Reform of the SEC

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SEC may require more details of wrongdoing to be disclosed in settlements

The Securities and Exchange Commission might end its long-standing practice of letting companies and individuals settle charges of wrongdoing without publicizing the detailed findings of its investigations, according to a senior official, a move that could reshape the enforcement of laws against corporate crime.

Under existing policy, companies and executives that settle lawsuits filed by the SEC typically pay a fine and agree to other sanctions, but they neither have to admit wrongdoing nor undergo a trial in which the details of their alleged misconduct would be unveiled. A settlement, the only public record of the case, can often be only a few pages in length.

But Robert Khuzami, the SEC's enforcement director, said in an interview that the agency is reconsidering the policy. "Typically our practice has been not to file in-depth factual findings of the investigation," Khuzami said. "We're taking a look at the practice and deciding whether it makes sense to provide a more fulsome record" in an effort to be more transparent.

Securities lawyers said a more detailed public record of cases could make defendants less likely to settle and make it easier for shareholders to file class-action lawsuits piggybacking on the SEC's claims. It could also lead to embarrassment for executives if the agency publicized their roles in violating securities law, even if they are not personally charged.

"If you're being accused of wrongdoing, it's in your interest to have as few of the facts revealed as possible," said Russell G. Ryan, a securities lawyer at King & Spalding. "To the extent that the SEC adopted a policy that would require a detailed recitation of the facts, companies might be more reluctant to agree to a settlement."

'Cynical relationship'

The question of whether the SEC should publicize details of its probes came into sharp focus recently after a federal judge challenged the agency's handling of its lawsuit accusing Bank of America of lying to investors. The SEC had accused the bank of concealing plans to pay billions of dollars in bonuses to employees of Merrill Lynch, the Wall Street firm it was buying. In its settlement with Bank of America, the agency issued a cursory overview of the allegations and set a $33 million fine. The bank denied wrongdoing, saying it agreed to the settlement to avoid a costly tussle with one of its key regulators.

The judge in the case, Jed S. Rakoff of the Southern District of New York, rejected the settlement in the fall. "This case suggests a rather cynical relationship between the parties: the S.E.C. gets to claim that it is exposing wrongdoing on the part of the Bank of America in a high-profile merger; the Bank's management gets to claim that they have been coerced into an onerous settlement by overzealous regulators," he wrote at the time. "And all this is done at the expense, not only of the shareholders, but also of the truth."

Rakoff ordered the case to trial, but instead, the SEC and Bank of America agreed to a new settlement that added charges, nearly quintupled the fine and provided the court with thousands of pages of detailed evidence.

Supporters of a change in the agency's policy say it would put meat on the bones of SEC settlements and fit with its overall effort to revitalize its image as an aggressive enforcer of laws against financial crime.

"The settlement document has been an artifact," said John Coffee, a securities law professor at Columbia University. "The SEC is premised on the idea that sunlight is the best disinfectant, and a nontransparent settlement harms the SEC's reputation."

Today, settlements are carefully negotiated between SEC lawyers and defendants before they are submitted to a court for formal approval and publicized. SEC lawyers have often favored reaching settlement as quickly as possible to conserve resources by reducing the number of open cases. Securities lawyers say the policy change could delay settlements significantly.

"In a settlement, one of the benefits to resolving an action is you have some say or ability to make sure the facts are at least reasonably stated," said Barry Goldsmith, a securities lawyer at Gibson Dunn. "This would result in more prolonged and protracted negotiations to make sure those facts are accurate."

Seeking transparency

Khuzami, a former federal prosecutor, said a change in policy would increase transparency and offer more guidance about why the agency is taking the action it is taking. Sanctions tend to include fines, expulsion from the securities industry and orders for changes in business practices. The SEC can also refer matters to the Justice Department for criminal prosecution.

Virtually all SEC settlements include language stating that the defendants neither admit nor deny the allegations, even while they agree to sanctions. Those words can help protect defendants from class-action lawsuits that base their claims at least in part on an SEC settlement. Class-action suits cost companies many millions of dollars in additional legal fees and potential payout than regulatory action.

But securities lawyers say a more detailed explanation of wrongdoing could increase the odds of these suits being accepted by courts, despite the disclaimer.

If enacted, the change in settlement policy would put the SEC ahead of many other law enforcement agencies in terms of public disclosure of the wrongdoing its investigations uncover. The Justice Department, for example, often files a brief description of the facts supporting criminal charges when a defendant pleads guilty.

Then again, defendants must do other things to acknowledge culpability, including accepting responsibility in court and possibly a jail sentence.

Congressional oversight of SEC reforms

"Securities and Exchange Commission Chairman Mary Schapiro spent seven months overhauling the agency before an internal investigator blamed “systemic” failures for missing Bernard Madoff’s $65 billion fraud. Now, Congress will decide whether she’s doing enough.

Schapiro shook up the enforcement and inspections units, both faulted in a 457-page report by SEC Inspector General H. David Kotz last week that said the agency never conducted a “competent” inquiry of at least six warnings about Madoff’s New York money-management firm since 1992. Tomorrow, the Senate Banking Committee holds the first of several hearings to study the findings amid an overhaul of Wall Street oversight.

“Turning around the SEC is like turning around a very large crude-oil carrier,” said John Coffee, a securities law professor at Columbia University who has testified to Congress on financial regulations. “Schapiro’s done a good amount already, but there’s much more to be done.”

SEC reform actions

"In the wake of the Madoff fraud, the SEC’s Office of the Inspector General launched an internal investigation in December 2008 to determine why the agency did not detect the scheme. While awaiting the report, the SEC has been taking decisive and comprehensive steps to reduce the chances that such frauds will occur or be undetected in the future.

  • Safeguarding Investors’ Assets: The SEC in May proposed two rules that would better protect clients of investment advisers from theft and abuse. The rules would provide assurance to these clients that their accounts contain the funds that their investment adviser and account statements say they contain. Among other things, the rules would encourage investment advisers to place their clients’ assets in the custody of an independent firm.
  • Surprise Exams: One proposal would require all investment advisers who control or have custody of their clients’ assets to hire an independent public accountant to conduct an annual “surprise exam” to verify those assets actually exist. This surprise examination would provide another set of eyes on the clients’ assets, thereby offering additional protection against the theft or misuse of funds.
  • Third Party Reviews: A second proposal would apply to investment advisers who do not use independent firms to maintain their clients’ assets. Such advisers would be required to obtain a third party written report assessing the safeguards that protect the clients’ assets. The report — prepared by an accountant registered and inspected by the Public Company Accounting Oversight Board — would, among other things, describe the controls that are in place to protect the assets, the tests performed on the controls, and the results of those tests. Existing rules make no distinction between an investment adviser whose affiliate holds its clients’ funds and an investment adviser that uses a truly independent custodian.
  • Revitalizing the Enforcement Division: Under the leadership of a new Enforcement Director, the SEC is restructuring the division to better ensure that it focuses on significant cases that will have a meaningful impact. The restructuring will reduce bureaucracy and speed up the enforcement process by removing a layer of management in the 1,100 person division. The newly structured division will include specialized units that will enable staff in those units to concentrate their expertise in focused areas and help detect patterns, links, trends and motives. In addition, the Division is streamlining internal processes to make investigative procedures more efficient.
  • Revamping the Handling of Complaints and Tips: In order to improve the handling of hundreds of thousands of complaints, tips, and referrals it receives each year, the SEC has contracted with Mitre, a federally funded research and development center, to help the agency revamp its processes across the agency. After reviewing and analyzing its intake procedures, the SEC is now beginning to improve upon its processes for collecting, recording, investigating, referring and tracking this information. Among other things, the agency is creating a centralized system for handling this information. Once the information and processes are centralized, the agency will apply risk analytics to better enable it to reveal links, trends, statistical deviations and patterns that might not be observable when each complaint is examined one at a time.
  • Advocating for a Whistleblower Program: The SEC has advocated for expanded authority from Congress to reward whistleblowers who bring forward substantial evidence to the agency about significant federal securities violations. In proposed legislation that the Chairman sent to Congress, a fund would be established to pay whistleblowers using money collected from wrongdoers that is not otherwise distributed to investors.
  • Conducting Risk-Based Examinations of Financial Firms: The SEC has dispatched its examiners to conduct a “sweep” of firms that present certain risk characteristics to ensure, among other things, that the clients’ assets in fact exist. Such risks include advisers whose clients’ assets are held with an affiliate, as opposed to an independent entity; hedge funds that seem to have “smooth” or outlier returns; firms that use an unknown auditor or no auditor at all; firms with a disciplinary history; and broker-dealers that sell an affiliate’s hedge fund or limited partnership.
  • Increasing Focus on Agency-Wide Risk Assessment: The SEC is assessing and improving the use of risk assessment techniques, agency-wide, to more proactively identify areas of risk to investors. The agency is increasing collaboration with third parties and other government agencies to identify firms or products that may pose risk to investors or markets. The agency is also improving our ability to monitor the industry — by identifying the data and information that financial firms would submit to the SEC — to allow it to better identify those particular firms that warrant a closer look by examiners and enforcement staff.
  • Improving Fraud Detection Techniques for Examiners: The SEC instituted measures to improve the ability of examiners to detect fraud and other types of violations. The measures include more rigorous reviews of firms before the examiners enter the premises, and a more complete exam guide that focuses not only on obvious signs of fraud but also more subtle signals that deserve closer inspection, such as a firm using an unknown accountant. The measures also include increased checks on outside entities to verify that assets actually exist there and expanded use of exams of an entire entity when firms have joint or dual registrants such as affiliated broker-dealers and investment advisers.
  • Recruiting Staff with Specialized Experience: The SEC is working to bring in new staff with diverse skill sets to expand its knowledge base and improve its ability to assess risk, conduct examinations, detect and investigate wrongdoing, and focus our priorities. Some initial examples included:
  • Senior Specialized Examiners: The agency is hiring new staffers to the examination unit who have specialized experience in areas such as trading, operations, portfolio management, options, compliance, valuation, new instruments and portfolio strategies, and forensic accounting.
  • Industry and Market Fellows Program: The agency is hiring new staffers who are highly-seasoned financial experts to keep pace with the practices of Wall Street and protect investors. These experts would provide other staffers with new information and perspectives to help them identify emerging issues and understand the ways the industry is changing.
  • Expanding and Targeting Training: The SEC is providing its staff with targeted training related to hedge funds and specialized products, derivatives and options, complex trading, and investigations of regulated entities. Additionally, the SEC is conducting programs to train hundreds of staffers to become Certified Fraud Examiners, and expanding the availability of programs for staffers to become Certified Financial Analysts.
  • Seeking More Resources: The SEC has been seeking additional funding to hire more examiners who can go into more financial firms to see whether they are in compliance with the law, as well as for more enforcement staff who can bring more enforcement cases when fraud and other violations of the law are found. In recent years, the SEC has not had adequate resources to oversee the securities industry. For example, the SEC has just over 450 people in its exam program to examine the more than 11,000 regulated investment advisers and 8,000 mutual funds.
  • Integrating Broker-Dealer and Investment Adviser Examinations: The New York Regional Office has adopted a protocol that will integrate examination teams to make sure people with the right skill sets are assigned to examinations. Under the new protocol, a single team of examiners, drawn from the broker-dealer and investment managements units, will jointly examine selected firms to ensure that the examination team includes those most expert in the subject of the exam. In addition, this initiative includes greater cross-training and coordination between broker-dealer and investment management staff on their examination plans.
  • Enhancing Licensing, Education and Oversight Regime for “Back-Office” Personnel: Working with senior SEC staff, FINRA has committed to establish a new system to enhance the oversight and professional requirements of personnel performing back-office functions at broker-dealer firms. “Back-office” personnel typically perform critical custody, accounting, transfer agency and account maintenance functions. They have an important role that must be performed with skill and integrity. Under the new regime, certain back-office personnel would be subject to licensing and education requirements as well as enhanced oversight. The new regime will further promote the qualifications and professionalism of those performing back-office functions so that client accounts are better protected.


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