SEC Inquiries: Opportunities, Wrapped In Hysteria, Inside A Catastrophe - Part I

by: Five Plus Investor

The World War II era has always held a fascination for me. Perhaps this comes from having both grandfathers in the war: one stationed with the Army in the Pacific (New Guinea), one stationed in a Naval munitions plant in the Florida everglades.

Winston Churchill is a particular World War II hero of mine, and he is famous for this quote:

"I cannot forecast to you the action of Russia. It is a riddle, wrapped in a mystery, inside an enigma; but perhaps there is a key. That key is Russian national interest."

This quote, as used today, refers to a seemingly unknowable mystery, a puzzle difficult to solve. This colloquialism does not quite capture the full essence for us as investors. Churchill was referring to Russia: a country whose political system was diametrically opposed to Western capitalism. Russia's alignment with the Allies was uncomfortable for both Churchill and Roosevelt, but was necessary in the defeat of Hitler's forces.

Or, if put to a high school history class, Russia for the Allies was the ultimate "frenemy."

The Art of War / The Art of Income Investing

There are times where income investing feels like a war. You put a stake on a certain income position; then the "other side" (since I'm speaking to a long crowd, I'm referring to shorts) gains ground. You are faced with a decision: double down on your position, or retreat?

The best decisions are not made with emotion or by a quick trigger finger. Instead, Sun Tzu in "The Art of War" states it best:

"If you know the enemy and know yourself, you need not fear the result of a hundred battles. If you know yourself but not the enemy, for every victory gained you will also suffer a defeat. If you know neither the enemy nor yourself, you will succumb in every battle."

I believe most income investors start at the level of neither knowing themselves, or their enemies. Lots of mistakes are made by all of us in our early investing years.

Eventually most of us graduate to the middle level; we know and achieve success with "ourselves", meaning our own strategy. It's easy then to become confident…until the enemy in its various forms - Mr. Market, short sellers, bad news or dividend cuts - sneak attacks.

Then, to be frank with you all, I see a lot of "hysteria" and calls of "catastrophe."

I think this comes from too many income investors seeing virtue in simply ignoring the enemy.

My advice is: let's graduate to the level Sun Tzu advises. Let's understand both our strategy, and our "enemies" and "frenemies".

With that introduction, I bring you the Security and Exchange Commission (SEC)…the investors' ultimate "frenemy."

The Securities and Exchange Commission: "We're here for YOU…"

The SEC was created through The Securities Act of 1933 and the Security Exchange Act of 1934, in reaction to the stock market crash of 1929 and the resulting depression. The Securities and Exchange Commission calls themselves "The Investor's Advocate", with this stated goal: "to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation."

SEC regulations are supposed to insure transparency so that "all investors…should have access to certain basic facts about an investment prior to buying it."

The method of enforcing this transparency is through civil legal enforcement through sanctions, censures, monetary penalties and other measures. Infractions would include insider trading, accounting fraud and providing false or misleading information about a security.

The SEC was created for the good of the people, with the best of intentions. Yet like most government interventions, the good it accomplishes is offset by the problems it creates. That is:

The minute the SEC actually does what it's supposed to do, the market reacts with such mayhem that it appears to undo the good it is supposed to do!

Since the protective actions of this agency can work against the shareholders of the company they investigate, it is best to know your "frenemy". An investor needs to understand:

1) The flow of an SEC inquiry and investigation, and
2) React appropriately to typical market reaction.

Understanding the SEC Flow Chart: Fact-Finding Comes Before Formal Investigation

The use of "inquiry" and "investigation" are erroneously and interchangeably used, even by the media, but the two are not synonymous. An inquiry is not an investigation. Instead, the inquiry precedes an investigation.

Based on share action, investor tips or complaints, market surveillance, industry sources or media reports, the first action taken by the SEC against any company it may think violated SEC regulations is the "informal inquiry". During the informal inquiry:

"Facts are developed to the fullest extent possible through informal inquiry, interviewing witnesses, examining brokerage records, reviewing trading data, and other methods".

It is the informal inquiry process that allows the SEC to determine whether or not further investigation is required.

In addition to the early process being considered voluntary and informal, the SEC does not release announcements of the inquiry. It is considered "private"; it is up to the company to release any information on the SEC probe.

If the SEC deems a possibility of infraction out of the evidence of the informal inquiry, the next stage is the "formal order of investigation":

"With a formal order of investigation, the Division's staff may compel witnesses by subpoena to testify and produce books, records, and other relevant documents".

A formal investigation is where the stakes become much higher, because the outcome of the formal investigation can lead to a federal court case or administrative action:

"Following an investigation, SEC staff present their findings to the Commission for its review. The Commission can authorize the staff to file a case in federal court or bring an administrative action. In many cases, the Commission and the party charged decide to settle a matter without trial."

Understanding the Market's Turbulent Relationship with SEC Inquiries

With this explanation under our belts, I now introduce to you the latest "victim-du-jour" of the SEC: Linn Energy, LLC (LINE) and LinnCo, LLC (LNCO). Actually, our latest subject-of-scrutiny needs no introduction. We have been talking about this one for a solid week.

On July 1st, Line Energy / LinnCo announced that it was the subject of an SEC informal inquiry. Up until this date, the stock had been trading somewhat in tandem with most other MLPs; slightly down, but with no panic selling. Witness the chart action on this one on July 1st and subsequent trading days:




Interestingly, other upstream MLPs which have no relation to the SEC inquiry or Line Energy traded in similar fashion:




This article series will not attempt to hash out the issues that prompted the inquiry. The accounting and merger issues leading up to July 1st are handled deftly, from differing viewpoints, by the following Seeking Alpha articles and comment sections:

· Tim Plaehn, "Have the Short Sellers Taken Down Linn Energy?"

· Mike Maher, "Why Linn Energy Isn't Done Dropping"

Instead we will take a more global approach. This will not be the last time the SEC will initiate a probe, and the next time may be with another one of your holdings.

To conclude Part One of this series: It is best to understand your "frenemy" so that you aren't subject to "hysteria" or "catastrophe".

Continue on to Part Two>>>

Disclosure: I am long LINE, LNCO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.