The Securities and Exchange Commission (SEC) has made significant changes to its policies and practices in its Enforcement Division, signaling swifter and more focused investigations.
Key Appointments
Chairwoman Mary Schapiro made an unprecedented selection by choosing Robert Khuzami, a former federal prosecutor and Chief of the Securities Fraud Unit of the U.S. Attorney's office in the Southern District of New York, as the SEC's new Director of the Division of Enforcement. Never before has a former federal criminal prosecutor led the SEC's Enforcement Division. The new Director of the SEC's New York regional office, George Canellos, is also a former federal criminal prosecutor.
These appointments have translated into recently announced significant changes to the SEC's investigative process. To understand their significance, let's review the historical problems with SEC investigations.
Lengthy SEC Investigations
Typically, SEC investigations are lengthy, often taking years to complete. Many factors cause this. First, the SEC staff's tendency is not to focus on a few key individuals. Instead, they cast a wide net, obtaining documents and taking sworn testimony from anyone remotely connected to the conduct at issue.
Second, the staff was not organized into specialized subject matter groups. So, for example, the staff investigating the municipal securities markets may have no experience whatsoever in that area, and so must learn the subject matter as it investigates.
Third, the staff must have a formal order of investigation to issue subpoenas for documents and testimony. But approval of all five SEC commissioners was needed to obtain this. This cumbersome process often led the staff to avoid seeking a formal order and, instead, give companies and individuals plenty of time to conduct internal investigations, locate and produce documents, discuss limiting issues, refine the scope of the requested documents with the staff, and provide voluntary testimony. This informal process led to further delay.
Fourth, the SEC staff has never had a customary practice of granting immunity to peripheral players to make a case against key individuals at the heart of the alleged misconduct. Instead, they pursue each individual who may have violated the federal securities laws, even if one person has less culpability and could help bolster an enforcement action against a more culpable person. Similarly, while companies may get credit for cooperation, the SEC has not had such a policy for individuals. So, counsel for individuals have not flipped their client to provide evidence against others to get leniency.
Finally, when the investigation ends and the staff notifies targets of its intention to recommend an enforcement action through a Wells notice, the list is often long. For example, in a revenue recognition investigation, expected targets are the CEO, CFO, and chief accounting officer. But the SEC staff often targets salespeople and lower-level accounting staff. Such individuals often were not aware of any problem, but the staff argues that they failed to respond to red flags. Such peripheral individuals must prepare Wells submissions and request meetings with senior SEC officials. And, if the SEC takes an aggressive settlement position, such individuals have little incentive to settle if they have the financial means--personally, or through insurance or indemnification—to defend themselves. This leads to more delays.
More Focused Investigations
Criminal prosecutors typically focus their investigations on the main wrongdoers and use marginal players to build their case. Given the high burden of proof, criminal prosecutors must think carefully before charging those on the periphery. And prosecutors turn marginal players against the principal wrongdoers in return for immunity or a reduced sentence. Finally, federal prosecutors are typically organized into subject matter teams that develop expertise.
Modeled on his criminal prosecutorial background, Khuzami recently announced significant changes to the SEC's Enforcement Division designed to expedite the process. The first change is establishing specialized subject matter units. Each unit will be headed by a unit chief and staffed nationally by members with relevant expertise who will receive special training. The goal is to bring to bear greater expertise, sophistication, and experience on understanding complex products, transactions, and industry practices.
Specifically, the existing Subprime Working Group will continue to focus on credit products, including mortgage-related securities. And five new specialized units will be created. The Asset Management Unit will focus on investment advisers, investment companies, hedge funds, and private equity funds. It will address disclosure, valuation, portfolio performance, due diligence and diversification, transactions with affiliates, misappropriation, and conflicts of interest. The Market Abuse Unit will focus on large-scale market abuses and complex manipulation schemes by institutional traders and market professionals. The Structured and New Products Unit will focus on complex derivatives and financial products, including securitized products. The Foreign Corrupt Practices Act Unit will work with foreign agencies to uncover bribery of foreign officials by U.S. companies to obtain government contracts and other business. Finally, the Municipal Securities and Public Pensions Unit will focus on disclosure, tax, arbitrage-driven activity, and pay-to-play schemes in which money managers pay kickbacks to obtain advisory business.
A second change is Khuzami's decision to delegate certain authority to those below him and to create a less hierarchical management structure. He has delegated to senior officers the authority to make case decisions, such as routine settlements, Wells calls, and opening of new matters. And--the commission having delegated to him the authority to issue formal orders of investigation--Khuzami has, in turn, delegated this authority to senior officers below him. So the staff will not need prior approval from the commission or Khuzami himself to issue subpoenas. Khuzami also has eliminated the branch chief position (a first-level supervisory role) to create a flatter and more streamlined management structure.
Third, Khuzami will require senior division officials to approve all tolling agreements, which will be granted only as an exception, not the rule. This is intended to prevent extended delays in completing investigations. He also intends to shorten the action memo (a memo from the staff to the commission that recommends an enforcement action) and subject it to fewer reviews.
Fourth, the staff will use several new enforcement tools designed to reward extraordinary cooperation. These include new standards governing cooperation by individuals and delegating authority to submit immunity requests to the Department of Justice. It also will provide witnesses with early oral assurance that they will not be charged. When appropriate, the staff will recommend to the commission deferred prosecution agreements with individuals or entities, subject to full cooperation, waiver of statutes of limitations, and compliance with certain undertakings. These significant changes give the staff greater flexibility to negotiate immunity or leniency for persons with important evidence against other persons.
Finally, Khuzami intends to address personnel issues. The Enforcement Division will triple the previous number of paralegals and support personnel, and hire more Trial Unit lawyers. A new position, Chief Operating Officer, has been created and filled to oversee project management, workflow, and information technology. Lastly, a new Office of Market Intelligence will collect and analyze the hundreds of thousands of tips and complaints that the SEC receives yearly.
Conclusion
These significant changes are intended to speed up and create more efficient SEC investigations. And they may well do so. But unintended consequences may result. Speed and efficiency are not coextensive with fairness. Within the world of the SEC, the Madoff case and similar Ponzi schemes--which are simply theft--are not the norm but the exception. SEC investigations often focus after the fact on disclosure issues that involve difficult matters of judgment by corporate executives. By distancing experienced senior SEC officials from important decision-making points, the danger is that charging or settlement decisions will be made without careful consideration. So, these changes may lead to unwarranted charges and more litigation, not less.