Part I: SEC Enforcement Trends, 2009: Calls For Reform And Their Background

The future of the SEC and securities regulation is at a cross-road. Calls for reform seem to be made virtually every day. Some are rooted in the current market crisis. Others stem from persistent scandals that have left the SEC in crisis. Confidence in the Commission’s ability to effectively police the securities markets is at a low point. An agency that until recently was hardly recognized on main street U.S.A. is now unfortunately becoming known not for its past successes, but for its failure to protect investors. These events will help shape the future of the SEC and securities regulation.

Examination of the demands for reform begins with a brief statistical look at the enforcement program. Last year, the SEC claims it brought a record number of cases, 671. This is the first increase in recent years.

While SEC officials may point to the increased number of cases as a sign of the enforcement program’s vitality, others question the meaning of the number. Many critics note that the number is bolstered by defaults and similar actions. Others point to recently published NERA statistics which demonstrate that the number of cases settled in 2008 declined to one of the lowest levels in years.

While there seems to be a growing trend toward the criminalization of securities enforcement, a recent study published by Syracuse University based on Department of Justice data suggests otherwise. That study found that the number of securities fraud prosecutions declined significantly in 2008. At the same time the FBI reports that it is overburdened with 530 corporate fraud investigations underway. These cases focus on financial fraud and insider trading.

These statistics seem to raise more questions than they answer. While it can be hazardous to make projections from this modest collection of statistics, they seem to undermine SEC claims of a vibrant enforcement program, but point to a future increase in the number of enforcement actions.

Beyond the statistics, the current market crisis has spawned repeated calls for the reform of securities regulation as well as other financial regulators. Many have criticized the SEC’s performance during the current crisis as lackluster, at best. A report from the SEC’s Inspector General, for instance, is highly critical of the agency’s performance during the demise of Bear Stearns. SEC’s Oversight of Bear Stearns and Related Entities, Report No. 446-A Sept. 25, 2008. That same report also criticized the agency’s now defunct program of voluntary supervision over investment bank holding companies.

When the SEC did react to the market crisis, not only was it criticized, but perhaps worse, the agency second-guessed itself. In August, the SEC initiated a ban on short trading for the shares of certain financial institutions. Regulators around the globe instituted similar bans which lasted far longer than the modest few-week embargo imposed by the SEC. Yet, after the SEC’s ban ended then Chairman Cox claimed it was the biggest mistake of his tenure, undertaken only because of pressure from the Secretary of the Treasury and the Chairman of the Federal Reserve.

Scandals are another force propelling the calls for reform. The Pequot Capital debacle seems to be the scandal that will not die. Initiated by a former SEC staff member turned whistleblower, congressional hearings probed claims of undue influence and favoritism in an insider trading investigation of a hedge fund where the testimony of a prominent witness was not taken for reasons which are far from clear. A Senate report was highly critical of the SEC’s performance. Just as the scandal seemed to be fading from view, reports surfaced that there is now a criminal insider trading investigation underway as well as an SEC inquiry, both focused on the same allegations that were involved in the initial botched inquiry.

If Pequot raised difficulties for the agency, Madoff added the finishing touches. Here the SEC had multiple opportunities to discover at an earlier time what appears to be the Ponzi scheme fraud of the ages. The agency was even given a road map to the fraud — but lost its way. The impact of this failure has only been intensified by the surprising comments of then SEC Chairman Cox who sought to distance himself from the scandal by blaming the staff. (There are reports that a biography of Harry Truman who famously said “the buck stops here” has been sent to Mr. Cox.) Apparently heeding the comments of their leader, the entire senior staff of the agency completed the dismal portrait painted of the agency for the public by effectively taking the Fifth Amendment in response to questions from a congressional oversight committee about the SEC’s failed investigative efforts.

Now there is a growing chorus of calls for reform. Some focus on reforming what is seen as an antiquated market regulatory scheme which, having been born of the great depression in the 1930’s, has simply been passed by time and events. This is the predicate for reforms such as those offered by former Treasury Secretary Henry Paulson. Under his proposal the entire financial services industry would be revamped. The SEC would be merged into the CFTC, a proposal which has received favorable comments from others such as SEC Commissioner Luis Aguilar.

Other calls for reform focus on elements of the current market crisis such as adding oversight authority over credit default swaps, hedge funds and investment bank holding companies. Former SEC Chairman Cox repeatedly requested authority over the CDS market and investment bank holding companies but, ironically, not hedge funds, despite his testimony in 2006 before Congress vowing to regulate the entities. At the same time, pending legislation calls for the Commodity Exchange Act to be amended to extend regulation over credit default swaps and give supervisory authority to the CFTC, while investment bank holding companies would be placed under the jurisdiction of the Federal Reserve. The Financial Regulation Reform Act of 2008, S. 3691 (Introduced Nov. 19, 2008).

Other calls for reform focus on the internal operations of the SEC and its enforcement division. Former Commissioner Paul Atkins, for example, published an article last summer calling for the reform of enforcement practices. Paul S. Atkins and Bradley J. Bondi, Evaluating the Mission: A Critical Review of the History and Evolution of the SEC Enforcement Program, 13 Fordham J. Corp. & Fin. L. 367 (2008). In a recent speech Commissioner Luis Aguilar also called for internal reforms to strengthen the enforcement program. Speech, Commissioner Luis Aguilar: Empowering the Markets Watchdog to Effect Real Results, delivered to North American Securities Administrators Association (Jan. 10, 2009).

While the precise path of reform has yet to be charted, new SEC Chairman Mary Schapiro took office with a vow to reform and rejuvenate the enforcement program and has moved swiftly in that direction. With only a few weeks at the helm, Ms. Schapiro has already brought in a new general counsel and a new enforcement director. She has also reversed the “pilot program” of former Chairman Cox which required the question of corporate penalties to be submitted to the Commission prior to staff settlement negotiations and streamlined the process for obtaining a formal order.

Ms. Schapiro is off to a quick start and deserves time to put her program in place, but she may not get it. Recently she received a letter from Senator Grassley inquiring as to whether the SEC followed-up on information give to the enforcement division last year by a Senate committee. The information implicated Lehman Brothers in insider trading. This could trigger more difficulties for the embattled agency.

Regardless of the response to Senator Grassley however, the calls for reform will continue. Whether Ms. Schapiro can revamp the SEC and obtain new tools from Congress to help effectuate its mission, or a legislative fix will merge the agency out of existence is unclear at this point. What is clear from the case load of the FBI is the need for effective enforcement and the potential for many more securities enforcement actions in the future.