help identify patterns of illicit activity by hedge funds, firms or individuals, is submitted in an attachment that must be opened individually under the system’s design. As such, it is not part of the searchable database, the G.A.O. said.

In addition, only branch chiefs in the office of market surveillance, a unit of the S.E.C.’s enforcement division, have access to the referral data. So S.E.C. lawyers working on a case have to ask market surveillance for help or contact the exchanges directly, rather than search for the information electronically, the G.A.O. said.

The report also said that because the referral and case tracking systems are not linked, the effectiveness of the referral and investigation process cannot be analyzed.

In a letter to the G.A.O. responding to its report, Christopher Cox, chairman of the S.E.C., agreed that technology changes might help the enforcement staff analyze trends, manage caseloads and focus on areas worthy of their investigation. “We will assess the feasibility of the recommended system improvements,” he concluded.

Even more troubling, Mr. Grassley said, is that the S.E.C. does not automatically receive reports from the exchanges of the internal audits and investigations they conduct. Instead, the commission simply asks that the exchanges permit access to these documents when the S.E.C. drops by for an inspection.

This is an odd approach for an agency that is supposed to be interested in efficiency. By regularly reviewing what turned up in the exchanges’ internal investigations, the commission could identify problem areas and potential improprieties early on. Limiting its access solely to the times when it inspects self-regulatory organizations — once a year at best — means the commission is putting itself and investors at a disadvantage.

BY the way, this isn’t the first time the commission has been urged to review exchanges’ internal reports more regularly. The G.A.O. made the same recommendation three years ago. As that report was conducted, however, S.E.C. officials told G.A.O. researchers that the routine use of internal audits and investigations might have a “chilling effect” on the relationships between audit staffs at the exchanges and other employees there.

“Given that S.R.O.’s are entrusted with direct regulation of the securities industry, there is no excuse for them being anything less than completely transparent to the S.E.C.,” Mr. Grassley wrote in a letter late last week to Mr. Cox. “I would appreciate an explanation of why the S.E.C. has been so slow to act on this matter and a description of your plans for ensuring that the S.E.C. begin to routinely obtain and review internal S.R.O. audits and investigations.”

Mr. Grassley asked Mr. Cox to reply by January 4, 2008.

As the G.A.O. pointed out, the commission is unusual in its reluctance to use contemporaneous reviews of exchanges’ internal investigations. Federal bank examiners base their risk assessments of the institutions they oversee at least partly on internal audit reports produced by these institutions. By not including internal audit information in its planning, the S.E.C. may duplicate the exchanges’ efforts or miss opportunities to uncover new areas of investigatory interest, the report said.

The bad news is that these regulatory lapses seem so basic that it is hard to believe no one at the S.E.C. has resolved them by now. The good news is, because they are so basic, they can be fixed promptly.

And if they aren’t? Call it one more data point for those who increasingly wonder whose side the S.E.C. is on.

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