Wall Street History

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Wall Street History

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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