Securities Law Blog

As reported in last Sunday’s New York Times, the SEC was allegedly chasing “small fish” while the Madoff White Shark was swimming up and down the east coast eating everything in his path. As reported by Joe Nocera:

Talking Business
Chasing Small Fry, S.E.C. Let Madoff Get Away
By JOE NOCERA

Three months ago, in a courtroom in Bridgeport, Conn., a 72-year-old former Morgan Stanley broker named Richard A. Kwak was cleared of any involvement in a small-time stock manipulation scheme.
The Boston office of the Securities and Exchange Commission began the investigation around 2001. Three years later, formal charges were brought against Mr. Kwak and seven others. By the time the case went to trial, in 2007, only three defendants were left; the others had settled with the S.E.C.
In that 2007 trial, Mr. Kwak and another defendant, Stephen J. Wilson, were cleared of one charge, with a hung jury on the remaining charges. (The third defendant, who foolishly acted as his own lawyer, was found liable and fined $10,000.)

The S.E.C. retried Mr. Wilson in 2008. He was cleared. Finally, in March 2009, the S.E.C. retried Mr. Kwak, with the same result. The jury took less than four hours to exonerate him.
Mr. Kwak’s life is now in tatters. He is around $1 million in debt and suffers from emotional problems. He has struggled to stay out of bankruptcy. Although he is still a broker — he certainly can’t afford to retire — he long ago lost his job with Morgan Stanley, where he had spent several decades without so much as a hint of impropriety. Needless to say, his business is a small fraction of what it once was.

“It pretty well wiped me out,” he said a few days ago. He is extremely bitter. The same is true of Mr. Wilson, who is also deeply in debt and struggling to reclaim his life.

I bring all this up because this Monday, Bernard L. Madoff, a contender for the title of greatest financial criminal in history, will be sentenced for the Ponzi scheme he ran for years. Mr. Madoff ruined lives, destroyed philanthropies and cost his investors billions of dollars — yet the S.E.C. was nowhere to be found, despite the repeated entreaties of a whistle-blower, Harry Markopolos.

Indeed, it was the agency’s Boston office — the same one that so relentlessly pursued Mr. Kwak — that Mr. Markopolos first approached about Mr. Madoff, whom he strongly suspected of financial chicanery. In 2000, 2001 and 2005, he peppered investigators with evidence that, while circumstantial, was far more compelling than anything the S.E.C. ever had on Mr. Kwak. In 2005, the Boston office finally referred the Madoff matter to the S.E.C.’s New York office, which did nothing.

After Mr. Madoff’s crimes were exposed, there was an outcry over the failure of the S.E.C. to uncover the Madoff scandal. What in the world was it doing all that time? Now we know the answer. Among other things, it was prosecuting two men who, in all likelihood, did nothing wrong.

When you talk to lawyers who defend people in trouble with the S.E.C., they tend to make several broad complaints. The first is that the agency spends too much time going after small fry like Mr. Kwak. “It happens more times than you can possibly imagine,” said Steven N. Fuller, one of the lawyers in the case.

This is an allegation the S.E.C. fiercely denies: “I have been at the agency for over 10 years, and I haven’t seen any evidence of that,” said Sylvester Fontes, who prosecuted Mr. Kwak.
But even the new S.E.C. enforcement chief, Robert Khuzami, acknowledges that the agency has for too long judged itself primarily on “quantitative metrics” — that is, the number of actions it brings and cases it settles — something he hopes to change. John A. Sten, a former S.E.C. lawyer who was Mr. Kwak’s lawyer during the second trial, said, “As an investigator, you are pressured to generate ‘stats.’ ” Clearly, it is far easier for the S.E.C. to add scalps by going after little guys, who will often agree to a settlement and a fine even when they are innocent. They either run out of money, or lose the will to keep fighting, or both.

A second issue is that the S.E.C. has a very difficult time shutting a case down once the commissioners have agreed to pursue it. Even if the facts start to look shaky, the internal dynamics of the agency push its lawyers to either settle or go to trial, but never to abandon it. “The staff has a real problem persuading the commission to cut off a case once it has begun,” Mr. Sten said.
Now that it has new leadership, the enforcement division is undergoing “a self-assessment of our management structure, process and operations,” Mr. Khuzami told me. He wants to make sure the agency puts a premium on cases that grew out of the financial crisis — such as the fraud and insider trading charges the S.E.C. recently brought against Angelo R. Mozilo, the former chief executive of Countrywide Financial.

But when I brought up the Kwak case, Mr. Khuzami cautioned me against “drawing any inference about how we handle all our cases from a single case.” I suppose he’s right about that. Still, even as a narrow window into the culture of the S.E.C., it is hard not to see the Kwak case as an example of misspent resources and misplaced priorities. It boggles the mind to think that the S.E.C. spent eight years pursuing this case while taking a pass on Mr. Madoff.

Of course, no stock manipulator should get a pass, no matter how small a fish. But in this case, even though five defendants settled with the agency and one was found liable, it is far from certain that a manipulation scheme even existed, much less that it involved Mr. Kwak and Mr. Wilson.

The supposed ringleader was a former Prudential broker named Chauncey D. Steele, who, everyone agrees, was enamored with Competitive Technologies, an over-the-counter stock with the symbol CTT. The company marketed university patents, and made money by taking a cut from licensing deals it negotiated.

In truth, the company has never amounted to much, but it’s always had fans like Mr. Steele, who think every new patent it acquires will be the road to riches. Mr. Kwak and Mr. Wilson were also fans of the stock, and they recommended it to clients and chatted about it incessantly with their fellow CTT aficionados. “These guys spent a tremendous amount of their time doing nothing else but talking about the company,” said Mr. Fuller.

To the government, all those phone calls — Mr. Steele called the others literally thousands of times over a three-year period — meant that the men were conspiring to drive up the stock. The S.E.C. claimed that the men were buying CTT in concert, especially at the end of the day, so the stock would end up on an uptick.

But the only evidence they had were those phone records, which didn’t tell the investigators anything about what the men actually said to one another. Mr. Wilson told me that many of the calls he got from Mr. Steele went straight into voice mail; he stopped taking them because Mr. Steele was driving him crazy. Mr. Kwak told me that although he spoke to Mr. Steele frequently, the conversations were always about the company, not about manipulating the stock.

Nor did the allegation that they were acting in concert hold up; the trading records showed occasional coincidental trades, but nothing that would suggest a systematic attempt to manipulate the market. Indeed, for people who were supposedly manipulating the stock, they lost their shirts because they never sold any shares, not even when it topped $17 a share during the Internet bubble. (It closed on Friday at $1.72.)

So why did five of the defendants settle with the government? None of them are allowed to contest the government’s allegations — that’s part of any S.E.C. settlement — but I came away convinced that they settled because they could no longer stand up to the pressure of an S.E.C. enforcement action. Only Mr. Steele was hit with a major fine, $150,000. Another man, Frank R. McPike, the former chief executive of Competitive Technologies, had insurance to cover his fine, but only if he settled “without admitting or denying the charges,” as the S.E.C. boilerplate reads. If he went to trial and lost, he would have to pay out of his own pocket. (Mr. McPike was ensnared because he was in charge of the company’s stock buyback program, which the government claimed was part of the scheme.)

Mr. Kwak and Mr. Wilson, however, refused to settle. Even though fighting to the bitter end had ruinous financial consequences, they couldn’t bear the thought of admitting to something they didn’t do. “For Richard Kwak, this was a matter of honor,” said Elliott Dudnick, who is one of his brokerage clients and testified on his behalf at the first trial.

Mr. Kwak, a former Marine, agreed. “The day they told me I was charged, I told them I would fight them until the day I died,” he said. “I would never be involved in timing a trade. I have always followed the rules.”

Even though his wife and sons begged him to settle, he wouldn’t. He couldn’t.
So long as the case was going on, Mr. Kwak held himself together, but these last few months have been difficult. Several people who know him told me that he has shown symptoms of post-traumatic stress disorder.

There is one thing he did, though, early this year. He made tapes of the hearings in which the S.E.C. was excoriated by Congress for failing to uncover Mr. Madoff’s Ponzi scheme. “I’ve kept them,” he said. I asked him why.

“They chose me instead of Bernie Madoff.”