Subject: File No. S7-19-07
From: Paul Floto
Affiliation: Retired Chief Financial Officer

September 4, 2007

One wonders whether anyone at the SEC reads these comments, and whether anyone at the SEC cares about maintaining honest markets for honest investors, when anyone at the SEC is most likely to seek future employment with the parties manipulating the markets for private gain.

I would like to add this article to the public record:

#1: The SEC, regulator of our nations capital markets, has been at least partially captured by financial elites to the point that it favors Wall Street over Main Street.

This post has two sections, A and B. The former is duller than dishwater but relates the history of the political concept of "capture" in as sexy a manner as I could muster. The latter applies it to recent events surrounding the Securities and Exchange Commission and is sexy. If you enjoy intellectual history you may find the first piece interesting, but you can easily skip it with no harm to sense or understanding.

A. A Brief History of Capture

As odd as the political concept of capture sounds at first, it has a pedigree that spans the political spectrum, from Montesquieu and our Founding Fathers, to Karl Marx, to economists such as Stigler and Friedman (who are generally - if somewhat inaccurately - associated with the Right), to Harvard Law Schools Jon Hanson (who has extended the concept in his Critical Realism theory of deep capture). I will review the evolution of this idea before turning to recent events involving the SEC.

The Founding Fathers understood capture." Consider The Federalist, a series of 85 essays written by James Madison, Alexander Hamilton, and John Jay (all sharing the nom de plume, Publius) and published over the second half of 1787 in an effort to convince New Yorkers to ratify the recently drafted US Constitution (for all references to The Federalist, click here). The most famous of these essays is Federalist #10, written by James Madison, which took up the subject of special interests, or what he called factions (By a faction, I understand a number of citizens, whether amounting to a majority or a minority of the whole, who are united and actuated by some common impulse of passion, or of interest, adversed to the rights of other citizens, or to the permanent and aggregate interests of the community). Madison recognized that in a free society special interests are unavoidable (Liberty is to faction what air is to fire, an aliment without which it instantly expires), and that they represent the greatest threat to the democratic experiment (The friend of popular governments never finds himself so much alarmed for their character and fate, as when he contemplates their propensity to this dangerous vice The instability, injustice, and confusion introduced into the public councils have been the mortal diseases under which popular governments have everywhere perished). In favor of the proposed Constitution, Madison argued that, were it ratified, the new republic would be large enough to contain so many special interests they would cancel each other out (the society itself will be broken into so many parts, interests, and classes of citizens, that the rights of individuals, or of the minority, will be in little danger from interested combinations of the majority). In fact, so much weight did he assign to the problem of special interests that he held the greatest virtue of the proposed Constitution its ability to check them (Among the numerous advantages promised by a well constructed Union, none deserves to be more accurately developed than its tendency to break and control the violence of faction).

Madisons argument in Federalist #10, that in the republic that was to come special interests would be checked by their sheer number, is strikingly half-hearted. Reading it, one senses that Madison knew he was writing a check that might not cash (The valuable improvements made by the American constitutions on the popular models, both ancient and modern, cannot certainly be too much admired but it would be an unwarrantable partiality, to contend that they have as effectually obviated the danger on this side, as was wished and expected). And it is certainly interesting to note where Madison located the greatest source of factions:

But the most common and durable source of factions has been the various and unequal distribution of property. Those who hold and those who are without property have ever formed distinct interests in society. Those who are creditors, and those who are debtors, fall under a like discrimination. A landed interest, a manufacturing interest, a mercantile interest, a moneyed interest, with many lesser interests, grow up of necessity in civilized nations, and divide them into different classes, actuated by different sentiments and views. The regulation of these various and interfering interests forms the principal task of modern legislation...

By late in the 19th century the U.S. government was beginning to shift some of its affairs from legislative bodies (where there was at least some modicum of sunlight and expectation of concern for the aggregate interests of the community) to regulatory bodies. One example that has served ever since as a cautionary tale was the U.S. Interstate Commerce Commission, established in 1887 to regulate the railroads, but quickly subverted by the industry it was intended to oversee as its staff learned that if they regulated the railroad industry (and later, the trucking industry) by fixing prices artificially high and restricting new entrants, cushy jobs and directorships would await them upon their retirement.

As Milton Friedman wrote of the process (see Free to Choose, pages 196-197):

It took about a decade to get the commission in full operation. By that time the reformers had moved on to their next crusade. The railroads were only one of their concerns. For the railroad men the situation was entirely different. The railroads were their business, their overriding concern And who else had the staff and expertise to run the ICC? They soon learned how to use the commission to their own advantage.

The first commissioner was Thomas Cooley, a lawyer who had represented the railroads for many years. He and his associates sought greater regulatory power from Congress, and that power was granted. As President Clevelands Attorney General, Richard J. Olney, put it in a letter to railroad tycoon Charles E. Perkins only a half-dozen years after the establishment of the ICC:

The Commission, as its functions have now been limited by the courts, is, or can be made, of great use to the railroads. It satisfies the popular clamor for a Government supervision of the railroads, at the same time that the supervision is almost entirely nominal. Further, the older such a commission gets to be, the more inclined it will be found to take the business and railroad view of things. It thus becomes a sort of barrier between the railroad corporations and the people and a sort of protection against hasty and crude legislation hostile to railroad interests the part of wisdom is not to destroy the Commission, but to utilize it."

I would be remiss not to mention Karl Marxs insights on the subject of "capture." Thomas Sowell, a highly-regarded economist (one - again somewhat inaccurately - associated with the Right) has written of Marx that his ...intellectual legacy, especially his insights concerning history, are now part of the general intellectual equipment of modern man (Marxism, page 187). A significant part of that legacy is his view that what we experience as law, culture, and civil society, is largely a cloak for the powerful economic interests that truly determine our social outcomes. Thus the Marxian sense of capture runs deeper than mere political influence with the legislature: for him, it was more of a complete occupation of the surface area of civil society.

This Marxian tradition lives on, somewhat notoriously, at our universities, in courses and departments which use the word critical in their name (a kind of tip o the hat to the Frankfurt School of Marxism). The Critical Legal Studies tide came in at Harvard Law School a generation ago and was out by the 1990s. However, the recent work of Harvard Law Professor Jon Hanson, a self-defined Critical Realist, postulates what he calls deep capture: the notion that powerful economic interests have captured not only regulators and legislatures but journalism, universities, and popular culture (see The Situation: An Introduction to the Situational Character, Critical Realism, Power Economics, and Deep Capture). If he is right, then (metaphorically) we live in a Matrix-like world dominated by an economic machine that taps us for energy while keeping us happy and deluded about our fate (unless we heed glimpses of evidence that could waken us from our fate). Please put a pin in this idea of "deep capture."

For further reading on regulatory capture, see George Stiglers seminal 1971 paper, The Theory of Economic Regulation (one of the works for which he won his Bank of Sweden Prize in Memory of Alfred Nobel), and Laffont Tiroles 1991 paper, The Politics of Government Decision Making: A Theory of Regulatory Capture. For information on regulatory capture in developing countries, see Columbian researcher Frdric Boehms Regulatory Capture Revisited Lessons from Economics of Corruption, along with World Bank economist Anwar Shahs Corruption and Decentralized Public Governance. Please note that throughout this literature there exists a theme of staff moving back and forth between the regulator and the industry it oversees, and the pathological incentives thus created.

In sum, then, capture has been a concern from as far back as our republics founding to as recently as current World Bank institution building programs. Capture threatens regulators in every country. It happens in market and socialist economies. In this country it happens under Democrats and Republicans. It happens often enough that economists had to create a term (captured regulator) to describe it. So when I suggest that our financial regulator (the SEC) may have been at least partially captured by the industry it regulates (Wall Street), I do so not from a desire to abuse or insult fine people engaged in public service. I wish only to raise, in a clinical and dispassionate way, the possibility that what Madison saw as the mortal disease under which popular governments have everywhere perished, and what economists from Marx to Friedman and Stigler described as a regular feature of regulation, is also a possibility with regard to our financial regulator. In fact, given that they are trying to regulate the deepest pools of money in the world (Wall Streets), it would be extraordinary if they were not in fact targets of regulatory capture.

All of which leads us to the curious case of Mr. Gary Aguirre, formerly of the SEC.

B. Wall Street Captures the SEC

In early 2005 I became aware of some inexplicable behavior on the part of the SEC, and by the summer of 2005 I began publicly stating that one of two possible hypotheses for this behavior was that the SEC had been captured. Shortly after I started saying this, an SEC Senior Investigator named Gary Aguirre began echoing it, first in a letter to SEC Chairman Christopher Cox, and then in May 2006 in a brilliant letter to the United States Senate. Mr. Aguirre did so, he has informed me, without knowledge of my own public statements, which preceded his by a matter of two months only.

The proximate cause of Aguirres complaint was that an insider trading investigation he had been conducting into the trading activities of Pequot Capital, a powerful Connecticut hedge fund, was derailed (he claimed) once the trail started leading towards John Mack, the influential boss of Morgan Stanley. Mr. Aguirre claimed that his SEC bosses had maneuvered to kill his investigation while warning Aguirre that Mr. Mack had too much juice to pursue.

The more general theme of Mr. Aguirres letter, however, was the capture of the SEC by powerful financial interests to the detriment of those other citizens who follow the law. As former SEC Senior Investigator Aguirre wrote to the United States Senate:

is the SEC adequately protecting the nations capital markets and their participants from the risk of manipulation and fraud by the nations 11,500 hedge funds? The answer is no.

And the answer is no whatever facts you consider. It is no when the SEC fails to recognize any hedge fund fraud or manipulation against other market participants for a quarter century: from 1979 to 2004. It is no when the SEC fails to protect mutual fund investors when billions of dollars are siphoned from their accounts by hedge funds. It is no when you compare what the SEC is doing and saying about hedge funds with what its counterparts in Europe are doing and saying.It is a deafening no when the SEC halts an insider trading investigation of one of the nations largest hedge funds because the suspected tipper has powerful political connections, as they did with the investigation assigned to me

I believe our capital markets face growing risk from lightly or unregulated hedge funds just as our markets did in the 1920s from unregulated pools of money then called syndicates, trusts or pools. Those unregulated pools were instrumental in delivering the 1929 Crash. There is growing evidence that todays pools-hedge funds-have advanced and refined the practice of manipulating and cheating other market participants

Fixing the SEC so it can protect investors and capital markets from hedge fund abuse will not be an easy task. Powerful interests want the SEC to stay just the way it is or, better yet, to become even weaker. Those interests are not just the hedge funds. They include the financial industries that are receiving tens of billions of dollars in revenues for helping hedge funds cheat other market participants or close their eyes to the carnage. At the top of that list are the big investment banks, e.g., Goldman Sachs, Morgan Stanley, Merrill Lynch and Bear Stearns. Those interests know how to reward friends and punish perceived enemies. Their tentacles reach far. They stopped the hedge fund investigation I was assigned to conduct. They cost me my job.

Wall Streets misuse of influence is nothing new.

It would be difficult to devise a more eloquent statement of regulatory capture, or one more informed by personal experience, than this letter from SEC Senior-Investigator-turned-whistleblower Gary Aguirre.

In June 2006, Mr. Aguirre was asked to testify before the U.S. Senate Judiciary Committee, to which he had delivered boxes of evidence (which he apparently carried out of the SEC). The U.S. Senate Judiciary Committee began demanding answers of the SEC. The SEC stalled while threatening criminal charges against Aguirre for his whistle-blowing, prompting U.S. Senator Charles Grassley in August to write a remarkable letter lecturing the SEC on congressional oversight and the U.S. Constitution.

In September 2006, the Senate wrote two letters pressing the General Accounting Office to conduct a formal investigation into Aguirres allegations of regulatory capture and the overall regulatory framework of our countrys capital markets (see here and here).

In October 2006, Gretchen Morgenson and Walter Bodganich of The New York Times began to report on the serious implications of this story.

On December 5, 2007, however, New York Times reporter Floyd Norris wrote a story that was dismissive of Mr. Aguirre's allegations and derisive of his motives ("Get a Job, then Sue Because You Were Not Hired Earlier"). Reporter Norris included no quote from Mr. Aguirre and precisely one sentence ("He contends that the S.E.C. was unwilling to go after John Mack, now the chief executive of Morgan Stanley, because of his political clout") that reflected Aguirre's position. Norris made no mention of Aguirre's deeper claims about the systematic capture of the SEC, nor about hedge funds cheating other market participants, nor about the systemic risk thereby engendered (we will see that such omissions display a remarkable regularity and near-total consistency in our mainstream financial press). However, Norris did find space to cover the SEC's position liberally, including a statement of the SEC's denial of Aguirre's claims, their reasons for that denial, the position of SEC Enforcement Director Linda Thomsen reaffirming that position, the same from an EEOC judge, two rhetorical questions aimed at deriding Mr. Aguirre's actions, and a quote from an SEC lawyer attacking Aguirre. Mr. Norris closed by saying of that attack by the SEC's own lawyer, "It certainly sounds as if that opinion was correct." Such was the fair and impartial approach taken by "our newspaper of record."

Mr. Norris and The New York Times displayed perfect timing, for that very day Gary Aguirre was to appear to testify at a Senate hearing. Notwithstanding the mocking and derisive tone taken by "our newspaper of record," the U.S. Senate Judiciary Committee went ahead with Mr. Aguirre's testimony (see parts 1 and 2). Several SEC officials appeared to refute Mr. Aguirres claims (click here). Giving testimony that drew sharp replies from the U.S. Senate Judiciary Committee members these SEC officials contradicted each other and their own email records. The Inspector General of the SEC refused to answer questions on the advice, he said, of the U.S. Department of Justice (read that again: the Internal Affairs of the SEC essentially invoked the 5th Amendments protection against self-incrimination).

When the Wall Street Journal played its normal and customary role of downplaying these events on the behalf of Wall Street, it drew a public letter from Senator Grassley rebuking them for their misdirection.

In January 2007, the Senate released a preliminary report. An AP News story by Marcy Gordon summarized:

an official review raises serious questions about the Securities and Exchange Commission's handling of an insider-trading investigation and the possibility of a cover-up amid allegations of political interference.After taking testimony and reviewing thousands of documents, many of them provided by the SEC, the judiciary panel's preliminary findings show extraordinarily lax enforcement by the SEC and ... may even indicate a cover-up by the SEC, Senator Arlen Specter said. The SEC's handling of the matter, including a review of the attorney's allegations by the agency's inspector general, has all of the earmarks of the obstruction of justice, he said.

In March 2007, Mr. Aguirres allegations were covered sympathetically in a PBS news story.

In August 2007, the final report was released under the imprimatur of the Committee on Finance of the U. S. Senate. A good summary of the report can be found in this Reuters story.

The Senates report stated the following conclusions (emphases in the original):


Staff Attorney Gary Aguirre said that his supervisor warned him that it would be difficult to obtain approval for a subpoena of John Mack due to his very powerful political connections. Aguirres claim is corroborated by internal SEC emails, including one from his supervisor, Robert Hanson. Hanson also told Aguirre that Macks counsel would have juice, meaning they could directly contact the Director or an Associate Director of Enforcement.

SEC management delayed Macks testimony for over a year, until days after the statute of limitations expired. After Aguirre complained about his supervisors reference to Macks political clout, SEC management offered conflicting and shifting explanations.

The SEC fired Gary Aguirre after he reported his supervisors comments about Macks political connections, despite positive performance reviews and a merit pay raise.

After being contacted by a friend in early September 2005, Associate Director Paul Berger authorized the friend to mention his interest in a job with Debevoise Plimpton. Although that was the same firm that contacted the SEC for information about John Macks exposure in the Pequot investigation, Berger did not immediately recuse himself from the Pequot probe. Berger ultimately left the SEC to join Debevoise Plimpton. When initially questioned, Bergers answers concerning his employment search were less than forthcoming.

The SECs Office of Inspector General failed to conduct a serious, credible investigation of Aguirres claims.

The conclusion of the Senate report (page 104) expands on this last point regarding the Office of the Inspector General, the part of the SECs organization tasked with preventing precisely the regulatory capture implicated in these events:

The OIG investigation into Aguirres allegations was flawed from the beginning and hindered by missteps during the entire process. Every step seems to have been based on a desire to go through the motions and close the case. How the OIG could assess Aguirres credibility without ever speaking to him remains a mystery. One of the major problems with the OIG seems to be the perception within the SEC regarding the independence of the office and whether or not employees who approach the OIG are treated fairly. We interviewed a number of current and former SEC employees who indicated that the OIG is not well respected and that there is a general reluctance to approach the OIG with concerns. Aguirre was no exception. Based on our review, the OIG at the SEC seems to have failed in its mission. Other SEC employees perceive it as a tool of management, used for retaliatory investigations against disfavored staff.

The New York Times summarized all of this in a story with the tepid headline, S. E. C. Erred on Pequot. Indeed, if derailing investigations into wealthy elites with juice while negotiating high-flying jobs with their white shoe law firms and ensuring an Inspector General conducts a half-hearted investigation before whitewashing the cover-up-firing of an investigator too recalcitrant to go along for the ride all count as erring, then yes, The New York Times is correct, the SEC erred here.

In late July, 2007, SEC Chief Economist Chester Spatt resigned suddenly and effectively immediately. The U.S. Senate report was released on August 3, 2007. That afternoon, Walter Stachnik, Inspector General of the SEC, also resigned (according to this Forbes story he had held that position since its creation in 1989). The following Thursday, August 9, 2007, SEC Commission Roel Campos resigned as well. That same day news leaked of the impending resignation of a second commissioner, Annette Nazareth (who, as we shall see later, is tightly linked to the issues discussed here).

The SEC is overseen by seven people: five commissioners, a chief economist, and the Inspector General. On August 3, 2007 the Senate Judiciary Committee reported on its investigation into the political capture of the SEC. Within a three week period straddling that report's publication date, four of those seven (the Chief Economist, the Inspector General, and two of the five commissioners) were out. I do not know to what degree that constellation of facts is meaningful or coincidental, and I do not wish to disparage any individual's record of public service (well, actually, I do want to disparage Inspector General Stachnik's, but other than him...) In all cases, however, I trust that at this point my claim, The SEC, regulator of our nations capital markets, has been at least partially captured by financial elites, is now not as improbable as it may have initially sounded.

Given Mr. Aguirre's thorough vindication by the United States Senate Judiciary Committee and the GAO, I thought it would be interesting to ask The New York Times' Floyd Norris how he felt in retrospect about the hatchet job he had written on Mr. Aguirre. Surely a thoughtful, fair-minded journalist at "our newspaper of record" would welcome the opportunity to reflect on how his mocking and derisive attack on Aguirre looked in the soft glow of hindsight, especially given that Aguirre had risked fortune, reputation, and conceivably even his freedom, to blow the whistle on his former employer. So I wrote Mr. Norris a short note that included a link to his December 5, 2006 story, and the simple question, "How do you feel about this piece now?" The response I received from Mr. Norris was instructive:

"I have read our story on the Senate report, but not the report itself, and that does not change my opinion on Mr. Aguirre. I did not conclude in the blog that he was or was not fired for illegitimate reasons. The Senate thinks he was, judging by the article. The blog item remains accurate, to the best of my knowledge."

In short, concerning a one-sided story that lambasted a tiny corner of Mr. Aguirre's position while ignoring its most crucial elements, and which was devoted to parroting parroting attacks on Aguirre by the SEC, its director of enforcement, its lawyer, and asked derisive rhetorical questions by and ended with a quote from Mr. Norris opining that, "It certainly sounds as if the attack on Aguirre was correct," now, in the face of a Senate report which vindicates Mr. Aguirre and is seemingly causing the disintegration of the highest echelon of the SEC, Mr. Norris can bring himself to express neither remorse nor contrition. Please stick another pin in this as an expression of the standards of journalism thus evinced by our financial media in general and "our newspaper of record" in particular, for it is a topic to which we shall later return.

In any case, if we may assume that these claims regarding the regulatory capture of the SEC are worthy of at least tacit acceptance, then we may in good conscience turn to that alarm raised to the United States Senate by erstwhile SEC Senior Investigator Aguirre:

our capital markets face growing risk from lightly or unregulated hedge funds just as our markets did in the 1920s from unregulated pools of money then called syndicates, trusts or pools. Those unregulated pools were instrumental in delivering the 1929 Crash. There is growing evidence that todays pools-hedge funds-have advanced and refined the practice of manipulating and cheating other market participants

Last edited by Patrick Byrne on Tue Sep 04, 2007 6:47 pm edited 35 times in total