Deafened by the S.E.C.'s Silence, He Sued

Photo

ON May 18, Caremark Rx Inc., a pharmaceuticals services concern, surprised many investors when it disclosed that a day earlier federal prosecutors and the Securities and Exchange Commission had notified the company that they were scrutinizing how it awarded stock options to company insiders. Caremark's shares tumbled 6.8 percent on the news.

Some investors, however, found the regulators' interest in Caremark not so surprising. As early as last January, SEC Insight, an independent research firm, warned its clients that regulatory risks might be brewing at the company — noting that federal authorities had refused to release records on Caremark because doing so could interfere with enforcement activities. SEC Insight reiterated its warning on March 20.

The stock of Caremark, which is based in Nashville, has been a top performer in recent years. But shareholders who heeded SEC Insight's warnings and sold their stock dodged a significant loss.

In a world where truly independent stock research is a valuable and rare commodity, SEC Insight is even more unusual. The firm makes its calls after poring through correspondence and other internal S.E.C. documents it secures by filing requests under the Freedom of Information Act. Ever since John P. Gavin, a former money manager and chartered financial analyst, founded SEC Insight six years ago in Plymouth, Minn., he has prided himself on its ability to sniff out regulatory trails like a corporate bloodhound.

During the last two years, however, Mr. Gavin says, his snooping and his ability to send early warning signals to clients have been stymied by an unlikely adversary: the S.E.C. itself. The agency, overshadowed by aggressive prosecutors like Eliot Spitzer, the New York attorney general, has gone to great lengths recently to reassert itself as Wall Street's top cop. But the S.E.C. has made it nearly impossible for Mr. Gavin to round up documents it once routinely provided to his firm. Mr. Gavin's experience, he says, suggests that the agency, which bills itself as the investor's advocate, is less than forthcoming about what it actually finds at the companies it polices.

"In this post-Enron era, as the S.E.C. demands record levels of disclosure from public companies, it's a shame that the agency itself has become disclosure-challenged," Mr. Gavin said.

It is a troubling paradox, Mr. Gavin says. The S.E.C., which requires public companies to make full disclosure of all meaningful facts, has stopped granting most of Mr. Gavin's requests for regulatory correspondence. For his part, Mr. Gavin has sued the agency in federal district court in Minnesota, seeking to compel compliance with federal disclosure laws.

The suit aims to force the S.E.C. to turn over records to Mr. Gavin on 12 companies, which the S.E.C. has so far flatly refused to do. The judge overseeing the case has given the S.E.C. a deadline of Thursday to prove that it has reviewed the documents that Mr. Gavin requested on six of those companies. The agency has appealed that ruling, arguing that the task is too onerous.

"We are defending the action to protect our ability to complete these law enforcement investigations, and to protect investors by enabling us to get relief where appropriate, including disgorgement of ill-gotten gains," said Richard M. Humes, associate general counsel at the S.E.C. He declined to comment further.

Mr. Gavin, 44, is not the only one complaining that the S.E.C. is keeping investors in the dark. An analysis by 10k Wizard, an online search engine for S.E.C. filings, indicates that the agency's two-year-old pledge — to publish all correspondence between it and public companies and mutual funds about their accounting and other practices — remains puzzlingly unfulfilled. As a result, SEC Insight says, shareholders everywhere are missing out on information that could help them make astute investment decisions.

Even as the S.E.C. plays hardball with Mr. Gavin, costing his three-person firm more than $100,000 in legal fees, Christopher Cox, the S.E.C. chairman, recently noted his agency's crucial role in providing investors with that most basic of needs: information. Testifying on May 3 before the financial services committee of the House of Representatives, Mr. Cox said: "When it comes to giving investors the protection they need, information is the single most powerful tool we have. It's what separates investing from roulette."

YET since August 2004, the commission has failed to provide documents relating to 1,700 of SEC Insight's requests under the Freedom of Information Act. Under the law, such requests are supposed to be answered in 20 days, but in most cases the S.E.C. says it is still looking for documents more than a year after SEC Insight requested them.

Lucy A. Dalglish, executive director of the Reporters Committee for Freedom of the Press, said she was dubious that the S.E.C. found it too onerous to carry out its responsibilities. "I'm sure it is very expensive and it is a burden and they are trying to draw a line in the sand because they don't like to do this," she said. "But so what? The law is the law and the Freedom of Information Act says that they have to comply with this. It is inconceivable that all the information about some of these companies is off-limits. That just flat-out doesn't pass the smell test.

"Probably an undercurrent here is that the S.E.C.'s internal documents are earning this guy a living. But if they are truly upset about this guy making money off their records — and they are not their records, they are public records — then they can do a better job of posting them on their Web site."

At least, Mr. Gavin says, the S.E.C.'s enforcement division provides bare-bones responses to some of his requests. The agency typically sends him letters saying that there are no investigative materials, or, when it denies requests, citing a need for investigative secrecy. It was just such a denial that caused Mr. Gavin to conclude in March that Caremark Rx might face regulatory risk.

A Caremark official declined to comment beyond saying that the company is cooperating with the government inquiries.

Mr. Gavin's firm acknowledges in each report it publishes that it does not know what an investigation might involve and cannot predict whether it will lead to an enforcement action. Moreover, he tells his clients that S.E.C. investigations are fact-finding exercises and do not mean that a company or individual has done anything wrong. But any question about a company's practices, especially when the S.E.C. is the one raising it, can be an important data point for investors. And it is the S.E.C.'s flat-out refusal to supply correspondence with public companies that Mr. Gavin said he finds disturbing. These communications, known as comment letters, have been enormously useful in revealing potential problems at companies in the past, he says. The letters have pointed to aggressive accounting practices and pension problems, for example, long before those problems hit the headlines.

In October 2001, the S.E.C. wrote to Computer Associates, the Long Island-based software company now known as CA Inc., inquiring about potential accounting problems. Sanjay Kumar, the former CA chief executive, and other top managers have pleaded guilty to an accounting fraud that inflated the company's results in 1999 and 2000 and cost investors hundreds of millions in stock losses.

The S.E.C. addressed its letter to Ira Zar, the company's chief financial officer, and provided it to Mr. Gavin's firm in March 2002, less than a month after Mr. Gavin made his document request. Mr. Zar pleaded guilty to fraud at CA in 2004.

The S.E.C. made 15 points in the letter, mostly about CA's accounting. One-third of the issues raised by the S.E.C. involved CA's revenue recognition practices; these became central to the government's subsequent case against CA executives.

Photo

CA's shares traded around $33 when the letter was written. The stock rose to around $38 in January 2002, but news media reports about possible accounting irregularities and investigations at the company pushed the shares down to around $16 in February of that year. In March, when CA's stock was at $18.50, SEC Insight issued an alert to its clients about the company. By July, CA's share price had fallen to under $8 as the company's troubles mounted.

The speedy S.E.C. response to Mr. Gavin's CA request contrasted sharply with a request he made in 2004 related to the Andrew Corporation, a maker of communications equipment. Although the S.E.C. has twice told Mr. Gavin that there are no investigative records pertaining to the company, he has waited almost two years for other correspondence he has requested. Last September, the S.E.C. said its contractor would send the correspondence to Mr. Gavin's firm; those documents have not yet arrived.

The S.E.C. has not posted any comment letters regarding Andrew on its Web site, even though Andrew noted in a regulatory filing last December that it had paid its auditor $68,300 during 2005 to respond to a comment letter from the S.E.C.

When the S.E.C. announced in June 2004 that it would post all comment letters, it said the change would give investors access to the information in them. If a company asked for confidential treatment, the S.E.C. said, it could exclude only that information from publicly posted letters.

Alan Beller, former director of the S.E.C.'s division of corporation finance, said a year ago that the agency believed " it is appropriate to expand the transparency of our comment process by making this information available, free of charge, to an unlimited audience."

Last week, the S.E.C. had posted on its Web site 2,224 letters it had sent to companies. Most were from 2004 and 2005, but there were also a few from this year. Even so, there are some 23,000 public companies and roughly 8,000 mutual funds in the United States, and watchdogs like Mr. Gavin say that the Web site's postings do not reflect that reality. Many of the postings are different letters written to the same company.

AN analysis by 10k Wizard raises questions about the S.E.C.'s progress. Combing through regulatory filings back to May 2005, 10k Wizard found that 212 companies had voluntarily disclosed receipt of an S.E.C. comment letter. (Such disclosures are not required under securities laws.) Matching those companies with the S.E.C.-posted correspondence showed only 21 companies' letters on the agency Web site.

"We were very excited when the S.E.C. announced that they were going to make these comment letters available," said Martin X. Zacarias, chief executive of 10k Wizard. "We'd gotten requests from all of our clients for that information."

But Mr. Zacarias said his excitement faded soon after the program began. "We were disappointed with the initial batch and with subsequent letters," he said. "We started to suspect that we weren't getting a complete availability of letters." After his firm conducted an analysis of comment letters for this article, Mr. Zacarias said the study "confirmed what we suspected."

Many letters that appear on the S.E.C. Web site relate to small, obscure companies of little interest to investors. Among the letters written in 2005, for example, about 20 percent went to companies whose shares either trade on the OTC Bulletin Board or no longer trade in any organized market. Of the roughly 470 companies whose communications with the S.E.C. were posted on its Web site from April 2005 to April 2006, 46 percent have market values of less than $100 million. Only 20 percent have market values over $1 billion.

John W. White, director of the S.E.C.'s division of corporation finance, said: "A few years ago in response to a deluge of F.O.I.A. requests for S.E.C. review and correspondence from several commercial providers that planned to resell the information, we adopted a plan to instead publicly post that information on Edgar so that it would be readily available to all investors free of charge. We have now resolved the technical hurdles of posting the information on Edgar, and we have committed our resources to getting correspondence arising since August 2004 posted as soon as possible so that it will be readily available to all investors free of charge. We expect a significant number of new postings in the coming months."

Mr. Gavin first saw the value of S.E.C. documents when he was an analyst at American Express in the late 1990's. In 1999, Arthur Levitt, then the S.E.C. chairman, announced that the agency was sending letters to 150 companies that it suspected were using aggressive accounting practices. That led to Mr. Gavin's first Freedom of Information Act request, for the names of the 150 companies. The agency denied it.

Mr. Gavin then requested information about Network Associates, a technology company whose shares American Express owned on behalf of its clients. The request generated a 12-page comment letter from the previous year. "The letter was comprehensive," he said. "It challenged them on dates when they reclassified things, challenged them on an acquisition, questioned them about restructuring costs."

Days later, Network Associates warned that it would miss its earnings forecast. "I said, 'Hey, we can get this cool stuff from the S.E.C.,' " Mr. Gavin recalled. "We started doing it inside Amex and I left about a year later and started SEC Insight."

The firm's success was anything but immediate. By July 2001, a year after it opened shop, SEC Insight had only one customer. Then Mr. Gavin made a few good calls, including one about a company named Enron and its chief executive, Kenneth L. Lay. A report from SEC Insight dated Oct 23, 2001, a month before Enron collapsed, began: "We believe Enron's S.E.C. troubles are far less welcome and potentially far more serious than Ken Lay and the company lets on."

Mr. Gavin's clients consist of mutual funds and hedge funds. He charges upward of $50,000 a year for his service and keeps a "focus list" of companies that reflects the information he receives from his requests.

Two types of companies are on the list. The first, which the firm calls "troubled," are those where it has found signs of "compelling S.E.C. or other investigative activity" that may not have been disclosed to investors. Less problematic are those companies that SEC Insight advises investors to "monitor," because of possible regulatory risk.

SEC Insight put The New York Times Company on its "monitor" list in April after the S.E.C. partially blocked the firm's request late last year for information about the company. Mr. Gavin speculated that the response could relate to the S.E.C.'s examination of newspaper industry circulation practices that began in 2004. Mr. Gavin currently tracks 32 "troubled" companies as well as 160 on his "monitor" list, which also includes the Tribune Company, Dow Jones & Company and the Gannett Corporation.

Spokeswomen for The New York Times Company and Gannett said that the companies had given the S.E.C. all the information it requested two years ago and had since heard nothing from the agency. A spokesman for the Tribune Company said that it did not comment on speculation. Dow Jones did not return a call seeking comment.

Mr. Gavin said he first encountered problems with the S.E.C. in 2002. The agency, he said, gradually stopped providing information on company investigations, refusing even to state that an inquiry prevented it from responding. So Mr. Gavin sued the commission in 2004. As a result, he said, the S.E.C. started providing investigation letters again but stopped turning over comment letters, which the agency had been freely issuing before the suit.

Rachel Rosen, a lawyer at Cundy & Paul in Bloomington, Minn., who represents Mr. Gavin, described the S.E.C.'s actions as counterproductive. "By not releasing this information they are asserting that it is going to interfere with their investigations," she said, "but we think their actions are going to do more harm for investors than good."