The SEC's New Cop on the Beat

Financial Executive magazine/December 2009

This is a pre-edited version, not the version in FE's digital edition

If there were a corporate enforcement weathervane atop the Securities and Exchange Commission (SEC) headquarters on F St. NE in downtown Washington, D.C., it would have been gyrating wildly since new Obama Chairman Mary Schapiro and her enforcement chief, former federal prosecutor Rob Khuzami, took control of the agency’s financial police force earlier this year. Conventional wisdom said that the new Democratic hegemony in Washington stirred by a pissed-off public perception of at least American financial corporations stemming from last fall's near economic disaster would have launched the SEC down an aggressive enforcement path. Populist police on the prowl, holding leash-straining, fraud-sniffing dogs, that was the expectation. "People did expect last year’s election to result in a more aggressive SEC,” states Russ Ryan, a partner with King & Spalding and a former assistant director of enforcement at the SEC.

In an interview, Khuzami says, "Some think we should be doing more, and others think less. But I don't lead the division by adding up our supporters and detractors. Rather, our focus is on aggressively enforcing the laws against those who commit fraud and other misconduct."

Schapiro and Khuzami have rhetorically flashed their badges during their first year, announcing procedural and bureaucratic U-turns from the Chris Cox era. Enforcement cases have increased in number. New legal ground has been broken--depending on whom one talks to--with regard to accounting fraud charges. But so far--and that is an important caveat at this still early date--there has been a lot more flash than lash. The Obama SEC has so far taken a very reasonable, some would say--and one federal judge has publicly said so--timid, approach to corporate enforcement.

It is clear that the Obama SEC is bringing more cases, and is going after corporate officials, particularly, in some cases stretching the law beyond the bounds that constrained the George W. Bush SEC. By and large, under Chairman Schapiro and her enforcement chief, Rob Khuzami, the SEC is stepping up its pursuit of senior corporate officials," says Barry R. Goldsmith,a partner in the Washington, D.C. office of Gibson, Dunn & Crutcher and co-chair of the firm's Securities Enforcement Practice Group. "Many of these cases are being litigated and it remains to be seen how successful the Commission's stepped up focus on senior executives will be."

There have been two cases--one having to do with a financial restatement, the other with illicit foreign payments-- where Khuzami has charged corporate executives in legal areas where his predecessors in the Bush administration feared to tread. But in one of those cases the proposed fine was negligible. Moreover, in the Bank of America settlement Khuzami and Schapiro approved, a federal judge heatedly criticized them for not charging corporate officials, among other things.

Evidence of other mixed signals abound. The SEC agreed to a settlement with former AIG CEO Hank Greenberg in a case where the agency alleged Greenberg made material misstatements that enabled AIG to create the false impression that the company consistently met or exceeded key earnings and growth targets. But the $15 million fine ($7.5 million penalty/$7.5 million disgorgement), obviously substantial for mere mortals, was considered pocket change for Greenberg. He did not admit either guilt or innocence. Now he has started another insurance company. Michael Strauss, former chairman and CEO of American Home Mortgage agreed to pay an even smaller fine of $250,000 fine and $2 million in disgorgement to settle SEC charges that he fraudulently understated American Home Mortgage's first quarter 2007 loan loss reserves by tens of millions of dollars, converting the company's loss into a fictional profit.

Khuzamki notes the Greenberg penalty represents one of the largest, if not the largest, fines ever imposed on a corporate executive by the SEC. "In setting the appropriate fine level, we look at a variety of factors, including not just the personal wealth of the individual, but also the offense, the individual conduct, the strength of the evidence and likely result at trial, the impact on victims, other charges or settlements in the case, and other factors," he explains. "The goal is to achieve an appropriate level of deterrence, both for that individual and for others who might be contemplating similar action."

In terms of proposed settlements with corporations-- General Electric, Terex and Bank of America are prime examples--Schapiro and Khuzami have followed in the footsteps of the Bush SEC. "Sitting here today, no one can say based on the cases being pursued that it feels any different at the SEC than it did over the past couple years,” says Martin Wilczynski, a senior managing director at FTI Consulting and formerly an official in the SEC Division of Enforcement. He adds, however, "Everyone needs to hold off making an assessment until the transition is complete, the new leadership has settled in, and the reorganization is complete. Ultimately, people in industry expect the SEC will be reinvigorated."

So business's worst fears about a marauding SEC have not been realized, though some in the corporate community see cause for worry. Thomas Quaadman, executive director for financial reporting policy and investor opportunity at the Center for Capital Markets Competitiveness at the U.S. Chamber of Commerce, says his organization made 23 recommendations earlier this year aimed at turning the SEC into a more efficient, effective agency. "Some of that is happening," he states. But the Chamber thinks it is wrong to start down a road where corporate officials are charged under the Sarbanes-Oxley "clawback" provision when the SEC acknowledges (as it did in the CSK Auto Corporation case) that a corporate executive did nothing wrong (more on this case below).

While Schapiro and Khuzami appear to be upping the ante on corporate officials, their biggest embarrassment in Year One was the criticism by federal judge Jed Rakoff who in September blistered the agency for agreeing to a supine settlement with Bank of America. Rakoff, in disallowing the settlement, argued that the SEC should have charged some B of A officials. Judge Rakoff called the $33 million settlement unfair and inadequate. Khuzami is unrepentant about the settlement, which he approved. He says he would not do anything different despite Rakoff's criticism. "I supported the Bank of America settlement that was submitted to the Commission," he states.

Nonetheless, Rakoff's criticism makes it likely that the SEC will take a tougher line on corporate accounting fraud settlements. Also pushing the agency in that direction was a report from the SEC Inspector General which came out at about the same time as Rakoff's decision. The report listed SEC failures in the Madoff case going back more than a decade. In addition, New York State Attorney General Andrew Cuomo is breathing down Schapiro's back. "In light of the Madoff debacle and the increasing competition that the SEC has received from first Spitzer and now Cuomo, the SEC knows that it cannot move slowly or it will be left in the dust by other agencies," says John Coffee, Adolf A. Berle Professor of Law, Columbia School of Law, an expert of corporate governance and securities law. "In the case of Bank of America, they had to do something or look like they were missing at the scene of the crime. But they ended up trying to get away with a cheap victory. Schapiro needs to recognize that attempt to settle only with the corporation when it is its officers who were misbehaving will only embarrass the Commission and make it look as if it had been captured by those it is suppose to regulate."

Again, amidst very mixed signals, the SEC has appeared to lay the groundwork in a couple of instances for a more expansive legal attack on corporate officials than was the case during the Bush administration. The SEC had already filed a case--prior to Rakoff's decision--using a murky Sarbanes-Oxley section 304 provision to seek a $4 million clawback from a former CEO who had never been accused of wrongdoing in a case where his company, CSK Auto Corporation, had previously settled with the SEC because of charges of accounting fraud, after restating three years’ worth of financial statements. "That seems like a change in policy," states Ryan, "and it is unmistakably more aggressive."

Khuzami argues that the CSK case does not represent a new legal battlefront against corporate officials. As far as CSK, Section 304 by its terms does not require a CEO or CFO to have engaged personally in misconduct," he emphasizes. "That couldn't be clearer. We are not breaking new ground, since Congress has very clearly authorized us to bring such actions."

In the second case, the SEC filed an enforcement action under the Foreign Corrupt Practices Act at the end of July alleging the former CEO and CFO of Nature's Sunshine Products were at fault for payments made by the company's Brazilian subsidiary in order to get product into Brazil. The SEC asserted claims directly against the two individuals even though they (like the former CSK CEO) were not alleged to have either involvement in or knowledge of the alleged misconduct, based solely on their "control person" Again, Khuzami deflects charges by Washington attorneys that he is opening a new legal front in the area of "control person" liability. "Not having been there (in the Bush SEC) at the time, I can't speak to historical policies or practices," he says.

Financial statements and accounting fraud remain high priorities for the enforcement division, Khuzami declares. "I haven't seen the statistics for FY2009, but historically they have accounted for 20-25 percent of all enforcement actions, and I don’t expect that to differ significantly in FY 2009," he states. "We continue to look closely at cases involving revenue recognition, understating expenses, manipulating reserves, and capitalizing costs that should be treated as income."

In order to better pursue accounting fraud and other cases, Khuzami and Schapiro have not only given more authority to junior attorneys, but they have been moving 40 percent of the management personnel in the enforcement division to the front lines. Thomas Gorman, a former senior enforcement counsel at the SEC and currently the co-chair of the American Bar Association white collar securities section, says that the new freedom for enforcement division staffers to issue formal orders of investigations on their own, without the approval of higher ups, poses a “real danger” for corporations. Gorman is an attorney with Porter Wright in Washington, DC. “Companies should really be concerned about this,” he emphasizes, "because it is a disincentive for enforcement to do a thorough preliminary investigation, which, in the past, often resulted in circumstances which looked nefarious on the surface not turning out to be illegal. The SEC’s concerns can frequently be resolved quickly. Now there is no real incentive to do a preliminary investigation.” And while the increase in the number of enforcement actions has been impressive, the quality of some of those—Bank of America, for example—has been less so. So focusing on numbers alone don’t tell the whole story.

Khuzami disputes Gorman's argument. "I don't think that is an accurate assessment," he states. "The decision by staff investigators to both open a case and to seek a formal order, which permits subpoenas to be issued, is reviewed by senior supervisors, and in addition we report the issuance of all formal orders to the Commission."

Top-level staff appointments have impressed many people. Khuzami's top deputy is Lorin Reisner who served as an Assistant United States Attorney for the Southern District of New York from 1990 to 1994. The head of the New York Regional Office is George Canellos. From 1994 through 2002, he was a criminal prosecutor in the Justice Department office Reisner had previously left. "These are seasoned litigators who know how to bring cases and hopefully they will select them carefully," notes Goldsmith. "As former prosecutors who are used to exercising discretion and know that you need evidence and not just allegations, I don't expect them to go hog wild. On the other hand, corporate executives need to be sensitive to the fact that the SEC is now far more focused on individual culpability at senior levels than it has been in recent years."