Investors Beware: GAO Says SEC Isn't Effectively Fighting Insider Trading

Illegal "insider trading" can cause huge losses for ordinary investors. Consider a publicly traded, hypothetical company called Henron.  If only insiders know that Henron will file bankruptcy next week, some Henron execs might sell their stocks before the bankruptcy becomes public (i.e., before stock prices nosedive) to unsuspecting investors who will pay far more than the stocks are worth.

According to a Government Accountability Office (GAO) report, the U.S. Securities and Exchange Commission (SEC) hasn't been effectively cracking down on insider trading.  It's a complicated report, but The New York Times does a decent job of simplifying it:

"A report by the Government Accountability Office... indicates that in its battles against insider trading and market manipulation, the commission [SEC] declines to use one of the sharpest tools in its arsenal: the internal audits conducted by the nation's stock and options exchanges....

"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....

"Christopher Cox, chairman of the S.E.C., agreed that technology changes might help the enforcement staff...."  (NY Times)

In 2004, the GAO reportedly recommended that the SEC fix some of these technology problems. Why hasn't the SEC already fixed them?

One possible answer: the SEC has been under-funded for years. Apparently, that answer didn't satisfy Sen. Charles Grassley (R-ID), who commented:

"'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.... 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.'"

Grassley may be correct about the SEC's data-monitoring system.  However, former SEC branch chief Pat Huddleston, an attorney who founded Investors Watchdog, explained:

"The SEC is a scandalously small agency for the size of its mission. I hope that the next President will increase enforcement staff. There are already more violations than the current staff can handle.  With the baby boomers retiring, the number of securities law violations will skyrocket.  We need a bigger SEC in place now to be able to handle those violations."

Presidents appoint SEC chairmen, who affect the SEC's priorities. For example, Arthur Levitt (whom Bill Clinton appointed) was protective of ordinary investors.  Harvey Pitt (President Bush's first SEC chairman) was protective of big accounting firms and Wall Street players -- whose interests often clash with those of ordinary investors. (USA Today)

As well as costing ordinary investors money, widespread insider-trading could give the impression that the game is "rigged" and harshly affect capital markets, as Huddleston notes. 

"If  entrepreneurs are free to load up on stocks before a good news announcement or dump stocks before a bad news announcement, no reasonable investor would want to own the stock.  You never know when you’ll be on the losing end of the transaction.  So, unless the SEC enforces the insider trading laws stringently, money for new businesses, new plants, new products, new jobs, could dry up."

Let's hope that Congress helps the SEC by increasing funding -- and that the funds will be used to clean up the game.

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