Commissioner Walter Outlines The SEC’s “Market Crisis” Related Investigations

In testimony before the House Financial Services Committee, SEC Commissioner Elisse B. Walter outlined in part the enforcement efforts of the agency in response to the current market crisis. Ms. Walter’s testimony on this topic focused largely on the efforts of three Enforcement Division working groups, in addition to the division’s inquiries into the auction rate securities market. The current investigative efforts of these working groups may suggest the direction of future enforcement efforts. Testimony of Elise B. Walter, Commissioner United States Securities and Exchange Commission, before U.S. House of Representatives, Committee on Financial Services, March 20, 2009.

First, the Subprime Working Group, formed in March 2007, is coordinating the investigative efforts of the Commission relating to subprime lending and credit market issues. The group works in conjunction with other divisions at the SEC, as well as the SROs, DOJ, Treasury, the Federal Reserve, the TARP program and other federal and state regulators. Approximately 100 enforcement staff members are participating in the work of this group.

According to Commissioner Walters, the Subprime Group has focused its investigative efforts on three key areas: 1) subprime lenders; 2) investment banks and other large financial institutions; and 3) a catch-all group which includes those who securitize and sold tranches of subprime mortgage debt, credit rating agencies, home builders and companies that provided mortgages to investors to enable them to finance securities purchases.

The inquiries regarding subprime lenders center on improper accounting questions, disclosure issues and insider trading. The accounting issues under investigation include improper accounting for loan loss reserves and the valuation of assets. The disclosure issues focus on questions regarding loan quality and credit risk such as the exposure of the entity to the subprime market, understatement of mortgage delinquency and default rates and predictions about future financial performance in view of subprime exposure. Several of these investigations raise insider trading issues, according to Commissioner Walters.

Investigations involving large financial institutions are analyzing issues regarding the timing and amount of write-downs and the related disclosures. These investigations are also looking at questions regarding false disclosure about subprime exposure or concentration, financial condition, future financial performance and the valuation of assets. In some instances, investigators are looking at issues related to the possible intentional mispricing of securities and the knowing underwriting of securities based on collateral likely to default. The staff also is considering internal control procedures related to these issues.

Second, Enforcement’s Rumors and Market Manipulation Working Group is investigating matters such as the spreading of false rumors in combination with a short selling scheme. This group is coordinating with FINRA and the NYSE regarding the conduct of member firms. Some of these investigations are being conducted in parallel or jointly with the New York Attorney General’s office and the U.S. Attorney’s Office for the Southern District of New York.

The Hedge Fund Working Group is the third group conducting market crisis related investigations. According to Commissioner Walters the SEC has “dozens” of hedge fund related investigations. These inquiries tend to focus on offerings where the lack of transparency may conceal a Ponzi scheme and possible misconduct by “funds of funds” and “feeder funds,” where the hedge fund managers failed to exercise due diligence. Other hedge fund related investigations are considering the large number of liquidations and the suspension of redemption rights. These cases raise concerns regarding whether the adviser may be favoring their own interests or those of their employees over investors.

Finally, the SEC, in conjunction with FINRA and state regulators, is investigating participants in the auction rate securities market. In this area, the inquiries have focused in part on whether securities professionals misled investors about the risks in this market. While a number of settlements have been announced the inquiries are still on-going.