The SEC Chairman Must Be Fired 2: Where The Author Explains Himself More Thoroughly

Spend enough time in an insular community like Wall Street and you forget that the rest of the world doesn't see things through your jaded eyes.

Take the recent Securities and Exchange Commission subpoena seeking notes, emails, phone records and other correspondence from several respected financial journalists as part of an investigation into illegal trading practices. If you're unfamiliar with the players involved and how the system works, you probably saw the news and said, "Well, if the SEC thinks these reporters are doing bad things, they should be investigated. Good for the SEC."

But if you've spent more than a decade covering the Street's schemes and scams - often working with regulators at the SEC and other agencies - and have written co-bylined stories with one of the subpoenaed reporters, things appear in a very different light. Instead, you notice that the SEC under Chairman Christopher Cox is rapidly shifting its view of the regulatory landscape. The agency now sees the financial press as an enemy, not an adversary, a point hammered home in this online column by Newsweek's Charles Gasparino.

Taking Cox's explanation of the fiasco at face value, he should be fired because he has no control over his own department. Without naming names, Cox's statement painted the SEC's head of enforcement, Linda Chatman Thomsen, as an overzealous renegade, taking the extreme step of subpoenaing reporters without running it past a single person in his office. An SEC chairman who's that far out of the loop? Talk about a recipe for disaster. Ask Gary Lynch, who prosecuted Michael Milken and Ivan Boesky as the SEC's head of enforcement in the 1980s, or William McLucas, who headed the department in the 1990s, if they'd subpoena reporters without informing their respective bosses, John Shad and Arthur Levitt. It's unimaginable.

Unfortunately I don't accept Cox's word...and that's why I think he's a real danger to the financial markets. For starters, Thomsen seems as secure as ever. Meanwhile Cox clearly is fostering a politically paranoid environment where rather than working with financial journalists - traditionally some of the agency's strongest allies - the SEC is looking to prosecute them. This shift may be in line with the Bush administration's overall handling of the media, but it's extremely naïve and short-sighted when it comes to regulating Wall Street.

See, there's a nuanced difference between the White House press corps and the financial media. They're two distinct animals in the ways they approach their jobs. Reporters at the White House and on Capital Hill make their bones by exposing political fraud. But the business press generally works with regulators to investigate financial fraud. Crusading politicians and zealous law enforcement officials are standard heroes in the business news narrative. Cox clearly is out of his depth by setting a policy of shooting his allies. And because he has a better chance of being named Pope than getting canned, we all should be very frightened by what he's doing.

To better understand what I'm talking about here, you probably need some background on the "dirty little secret" of the relationship between the financial press and the SEC. The Securities and Exchange Commission was created after the 1929 stock market crash to be the regulator the financial community never wanted. But Wall Street took such a beating after '29 that the markets were pretty sleepy for the next several decades and there wasn't much need for aggressive regulation. The fact is, until the 1980s the SEC was a fairly toothless tiger.

In the 1980s the stock market started to take off, fueled by a junk-bond led merger boom, and insider trading became more prevalent - and profitable. So the SEC was forced to step up its enforcement efforts. Meanwhile, savvy financial reporters like Pulitzer Prize winners James B. ("call me Jim") Stewart and Daniel Hertzberg of The Wall Street Journal started doing their own enterprising detective work. Their stories, dripping with deep law enforcement sources, set the tone for the SEC's crackdown on the financial markets, and often unearthed new information useful in the agency's investigations. Over time, the SEC prosecuted several key Wall Street players and helped reform the insider-trading laws. And the financial press recorded the proceedings, almost pornographically, every step of the way.

In the 1990s, the symbiotic relationship between the press and the SEC became even more important because the agency didn't have the investigative resources to keep up with the Internet-led explosion in the stock market. Basically the SEC, as a government institution, was being starved of funding, while companies flush with cash were throwing wads of dough at anyone who could help them circumvent financial regulations. At the same time, the Internet also was leading to a proliferation of financial information, dramatically increasing the number of journalists covering the market day-to-day and minute-to-minute.

So when you look at how the financial regulatory environment has evolved, the SEC now often finds itself following the media, which can be a major source of leads and ideas. It's hardly surprising that the outmanned agency failed to spot major stock market fraud as it was happening during the 1990s bubble and was stuck playing catch-up in New York State Attorney General Eliot Spitzer's aggressive Wall Street investigations after the bubble burst. You can't go to war with a cap pistol against guys armed with assault rifles. (Just ask Dick Cheney!)

Still, this is not to say that the relationship between the SEC and the media always has been rosy. The first major 1980s insider trading case involved the reporter R. Foster Winans of The Wall Street Journal, who would tip off a trader about what was going to appear in his column before it ran. He went to prison. And in 1996, Dan Dorfman, a legendary figure in financial news circles, lost his job with Money magazine because he refused to reveal sources to his editor after being investigated for insider trading. This is a particularly disgraceful legacy for Dorfman because he trashed the one bond he had with his readers - trust.

And that brings me to the SEC's recent decision to subpoena financial journalists as part of an investigation into illegal trading. If we as a society truly prize a free press, subpoenaing journalists should be a last resort for a government investigator seeking information. If the SEC has evidence of a journalist participating in illegal trading activity - like suspiciously timed stock movements or bank deposits - it should be prosecuted like any other crime. But the agency doesn't have evidence like that. Instead the SEC has blindly snared journalists in a fishing expedition of an investigation into a complicated form of trading called short selling.

The first thing you need to understand is that short selling is completely legal. It's simply a trade that enables you to bet that the price of a stock is going to fall. The way it works is: Say IBM's trading for $100 and I think that's too high. So I call my broker and ask him to put together a trade where I'll "sell short" 100 shares of IBM at $100. The brokerage house then literally lends me 100 shares of IBM, which I sell on the open market. Now I have $10,000 in my pocket and an IOU to the brokerage house for the 100 shares. And then we wait. If the price of IBM falls to, say, $90, I can buy back the stock for $9,000 and keep the $1,000 remaining as my profit. But if the price of IBM rises, it becomes increasingly expensive for me to buy back the stock I owe with money from my own pocket. That's the risk of short selling - if you're wrong, you can lose a lot quickly.

When you're faced with complex new financial concepts, your first natural instinct is to try to separate the "good guys" from the "bad guys." And if you think about it, anyone who makes money betting on businesses to fail basically is a dictionary definition of a "bad guy." But you have to avoid those kinds of black-and-white clichés in the financial markets. If you need a metaphor to understand Wall Street, try looking at is as more of an evolving ecosystem with various characters performing different functions, some uglier than others. Short sellers are the scavengers, the jackals. What they do isn't pretty, but it is necessary because they provide a vital check-and-balance in a system prone to hype. That doesn't mean short sellers are boy scouts; the community has more than its share of scoundrels. But if you accept the principles of the free market, you also have to accept that there's nothing inherently nefarious in what they do.

Now there's one big difference between short selling and illegal "naked" short selling - one's fake. Naked short selling is a phony version of a short sale where you bet that a stock price is going to decline but don't actually borrow the shares. So using the above example with IBM, I'd work a deal with my broker where the house would count me as being short 100 IBM shares at $100 without going through the motions of having me borrow the stock, sell it, and then buy it back. I'd just be betting that IBM was going to fall from $100, without all the fuss. It's illegal because, other than the fact that it's a completely fictitious arrangement, taken to its extremes it could put limitless downward pressure on a stock.

Some executives, particularly the head of Overstock.com, Patrick Byrne, have complained that naked short selling is a serious problem in the market. Byrne maintains that there's a conspiracy among short sellers and the press to drive down the price of his company's stock. For all I know, he has a point. His stock has lost more than 70 percent of its value in the last 15 months and the short interest is exceedingly high, meaning there's a lot of money being bet against the company.

But there could be another explanation for Overstock's lagging stock price. The company hasn't turned a profit in its history and is operating in a business that's prone to failure. When you strip away all the fancy business jargon, Overstock is a discount liquidation store that operates on the Internet. The company's basic strategy is to offer products cheaply from an Internet brand that people trust. So Overstock has to advertise heavily to build its brand and then focus on cutting prices as steeply as it can. The problem is Overstock's swimming in a pond with ruthless retail behemoths like Wal-Mart and Amazon, and other aggressive upstart competitors, meaning it has to consistently keep its margins razor thin.

And then there's Byrne himself, or Dr. Patrick M. Byrne, as he prefers to be called (in recognition of his doctorate in philosophy from Stanford.) As president of Overstock, Byrne's hardly an active hands-on manager. He operates an investment company in Park City, Utah, called High Plains Investments, and in his own biography he describes himself as "an investor by trade." This probably explains why the guy spends most of his time and energy focused on his company's stock price rather than its earnings. If Byrne hasn't figured out how to make a dime out of this company by now, isn't it logical that investors would start to wonder if he ever will? Do you think that might have something to do with Overstock's tanking stock?

Of course that's not what Byrne wants to talk about. Instead he rails on about how naked shorting is killing his business and destroying America along with it. And apparently he finally found a sympathetic ear at the SEC.

Whether naked shorting is even affecting his stock is debatable since so far there's been no evidence of the practice. But even if Overstock is under an illegal organized attack, naked short selling still is a relative niche concern for a very small corner of the stock market. In terms of the real issues facing average investors, this is a head-fake. It hardly rises to the level of Enron-style accounting fraud or illegal trading in mutual funds, or any of the myriad other scandals the SEC could've unearthed in the past few years, but didn't.

So what you have is Christopher Cox's SEC allowing itself to be led down the dangerous road of subpoenaing investigative reporters based on the specious word of a single executive with a failing company and serious ax to grind. And all of this is being done as part of an investigation into a practice that, while illegal, hardly is as widespread as, say, good old fashioned accounting fraud, which is the kind of thing the SEC should be focused on.

As I wrote earlier last week, if all of this isn't a firing offense, I don't know what is.