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Wall Street History
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02/13/2004
Ray Dirks v. the SEC, Part II
[Next column 2/27]
I thought I would clean up some loose ends on the Ray Dirks story. If you didn’t read part I, the following won’t make any sense to you. And admittedly this is very dry stuff, but the case of Raymond L. Dirks v. Securities and Exchange Commission was an historic one and helped define insider trading, as well as the treatment of whistleblowers, analysts and the press. As you read the full tale, though, it’s also more than a bit apparent that the SEC has continually failed to execute its regulatory duties, decade after decade.
Reminder, the Justice Department under the presidency of Ronald Reagan fought for Dirks when he took his suspension all the way to the U.S. Supreme Court. Following are further details, in the solicitors’ words, of the ‘brief’ filed by Dirks’ supporters. The High Court later reversed the ruling of the Appeals Court and Dirks was cleared. [Note: “Commission” refers to the SEC and I have substituted Dirks where “petitioner” was used to make it a little easier to read.]
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Both the state and the public at large have an interest in exposing corporate misconduct. Ordinarily, we would expect that official law enforcement agencies would be sufficient for that task, but this case shows that the organs of government are not always able to accomplish swift investigation of possible crimes. The press also has an historic role in discovering and exposing wrongdoing, but here, too, the press failed to move as quickly as Dirks, who had more immediate financial and reputational incentives to discover the truth about Equity Funding .
The Commission’s erroneous imposition of liability in this case has serious consequences for federal law enforcement, which frequently depends on private initiative to uncover criminal conduct. If the antifraud provisions of the federal securities laws, backed by administrative, civil, and criminal sanctions, forbid analysts to trade with or transmit evidence of crime obtained through honest investigation, then few analysts will have an incentive to invest the resources needed to investigate corporate frauds like the Equity Funding fraud. Few analysts will be willing to devote substantial resources and expose themselves to personal danger to investigate rumors of crime – as Dirks did – if they are forbidden to utilize the information they obtain until after it is fully revealed to the investing public .
The Commission and the court of appeals concluded that Dirks was subject to a duty to disclose to the public at large his evidence of criminal conduct or abstain from passing it on to anyone. The premise of that conclusion was that the sources of the information – present and former officers of Equity Funding – were subject to a fiduciary duty to the company’s securityholders. The Commission believed that Dirks “assumed” that fiduciary duty simply by receiving the information, and that this prevented him from either tipping or trading .
The information at issue in this case – evidence of a massive, ongoing criminal scheme – was not “confidential” information available “only for a corporate purpose.” Evidence of crime is not the private property of anyone. It is not amenable to “conversion.” Those who discover it and spread the news to others are not guilty of misappropriation or theft. Quite to the contrary, any effort to disseminate such information is encouraged by the law, while efforts to preserve its secrecy are strictly forbidden .
Secrist (the Equity Funding official who first went to Dirks), originally provided the information and monitored its use, (intending for Dirks) to divulge the information to institutional traders who would precipitate large-scale market activity, and thereby hasten the investigation and termination of the fraud. Secrist also gave his permission to convey the information to the Wall Street Journal. Dirks’ communications with the auditors further advanced Secrist’s stated objective of exposing the fraud. And, precisely as Secrist anticipated, Dirks’ activities quickly achieved the desired objective while regulatory authorities lagged behind. Far from inflicting a tortuous injury on the corporation, Dirks’ actions served to expose and terminate corrupt wrongdoing by some of its highest ranking officials
As (Appeals Court) Judge Wright observed, “Largely thanks to Dirks one of the most infamous frauds in recent memory was uncovered and exposed,” while governmental authorities “repeatedly missed opportunities to investigate Equity Funding.” The Commission also acknowledged Dirks’ “important role in bringing Equity Funding’s massive fraud to light”, but concluded that its censure order would not “chill” other analysts in the “investigation of rumors” of similar corporate frauds. We are not so sanguine about the impact of the Commission’s order on the private investigation of corporate crime ..
Dirks spent several weeks investigating Secrist’s allegations – on his own time, at his own expense, and despite substantial personal danger. The direct result of his investigation was that the price of Equity Funding stock fell dramatically, trading was suspended, and government authorities ultimately took remedial action. As the principal architect of the Equity Funding fraud conceded, Dirks deserves “personal credit” for uncovering it. Had Dirks not taken action, the illegal scheme, which lasted for nearly a decade, could have persisted for an additional period of time – causing even greater injury to the public .
The Commission’s decision in this case (to suspend Dirks) threatens to undermine, rather than enhance, investor confidence. If administrative rulings strip away the incentive of security analysts to investigate frauds, there will be more frauds in the future and they will persist for longer periods of time. By contrast, if investors may continue to expect that competent analysts, acting in their own economic interest, will assist the government in policing the securities markets, their reliance on the integrity of the marketplace will be strengthened .
It was inevitable that the Equity Funding fraud would have victims. Because of Dirks’ actions leading to the discovery of the fraud, there were fewer victims than there otherwise would have been. And to the extent that private parties retain an incentive to act as Dirks acted there are likely to be fewer victims of such frauds in the future.
Respectfully submitted,
Rex E. Lee, Solicitor General Dl Lowell Jensen, Assistant Attorney General Stephen M. Sharpiro, Special Assistant to the Solicitor General Roger M. Olsen, Deputy Assistant Attorney General
October, 1982
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Note: As part of the investigation into the fraud, it was discovered that of more than $3 billion worth of life insurance ostensibly issued by Equity Funding between 1964 and 1973, more than $2 billion proved to be fictitious.
Source: U.S. Department of Justice archives, briefs / 1982
Wall Street History will return February 27.
Brian Trumbore
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