As 2009 BEGAN, the economic crisis, an unprecedented and unpopular government bailout of Wall Street, and the Bernie Madoff Ponzi scheme prompted calls to increase securities oversight and enforcement. As a result, 2009 was a year of intense activity and change at the SEC. Below, we highlight what we consider to be the ten most significant developments.
1. New SEC Leadership and Tone
While 2009 saw many changes at the SEC, perhaps none was as significant as the addition of new senior officials. Mary L. Schapiro’s return to the SEC as Chairman helped assuage fears that the SEC would continue to drift in the face of challenging market conditions, but did not eliminate calls to cut the SEC’s authority.
Schapiro wasted no time hiring a number of well-regarded former federal criminal prosecutors, all from the Southern District of New York’s U.S. Attorney’s Office—Robert Khuzami, Enforcement Division Director, Lorin L. Reisner, Deputy Director, and George S. Canellos, Regional Director of the SEC’s New York Regional Office. With Schapiro, these senior officials quickly established a new tone and approach. Indeed, their first few months on the job were marked by a panoply of new and creative initiatives whose full impact may not be known for years. Most recently, the SEC hired Carlo DiFlorio to reinvigorate its embattled Office of Compliance, Inspections and Examinations.
2. New Enforcement Tools: “Southern Districtization” of the SEC
Apart from its new personnel, the most significant change to the Enforcement Division is its adoption of tactics used successfully by federal criminal prosecutors to leverage resources and build cases efficiently. Due to the pedigree of key Enforcement officials, some have termed the SEC’s adoption of these tactics as the “Southern Districtization” of the SEC.
Khuzami’s much-anticipated policy to encourage cooperation by individuals could be the most significant development. By offering cooperation, deferred prosecution and non-prosecution agreements within a framework to evaluate cooperation, including the timing and benefit of the information provided to the SEC’s inquiry, only time will tell whether the policy will fulfill Khuzami’s prediction that it will be a potential “game changer.”1
On a more practical level, the government’s recent high-profile insider-trading criminal and civil actions revealed the use of wiretaps and consensual recordings never before used in insider-trading investigations. With DOJ alumni now heading the Enforcement Division, increased cooperation between the SEC and prosecutors is a foregone conclusion. The DOJ-led Financial Fraud Enforcement Task Force, with the SEC as part of the steering committee to coordinate with two dozen other federal agencies, promises to strengthen efforts to combat financial crime.2 Indeed, Khuzami recently testified that the SEC coordinated 75% of its “most recent high-priority cases” during 2009 with criminal and other regulators.3
3. Internal SEC Changes: Delegation and Specialized Units
Schapiro and Khuzami both unveiled internal changes that will modify not only who makes important decisions, but how the SEC is organized to do so. Schapiro ended a pilot program under which Staff attorneys were required to seek settlement ranges from the Commission before commencing civil penalty negotiations with a public company.4 Although designed to ensure consistency, critics claimed the policy caused unnecessary delays and deterred Staff from seeking penalties.
The Commission delegated to Khuzami, who sub-delegated to “senior officers,” the ability to open formal investigations on a one-year trial basis.5 Thus, Staff no longer need Commission authority to open formal investigations or, more importantly, to issue subpoenas seeking documents and testimony. (Commission approval is still required to go to court seeking to enforce subpoenas.) Similarly, Khuzami delegated to senior Staff the authority to make routine investigation-related decisions, such as issuing Wells notices or settlement demands.
Khuzami also announced the creation of five specialized units dedicated to complex and high-priority areas, including units for Asset Management, Market Abuse, Structured and New Products, Foreign Corrupt Practices and Municipal Securities and Public Pensions.6 To maximize resources, Khuzami “flattened” the management structure of the Division, redeploying branch chiefs from supervision to conducting investigations and announced plans to hire additional trial lawyers and enhance technology, support staff and other resources.7
The SEC also created the Office of Market Intelligence to handle tips and complaints in an effective and efficient manner.8 To supervise that office, the Enforcement Division hired its first chief operating officer, who is also responsible for initiatives to relieve Staff of administrative duties and permit them to devote more time to investigating cases and bringing enforcement actions.9
4. Hedge Fund Focused Insider-Trading Investigations and Litigation
Perhaps not since the 1980s scandals involving Ivan Boesky, Dennis Levine and Michael Milken, has insider trading been such a focus for the SEC (and criminal authorities) and the public. Khuzami’s message to the hedge fund industry couldn’t be clearer: The SEC is “committed to pulling back the curtain on hedge fund operations and taking a close look at their activity,”10 especially regarding insider-trading claims.
Indeed, within a span of three weeks beginning in October, the SEC filed three high-profile hedge-fund related insider-trading actions: SEC v. Galleon, the “biggest hedge fund insider-trading case ever brought,” according to Khuzami11; SEC v. Tang; and SEC v. Cutillo.12 These actions (and related criminal proceedings) involve 30 individuals and allege more than $60 million in alleged insider-trading gains or losses avoided. As noted, these cases revealed the government’s extensive use of wiretaps and consensual recordings.13 Khuzami ominously warned that “[p]ersons involved in illegal insider-trading schemes now must rightly consider whether their conversations are under surveillance.”14
The SEC also has ratcheted up efforts to collect evidence about how information is shared among hedge funds and others through more expansive informational requests in insider trading and other investigations. Rather than limiting requests for information to specified topics, some of the SEC requests now seek “all emails” from certain hedge fund personnel as well as communications between hedge funds and third-party providers, such as administrators, auditors and prime brokers. By casting a wider net, the SEC hopes to collect more evidence about relationships with which to build additional insider-trading cases.
In addition, the SEC is seeking to expand the parameters of insider trading. In SEC v. Cuban, for instance, the SEC is attempting to overturn the dismissal of an insider-trading case brought under the “misappropriation theory” where the SEC alleged that the trader promised to keep information confidential but did not promise not to trade based upon that information. In dismissing the case, the court questioned SEC Rule 10b5-2, which specifies certain non-exclusive bases for bringing misappropriation insider-trading cases.15 In SEC v. Rorech, the SEC brought its first case alleging insider trading in credit default swaps, thereby signaling its intention to broaden the SEC’s insider-trading focus beyond traditional equity markets and into more complex products and markets.16 There, the Court denied defendants’ motion for judgment on the pleadings, finding that the issue of whether the particular CDS at issue was a security-based swap could not be decided as a matter of law.17 And SEC v. Dorozhko involves an insider-trading claim against a computer hacker who owed no duty to the source of the allegedly misappropriated information or the issuer.18 In their own way, each of these cases is part of the SEC’s aggressive efforts to expand insider-trading liability.
5. Pursuit of Financial Crisis Cases
The SEC has pursued numerous financial crisis-related investigations, many of which have already resulted in enforcement actions. For example, the SEC achieved a number of settlements involving the marketing and sale of auction rate securities, including requiring ARS repurchases and other arrangements that the SEC says have restored $60 billion in liquidity to the ARS market.19
The SEC also brought actions against former executives of two of the largest subprime mortgage lenders, Countrywide Financial and New Century Financial Corp.20 Both cases assert insufficient disclosure of risks of the lenders’ subprime loan portfolio as the market deteriorated. The Countrywide case also alleges market manipulation and insider trading by the former CEO, while New Century also asserts accounting allegations. In another notable case related to the financial crisis, SEC v. Reserve Management Co., the SEC alleged that the Reserve Primary Fund money market fund failed to disclose material facts about the fund’s vulnerability as Lehman Brothers sought bankruptcy protection, leading to the fund’s $62.5 billion collapse.21
Finally, although a jury rejected related criminal claims, the SEC will pursue its civil case against the former Bear Stearns hedge fund managers whose funds incurred substantial losses due to investments in collateralized debt obligations based largely on subprime mortgage-backed securities.22
6. Effective Use of Traditional Tools
The SEC continues to pursue ongoing investigations, open new ones and pursue an increasing number of enforcement actions. Robert Khuzami’s first-day promise that the SEC’s enforcement efforts would be “Swift, Smart, Strategic and Successful”23 may be new, but there’s nothing novel about the SEC’s basic approach. For example, as noted below, the SEC has brought many emergency actions seeking TROs and asset freezes in response to alleged Ponzi schemes.
Perhaps recognizing the negative impact that even an undisclosed investigation can have on those involved, the Staff seemingly have increased efforts to close stale matters, including recommendations not to pursue enforcement actions. Most notable here are the stock option backdating investigations underway since 2005. Anecdotally, at least, it appears that the SEC is attempting to obtain closure on investigations involving dated conduct.
Meanwhile, the SEC’s actions this year also have renewed old debates, such as the use and size of corporate penalties. That issue was central to Judge Jed S. Rakoff’s rejection of the September 2009 proposed $33 million settlement between the SEC and Bank of America. Judge Rakoff criticized the settlement as a “contrivance” to provide the SEC with the “façade of enforcement.”24 He also pointedly asked why shareholders should face the double-whammy of paying a financial penalty for alleged harm caused by unnamed corporate executives, deeming such result “worse than pointless: It further victimizes the victims.”25
7. Focus on Ponzi Schemes
Although the SEC was criticized for missing Bernie Madoff’s $65 billion alleged Ponzi scheme, it aggressively has pursued other alleged Ponzi schemes, including claims against investment advisers or those posing as such. During fiscal 2009, 20% of the SEC’s enforcement cases involved alleged Ponzi schemes or Ponzi-like payments,26 including a noteworthy case against R. Allen Stanford concerning an alleged $8 billion fraud.27 In the typical Ponzi-scheme case, the SEC files an emergency action, seeks an asset freeze and appoints a receiver to maximize investor recovery and stop the alleged fraud.
8. Creative Efforts to Expand Liability
In addition to insider trading, the SEC has stepped up enforcement in other areas. For example, 2009 saw the SEC’s first use of Sarbanes-Oxley § 304’s “clawback” provision. In SEC v. Jenkins, the SEC seeks the return of $4 million in bonus and stock sale profits from the former CEO of CSK Auto Corp.28 The case is noteworthy because the clawback suit is premised solely on the company’s restatement; it does not allege that the CEO violated the securities laws, though the SEC filed a settled action against the company and is litigating related proceedings against other executives. The SEC also filed its first enforcement action for violation of Regulation G, which requires companies to reconcile GAAP and non-GAAP financial measures and prohibits use of misleading non-GAAP financial data. In its settled action, SEC v. Safenet, Inc., the SEC asserted that the company, its former CEO, CFO and three former accountants improperly used non-GAAP financial measures and imposed a $1 million fine against the company.29
Finally, the SEC appears to be expanding Section 20(a) control person liability. In two settled matters, the SEC charged three individuals based solely on control person liability, without alleging that the defendants violated or aided and abetted the alleged underlying violations.30 That is, the SEC did not allege that the defendants acted knowingly or with scienter. Thus, while violations of the federal securities laws generally require more than negligence, by alleging only control person liability,31 the SEC obtained penalties that it otherwise could not obtain without alleging knowing or scienter-based conduct. The courts of appeals are split about whether the SEC can bring an enforcement action based solely on control person liability.32 Whether the SEC will attempt to do so in a litigated matter remains to be seen. If it does so successfully, the SEC may have added another weapon to its arsenal.
9. Negative Inspector General Reports
The SEC’s newly relevant and powerful Office of Inspector General (“OIG”) issued a series of negative reports about the SEC during 2009. Most noteworthy was the OIG’s Madoff report, which detailed multiple failures by Staff in numerous offices to respond appropriately to at least six detailed and substantive complaints raising significant “red flags.”33 The report revealed that the Staff conducted no fewer than five examinations of Madoff’s operations, but the investigators’ inexperience and failure to appreciate or follow up on inconsistencies prevented a thorough and comprehensive investigation that, according to the OIG’s report, would have uncovered Madoff’s fraud years ago.
10. Ongoing Restoration of the SEC’s Reputation
We may never know how realistic the proposal was early this year to eliminate the SEC or combine it with other regulators. But after the SEC’s new leadership took over in early 2009, the SEC’s reputation has improved significantly. Moreover, the administration is proposing substantially increasing the SEC’s $1 billion budget and expanding its regulatory authority. Most notable are proposals for the SEC to regulate the $600 trillion derivatives market and increase its oversight of the hedge fund and private equity industries. Armed with new leadership, organizational structure, enforcement tools and attitude, the SEC seems eager to reassert itself as a preeminent federal agency and tough Wall Street cop.
- 5% increase in pending investigations (4,316 vs. 4,088)
- 6% increase in investigations opened (944 vs. 890)
- 100% more formal investigations opened (496 vs. 233)
- 32% fewer informal investigations opened (448 vs. 657)
- 70% of investigations resulted in enforcement action within 2 years of opening investigation (8% increase)
- 170% increase in disgorgement orders ($2.09 billion vs. $774 million)
- 35% increase in penalties imposed ($345 million vs. $256 million)
- 82% more TRO actions and 78% more asset freeze orders
- 30% more cases coordinated with criminal actions (154 vs. 108)
- 92% of cases result in “successful” outcome for SEC (through litigation, settlement or default judgments, calculated on per-defendant basis)
- 626 settling defendants (fewest since Sarbanes-Oxley’s enactment)
- 435 settling individuals and 191 settling companies
- 58% of settlements involve disgorgement or penalty
Sources: U.S. Securities and Exchange Commission Division of Enforcement, Select SEC and Market Data Fiscal 2009 Report, available at http//www.sec.gov/about/secstats2009.pdf; Robert Khuzami, Director, SEC Enforcement Division, “Testimony Concerning Mortgage Fraud, Securities Fraud and the Financial Meltdown: Prosecuting Those Responsible,” Dec. 9, 2009, available at http//www.sec.gov/news/testimony/2009/ts121109rk.htm; SEC’s 2009 Performance and Accountability Report, available at http//www.sec.gov/about/secpar209.shtml; and Jan Larsen, Dr. Elaine Buckberg and Dr. Baruch Lev, SEC Settlements Trends: 3Q09 Update, Number of Settlements Declines in Transitional FY 2009, NERA Economic Consulting (Dec. 7, 2009).