On Tuesday, June 28, 2011, Robert Khuzami, Director of the Division of Enforcement of the U.S. Securities and Exchange Commission (the “Commission”), answered questions from moderator Richard Walker, Managing Director and General Counsel of Deutsche Bank, and the audience at the SIFMA Compliance and Legal Society Monthly Luncheon.
Director Khuzami began by addressing the expected duration of the Commission’s ongoing inquiry into issues related to the financial crisis, with the Director emphasizing the “high priority” and “significant resources” the Commission has given to these issues and focusing specifically on the Commission’s creation of specialized structured product units.
Director Khuzami next addressed the misperception that corporate executives were not being held accountable for the financial crisis. The Director touted the Commission’s “impressive record . . . with respect to charges . . . brought on the mortgage origination side — the CEOs, CFOs, and other high ranking corporate officers of Countrywide, New Century, and Indymac — and in the mutual fund space.” He reminded the audience that the Commission has “charged portfolio managers and others with nondisclosure to the extent to which mortgage assets were in the funds and not properly disclosed,” as well as “charged senior executives” in the “credit area.” The Director conceded, however, that no “heads of investment banks or other high profile institutions” have been charged, explaining that these cases were “challenging” to bring because “unlike traditional accounting or financial disclosure fraud cases . . . in the structured products world these institutions set up desks to generate these products, but [the desk is] often two, three, four, five levels down in the organization where the machine is set up and the products are being manufactured and sold.” He continued to explain that “often the people that are selling them aren’t necessarily involved in the disclosures . . . which makes it difficult to reach into the highest levels of the organization.” In the end, the Director offered that the “same dynamic” that existed with Countrywide, New Century, and Indymac “is not really true in the structured products world.”
The Director next addressed the notion that the nine-figure penalties recently issued by the Commission in two collateralized debt obligation (“CDO”) cases involving isolated institutional market transactions between lower level employees and sophisticated investors established a new penalty “benchmark.” The Director explained that the penalties were relative to the size of the “$500 million to $2 billion” transactions at issue, and he contended that the penalties were “consistent with statutory penalty authorization and penalty guidance.” Regardless of their size, he emphasized that the penalties stemmed from the fact that “investors . . . were defrauded” and/or “the manufacturer of these products did not conduct the kind of disclosure they should have.” Importantly, and consistent with Greenberg Traurig’s recent experiences, the Director confirmed that the Commission is in fact looking to use penalties to “reimburse investors for their losses.”
The Director then addressed the implementation of the new cooperation and deferred and non-prosecution agreements. Director Khuzami advised that the Commission has had 25 individuals who have signed cooperation agreements and that recently the first deferred and non-prosecution agreements were signed in two separate matters. The Director stated that he believed the agreements would gain traction over time as both Commission staff and defense counsel got familiar with these new tools. He reinforced that the Commission’s “policy statement” was “to embrace these programs” and that the staff was “fully behind” them. At the same time, however, he conceded that for defense counsel, the lack of historical reference points will be problematic initially because — unlike criminal matters, where defense counsel can advise clients about the likely effects of cooperating based upon experience — the new agreements present a relatively “blank slate.” Moreover, even as defense counsel learn to adapt to the Commission’s new interest in cooperation/non-prosecution agreements, to ensure complete closure of a matter it will also be critical to coordinate with other government agencies, such as the Justice Department, a point also reinforced by the Director and again consistent with Greenberg Traurig’s experience.
The Director continued to distinguish the purpose and utility of each new agreement, stating that the purpose of the new instruments was to “create more flexibility” by having documents available to fit particular situations, as well as to “create more transparency.” The Director recognized that similar past endeavors had failed because the Commission never articulated in an order or a decision how it applied cooperating factors to any particular case. He said that one goal of these agreements is to better collect, categorize, and deliver standardized information to the public so that defense counsel and clients can more accurately understand the benefits of cooperating. He similarly touted the benefit of potentially avoiding charges through either a non-prosecution agreement where it is “reasonably clear that the law was violated” or a deferred prosecution agreement where the Commission has a relatively air-tight case but will defer prosecution due to “cooperation, remediation, disgorgement, and repayment to investors.”
Director Khuzami concluded his comments on this topic by explaining that all agreements would be vetted by a centralized committee made up of six or so senior Enforcement Division officers tasked with determining the appropriateness of agreements proposed by Commission staff. The committee recommendations are then subject to the “normal Enforcement Division review process,” including review by senior staff, the Director, and his counsel.
The Director next addressed the Commission’s current concerns, stating that while there are “certain issues” that the Commission focuses on “year in year out: insider trading, accounting and financial statement fraud, broker dealer violations, . . . suitability and sales practice cases,” there are also several new areas that the Commission “cannot help but to be concerned about,” including:
(1) IPO Valuations: The Director reminded the audience that “not long ago allocation practices were at the forefront and charges were brought against firms for Reg. M and after-market violations.” He advised that with the recent uptick in IPOs, the Commission will once again be monitoring these activities.
(2) Technology Driven Trading Vehicles: The Director stated that while the Commission has not “identified specific practices” relating to “high frequency trading, dark pools, and related concerns that potentially involve manipulation through spoofing, layering or certain momentum driven strategies, data latency, and timing issues” that “clearly violate the law,” it is “very concerned” with the “lack of transparency” and whether there is a “level playing field for investors.” For these reasons, the Commission is closely monitoring these activities, and institutions can expect inquiries (which is consistent with our recent experience).
(3) Structured Product Disclosures: The Commission is looking at “reverse convertible notes,” “principal protected notes,” and “ETFs and mutual funds that may have derivatives or other products in them that are not necessarily fully disclosed or the risks of such may not be fully disclosed.” (In light of the fact that we are handling more and more of these issues, both in the regulatory and litigation context, the Director’s statement that the Commission is “looking at” these issues would seem to be an understatement.)
(4) Loan Disclosures: The Commission is examining “loan loss issues, non-performing loans, loan loss reserves, and how those loans are treated” — both in terms of “valuing assets” and determining “whether portfolio activities are designed to avoid a loss rather than for a bona fide business purpose.”
(5) Asset Management and Investment Advisors: The Commission is focusing on looking “closely at the standard issues, valuations, conflicts, preferential redemption issues, and whether material non-public information in the mutual fund context is being misused for favorite customers or otherwise.” (Recently, we have seen more of these issues as well, both in regulatory matters and, to a lesser degree, in litigation matters.)
(6) Micro Cap Fraud: The Commission is investigating “a lot of micro cap fraud” and has started a “new working group in the last six months focused much more on the gatekeepers, the transfer agents, and the broker-dealers who are not fulfilling their responsibilities.”
Director Khuzami next spoke to various issues surrounding the Commission’s whistleblower program. He described the group as existing as a separate group with the Office of Market Intelligence and comprising 6 to 8 staff. The Director remarked that since Dodd Frank’s implementation one year ago, the number of whistleblower complaints has been “manageable” and of “higher quality — in some cases significantly higher quality — with . . . detailed allegations . . . and supporting documentation.” He also explained how the group would administer the complaints, utilizing the “same kind of process with respect to scrubbing and reviewing the complaints, assigning them out to the regions or the specialized units in the home office, and [working them] like any other complaint.”
The Director responded to concerns raised about whether the Commission would turn anonymous whistleblowers back to the involved institutions and how it would address and deter unmeritorious complaints. The Director first focused on the statute’s “fairly strict anonymity and confidentiality provisions,” which he said preclude the Commission from doing anything that might reasonably lead to the identification of the whistleblower, including turning over complaints to the institutions involved. He did emphasize, however, that once a complaint has been received, the Commission will coordinate with the institution involved so that it can initiate its own investigation, a process consistent with Greenberg Traurig’s experience. Director Khuzami also highlighted the incentives a whistleblower has to report first to the involved institution, including: (1) providing that the first reporting date to the institution will be the same date for a later complaint made to the Commission, if made within 120 days; and (2) giving the whistleblower the benefit of any information produced by the institution as part of the investigation, which in many cases will increase the penalty and thereby the whistleblower’s award. The Director downplayed the likelihood of unmeritorious claims by referencing the fact that whistleblower complaints must be signed under penalty of perjury and that, in the case of an anonymous complaint, the complainant must be represented by counsel who must sign the complaint under penalty of perjury. He also intimated that false claims could be turned over to the Justice Department for prosecution, although unlikely. In the end, the Director emphasized that what the Commission hopes to achieve through the whistleblower program is a heightened ability to uncover “fraud and misconduct, particularly at senior levels of an institution” in the “early stages of that conduct” “before losses have mounted, the evidence is stale, and the cases are much more difficult to make.”
Director Khuzami next explored how the Commission evaluates whether a charge should be made where only junior-level employee misconduct is involved, stating that the Commission examines an institution’s policies and procedures to determine whether they were “reasonably designed to prevent the problem” or if the problem resulted from “a unique set of circumstances.” He cited the CDO cases as an example, advising that what the Commission saw there was that pitch books and term sheets were being drafted by sales personnel who simply revised old documents without sufficient oversight from the Legal or Compliance departments. The Director commented that if the materials had gone up to a “reputational risk committee” which had engaged in a “good faith effort to assess the product and comply with the law, then that is obviously a significant factor that would go into deciding whether or not there is institutional responsibility.” Nationally, Greenberg Traurig has handled significant matters involving these same issues, both in regulatory and litigation matters, and these processes are something both regulators and the plaintiffs’ bar appear to be focused on right now.
The Director then described how the Commission is handling underwriting concerns, stating that the Commission generally is “concerned” with “the market” but that it is “looking closely” at “valuation issues with respect to certain assets” and “pension liability,” “tax arbitrage,” and “other liability disclosures.”
Director Khuzami closed by commenting upon what he had recently called “troubling” defense tactics, included obviously coached witness testimony and the prompting of witnesses during examinations. The Director warned that the Enforcement staff has been told to be sensitive to these issues and to raise them both with defense counsel and with the Commission. Although staff was told not to take extreme measures, such as demanding counsel immediately leave the room, the Commission has advised staff to immediately raise these issues to see if a resolution can be reached. The Director described some tactics as “disturbing, particularly where you have multiple representations among numerous individuals and you get remarkably consistent and not-so-obvious interpretations of events, definitions, or testimony about events reflected in emails or elsewhere that would not be the first, second, or third most obvious interpretation of what happened.” The Director further warned that the Commission would draw “certain inferences” from such conduct where appropriate.