[Senate Hearing 111-175]
[From the U.S. Government Publishing Office]
S. Hrg. 111-175
STRENGTHENING THE SEC'S VITAL ENFORCEMENT RESPONSIBILITIES
=======================================================================
HEARING
before the
SUBCOMMITTEE ON
SECURITIES, INSURANCE, AND INVESTMENT
of the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED ELEVENTH CONGRESS
FIRST SESSION
ON
EXAMINING THE IMPORTANT ROLE OF THE SECURITIES AND EXCHANGE COMMISSION
IN PROTECTING INVESTORS BY AGGRESSIVELY ENFORCING FEDERAL SECURITIES
LAWS
__________
MAY 7, 2009
__________
Printed for the use of the Committee on Banking, Housing, and Urban
Affairs
Available at: http: //www.access.gpo.gov /congress /senate/
senate05sh.html
U.S. GOVERNMENT PRINTING OFFICE
53-779 WASHINGTON : 2009
-----------------------------------------------------------------------
For sale by the Superintendent of Documents, U.S. Government Printing
Office Internet: bookstore.gpo.gov Phone: toll free (866) 512-1800; DC
area (202) 512-1800 Fax: (202) 512-2104 Mail: Stop IDCC, Washington, DC
20402-0001
COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
CHRISTOPHER J. DODD, Connecticut, Chairman
TIM JOHNSON, South Dakota RICHARD C. SHELBY, Alabama
JACK REED, Rhode Island ROBERT F. BENNETT, Utah
CHARLES E. SCHUMER, New York JIM BUNNING, Kentucky
EVAN BAYH, Indiana MIKE CRAPO, Idaho
ROBERT MENENDEZ, New Jersey MEL MARTINEZ, Florida
DANIEL K. AKAKA, Hawaii BOB CORKER, Tennessee
SHERROD BROWN, Ohio JIM DeMINT, South Carolina
JON TESTER, Montana DAVID VITTER, Louisiana
HERB KOHL, Wisconsin MIKE JOHANNS, Nebraska
MARK R. WARNER, Virginia KAY BAILEY HUTCHISON, Texas
JEFF MERKLEY, Oregon
MICHAEL F. BENNET, Colorado
Edward Silverman, Staff Director
William D. Duhnke, Republican Staff Director
Dawn Ratliff, Chief Clerk
Devin Hartley, Hearing Clerk
Shelvin Simmons, IT Director
Jim Crowell, Editor
______
Subcommittee on Securities, Insurance, and Investment
JACK REED, Rhode Island, Chairman
JIM BUNNING, Kentucky, Ranking Republican Member
TIM JOHNSON, South Dakota MEL MARTINEZ, Florida
CHARLES E. SCHUMER, New York ROBERT F. BENNETT, Utah
EVAN BAYH, Indiana MIKE CRAPO, Idaho
ROBERT MENENDEZ, New Jersey DAVID VITTER, Louisiana
DANIEL K. AKAKA, Hawaii MIKE JOHANNS, Nebraska
SHERROD BROWN, Ohio BOB CORKER, Tennessee
MARK R. WARNER, Virginia
MICHAEL F. BENNET, Colorado
CHRISTOPHER J. DODD, Connecticut
Kara Stein, Subcommittee Staff Director
William Henderson, Republican Subcommittee Staff Director
Randy Fasnacht, GAO Detailee
(ii)
C O N T E N T S
----------
THURSDAY, MAY 7, 2009
Page
Opening statement of Senator Reed................................ 1
Opening statements, comments, or prepared statements of:
Senator Bunning.............................................. 2
Senator Dodd
Prepared statement....................................... 27
WITNESSES
Richard J. Hillman, Managing Director, Financial Markets and
Community Investment, Government Accountability Office......... 4
Prepared statement........................................... 28
Response to written questions of:
Senator Reed............................................. 61
Robert Khuzami, Director, Division of Enforcement, Securities and
Exchange Commission............................................ 6
Prepared statement........................................... 42
Response to written questions of:
Senator Bunning.......................................... 62
Senator Schumer.......................................... 64
Mercer E. Bullard, Associate Professor of Law, The University of
Mississippi School of Law...................................... 8
Prepared statement........................................... 51
Response to written questions of:
Senator Reed............................................. 68
Bruce Hiler, Partner and Head of Securities Enforcement Group,
Cadwalader, Wickersham & Taft LLP.............................. 10
Prepared statement........................................... 58
Response to written questions of:
Senator Dodd............................................. 76
Additional Material Supplied for the Record
Statement of Colleen M. Kelley, National President, National
Treasury
Employees Union................................................ 84
(iii)
STRENGTHENING THE SEC'S VITAL ENFORCEMENT RESPONSIBILITIES
----------
THURSDAY, MAY 7, 2009
U.S. Senate,
Subcommittee on Securities, Insurance, and Investment,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Subcommittee met at 2:34 p.m., in room SD-538, Dirksen
Senate Office Building, Senator Jack Reed (Chairman of the
Subcommittee) presiding.
OPENING STATEMENT OF SENATOR JACK REED
Senator Reed. Let me call the hearing to order.
I want to thank you all for coming today, and particularly
thank the witnesses and thank my colleague, Senator Bunning.
Today's hearing examines the important role of the
Securities and Exchange Commission in protecting investors by
aggressively enforcing Federal securities laws.
It is no secret that the Securities and Exchange Commission
finds themselves in a challenging time, facing severe
criticism--some fair, some not--for failing to prevent the
subprime meltdown and subsequent financial crisis and, more
recently, from its failure to detect and prevent the estimated
$60 million Bernard Madoff Ponzi scheme. When the SEC falls
behind on its responsibilities, these effects are seen not just
on Wall Street but on Main Street throughout this country.
For instance, a philanthropic foundation that donated over
$24 million last year to nonprofits around the country,
including $350,000 in my own home State, closed its doors in
January because the foundation's donors funds were being
managed by Mr. Madoff.
As the SEC tries to restore its aggressive watchdog
capacities, we are grateful that GAO joins us today to share
the results of a study Senator Dodd and I requested back in
March of last year that provides key in-depth information to
help us consider improvements to the Securities and Exchange
Commission. GAO's review of the SEC's enforcement division,
which included in-depth focus group interviews with staff
throughout the division, found that in recent years significant
resource challenges and internal policy changes undermined the
Agency's ability to bring enforcement actions and these
problems occurred at the very time the SEC needed to be more
aggressive than ever at overseeing our securities markets.
I just want to highlight a few of the more significant
findings in the GAO report. The SEC managers and attorneys
throughout the Agency agreed that two corporate penalty
policies put in place in 2006 and 2007 had the effect of
delaying cases and producing fewer, smaller penalties, with
penalties declining at an accelerating rate, falling 39 percent
in 2006, 48 percent in 2007, and 49 percent in 2008.
Staff also felt that the SEC had retreated--in their
words--on penalties and made it more difficult for
investigative staff to obtain formal orders of investigation
which allow issuance of subpoenas for testimony and records.
Formal orders decreased 14 percent since 2005.
In addition, a burdensome system for internal case review
has slowed cases and created a risk-averse culture.
Finally, resources challenges have delayed cases, reduced
the number of cases that can be brought, and potentially
undermined the quality of some cases. Adjusted for inflation,
the Division of Enforcement's fiscal year 2008 budget amount is
down 8.2 percent from the fiscal year 2005 peak. Total
enforcement staffing has declined 4.4 percent, and the number
of front-line investigative attorneys declined 11.5 percent
from 2004 to 2008.
I am, however, encouraged by the SEC's steps to address
some of these problems, most notably to change policies to
``take the handcuffs off of enforcement staff,'' as Chairman
Schapiro has described it. I hope today to hear what additional
improvements the SEC is considering.
It is clear to me that, although you can't address all of
the SEC's challenges just by giving them new resources, GAO's
report confirms what many of us have known for a while: the SEC
needs more resources to effectively meet its mission of
policing large and complex securities markets.
Last week, I sent a letter to the Appropriations Committee,
cosigned by 12 of my Senate colleagues, requesting an increase
in funding for the SEC to hire more examiners and enforcement
attorneys and invest in technology that will help get the
Agency on the same playing field as the institutions that it
oversees.
I will continue to work with my colleagues to provide these
resources and the oversight that is critical to the success of
the Agency.
At this time, I would like to call on the Ranking Member,
my colleague, Senator Bunning.
STATEMENT OF SENATOR JIM BUNNING
Senator Bunning. Thank you, Mr. Chairman.
I appreciate our witnesses coming out this afternoon to
talk about the report being issued by the GAO and about
enforcement matters in general. I think the report provides
some useful information, such as recommendations to review and
revise the structure and policies of the Office of Collections
and Distributions.
The report also adds to what we already know, there are
real problems at the SEC. Some of those problems may be in the
budget and resources of the Agency, but I think the much larger
and more significant problems are in the structure and policies
of the Agency. For example, there are too many layers in the
chain of command. I am also concerned that the tension between
the staff of various divisions and the Commission itself not
only reduces the overall effectiveness of the Agency, but also
leads each to undermine the other.
I do think the new SEC Chairman has taken some positive
steps, since she moved to the Commission, and her quick action
on the recommendations of this report shows that she is willing
to attempt to fix problems at the Agency.
However, we should not kid ourselves that all of the Agency
problems will be fixed by new management. After all, the last
agency the new Chairman was in charge of did not do anything to
stop the Bernie Madoff fraud, as my Chairman has also brought
out.
I also do not think just adding to the SEC's budget will
fix all the problems. Every time this or any agency fails in
their mission, they always claim they need more resources. In
fact, that is what we heard after WorldCom and Enron. Yet, even
after new laws and more staffing and funding, Madoff, Stanford,
auction rate securities, and the whole subprime scandal, just
to name a few, still happened under the nose of the SEC.
I think the new management should focus on spending its
resources more effectively rather than just increasing its
budget. For example, as the GAO report points out, it may make
more sense to hire administrative and support staff to help the
investigators rather than just adding to the numbers of
attorneys. The Agency should also be looking at hiring experts
in the field like accounting and computers, as well as those
who have experience in our ordered, complicated markets to
support existing investigations rather than hiring new
investigators.
If the Agency truly needs more resources to accomplish
this, Congress should consider the request, but that request
should first explain how they will use their resources more
effectively. One good place to start is with a flatter chain of
reporting.
I look forward to hearing from our witnesses and look
forward to more hearings in the future to look into the
problems at the SEC and how we can address them.
Thank you.
Senator Reed. Thank you very much, Senator Bunning.
Let me now introduce our panel. Our first witness will be
Mr. Richard Hillman, the Managing Director of the Financial
Markets and Community Investment Group at the Government
Accountability Office. Mr. Hillman has served over 30 years
with the GAO and has recently overseen reviews of TARP,
regulatory modernization, hedge funds, private equity funds,
BASEL II capital standards, and sovereign wealth funds.
Welcome, Mr. Hillman.
Our second witness will be Mr. Robert Khuzami, the Director
of the Division of Enforcement at the Securities and Exchange
Commission. Before joining the Securities and Exchange
Commission, Mr. Khuzami was a Federal prosecutor for 11 years
with the United States Attorney's Office for the Southern
District of New York and more recently as the General Counsel
for the Americas at Deutsche Bank.
Our third witness today will be Professor Mercer Bullard,
Associate Professor of Law at the University of Mississippi
School of Law where he teaches courses in securities, banking,
and corporate law. He previously practiced in the SEC
Enforcement and Investment Management Offices of WilmerHale and
was an Assistant Chief Counsel in the SEC's Division of
Investment Management. He is also the Founder and President of
Fund Democracy, a mutual fund shareholder advocacy group.
Our fourth witness is Mr. Bruce Hiler, Partner and Head of
the Securities Enforcement Group at Cadwalader, Wickersham &
Taft LLP. His practice focuses on securities enforcement and
regulatory defense, corporate and regulatory counseling,
internal investigations, and securities litigation.
Thank you, gentleman, for joining us today. We will begin
with Mr. Hillman.
STATEMENT OF RICHARD J. HILLMAN, MANAGING DIRECTOR, FINANCIAL
MARKETS AND COMMUNITY INVESTMENT,
GOVERNMENT ACCOUNTABILITY OFFICE
Mr. Hillman. Chairman Reed, Members of the Subcommittee, I
am pleased to be here today to discuss the results of our
recent study of the Securities and Exchange Commission's
Division of Enforcement.
While the Division plays a key role in helping the Agency
meet its mission by protecting investors and maintaining fair
and orderly markets, in recent years questions have been raised
about the capacity of the Division to manage its resources and
fulfill its law enforcement responsibilities.
My prepared statement discusses the results of our recent
study and the major recommendations we made to help ensure that
the SEC is effectively and efficiently using its resources in
bringing enforcement actions. I would like to focus my opening
remarks on two important areas: the first related to the extent
to which the Enforcement Division has an appropriate mix of
resources; and the second on recent trends and penalties and
disgorgement ordered and the effects of adoption and
implementation of recent penalty policies.
Overall, enforcement resources and activities have been
relatively level recently but the number of nonsupervisory
investigative attorneys decreased 11.5 percent during fiscal
years 2004 through 2008. Enforcement management told us that
resource levels had not prevented the Division from continuing
to bring cases across a range of violations but both management
and staff said resource challenges had delayed cases, reduced
the number of cases that could be brought, and potentially
undermined the quality of some cases. Specifically,
investigative attorneys cited the low level of administrative,
paralegal and information technology support, and
unavailability of specialized services and expertise.
Also, enforcement staff said a burdensome system of
internal review had slowed cases and that there was a culture
of risk aversion.
During our review, enforcement management had begun to
examine how to streamline the case review, but their focus was
more process oriented and did not give consideration to
assessing organizational culture issues. To address these
issues, we recommended that the Chairman further evaluate the
level and mix of resources dedicated to the Enforcement
Division and assess the impact that the Division's current
review and approval process where investigative staff work has
on organizational culture and the ability to bring timely
enforcement actions.
Regarding our work on penalties and disgorgements, we
reported that the total penalty and disgorgements amounts can
vary on an annual basis based upon the mix of cases concluded
in any particular period. However, overall penalties and
disgorgements ordered had declined significantly since the
2005-2006 period. Specifically, total annual penalties fell 84
percent from a peak of $1.6 billion in fiscal year 2005 to $256
million in fiscal year 2008. Disgorgements similarly fell 68
percent from a peak of $2.4 billion in fiscal years 2006 to
$774 million in fiscal year 2008.
While a number of factors can affect the amount of penalty
or disgorgements that enforcement staff seek in any individual
enforcement action, enforcement management, investigative
attorneys, and others agreed that two recent corporate penalty
policies had a significant impact. In 2006, the Commission
adopted a policy that focused heavily on two factors for
determining corporate penalties: the economic benefit derived
from wrongdoing; and the effect a penalty might have on
shareholders.
Further, in 2007, the Commission adopted a policy--now
discontinued--that required Commission approval of penalty
ranges before settlement discussions. On their face, the
penalty policies are neutral in that they neither encourage nor
discourage corporate penalties. However, enforcement management
and many investigative attorneys and others agreed that the two
corporate penalty policies, as implemented, delayed cases and
produced fewer and smaller penalties.
Further, the Commission's handling of cases under the
policies transmitted a message that the corporate penalties
were highly disfavored.
We identified other concerns, including the outward
perception by some that the SEC had retreated on penalties,
which made it more difficult for investigative staff to obtain
formal orders of investigation which allows for the issuance of
subpoenas for testimony and records.
Our review also showed that in adopting and implementing
the penalty policies, the Commission did not act in concert
with Agency strategic goals calling for broad communication
with and involvement of the staff, in particular within the
Enforcement Division, who had limited input into the policies
that they were responsible for implementing. As a result,
enforcement attorneys reported frustration and uncertainty in
applying the penalty policies.
To begin to address these issues, we recommended that the
Chairman determine if the 2006 corporate penalty policy was
achieving its stated goals and any other effects that the
policy may have in adoption and implementation.
We also recommended that the Chairman take steps to ensure
that the Commission, in creating, monitoring, and evaluating
policies, adheres to its strategic goals and follows other best
practices for communication with, involvement of the staff
affected by such changes. The SEC Chairman agreed with each of
these recommendations and was taking steps to implement them.
Mr. Chairman, this concludes my prepared statement. I would
be happy to answer any questions at the appropriate time.
Senator Reed. Thank you very much, Mr. Hillman, not only
for your statement, but for your very thoughtful and
professional report, which will aid us immensely. I appreciate
it.
Before I move on, let me say something I should have said
initially. Am I pronouncing your name correctly, sir?
Mr. Khuzami. Absolutely right.
Senator Reed. So it is Khuzami?
Mr. Khuzami. Correct.
Senator Reed. Well, given my Rhode Island accent, that is
amazing. So Mr. Khuzami, would you please give your testimony.
STATEMENT OF ROBERT KHUZAMI, DIRECTOR, DIVISION OF ENFORCEMENT,
SECURITIES AND EXCHANGE COMMISSION
Mr. Khuzami. Thank you. Thank you, Chairman Reed, Ranking
Member Bunning, Members of the Subcommittee. Thank you for
inviting me to testify on behalf of the Securities and Exchange
Commission.
I would also like to thank the GAO and its team for its
report. I concur completely with their recommendations.
The Division of Enforcement is the public face of the SEC,
in many ways. Our lawsuits and legal proceedings against those
who lie, cheat, and steal in our securities markets give the
investing public comfort that their interests are being
protected. We have a long and proud history of aggressively
pursuing wrongdoers and thus helping to maintain the integrity
of our markets.
Now to echo the comments by Chairman Reed and Ranking
Member Bunning in the beginning of this hearing, it is true
that many have questioned our effectiveness in light of the
revelations surrounding Bernard Madoff and his egregious
misconduct. Let me be very clear, we failed in this instance in
our mission to protect investors. Whatever explanations
eventually surface, be they human failure, organizational
shortcomings, or shortcomings in process, or all three, there
are no excuses. And not a day goes by that we in the
Enforcement Division do not regret the consequences.
But faced with this, we have done what any responsible
public agency should do. We have used this episode as a wake up
call to undertake a rigorous self-assessment of how we do our
job. As our Chairman, Mary Schapiro has said, reinvigorating
the Enforcement Division is a top priority for the Commission.
I am highly confident that we will succeed in this
assessment. As a former Federal prosecutor, defense attorney
and most recently as an in-house general counsel with a
financial institution, I have seen the SEC from many different
angles. But from whatever angle, I always saw integrity,
excellence, dedication, and a passion for investor protection.
Five weeks into the job, I can assure you and the public that
these traits are alive and well at the SEC.
You have asked me to address the issues of changes we are
making, resource needs, and steps Congress should consider
taking to assist us in helping us achieve our mission.
With respect to changes, even before I arrived, the
Commission began to initiate changes consistent with GAO's
recommendations. First and foremost, with respect to the
abolition of the penalty pilot program. That effort continues
uninterrupted. On my first day on the job, I asked the staff to
embrace four principles. We need to be strategic, swift, smart,
and successful.
To meet those goals, our self-assessment is considering the
following: first, to reorganize the division into specialized
groups focused on particular markets, products, entities, and
transactions in order to build expertise to permit us to
conduct investigations faster, more thoroughly, and with
increased understanding in order to enable us to better spot
patterns, trends, and motives.
Two, to adopt a more efficient management structure that
streamlines our processes and frees up experienced managers to
focus on making cases and investigating fraud.
Three, to adopt new metrics that are less about measuring
our performance by the number of cases we file and more about
the quality, timeliness, and deterrent impact of what we do.
Four, to revamp our system for handling tips and complaints
to better gather, risk analyze, and triage that information.
And last, to expand our program to award cooperating
witnesses who provide valuable information about wrongdoers.
Now this self-assessment has not come at the expense of our
ongoing investigations. In the past 2 weeks alone we have
brought cases against those involved in the credit default swap
markets, subprime mortgages, Ponzi schemes, and money market
funds. And you can expect to see more of those.
Now even with these changes, which we believe will make us
more efficient, the fact remains that we have suffered from
flatter, declining budgets in recent years, while at the same
time the products, the markets, the transactions, and the
schemes that we are duty bound to investigate become
increasingly complex. The 7 percent increase included in the
President's budget, released today, recognizes this fact. But
even with that, the SEC will have significantly fewer resources
than it had 4 years ago.
And I am prepared to lead the Division under the current
measures, but I would welcome additional resources. We
sincerely appreciate the support of Chairman Reed and many
others on this panel, who have been strong advocates on this
front, most recently by advocating for additional
appropriations in fiscal years 2010 and 2011.
I also thank Senators Schumer, Dodd, and Shelby for their
recent successful amendment to authorize additional enforcement
funds. If we were to get those funds, we would use them in the
following ways: first, as mentioned previously, administrative
and paralegal support for our investigations and trials. Too
much time is spent by lawyers and investigators on tasks more
efficiently handled by others. On new information technology
and databases to collect and analyze our documents. More
lawyers in our trial unit to litigate cases. We need to have a
strong courtroom capability to secure favorable settlements or
win in court.
Last, I believe there may be some legislative changes that
could clarify our authority so that we can better enforce the
laws. This includes legislation to broaden our jurisdiction
over hedge funds, securities based swaps agreements, and to
expand our whistleblower program.
I am confident that through this self-assessment we will
emerge stronger, bolder, and more effective in our mission. The
source of my confidence is the men and women of the Division of
Enforcement, since what has not changed at the Division is what
they offer, an abundance of talent, core values of
professionalism and fairness, and a total commitment to
mission.
I would like to thank you again for inviting me today and
the opportunity to appear before you and I look forward to
answering your questions.
Senator Reed. Thank you very much.
Professor Bullard.
STATEMENT OF MERCER E. BULLARD, ASSOCIATE
PROFESSOR OF LAW, THE UNIVERSITY OF MISSISSIPPI SCHOOL OF LAW
Mr. Bullard. Chairman Reed, Ranking Member Bunning, Members
of the Subcommittee, thanks very much for the invitation to
appear before you today to discuss the SEC's enforcement
program. It is an honor and a privilege to appear before the
Subcommittee today.
The GAO report that was released yesterday provides strong
evidentiary support for what many of us have suspected for
quite some time. The SEC's Enforcement Division's effectiveness
has been compromised, both by a lack of resources and by poor
leadership by the Commission itself.
The appointment of Mary Schapiro as Chairman is a strong
step toward solving the problem of leadership at the
Commission. Throughout her career, Chairman Schapiro has
demonstrated a solid commitment to a vigorous and effective
enforcement program. In her very short tenure, she has already
taken decisive steps to end some of the practices that have
hindered the Commission's enforcement program in recent years.
The problem of inadequate resources, however, remains
unsolved. The Commission does not have the funds to provide the
level of enforcement necessary to protect investors and promote
efficient capital markets. I strongly recommend the Congress
substantially increase the SEC's appropriation to enable
Chairman Schapiro and the SEC's enforcement staff to do the job
that they are better at than anyone else.
This is not just a matter of adequate enforcement. It is
also a matter of justice for investigated entities. Inadequate
resources often have the effect of unfairly increasing burdens
on parties defending SEC investigations.
The importance of the SEC's enforcement program cannot be
underestimated. The Commission is the leading voice for the
enforcement of securities laws and the development of free
capital markets, not only in the United States but worldwide.
When the Commission speaks, it makes uniform law across all 50
States that private actors can rely on to guide their business
practices. When the Commission remains silent, the void is
filled with the noise of dozens of regulators and courts and
private actions creating a patchwork of rules. It is incumbent
on the Commission to provide the coherence and uniformity in
the securities laws that only it can provide. And it is
incumbent on Congress to provide the Commission with the
resources it needs to do so.
In addition, the GAO report has highlighted certain
problems that are internal to the Commission. First, the report
shows that part of the SEC's resource problem may actually be
an allocation problem. When there is inadequate administrative
personnel or accountants or technology to support the lawyers
working on a case, the solution may be to spend less money on
the lawyers and more on the areas that are creating the
resource imbalance.
Second, the report confirms the SEC's internal review
process and multilayered staffing hinders its effectiveness.
The SEC should eliminate one or more supervisory layers and
streamline its review process.
Third, the SEC should not shy away from bringing cases
involving industry-wide misconduct, but it does not need to
bring every case. When industry-wide misconduct does not
constitute a clear violation of securities laws however, no
enforcement action should be brought. Instead, the SEC should
clarify the law and conduct rule making as appropriate.
The most distressing aspect of the GAO report is the
substantial evidence that individual Commissioners were
permitted to effectively subvert the SEC's enforcement program.
These Commissioners may have been motivated by genuine
ideological differences with SEC policies, but their approach,
coupled with a well-meaning desire for consensus, materially
damaged staff morale and the SEC's authority and undermined the
SEC's enforcement program.
Chairman Schapiro has indicated that she will not sacrifice
the Agency's mission at the altar of consensus. I hope that
future four-to-one and three-to-two votes on enforcement and
regulatory matters will not be interpreted as a failure to
fully consider all viewpoints on the Commission.
I also hope the Commissioners who find themselves in the
minority will not feel it necessary to undermine the
Commission's authority by publicly attacking its positions even
after they have been given a full and fair internal hearing.
In conclusion, I would like to make a general observation
that may relate to the friction that the GAO has identified
between individual Commissioners and the staff. There is an
illusion among some well-meaning proponents of free markets
that when the SEC refrains from action, whether it be
enforcement action or regulatory action, free markets are
allowed to operate with greater freedom. This is not the case.
When the SEC refrains from action, the result is often to
impede the operation of free markets. SEC inaction creates a
void that is filled by dozens of other private and public
actors, all following their own conception of the meaning of
the securities laws.
Like many securities lawyers, I began my career reviewing
documents pursuant to a request from the SEC's Enforcement
Division and from a State Securities Administrator and from a
U.S. Attorney and from 22 private litigants. There are many
sources of law that are waiting to step in when the SEC
abdicates its responsibilities.
The only free market that is invigorated by SEC inaction is
the free market for competing sources of regulatory authority,
which for financial services firms means regulatory chaos. The
SEC alone has the authority to establish uniform regulatory
policy and avoid the inefficiencies of legal uncertainty.
I hope that the proponents of free markets, among which I
include myself, will keep this in mind.
Thank you, and I would be pleased to answer any questions
you may have.
Senator Reed. Thank you very much.
Mr. Hiler, and again, I am pronouncing your name correctly,
I hope.
Mr. Hiler. Absolutely.
Senator Reed. Thank you, Mr. Hiler.
STATEMENT OF BRUCE HILER, PARTNER AND HEAD OF
SECURITIES ENFORCEMENT GROUP, CADWALADER, WICKERSHAM & TAFT LLP
Mr. Hiler. Thank you, Chairman Reed, Ranking Member
Bunning, and Members of the Subcommittee.
I am pleased to have the opportunity today to testify
concerning the responsibilities of the Securities and Exchange
Commission in policing our financial markets and protecting
investors.
I formerly served as an attorney in the Division of
Enforcement, and as an Associate Director. I left the
Commission in 1994 and since have represented clients in SEC
and other governmental investigations, internal investigations,
and securities litigation.
Although recently the Commission has come under fire for
reported lapses in detecting the activities of some individuals
in the marketplace, the Commission has long been viewed as a
premier regulatory and enforcement agency. If there have been
lapses, I am confident that the Commission will evaluate those
situations and develop new policies and procedures to avoid
them in the future.
In this regard, I think it's important to understand the
effects that the vagaries of funding and resource allocation,
the exponential expansion both of market activity and of
sophisticated instruments and investment strategies, and the
day-to-day pressure of operating in the glare of public
scrutiny can have on any organization.
With that said, there still are a number of areas I believe
the Commission's enforcement efforts could or should be
modified or improved on. There are three areas which I would
like to discuss today.
First, I believe that the efficient and speedy resolution
of SEC investigations is important both for effective
protection, investor protection, and enforcement efforts as
well as for ensuring fairness and justice to the subjects of
the investigations. In my view, these goals could be enhanced
by having fewer layers of management between those working day-
to-day on investigations and those who ultimately must
recommend to the Division Director whether an investigation
should be moved forward or closed.
Currently, in the Commission's D.C. headquarters, the
Division has five Associate Directors indirectly supervising
hundreds of attorneys and cases. The Associate Directors
typically are among the most experienced professionals in the
Division and they are looked upon internally as having the
judgment and expertise to make appropriate case
recommendations.
Yet, these are also the individuals who have the least
amount of time to be involved in the day-to-day decision making
and the day-to-day review of facts on any particular matter as
those facts are being discovered and analyzed. I believe there
should be fewer layers between the Associate Directors and
those directly working on investigations. This does not mean
necessarily fewer management slots. Rather, I believe the
number of senior experienced officials in the Enforcement
Division should be dramatically increased.
These managers should be charged with direct involvement in
the day-to-day activities of the matters under their
supervision and such matters should be kept to a reasonable
caseload so that they can become familiar with the key facts
and issues as they develop, not only at the recommendation
stage.
Second, efficiency must not be achieved at the expense of
fairness or thorough evaluation. SEC investigations can involve
sophisticated instruments and trading strategies, as well as
complex issues such as accounting, risk analysis, and economic
modeling, all of which fall outside the normal expertise of
attorneys. These investigations do take time.
But I do believe that the addition of a cadre of experts in
a variety of fields, such as I mentioned, to assist in
enforcement inquiries will lead to more efficient and better
informed decision making.
Third, I believe that the detection of fraudulent conduct
is an extremely difficult task and that no one can expect the
SEC or any agency will be able to anticipate specific frauds at
specific entities. However, a regulator may be able to get an
early warning sign of conduct which, though not illegal, on
close examination the regulator may determine needs additional
regulation or is not sufficiently understood that it poses
unknown dangers to the financial system.
To do so, to get this early warning, I think a regulator
must reach out to and foster an open line of communication with
those in charge of compliance and management at the relevant
entities. It is difficult to maintain open and timely
communication where the regulator or the regulated views the
other in an atmosphere of suspicion. I believe that in the last
decade, increased scrutiny by criminal authorities of
securities law matters and public pressure on the SEC to hold
anyone and everyone responsible for the stock market crash of
1999, for corporate bankruptcies and defalcations, and more
recently for the current economic turmoil have contributed to
such an atmosphere.
I believe that the line between civil and criminal cases
has been blurred and that there has been a shift to an
inappropriately low level in what authorities view as conduct
that demonstrates sufficient scienter or ``state of mind'' to
make even a civil securities case.
It is possible for the Commission to adopt substantive
internal guidelines to ensure it is making consistent, fair,
and efficient decisions and judgments on the subjective
judgments that are required to bring an enforcement action. I
also believe that the Commission should have a major role in
determining whether cases which predominantly involve Federal
securities law issues and our capital markets should be pursued
by criminal authorities. Efforts in these two areas, I think,
would help promote an atmosphere of communication and openness
that could assist the Commission in all of its regulatory
roles.
I am sure there are other areas that Members of the
Subcommittee are interested in. I hope that I am able to be of
assistance to you, and I will be happy to answer any of your
questions.
Senator Reed. Well, thank you very much, Mr. Hiler, and
thank you all, gentlemen, for very fine testimony.
Let me begin and address a question first to Mr. Khuzami,
but also to ask everyone to respond. Inherent in the GAO report
is a recommendation, which Chairman Schapiro has already taken,
to take the handcuffs off the Enforcement Division. One issue
is how hard is that to maintain, not just in the next few
months or years, but going forward? But, second, it raises, I
think, a more fundamental issue, which is the relationship
between the appropriate oversight of the Commission and the
Commissioners and the Enforcement Division. So if you have some
thoughts about that, Mr. Khuzami, please begin, and I will call
on your colleagues also.
Mr. Khuzami. Thank you, Mr. Chairman. From my experience,
since I have arrived at the Commission, which is approximately
5 weeks now, I have seen nothing but a great deal of
interaction, discussion, and shared views between the
Commissioners, the Chairman, myself, and the staff of the
Division of Enforcement. To bring it down to practicalities, we
have been in Chairman Schapiro's office on many occasions to
discuss cases. The Commissioners have invited me into their
offices to discuss their views and share them with me. And I
cannot speak to the environment that existed prior to my
arrival, but everything I have seen since then indicates that
any policy matters or judgments are going to be fully informed
with the views of the enforcement staff.
Senator Reed. Thank you. The same general question,
Professor Bullard, about in the long term how do you have a
balance between the Commission's appropriate role and not
handcuffing the Enforcement Division and initiative at the
lower level?
Mr. Bullard. I think I can really only just echo what the
Enforcement Director has said, but I think I would add that it
is important that Chairman Schapiro encourage strongly the
members of the Commission, regardless of whether there are
ideological positions that they bring to the table, to work out
those issues they might have in the Enforcement Division
internally. And I would encourage the enforcement staff to be
very aggressive in communicating with those Commissioners,
keeping them apprised of the development of cases, to try to
reinvigorate the internal vetting of issues within the
Commission.
The Commission has always had a very good practice of a
healthy, vigorous internal debate. But as soon as that turns
into what the GAO described as a situation where you had the
staff cutoff not only from some key decisions but from the
development of policies that really should have been conceived
in the staff, then you have a staff that is working against the
Commission and no longer can really function effectively as an
agency.
Senator Reed. Your comments, Mr. Hiler?
Mr. Hiler. Yes, thank you.
Senator Reed. Could you activate your microphone?
Mr. Hiler. Sorry. You know, I think in every organization
or agency there are going to be different points of view. I
cannot say that I or my clients have felt that the Division of
Enforcement staff has been shackled, unfortunately. But I
wanted to go to one thing in the GAO report in this regard. I
noted that staff members had talked about other Divisions
hampering their enforcement activities and having to be--and
that they did not like other Divisions having to review aspects
of their cases. And we laugh out here in the private bar when
people like me say, ``When I was at the Commission,'' but I
will say it anyway.
When I was at the Commission, I and my staff in
Enforcement, when I was a branch chief and assistant director,
we happily sought out the views of the other Divisions at the
beginning of our investigation, throughout our investigation,
and at the end of our investigation. And we did that because
those Divisions have extreme expertise in the rules and
regulations that we in Enforcement were trying to interpret,
apply, and enforce. And so by the end of the investigation, we
were probably all on the same page, and I don't recall many
times, although there probably were some, where at the end of
an investigation where I was trying to make a recommendation I
felt that another Division was, you know, opposing me to some
extent. But if they were going to oppose me, I had my view, and
I felt completely confident that we could express our view to
the Commission.
So I think it is just very important that there not be a
sense of competition in the Commission between Divisions and
that the Division of Enforcement also should feel free and
should consult with those other Divisions right at the
beginning of an investigation.
Senator Reed. Mr. Hillman, your comment?
Mr. Hillman. I share many of the comments that have been
discussed associated with this question. One in particular that
I believe is very important is that there seemed to be a
difference of view regarding the Commission's perspectives on
penalties and that of the Enforcement Division. And in going
forward, I think it would be very important for the Commission
and the Division to come up with a shared set of goals and
ideals for moving forward in the penalty and disgorgement area.
Once that vision is established, then the Commission should
seek out regular input from enforcement management and staff on
policies and procedures in order to implement those goals.
Senator Reed. Thank you very much.
I anticipate, since we are fortunate we have three Members
here, several rounds, but let me now yield to the Ranking
Member for his round of questioning, and then Senator Johanns,
and then I have other questions. Senator Bunning.
Senator Bunning. Thank you, Mr. Chairman.
Mr.--``Khuzaman''?
Mr. Khuzami. ``Khuzami.''
Senator Bunning. ``Khuzami,'' I am sorry. I should pay
attention. Let me just--on the surface, some of the worst cases
of fraud have been hiding in plain sight. Plain sight. Madoff,
Stanford, subprime mortgage practices, and auction rate
securities. What are you doing differently now so that these
things in plain sight are observed and treated quickly?
Mr. Khuzami. Well, Senator, we are taking a number of
initiatives. I am not sure that in many of the matters that
have been publicly identified that they are necessarily frauds
that are in plain sight. Some of them are fairly difficult in
terms of attempting to investigate them. But no matter, we are
establishing--for example, we have a series of working groups
set up nationwide focusing on specific areas of conduct,
including subprime, hedge funds, auction rate securities, and
historically, options backdating and other matters so that we
can gather the necessary expertise and target our energy and
resources into particular areas.
In the Ponzi scheme area, which is an area that we have
focused our efforts on for a long period of time, you know, the
challenge there, of course, is to make sure that you can find
credible evidence of the wrongdoing. And, unfortunately, often
investors are not a good source of that because they are
receiving their out-sized returns and do not identify any
wrongdoing. So the challenge there is to get inside the
organizations and get credible evidence so that we can stop
them.
But we are, with a renewed focus across all the areas that
you have identified, dedicating our resources and sharpening
our tools.
Senator Bunning. The same person, what changes are being
implemented to allow or encourage staff to bypass the normal
chain of command if they feel serious issues or cases are not
being properly addressed? That is where I hear we have had a
problem.
Mr. Khuzami. Well, Senator, we are, as I indicated in my
testimony, undertaking a review of the entire management
structure, and so that will hopefully result in streamlined
processes.
The other thing I would point to is simply, you know, I
have appeared before the staff on numerous occasions already
and made it very clear to them that we are focused on these
cases and that they should be free to raise their hand and
bring forth any issue that they feel needs attention with
respect to their cases.
I do not sense any reluctance on the part of the staff to
identify questions or issues in their cases. If anything, I
think they feel a renewed sense of vigor and the importance of
bringing cases in a timely manner.
Senator Bunning. In your testimony, you mentioned that the
Commission has filed 23 cases involving Ponzi schemes or Ponzi-
like payments. With the report just now coming out that the SEC
received warnings back in 2002 regarding the Stanford fraud
investigation, how long was the SEC aware of these 23 or so
particular cases before formal filings, you know, where a
charge was made?
Mr. Khuzami. Senator, I would have to, in order to provide
a thoughtful answer to you, perhaps have----
Senator Bunning. No, a factual answer. I would rather have
a factual answer.
Mr. Khuzami. How about thoughtful and factual?
I would like to be thorough in my response. I cannot tell
you as I sit here right now what the history was, if any, with
respect to these actions that we have brought. I will say with
respect to the Stanford matter----
Senator Bunning. Could you really get that to us, to the
Chairman and myself, in writing a report on those 23?
Mr. Khuzami. Certainly.
Senator Bunning. I would appreciate that very much.
Do you agree with Mr. Hiler's recommendation to increase
the number of senior officials with smaller caseloads who can
get more involved in individual cases--in other words,
providing investigators with more access to key gatekeepers?
Mr. Khuzami. As a general matter, I agree, in a streamlined
and targeted management system that has no more managers than
necessary and those that exist have the resources and the time
to dedicate to properly reviewing cases early on so that we do
not waste resources on cases that are not worth pursuing, and
that we can focus on moving those cases that we should be
bringing in a faster manner. Now, whether or not that means
adding resources at the associate level or a different level,
those details remain to be seen. But I certainly agree with the
general principle.
Senator Bunning. Thank you, Mr. Chairman.
Senator Reed. Thank you very much, Senator Bunning.
Senator Johanns.
Senator Johanns. Mr. Chairman, thank you. And to every
member of the panel, thank you for being here today.
Mr. Hillman, if I could start with a few questions for you.
I read the summary, if you will, of the recommendations from
your report, and having been in charge of a complex Government
organization, I have to tell you, to be very candid with you, I
could pick up that language and I think drop it into every
Federal department.
Here is what I am saying to you: I think every Federal
department would say we do not have enough resources. They
would probably say, yes, sometimes we do not even pay attention
to our internal goals. The right hand does not always know what
the left hand is doing. And I am not saying that to justify it.
I am just saying that you are findings here leave me asking the
question: Is there a story within the story?
And then I listened to the testimony about Mr. Madoff. You
know, I said at the first hearing on that, ``I don't get it. I
really don't understand it.'' You had a whistleblower that
pretty well called this guy out, kind of laid the road map for
what was going on, and yet there was not follow-up, and people
really, really were hurt by that.
So what I want to try to examine with my questions is: What
is the story within the story? Is this a situation where you
have a piece of the Federal government that is not getting
along with the Commissioners? Is there a personality conflict?
Is there a difference of opinion as to what the goals of the
SEC are?
Mr. Hillman, let me start with you. Is that the case here?
Mr. Hillman. I think you raise an excellent question about
what the real root causes are associated with the difficulties
that we found within the Enforcement Division. We pondered that
thought many times during the course of our review as well.
You are absolutely correct, many of the examinations that
we have conducted at SEC and other regulatory agencies--banking
regulators and others--we uncovered very similar practices.
What I think was most startling by this review, however, was
that the unanimity of views from the enforcement management,
from their middle management, from their investigative
attorneys as to the problems that they were seeing within the
Enforcement Division, which was startling and clearly in need
of some attention to address organizational culture issues, to
address organization communication issues, and to really set a
tone at the top as to how penalties and disgorgements were
going to be ordered.
Senator Johanns. See, and here is what worries me about
that. I think the easy answer is always, ``I need more
resources.'' But then I kind of dig deeper into the report
here, and on page 5 you say, you know, but the enforcement
cases are about where they were when we talked to the attorneys
involved, what they bring up is they need more support staff,
the paralegals, et cetera. It is not like they are asking us to
double the number of attorneys, although I suspect they would
like additional help with attorneys.
So, again, Mr.--``Kozumi''?
Mr. Khuzami. ``Khuzami.''
Senator Johanns. ``Khuzami.'' Everybody botches
``Johanns,'' too. Although the Chairman got it right.
Mr. Khuzami. My mother sometimes mispronounces it. That is
OK.
[Laughter.]
Senator Johanns. Here is what I am trying to figure out
with you. I think there is always a new energy with new people.
There was when I went to the USDA, and I do not know that I was
any better or worse than the person before me. But it is
culture and processes and not necessarily building more staff,
or whatever, that solves problems.
Dig there with me. What is wrong with the culture? What is
not working over there that literally you could have a
whistleblower drop Madoff on somebody's desk and nothing
happens? For me, as a former Cabinet member, that would have
been a grenade. I would have been on the phone to GAO, to my
Committee of jurisdiction, to the Solicitor General, to
everybody I could get on the phone to, saying, ``Oh, my Lord,
what are we going to do about this?'' And yet this just seemed
to go on. What is wrong? What do you see?
Mr. Khuzami. Well, Senator, due to an ongoing Inspector
General's report, I do not have the answers yet as to the
sequence of events and what actually happened with respect to
the complaints regarding Mr. Madoff. I do not know if it is
predominantly the failings of a single or small number of staff
members, which would be one thing; whether or not it represents
a failure in process or organization. So when we get those
findings, we will certainly look at them closely. But we are
not waiting for them, either.
My sense is that there has been, you know, a certain lack
of urgency about the mission. My sense is that, as Mr. Hillman
has pointed out, there are policies or approaches that may not
have been intended to be anti-enforcement or to discourage
enforcement, but they were perceived as such or taken as such,
and that sent a message down the line.
I think that the Division needs to do a better job to
maintain current with the markets and the products and the
transactions that they are obligated to investigate. Just for a
simple example, if the person who reviewed the Madoff complaint
or any other complaint had specialized training in certain
types of trading strategy, that might have resulted in a
different result. And we do much more of that now than we did
previously.
But the best way I know to change culture is, as was
mentioned, starting with a tone at the top, which the Chairman
and the Commissioners have done, to set policies that are fair
and appropriate and that allow the Enforcement Division to do
its job, because those policies will live far beyond my tenure
or the tenure of any staff attorney, but they will continue to
pollinate the Division with the sense of urgency and mission
that it needs to effectively do its job.
Senator Johanns. Thank you, Mr. Chairman.
Senator Reed. Well, thank you, Senator Johanns. And, again,
I think we have the luxury of continuing our questioning, so
let me initiate another series of questions.
We have talked about this issue of resources, and I think
there is a general consensus agreement that additional
resources, and perhaps more appropriate with respect to
paralegals, investigative personnel, and others is appropriate.
There is another aspect of resources, and that is
predictability. And given that you are subject to the
appropriations process, that is not entirely predictable.
There are other Federal regulatory agencies--FDIC being
one--who have essentially a claim through their supervised
entities on funds, and I just want your thoughts whether that
model might be--or some form of that model might be appropriate
for the SEC, that it would be, in fact, some type of funds that
are always there, not subject to appropriations, that would
provide the certainty for infrastructure improvements,
technology improvements, hiring specialists, et cetera. So let
me begin with, Mr. Hillman, your thoughts and then move down
the line.
Mr. Hillman. We had done a study earlier looking at self-
funding mechanisms of the regulators, across the banking
regulators and securities regulators, and identified advantages
and disadvantages of alternative approaches. The SEC, as you
may know, is collecting fees associated with activities
occurring within the financial markets. They receive
registration fees for new stocks and bonds. They receive
transaction fees paid over by national securities exchanges.
They also have fees from proxy solicitations for mergers and
acquisitions and the like. These fees do not come directly to
the SEC. They are put within the Treasury's accounts, and the
SEC has its own appropriations.
Some of the advantages of having SEC be removed from the
appropriations process and going to a self-funding basis, based
off the fee income which they are receiving, would be to have
greater control over their budgets, have an ability to plan for
their activities over a longer period of time, 5 years or more,
perhaps, and have a greater ability to address its challenges
in their workload areas.
Some of the disadvantages, however, have to do with the
fact that a self-funding structure is not going to deal with
all their problems that we are seeing within the SEC associated
with, in the past, retention issues within their control,
changing the mix of their resources and the like. It also
significantly reduces the checks and balance systems that
currently exist within the budgetary and appropriations
process.
Senator Reed. Well, thank you very much.
Mr. Khuzami, your comments and thoughts?
Mr. Khuzami. Well, Mr. Chairman, I agree with your point
absolutely about appropriations and resources. I told my staff
on the first day that the appropriations was a little like the
cavalry. You do not know if they are going to show up, when
they are going to show up, and how long they are going to stay.
And that is why it was incumbent upon us to organize our own
house as efficiently as possible to make sure that the
taxpayers received value for their dollar.
With respect to the issue of self-funding, I must say I
have not spent really any time studying it. Obviously, the
advantages are very appealing to me, but I think I will defer
while the Chairman and the Commissioners consider those issues.
Senator Reed. Professor Bullard and Mr. Hiler. Professor
Bullard first.
Mr. Bullard. I have spent a fair amount of time thinking
about this issue, but it is not necessarily going to help you
any because I have not really reached a firm conclusion what
the best model is. I think the checks and balances point is
right on the money. There is a lot of benefit to the political
accountability. The SEC must demonstrate in contexts such as
this one when it is going back to the hand that feeds it. On
the other hand, having a more reliable source of income that is
industry based has certain efficiencies.
I am sorry I cannot give you much of an opinion on that.
Senator Reed. That helps.
Mr. Hiler.
Mr. Hiler. Yes, I think that having some consistency at a
certain level of funding is really imperative and would be
extremely helpful for the Commission.
In terms of the checks and balances, I assume--I am a
securities lawyer, but I assume that Congress could deal with
that by calling the Commission and asking them to come over,
submit their budget, see what is going on. But I think that
would be a very good turn of events if the Commission could
know from year to year that at least it has some source of
funding and it does collect fees. I think years ago it used to
be basically a surplus to the Treasury from when you balanced
out what it was collecting in fees and so forth and what it was
spending.
I think that some of the funds really, really should be
best spent on paralegals, document control issues and document
control assistance, IT and experts like we have all talked
about in the GAO report and that I have talked about. I think
that document control, knowing the size of these cases the SEC
works on, that is one of the biggest consumers of time of an
attorney, and they just do not have people there to help with
that, and IT as well, and paralegals.
Senator Reed. Can I just make the point that it might be in
your expertise as a practitioner, on the other side the
technology, both in the regulated industries and their
attorneys, it must be phenomenal relative to the SEC. It is
like, you know, sort of those Civil War militias going up
against the 82nd Airborne.
Mr. Hiler. Well, I will say that I do not feel that we have
that much of an advantage. There are some very good attorneys,
and they know their cases when we go up against them. They
really know their cases. They know every document, and they
have looked at it sideways and on the creases. So they make up
for it in certain ways. But, yes, I think they are lagging
behind in the technology, in the document control area for
certain.
Senator Reed. And just another point, too, and then I am
going to recognize Senator Bunning, and we have been joined by
Senator Schumer. In terms of understanding some of these new
products, et cetera, the sophistication and the computer
modeling is so significant, and I would assume even if you have
suspicions or one of your attorneys, Mr. Khuzami, has
suspicions, that to be able to understand what they are doing
and feel that it is clearly wrong is a challenge without not
only the computer technology but the market expertise that is
on the other side. Is that a fair insight?
Mr. Khuzami. That is correct, Mr. Chairman. The challenge
comes in a couple of different areas. One, it is understanding
the markets. Two, it is being able to get the kind of training
and other information that you need, particularly in the
unregulated markets such as hedge funds and derivatives, in
order to get the information and have it reported in a uniform
way so you can put the story together and see whether or not
there is suspicious or wrongful activity. And it is then the
resources and the technology to be able to do that. So, as you
say, it is a technological challenge across a number of fronts.
Senator Reed. Thank you.
Senator Bunning, questions?
Senator Bunning. Yes, thank you very much.
Mr. Khuzami, I would like to just ask you, What is a better
measure of enforcement success--the amount of fines or the
amount of cases handled? Or whatever else might come.
Mr. Khuzami. Well, yes, I think that would be a hard choice
between the two of them because I think they both have some
inadequacies. From my perspective, the best measure of both the
performance of an individual attorney at the Commission as well
as the overall program would be to focus less on quantity,
although that still matters, but more on things like
timeliness, how quickly do you bring a case. You know, the gap
between conduct and atonement, if you will, the longer that
stretches out, the less of a deterrent message you are able to
send.
Two, you want to look at programmatic priorities. If the
Enforcement Division decides that, you know, we see a lot of
suspicious activity and insider trading by hedge funds, then we
should be setting that as a priority and measuring our success
on whether or not we are achieving results in that area.
And the third area that is of interest to me is really the
deterrent impact, probably maybe the most important, but the
most difficult to measure. How do you decide whether or not a
case you bring has prevented others from doing the same thing?
That is a big challenge. One of the ways I have seen it done
successfully was by one of my predecessors, and it was not even
in an enforcement case. But he announced to the Wall Street
firms and said, ``You have to scrub your own institutions and
your own business people and your own desks to look for
conflicts of interest. And you better find them and identify
them and remediate them, or we are going to come in and do it
for you.''
And I was at one of those financial institutions when that
word came down, and we spent an enormous amount of time and
money doing exactly that. We looked at our conflicts. We made
disclosures. We cured some. We exited certain businesses.
Now, there was never a single case that was brought. Right?
It would not show up in anybody's statistics. But the amount of
good and effective deterrence that that achieved is probably
immeasurable.
And so I would like to see us moving in some cases to more
of a model like that where we can achieve that kind of
deterrence, because ultimately, you know, we can sue people and
try and get their money back, but we are all in a much better
position if we stop it before it starts.
Senator Bunning. To follow up, last year there were 700,000
complaints that were sent to the SEC that were not investigated
or followed up on. Now, how can the SEC account for that?
Mr. Khuzami. Senator, I do not think it is the case that
they were not followed up on. I think that is simply the raw
number that was----
Senator Bunning. Received.
Mr. Khuzami. ----received by the Commission. There was, in
fact, and is, in fact, a rigorous program for collecting,
investigating, monitoring, and referring those complaints that
is in place.
Now, having said that, we all recognize that we can do a
better job here, and one of the first things that Chairman
Schapiro did was to order an independent vendor to study our
processes, where we would be collecting all of these complaints
in one area. Now it simply comes into too many different areas
within the Commission. To collect it in one place, log it,
analyze it, review it, look for patterns and trends across
complaints to see if it tells a story, refer it out to the
proper area, perhaps combine it with specialized units so that
the people looking at these will have good eyes.
Senator Bunning. But you have no idea how many were
followed up on or were not followed up on out of the 700,000?
Mr. Khuzami. I am sure many, many, many of them were. I am
happy to get those statistics.
Senator Bunning. OK, I would appreciate that.
Mr. Khuzami. Sure.
Senator Bunning. About more money and about better
enforcement, you know, you were about to say something. I
probably cut you off on the Stanford thing, and I did not mean
to do that. If you have something to expand on that, now is the
time. But a whistleblower on Madoff, and it took so long to get
to the problem? That just--you know, to the ordinary citizen
and to us sitting back who are watching SEC to enforce, we
cannot imagine that happening.
Mr. Khuzami. I understand that, Senator. I mean, in the
particular Stanford case you are referring to, there were--we
did receive complaints early on, not necessarily particularly
detailed or specific, but complaints. And there were a number
of challenges in that case having to do with the cooperation
not only of Mr. Stanford, but the inability to obtain documents
from offshore, the cooperation of the Antiguan authorities, and
the lack of witnesses from the investors. And we continually,
starting in approximately 2005, looked at that case going
forward and continued to investigate. It was not a situation
where someone gave us a complaint and we looked at it and
decided there was nothing to do and moved on. We were
continually investigating the case. It just took an
extraordinarily long period of time in order to gather the
evidence to bring the case. And once we did, we moved very
quickly.
I agree that, you know, these cases should be brought in as
timely a way that you can, and we are focused on that. But
sometimes it just takes a considerable period of time to make a
case.
Senator Bunning. Good luck.
Senator Reed. Thank you, Senator Bunning.
Senator Schumer.
Senator Schumer. Thank you, and I thank the witnesses.
My first bunch of questions may be all for Mr. Khuzami, but
after he finishes, anyone can chime in.
The first one is about industry experts. The SEC, known as
``the gem of the financial regulatory world'' a long time ago,
and the SEC's police, your Division, the Enforcement Division,
was its public face and its iron fist. And now what we have
seen after the financial crisis is how understaffed,
inexperienced, and underfunded the Division of Enforcement has
been under the previous administration. It is the idea
Government is bad, cut it back, you know.
To oversee 30,000 registrants, 12,000 public companies,
4,600 mutual fund families, 11,000 investment advisers, et
cetera, the Enforcement Division has a staff of 1,100. That is
10 percent less in absolute numbers than the staff it had in
2005. That is why Senator Shelby and I introduced the Safe
Markets Act, to give the Enforcement Division the additional
resources it needs. And Senator Reed, of course, has been a
long-time champion of increased SEC funding.
It is also why I fought so hard for an amendment to the
Fraud Enforcement Act on the floor last month to ensure that
the SEC get the funding it desperately needs. That amendment
passed, and a version of the bill with SEC funding intact, I am
proud to say, just passed the House yesterday. So the SEC
should be seeing the extra $40 million we fought to get you
pretty soon.
Now, I want to know with some specificity how the SEC plans
on using the $40 million, and I know Senator Bunning touched on
this, but I would like to go a little bit further.
The Enforcement Division is almost exclusively staffed by
attorneys, not by investment analysts who know how to crunch
the numbers and analyze complex financial data and trades. You
have announced a plan to reorganize the Division into
specialist teams and give the enforcement attorneys more
autonomy along the line of prosecutors at the U.S. Attorney's
Office, and I applaud that. I think that is a good idea.
But do you plan to hire financial analysts, traders, and
accountants with real industry knowledge and experience to help
you investigate and oversee today's increasingly complex
capital markets? And if so, give me some top-of-the-envelope
idea of how many?
Mr. Khuzami. Well, Senator, we absolutely do plan on doing
that. One of the advantages of having specialized groups is
that you will now have a fixed point within the organization
where you can actually hire and assign these market specialists
to a particular one. So if you have a structured products and
securitization group, you can go out and hire structurers or
traders, many of whom are currently unemployed, and bring them
into the Division.
The numbers that we plan on hiring, you know, I do not have
a firm number yet, but it depends in part on, you know, which
kind of units we set up. But we get many inquiries from folks
who want to help, retired traders----
Senator Schumer. But is it going to be a significant
percentage, not one here or one there? I think there has been
too much of a reliance on lawyers--I am not against lawyers; I
am one--and not enough on the investigative type people who
have had experience in the financial world.
Mr. Khuzami. It will be a significant number.
Senator Schumer. OK, good. When do you expect all of this
to happen, your reorganization plan, including these new
people?
Mr. Khuzami. Well, it is somewhat of an execution challenge
to roll this out, obviously, when you talk about restructuring
a large part of the Division. But we are going to start doing
the initial planning stages very soon. We have identified a
small number of specialized groups that we want to start out
with, and I suspect that we will start this process in a matter
of weeks.
Senator Schumer. Good. OK. The next question deals with
sort of the siloization of investigations, which is not your
fault. That is what Congress has done because of all our
jurisdictional turf battles. Last year, the Enforcement
Division received 700,000 tips, complaints, and referrals from
the public and Federal agencies. When the Enforcement Division
receives a tip, it now only has the ability to investigate SEC-
regulated activities or entities. Do you think this is
sufficient in protecting our markets? Or do you think the SEC
should also have investigative powers over currently
unregulated entities--hedge funds and unregulated products like
credit default swaps--to ensure the integrity of our capital
markets?
Mr. Khuzami. My answer to that, Senator, is a strong yes.
My view is that we need access to hedge funds, credit
derivatives, and other products, particularly the trading
information, so that we can combine that with other information
that we see in the regulated entities to make sure that we have
a full picture of what is going on and to be able to detect
wrongdoing.
Senator Schumer. Good. Next one. You know, the SEC has
limited resources, but they may not be used most effectively.
According to the data provided by the SEC, 40 percent of
enforcement personnel and 20 percent of examinations personnel
are based in Washington, DC, which, until last fall, was not
the financial center of the country, and still is not the
financial center--will not be again soon. New York is coming
back.
But despite the overwhelming concentration of financial
entities in the New York City metropolitan area, the SEC has
stationed only 15 percent of its enforcement personnel and a
quarter of its examination personnel there. That seems to me a
misallocation of resources. While I think we need to put in
certain rules and regulations to ensure that the relationship
between regulators and the regulated does not become close or
too close, I also think agents have a much harder time staying
on top of what is going on in the capital markets when they are
200 miles away.
Do you agree? Will you consider allocating or reallocating
some of the personnel to New York City as part of the shake-up
of your Enforcement Division?
Mr. Khuzami. Senator, I have not looked specifically at
that issue, but I will certainly consider it. The one thing I
will say is that our specialization effort will result in
nationwide teams of investigators and attorneys looking at
particular areas. So that in some sense, geographical location
will become less important because you will have a team across
the Nation focusing----
Senator Schumer. I know, but when the team is having lunch
in Phoenix, they do not pick up as much information as they do
in downtown Manhattan. So I am going to ask you again. What are
you going to do about reallocating personnel to New York City?
Mr. Khuzami. I have not considered that in my 5 weeks, but
I will certainly take that under advisement.
Senator Schumer. I think the SEC should move to New York
City, at least the Enforcement Division as a whole. I do. I
think it would do a much, much better job.
I also think the New York regional office is badly in need
of permanent leadership, and soon. I would urge you to act
quickly and consider naming someone like yourself who is a
former Federal prosecutor with securities experience. How
closer are you to naming someone? And are you considering the
kind of people with the background I mentioned? I do not have
anyone specific in mind.
Mr. Khuzami. We are in the very final stages of that
process, and we have an abundance of highly qualified
candidates, including those with the profile that you mention.
Senator Schumer. What is the likelihood one of them is
going to be picked with that profile?
[Laughter.]
Senator Schumer. You are a lawyer. I can ask questions,
too.
Mr. Khuzami. Well, I do not want to pre-judge the process
Senator Schumer. OK.
Mr. Khuzami. But I hear what you are saying.
Senator Schumer. OK, thank you. Finally--let us see. I have
two more with the Chairman's indulgence. OK.
Unlike the other Divisions at the SEC--this is about small
investor protection--the Division of Enforcement does not have
a hotline the public can call. For instance, one of my
constituents is a victim of one of the reserve funds. You
charged their directors with fraud this week. The constituent
has contacted my office regularly since the fund broke the buck
last fall because there is no other place he can turn to ask
questions, get status updates, register complaints about the
way the situation is being handled, and that is an unacceptable
situation.
I hear that the Office of Investor Education and Advocacy,
which is charged with the mission of advising the small
investor, has received so many calls, it maintains a database
of investor complaints of fraud.
Do you agree that the Enforcement Division should have a
hotline?
Mr. Khuzami. Senator, our entire complaint, tip, and
referral process is under investigation. A hotline certainly
sounds like a pretty good idea. I have no idea if that is in
the works, but I will pass that suggestion along the line.
Senator Schumer. Could you please? Yes, and get back to me.
On all of these, if you could get back to me in writing--within
5 days, is that OK? A week?
Mr. Khuzami. Yes.
Senator Schumer. OK, great. Can you explain to me how the
Enforcement Division coordinates with the Office of Investor
Education and Advocacy and other Divisions who receive calls
about fraud and violations?
Mr. Khuzami. Senator, the complaints, tips, and referrals
that we get come in from many different portals within the SEC,
and that is one of the things we are trying to consolidate.
They come in, but they are all collected in central areas and
are analyzed and triaged and referred. We are going to be doing
a better job of that, but that is the current structure.
Senator Schumer. So who receives the calls--I mean, again,
they are all referred or triaged----
Mr. Khuzami. Yes.
Senator Schumer. ----and referred?
Mr. Khuzami. Yes.
Senator Schumer. So if you are two out of the three, you do
not get any response?
Mr. Khuzami. I am sorry. I do not follow.
Senator Schumer. Well, if it is triaged, that is one----
Mr. Khuzami. Well, by triage, I mean spam and, you know,
kind of the nonsense----
Senator Schumer. OK. But anyone who calls with an actual
complaint or whatever will be given a call back.
Mr. Khuzami. They will be referred to the appropriate area,
and the complaint will be followed up on.
Senator Schumer. OK, thanks.
Finally, last but not least, rule-making consultation. The
Divisions of Corporation Finance, Trading and Markets, and
Investment Management are the rule-making Divisions while
Enforcement enforces the rules. During the rule-making process,
the industry and the public are consulted and have the
opportunity to submit comments.
Are you consulted, is the Enforcement Division consulted on
the enforceability of the rules the other Divisions are
writing?
Mr. Khuzami. Yes, Senator. When new rules are being
proposed, the views of Enforcement, especially with respect to
whether or not the proposed rules have an enforcement impact,
we are consulted and permitted to voice our views in the same
way that these other Divisions voice their views on our
enforcement cases.
Senator Schumer. Permitted, but is it part of the process?
Mr. Khuzami. Yes
Senator Schumer. Good. And, finally, last question: Can you
explain to me how the other Divisions train and assist the
enforcement attorneys?
Mr. Khuzami. Well, all of our cases--well, first of all, we
are well aware within the Division of the expertise in our
other Divisions. So if we have a question, we just pick up on
the phone and call them.
There is a more formalized process as part of our case
review where they get to review proposed actions and comment on
them. One of the benefits of specialization, we hope, is that
we can get that expertise in sooner to our investigations in
order to take advantage of it. You know, why go outside first
when you have got some of the best experts in the country in-
house.
Senator Schumer. OK. Does anyone else have a comment on any
of the things I mentioned? If not, then thank you all for being
here, and thank you, Mr. Chairman.
Senator Reed. Thank you, Senator Schumer.
I have two statements, one from Chairman Dodd and one from
the President of the National Treasury Employees Union, to
include in the record, and I have checked with the minority
staff, and without objection, I would order these statements be
made part of the record.
Senator Reed. Let me just raise one question. Senator
Schumer has highlighted a question about competition among the
Divisions, Mr. Khuzami, and Mr. Hiler made that point, too, and
you have responded. Is there anything else you would like to
say about this issue of competition among Divisions?
Mr. Khuzami. Candidly, Mr. Chairman, I have not seen
evidence of that. We really--to some degree--my view at this
point is that it is a highly collegial environment. We kind of
operate in similar but different spheres, so it is not the case
that we are focused on the same issues. We get their inputs;
they give us their input. And, to me, it is a very
collaborative process that works well.
The only issues I have seen is whether--you know, sometimes
things take too long to move through the process as you consult
multiple Divisions, and we hope to be able to streamline that.
Senator Reed. And let me ask another question which was
suggested by one of Mr. Hillman's comments; that is, the
retention of qualified attorneys. It might be easier now given
that competing private companies are not as flush or lush, but
that issue is always there in terms of maintaining highly
qualified personnel.
I think both Professor Bullard and Mr. Hiler worked for the
Commission, and then their academic and professional challenges
left. Your comment on what we can do--and you might even want
to think about this and get back to us--about providing
appropriate incentives to attract the right people and then
keep them there, provide long-term expertise. Do you have any
comments?
Mr. Khuzami. Well, Senator, you know, the pay parity rules
that were passed a few years ago that increased the salaries
were very helpful in terms of retaining talent. We do fluctuate
as markets fluctuate and the demand changes.
I think that one of the great benefits of refocusing on
enforcement and specialization and the other things we are
considering is that the Division, I think, is just going to be
a more attractive place for people to work, and they will stay
longer because they are doing good cases in an active way and
their contributions are valued. And if the gentleman to my left
wanted to return to the Division to work, we would be more than
happy to consider it.
Mr. Hiler. I am surprised to hear that, actually.
[Laughter.]
Mr. Bullard. I do not think he has checked that with some
of his colleagues.
Senator Reed. I am glad we are able to have a job fair as
well as a hearing. This is sort of doing double duty today.
Gentlemen, thank you very much for your very insightful
testimony. I would ask that if any of my colleagues have
additional questions they would submit them no later than May
13th so that we could get them to the witnesses. And I know
some of the witnesses have suggested they will respond--is a
week appropriate, Mr. Khuzami, given you--or we could make it 2
weeks.
Mr. Khuzami. Two weeks would be fine, if that is----
Senator Reed. Let us just suggest that any requests for
information by the Ranking Member or Senator Schumer or anyone
on the Committee, if you could comply within 2 weeks, I would
appreciate it very much.
That concludes the hearing. Thank you very much, gentlemen.
[Whereupon, at 3:53 p.m., the hearing was adjourned.]
[Prepared statements, response to written questions, and
additional material supplied for the record follow:]
PREPARED STATEMENT OF SENATOR CHRISTOPHER J. DODD
I am pleased that the Securities Subcommittee is holding today's
hearing and commend my colleague, Senator Reed, for his work to enhance
the performance of the Securities and Exchange Commission.
The SEC's Division of Enforcement has a vital role in promoting
compliance with the securities laws. It is critical to promoting the
integrity, fairness, and efficiency of U.S. financial markets. Strong
enforcement promotes investor confidence and participation in these
markets, which enables companies to raise capital, grow, provide jobs,
and create wealth. It is important that this division be strong.
On March 20, 2008, Senator Reed and I asked the GAO to study the
SEC's Division of Enforcement. We asked them to assess whether it has
sufficient staff and funds to perform its mission. We also asked them
to analyze the significant decrease in penalties and disgorgements the
SEC has collected in recent years, and the policies which put speed
bumps in the course of staff settlement negotiations. We asked the GAO
to examine rumors of declining staff morale and to assess the
Commission's progress in implementing suggestions made by a GAO study
from August of 2007.
Since the date of our letter, there have been additional public
concerns raised about enforcement. They came to a crescendo with
revelations about the failures of the SEC and the self-regulatory
organization it oversees to discover the Bernard L. Madoff Investment
Securities Ponzi scheme--even after the SEC received extensive and
credible tips.
Today's GAO study has identified several areas of concern. The
number of attorneys responsible for primary enforcement declined 11.5
percent between 2004 and 2008--precisely at the time that some of the
most egregious behavior, such as the Madoff Ponzi scheme, was
occurring. The GAO has found significant shortcomings in the SEC's data
technology that have hampered its enforcement work.
I am concerned about these and other shortcomings identified in the
report, and hope that the SEC will carefully review GAO's
recommendations and make necessary improvements. I am further
disappointed that the SEC did not raise these problems directly with
the Committee on any of the numerous occasions on which it appeared
before us.
The Congress has recently given the Commission additional resources
and stands ready to provide more as needed. However, we also need to
take a hard look at the way the Commission has used the resources they
have already been given.
While the decline in enforcement attorneys is certainly troubling,
the GAO indicates that SEC enforcement has not effectively managed the
staff it does have. Within one program, a Director complained that
``most staff ostensibly in his office are in fact within the
organizational structure of a different division.'' GAO indicates that
complex approval procedures for investigations have led some attorneys
to close cases rather than go through the bureaucracy needed to keep
them open. This potentially allowed fraudsters to go unprosecuted.
Even though I recognize that the SEC needs more enforcement
funding, I have some concerns about how they have used some of the
funding they have already been given. For example, the SEC Inspector
General reported last month that the Commission spent nearly $4 million
rearranging offices in an apparent vain effort to improve communication
among staff members. The Inspector General concluded that it was not
clear that this ``restacking'' project was necessary or had any
meaningful impact on communication among the staff or productivity. GAO
said that ``the SEC should have conducted a formal cost-benefit
analysis of the restacking project and, had such an analysis been
prepared, it may have led to the conclusion that the restacking project
was not worth the costs and disruption to the Commission.''
The Commission should assure Congress that it will manage its
resources wisely, to promote the agency's mission.
The need for the government to detect and prosecute fraud and other
financial crimes has never been more crucial. The Division of
Enforcement is vital to protecting investors. It must have the talent
and tools needed to perform a superior job. And we must also demand
excellence for our money. We must ensure that money is being spent on
management, programs, and procurements that work. We must insist that
management be more efficient and that enforcement attorneys are held to
the highest standards. American investors deserve nothing less.
I thank the GAO for its work and look forward to improved
performance from the Division of Enforcement under its new leadership.
PREPARED STATEMENT OF RICHARD J. HILLMAN
Managing Director,
Financial Markets and Community Investment,
Government Accountability Office
May 7, 2009
PREPARED STATEMENT OF ROBERT KHUZAMI
Director,
Division of Enforcement,
Securities and Exchange Commission
May 7, 2009
Introduction
Chairman Reed, Ranking Member Bunning, and Members of the
Subcommittee, thank you for inviting me to testify today on behalf of
the Securities and Exchange Commission and its Division of Enforcement.
I am both honored and proud to be here as the SEC's new Director of
Enforcement. I am also extremely grateful for this Subcommittee's
support and assistance in, among other things, efforts to increase our
budget, meet our enforcement responsibilities, and fulfill our mission
of protecting investors.
I would also like to thank the GAO and its team. I truly appreciate
the careful work that is evident in the GAO Report: Securities and
Exchange Commission: Greater Attention Needed to Enhance Communication
and Utilization of Resources in the Division of Enforcement (GAO-09-
358), and the extensive cooperation that our two agencies have shared
not only with respect to this report, but with respect to others in the
past. As our Chairman, Mary Schapiro, has noted, reinvigorating the
SEC's Enforcement program is a top priority, and I fully concur with
the GAO's recommendations.
In your letter inviting me to appear, you asked me to provide my
views on: (1) the extent to which the resource shortages and
enforcement policies of the SEC in recent years have hampered
aggressive enforcement of securities laws; (2) what changes are needed
to ensure that the SEC does not once again fall behind on its
enforcement responsibilities; and (3) what changes Congress should
consider to ensure adequate resources and authority for the SEC to
fulfill its vital enforcement role.
As I will discuss in more detail, we have faced and are facing many
challenges, including a complex and growing market and limited
resources. It is critical not only that we do our job and do it right,
but that in so doing, we help restore confidence in the agency and in
the marketplace. In my testimony, I will outline for you our plan for
addressing the challenges that we face. I will discuss some of the
changes Chairman Schapiro has instituted since her arrival that have
already helped our program. Additional resources in my view also would
enhance greatly our ability to keep pace with ever-changing
developments in a dynamic marketplace, as well as rapid advances in
technology. Further in this regard, I will touch on some potential
legislative changes.
The proposed plan I will outline dovetails with the GAO report and
its recommendations concerning an alternative organizational structure
and reporting relationship for the SEC's Office of Collections and
Distributions; further review of the level and mix of Enforcement
resources and the Division's current internal processes; review of the
2006 corporate penalty policy; and enhancing communications. And, I
will address the GAO report and each of its recommendations in turn.
Before I begin, however, I am mindful that this panel--and the
public--is deeply concerned about the Division's failure to detect the
fraud perpetrated by Bernard Madoff. I am not here today to defend the
agency's actions, nor am I in a position yet to explain precisely what
went wrong. I am here to say that I will be the first to admit mistakes
when they are made and to work toward preventing them from happening
again. But, I am also here to ask that you consider this failure in the
context of the Division's storied history of successful enforcement and
vigorous efforts to protect investors, and the many talented and
committed members of the enforcement staff who work very hard every day
on behalf of investors.
My belief as a newcomer is that there may have been multiple things
that contributed to the agency's failure to act timely in the Madoff
matter. But, whatever the agency's internal investigation concludes in
this regard, not a day goes by that I don't think about how we can stop
the next big fraud.
I am here to pledge my best efforts toward revitalizing the
Division and earning back the respect of investors. I know there is
much to do, and we've gotten a lot of things started. But all of our
ideas and initiatives will take time and effort. I look forward to
discussing some of these efforts with you today and in the future. We
expect that some of our improvements will require legislative
assistance, and your interest in a stronger SEC is greatly appreciated.
Background
Since I am new to the SEC and this is the first time I am appearing
before you, I hope you will permit me to tell you a little about myself
and about the Division of Enforcement, particularly its recent
successes. Over my career, I have been blessed to work in a wide range
of legal jobs among some of the most talented members of the
profession. These include positions as a judicial law clerk with the
United States Court of Appeals for the Eighth Circuit; an associate
with a long-established law firm in New York; 11 years as a federal
criminal prosecutor of terrorism and white-collar criminal cases in the
United States Attorney's Office for the Southern District of New York
in Manhattan; and 7 years as a general counsel for a large financial
services firm. Despite these experiences, and all that I learned from
each one, I can say without hesitation or qualification that, to be
asked by our Chairman, Mary Schapiro, to join the SEC, an institution
with such a rich tradition of excellence and commitment to protecting
investors, was the greatest day of my career.
Although I am new as a member of the SEC staff, over the years I
have had much experience with the agency and particularly, with the
Division of Enforcement. As a Federal prosecutor, defense counsel, and
most recently, in-house counsel, I have worked with the Division--and
against the Division--and I have seen it from many perspectives.
Through it all, I consistently saw in the Division staff integrity,
excellence, dedication, and a passion for investor protection. I saw
professionalism and teamwork. I saw a commitment to justice. And in my
38 days as Director of the Division of Enforcement, I can assure you
that despite the enormous challenges we have faced and are facing, I
have seen these traits in abundance. They are alive and well and, in my
view, one of the great, distinguishing safeguards of the integrity of
our capital markets.
The Division of Enforcement and Recent Successes
The Enforcement Division is in many ways the face of our investor
protection agency. Ours is the Division authorized to investigate and
bring civil charges in federal district court or in administrative
proceedings based on violations of the Federal securities laws. These
violations include fraud by any person or entity, whether or not such
actor is otherwise regulated by the SEC, as long as the violation is in
connection with the offer, purchase, or sale of securities. In addition
to fraud, we also investigate and prosecute regulatory misconduct,
including registration, reporting, and recordkeeping violations
relating to issuers, broker-dealers, municipal securities dealers,
investment advisers, investment companies, and transfer agents.
We initiate investigations based on our own surveillance efforts,
information from other regulators, and complaints and tips from
investors and other members of the general public. Although we have
delegated authority to initiate investigations on an informal basis, we
require Commission approval in the form of a formal order of
investigation, in order to issue subpoenas.
When we find violations of the Federal securities laws during our
investigation, if appropriate, we recommend to the Commission that it
authorize us to bring an enforcement action, including seeking any
appropriate relief, against the alleged wrongdoers. Our potential
remedies include: injunctions, cease-and-desist orders, disgorgement of
ill-gotten gain, financial penalties, revocations of registration,
undertakings to maintain or improve internal procedures, and bars from
associating with broker-dealers or investment advisers, practicing
before the Commission as an accountant or an attorney, serving as an
officer or director of a public company, and participating in the offer
or sale of a penny stock. In emergency actions, we often seek temporary
restraining orders, asset freezes, appointments of receivers, and other
ancillary relief. Whenever practicable, we seek to return monies to
harmed investors. In addition, we frequently work closely with the
Department of Justice, criminal investigators, and State and Federal
regulators, including conducting parallel and coordinated
investigations, and cooperating with prosecutions as appropriate.
We have brought many important and timely cases this year. Here is
a small sample of our recent actions:
Public trust: In March, we charged New York's former Deputy
Comptroller and a top political advisor with allegedly
extracting kickbacks from investment management firms seeking
to manage the assets of New York's largest pension fund, the
New York State Common Retirement Fund. Last month, we amended
the complaint to add a former New York State political party
leader, a former hedge fund manager, and a Dallas-based
investment management firm and one of its founding principals,
in connection with the alleged multimillion dollar kickback
scheme. \1\
---------------------------------------------------------------------------
\1\ SEC v. Henry Morris, et al., Lit. Rel. No. 20963 (Mar. 19,
2009), Lit. Rel. No. 21001 (Apr. 15, 2009), Lit. Rel. No. 21018 (Apr.
30, 2009).
Reserve Fund: On Tuesday, we filed fraud charges in the
Southern District of New York against the managers of the
Reserve Primary Fund, a $62 billion money market fund whose net
asset value fell below $1.00, or ``broke the buck,'' in the
fall. As part of this action, the Commission is seeking to
consolidate the numerous lawsuits involving the Reserve Fund,
and bring about an efficient and equitable pro rata
distribution to shareholders of the fund's remaining assets,
including the $3.5 billion set aside in the Fund's litigation
---------------------------------------------------------------------------
reserve.
Insider trading: Last week, we charged a former Citigroup
investment banker and seven others for allegedly engaging in a
widespread insider trading scheme that involved repeated tips
about upcoming merger deals. \2\
---------------------------------------------------------------------------
\2\ SEC v. Maher F. Kara, et al., Lit. Rel. No. 21020 (Apr. 30,
2009).
Subprime mortgages: In another important case filed last
week, we charged two former executives at American Home
Mortgage Investment Corporation for allegedly engaging in
accounting fraud and making false and misleading disclosures,
including misleading disclosures relating to the riskiness of
the mortgages originated and held by the company, to conceal
from investors the company's worsening financial condition in
early 2007 as the subprime crisis emerged. \3\
---------------------------------------------------------------------------
\3\ SEC v. Michael Strauss, Stephen Hozie, and Robert Bernstein,
Lit. Rel. No. 21014 (Apr. 28, 2009).
Auction rate securities: In February, as part of the
auction rate securities settlements, we announced a settlement
that would provide more than $7 billion in liquidity to
thousands of customers who invested in auction rate securities
before the market for those securities collapsed. \4\
---------------------------------------------------------------------------
\4\ SEC v. Wachovia Securities, LLC, Lit. Rel. No. 20885 (Feb. 5,
2009).
Ponzi schemes: Also last week, we obtained an emergency
court order freezing assets and providing other relief against
a California-based financier and his two companies for
allegedly defrauding investors of hundreds of millions of
dollars by misrepresenting investments in the life insurance
policies of senior citizens and in timeshare real estate. The
complaint alleged, among other things, that investors were
misled by false claims that their returns would come from
proceeds made on their investments, when instead some of the
purported returns were paid out of funds raised from newer
investors. \5\ Since January, we have filed 23 cases involving
Ponzi schemes or Ponzi-like payments, in which we charged that
perpetrators fraudulently raised funds from new investors to
pay ``returns'' to existing investors. \6\ Of the 23, 19 cases
sought emergency relief in the form of an asset freeze to
prevent the possible dissipation of investor assets and, in
some instances, a temporary restraining order to halt ongoing
conduct.
---------------------------------------------------------------------------
\5\ SEC v. Private Equity Management Group LLC, et al., Lit. Rel.
No. 21013 (Apr. 27, 2009).
\6\ The cases are:
1. SEC v. Bradley L. Ruderman, et al., Lit. Rel. No. 21017 (Apr.
29, 2009) (sought emergency relief to halt an alleged $38 million
Beverly Hills-based hedge fund fraud that included at least one Ponzi-
like payment).
2. SEC v. Private Equity Management Group LLC, et al., Lit. Rel.
No. 21013 (Apr. 27, 2009) (sought emergency relief in California-based
scheme involving hundreds of millions of dollars).
3. SEC v. Donald Anthony Walker Young, et al., Lit. Rel. No.
21006 (Apr. 20, 2009) (sought emergency relief to halt alleged scheme
involving a Philadelphia-area investment adviser and its principal, who
misappropriated more than $23 million from investors);
4. SEC v. Maximum Return Investments, Inc., and Clelia A. Flores,
Lit. Rel. No. 20997 (Apr. 13, 2009) (charged promoter and firm with
allegedly operating a $23 million scheme primarily targeted at
California's Hispanic American community);
5. SEC v. Robert P. Copeland, Lit. Rel. No. 20994 (Apr. 9, 2009)
(charged Georgia attorney who allegedly fraudulently raised over $35
million from at least 140 investors in several States, including
Georgia);
6. SEC v. Market Street Advisors, et al., Lit. Rel. No. 20992
(Apr. 7, 2009) (sought emergency relief against Colorado adviser for
allegedly conducting multimillion dollar scheme);
7. SEC v. Oversea Chinese Fund Limited Partnership, et al., Lit.
Rel. No. 20988 (Apr. 6, 2009) (sought emergency relief to halt alleged
$50-75 million scheme involving a Toronto-based hedge fund and
targeting members of the Chinese American community);
8. SEC v. Edward T. Stein, Lit. Rel. No. 20983 (Apr. 1, 2009)
(sought emergency relief to halt alleged ongoing $55 million scheme);
9. SEC v. Millennium Bank, et al., Lit. Rel. No. 20974 (Mar. 26,
2009) (sought emergency relief to halt alleged ongoing $68 million
scheme involving the sale of bogus high-yield CDs issued by Caribbean-
based bank and its Swiss affiliate);
10. SEC v. Brian J. Smart, et al., Lit. Rel. No. 20946 (Mar. 12,
2009) (sought emergency relief to halt alleged ongoing scheme that
raised $1.68 million from investors, including senior citizens);
11. SEC v. John M. Donnelly, et al., Lit. Rel. No. 20941 (Mar.
11, 2009) (sought emergency relief in alleged scheme based in
Charlottesville, Virginia, and involving $11 million);
12. SEC v. Anthony Vassallo, et al., Lit. Rel. No. 20943 (Mar.
11, 2009) (sought emergency relief in alleged $40 million scheme based
in Northern California);
13. SEC v. Shelby Dean Martin, et al., Lit. Rel. No. 20935 (Mar.
6, 2009) (sought emergency relief to halt alleged $10 million scheme
based in North Carolina);
14. SEC v. Ray M. White, et al., Lit. Rel. No. 20925 (Mar. 4,
2009) (sought emergency relief in alleged $11 million scheme based in
Dallas);
15. SEC v. Daren L. Palmer, et al., Lit. Rel. No. 20918 (Feb. 26,
2009) (sought emergency relief in alleged $40 million scheme based in
Idaho Falls);
16. SEC v. Billions Coupons, Inc., Lit. Rel. No. 20906 (Feb. 19,
2009) (sought emergency relief to halt alleged Hawaii-based scheme
targeting deaf investors);
17. SEC v. William L. Walters, Lit. Rel. No. 20904 (Feb. 18,
2009) (charged former registered representative with allegedly
operating a Ponzi scheme promising annual returns ranging from 20-40
percent);
18. SEC v. Stanford International Bank, et al., Lit. Rel. No.
20901 (Feb. 17, 2009) (sought emergency relief in connection with an
alleged $8 billion Ponzi scheme).
19. SEC v. Craig T. Jolly, et al., Lit. Rel. No. 20890 (Feb. 9,
2009) (alleged $40 million Internet-based Ponzi scheme based in
Spokane);
20. SEC v. Rod Cameron Stringer, Lit. Rel. No. 20857 (Jan. 21,
2009) (sought emergency relief in alleged hedge fund Ponzi scheme based
in Texas);
21. SEC v. CRE Capital Corporation and James G. Ossie, Lit. Rel.
No. 20853 (Jan. 15, 2009) (sought emergency relief to halt alleged
ongoing $25 million Ponzi scheme based in Atlanta);
22. SEC v. Gen-See Corp., et al., Lit. Rel. No. 20858 (Jan. 8,
2009) (sought emergency relief to halt alleged ongoing affinity fraud
scheme targeting clergy, Catholics, and senior citizens); and
23. SEC v. Joseph S. Forte, et al., Lit. Rel. No. 20847 (Jan. 8,
2009) (sought emergency relief to halt alleged $50 million scheme
operating from Pennsylvania for 15 years).
Other emergency actions: In addition to the 19 emergency
actions involving Ponzi schemes or Ponzi payments filed in the
last 4 months, we have also filed several emergency actions
related to other types of misconduct. In the last 2 weeks
alone, we obtained an emergency court order to freeze the
assets of a Connecticut-based money manager and the hedge funds
that he controls, alleging that he forged documents, promised
false returns, and misrepresented assets managed by the funds
to illicitly raise more than $30 million from investors; \7\ we
obtained an asset freeze against a Florida-based adviser for
allegedly misrepresenting the nature of $550 million in
investments; \8\ and we obtained emergency relief against a
Texas businessman and his company--both subjects of a previous
SEC enforcement action in 2001--for allegedly fraudulently
raising approximately $40 million from hundreds of investors
through a high-yield debenture offering. \9\
---------------------------------------------------------------------------
\7\ SEC v. Ponta Negra Fund I, LLC, et al., Lit. Rel. No. 21012
(Apr. 27, 2009).
\8\ SEC v. Founding Partners Capital Management Co., et al., Lit.
Rel. No. 21010 (Apr. 23, 2009).
\9\ SEC v. Benny L. Judah, et al., Lit. Rel. No. 21009 (Apr. 22,
2009).
---------------------------------------------------------------------------
Challenges and How To Refocus the Division of Enforcement
These are challenging times. The financial industry has grown
dramatically over the last decade in both size and scope. As evidenced
by the current financial crisis, our markets attract a large and
complicated group of participants that deal in a variety of new,
complex, and ever-changing financial products. In today's market, the
SEC oversees more than 30,000 registrants, including more than 12,000
public companies, 4,600 mutual fund families, 11,000 investment
advisers, 600 transfer agents, and 5,500 broker dealers. In fiscal year
2008, the Enforcement Division received more than 700,000 complaints,
tips, and referrals regarding potential violations of the Federal
securities laws. Yet, our entire Enforcement staff nationwide--
including lawyers, accountants, information technology staff, and
support staff--is just above 1,100. Our mandate is broad, including not
only regulatory misconduct by registered entities and persons but also
fraud by any entity or person, whether registered or not, in connection
with the purchase or sale or in the offer or sale of securities or
security-based swap agreements. The challenge of our mandate grows as
new financial products emerge that may fit the definition of a
``security.''
In the face of these growing challenges, the Division needs
sufficient resources to meet its mandate. Yet, because of several years
of flat or declining SEC budgets, the SEC has faced significant
reductions. As a result, even after receiving a much appreciated budget
increase in 2009, the SEC's workforce still will have significantly
fewer staff than in 2005. As noted in the GAO Report, this decline is
reflected in Enforcement's staffing levels as well. And our budget for
new technology investments is still more than 50 percent lower than the
2005 level. If the SEC were to receive additional Enforcement
resources, we would be able to continue rebuilding our staff and
technology investments, which would reinvigorate the Enforcement
Division and help restore investor confidence.
We have a talented and dedicated staff and the support of a
Chairman and Commissioners who are committed to a strong Enforcement
program. And, I am reminded daily that a change in culture within the
division has already started to occur. The staff has redoubled their
efforts to meet the challenges of this ongoing financial crisis. By way
of comparison, since the end of January:
We have filed at least 27 emergency temporary restraining
orders. During roughly the same period last year, we filed 7.
We have opened more than 287 investigations. During roughly
the same period last year, we opened 217.
The Commission has issued at least 138 formal orders.
During roughly the same period last year, the Commission issued
57.
Chairman Schapiro also has begun to implement changes in our
policies and procedures. For example, she streamlined the formal order
approval process. As the Chairman has noted, in investigations that
require the use of subpoena power, time is of the essence, and delay
can be costly. To ensure that subpoena power is available to the staff
when needed, the Chairman returned the SEC to a policy of faster
consideration of formal orders, where appropriate, by a single
Commissioner acting as duty officer. Another change, discussed more
fully below, is the Chairman's abolition of the ``penalty pilot''
program, which had required Enforcement staff to obtain full Commission
approval before the staff could begin settlement negotiations regarding
civil penalty amounts with public issuer defendants.
But there is more to be done. With what I have already learned--and
am still learning--as Division Director, I am prepared to make changes
to the structure of the Division, how we conduct business internally,
how we view the world, and most importantly, how we can rise to the
challenge and fulfill our critical mission of enforcing the Federal
securities laws, pursuing violators, and protecting investors, in a
timely and effective way. We have heard the criticisms and the
commentary, and we are doing what any responsible trustee of the public
faith should do--we are using it to conduct a serious self-assessment
to determine what we can do to improve and move forward, and be all the
better for the adversity. We are learning as many lessons from the few
things we have handled less effectively as we have learned from the
many we have handled highly effectively. We need to do this so that we
can restore investor confidence and send a strong message to would-be
violators that the SEC is on the beat. As our Chairman noted before the
full Banking Committee, the SEC is the only agency focused primarily on
the protection of investors. As the agency's most public face in its
efforts to protect investors, a strong Division of Enforcement is
critical to the investing public's confidence in the integrity of our
markets.
I met with Division staff my first day on the job and I asked the
staff to embrace four principles:
First, we have to be as strategic as possible. We need to
use our resources as efficiently as possible and in a manner
that achieves the greatest impact. This means a focus on cases
involving the greatest and most immediate harm and on cases
that send an outsized message of deterrence.
Second, we have to be as swift as possible. A sense of
urgency is critical. If cases are unreasonably delayed, if
there is a wide gap between conduct and atonement, then the
message--to the investing public that the SEC is vigilant and
effective, as well as the message to those who might themselves
be considering a step outside the law--is diluted. Timeliness
is critical. Corporate institutions are dynamic and ever-
changing. People come and go. When a case is brought years
after the conduct, the fines and the penalties still hurt, but
the opportunity to achieve a permanent change in behavior and
culture is greatly reduced.
Third, we have to be as smart as possible. Investigating
cases or individuals past the point of diminishing returns is
as inefficient as choosing the wrong case to investigate up
front. This means a constant focus on investigative plans. We
need to have regular decision points during the life-cycle of a
case, where we determine on an informed basis how to shape the
investigation and charge the case. We also need other tools to
help us better track and analyze case progress, or lack
thereof.
And last, we have to be as successful as possible. We need
to win. This means building strong cases so that defendants
settle quickly on the Commission's terms or face a trial unit
armed with compelling evidence.
There was, and is, little dispute over these goals. The challenge,
as always, is one of execution. But I assure you that I am committed to
implementing the changes necessary to achieve our goals. To that end,
10 days into the job, I assembled approximately nine advisory groups
within the Division, staffed by senior personnel to assess and propose
changes to virtually all significant aspects of our work and processes.
The advisory groups looked at issues relating to, among other things,
Division structure, case management and handling, streamlining, and
better training. The marching orders in this top-to-bottom review were
simple--in each context, ask yourselves, what works better? These
advisory groups then gathered and presented their preliminary findings
just 2 weeks later to a group of approximately 175 managers in the
Division. The result was 2 days of commentary, feedback, and
brainstorming. We also had the aid of a management consultant who has
analyzed and restructured law firms and law departments in both the
public and private sectors. The discussions were free-flowing and
highly constructive.
The result of this exercise is that we have recognized critical
items that need to be addressed if we are to improve our protection of
investors. Consistent with the GAO's recommendations, I propose
allocating additional resources to the following categories:
Administrative and paralegal support: The Division's
lawyers and accountants spend too much time doing document or
organizational tasks that are better handled by
paraprofessional personnel. This includes document collection,
organization, uploading, and indexing, as well as tasks related
to the collection and distribution of disgorgement and
penalties. It would be much more efficient, and free-up much
more time for high-value investigative tasks, if these efforts
were transferred to administrative and support staff.
Information technology support: The SEC is working on a
number of technology initiatives designed to bolster its
ability to detect, investigate, and prosecute wrongdoing. These
initiatives include a review of how the SEC handles tips,
complaints, and referrals; the improvement and expansion of the
Division's document management, reporting, and case management
capabilities; and the improvement of the SEC's ability to
identify, track, and analyze data to identify risks to
investors better.
Trial lawyers: It is important that the Commission maximize
the capacity and ability of its trial unit. Simply stated, we
must convey to all defendants in SEC actions that not only do
we assemble winning cases against them, but also we are
prepared to go to trial and we will win. Only then can we
expect to secure the type of settlements that both achieve
justice for investors and save resources to be used in pursuing
the next case. Without that credible threat, we are at a severe
disadvantage. Our trial unit does an admirable job, but given
the increased caseload, particularly the great increase in the
number of emergency actions such as temporary restraining
orders and asset freezes, it needs to grow.
Hiring a Chief Operating Officer/Business Manager: the
Division lacks a business manager or COO who can manage
administrative, information technology, project management, and
human resource issues. Additional staffing in the Office of
Collections and Distributions would be welcome, as our
attorney-investigators spend a significant amount of time doing
collection and distribution work--approving distribution plans
and distribution service providers--when they could be
investigating cases.
Resources are critical, and I believe there is a compelling need at
the Division for greater assistance. An increased budget would enhance
significantly our ability to make the changes I believe we need to do
our job to the best of our abilities. But as I told the SEC staff who
gathered on my first day on the job, relying on new resources is a
little like waiting for the cavalry--you don't know if they will come,
you don't know when they will come, and you don't know how long they
will stay. So it is our obligation--to those who are evaluating whether
we should be afforded additional resources as well as to the taxpayer--
to efficiently use the resources we already have.
To that end, our self-assessment effort is underway, in which we
are asking ourselves a number of pointed questions to identify those
changes that will allow us to be more efficient and successful. These
questions include:
Specialization: Should we increase our use of specialized
groups organized along product, market, or transactional lines,
in order to understand better the areas we investigate and to
see patterns, links, trends, and motives? Would such a
structure permit us to better gather in one place and harvest
the accumulated expertise that exists throughout the Division,
to target focused training at such a group, and to utilize
outside market specialists better?
Management: Would a different management model enable us to
do our job with fewer managers, thus freeing up those
managers--including many highly talented and experienced
investigators--to conduct more investigations and bring more
cases?
Approvals and Procedures: The Division has a number of
processes by which approvals must be secured at the highest
level of the Division. Are these approvals necessary or can
they be delegated to those running the investigations day-to-
day? We are also considering whether changes to agency-wide
procedures will help make our processes more efficient.
Metrics: Can we de-emphasize the current quantitative
metrics used to evaluate personnel and programs--the number of
cases opened and the number of cases filed--in favor of a more
qualitative standard, which includes concepts like timeliness,
programmatic significance, and deterrent effect of a case?
National Program: Can we undertake efforts to break down
the roles that naturally exist when one is organized along a
regional basis and think of ways to encourage and incentivize
more collaboration across regions? (Specialization, in which
groups are created that are staffed nationally, could be one
way to do this.)
Complaints, Tips, and Referrals: As Chairman Schapiro has
previously noted, we have retained Mitre, a Federally Funded
Research and Development Company, to advise us on how we can
better collect, record, investigate, refer, and track the
hundreds of thousands of complaints, tips, and referrals that
we receive each year. How can we analyze them better in order
to reveal links, trends, statistical deviations, and patterns
that might not be observable when they are examined on a less-
than-comprehensive basis?
Rewards: Would it improve our program to use tools that we
either already have, or would like to have, to reward persons
for coming forward with information about wrongdoers before it
is too late? Such tools include a whistleblower program and a
greater use of benefits--reduced sanctions, immunity, or
agreements similar to a deferred prosecution agreement--for
persons who come forward to identify and provide evidence
against those who violate the law. Some of the most credible
and valuable evidence is gathered in this manner by criminal
and other authorities, and we seek to determine if we are
taking full advantage of this opportunity. As Chairman Schapiro
has stated, we are actively considering coming to Congress soon
with a request for authority to compensate whistleblowers who
bring us well-documented evidence of fraudulent activity.
Cooperation: Could we cooperate further with other law
enforcement agencies and regulators to leverage resources more
effectively? The Commission staff works closely with other
authorities, for example, in securities-related criminal
actions. The nature and extent of the cooperation varies from
case to case and can include referrals, the sharing of
information in parallel investigations, simultaneous actions,
and staff assistance on criminal cases. Additional cooperation
and coordination with criminal and other authorities may yield
even better results.
These are, in broad strokes, some of the questions we are asking
and changes we are considering. The focus, as I said, is on being more
strategic, swift, smart, and successful in our job--protecting the
investor.
Potential Legislative Changes
As I discussed earlier, I believe that an increased budget would
enable us to address our resource concerns better, both in terms of
staffing and technological support. We greatly appreciate the support
we have received time and again from you, Chairman Reed, as well as
Chairman Dodd, Ranking Member Shelby, and many others on the Banking
Committee who have advocated for the SEC on this front.
With regard to specific legislative changes, there are a number of
ways to broaden or clarify our authority so that we can better enforce
the Federal securities laws and protect investors. I have discussed a
number of items with Chairman Schapiro that would aid our enforcement
efforts, including a whistleblower program, additional aiding and
abetting authority, and legislation in areas such as swap agreements
and hedge fund regulation. I understand that she will be providing some
of these legislative recommendations to you very soon. These proposals
will be aimed, in part, at ensuring we have sufficient authority and
reach to combat fraud and other market misconduct.
We also expect to request other legislative measures we have
discussed with you in the past, which would provide important
substantive and procedural tools to the Enforcement Division. Some of
those include giving the Commission the authority to seek penalties in
cease-and-desist proceedings and authorizing civil money penalties
against aiders and abettors under the Investment Advisers Act. We also
believe providing for nationwide service of process in civil actions
filed in Federal courts would afford significant savings of travel
costs and staff time through the elimination of duplicative depositions
and adds the benefit of having live witnesses and party testimony
before the trial court.
The GAO Report
Let me now turn to the GAO Report. As Chairman Schapiro has noted,
reinvigorating the SEC's enforcement program is a top priority for the
Commission, and I welcome the GAO's report and recommendations. The GAO
report and its recommendations are timely and dovetail with our
proposed initiatives to strengthen our Enforcement Division, maximize
our resources, and meet the challenges that lay ahead.
The GAO's report has identified four specific recommendations for
actions that the SEC can take to enhance the operations of our
enforcement program. I agree with each of the recommendations.
To consider an alternative organizational structure and reporting
relationship for the Office of Collections and Distributions
The Commission in September 2007 established a new centralized
office, the Office of Collections and Distributions, to expedite the
distribution of Commission recoveries to injured investors. The Office
is responsible for overseeing the distribution of billions of dollars
to investors who have been injured by securities laws violations,
implementing the Division's collections and distributions programs, and
conducting litigation to collect disgorgement and penalties imposed in
certain Enforcement actions. In addition, the Office tracks, records,
and provides financial management assistance with respect to the
distribution funds, and provides overall case management for the
Division.
The GAO's review has identified the need for improvements to the
Office's organizational structure. The SEC agrees with this
recommendation and is working to identify and evaluate various
alternatives for reforming the Office's organizational structure. We
are considering how best to improve the administration of the Office of
Collections and Distributions and to make sure that the Office's
workflows and processes are run efficiently. By making the necessary
changes, we hope to enhance the Commission's ability to collect
disgorgement and penalties and swiftly and efficiently distribute the
monies to harmed investors.
To further review the level and mix of resources dedicated to
Enforcement, and assess the impact that the Division's current
review and approval process for investigative staff work has on
organizational culture and the ability to bring timely
enforcement actions
Declining staffing levels have had an impact on the SEC's ability
to pursue an aggressive enforcement program. The GAO report notes that
the total number of staff who work in the enforcement program is down
4.4 percent since 2005, and the total number of nonsupervisory
investigative attorneys is down even more significantly, by 11.5
percent, since 2004. The report also identifies the need for additional
resources in Enforcement devoted to administrative and paralegal
support, information technology support, and specialized services and
expertise.
I concur with GAO's recommendation. Given the number of Enforcement
Division staff as compared with the broad area that is potentially
under our purview, it is clear that smart and strategic use of
resources is critical to the success of our mission to protect
investors. I have consulted at length with Division staff, as well as
with the Chairman, to find ways to work smarter with our current
resources and to identify the highest impact use of any additional
funds that Congress may provide. As described above, I believe we need
to allocate more resources to administrative and paralegal support,
information technology, trial lawyers, and to hiring a COO/business
manager. With regard to specialized services and expertise, as outlined
above, I am also exploring the increased use of specialized groups as a
way to enhance our understanding of the areas we investigate and our
ability to see patterns, links, trends, and motives. Such groups may
also provide a better forum in which to hire persons with specialized
expertise in various aspects of the securities industry to improve our
collective ability to detect fraud and prosecute violators. Similarly,
a national program that reaches across the current regional lines may
enable us to share information and expertise better.
The GAO report also identifies the need to ensure efficiency in the
internal case review process so that Enforcement staff can bring
enforcement cases more quickly and spend more time on investigations. I
concur with this recommendation. To this end, as outlined above, we are
exploring changes in management structure and whether certain
procedures and processes are necessary or can be improved.
To examine the effects of the 2006 corporate penalty policy to
determine whether the policy is achieving its stated goals, and
any other effects the policy may have had in adoption or
implementation
In January 2006, the Commission issued a Statement Concerning
Financial Penalties. The Statement identified two key considerations
and seven additional factors to be considered in determining whether to
impose a penalty. The two key considerations are (1) the presence or
absence of a direct benefit to the corporation as a result of the
violation; and (2) the degree to which the penalty will recompense or
further harm the injured shareholders. The other factors are the need
to deter the particular type of offense, the extent of the injury to
innocent parties, whether complicity in the violation is widespread
throughout the corporation, the level of intent on the part of the
perpetrators, the degree of difficulty in detecting the particular type
of offense, the presence or lack of remedial steps by the corporation,
and the extent of cooperation with Commission and other law
enforcement. The purpose of the guidelines was to provide ``clarity,
consistency, and predictability'' to the issuer penalty process.
I concur with the recommendation in the GAO Report that the
Commission examine whether the 2006 corporate penalty policy is
achieving its intended goals. Although my tenure has only recently
begun, I have already initiated discussions with various members of the
staff and will report back to the Commission with findings and
recommendations. To me, however, the focus of any penalty policy should
be assurance that malefactors get appropriately severe sanctions to
sufficiently deter them and others from engaging in similar misconduct
in the future.
The GAO Report also raised concerns about the Commission's 2007
``penalty pilot'' program. Before I arrived, Chairman Schapiro ended
the 2007 ``penalty pilot'' program, which had required Enforcement
staff to obtain a special set of approvals from the Commission in cases
involving civil monetary penalties against public companies as
punishment for securities fraud. I believe this decision has had a
positive effect on Enforcement staff.
To take steps to ensure that the Commission, in creating, monitoring,
and evaluating its policies, follows the agency strategic goal
and other best practices for communication with, and
involvement of, the staff affected by such changes
Finally, the GAO recommends that the SEC take steps to ensure that
the Commission better involves, and communicates with, Enforcement
staff in its decision-making process relating to the management of the
Enforcement program. Again, I concur with this recommendation.
Communication is a top priority and critical not only to the effective
performance of our jobs but to one of our most important intangibles--
the morale of our staff on the ground. I am a strong believer that all
constituencies should be heard. Since my arrival at the SEC, I have
conducted Enforcement-wide Town Hall meetings, I have met individually
and in groups with many members of the staff and with the management of
the Division, I have solicited commentary and feedback and brainstormed
with Division managers on the restructuring of the Enforcement Division
and other issues, and I have asked and will continue to ask for input
from Enforcement staff and others. I intend to keep the lines of
communication open not only within Enforcement, but with other SEC
Divisions and Offices and with the Chairman and the Commissioners.
Conclusion
I would like to thank you again for the privilege and opportunity
to appear before you today, and to thank the GAO and its staff for
their hard work and cooperation. I would be happy to answer any
questions you might have.
PREPARED STATEMENT OF MERCER E. BULLARD
Associate Professor of Law,
The University of Mississippi School of Law
May 7, 2009
Chairman Reed, Ranking Member Bunning, Members of the Subcommittee,
thank you for the opportunity to appear before you to discuss the SEC's
enforcement program. It is an honor and a privilege to appear before
the Subcommittee today.
I began my career working on SEC investigations at WilmerHale,
served as an Assistant Chief Counsel in the SEC's investment management
division, and more recently have provided expert witness services in
plaintiffs and defendants in private securities cases and public
enforcement matters. I am currently an Associate Professor of Law at
the University of Mississippi School of Law, the Founder and President
of Fund Democracy, a nonprofit advocacy group for mutual fund
shareholders, and a senior adviser with the financial planning firm
Plancorp, Inc. I am testifying today based on my general securities law
experience, rather than in my advocacy capacity.
Introduction
The GAO Report, SEC: Great Attention Needed to Enhance
Communication and Utilization of Resources Within the Division of
Enforcement, provides strong evidentiary support for what many have
known for quite some time. The SEC enforcement division's effectiveness
has been compromised, both by a lack of resources and poor leadership
by the Commission itself. The appointment of Mary Schapiro as Chairman
is a strong step toward solving the problem of leadership within the
Commission. Throughout her career, Chairman Schapiro has demonstrated a
solid commitment to a vigorous and effective enforcement program. In
her very short tenure, she has already taken decisive steps to end some
of the practices that have hindered the Commission's enforcement
program in recent years.
The problem of a lack of resources, however, remains unsolved. The
Commission does not have the funds necessary to provide the level of
enforcement necessary to protect investors and promote efficient
capital markets. I strongly recommend that Congress substantially
increase the SEC's appropriation to enable Chairman Schapiro and the
SEC's enforcement staff to do the job that they are better at than
anyone else. This is not just a matter of adequate enforcement; it is
also a matter of justice for investigated entities. Inadequate
resources often have the effect of unfairly increasing burdens on
parties defending SEC investigations.
The importance of the SEC's enforcement program cannot be
underestimated. The Commission is the leading voice for enforcement of
securities laws and the development of free capital markets not only in
the United States, but worldwide. When the Commission speaks, it makes
uniform law across all 50 States that private actors can rely on to
guide their business practices. When the Commission remains silent, the
void is filled with the noise of dozens of regulators and courts in
private actions creating a patchwork of rules. It is incumbent on the
Commission to provide the coherence and uniformity in the securities
laws that only it can provide. And it is incumbent on Congress to
provide the Commission with the resources it needs to do so.
The remainder of this testimony is divided into two parts. The
first part discusses some of the findings of the GAO Report and
recommends reforms that the Commission should consider in the process
of revitalizing its enforcement program. The second part discusses
other issues that relate to a number of occasions on which the
Commission has failed to take action in the face of known industry
abuses, and proposes two analyses of what might be the causes of this
problem.
GAO Report
The GAO Report provides useful insight regarding how the Commission
can most effectively and efficiently fulfill its enforcement role. The
input provided to the GAO by SEC staff draws a very clear picture of
potential areas of improvement, as discussed further below.
Consensus Management. The most striking aspect of the GAO's Report
is the picture it presents of the apparent subversion of the SEC's
enforcement program through the efforts of individual Commissioners.
The GAO reported that individual Commissioners blamed ``the quality of
management'' in the enforcement division for declining amounts of
penalties and disgorgement, even while the same Commissioners
apparently spearheaded efforts to require pre-approval of penalties.
Individual Commissioners claimed that ``the staff elect[ed] on its own
to retreat from penalties,'' although the GAO found that staff
consistently interpreted Commission positions to have been intended to
have this effect. In a very revealing admission, an individual
Commissioner emphasized that it was ``important to understand that the
division worked at the direction of the Commission, not as an
independent entity.'' This apparent desire by individual Commissioners
to ``remind the staff who's boss,'' coupled with Chairman Cox's
publicly expressed preference for consensus on the Commission, was a
recipe for disaster and explains much about the recent deterioration in
the Commission's enforcement program. The GAO reports that penalty pre-
approval policy was developed without input from the enforcement
division when it should have been the division that produced the first
draft of such a policy. The GAO reports that controversial cases were
frequently re-calendered. The seriatim approval of investigations was
suspended. As a whole, these findings paint a troubling picture of a
concerted effort to impede the enforcement of the securities laws from
within the Commission itself. \1\
---------------------------------------------------------------------------
\1\ There is strong evidence of similarly subversive intent with
respect to various Commission rule makings where a number of public
dissents seemed to have been written more for the purpose of aiding and
abetting challenges to the Commission's authority than documenting
constructive grounds of disagreement.
---------------------------------------------------------------------------
This should not be read as a critique of the ideological views or
motives of certain Commissioners, who may have had well-meaning
intentions to introduce newer ideological perspectives to the
Commission's enforcement culture. Indeed, I agree with their general
ideological misgivings regarding the efficacy of certain corporate
penalties and encourage the Commission to continue to work through the
problem of promoting corporate deterrence without harming innocent
shareholders. But there is a right way and a wrong way to seek to
influence the culture of an organization. The GAO Report provides a
roadmap of how the wrong approach taken by individual Commissioners,
especially when coupled with the enabling effect of the Chairman's
desire for consensus, can have disastrous consequences.
The Commission appears to be well on its way to correcting this
situation. Chairman Schapiro has wasted no time in suspending the
``penalty pilot'' program and ordering a review of the 2006 corporate
penalty statement; reinstating seriatim or individual approval of
formal orders of investigation; and ending the re-calendaring process.
These are important steps, but misguided, subversive interference by
individual Commissioners will not cease unless the Chairman is willing
to prosecute cases without reaching a consensus. Chairman Schapiro's
March 25, 2009, letter to the GAO, in which she specifically noted that
the re-calendaring resulted from a perceived need for ``consensus,''
seems to signal that she will not tolerate the undermining of the
Commission's enforcement program from within.
Disfavoring Cases Involving Industry-wide Practices. The GAO Report
refers to a single statement by an enforcement manager that the
Commission disfavors industry-wide ``issues,'' preferring instead to
handle these issues through the rule-making process. Certainly a single
statement is not necessarily representative of an office-wide position,
but it echoes sentiments frequently expressed in the securities bar and
should be considered carefully. The statement raises two issues.
First, to the extent that ``issues'' is a euphemism for clear
violations of the securities laws, then industry-wide cases are the
most important cases for the enforcement division to bring. When clear
misconduct has become pervasive, public confidence in the capital
markets is undermined. A strong enforcement response is critical. That
being said, an enforcement response to industry-wide violations need
not include enforcement actions against every violator. As discussed in
greater detail in the second part of this testimony, the Commission
does not add value by investing resources in bringing dozens of cases
involving the same misconduct once it has clearly established its
position. Rather than pursuing the 15th or 20th mutual fund market
timing case, the Commission should invest those resources in
identifying other areas of misconduct before they becomes industry-
wide. Chairman Schapiro's recent statement that the Commission has
``150 active hedge fund investigations'' \2\ raises the question of
whether the incremental benefit from the 20th, 50th, or 100th hedge
fund investigation is greater than the incremental benefit that could
be gained by assessing risks and identifying cases in other areas.
---------------------------------------------------------------------------
\2\ Comments of Mary Schapiro, Chairman, Securities and Exchange
Commission, before the Society of American Business Editors and Writers
(Apr. 27, 2009) available at http://www.sec.gov/news/speech/2009/
spch042709mls.htm.
---------------------------------------------------------------------------
Second, if the term ``issues'' is a euphemism for misconduct that
the law does not clearly prohibit, then no enforcement actions should
be brought. This is the ``gotcha'' problem about which defense lawyers
often complain. A small number of industry participants may seek a
competitive advantage by engaging in questionable practices, and, when
the Commission does nothing in response, an industry-wide issue is
created when the practices become widespread. Enforcement cases should
not be used to correct such misconduct. In this case, good enforcement
practice is to ensure that the SEC's operating divisions act promptly
to provide public clarification of industry members' legal obligations,
including rule making as necessary.
Resource Allocation. Many of the complaints expressed by SEC staff
may reflect a failure to balance priorities rather than inadequate
resources. For example, assume that an office of 12 attorneys needs two
administrative staff, one accountant, and a $1,000 technology
investment, but it has only one administrative person. The best
solution may be to fill the next attorney vacancies with an
administrative person and accountant and to spend the remaining funds
on the technology. As noted in the GAO Report, however, the Commission
may have a tendency to overhire lawyers. \3\ This means that increasing
the SEC's budget could actually exacerbate the complained about
shortages. If, in the foregoing example, the Commission used additional
funding to hire another 12 attorneys, the funding would actually make
the resource shortfall worse. The shortfall of administrative staff,
accountants, and technology would be increased. Thus, it may be top-
heavy staffing that creates scarcity, not a lack of funding. The
Commission should ensure that, regardless of funding levels, resources
are allocated efficiently so as not to create unnecessary imbalances.
---------------------------------------------------------------------------
\3\ See GAO Report at 29.
---------------------------------------------------------------------------
Internal Review. Another example of internally created resource
constraints is what the Report describes as ``the burden of the
division's internal review.'' \4\ As reported by the GAO, Commission
action memoranda may be subject to five or six layers of overlapping
review before being presented to the Commission. There are many legal
offices in the Federal government that manage with a substantially
flatter structure than the SEC. It is not unusual for a single attorney
to supervise dozens of senior lawyers. In contrast, the Commission (not
just the enforcement division) uses multiple supervisory layers that
create inevitable backlogs. The Commission should flatten its reporting
not only in the enforcement division, but throughout the Commission.
The first step would be eliminate branch chief positions across the
Commission and replace them with a kind of senior staff designation.
Case supervision should be provided by an Assistant Director or
Associate Director, but not both. Similarly, work product such as
action memoranda should be reviewed by an Assistant Director or
Associate Director, but not by both, before being reviewed by the
Director. Many matters should be able to taken to the Commission
without the Director's direct involvement. In addition, the Commission
should also consider limiting more senior review to a summary document
that is most likely to receive the most attention from the Commission.
Conversely, Commissioners should not be expected to flyspeck every
detail of every enforcement action, an expectation that, based on
recent experience, may need to be expressly enforced by the Chairman.
---------------------------------------------------------------------------
\4\ See GAO Report at 28.
---------------------------------------------------------------------------
Other Issues
One important SEC management issue that is not addressed by the GAO
Report, or least this GAO Report, is the SEC's recent record of
inaction with respect to known abuses in the securities industry. In a
number of areas, the Commission has abdicated its policymaking
responsibilities to State regulators and private litigants. The result
has been a decline in public confidence in the markets, a reduction in
investor protection, and an increase in uncertainty regarding
applicable legal standards. This part of this testimony provides
examples of this problem and proposes two analyses of its potential
source and possible solutions.
For example, in the early part of the decade a number of States
initiated enforcement actions relating to mutual fund trading practices
and analysts' conflicts of interests. The problem of stale pricing by
mutual funds and accompanying trading abuses had been well-known to the
Commission for years. The Commission took no action to address these
abuses which expanded to cover a large segment of the fund industry.
Ultimately, whistleblowers took their cases to State regulators (in one
case after having been rebuffed by the SEC), who then brought
enforcement actions against dozens of fund managers, traders and
salespersons.
State actions relating to analysts' conflicts of interest reflect a
similar pattern. The problem of analysts' recommending securities in
order to attract and retain investment banking business was well-known
before the New York Attorney General began his investigation. The
investment banking industry complained that State prosecutions
threatened to create a 50-State patchwork of regulatory standards, a
situation that could have been avoided if the Commission had previously
established uniform standards governing analysts' conflicts. There has
never been a more obvious or greater risk of analysts' conflicts than
during the Internet boom of the late 1990s, yet the Commission was
unable to provide effective oversight and address conflicts of interest
before they became systemic.
The Commission has continued to allow States to take the lead on
other known abuses in the securities markets. Massachusetts, New
Hampshire, and California have brought cases relating to the
nondisclosure of conflict of interest payments in connection with fund
sales. For years, the Commission was aware that funds were compensating
brokers for selling fund shares by directing brokerage to the brokers'
firms. It banned this practice only after State enforcement actions
directed attention to the problem. The Commission also was aware that
funds had been making undisclosed revenue sharing payments to brokers.
The Commission has yet to establish a clear legal standard for the
disclosure of such payments, leaving it to State regulators and the
plaintiffs' bar to protect investors from such abuses.
Most recently, States have brought a slew of cases in connection
with mutual funds in 529 plans that improperly allocated assets to
high-risk investments. These plans offered investment options with
substantial equity components for children who were expected to begin
college in 1 to 2 years. Once again, the Commission is sitting on the
sidelines, apparently willing to leave the solution to a national
problem to the States. The result is likely to be a patchwork of
conflicting court decisions on the disclosure obligations of mutual
funds. In the meantime, investors who simply wanted an easy way to
invest for their children's college education have been left wondering
what is the purpose of securities regulation that can be so fatally
inadequate. (I note that just prior to the finalizing of this
testimony, Chairman Schapiro made remarks regarding target-date funds
that may indicate a change in the SEC's approach to this area. \5\)
---------------------------------------------------------------------------
\5\ See Remarks of Mary Schapiro, Chairman, Securities and
Exchange Commission, before the Mutual Fund Directors Forum Ninth
Annual Policy Conference (May 4, 2009) available at http://www.sec.gov/
news/speech/2009/spch050409mls.htm.
---------------------------------------------------------------------------
In other areas, the Commission has abdicated its responsibility to
establish uniform standards to private litigants and Federal courts.
The most glaring example is excessive fee claims under section 36(b) of
the Investment Company Act. That provision was enacted in 1970
specifically at the behest of the Commission in order to establish an
express fiduciary duty for advisers with respect to compensation
received from mutual funds. It granted express enforcement authority to
the SEC, but the agency has never brought an excessive fees case. In
contrast, the New York Attorney General extracted a number of
settlements from funds that charged excessive fees and initiated
litigation for charging excessive fees against at least one fund
manager. Remarkably, the Commission criticized the NYAG for bringing
these cases even while the Commission itself had never taken any steps
to establish standards for excessive fees.
Not surprisingly, in the absence of clear regulatory guidance not
one private claim under section 36(b) has prevailed in a litigated
action (there have been substantial settlements). A U.S. Court of
Appeals panel recently held that, in effect, a mutual fund fee set in a
``free'' market cannot be excessive. The Supreme Court has granted
certiorari in that case, yet there is still no sign that it will have
the benefit of any guidance from the agency responsible for creating
and administering this Federal claim. The Commission remains silent.
The Commission apparently believes that there is no such thing as an
excessive mutual fund fee and that it has no responsibility to give
content to statutory standards for which it is primarily responsible.
It is likely that, even after the Supreme Court establishes a new
standard for excessive fees cases, the industry and plaintiffs' lawyers
will spend millions of dollars litigating its meaning, fund directors
will continue to flounder when reviewing fund fee arrangements, and the
Commission will sit by doing nothing.
Each of these cases involves an open and notorious problem in the
securities markets that the Commission has ignored until forced to act
under public pressure. This is not a complete list. One could add the
failure of the auction-rate securities market and the options
backdating scandal, among others. Indeed, the current liquidity crisis
in fixed income instruments is partly the result of the SEC's failure
to push more aggressively for the development of liquid debt markets.
Somehow a division of the Commission that exists for the purpose of
enforcing the securities laws has demonstrated willful blindness until
abuses became so widespread that they were impossible to ignore. What
enables or motivates State regulators with fewer resources and less
depth of expertise than the Commission to bring these cases? Why does
the Commission wait until misconduct reaches epic proportions before
taking action?
There are no definitive answers to these questions. The following
discussion provides two analyses of the SEC's enforcement program that
are intended to foster debate and prompt action. The first analysis
posits that a misapplication of the principle of deregulation has
caused a kind of regulatory paralysis at the Commission that has
resulted in the delegation of the SEC's enforcement responsibilities to
less efficient, State and private legal mechanisms. The second analysis
posits that the dominant metrics used to measure the SEC's enforcement
success has resulted in an inefficient and ineffective allocation of
resources.
The Myth of Deregulation
One answer may be that the SEC staff as a whole has become
paralyzed by a misapplication of deregulatory principles. One of the
positive developments of the 1990s was the introduction of deregulatory
thinking at the SEC. In its positive form, deregulation refers to
regulation that seeks to maximize societal gain while minimizing
societal cost. Deregulation, properly understood and applied,
strengthens investor protection and capital markets. But the principle
of deregulation as understood and applied by the Commission has long
since devolved into a reductive version that equates deregulation with
the simplistic mantra of ``let free markets decide.'' The problem with
this populist version of deregulation is that, in the absence of SEC
action, the free markets are likely to have less influence, not more.
Effective deregulation does not mean nonregulation or inaction in
the face of change. Deregulation refers to a kind of affirmative
regulation. When the SEC's position on the law regarding an area of
legal duties is unclear, deregulation does not always mean it should
leave it to ``free markets'' to resolve the uncertainty. The idea that
the markets in this sense are the ``markets'' of privately contracted
arrangements is an illusion. In the absence of clear SEC guidance, the
``markets'' that guide the conduct of private actors are the panoply of
alternative policymaking and dispute resolution structures that
naturally fill in the void created by SEC inaction. They are the 50
State attorneys general; hundreds of State securities enforcement
staff; thousands of State courts; hundreds of Federal bankruptcy
courts, district courts, and courts of appeal; State and Federal
banking regulators; the Department of Labor; the Department of Justice;
and others. The list is a long one, but no one on it has the
expertise--the capital markets expertise--and the ability to establish
efficient, uniform capital markets standards as the SEC. When the
Commission fails to establish standards of conduct, the standards will
be established by other regulatory means. The result of this populist
version of ``deregulation'' actually leads to more costly, less
efficient regulation. This kind of ``deregulation'' leads to regulatory
anarchy, not regulatory efficiency. It should be kept caged in the
academic zoo where it was conceived and can do no real harm.
The operation of an efficiently ``deregulatory'' regime is not
reflected in bureaucratic paralysis, but in decisive action that is
based on full consideration of the costs and benefits of regulation.
The view that ``deregulation'' means a kind of regulatory neutrality
consigns the financial services industry to being whipsawed back and
forth between periods of inaction and a convulsive overreaction This is
not merely a problem with SEC enforcement. It is a problem across the
full spectrum of financial services regulation. An extended period of
populist deregulation (as opposed to productive deregulation) has left
glaring problems unaddressed for years, and the current regulatory
response in some areas has initiated some of the most excessive over-
regulation this country has ever seen.
In short, the problems experienced in the SEC's enforcement program
may reflect not industry capture, but deregulatory capture. The
Commission was aware of, and ``working'' on, many of the problems
underlying these enforcement matters before they surfaced as State and/
or private claims. But the Commission was unable to resolve them. In
this ``deregulatory'' era, the staff has become so paralyzed that it
has become unable to take definitive policy positions or bring
enforcement actions. This is consistent with the enforcement staff's
statements that internal case review roadblocks ``created a risk-averse
culture.'' In many instances, this paralysis has not resulted in less
regulation, but more. The SEC's failure to take definitive policy
positions handcuffs its own enforcement efforts, \6\ creates legal
uncertainty, and increases private and State litigation.
---------------------------------------------------------------------------
\6\ The GAO reported that a number of SEC enforcement staff
perceived ``that other divisions have become too influential in
effectively controlling Enforcement activities.'' GAO Report at 28.
This is not surprising because the SEC's operating divisions are far
more risk averse and susceptible to outside influence than the
enforcement division.
---------------------------------------------------------------------------
The SEC's failure to correct stale pricing by mutual funds,
commission overcharges by brokers, options backdating by executives,
conflicted recommendations by analysts and similar misconduct early on
in its evolution, and its continuing failure to establish standards for
the disclosure of revenue sharing and excessive mutual fund fees, for
example, impose costs not only on investors, but also on the financial
services industry. When known misconduct becomes widespread, it becomes
difficult for compliance officers and legal counsel to persuade their
clients that the misconduct is illegal. Firms that seek to compete in a
free enterprise market are undercut by those who compete by breaking
the rules. In some cases, the internal tension created by the
misconduct escalates until it reaches crisis levels and public pressure
forces the Commission to act. The inefficiencies and competitive
distortions created by ignored misconduct are resolved in an expensive,
time-consuming spasm of litigation and over-regulation. In cases that
never escalate to this level, the regulatory void created by SEC
inaction operates as a permanent tax on financial services. Mutual
funds are left defending revenue sharing and excessive fee cases
brought by States and private litigants largely because the Commission
has not established clear regulatory guidance.
The SEC's position on target-date funds provides another
illustration. A number of target-date 2010 funds (intended for workers
retiring around that year) have invested far more in equities than
would normally be considered prudent. When Congress asked the
Commission about this problem, the SEC's response was as follows:
Given that there is variation among investment professionals
regarding the appropriate allocation of assets as investors
age, our review of target date funds has generally focused upon
ensuring that prospectuses provide full disclose of the asset
allocations in the funds and the corresponding strategies and
risks related to these allocations. By ensuring [that] funds
provide full disclosure, plan fiduciaries and investors are
then able to assess the appropriateness of these funds as
investment options.
This response is wrong as a matter of law and gratuitously provides
litigation support to funds that use misleading names. But this
critique is, admittedly, a policy critique. The deeper problem is that
it is completely unresponsive. It does not address the fact that many
investors will expect a target date 2010 fund to invest according to a
typical allocation for someone very near retirement--regardless of what
the prospectus says or how clearly it says it. Like the sponsors of
these funds, the Commission is hiding behind the prospectus language
that it permits to directly contradict the impression created by the
fund's name, although recent statements appearing in press reports. And
the lack of legal clarity on this issue will result in unnecessary
losses for investors and unnecessary litigation for all concerned.
I believe that the Commission should require that a ``Target-Date
2010 Fund'' should be required to invest consistent with a conventional
asset allocation for someone at the brink of retirement. But again,
that is one viewpoint. The point here is not that the Commission should
take a particular policy position, but that the Commission has no real
policy on the issue at all. Even if the Commission were to take the
position that the fund's name could not be inherently misleading--no
matter how strongly suggestive it was--if the impression created by the
name was corrected by fund disclosure (essentially codifying a kind of
bespeaks caution analysis), investors and the industry would be better
off than they are with the SEC's ``deregulatory'' pablum quoted above.
The SEC's guidance regarding ``full disclosure'' is the functional
equivalent of a prescription to go forth and litigate and let us know
how it all comes out. (I note that just prior to the finalizing of this
testimony, Chairman Schapiro made remarks indicating that the
Commission was reconsidering a disclosure-only approach to the issue of
target-date funds. \7\)
---------------------------------------------------------------------------
\7\ See supra note 5.
---------------------------------------------------------------------------
The Metrics of SEC Enforcement
Another answer may be that the Commission has become captured by
its own metrics. The most common measure of the enforcement division's
performance has become the number of investigations it opens and cases
it files in a fiscal year. \8\ It is no coincidence that this metric
matches up with the kind of epic investigations that the Commission
often launches under public pressure. After bringing a few enforcement
cases based on similar fact patterns, the deterrence benefit rapidly
diminishes, but the efficiency with which the Commission can rack up
additional settlements increases. The Commission uses a metric that
provides an incentive to bring dozens of cookie cutter cases where it
can spread the fixed costs of the investigation over a large caseload.
---------------------------------------------------------------------------
\8\ See GAO Report at 21-22 (``Enforcement officials said they
focus on two process-oriented performance indicators to track the
division's activities: number of investigations opened annually, and
number of enforcement actions filed annually.'').
---------------------------------------------------------------------------
For example, consider the most recent settlement in the never-
ending mutual fund trading scandal. The most recent of these cases was
settled just 2 weeks ago. The alleged misconduct took place between
2000 and 2003, it was very similar to misconduct alleged in dozens of
previous cases, and the charge was mere negligence. If this prosecution
was typical, it involved numerous, often redundant and expansive
document requests demanding immediate compliance followed by extended
periods of SEC inactivity and silence. The individuals remained under
the cloud of the investigation throughout this period with no
indication as to the SEC's position on their culpability. At the end of
the investigation, the settlement broke no new ground, provided no
additional general deterrence, and did not even finalize the amount to
be disgorged, that process having been left to a distribution
consultant to be retained well into the next decade. Remarkably, most
of the rule-making initiatives arising out of the mutual fund scandal
were developed, proposed, and adopted long before many cases were
closed. Most lawyers who defend SEC investigations probably would agree
that the process leading to a settlement is usually far more costly and
burdensome than the penalties ultimately imposed.
But bringing large numbers of cases in a limited number of areas of
misconduct matches the metric of producing the largest number of
settlements. By analogy, if the Center for Disease Control's success
were measured by the number of swine flu victims who were cured after
an outbreak had been identified, it would have an incentive to invest
in curing large numbers of victims rather than in detecting the
earliest signs of an epidemic and preventing its spread. While the
Commission is developing its 50th mutual fund trading case, the staff
working on that case is not seeking to identify the seeds of the next
enforcement problem. When those seeds germinate and bloom into a
systemic crisis, the Commission will shift resources to another endless
series of cases while other problems begin to take root.
The BISYS case provides a current illustration of the likely
overcommitment of resources to stale matters. In September 2006, the
Commission reached a settlement with BISYS Fund Services, Inc., that
was based on BISYS's payments to 27 unnamed fund managers in return for
their recommending that their funds use BISYS as the fund's
administrator. The arrangements were in place from June 1999 and July
2004, which means that more than 2 years already had passed before the
Commission settled with BISYS. Since then, the Commission has settled
with only one of the 27 fund managers, and that occurred another 2
years after the BISYS settlement, in September 2008. \9\ The fund
managers' arrangements with BISYS had already been terminated for over
4 years. Many of the funds have reached private settlements with the
fund managers who were involved in the scandal. But the fate of the
other 26 fund managers appears to remain unresolved. The investigations
regarding the unlucky 26 are probably ongoing, with some inching toward
a resolution and others floating motionless in an investigation
purgatory awaiting a final decision on their fate. \10\
---------------------------------------------------------------------------
\9\ See In the Matter of AmSouth Bank, Admin. Proc. No. 3-13230
(Sep. 23, 2008) available at http://www.sec.gov/litigation/admin/2008/
ia-2784a.pdf.
\10\ The GAO reports a 264 percent increase in case closings from
2007 to 2008, which officials attributed, in part, to new quarterly
reports that list cases that are 5 or more years old. See GAO Report at
14. On the one hand, the staff should be applauded for this dramatic
increase in case closing. On the other hand, cases should be considered
old long before they reach the 5-year mark. In a real-time enforcement
environment, any case older than 2 years should carry a rebuttable
presumption that it should be closed.
---------------------------------------------------------------------------
In lieu of the staff time invested in settling cases based on
ancient misconduct, the Commission could have been looking for
developing problems in other areas. This approach to the allocation of
staff resources would result in a smaller number of settlements,
however, and current indications are that the Commission is committed
to keeping its numbers up. The SEC Chairman recently stated, for
example, that the Commission has ``150 active hedge fund
investigations,'' ``two dozen active municipal securities
investigations,'' and ``50 current investigations involving Credit
Default Swaps, [CDOs] and other derivatives-related investments.'' \11\
That totals 224 investigations, all of which are, not surprisingly, in
areas that have recently received a great deal of public attention.
While these matters should be investigated, is it prudent to commit the
resources necessary to investigate 150 hedge funds? Why not only 20, or
50, or even 100? Are these investigations triggered primarily by
allegations of alleged misconduct or by simply being a large hedge
fund? Hedge funds and credit default swaps are generally purchased by
sophisticated investors. What about investigations of the losses
suffered in 529 plans by investors who will not be able to afford to
send their children to college? Or in target-date 2010 funds by 65-
year-old investors who will not be able to retire? Like the dozens of
mutual fund trading, options backdating, and other massive
investigations, the current slew of topical matters will take years to
resolve.
---------------------------------------------------------------------------
\11\ Comments of Mary Schapiro, Chairman, Securities and Exchange
Commission, Before the Society of American Business Editors and Writers
(Apr. 27, 2009) available at http://www.sec.gov/news/speech/2009/
spch042709mls.htm.
---------------------------------------------------------------------------
The Commission needs to bring a smaller number of targeted
enforcement cases covering a wide range of activities in real-time, not
develop a massive caseload of factually similar cases in a narrow set
of circumstances over a 5- or 10-year period. To do this, the
Commission needs to develop new metrics, which will require new
settlement strategies. For example, it should develop a self-reporting
approach to suspected widespread misconduct. The company internal
investigation that is conducted promptly (within 4 months) and credibly
and accompanied by a fair resolution for injured parties should be
rewarded; the laggard that produces a half-hearted investigation
without any clear resolution should be penalized and considered for
formal prosecution. Entities do not engage in wrongdoing, people do,
and those people generally do not include independent directors. If the
Commission promises to reward shareholders whose independent directors
engage in prompt investigation, cooperation, and mitigation, the
shareholders and their boards will have a strong incentive to conduct
an expedited, impartial investigation, leaving a smaller number of more
egregious cases on which the SEC staff can focus. (Admittedly, the
efficacy of this approach is undermined when the chairman is also the
CEO whose oversight and individual conduct are inevitably the subject
of investigation.)
Once these potential enforcement targets have been identified, the
Commission should establish real-time enforcement guidelines that are
designed to produce a settlement or a complaint within 18 months. This
will often mean winnowing out the less egregious or more complex cases,
even where there is known misconduct. But it is not the SEC's role to
bring enforcement actions against every wrongdoer. It is the SEC's duty
to use its unique position to deter misconduct, communicate and set
uniform standards, and inspire confidence in the rules governing the
financial markets. A small number of targeted enforcement actions
brought (and section 21(a) reports issued) on a real-time basis will
allow the Commission to invest resources in identifying abuses before
they become systemic while sending strong signals to compliance
officers about what kinds of conduct will not be tolerated.
This approach cannot succeed, however, without the development of
explicit metrics against which the Commission publicly measures its
performance that are keyed to fewer cases brought across a wider
spectrum of misconduct. If the SEC's performance continues to be
measured by the number of cases that it brings, it inevitably will,
consciously or otherwise, tend to strategies that produce more cases.
New metrics must be explicitly adopted and past performance re-
evaluated in light of those metrics. The first step might be to
determine the range of types of cases brought in the previous fiscal
year and actively promote this measure as an alternative benchmark to
gross numbers of enforcement actions. Whatever alternative metrics are
developed, they must be accompanied by repeated reminders by the
Commission and senior staff that the Commission cannot and does not
seek to bring every case. Calls for ever more enforcement staff create
an impression that if the Commission only had enough staff it could
detect every fraud and bring every case. The Commission needs more
staff, but the staff needs clear direction that is consistent with its
limited but critical role in a broad spectrum of regulatory mechanisms.
______
PREPARED STATEMENT OF BRUCE HILER
Partner and Head of Securities Enforcement Group,
Cadwalader, Wickersham & Taft LLP
May 7, 2009
Chairman Reed, Ranking Member Bunning, and Members of the
Subcommittee: I am pleased to have the opportunity today to testify
concerning the responsibilities of the Securities and Exchange
Commission and its Division of Enforcement in policing our financial
markets and protecting investors. I formerly served as an attorney in
the Division of Enforcement and as an Associate Director of the
Division. I left the Commission in 1994 and have since been a partner
in two different law firms, where I have represented clients in SEC and
other governmental investigations, internal investigations, and
securities litigation.
Although recently the Commission, and particularly its enforcement
efforts, have come under fire for reported lapses in detecting or in
quickly reacting to the activities of some individuals in the
marketplace, the Commission has long been viewed as a premier
regulatory agency and, through its Division of Enforcement, a premier
civil enforcement agency. If there have been lapses, I am confident
that the Commission will evaluate those situations and develop new
policies and procedures to avoid them in the future. In this regard, I
think it is important to understand the effects that the vagaries of
funding and resource allocation, the exponential expansion both of
market activity and of sophisticated instruments and investment
strategies, and the day-to-day pressure of operating in the glare of
public scrutiny can have on any organization.
Nevertheless, from the standpoint of a private practitioner who
also served in the SEC's Division of Enforcement, I have seen a number
of areas in which I believe the Commission's enforcement efforts could
or should be modified or improved. In particular, there are three areas
which I would like to discuss briefly today: the management structure
of the Division of Enforcement; the availability of specialized
resources to enforcement attorneys; and the relationship between the
Commission and the market participants it regulates.
First, I believe that the efficient and speedy resolution of SEC
investigations is important both for effective public protection and
enforcement efforts, as well as for ensuring fairness and justice to
the subjects of the investigations. In my view, both the speed of
resolution of enforcement investigations and the consistency and
fairness of outcomes of those investigations could be enhanced by
having fewer layers of management between those working day-to-day on
investigations and those in the Division of Enforcement who ultimately
must recommend to the Director of the Division whether an investigation
should move forward or should be closed without action. However, this
does not necessarily mean fewer management slots. Rather, in my view,
it requires more positions for experienced, senior managers.
Currently, in the Commission's D.C. headquarters offices, the
Division has two deputy directors and five associate directors. Through
assistant directors and branch chiefs, the associate directors
indirectly supervise hundreds of investigative attorneys, and they may
be supervising dozens, if not scores, of investigations and active
litigations, in addition to fulfilling other management
responsibilities. The associate and the deputy directors typically are
among the most experienced professionals in the Division, and they are
looked upon internally as having the judgment and expertise to make
appropriate case recommendations. Yet, these are also the individuals
who have the least amount of time to spend on any one matter, and who
are relatively infrequently involved in any one particular matter on
the day-to-day decision making or day-to-day review of facts, as they
are discovered or analyzed by those directly involved in the
investigations.
In my view, there should be fewer layers between these senior
individuals and those directly working on investigations. To best
achieve this result, I believe the number of senior, experienced
officials should be dramatically increased. These senior managers
should be charged with direct involvement in the day-to-day activities
of the matters under their supervision, and such matters should be kept
to a reasonable case-load so that they can become familiar with key
facts and issues as they develop, and can spend time directly reviewing
the factual records.
Second, efficiency must not be achieved at the expense of fairness
or thorough evaluation. The SEC has a long history of careful
evaluation of important and complex issues and constantly must guard
against public pressure to act too quickly or to be rushed to
enforcement resolutions which may have significant policy implications.
The matters which the SEC investigates can be extremely complex, and
some conduct may easily be made to appear nefarious to the public and
in media reports because of its novel or complex nature. SEC
investigations can involve sophisticated instruments and trading
strategies, as well as complex issues, such as accounting, risk
analysis, and economic modeling, that fall outside of the normal
expertise of attorneys. Although there are individuals at the SEC with
expertise in some of these areas, their numbers should be increased and
the Commission should organize these individuals by expertise outside
of the Division of Enforcement. These experts should be available to
consult and to work day-to-day on enforcement investigations. I believe
that the addition of a cadre of experts in a variety of fields to
assist in enforcement inquiries could lead to more efficient and better
informed decision making, and may assist in determining when issues are
better resolved by way of considered regulatory or policy judgments.
Third, I believe that the detection of fraudulent conduct is a
difficult task, and no one can expect that the SEC or any agency will
be able to anticipate specific frauds at specific entities. However, a
regulator may be able to get early warning signs of conduct which may
have become acceptable due to macroeconomic or social events, but
which, on close examination, the Commission would like to halt or
believes is not sufficiently understood such that it poses unknown
dangers to the financial system. In order to get early warning signs of
such conduct, I believe a regulator must maintain and foster an open
line of communication with those in charge of compliance and management
at the relevant entities. It is difficult to maintain open and
sufficiently timely communication where the regulator or the regulated
views the other with suspicion and where the regulated has reason to
question the process by which its conduct is or will be judged. I
believe that such an atmosphere of mutual suspicion began to develop in
the last decade between the Commission and some of the entities with
which it interacts.
I believe that the causes of this mutual suspicion are varied.
However, I believe that increased scrutiny by criminal authorities of
securities law matters and public pressure on the SEC to hold anyone
and everyone responsible for the stock market crash in 1999, for
corporate bankruptcies and defalcations, and, more recently, for the
current economic turmoil have contributed to this atmosphere. Increased
attention to securities cases by criminal prosecutors is not in and of
itself a cause for concern, but I believe that the line between civil
securities cases and criminal securities-based fraud cases has been
blurred, and that there has been a shift to an inappropriately low
level in what authorities view as conduct that demonstrates sufficient
scienter or ``state of mind'' to make even a civil securities case.
The Commission should develop internal guidelines that set forth
its views on the standards that should be applied in determining what
constitutes ``fraud'' under the Federal securities laws. A starting
point, for example, could be guidelines concerning permissible
inferences that can be drawn in cases to support such a charge. The
U.S. Supreme Court in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551
U.S. 308 (2007), recently held that, in determining whether the pleaded
facts in a private securities fraud case give rise to the required
``strong'' inference of scienter under applicable pleading standards, a
court must take into account ``plausible opposing inferences.'' Id. at
323. In other words, the court must consider ``plausible, nonculpable
explanations for the defendant's conduct,'' and the case should be
permitted to proceed ``only if a reasonable person would deem the
inference of scienter cogent and at least as compelling as any opposing
inference one could draw from the facts alleged.'' Id. at 324. It thus
is possible for the Commission to adopt reasonable internal guidelines
to ensure it is making consistent and fair decisions on the subjective
judgments of whether to bring enforcement actions or continue to pursue
investigations. I also believe that the Commission should have a major
role in determining whether cases which predominantly involve Federal
securities law issues and our capital markets structure should be
pursued by criminal authorities. I believe that efforts in these two
areas would help promote an atmosphere of cooperation and communication
that could help assist the Commission in all of its regulatory roles.
There are other areas in which I know the Members of this
Subcommittee are interested. I also believe that the SEC historically
has responded positively to constructive assessment of its operations
and programs. I hope that I am able to be of assistance to you, and I
will be happy to answer your questions on this important subject.
RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED
FROM RICHARD J. HILLMAN
Q.1. As the Bernard Madoff case clearly illustrated, the SEC
fell short in responding adequately to what were clear signs of
fraud. It's not clear that this was a problem of a lack of
resources. Do you have suggestions on steps the SEC could take
to improve its oversight in this area? What information would
better assist the SEC in identifying and acting upon problems
such as market manipulation, insider trading, and other
misconduct? What surveillance tools would help this effort?
A.1. Since we did not review SEC's oversight of Madoff's firm
or the agency's actions regarding tips received about the
fraud, we cannot specifically comment on the circumstances or
any deficiencies SEC may have in handling this fraud case.
However, in several GAO reports where we reviewed SEC's OCIE
and Enforcement functions, we have made a number of
observations and recommendations for improvement in its
examination and surveillance-related effort.
SEC's routine examinations are risk based and as such,
relatively low-risk areas are generally not examined. For
example, in our 2005 report on mutual fund trading abuses, we
noted that SEC staff did not examine for market timing abuses
or assess company controls over that activity because they
viewed market timing as low risk and determined that mutual
fund companies had financial incentives to establish effective
controls over frequent trading. We observed that SEC could
strengthen its ability to detect market timing activities by
conducting independent assessments of controls (through a
variety of means including interviews, reviews of compliance
reports or internal audit reports, and transaction testing as
necessary) at a sample of companies to verify assessments about
risks and the adequacy of controls in place to mitigate those
risks. SEC could apply this process to other perceived low-risk
areas.
In a 2007 report, we noted that since the detection of
mutual fund trading abuses, OCIE has shifted its approach to
examinations of investment companies and advisers from one that
focused on routinely examining all registered firms, regardless
of risk, to one that focuses on more frequently examining those
firms and industry practices at higher-risk for compliance
issues. The effectiveness of OCIE's revised approach largely
depends on OCIE's accurately assessing the risk level of
investment advisers. Since many firms rated lower-risk are
unlikely to undergo routine examinations within a reasonable
period of time, if at all, harmful practices could go
undetected if firms are inappropriately rated as lower-risk. We
noted that the method that OCIE employs to predict the level of
risk for the majority of advisers has some limitations,
particularly in that this method relics on proxy indicators of
compliance risks without incorporating information about the
relative strengths of a firm's compliance controls. We continue
to believe May 7, 2009, that using compliance reports from
firms could potentially help OCIE better identify higher-risk
firms. In some cases, SEC will have to test the quality of the
firm's internal audit function before relying on its
assessments.
Self-regulatory organizations (SROs), rather than SEC, are
responsible for the surveillance of the trading activity on
their markets. As a result of a 1985 study, SEC determined that
SROs had created a viable intermarket surveillance program, and
terminated its then tentative Market Oversight and Surveillance
System project by determining not to develop the direct
surveillance capabilities the system would have allowed. SROs
employ electronic surveillance systems to monitor market
participants' compliance with SRO rules and Federal securities
laws. One of the key surveillance systems employed by SROs
monitors the markets for insider trading. Since SROs only have
jurisdiction over entities and individuals that are part of
their membership, any suspected violations on the part of
nonmembers are referred directly to SEC's Enforcement Division.
In a 2007 report, we noted that Enforcement's referral receipt
and case tracking systems do not allow Enforcement staff to
electronically search all advisory and referral information,
which may limit their ability to monitor unusual market
activity. We recommended that SEC considers system
improvements.
Finally, as we noted in our 2009 report, some Enforcement
attorneys felt that the division's in-house expertise in a
range of areas was inadequate. These include forensic
accounting, complex trading, and complex financial instruments.
Several attorneys also said that the investigative staff do not
have access to real-time trading information, which can be
pivotal to bringing certain cases such as pump and dump
schemes. Getting access to such specialized services and
expertise would aid in case development. We recommended that
SEC review the level and mix of Enforcement resources.
------
RESPONSE TO WRITTEN QUESTIONS OF SENATOR BUNNING
FROM ROBERT KHUZAMI
Q.1. In your testimony, you mentioned that the Commission has
filed 23 cases involving Ponzi schemes or Ponzi-like payments.
With the report just now coming out that the SEC received
warnings back in 2002 regarding the Stanford fraud
investigation, how long was the SEC aware of these 23 or so
particular cases before formal filings where a charge was made?
A.1. Of the 23 cases involving Ponzi schemes or Ponzi-like
payments referenced in the written testimony, we investigated
and filed 18 of them, or 78 percent, within 6 months of the SEC
becoming aware of possible misconduct through a complaint, tip,
referral, or staff surveillance. Fifteen of the 18, or 83
percent, were filed within 2 months of the complaint, tip,
referral, or surveillance. In three of those cases, or 16
percent, we filed charges within 2 weeks of becoming aware of
the possible misconduct.
Of the remaining five cases, more time was needed to
develop each case. As an initial matter, I note that
complaints, tips, or referrals often lack specific, admissible
evidence of wrongdoing; rather, further investigation must be
undertaken before charges can be filed.
Turning to the remaining five cases, one was the Stanford
matter that I referred to in my oral testimony. In that case,
there were various impediments to filing charges, most notably
the absence of sufficient evidence of wrongdoing, due in part
to the lack of cooperation from Stanford and the Antiguan
authorities. For a variety of reasons, the remaining four cases
in this category were brought more than 1 year after the
complaint, tip, or referral. In two of the remaining cases, the
staff learned that the conduct had ended and that significant
assets did not exist which might justify emergency action.
Thus, the investigation continued to allow for evidence to be
collected upon which the wrongdoers could be charged. In the
third case, there was initially a lack of credible evidence of
wrongdoing, since none of the victims complained, there was no
investor list, and there was an absence of affirmative
misstatements of fact. Subsequently, the staff worked
diligently and ultimately obtained bank records to trace
investor funds, an independent third party receiver was
retained to marshal any remaining assets, and the case was
filed. In the final case, once the staff became aware of the
true nature of the conduct, the staff investigated and brought
the action in an expeditious manner--moving from a formal order
of investigation to filing in Federal district court in less
than 2 months.
Q.2. Out of the 700,000 complaints, tips, and referrals
received last year, how many were followed up on?
A.2. There are a variety of ways that complaints, tips, and
referrals come into the SEC, including through various
divisions and the agency's eleven regional offices. By volume,
the Enforcement Division's Complaint Center (ECC) and the
Office of Investor Education and Advocacy (OIEA) receive the
vast majority of such contacts.
In Fiscal Year 2008, the Division received approximately
615,000 submissions through the ECC, an online mailbox of the
Division of Enforcement that receives e-mail tips and
complaints from investors and other members of the public.
Every complaint received through the ECC is reviewed by a
member of Enforcement staff, and passes through a multistage
triage process. At each stage, some complaints are eliminated,
either because they fall outside the agency's jurisdiction,
or--later in the process--because they do not present
compelling facts, do not establish the potential for a Federal
securities law violation, or are judged not to be an efficient
use of resources. In the later stages of this triage, reviewing
staff may also forward a higher-quality complaint to
Enforcement staff as a ``referral'' to be considered for
further investigation or action. Even if e-mails are not
formally referred, they are archived and can be researched
should a future investigation be opened. Given the multilayered
review and referral process, together with current
technological and resource limitations, there does not
currently exist a capability for specific tracking of each e-
mail throughout its review and triage.
During that same time period, OIEA received approximately
81,000 investor complaints, questions, or other contacts. OIEA
reviews the contacts received and decides whether to refer it
to the Division of Enforcement, another SEC Office, or another
regulator. A relatively small number of the contacts received
by OIEA are tips or complaints referred to Enforcement for
further action. The remaining contacts (questions, requests for
information, comments, etc.) are handled by OIEA directly or
sent to the appropriate SEC Office or Division for disposition.
In addition, the Division of Enforcement receives
complaints, tips, and referrals from self-regulatory
organizations, other regulators, other Divisions and Offices of
the SEC, and correspondence from the public not routed through
these other sources. Enforcement staff members also find
matters to investigate through their own surveillance.
Last fiscal year, 1,224 matters under inquiry were opened
based on information received from all sources.
On March 5, 2009, Chairman Schapiro announced that the
agency is undertaking a comprehensive review of the process by
which all complaints, tips, and referrals are handled. As part
of that review, we are considering new processes and systems
for receiving, tracking, analyzing, and acting upon the tips,
complaints, and referrals from outside sources. The team
overseeing this initiative expects to present to the Chairman
in the near future recommendations regarding how to improve the
efficiency, effectiveness, and overall management of how the
agency addresses tips, complaints, and referrals, and how SEC
staff utilizes the information received to protect investors.
------
RESPONSE TO WRITTEN QUESTIONS OF SENATOR SCHUMER
FROM ROBERT KHUZAMI
Q.1. How does the SEC plan to use the additional $40 million in
funding that it may be receiving? Do you plan to hire financial
analysts, traders, and accountants with real industry knowledge
and experience to help you investigate and oversee today's
increasingly complex capital markets? If so, how many?
A.1. We intend to hire staff with specialized expertise in
financial services and other related areas, including product
specialists, traders, and others. The exact numbers of these
specialized hires will depend, among other things, on
availability and competing demands for resources. For example,
we also need to hire more trial lawyers, which will enable the
SEC successfully to litigate increasingly complex cases and
demand tough sanctions. We need additional support staff, since
attorneys and others currently spend far too much time doing
tasks more efficiently undertaken by paraprofessionals.
Finally, we require improved information technology systems,
including document management systems, so that cases can be
investigated and brought more quickly and efficiently.
Q.2. When do you expect the reorganization, including the
hiring of new staff, to occur?
A.2. Various workstreams have been examining different aspects
of our structure and operation. Some recommendations, primarily
those dealing with internal procedures and process, have
already emerged from that process, and we are preparing to
discuss those recommendations with other SEC divisions and
others within the SEC, and then to commence implementation.
Other aspects of our initiative, including recommendations as
to specialized groups and management restructuring, will be
forthcoming on a rolling basis starting in June 2009. The
hiring of new staff is also conducted on a rolling basis, and
we have already begun the task of reviewing resumes from
various market specialists. We have also closed out the posting
for a new Business Manager for the Enforcement Division and
expect to commence interviews immediately.
Q.3. Should the SEC have investigative powers over currently
unregulated entities, including hedge funds, and unregulated
products, including credit default swaps, to ensure the
integrity of our capital markets?
A.3. I believe that it is critical to have investigative powers
over unregulated entities, particularly hedge funds, and
unregulated products, including credit derivatives. Although
the SEC has antifraud authority in many of these areas, my view
is that we need significant additional access to information
regarding those entities and products. In particular, we need
access to trading information to enable us to combine that
information with information obtained from regulated entities
to make sure that we have a full picture of the financial
markets and to be better able to detect wrongdoing.
Hedge Funds: Unregistered and unregulated private funds,
such as hedge funds, represent a significant segment of the
financial markets that is predominately below the radar. The
Commission currently lacks basic data about private funds and
thus, lacks significant knowledge concerning an important
segment of the market. It is essential that we have better
knowledge of who these private funds and their managers are,
how they meet their obligations to their investors, and the
impact their investment activities have on the overall
financial markets. Currently, without specific SEC authority to
register and oversee private funds and their advisers, our
access to this information is limited, which makes it much more
difficult for the Commission to identify misconduct.
Registration of private funds will accomplish two important
objectives. First, it will enable us to gather and compile
comprehensive information about the entire private fund
industry--permitting us to measure the size, influence, and
impact of the industry in a manner currently unavailable to the
Commission. Second, registration and rule-making authority over
private funds will permit us to ensure that individual hedge
funds are maintaining information, especially trading records,
across financial instruments in a uniform manner. With uniform
reporting and recordkeeping standards, we can then more
effectively examine and investigate whether hedge funds and
other institutional traders are engaging in manipulative
conduct across financial instruments.
Security-Based Swap Agreements: Although the SEC has
antifraud jurisdiction over security-based swap agreements,
including credit default swap agreements, the agency does not
have authority to promulgate rules related to reporting or
recordkeeping in this area, which would provide the type of
information we typically would use to identify suspicious
trading patterns. This information gap substantially inhibits
our enforcement efforts in this area. Although efforts to
provide central clearing for credit default swaps will bring to
this market much-needed transparency, providing the Commission
with authority to impose uniform recordkeeping and reporting of
derivative transactions, particularly by hedge funds and
broker-dealers, will bring significantly more transparency to
our complex financial markets. For example, with this
authority, staff can more easily pinpoint where manipulative
credit derivative trading occurs in tandem with other trading
strategies, such as short selling, that put selling pressure on
particular securities. With enhanced regulatory authority over
certain derivatives, SEC staff, particularly its examination
and enforcement staff, can better surveil, examine, and uncover
deceptive or manipulative conduct across both standard and
complex financial instruments.
Q.4. Will you consider allocating or reallocating some of the
personnel to New York City as part of the shake-up of your
Enforcement Division?
A.4. We will undertake to review the allocation of resources to
the New York Regional Office. Having said that, we are at the
same time attempting to break down the silos that can flow from
a regional structure, and to create a truly national program in
which the connectivity amongst staff and offices is increased,
thus facilitating the sharing of knowledge and efficient use of
resources.
Q.5. How close are you to naming someone to lead the New York
Regional Office? Are you considering naming someone who is a
former Federal prosecutor with securities experience?
A.5. We are in the very final stages of the hiring process. We
have an abundance of highly qualified candidates, including
those with the profile you mention. We anticipate making an
announcement shortly.
Q.6. Should the Enforcement Division have a hotline the public
can call?
A.6. Although the public has a variety of ways it can contact
the SEC, including phone lines, the establishment of an
Enforcement hotline number is one item under consideration as
part of the Commission's current assessment of its handling of
complaints, tips, and referrals.
On March 5, 2009, Chairman Schapiro announced that the SEC
enlisted the services of the Center for Enterprise
Modernization, a federally funded research and development
center operated by The MITRE Corporation. The MITRE Corporation
is currently working with the SEC to (1) conduct a
comprehensive review of internal procedures used to receive and
evaluate tips, complaints, and referrals, (2) identify ways to
improve the quality and efficiency of the agency's current
procedures, and (3) recommend potential technology solutions
that can assist the SEC staff in more effectively managing and
utilizing tips, complaints, and referrals. This priority
initiative is moving forward swiftly.
Q.7. How does the Enforcement Division coordinate with the
Office of Investor Education and Advocacy and other Divisions
who receive calls about fraud and other securities law
violations? Do individuals who call with an actual complaint
get a call back?
A.7. The complaints, tips, and referrals Enforcement receives
come in from many different portals within the SEC. Complaints
are routed to different groups in Enforcement for handling, and
each group has developed its own protocol regarding how to
process, review, and retain information regarding the referral
or complaint. For example, online complaints and referrals from
the Office of Investor Education and Advocacy are processed
through Enforcement's Office of Internet Enforcement, and SRO
referrals are processed through the Office of Market
Surveillance.
Complaints by individuals taken over the phone are referred
and followed up on as appropriate. For example, the Office of
Investor Education and Advocacy receives tips and complaints
from individuals who call the Office's investor information
number and refers these tips and complaints to Enforcement's
Office of Internet Enforcement as appropriate.
This structure is currently under review. We are
undertaking a comprehensive review of our processes and systems
for receiving, tracking, analyzing, and acting upon the tips,
complaints, and referrals from outside sources. The goal of the
review is to improve the efficiency, effectiveness, and overall
management of how the agency addresses tips, complaints, and
referrals, and how SEC staff utilizes the information received
to protect investors. In this regard, the Commission is seeking
to establish a more centralized process that will more
effectively identify valuable leads for potential enforcement
action as well as areas of high risk for compliance
examinations.
Q.8. Is the Enforcement Division consulted on the
enforceability of the rules the other SEC Divisions are
writing? Is it part of the process?
A.8. Enforcement does comment on SEC rule making, especially
with respect to whether or not proposed rules have an
enforcement impact. There is a process, although not
formalized, by which Enforcement is consulted and reviews and
comments on proposed rule making.
Q.9. How do the other Divisions train and assist the
Enforcement attorneys?
A.9. We have a wealth of in-house expertise. During the course
of any given inquiry or investigation, Enforcement staff can
consult with staff of the other Divisions and Offices. Some
cases--because they are more difficult, novel, or technical--
may require more consultation than others. Topics can run the
gamut from technical expertise on the specific requirements of
a particular rule to broader questions of industry practice,
how to charge a case, or how a contemplated case may impact the
industry.
There is also a formalized process as part of our case
review whereby the other Divisions and Offices review and
comment on proposed Enforcement recommendations before
Enforcement staff presents the recommendations to the
Commission. The other Divisions and Offices may also comment on
Enforcement recommendations when they are being presented to
the Commission.
Part of our training for new hires includes presentations
from the other Divisions and Offices about their areas of
expertise and how they can be of assistance to Enforcement
staff. In addition, the other Divisions and Offices may offer
training sessions for their own staff, to which Enforcement
staff is invited.
Finally, we hope that one of the benefits of specialization
is having more in-house Enforcement expertise that our staff
can turn to earlier in their investigations and more often.
------
RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED
FROM MERCER E. BULLARD
Q.1. As the Bernard Madoff case clearly illustrated, the SEC
fell short in responding adequately to what were clear signs of
fraud. It's not clear that this was a problem of a lack of
resources. Do you have suggestions on steps the SEC could take
to improve its oversight in this area?
A.1. I agree that the failure to detect Madoff's fraud was not
the result of inadequate resources. I have described below the
regulatory causes of the Madoff scandal, in order of
importance, and suggested steps that the SEC could take to
improve its oversight with respect to each cause.
Cause 1: The principal regulatory cause of the scandal was
the failure of Madoff's primary regulator, the Financial
Industry Regulatory Authority (FINRA) to detect his fraud.
During the entire period of his fraud, Madoff was a broker-
dealer regulated primarily by FINRA. Until 2006, when Madoff
registered an investment adviser, FINRA was Madoff's sole
Federal regulator.
FINRA's oversight responsibilities would have included
confirming that client assets custodied with Madoff were
actually in the possession of his broker-dealer firm. FINRA
also is responsible for overseeing advisory activities of
registered representatives of a broker-dealer provided away
from the firm. It is not clear how FINRA could have been
ignorant of Madoff's advisory activities. It appears he was
widely known and sought after as a money manager. When
interviewed by FINRA personnel in the course of inspections,
did Madoff and his employees state that the firm and Madoff
provided no money management services? If FINRA knew about his
money management activities, it should have confirmed the
firm's custody of client assets. In any case, Madoff's 2006
investment adviser registration stated that his broker-dealer
was the custodian for client assets. This should have been a
red flag for FINRA.
The SEC should take a number of steps to address the
problems exposed by the Madoff scandal. \1\ First, it should
order FINRA to conduct an investigation of its failed oversight
and report its findings to the SEC and your Committee. Second,
it should revise its policies that improperly permit brokers
such as Madoff who provide individualized investment advice to
avoid regulation as investment advisers. Third, the SEC should
abandon its plan to recommend legislation that would enable
FINRA to become the primary regulator for investment advisers
pending the completion of the two suggestions provided above.
Fourth, Chairman Schapiro and Commissioner Walter should recuse
themselves from any role in any of the three matters discussed
above on the ground that their prior employment at FINRA
creates at least the appearance of a conflict of interest.
---------------------------------------------------------------------------
\1\ The SEC recently proposed new custody rules, but these rules
would have not have applied to Madoff prior to 2006 because he was not
a registered investment adviser prior to that date.
---------------------------------------------------------------------------
Cause 2: A second regulatory cause of the scandal was the
SEC's policy of permitting brokers who provide nonincidental
investment advice to evade regulation as investment advisers.
If Madoff had registered as an investment adviser in the early
1990s when his fraud began, it is highly likely that an
investment adviser inspection would have uncovered his fraud
many years ago.
The definition of investment adviser under Federal law does
not apply to a broker who does not receive special compensation
and whose advice is solely incidental to his brokerage
services. The SEC has adopted an absurdly broad definition of
``solely incidental'' that until just recently allowed advisers
who exercised discretionary authority over client assets but
charged only commissions (such as Madoff) to evade registration
as investment advisers. There is no and never has been a
rational basis for believing that the exercise of discretionary
oversight could be consistent with ``solely incidental''
services. The SEC conceded this only recently. The SEC's
belated recognition of this fact will not prevent the next
Madoff, however. Under SEC positions, it will be easy for a
broker to claim not to exercise discretion while exercising
effective control over client accounts and thereby run an
unregistered advisory program that is exempt from adviser
inspections. The SEC takes the position that any services
provided ``in connection with and reasonably related to''
brokerage services can be considered ``solely incidental.''
Under this interpretation, it is difficult to imagine any
broker being unable to rely on the ``solely incidental''
exclusion. Any broker that wishes to ensure that only FINRA
oversees its advisory operations can continue to do so.
The steps that the SEC should take in this respect are
simple. It should apply the plain meaning of the broker
exclusion's ``solely incidental'' trigger. Most ``brokerage''
services have become advisory in nature and should be regulated
accordingly. When investors received personalized investment
advice, they are entitled to--and intuitively expect--that the
advice will be subject to the same fiduciary duties that apply
to similar professional advice provided by lawyers and doctors.
Under current SEC positions, brokers can create the appearance
of acting as the client's agent while enjoying the benefit of a
salesman's nonfiduciary status. This is not to say that the
Madoff scandal reflects the failure to apply a fiduciary
standard to his conduct. Rather, it is to say that the Federal
securities regulatory scheme for retail services is designed
and should be applied so as to provide additional investor
protection as the relationship increasingly engenders trust and
confidence in the regulated professional. Madoff's business
model depended on a high level of client trust and confidence,
but because of lax SEC positions that relationship was not
subject to the heightened regulatory standards that would have
caught his fraud much sooner, if not prevented it altogether.
Cause 3: A third regulatory cause of the scandal was the
SEC's failure to act on tips from Harry Markopolos. This cause
is only third in this discussion for two reasons. First, the
tips did not begin until 1999, whereas the fraud had been
perpetrated under FINRA's nose since the early 1990s, as
discussed above. Second, earlier registration as an investment
adviser also would have stopped Madoff's fraud long before
1999. Both failed FINRA oversight and Madoff's delayed
registration as an adviser are far more significant factors in
the scandal than the breakdown in the SEC's whistleblower
procedures.
Indeed, whistleblower tips are an inherently inefficient
means of achieving enforcement goals. It would be impossible
for the SEC to conduct a complete investigation of every one of
the hundreds of thousands of complaints that it receives each
year. If it did so, it would do nothing else. The most
efficient means of detecting fraud is through inspections and
market monitoring.
That being said, whistleblowers can be a useful source of
information, provided that it is understood and accepted that
some credible allegations of violations inevitably will slip
through the system. There is no mechanical system that will
catch every credible complaint, and no system based on human
judgments can eliminate the possibility of human error. We
should expect and accept that there will be significant frauds
that are revealed in complaints but not fully investigated. The
costs of a system designed to investigate fully all such
complaints would far outweigh the benefits.
Any system that failed to surface Markopolos's tips,
however, could not have been reasonably designed to provide an
effective means of reviewing complaints. In that case, the
failure exposed a flawed system of reviewing complaints.
Chairman Schapiro's proposed whistleblower reforms are the
right way to address this problem. The SEC has enlisted the
Mitre Corporation to assist it in developing an efficient
system for managing and utilizing tips, complaints, and
referrals. The SEC appears to recognize that the importance of
applying modern information management systems in this context
while avoiding promises of a perfect process.
Cause 4: A final cause of the scandal was the SEC's failure
to inspect Madoff once he registered as an investment adviser
in 2006. An SEC inspection would have included verification of
custody of client assets, which would have uncovered his fraud.
It should be noted, in this respect, that Madoff's fraud had
been underway since the early 1990s, when he was subject only
to FINRA's oversight, and Markopolos first provided information
to the SEC in 1999. The failure to inspect Madoff was only a
regulatory cause of the scandal to the extent that it operated
from 2006 to 2008. It should also be noted that Madoff's
registration occurred at the time when thousands of firms were
newly registering in response to the SEC's new requirement that
hedge fund managers register, but this does not excuse the
failure to inspect Madoff in a timely manner.
At the time that Madoff registered, he claimed to have $17
billion in client assets under management. Although the failure
to conduct inspections may, in some cases, be attributable to a
lack of resources, the failure to inspect Madoff was not. When
an advisory firm of that size files its initial registration,
an inspection should be immediate. In other words, resources
that are available should be devoted first to this kind of
inspection. The failure was one of allocating resources, not a
lack of resources.
The improvement that needs to be made to address this
oversight is to ensure that certain filings automatically
trigger an inspection, such as the new registration of an
investment adviser with more than a certain amount of assets
under management. Lori Richards, Director of the SEC's Office
of Compliance Inspections and Examinations, spoke recently
about the SEC's surveillance in which it analyzes data in
investment adviser registration forms to assess their relative
compliance risks. \2\ This is the kind of program that should
trigger an immediate inspection for a new registrant such as
Madoff. Richards stated that this analysis is run only once
each year (in September), however. It should be run on a
continuous basis with respect to all new registrations and
certain types of registration amendments.
---------------------------------------------------------------------------
\2\ Her speech is available at http://www.sec.gov/news/speech/
2008/spch121608lar.htm.
Q.2. What information would better assist the SEC in
identifying and acting upon problems such as market
manipulation, insider trading, and other misconduct? What
---------------------------------------------------------------------------
surveillance tools would help in this effort?
A.2. The SEC generally has an effective system for identifying
problems such market manipulation, insider trading, and other
misconduct. The question of what information would better
assist the SEC in acting upon problems once they have been
identified is discussed below.
Q.3. The Enforcement Division faces key challenges in targeting
its resources among a large and constantly changing universe of
potential fraud. The SEC must act decisively to address new
activities, while conserving precious resources for other
important areas. How can the SEC most effectively target its
resources to oversee a broad and changing set of issues?
What are the key factors the SEC should be identifying and
considering to determine if and how to take action?
You note in your written testimony that the SEC does not
add value by investing resources in dozens of cases involving
the same misconduct once it has clearly established its
position. Please elaborate on this statement.
A.3. I have combined my answers to these three questions
because they are essentially interrelated.
The mission of the SEC's enforcement program should be to
prevent, detect, and deter securities fraud, and to play the
leading role in securities enforcement. Toward this end, the
SEC has developed an effective strategy for efficiently
allocating its resources, responding to a quickly changing
business environment, and deciding when and how to take action
in response to fraud. As noted in my testimony, however, the
SEC may have a tendency to overinvest resources in multiple
cases involving the same underlying conduct. This tendency
results in an inefficient allocation of resources and diverts
attention from developing problems in the financial services
industry. It also undermines the SEC's leadership role in
securities enforcement. The SEC should be more strategic in
deciding when and how to take action in response to widespread
fraud.
In a number of instances, the SEC has brought dozens of
cases involving essentially the same kind of misconduct. In
some of these cases, it has done not on its own initiative, but
following the lead of State enforcement agencies and private
litigants. In other areas of misconduct, it has not brought any
enforcement actions, choosing to allow the law to be determined
by multiple State actors and State and Federal courts without
the uniformity that only the SEC can provide. The result is
less effective protection for investors and more costly
compliance for regulated entities.
The SEC should seek to identify potential areas of fraud,
investigate them, and prosecute misconduct in a way that
exploits the potential benefits of overlapping jurisdiction and
efficiently manages its resources. There are many actors on the
securities enforcement stage, but only one actor can provide
the centralized leadership and uniformity that optimizes
efficient and effective national securities enforcement. The
SEC is uniquely situated to gauge the significance of potential
areas of fraud across the country, uniquely skilled in
understanding the ideal balance between investor protection and
free markets, and uniquely equipped to coordinate enforcement
activities across a wide spectrum of actors.
The SEC should respond to widespread abuses by using the
full range of mechanisms that are available to accomplish its
enforcement goals. For example, one might roughly organize
potential mechanisms and the related investment of SEC
resources for widespread misconduct, such as mutual fund market
timing or options backdating, as follows:
Federal and State criminal action followed by SEC
administrative action,
SEC administrative action,
Joint SEC/State administrative Action,
Section 21(a) investigation report,
State administrative action,
Private lawsuits,
Nonlitigation private resolution (e.g., board
action),
Private voluntary remediation pursuant to internal
investigation,
Rule-making/interpretive guidance, and
Commission/Director speeches.
Each of these mechanisms can provide significant prevention
and deterrence benefits, in many cases with a much smaller
expenditure of SEC resources than would be incurred in a full-
blown investigation. In cases of widespread misconduct, the
egregiousness of the misconduct typically varies greatly. Some
cases will militate for criminal penalties and administrative
proceedings--the highest investment of SEC resources. At the
other end of the spectrum will be marginal misconduct that can
be addressed, for example, through Commissioner speeches
reminding regulated entities of their responsibilities.
For the cases that warrant administrative action, the SEC
does not need to bring every case itself. State securities
commissioners and attorneys general have demonstrated their
interest in securities enforcement. The SEC should not hesitate
to refer cases for prosecution solely by State authorities, or
to bring joint proceedings where the SEC's investment of
resources can be reduced through a sharing arrangement. When
misconduct is the subject to private litigation, the SEC should
consider whether that mechanism will serve an adequate
enforcement function in lieu of an SEC action. In some cases,
the SEC may wish to intervene in such cases, which would still
place less strain on SEC resources than a full-blown
administrative proceeding. In other instances, a fund board or
board of an operating company may negotiate a settlement and
airing of the facts that is adequate. A self-reported internal
investigation with follow-on remedial measures can serve a
similar purpose. The SEC's evaluation of its enforcement
program should integrate all of these mechanisms, especially in
view of the SEC's role in the administration of the FAIR Fund
program.
The following discussion provides three illustrations of
these principles. The first illustration is the mutual fund
market timing scandal in which the SEC brought dozens of cases.
The scandal was based partly on arbitrageurs' exploitation of
mispriced fund shares, a problem that was known to the SEC and
about which it had done nothing. Not surprisingly, a State
attorney general brought the first market timing cases, with
the result being that it, rather than the SEC, played the
leading role in establishing standards in certain respects for
mutual fund operations, governance and fees. To this day, the
SEC has not brought an enforcement action for stale pricing.
The same attorney general also took the lead in establishing
standards for addressing analysts' conflicts in yet another
problematic area of which the SEC was fully aware but
inexcusably inactive.
The mutual fund scandal also illustrates the inefficient
use of SEC resources by bringing dozens of cases even after the
SEC's position has been clearly established in the area. The
SEC should not bring every case when it discovers widespread
abuses such as mutual fund market timing, analyst conflicts,
and backdating options. Market timing cases are still being
resolved today, more than five years after the scandal began.
As discussed above, the SEC should evaluate the egregiousness
of the conduct involved and take a range of actions that are
matched to the conduct. In cases of widespread fraud, many of
the implicated parties will not represent inherently bad
actors, but rather firms whose well-meaning compliance
procedures were not adequately designed to prevent abuses. When
many industry participants engage in certain types of
misconduct, the line between legal and illegal conduct becomes
blurred and it becomes more difficult for compliance
departments to take strong positions against the natural
pressures of competition. In many cases, there is little gained
by bringing an enforcement action rather than seeking a
resolution through less resource-intensive approaches.
I have conducted an extensive review of the enforcement
actions brought in the market timing scandal, and it is my
opinion that the SEC brought far too many cases. It is likely
that the options backdating cases reflect a similar problem.
The SEC should more aggressively pursue alternative approaches
to many of these cases, including handing off more
investigations to States, issuing section 21(a) reports, and
monitoring private resolutions and internal investigations. The
SEC must be willing not to bring cases number 10 through 20 in
one area in order to redirect those resources to bringing cases
number 1 through 5 in areas that otherwise would go untended.
SEC resources are finite, and every additional market timing or
options backdating cases reflects an investment in resources
that are not invested somewhere else.
The BISYS case provides a current illustration of the
likely overcommitment of resources to stale matters. In
September 2006, the Commission reached a settlement with BISYS
Fund Services, Inc., that was based on BISYS's payments to 27
unnamed fund managers in return for their recommending that
their funds use BISYS as the fund's administrator. The
arrangements were in place from June 1999 and July 2004, which
means that more than 2 years already had passed before the
Commission settled with BISYS. Since then, the Commission has
brought cases with respect to only one of the 27 fund managers,
the earliest occurring another 2 years after the BISYS
settlement, in September 2008. \3\ The fund managers'
arrangements with BISYS had already been terminated for over 4
years. The fate of the other 26 fund managers appears to remain
unresolved. The investigations regarding the unlucky 26 are
probably ongoing, with some inching toward a resolution and
others floating motionless in an investigation purgatory
awaiting a final decision on their fate. \4\
---------------------------------------------------------------------------
\3\ See In the Matter of AmSouth Bank, Admin. Proc. No. 3-13230
(Sep. 23, 2008) available at http://www.sec.gov/litigation/admin/2008/
ia-2784a.pdf.
\4\ In the latest twist in the BISYS scandal, BISYS (now a
Citigroup subsidiary) has submitted to the SEC a proposed plan to
distribute settlement amounts to the 27 fund families that had
marketing arrangements that were subject to original enforcement
action. None of the fund families is named, notwithstanding the strong
implication that each fund manager engaged in wrongful conduct and the
distributions' indirect reflection of a finding that each fund manager
engaged in wrongdoing.
---------------------------------------------------------------------------
The types of relationships involved in the BISYS case
trigger complex regulatory issues. Every attentive mutual fund
lawyer would have read the BISYS settlement with an eye to
future settlements that would clearly delineate appropriate
from questionable conduct. It is not the plain vanilla bribery
case that needs further explication--there, severe punishment
and the deterrence it creates should be the SEC's primary goal.
No guidance is necessary. But among the 27 fund managers with
whom BISYS had a relationship there are undoubtedly borderline
cases, i.e., fact patterns that compliance personnel might not
immediately recognize as being questionable or crossing the
line into illegality. Yet no such guidance has been
forthcoming. The BISYS scenario remains an area of legal
uncertainty. The SEC should bring more cases to clarify the
contours of what it considers to be illegal conduct. (Many of
the funds have reached private settlements with the fund
managers who were involved in the scandal which may reflect an
adequate enforcement resolution in those cases.)
A final illustration is the SEC's recent enforcement action
for a violation of section 15(c) of the Investment Company Act.
\5\ The SEC settled charges with a fund manager for violating
section 15(c)'s requirement that it provide material
information to the fund's board that was necessary to for the
board to evaluate the fund manager's fee. The SEC also found
that the fund manager's actions constituted willful fraud under
the Investment Advisers Act. These facts also would have formed
the basis for liability under section 36(b) of the Investment
Company Act, which creates a private and public cause of action
against a fund manager that violates its fiduciary duty to the
fund with respect to the fees it receives. \6\ While the SEC
has developed no precedent under section 36(b), private
litigants have brought numerous cases over many decades that
have generated various interpretations by dozens of judges. \7\
Conflicts among these judges' positions recently led the
Supreme Court to take a section 36(b) case (Jones v. Harris
Associates). The Court will be left to make this determination
with virtually no guidance from the SEC.
---------------------------------------------------------------------------
\5\ See In the Matter of New York Life Investment Management LLC,
Admin. Proc. No. 3-13487 (May 27, 2009).
\6\ It is not possible for someone not involved in the
negotiation of this section 15(c) settlement to know definitively
whether this particular case was the right opportunity to bring a
section 36(b) claim (e.g., perhaps the factual basis was not as strong
as the record suggests and the defendant refused to agree to a finding
under section 36(b)). The point here is that the SEC's enforcement
program should be designed so that the potential strategic benefits of
bringing a section 36(b) claim in such a case would be thoroughly
reviewed. The fact that the SEC has failed to provide guidance as to
what constitutes a violation of section 36(b) illustrates a failure to
apply this approach.
\7\ In connection with the mutual fund market timing scandal, the
New York State Attorney settled a number of claims for excessive fees
in which the fund manager agreed to reduce its fees for a certain
period. Remarkably, the SEC criticized the NYAG for bringing these
claims, notwithstanding the SEC's own failure to establish any standard
for excessive fees.
---------------------------------------------------------------------------
The 15(c) case cited above illustrates the kind of
opportunity that the SEC has failed to take to clarify the law
and create efficiencies for shareholders and fund managers
alike. The only beneficiaries of the uncertainty created by the
SEC are litigators. After the Supreme Court decides Jones, the
situation is likely to be exacerbated. The Court will provide
guidance as to the standard for excessive fee cases, and
Federal trial and appellate courts will spend years defining
the precise contours of the new standard. This situation could
have been avoided if the SEC had established clear standards
under Section 36(b). Its failure to do so has imposed and
continues to impose a heavy tax on investors.
The Commission is under pressure to generate a large number
of enforcement actions, which can undermine its effectiveness
as an enforcement agency. Chairman Schapiro stated recently
that the SEC has ``approximately 150 active hedge fund
investigations . . . about two dozen active municipal
securities investigations . . . and more than 50 current
investigations involving Credit Default Swaps, Collateralized
Debt Obligations and other derivatives-related investments.''
How will these investigations be winnowed to a group of
enforcement actions? If the SEC finds a common type of fraud in
these cases, will it feel compelled to bring an enforcement
action in every case? If 120 cases can be made in the 150 hedge
fund investigations, will the SEC bring all of them, thereby
adding 120 actions to its headcount for the year? If it does,
will that prevent it from committing additional resources
necessary to supporting a handful of criminal prosecutions?
What would the resources being invested in hedge fund
investigations number 10 through 150 be invested in if not in
those cases? What are the opportunity costs?
The enforcement division should develop a structure for
conducting an opportunity cost analysis for every area in which
the staff is investing resources. This structure would identify
alternative areas of inquiry in which those same resources are
not being invested and provide a cost-benefit analysis to
determine whether prevention, detection, and deterrence goals
continue to be best served by prosecuting multiple cases
involving similar misconduct. Metrics should be developed to
recognize and quantify the value of an enforcement program that
prizes efficient utilization of resources rather than brute
case totals. Securities enforcement is not a business activity,
but the application of business principles can help the SEC
greatly improve its process of deciding if and how to take
action.
------
RESPONSE TO WRITTEN QUESTIONS OF SENATOR DODD
FROM BRUCE HILER
Q.1. It is important that the SEC continually strive to have an
Enforcement staff with the expertise and industry experience to
properly police the markets. You noted in your written
statement that although there are individuals at the SEC with
expertise outside of the normal expertise of attorneys
(sophisticated financial instruments, trading strategies,
accounting, risk analysis, economic modeling), it should expand
the number of such experts. Please elaborate on this statement.
A.1. As I noted in my written statement, there already are
individuals at the Commission with expertise in areas outside
of the legal field. Many of these individuals are not in the
Division of Enforcement. For example, members of the Office of
Economic Analysis are available to perform market and economic
analyses relevant to certain types of investigations. Members
of the Office of the Chief Accountant, the Office of the
General Counsel, the Division of Trading and Markets and the
Division of Investment Management similarly are available to
assist in analysis and interpretation of the rules which they
have drafted for adoption by the Commission, and to provide
input on the operation of the markets and market participants
in the areas which those offices cover, e.g., accounting
issues, broker-dealer firms, mutual funds, clearing agencies,
and transfer agents.
However, individuals in these other offices and divisions
have other duties, and they are not regularly available to
assist in the day-to-day investigative work of the Division of
Enforcement. They also may not be readily identifiable by
Enforcement personnel, and some Enforcement personnel may be
reluctant to seek the advice of these individuals. For example,
as noted in the GAO Report which was a topic of the May 7
hearings, some personnel in Enforcement who were interviewed
expressed the view that other offices and divisions at the
Commission ``had become too influential in effectively
controlling Enforcement activities.'' GAO Report at p. 28. As I
noted in my oral response to a question from Senator Bunning, I
believe that in fact it is important for members of the
Division of Enforcement to consult with individuals in other
offices and divisions on issues within the expertise of those
offices early in an investigation and throughout an
investigation. It is members of those offices who have drafted,
proposed, analyzed the public comments on, and presented the
rules and regulations being enforced to the Commissioners for
consideration and adoption. The Commissioners do and should
value the input of those offices. This type of in-depth
consultation by the Division of Enforcement, if fully
effectuated, however, would place an additional burden on the
resources of those other offices and divisions.
In my view, to deal with the expertise issue, the
Commission should either add experts in various fields to
special units within the existing offices and divisions and
assign them to be readily available to the Enforcement
Division, or form a new office in which it could group experts
who would be available to assist the Division of Enforcement on
a regular, day-to-day basis with investigations. These experts
also could work with divisions other than the Division of
Enforcement on special projects within their expertise. I think
the areas of expertise most needed involve (i) knowledge of the
structure of new, complex financial products, which are ever-
evolving, and of the market forces driving the creation of
those products, (ii) the ability to analyze risk associated
with, and the reasoning behind, complex trading strategies and
positions, (iii) knowledge of corporate treasury and earnings
management strategies, and (iv) knowledge of various types of
economic modeling.
It will be difficult to attract such individuals without
something approaching pay parity with the private sector. I
also believe that having a separate office of such experts will
increase the likelihood of attracting well-qualified
individuals. Having a separate office and title structure will
allow the work of these individuals to be, and to be viewed as,
more objective, and would give them additional prestige within
the Commission. I believe that experts who are not ``tied'' to
the Enforcement Division, will view the opportunity for broader
exposure to the work of the other offices and divisions of the
SEC, and for being able to interact more closely on a daily
basis with colleagues with similar expertise and experience, as
pluses in terms of recruiting.
Q.2. As the Bernard Madoff case clearly illustrated, the SEC
fell short in responding adequately to what were clear signs of
fraud. It is not clear that this was a problem of a lack of
resources. Do you have suggestions on steps the SEC could take
to improve its oversight in this area? What information would
better assist the SEC in identifying and acting upon problems
such as market manipulation, insider trading, and other
misconduct? What surveillance tools would help this effort?
A.2. I am not in a position to comment on the Madoff situation.
In addition to the fact that my law firm has clients who
invested with Mr. Madoff, I simply am not privy to sufficient
facts to make a judgment about the SEC's conduct in that
matter. In my experience, however, it certainly is not the
usual course of conduct for the SEC to fail to respond
appropriately if there are ``clear signs of fraud.'' Indeed, I
and many in the private securities bar are more concerned over
the SEC being pushed to act precipitously or to expand its view
of what is fraudulent conduct in response to criticisms that it
has ``missed'' frauds or has come late to the investigative
party. I speak more to this below, in response to the third
question presented to me.
In terms of resources and oversight relevant to discovery
of situations like that alleged in the Madoff matter, the SEC
does employ market and financial analysts who are available to
assist on enforcement investigations, and many staff attorneys
have experience in dealing with Ponzi schemes and misuse of
investor funds by advisors. In my experience, the SEC presently
relies on at least four sources for information about possible
market manipulations and insider trading. I lump these two
types of conduct together, because they are trading-based
frauds, and thus have common sources of surveillance. First,
and foremost, the stock and option exchanges and the Financial
Industry Regulatory Authority (FINRA) utilize sophisticated,
computer-based systems for identifying possible manipulative
trades or trades that may be indicative of trading on inside
information. These entities compile and review this information
and forward it to the SEC for investigation, though in certain
cases, where they have ``jurisdiction,'' they also investigate
the matter themselves. Second, the SEC's Office of Compliance,
Inspections and Examinations (OCIE) conducts inspections of
regulated market participants, and attempts to identify
possible illegal trading either by the participants or their
customers. Third, the SEC relies on tips from members of the
public who may have heard of possible manipulative or insider
trading. Finally, SEC staff members monitor the markets and the
press to spot irregular trading patterns that may be indicative
of such conduct.
In terms of ``other misconduct'' mentioned in your
question, there are numerous types of possible misconduct which
the SEC regularly investigates, which differ significantly from
the conduct alleged in the Madoff matter. These types of
conduct sometimes involve different regulatory regimes or
statutes within the SEC's responsibility. The sources of
information used by the Division of Enforcement to uncover
misconduct differ depending on the type of conduct or the
entity engaging in the conduct--For example, OCIE examines
registered investment advisers, broker-dealers and other
regulated entities, and may uncover misconduct involving an
adviser or broker-dealer vis-a-vis their customers. Those
customers can include individuals, institutions and mutual
funds. The Division of Trading and Markets or Investment
Management may notice suspect activity in reviewing reports
filed by the market participants with which they are generally
involved. The Division of Corporation Finance may uncover
misconduct in reviewing and commenting on public filings by
issuers. An outside auditing firm or an insider at an entity
also may uncover misconduct and report it to the Commission
staff.
Despite the SEC's pursuit of and access to the above
sources of information, as I noted in my written statement, it
can be difficult for any agency to detect fraud at anyone of
the thousands of entities over which an agency such as the SEC
has some jurisdiction. Individuals who commit frauds generally
try to hide them, and some conduct which may appear suspicious
or ``unusual'' at first look, may be entirely legal, though
novel or complex. Where an individual or individuals are
determined to falsify books and records and where third parties
who may review or be provided copies of those records fail to
notice irregularity, it can be difficult for the SEC quickly to
obtain credible evidence of that irregularity. The SEC's
statutory authority also provides various surveillance tools,
such as those mentioned above: regulated market participants
are subject to inspection by the SEC and by self-regulatory
organizations; independent audits are required of certain
entities; financial condition filings and reports by certain
entities are required and are available for review by the SEC,
institutional investors and the public generally, and the
exchanges and FINRA have sophisticated computer-based market
surveillance systems. Despite all of this, an organization can
only get through so much data per employee in a disciplined
fashion, and fraud can be difficult to detect even by auditors
who have on-site and extensive access to the books and records
of the entities which they audit.
In light of the above, I am not aware of additional,
realistic surveillance tools which could assist the Commission.
I am afraid that the best suggestion I can come up with to
increase detection and prevention of fraud is a ``boots on the
ground'' approach, and the suggestion I made in my written
statement, and which I discuss below, concerning nonadversarial
contact by regulators with market participants.
Q.3. In your statement you said that the SEC might be more
successful at getting early warning signs of problems if it
maintained more of an open line of communication with regulated
firms, and moved away from the current atmosphere of suspicion
that exists today. Can you expand on your thoughts? Does this
present risk of regulatory capture?
A.3. In my experience, one of the best sources of information
about risky conduct or possible misconduct may be someone with
experienced-based knowledge of a particular industry or of an
organization and its practices. This does not have to be an
actual insider of the organization, and it does not mean that
anything an insider or former insider says should be accepted
at face value. Indeed, in my experience the Commission staff
is, and should be, cautious about statements made by a
potentially disgruntled employee or former employee of an
entity, or by a competitor of an entity. And, of course, once
an insider decides to expose possibly violative conduct, it has
been ongoing for at least some period of time.
I believe that first-hand experience of SEC staff personnel
with market participants, outside of an Enforcement inquiry or
an inspection, is one of the best ways for the staff to assess
the credibility of and the risks associated with a business
organization. The SEC often forms advisory groups with which it
consults on various issues, but it also is important to
establish an open line of communication on a more regular basis
with market participants and issuers and for the SEC to reach
out to business leaders regularly to discuss business and
regulatory issues informally. It is through such contact that
the SEC can gain a more up-to-date understanding of the issues
facing the markets and the risks associated with certain
strategies. Through these communications the SEC can also move
more quickly to give public guidance in areas involving complex
or emerging issues, and to avoid after-the-fact review of
conduct and situations which may develop in a fashion which the
SEC later determines is not appropriate.
I do not believe that such contact will result in
``regulatory capture.'' Those who work at the SEC are
professionals who make certain sacrifices in choosing public
service, and, though they are not immune from normal human
reactions to more frequent contact between individuals, the
context of the contact, the relative infrequency of it even if
an open line of communication is established, the sensitivity
on both sides to the interests which each participant
ultimately serves, and the close monitoring of the SEC by
Congress, the media and the public in general, I believe will
provide sufficient protection from regulatory capture.
An open line of communication must be a two-way street to
be effective. The regulated must be willing to respond. As I
noted in my written statement, I believe that in the last 10
years, an atmosphere of suspicion has developed between the SEC
and market participants and issuers in some cases. In my
written statement I briefly noted my thoughts on the sources of
this tension. One source is, that in stark contrast to the
picture of weak SEC Enforcement efforts painted in the media, I
believe that many market participants and issuers view the
SEC's Enforcement efforts in this decade as very aggressive
across the board. In the last 5 years, the SEC has conducted
numerous market ``sweeps,'' in which it sends requests for
voluminous information to many market participants or issuers
at the same time regarding different areas of concern or
interest. The sweeps call for extensive document production as
well as provision of written statements or information, and are
very time consuming and expensive. Regulatory inspections have
been often lengthy and may overlap with other regulatory bodies
or even other offices within the SEC.
In addition, as expressed in the Report on the Current
Enforcement Program of the Securities and Exchange Commission,
issued by the U.S. Chamber of Commerce in March 2006 (Chamber
of Commerce Report), it seems that ``the current pro-
enforcement atmosphere and criticisms of the Commission's
enforcement program . . . have encouraged the Commission to
advance aggressive theories through enforcement actions, where
the relevant facts are far from clear.'' Chamber of Commerce
Report at page 17. I and my law firm were counsel to David
Andrews, who was engaged by the Chamber of Commerce to develop
the Report, and I refer to it because of my participation in
authoring it and because the views expressed in the Report are
consistent with mine. The Commission relies extensively on the
Staff to interpret facts discovered in an investigation and to
recommend enforcement actions. This often requires evaluation
of difficult factual issues and determination of whether
malleable standards like ``recklessness'' or ``materiality''
are met. As noted in the Chamber of Commerce Report, although
no one disagrees that clear cases of fraud should be pursued
aggressively, there is a feeling ``that there is a lack of
appropriate consideration by the Commission of the difficulties
with which executives are faced in interpreting complex
disclosure, accounting and legal issues and in uncovering
fraud.'' Chamber of Commerce Report page 17. As former SEC
Chairman Donaldson cautioned in a speech in September 2003,
``enforcement of the laws can, in some circumstances, become a
vehicle for changing the rules . . . an enforcement proceeding
can realign an industry standard in much the same way as a new
rule, at times, making the line between rule making and
enforcement unclear.'' \1\ This issue also extends to
consideration by criminal prosecutors dealing with securities
law cases, and can be much more acute in such instances. See
Chamber of Commerce Report at pp. 23-24.
---------------------------------------------------------------------------
\1\ William H. Donaldson, Speech by SEC Chairman: Speech to NASAA
Annual Conference (Sep. 14, 2003) (available at http://www.sec.gov/
news/speech/spch091403whd.htm).
---------------------------------------------------------------------------
Another source of tension between the Commission and
industry participants and issuers is the Commission's use of
its penalty powers. The GAO Report which was a topic of the May
7, 2009, hearings, spent some time reporting its findings on
the SEC's penalties program, and concluded, among other things
that recent SEC policies ``have had the effect of making
penalties less punitive in nature . . . '' and that there is
``a perception that the SEC has retreated on penalties,'' GAO
Report at page 7. I agree that the SEC's recent pilot program
requiring that the Commission approve a range of possible
penalties before the Enforcement staff was allowed to begin
negotiating a settlement with an entity that is the subject of
a possible enforcement action slowed the process. However, I
disagree with the implication that penalties serve a deterrent
purpose on corporate or other entities, and that penalties must
be ``punitive'' and must ``punish'' entities for the misdeeds
of their employees, at least where the entity itself is not an
entirely corrupt organization. Rather, I believe that the
publicity and cache given to the size of penalties in the
public eye encourages the SEC to seek larger and larger
penalties and discourages entities from engaging in a dialogue
with the Commission staff about uncertainties over trading
strategies or other activities. When coupled with an aggressive
interpretation of standards for fraud liability, a move toward
large corporate penalties only exacerbates tensions between the
Commission and those it regulates.
One might not be concerned about such tension if penalties
on entities truly did deter future conduct. However,
corporations do not commit fraud; individuals who work for them
do so. And I do not believe that monetary penalties appreciably
increase the incentive of corporate boards or executives to
attempt to prevent and detect fraudulent conduct. Honest
corporate boards, executives and employees already have
adequate incentive, and indeed, legal requirements, to police
themselves and those who work around them. Corporations are
required by the Federal securities laws, including recent
additions under the Sarbanes-Oxley Act of 2001, to take
extensive steps to set internal controls and to monitor and
attempt to prevent and detect fraudulent conduct by employees.
In addition, the monetary costs incurred by an entity which
becomes involved in an SEC investigation are in effect a
penalty, and are potentially enormous. The cost to the entity
to retain counsel and experts to conduct an internal review, to
defend the corporation in an investigation and often to provide
separate counsel to its Audit Committee and employees can be in
the tens of millions of dollars. Many of these direct costs may
be defrayed by D&O insurance, depending on the amount that had
been purchased, but insurance policy amounts run out and
increased insurance costs in the future are real. Also, there
is inevitable shareholder litigation which may take multiple
forms and which requires additional counsel and experts to be
retained. Settlements of shareholder actions can run into the
hundreds of millions of dollars in egregious cases. The cost in
person hours, morale, and loss of goodwill and good employees
also can be very high, especially in light of more recent media
and shareholder sophistication and attention to such issues.
When conduct of some at a corporation begins to make headlines,
whether or not involving egregious misconduct, the jobs of even
those executives who were not involved in the conduct are at
risk and their reputations are severely damaged. All of this
provides adequate deterrence and incentive to the honest
employees of a corporation or other entity to take strict
measures to prevent and detect improper conduct.
Finally, I have never accepted that an individual who is
brazen and self-interested enough to engage in a fraud at a
public company or a regulated entity would be deterred, let
alone punished, by the idea that if they are caught a penalty
may be levied against his or her employer. Indeed, by the time
the fraud is discovered and gets to a penalty stage, the
offending employee(s) most certainly are gone and their last
concern is about what happens to the entity.
I have heard the argument that if penalties do not deter,
then why is there so much concern over them? Despite their best
efforts, honest boards of directors, executives, and employees
cannot be certain that they are preventing fraudulent
activities by even senior executives. Thus, the concern over
penalties and over an apparent race to satiate the public
appetite for ever larger penalties is that an entity will
someday be caught in the vise of public outcry and the
practical need to resolve a matter in which the government is
calling for a very large penalty as a result of conduct which
honest executives or board members were unable to prevent. I
also believe that the push for greater penalties and the
publicity which it generates helps to advance the growing,
inaccurate, and very unhelpful public perception that corporate
America is corrupt or tends toward corruption, and that huge
penalties are the only thing standing between honest investors
and corrupt executives.
I believe that the above factors combine to create a
perception among some issuers and regulated entities that
increased dialogue and contact with Commission staff may only
lead to second-guessing based on a lack of understanding, and
possibly an investigation and a wide net being cast over almost
anyone near some conduct that is deemed inappropriate or
improper. Although this view may not be entirely justified,
especially with rule-making divisions within the Commission,
the trifecta of (i) the Commission being widely criticized and
pushed to be more aggressive in the enforcement area; (ii)
public pressure for ever-increasing entity penalties, and (iii)
the case with which complex factual situations can be
misinterpreted and read to infer misconduct under malleable
legal principles, combine to put pressure on both the
Commission and those whom it regulates and monitors to interact
only in an adversarial or semi-adversarial setting.
Q.4. You noted in your testimony that the line between civil
and criminal securities cases has been blurred. Can you share
your thoughts on the role of the SEC with respect to criminal
securities fraud cases?
A.4. As to the role of the SEC in criminal securities cases, I
believe that the SEC should have a major, consultative role and
should be intimately involved in decision making with criminal
authorities where a case is predominately a securities law case
or is a case that affects a regulated entity under SEC
supervision. The SEC administers, enacts rules under, and
interprets a number of statutes covering a variety of
businesses and business organizations, including public
companies, broker-dealers, investment advisers, and mutual
funds. These statutes and related rules are often complex and
reflect long-reviewed and thought-out policy considerations.
The SEC is charged with consistently applying these statutes
and rules to the activities of individuals and entities to
provide uniformity across all such activities in the areas of
the SEC's expertise, no matter in what jurisdiction the
individuals or entities operate in the United States. Indeed,
the SEC's jurisdiction can reach to entities that are not
predominately U.S. organizations.
Although some frauds are clear or brazen, the above
considerations still apply to cases brought as ``straight-
forward frauds,'' which may not on their face involve any
complex rule or regulation. Indeed, recent criminal securities
``fraud'' cases still involved interpretation of esoteric
accounting principles or required the criminal authorities to
pursue theories which involve those authorities advancing what
they believe was or was not a proper business purpose for a
transaction.
In an atmosphere where even a threatened criminal action or
a threat by a State to shut down a major brokerage firm can
have a dramatic and swift effect on that organization and the
market as a whole, I believe that the agency charged with the
strong public policy interests expressed in the Federal
securities laws should have a major role in determination of
whether actions involving conduct or entities directly within
its jurisdiction should be criminally prosecuted under any
particular set of facts. For a further discussion of issues
relating to criminal enforcement of the Federal securities
laws, I refer you to the Chamber of Commerce Report, pp. 22-24
and note 82 therein.
Once again I thank you for the opportunity to appear before
the Subcommittee and to provide information on the important
work which you are doing in the area of SEC enforcement. I hope
that my comments are helpful, and I look forward to assisting
you in the future if called upon.
Additional Material Supplied for the Record
PREPARED STATEMENT OF COLLEEN M. KELLEY
National President,
National Treasury Employees Union
May 7, 2009
Chairman Reed, Ranking Member Bunning, and Members of the
Subcommittee, I greatly appreciate the opportunity to provide testimony
to this distinguished Subcommittee.
These are challenging times for the United States Securities and
Exchange Commission and for its Division of Enforcement in particular--
but these times also present a unique opportunity to engage SEC
leadership to recognize and utilize what is best about government
service to make the agency more responsive to our Nation's needs.
During our Nation's current financial crisis, I am confident that the
talents and expertise of front-line SEC employees, many of whom have
been too often overlooked, can and will be tapped to help restore
confidence in our Nation's capital markets achieve the fundamental goal
of protecting our Nation's investors. As President of the National
Treasury Employees Union (NTEU), representing more than 150,000 Federal
employees in over 31 different agencies and departments throughout the
government, including the over 2,500 bargaining unit employees at the
SEC, I look forward to working with you to help the SEC succeed in its
fundamental mission.
The challenges that we face as we work together to revive our
economy and ailing financial institutions are complicated and broad
ranging. But much has happened in the past several months. We have a
new president and a new SEC chairman who see government as part of the
solution to our Nation's challenges, rather than as the problem. We are
hopeful that in this new era, the SEC will begin the work of restoring
the morale of the SEC's front-line staff and rededicating the agency to
its mission as the investor's advocate, rather than as an arbiter
between those who favor a smart, efficient regulatory landscape and
those who oppose it.
Indeed, a renewed dedication to public service has never been more
important. I was proud that NTEU's award-winning public service
campaign, ``Federal Employees . . . They Work for U.S.,'' was well
received throughout the country. We were proud to air radio spots on 65
stations, in 50 markets nearly 17,000 times, and TV spots that resulted
in 14 million impressions. These ads reminded the public of the
important work Federal employees do in an array of agencies and
communities throughout the Nation.
NTEU believes that fundamental improvements to the SEC's
Enforcement Division are long overdue. We support the new Director of
the Division of Enforcement, Robert Khuzami, and his basic goal of a
smart, swift, strategic, and successful enforcement program. In our
view, Enforcement Division reforms should be carefully considered and
based upon lessons learned about the Division's strengths and
weaknesses over the past several years. And I think it is important to
note, that whether in connection with market timing, options
backdating, the subprime mortgage crisis, or the Madoff Ponzi scheme,
the common thread among these failures has not been a failure of the
front-line investigative staff, but rather a failure of past SEC
management to acknowledge or respond swiftly to significant allegations
of improper conduct and inordinately high systemic risks.
The extent to which the SEC's Division of Enforcement will be
successful in its mission rests in large measure with the Federal
employees charged with carrying out the agency's fundamental mission of
enforcing the Federal securities laws to protect our Nation's
investors. In the final analysis, a great country is the sum of the
actions of its people--and in few, if any endeavors, does that hold
more truth than in the work of the attorneys, accountants, and support
staff who are employed in the SEC's Division of Enforcement. These
highly skilled women and men have dedicated themselves to answering the
call to public service. The change in administrations clearly provides
a window of opportunity not only for improvements in the Division of
Enforcement and the way it conducts itself--and thus how it serves the
public--but in the way it attracts and retains those who perform the
people's work.
Improving the Organizational Structure of the Enforcement Division
The primary challenge currently faced by the front-line SEC
enforcement staffers that NTEU represents is the existence of a
multilayered and redundant management structure within the Division of
Enforcement. Every four or five front-line enforcement employees
currently report to a ``Branch Chief,'' who reports to an Assistant,
who reports to an Associate. The vast majority of these front-line
enforcement staffers are highly qualified, skilled, and motivated
attorneys and accountants who are fully capable of handling their
investigations independently, without the level of constant supervision
that flows naturally from this ratio of managers to staff persons.
As a result of this structure, it often takes as long to determine
what to do about a violation as it does to determine whether there was
a violation in the first instance. This robs the Division of its
ability to have a swift and timely regulatory impact.
NTEU generally supports President Obama's laudable reform goal of
flattening management layers in the Federal government, as well as
recent remarks by Enforcement Director Khuzami indicating a willingness
to consider such changes. The SEC's Enforcement Division is an example
of an entity that would be well served by a reduction in the number of
redundant management layers. Such a flattening of the structure would
improve the speed and efficiency of the enforcement program, while,
simultaneously increasing front-line employee morale, engagement, and
empowerment. Re-designating unnecessary enforcement managers would also
result in a substantial increase of up to 20 percent in the number of
front-line investigative enforcement staff who are actually
investigating cases, without requiring an increase in funding from
Congress.
Need for Additional Market, Financial, and Accounting Expertise
Mr. Khuzami has recently expressed the view that the SEC's
enforcement program might benefit from hiring additional experts to
assist the front-line staff in conducting their investigations, as well
as by more effectively leveraging the experts that it already employs.
NTEU supports this recommendation. The SEC's front-line enforcement
attorneys are highly skilled experts at what they do--that is,
identifying and developing evidence critical to evaluating possible
violations of the Federal securities laws. However, in an increasingly
complex global financial marketplace, those attorneys would benefit
greatly from more readily available technical and analytical support
staff. In recent years, the SEC has failed in providing this type of
support.
As an example to place this issue in perspective, the Enforcement
Division today employs approximately 500 nonmanagement investigative
attorneys, but it has only nine bargaining unit ``market surveillance''
experts nationwide. Increasing the staff of market, accounting, and
financial analysts and other investigative support staff available to
work with SEC attorneys would be an efficient improvement that would
help to achieve the Director's goal of smart, strategic, swift, and
successful results.
Reorganization of Enforcement into Specialist ``Silos''
During his first few weeks at the SEC, Mr. Khuzami has suggested
that the agency might perhaps more effectively fight securities fraud
by radically reorganizing its enforcement staff into a number of
``specialist'' groups that would target specific types of cases.
Employees would shift in and out of particular specialty areas every
couple of years. This type of specialist, or ``silo,'' model would
constitute a historic and fundamental sea change in the organization of
the Division of Enforcement. It therefore requires extremely careful
consideration and deliberation before implementation.
It is important to carefully consider the inherent logistical
problems raised by attempting to shift to such a model. If employees
are reassigned en masse into specialist ``silos,'' will the agency
transfer their cases to other employees if those cases do not fall
under their current specialty? If so, how would it be an efficient use
of agency resources to transfer numerous cases from staff possessing
historical knowledge of those cases to staff having no such knowledge?
If not, then what will specialization really mean? How long will
employees be expected to stay in a particular specialty area? When
their ``tour of duty'' in a particular specialty ``silo'' is over, will
they transfer their uncompleted cases to other employees? Will this be
efficient for the agency? If not then what will specialization really
mean? To deal with these problems, will employ be expected to stay in
certain specialty areas for extended periods of time, without the
ability to work in other areas of the Federal securities laws? Who will
decide which employees are reassigned to which groups, and what will be
the criteria for such reassignments? What will be the long term impact
of such decisions upon employee morale, and upon recruitment and
retention?
Even beyond these logistical difficulties, there are fundamental
questions about the efficacy of such a ``silo'' model that should be
carefully considered by the SEC. Most of the highly skilled SEC
enforcement lawyers and accountants that NTEU represents are organized
into groups which handle all of the types of cases brought by the
agency--most notably cases enforcing the Securities Act of 1933, the
Exchange Act of 1934, the Investment Company Act of 1940, and the
Investment Advisers Act of 1940. All of these types of cases have basic
similarities, and a great many investigations involve violations under
more than one provision. For this reason, the agency has traditionally
believed that it is important for the front-line enforcement employees
to possess a relatively broad knowledge of all of the securities laws,
even if in some cases that knowledge is not particularly deep.
In fact, it is not at all unusual for one enforcement investigation
to present issues that touch upon almost all aspects of the Federal
securities laws. A hedge fund investigation may involve, among other
things, insider trading, offering fraud, market manipulation, and
accounting fraud, as well as violations of the Investment Advisers Act.
This may be one reason why the SEC's historical experience with
specialized groups has often resulted in such groups dissolving back
into general enforcement. Cases frequently contain too many parts to
classify easily. In addition, while the SEC has used task forces in the
past, they have only existed for limited durations.
Thus, although there is some natural appeal to the broad concept of
``specialization,'' the SEC's enforcement attorneys and accountants are
already highly specialized by focusing on enforcement of the Federal
securities laws. In this regard, the Division of Enforcement is
different from the Department of Justice, where law enforcement is
divided into specialist groups. Federal securities law is already a
fairly narrow area of the law. By contrast, a typical U.S. Attorney's
Office is divided into a number of different groups dealing with
unrelated criminal activities. Even a small white collar crime group in
a U.S. Attorney's Office, for example, deals with a broader class of
investigations than just the violations of the Federal securities laws
currently handled by the SEC's Enforcement Division.
By creating ``specialized'' groups, the SEC would in reality be
creating microspecialized groups. This could be akin to transforming
SEC enforcement attorneys into assembly line workers who only attach
one part during an assembly process. Although, perhaps, some simpler
types of securities fraud cases could be completed more quickly in such
an environment, the cost could very well be increased staff alienation
and balkanization, and a generally less effective enforcement program,
particularly with respect to larger, more complex cases.
NTEU shares Mr. Khuzami's ultimate objective, which we believe is
to empower front-line enforcement investigators with the expertise and
resources necessary to regulate increasingly complex financial markets.
We believe, however, that the SEC should proceed very carefully with
any plans to fundamentally shift the organization of the Enforcement
Division toward a higher degree of specialization. In this regard,
Federal labor law and the collective bargaining agreement between NTEU
and the SEC set forth the negotiating process that is required before a
large scale reorganization of the Division could occur. NTEU leaders
look forward to engaging in a respectful and constructive dialogue
regarding these issues with SEC management.
Improved Enforcement Prioritization Metric
NTEU supports Mr. Khuzami's call for the introduction of an
improved Enforcement Division prioritization metric which would allow
every front-line employee to effectively evaluate potential enforcement
matters.
Walter Ricciardi, a Deputy Director in the Enforcement Division
from 2005 to 2008, recently remarked in an April 1 speech in New York
that SEC enforcement offices are evaluated on the number of cases, or
``stats,'' that they bring in, rather than on the regulatory impact of
those cases. This system, in which every case receives the same one-
size-fits-all ``stat,'' is woefully inadequate. Bringing an enforcement
action against Enron yields one ``stat,'' but an office could receive
100 ``stats'' for delisting 100 defunct companies for failing to file
annual reports.
All cases are not the same, and treating them as though they are
has the potential to create perverse incentives, as well as to devalue
the important work of front-line employees. Most importantly, the SEC's
prioritization metric should reflect actual harm to investors, current
or potential.
Empowering Front-Line Investigative Staff
Over the past year, there have been a number of press reports
regarding inquiries by Congress and the Office of the Inspector General
concerning SEC investigations in which senior managers allegedly met
with defense counsel outside the presence of the front-line staff
assigned to those investigations. These reports led one Senator to
comment in the press on what he perceives to be a ``culture of
deference'' toward ``big players'' on Wall Street.
A renewed public commitment by Enforcement Division management to
ensuring that front-line enforcement staff will be permitted to attend
all meetings between management and defense counsel on the matters that
those staffers are investigating would readily dispel such perceptions,
while simultaneously reinforcing the important role of the front-line
staff in enforcement investigations.
Reducing Bureaucratic Tasks
Today, front-line employees in the Enforcement Division expend a
great deal of time on bureaucratic tasks such as the updating various
internal databases and providing repetitive reports on their cases up
the management chain. Simply reducing these types of activities would
be an important step toward streamlining the enforcement process.
Expanded Regulatory Authority
NTEU supports increased regulatory authority for the SEC over
unregulated investment instruments and entities, including explicit
statutory authority to regulate hedge fund advisers as investment
advisers and to require hedge funds to disclose the contents of their
portfolios, leverage amounts, and counterparties.
Funding and Staffing
Any consideration of ways to strengthen the SEC's vital enforcement
responsibilities should include a discussion of the important human
capital issues currently facing the SEC. As the agency deals with what
is perhaps the most challenging period in its history, its single most
important asset continues to be its human capital--the stock of skills
and knowledge embodied by the talented group of front-line employees
who work at the agency and carry out its complex mission every day. For
that reason, maintaining a sound strategy to both attract and retain
the best possible work force will be critical to the long term success
of the SEC's enforcement program.
During the previous administration, however, the SEC displayed what
could only be viewed as a marked indifference to human capital issues.
Far too often, the agency was hamstrung, understaffed, underfunded, and
led by political appointees who were at best ambivalent about the
agency's mission. By actively engaging the SEC's workforce and
refocusing its mission, the agency's new management can take a
fundamentally different path which will assist it in more effectively
tackling our Nation's problems while simultaneously restoring vitality
to the SEC, including its Division of Enforcement.
Last year, NTEU pressed the case in Congress for additional SEC
staffing and an increase in the performance based pay budget requested
by the agency, even as the prior administration was asserting that the
SEC did not need any additional funds and that it expected substantial
staff attrition in FY2009. In hindsight, it is now abundantly clear
that permitting attrition to shrink the size of the SEC's staff,
including its enforcement staff--a strategy which was actively pursued
by the agency's previous management--could not have been more gravely
off the mark. For that reason, I am heartened by the fact that current
SEC Chairman Mary Schapiro has signaled a change in direction with
respect to staffing issues. I strongly support additional funding to
increase the agency's front-line staff.
But more needs to be done with respect to human capital issues at
the SEC. For example, the agency should deliver on its agreement, made
more than 2 years ago during its 2006 compensation negotiations with
NTEU, to provide a 2 percent increase in its retirement match for SEC
employees. In addition, SEC management should reverse the prior
administration's approach of repeatedly slashing the funding for its
performance based pay system.
The SEC's performance based pay system has had many flaws, both in
its implementation and execution. This was clearly evidenced by NTEU's
national arbitration victory against the agency in late 2007, which
ultimately resulted in a $2.7 million monetary settlement after an
arbitrator found that the system had had a discriminatory impact on
hundreds of SEC employees. The most glaring problem with the merit pay
system, however, has been past management's conscious decision to
inadequately fund it. For fiscal years 2007, 2008, and 2009, the agency
slashed its performance based pay budget, culminating in its most
recent request to Congress for only a 1.5 percent increase for FY2009.
This amount represented only half of the historic merit pay budget of 3
percent. Without SEC management support for adequate funding, the merit
pay system will never work as intended.
NTEU is looking forward to working closely with new SEC Chairman
Schapiro to alter the course of the misguided human capital policies of
the past administration. Without fundamental change in the agency's
approach to these issues, employee morale will continue to suffer,
which will have a concomitant negative impact upon recruitment and
retention--and ultimately upon the agency's ability to effectively
enforce the Federal securities laws.
Finally, NTEU supports a self-funding mechanism for the SEC to
ensure its independence in establishing its budget and staffing needs
from the fees that it collects. Currently, as you know, fees collected
by the SEC go into the General Treasury and the agency is funded and
staffed through appropriations. Other financial regulatory agencies
represented by NTEU, however, such as the Federal Deposit Insurance
Corporation, the Office of the Comptroller of the Currency, and the
National Credit Union Administration, all have such control over the
funds that they collect. The SEC should be afforded the same
independence and discretion.
Conclusion
The challenges facing the SEC's Division of Enforcement in our
Nation's current financial crisis are large and historically important.
I think that it is important to remember in this context that the
Chinese symbol for ``crisis'' contains both the symbols for ``danger''
and for ``opportunity.''
It is truly a new day for us all. The SEC has been through a lot in
recent years, suffering from depleted resources and staffing, as well
as poor judgment by prior management. But it also enjoys a deep
reservoir of highly skilled, resilient, and capable employees who will
continue to play a critically important role as we move ahead together
to address the problems that we face.