SEC faces setbacks, skepticism in trying to reform its enforcement image

By Zachary A. Goldfarb
Washington Post Staff Writer
Tuesday, April 6, 2010; A08

A year-long effort by the Securities and Exchange Commission to overhaul its enforcement of laws against corporate crime has run into courtroom setbacks and internal skepticism, underlining how difficult it is for the agency to remake itself as a get-tough cop.

Top SEC officials have undertaken what they describe as the most significant reform of the agency's enforcement operations in nearly 40 years, pledging to bring big cases as never before. SEC Chairman Mary Schapiro and her hand-picked enforcement director, Robert Khuzami, have trumpeted measures designed to rapidly file major cases, send more lawyers to the front lines of investigations and set up teams specializing in specific areas of financial crime. The actions are in response to years of criticism by former officials and investor advocates that the SEC took too light a touch with Wall Street.

But now, some senior SEC officials question whether the new measures will yield the kind of results that Schapiro and Khuzami are promising. "I'm looking to see whether or not all of the new initiatives are actually resulting in improved sanctions," said SEC Commissioner Luis A. Aguilar. "I don't yet see the empirical evidence."

Last year, after long getting beat by other law enforcement agencies, SEC investigators decided to race ahead on one of the most high-profile cases of alleged wrongdoing to come out of the financial crisis. The SEC abruptly broke off its teamwork with the New York attorney general's office, going it alone to reach a deal with Bank of America, forcing it to pay $33 million in fines for allegedly lying to investors.

But a judge threw out the settlement, ruling it was flimsy, and dealt an embarrassing setback to the SEC's efforts to energize its enforcement activities.

In pursuing the case, the SEC had differed with New York Attorney General Andrew M. Cuomo over strategy, according to an official familiar with the disagreement. Cuomo wanted to take more time to build a case against individual executives at the company. The SEC, which had been widely criticized for regulatory failures that contributed to the financial crisis, wanted to bring fast action against a major bank.

U.S. District Judge Jed S. Rakoff, however, called the SEC deal at odds with the "most elementary notions of justice and morality." He faulted it for providing almost no accounting of the bank's conduct and allowing the company's executives to escape punishment. The SEC later added new charges, provided more details of its investigation and nearly quintupled the fine, winning the judge's approval.

The SEC is Wall Street's top regulator, charged with ensuring that brokerages, mutual funds, hedge funds, money managers and other financial firms treat their customers fairly and don't break the law. The agency also is supposed to make sure that public companies give investors honest information. The enforcement division is expected to investigate allegations of wrongdoing and file suits when it finds violations, seek to bar individuals from the industry, fine executives and companies, and stop bad conduct.

Yielding results

But for the past several years, penalties have declined and the enforcement division's reputation has suffered, culminating in revelations that the division repeatedly failed to stop Bernard L. Madoff's Ponzi scheme. Schapiro, who was named by President Obama, and Khuzami wanted to restore the agency's reputation.

"I wanted to do whatever I could do to strip out the inefficiencies and delays," said Khuzami, who as a federal prosecutor had sent terrorists as well as white-collar criminals to jail. "A large part of the deterrent impact of our actions has to do with the immediacy of our actions."

Khuzami cites statistics and cases showing that the agency's efforts are yielding results. In 2009, the agency opened nearly 500 investigations, more than double the 2008 level, and ordered companies to pay 35 percent more in fines and repay 170 percent more in ill-gotten gains.

The agency has filed cases in new, complex areas, such as insider trading involving exotic financial instruments known as derivatives, and reached high-profile settlements, such as forcing General Electric to pay $50 million to settle charges it misled investors about its accounting.

But the agency also has faced setbacks. In addition to the Bank of America misstep, a judge rejected the agency's case against Cohmad Securities, which was a major supplier of business for Madoff. The judge called some of the SEC's allegations "speculatively and flimsy." Although the SEC had accused Cohmad of fraud, the judge said the agency did not present any evidence to support the allegation.

Other major cases brought by the SEC are proceeding, but it could be months, or even years, before the agency learns whether it has prevailed. "Once the case gets filed, the timeline is out of our control," Khuzami said.

More than nine months ago, the agency filed a complaint against Angelo Mozilo, former chief executive of major subprime mortgage lender Countrywide Financial, for fraud and insider trading, but the case is still in its initial stage. The agency is also pressing ahead with civil charges against the former managers of two Bear Stearns hedge funds that imploded at the start of the credit crisis in mid-2008. The managers have been acquitted of criminal charges brought by the Justice Department.

To help build stronger cases, Khuzami announced earlier this year that the SEC would use cooperation agreements with potential witnesses. The agency would offer immunity to executives who were aware of wrongdoing and even involved in it if they came forward and testified. Khuzami has called this new approach a "game changer."

But without similar guarantees from the Justice Department, defense lawyers who represent those potential witnesses are skeptical that they'd sign up.

"To make yourself attractive as a witness, you have to be able to deliver the goods and to deliver a true, compelling story of something that's quite unlawful," said Charles J. Clark, a securities lawyer at Kirkland & Ellis and former top enforcement lawyer at the SEC. "We won't want to do that without minimizing the risk of our clients being charged criminally."

Khuzami said this shouldn't be an issue in most SEC cases because typically there are not parallel criminal prosecutions.

A restructuring

Khuzami has begun to rearrange his division, reassigning mid-level managers known as bureau chiefs and redeploying many of them as investigators on the front lines. But the union representing SEC employees said the impact is limited because some of those branch chiefs must be promoted to oversee others who become investigators. "We do not anticipate the 'management restructuring' component of the reorganization will result in a significant increase in frontline investigators," the union said last month in a bulletin. "Nor have we seen any real evidence that the Division intends to change the basic management model that it has employed over the past decade."

The union also minimized the significance of Khuzami's initiative, which is just now underway, to set up teams specializing in different aspects of financial crime. The units, which make up about one-fifth of the enforcement division's staff, will focus on wrongdoing in asset management, structured and new financial products, municipal securities and public pensions, as well as foreign bribery and market manipulation. "Specialized units are essentially a formalization and consolidation of the working group models that have existed in the Division for years," the union said in its bulletin.

Khuzami, however, said the specialized units are a major improvement. "They have real structure, with heads and deputies who have authority," he said. "They are very much stand-alone, concrete, formalized prosecution units designed to be forward-looking."

Some observers of the SEC say that whatever the impact of these changes proves to be, the reform agenda at the agency has already bolstered its image.

When Schapiro began her tenure early last year, "there was a feeling that the SEC was a failed agency. There was talk of carving up the SEC and dividing its functions," said John Olson, a securities lawyer at Gibson, Dunn & Crutcher and a longtime observer of the agency. Schapiro "listened to the criticism and responded. A major part of that was showing that the SEC could bring in a tough former prosecutor in Rob Khuzami who could change the management style."

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