Insiders Tell All: Both the Stock Market and the SEC Are Rigged

Wall Street on Parade, By Pam Martens: April 14, 2014

Since bestselling author Michael Lewis appeared on 60 Minutes on March 30 to promote his new book, “Flash Boys,” and explained how the U.S. stock market is rigged; and Brad Katsuyama, the head of IEX, an electronic trading platform who plays a central role in the Lewis book, did the same on CNBC a few days later, the debate has gone viral.

But Lewis and Katsuyama were not the first to blow the whistle on rigged U.S. stock markets. Sal Arnuk and Joseph Saluzzi, Wall Street insiders and co-founders of Themis Trading LLC literally wrote the book on “Broken Markets” in 2012 and have been exposing details of the rigging  on their blog ever since.

Wall Street Journal reporter, Scott Patterson, mapped out the exotic and corrupt order types permitted by the stock exchanges to fleece the little guy in his 2012 book, “Dark Pools,” which follows the trading career of Haim Bodek, who has set up his own web site to blow the whistle on just how badly the stock market is rigged.

Following all the media hoopla, the FBI has recently announced that it has opened an investigation into the allegations. But under the Securities Exchange Act of 1934, the FBI is not in charge of rigged stock exchanges — the Securities and Exchange Commission is. But according to insiders, the SEC has stood down in much the same fashion that it ignored warnings about Bernard Madoff from whistleblower Harry Markopolos for years. The explanation for the SEC’s inaction, many traders feel, is that the SEC itself is rigged against Main Street in favor of big Wall Street firms. That view has found support among the SEC’s own insiders.

Since 2006, four attorneys at the Securities and Exchange Commission have put their reputations and family interests on the line by blowing the whistle on corrupt cronyism that is now so ingrained at the Nation’s regulator of stock exchanges and securities markets that it’s become part of the SEC’s business model.

Last week, James Kidney, an SEC trial attorney who retired at the end of March, set off pandemonium inside the SEC by giving an interview with Bloomberg News and releasing the full text of his March 27 retirement speech in which he castigated the SEC’s upper management for policing “the broken windows on the street level” while ignoring the “penthouse floors.” Kidney said in his speech that “On the rare occasions when Enforcement does go to the penthouse, good manners are paramount. Tough enforcement – risky enforcement – is subject to extensive negotiation and weakening.”

News of the speech was quickly amplified by the New York Times and multiple business press outlets.

Kidney blamed the demoralization at the agency on its revolving door to Wall Street as the best and brightest “see no place to go in the agency and eventually decide they are just going to get their own ticket to a law firm or corporate job punched.” (Retirement Remarks of SEC Attorney, James Kidney (Full Text).)

Kidney’s interview with Bloomberg came one day after American Lawyer published excerpts from 2,000 pages of documents it had obtained from the SEC under a Freedom of Information Act (FOIA) request, which showed that Kidney had pushed the SEC to investigate up the chain of command in the Goldman Sachs Abacus 2007-AC1 investment scam. Goldman Sachs knew that Abacus was designed to fail and allowed a hedge fund, John Paulson & Co., to bet against it while recommending it as a good investment to its own clients. The SEC only pursued a mid-level employee, Fabrice Tourre, while settling with Goldman Sachs for $550 million.

John Paulson was never charged officially by the government but he was named in the Securities and Exchange Commission’s outline of the crime. New York University, which has followed closely in the footsteps of the SEC’s brand of crony capitalism, allows Paulson to serve as a Trustee and has named the first floor lobby of Tisch Hall and the Stern School of Business auditorium in Paulson’s honor.

In the documents obtained by American Lawyer, Kidney is quoted as stating that “This was not a case where there was only one low-level vice president involved.”

At the end of last week, Kidney expanded further with NPR on the demoralization of public servants who are genuinely interested in doing an honest job, stating: “Washington has become — and I think everybody knows it — a bathtub full of cash. As long as you just go in the bathtub you’re going to come out with cash stuck on you – if you’re at least a certain, have certain jobs and have certain roles. And that’s why the revolving door is such a problem. It’s cultural, it’s the culture of Washington, it’s the culture of Wall Street and it hollows out the civil service…”

On June 28, 2006, Gary Aguirre, a former SEC attorney, testified before the U.S. Senate on the Judiciary. During his final days at the SEC, Aguirre had pushed to serve a subpoena on John Mack, the powerful former official of Morgan Stanley, to take testimony about his potential involvement in insider trading. Mack was protected; Aguirre was fired via a phone call while on vacation — just three days after contacting the Office of Special Counsel to discuss the filing of a complaint about the SEC’s protection of Mack.

Aguirre told the Senate hearing that the SEC had thrown a “roadblock” in his investigation because the suspected insider trader had “powerful political connections.” Aguirre returned on December 5, 2006 to testify further before the Senate Judiciary Committee, providing the following additional insights:

“My testimony today will focus on a favor. Senior SEC officials gave it. Morgan Stanley and its CEO, John Mack (Mack), accepted it.

“The favor had positive effects for some. It cleared the way for Mack’s return on June 30, 2005, as Morgan Stanley’s CEO. Without the favor, Mack would have faced the risk of an SEC lawsuit for insider trading over the next year…

“Few principles are more deeply engrained in Title 17 of the Code of Federal Regulations, which regulates the SEC’s operation, than the mandates obligating the SEC to handle all of its affairs, including the enforcement of the securities laws, with impartiality. No conduct would stray farther from those mandates than a double set of laws: one for the politically well connected and another for everyone else.”

Next in line was Darcy Flynn, also an attorney at the SEC. In 2011, Flynn told Congressional investigators and the SEC Inspector General that for at least 18 years, the SEC had been shredding documents and emails related to its investigations — documents that it was required under law to keep. Flynn explained to investigators that by purging these files, it impaired the SEC’s ability to see the connections between related frauds – a big benefit for the mega banks on Wall Street known for serial and elaborate frauds.

Up next was an anonymous whistleblower from inside the bowels of the SEC. On September 27, 2011, the SEC Inspector General released a heavily redacted report suggesting that SEC attorneys have come to understand that whistleblowing can be hazardous to their career so they now operate incognito.

The case involved an employee at the SEC who had sent an anonymous letter to the Inspector General, blowing the whistle on the SEC Director of Enforcement, Robert Khuzami, (now handsomely compensated as a partner at the law firm, Kirkland & Ellis). The anonymous whistleblower was complaining about Khuzami’s handling of charges that Citigroup executives had intentionally misled public investors about its exposure to subprime mortgages, understating the amount by $37 billion in the fall of 2007. According to the Inspector General’s report, the whistleblower alleged that:

“…just before the staff’s recommendation was presented to the Commission, Enforcement Director Robert Khuzami had a ‘secret conversation’ with his ‘good friend’ and former colleague, a prominent defense counsel representing Citigroup, during which Khuzami agreed to drop the contested fraud charges against the second individual. The complaint further alleged that the Enforcement staff were ‘forced to drop the fraud charges that were part of the settlement with the other individual,’ and that both individuals were also represented by Khuzami’s friends and former colleagues, creating the appearance that Khuzami’s decision was ‘made as a special favor to them and perhaps to protect a Wall Street firm for political reasons.’

“The complaint also alleged that Khuzami’s decision had the effect of protecting Citigroup from private litigation, and that by not telling the staff about his secret conversation, Khuzami ‘directly violated recommendations by Inspector General Kotz in previous reports about how such special access and preferential treatment can cause serious appearance problems concerning fairness and integrity of decisions that are made by the Enforcement Division.’ ”

The Inspector General’s report effectively whitewashed the claims against Khuzami, throwing more demoralization at the veteran attorneys in the SEC.

Any hope that President Obama would demonstrate a breath of fresh air by making independent appointments to the SEC and in cleaning up Wall Street were dashed to shreds with the appointment of Mary Jo White as SEC Chair early last year. White has now spun through the revolving door four times in 36 years, always returning to her corporate law firm, Debevoise & Plimpton. Between herself and her husband, John W. White, of corporate law firm Cravath, Swaine & Moore LLP, they or their law firms have represented every major Wall Street mega bank. Under Federal law, the conflicts of the SEC Chair’s spouse become her own conflicts.

Adding further outrage to the situation, Mary Jo White quickly named her close associate at Debevoise & Plimpton, Andrew Ceresney, to be the Co-Director of the SEC’s Division of Enforcement – the unit that decides who gets prosecuted and who gets an unfettered license to steal.

Ceresney is now the sole Director of Enforcement as his co-director, George Canellos, has left to rejoin the (wait for it) big Wall Street law firm, Milbank, Tweed, Hadley & McCloy, as a partner and head of litigation.

Just one year prior to moving into the top cop slot at the SEC, Ceresney had pulled off a major coup for Wall Street firms JPMorgan Chase, Citigroup, Wells Fargo, Bank of America and Ally. Ceresney was directly employed as counsel to JPMorgan Chase, but he also played a key role in the negotiations between the U.S. Justice Department, 49 state attorneys general and an army of Federal regulators to settle charges of mortgage, foreclosure and servicing fraud – all melded into the National Mortgage Settlement – a deeply flawed deal for defrauded homeowners.

A nonpartisan Congressional watchdog has also weighed in on the abysmal personnel practices at the SEC. On July 18 of last year, the Government Accountability Office (GAO) issued a stunning report on the declining morale among SEC employees. The report found that the SEC ranked 19 out of 22 similarly sized Federal agencies in overall satisfaction and commitment.

The GAO said its findings were consistent with the Partnership for Public Service’s analysis of the Office of Personnel Management’s 2012 Employee Viewpoint Survey. That analysis found that “SEC’s overall index score—which measures staff’s general satisfaction and commitment—declined from 73.1 in 2007 to 56 in 2012.”

The danger for the U.S. economy and our financial markets is that a system this tainted cannot stand – as we learned so well in 2008. It is inevitably destined to collapse under the weight of its own corruption.

The writings of economist Joseph Schumpeter explain creative destruction: failed systems and business models are meant to collapse in order to be replaced with more efficient, innovative ones. Studies indicate that impediments to the process of creative destruction have severe economic consequences.

The SEC is both an impediment to change on Wall Street and an impediment to regulatory reform. It is a dark pool of redactions and shredded documents; it has fired the truth-tellers and retained the timid; it is Wall Street’s top legal defense team in temporary quarters.