REJUVINATING ENFORCEMENT

This is the second in a series of articles examining future trends in securities enforcement

The SEC’s authority will almost certainly be augmented by Congress later this year as discussed in the initial segment of this series. What has received little notice is the fact that the Supreme Court may also have a significant impact on the Commission and particularly its enforcement program. The securities cases on the Court’s docket arise in suits which do not deal directly with the SEC’s enforcement program. Rather the issues involves private suits challenging investment adviser fees, the statute of limitations in damage actions, the constitutionality of the PCAOB and honest services fraud, a statute used to prosecute many executives in criminal securities fraud cases. Those cases are discussed here.

The High Court recently agreed to hear Morrison v. National Bank of Australia, another private damage action based on Exchange Act Section 10(b). This is the Second circuit’s so-called “foreign cubed” decision. The resolution of this case may impact the SEC’s Enforcement program.

In Morrison, discussed here, the Second Circuit concluded that the district court did not have jurisdiction over the securities fraud claims, essentially because the nexus to U.S. investors and markets was far too attenuated. In its brief opposing certiorari, the Solicitor General, joined by the SEC, argued that while the Second Circuit decision is correct but that the circuit court and most others have incorrectly phrased the question. The issue is not jurisdictional, but whether the conduct falls within the ambit of Section 10(b). If the issue before the Court is resolved by defining the reach of Section 10(b), the decision could have a significant impact on the Enforcement program since that Section is the typically the weapon of choice in most enforcement actions.

Regardless of the Court’s decision in Morrison or whether Congress gives the SEC new authority, the critical question for the Commission going forward is the retooling of Enforcement. Beginning with her confirmation hearings, Chairman Mary L. Schapiro promised to rejuvenate SEC enforcement. To most observers, the need for a retooling of the program was clear. Scandals such as the Madoff debacle, with the senior Commission staff invoking executive privilege before Congress when asked to explain the obvious failure to discover the fraud, and the Pequot inquiry, with its suggestions of favoritism, have taken their toll. Ms. Schapiro promised a new tone at the top which would emphasize speed, efficiency and coordination with other regulators.

The new Chairman has moved quickly to implement her promises. Processes have been streamlined and revamped. The so-called “pilot program” of former Chairman Cox was jettisoned. That program, which in the view of many had undercut the authority of the enforcement staff and slowed an already far too drawn-out settlement process, required that any case potentially involving a corporate penalty be considered by the Commission prior to settlement negotiations to assess if a penalty was appropriate and, if so, the range. This should help speed the enforcement process.

Other changes will also speed the process, although not all agree for the best. The processes for issuing a formal order of investigation and instituting a subpoena enforcement proceeding were streamlined by delegating authority to the Director of the Division of Enforcement to issue an order or institute the action. Efforts were also initiated to revamp the processes for handling tips and incoming leads for possible cases to ensure more efficient scrutiny.

To facilitate her agenda, Ms. Schapiro brought in new senior staff members. Robert Khuzami, formerly an Assistant U.S. Attorney in the Southern District of New York, was appointed Director of the Division of Enforcement. Management expertise was added to Enforcement with the creation of the new position of Managing Executive. Adam Starch, formerly of Goldman Sachs & Co., was appointed to this position, which is taxed with managing the work flow and internal management systems of the Division including supervision of the office of Market Intelligence. That office is responsible for analyzing the large number of tips received by the agency.

Following Chairman Schapiro’s themes, Mr. Khuzami has emphasized speed, efficiency and coordination with other agencies. This began with a “more boots on the ground” approach, calling for less management and more people in the field. The Director implemented this policy by eliminating a number of first level management or branch chief positions, although the number second level or Assistant Director positions is being increased. Expertise is being added to the Division by creating five groups, each headed by a Unit Chief. The groups will specialize in the areas of Asset Management, Market Abuse, Structured and New Products, FCPA and Municipal Securities and Public Pensions. The approach also encourages cooperation by individuals, possibly through incentives such as those traditionally offered to business organizations.

The focus on coordination with other agencies will be implemented through the new interagency task force established in November of last year by executive order. That task force revamps and expands the one created in 2002 to focus on the investigation and prosecution of financial crimes.

Mr. Khuzami, in year end remarks to the AICPA, ticked off accomplishments of the SEC’s revamped Enforcement Division. There, he emphasized that compared to the prior year the dollar amount of orders for disgorgement increased about 170% and for penalties by about 35%. At the same time, the number of TROs and asset freezes obtained and the number of formal orders issued, all increased significantly. NERA reported however, that the number of cases settled by the Division declined by about 8%. That result is consistent with trends in private litigation where NERA reported a drop in the number of private securities cases filed last year compared to the prior year.

At trial, the SEC had mixed results. The Commission prevailed in SEC v. Conaway, discussed here, a financial fraud case arising out of the demise of Kmart. The agency also won in SEC v. Colonial Investment Management, discussed here, a short selling case and in SEC v. Tedder, discussed here, an insider trading case. However, the Commission lost in SEC v. Anton, discussed here, because it failed to prove that an alleged tipper obtained any personal benefit. The SEC also lost after trial in SEC v. Competitive Technologies, a market manipulation case, discussed here.

While the Commission has worked hard to move past the scandals from prior years which tarnished its reputation, a new one in the form of the Bank of America case looms. There, the court rejected a proposed settlement in an enforcement action, calling the investigation a sham (discussed here). The action, based on claims that the bank lied to its shareholders when soliciting proxies for the approval of its acquisition of Merrill Lynch, is currently heading for trial.

Next: Selected significant cases of 2009.

A NEW DECADE WILL BRING NEW AUTHORTY FOR THE SEC

This is the first of a series of articles examining future trends for in securities enforcement.

A new decade and a new year begin with the prospect for significant changes in securities enforcement. Legislative initiatives being considered by Congress have the potential to dramatically alter the regulatory landscape. The Supreme Court, which is working through a docket of potentially blockbuster cases, could impact that regulatory picture. At the same time, the SEC is in the process of redefining enforcement in an effort to regain its position as Wall Street’s top cop. DOJ, however, is not only vying for that role, but has grabbed the lead in some areas with aggressive enforcement.

When Congress returns from its holiday recess, both the House of Representatives and the Senate will consider draft legislation which seems destine to rewrite financial regulation. That regulation should add to the authority of the SEC, an agency which just last year many considered to be on the brink of extinction. New Chairman Mary Schapiro and her team have worked hard to revive the embattled agency and now have it poised to receive significant new authority and funding.

While the precise contours of any final legislation are difficult to determine at this point, the various proposals under consideration have a number of common elements which seem destined to be written into law in some form. The various proposals which the House and the Senate will take up include provisions regarding OTC derivatives, hedge funds and a new consumer agency. Additional authority for the SEC regarding aiding and abetting, the harmonization of fiduciary standards, executive compensation and rating agencies also threads through the various proposals.

Rising out of the market crisis, the clamor for the regulation of OTC derivatives, such as credit default swaps and other exotic instruments, as well has hedge funds, is likely to command a great deal of lawmakers’ attention in coming months. For derivatives, Treasury is backing a plan which began with its White Paper last June, discussed here, carried through in proposed legislation, discussed here, and is now reflected to various degrees in a number of proposals such as the current version of the house bill, H.R. 4173 discussed here, and the Senate Finance Committee bill unveiled in November, discussed here. Essentially, those proposals call for standardized derivatives to be traded on exchanges. All derivatives would be subject to disclosure, margin and record keeping requirements, with a focus on transparency. The SEC and CFTC would share authority over this huge market.

SEC Chairman Schapiro and CFTC Chairman Gary Gensler have supported these proposals. Both have advocated robust regulation for derivatives. Mr. Gensler in particular, has strongly urged lawmakers to write comprehensive legislation which would force most derivatives onto exchanges and narrow any exceptions as discussed here. Former CFTC Chairperson Brooksley Born (1996-1999), who warned against deregulating these markets, as Congress did earlier in the Commodity Futures Modernization Act of 2000, would go even further. Ms. Born has urged Congress to require that all derivatives either be traded on an exchange or, for customized transactions that cannot be exchange traded, require that one party be a hedger.

As with derivatives, both the House and the Senate will consider the regulation of hedge funds. Both will likely pass legislation which includes new regulation over funds of a certain size. Here again, the proposals stem from the Treasury White paper, versions of which are included the pending House bill and the one crafted by the Senate Banking committee. The Treasury proposals mandate registration for fund advisers and impose record keeping requirements. H.R. 4173 along with various proposals being considered in the Senate, includes registration and record keeping requirements.

Any financial regulatory bill will likely contain provisions which will enhance the authority of the SEC in other areas as well. Those are likely to include additional authority in the area of aiding and abetting and rule writing authority to harmonize the duties of those who give investment advice. Versions these provisions, included in the pending House bill and the Senate finance committee bill, trace to the Treasury White Paper. There will also likely be provisions on executive compensation and “say-on-pay” and perhaps rating agencies.

H.R. 2873 would also enhance the authority of the SEC. That bill, which passed the House last year, would give the SEC nationwide service of process in district court enforcement actions – the same kind of authority currently available to DOJ in criminal cases. More controversial will be the provisions of S. 2886 which would effectively overrule the Supreme Court’s decisions in Central Bank and Stoneridge, discussed here, on aiding and abetting and scheme liability. If passed, the bill would give private litigants the ability to bring fraud damage actions based on secondary liability theories.

Perhaps the most far reaching bill pending on Capital Hill is S. 2886, introduced by Senators Cantwell and McCain. This bill would significantly redraw the financial landscape by essentially restoring the Glass-Steagall Act, the depression era law which separated commercial and investment banking. That statute was repealed in 1999 by the Gram-Leach-Bliley Act after being slowly undermined over the years through regulatory exceptions.

While proposals like McCain-Cantwell, as well as others, are sure to spark a heated debate on Capital Hill, a recent report by accounting firm Grant Thornton issued a recent report as part of its Capital Markets series will help fan the flames. That report suggests the emphasis on trading in recent years had undermined the IPO market in the United States. This trend, according to the report, has had a deleterious effect on the health of the U.S. capital markets in a number of areas including new exchange listings and job creation.

Whatever the final configuration of financial services legislation, it seems all but certain to include provisions which will enhance the authority of the SEC and its enforcement program. That legislation is likely to include new regulation for OTC derivatives and hedge funds. The SEC will almost surely receive enhanced authority in those areas as well as others identified by Treasury in its proposals, strengthening their overall presence in the market place and their enforcement programs. While this new authority will empower the agency, it will also create additional pressure to restore SEC Enforcement to its prior position as the top cop of Wall Street.

Next: Reorganizing the SEC enforcement program