SEC inspector general raises red flags in new report

In a new report, the SEC's inspector general, H. David Kotz, questions how probes deal with former agency officials.
In a new report, the SEC's inspector general, H. David Kotz, questions how probes deal with former agency officials. (Haraz N. Ghanbari/associated Press)
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By Zachary A. Goldfarb
Washington Post Staff Writer
Tuesday, March 23, 2010

About two miles separate the Securities and Exchange Commission's headquarters in Washington from the offices of Allied Capital, a District-based private-equity company.

But over the course of an 18-month government probe into whether Allied Capital overstated the value of its holdings, nobody from the regulator ever visited the firm to ask questions, according to a new, internal SEC review that raises questions about the agency's oversight of the financial industry.

The SEC's watchdog found that the agency failed to properly pursue serious allegations made against Allied Capital, a public company that invests in small to midsize businesses. But after heavy lobbying by Allied Capital, the agency aggressively pursued the hedge fund manager who had challenged the value of Allied's investments.

The SEC has been under intense scrutiny for failures in its regulation of financial firms, and the report by Inspector General H. David Kotz casts doubt about whether the SEC has the proper procedures in place for effectively policing the actions of public companies and Wall Street firms.

Among other things, Kotz questions how SEC officials decide to open investigations and whether they are unduly influenced by outside lawyers -- particularly former SEC officials -- in conducting the probes.

"The SEC needs to open investigations based on evidence, rather than unsupported allegations, so as not to waste the agency resources and focus needed for investors and market integrity," said Charles E. Grassley (Iowa), the ranking Republican on the Senate Finance Committee. "The revolving door is turning at the SEC, and the problems we've seen before with former senior SEC employees influencing enforcement decisions has been highlighted in this report."

The agency's leadership has been replaced with the new administration, and the new officials have pledged to fix the problems.

"We agree with each of the report's recommendations, have already implemented several of them and expect to complete the process in June," said John Nester, an SEC spokesman.

Allied Capital did not return two calls seeking comment. The firm has struggled amid the financial crisis, defaulting on debt and credt agreements. Its shares have lost most of their value in recent years, and the firm has accepted a buyout offer from New York-based Ares Capital.

Straw-man strategy

The case explored by the inspector general began in 2002, when a hedge fund manager named David Einhorn explained in a speech that he bet against Allied Capital's stock by short-selling it because he thought Allied overvalued its holdings.

Other investors proceeded to short Allied's stock, which declined sharply in value.

About the same time, Einhorn began contacting the SEC by phone and letter to explain his skepticism about Allied Capital's accounting techniques.

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