Things are not always as they seem. This sage maxim has been cited many times in different contexts. The resolution of Pequot insider trading investigation last week, along with the earlier scandal the initial inquiry generated, is a good illustration of how this principle applies in SEC investigations.

The inquiry began as many do with information from the exchange in 2004 about possible insider trading by Pequot Capital, a large hedge fund run by Arthur J. Samberg. By the Spring of 2005, the SEC staff began examining trading by Pequot in Microsoft securities. In April 2001 Pequot and Mr. Samberg had made a profit of about $14.7 million from a synthetic long position in Microsoft built prior to the first quarter earnings call. At the time the position was established, the market was awash with rumors that the company would miss its estimates when earnings were announced for the first quarter of the year, ended March 31. It turned out the rumors were wrong. Not only did the company meet the estimates, it exceeded them. The share price increased giving the fund and Mr. Samberg a profit.

At the time Pequot and Mr. Samberg built the long position, David Zilkha, a Microsoft employee had accepted a position with the fund, working for Mr. Samberg. He was not reporting for work until late April 2001, after the Microsoft earnings call. According to the court papers, prior to reporting for work Mr. Samberg had solicited information from Mr. Zilkha about his then employer. Mr. Zilkha gathered that information, which in part was reflected in e-mails, and reported to Mr. Samberg prior to the first quarter 2001 earnings call that Microsoft would meet or exceed expectations.

At the SEC, staff attorney Gary Aguirre was working on the Pequot investigation. A subpoena as sent to Mr. Zilkha for documents. The e-mails reflecting the inside information given to Mr. Samberg were not produced. In a December 2005 interview, Mr. Zilkha apparently suggested to the staff that he had not contacted anyone to obtain information about the earnings call and that he had nothing new to report about the company to his new employer.

As the inquiry slowly unfolded, attention turned to John Mack, then the incoming chief executive of Morgan Stanley. He was a friend of Mr. Samberg. Mr. Aguirre sought to issue a subpoena to Mr. Mack. The subpoena, however, was not served at that time.

By 2006 Mr. Aguirre, who was eventually fired after having received a positive performance review the prior year, became a whistle blower. In reports published in the New York Times and later before Congress, Mr. Aguirre claimed that his investigation was thwarted by senior SEC staff officials. Mr. Mack’s testimony was taken by the SEC. Congressional hearings were held. A Senate report on the matter was highly critical of the staff’s handling of the investigation as were many others. Scandal was in the wind, suggesting the staff botched the inquiry perhaps because of high level favoritism from senior SEC enforcement officials to a former high level government lawyer representing Mr. Mack. The Pequot investigation languished and was closed in October 2006. It was widely believed the staff had failed.

In January 2009 the SEC staff received copies of the 2001 e-mails Mr. Zilkha used to obtain information about Microsoft’s first quarter earning for Pequot and Mr. Samberg. Although they were withheld from the document production during the inquiry, Mr. Zilkha’s then ex-wife located them on a computer hard drive and furnished them to the SEC. An employment law complaint Mr. Zilkha prepared in 2007 against Mr. Samberg which recorded the story of the illegal trading also surfaced after having been under seal.

The SEC reopened its Pequot investigation. Mr. Zilkha was asked to testify. He declined, citing his constitutional privileges. An administrative proceeding was eventually brought against him, discussed here. An enforcement action was brought against Pequot and Mr. Samberg claiming insider trading, also discussed here. The now defunct hedge fund and Mr. Samberg settled, agreeing to disgorge their trading profits and pay a civil penalty. Mr. Zilkha is litigating.

Now it seems clear that the SEC’s investigation into Pequot and Mr. Samberg’s trading had merit. Those who criticized the staff’s efforts during the initial inquiry, suggesting some type of favoritism while appearing correct at the time, were clearly wrong. Claims that the Commission had botched the inquiry by not seeking the testimony of John Mack were unfounded. Mr. Mack’s testimony yielded nothing. The key was e-mails which were improperly withheld, something which is difficult at best to detect.

It appears that the SEC has been vindicated. There are however lingering questions. The reasons the initial inquiry conducted proceeded at such a slow pace remain unclear. The reasons for the delay in taking Mr. Mack’s testimony also remain unclear. The reasons the initial inquiry did not focus on more on Mr. Zilkha in view of his employment at Microsoft and subsequent position with Pequot is also unclear.

It is clear that the whiff of scandal which surrounded the closing of the initial inquiry was wrong. While the SEC was fortunate that it was able to resolve the case, that end came more from the good luck that a divorced wife turned over her ex-husband’s papers than from superior investigative work. In the end the tale of the Pequot investigation should serve as a good lesson for those who are quick to criticize. It should also serve as a reminder to those who conduct investigations which can result in accusations of wrong doing that carry significant consequences that care must be taken before making such an assertion – things are not always what they seem.