The SEC Learns Some Economics


The SEC tends to come in for a lot of good-natured joshing around here, and elsewhere, for amusing foibles like spending their days surfing porn, ignoring multibillion dollar Ponzi schemes when they're told about them directly, and complaining bitterly when anyone suggests that their priorities might be misplaced. Also on some people's complaint list is that the SEC tends to be heavy on lawyers and light on forensic accountants, economists, traders, quants, and just generally anyone who might have a glancing familiarity with things financial.

But credit where it's due: the SEC has gotten a bit better at using market mechanisms to find the next big, or little, or whatever fraud. This week has seen a spate of stories about how the SEC, and the Feds generally, are using new and existing whistleblower programs to encourage people to come to them first if they have negative information to peddle. The headliner is Grant Wilson, who new-best-friend-of-the-SEC Harry Markopolos recruited to expose some currency trading unpleasantness at his former employer BoNY Mellon, but others seem to be in the SEC's pipeline.

More intriguingly, though, the SEC is doing a great job at shutting down its competition. FT Alphaville points out that terrible Italian bank UniCredit is acquiring French independent investment research firm Kepler. Who cares, you ask? Well, they see a deeper message here: that independent research firms are having a tough time of it because, in a world in which the SEC is aggressively pursuing insider trading cases against expert networks, it is too risky to get investment advice from people who aren't part of the SEC-regulated big-bank industry. So, with increased insider trading enforcement, fewer independent firms are starting up, and more may soon sell out to big banks. (Relatedly, US securities laws help big companies.)

If you're, say, Harry Markopolos, and you want to build a business around rooting out negative information about public companies' nefarious doings, you could build that business in one of two ways. First, you could fund lawsuits and hold whistleblowers' hands when they talk to the SEC,* and then get a share of the reward. Second, perhaps more traditionally, you could find a fraud, short the hell out of it, and then talk about it on the internet and CNBC. The whistleblower approach is long and arduous and could involve the SEC losing your file/getting distracted by porn; the short selling approach will often be more efficient and scalable.

Why not both? That's what Felix Salmon asked last month:

If this tactic ends up paying huge dividends for Markopolos, Wilson, and their team, I also wonder whether the whistleblower space might not start getting a bit more crowded: it’s easy to imagine that in cases like this one, whistleblowing profits could end up being much bigger, and involve much less up-front investment, than short-selling profits. Should short-sellers start thinking about recruiting whistleblowers instead? And also, has anybody asked Markopolos whether he’s short BNY Mellon? He’s on the record saying that it’s “going to go down”. Is there some kind of rule which says that whistleblowers can’t or shouldn’t short the company they’re shopping to the government?

Turns out, there is: insider trading law. If a tipster at BNY told Markopolos all about shenanigans there, shenanigans that could cost BNY billions of dollars in fines – well, that seems material, and nonpublic, and the tipster probably had some obligation to keep it confidential. So if he traded on it that’s quite likely to be insider trading, though the law has some complications. In fact, shorting frauds based on anything but public documents is a risky business: the more digging you do, the more people you talk to who confirm your hunch that it's a fraud, the more risk you run of violating insider trading laws. And it's particularly risky when the SEC has announced that it's making a priority of prosecuting expert networks whose experts have intimate dealings with publicly traded companies.

When you find a fraud, short it, publicize your findings, and the SEC scrambles to months later do something about it, the SEC looks like a bunch of dolts.** When you find a fraud, bring it to regulators in exchange for a cut of the loot, and the SEC or DOJ brings an investigation, the regulators look proactive and smart. Given the beating the SEC's reputation and morale have taken recently, it makes sense for it to push fraud discovery into the take-it-to-the-SEC category. And it seems to be doing an effective job of encouraging whistleblowers to come to the SEC - and discouraging them from going elsewhere.

After Tip, the Claim For Reward [WSJ, blog]

Indie v sell-side research and a UniCredit spam alert [FTAV]

* Which has nonzero value. The SEC returns Markopolos's calls now. It's less clear that J. Random Whistleblower can get agency attention.

** My lawyer tells me to say: I have no idea what the deal is with Sino-Forest. Let's assume for now that they are in fact not a "near total fraud"; the general point is that the SEC was well behind short sellers on Chinese reverse merger badness generally.