9 February 2009
With the mother of all Ponzi schemes following closely on the heels of the subprime meltdown and the auction rate securities seize-up, Congress and the public have demanded a swift and strong enforcement response to the string of disasters that have left investors with "201(k)s." However, with meager funding, the regulator principally tasked to respond, the Securities and Exchange Commission, has seen the number of lawyers doing investigations in its Enforcement Division drop by over 10 percent from 654 in 2005 to 594 in 2008 - fewer lawyers than in many of the individual defense law firms it faces. Some of its enforcement teams have dwindled by half, while high staff turnover has slowed movement of some cases to a crawl.1 Staff morale has also suffered under a recent barrage of Inspector General investigations.
President Barack Obama acted early to appoint a credible enforcer to run the SEC. While new presidents typically do not get around to making their SEC picks for months, Mr. Obama selected FINRA chief Mary Schapiro as his new SEC chairwoman over a month before his inauguration.2 In appointing Ms. Schapiro, who has made a career of building and managing securities enforcement programs, Mr. Obama described her as "smart and tough - so much so that she's been criticized by the same industry insiders who we need to get tough on." Mr. Obama called on Ms. Schapiro to "crack down on the culture of greed and scheming that has led us to this day of reckoning."3
Ms. Schapiro has seen a regulator in crisis before. After six years as an SEC commissioner and two more as Commodity Futures Trading Commission (CFTC) chairwoman, Ms. Schapiro was tapped by the NASD in 1996 to head its new enforcement arm, NASD Regulation. At the time, both the SEC and the Justice Department were investigating serious allegations that the Nasdaq market did not treat investors fairly, and the NASD was responding with a "total restructuring" plan.
After just four months on the job, Ms. Schapiro announced a substantial budget increase and sweeping organizational changes, with each of the three NASD Regulation departments - enforcement, member regulation and market regulation - set to report directly to her.4 After rising to chairwoman and CEO at NASD, she went on to oversee the 2007 formation of FINRA, which combined NASD with the NYSE's enforcement, member regulation and arbitration functions.
At her confirmation hearing on Jan. 15, Ms. Schapiro responded strongly to Senate Banking Committee demands for tough enforcement. Noting that "the capital markets have collapsed, trillions of dollars of wealth have been lost, our economy is in recession, and investor confidence has been badly shaken," Ms. Schapiro said that "first and foremost," she would "move aggressively to reinvigorate enforcement at the SEC," and "go after those who cut corners, cheat investors, and break the law."5
In striving to deliver on these promises, Ms. Schapiro will find solid support among her four fellow commissioners. Elisse Walter, a Democrat, has worked in senior positions with Ms. Schapiro for almost 20 years at the SEC, CFTC, NASD and FINRA. The other Democrat, Luis Aguilar, recently made an exceptionally strong enforcement presentation to state regulators. Mr. Aguilar suggested giving SEC lawyers authority to bring criminal charges, increasing civil penalties for corporations and streamlining the process for authorizing penalties, making the SEC self-funding to assure adequate resources, simplifying the process for staff to get formal investigative orders, and establishing timetables to assure that commissioners do not delay consideration of "controversial" cases.6 The two Republican commissioners - Kathleen Casey, formerly staff director of the Senate Banking Committee, and Troy Paredes, formerly a securities law professor - will likely also be supportive of strong enforcement.
In these circumstances and with huge public demand for action, it is possible that we will see the most vigorous SEC enforcement program in the agency's 75-year history. As described below, there are a number of key areas where SEC defense lawyers will see special focus in the new enforcement environment of 2009.
The SEC reports that it already has a task force working on "more than 50 investigations in the subprime area," and the agency has stated that investigations growing out of the subprime mortgage and credit market crisis will be at the top of the SEC's enforcement agenda. The widespread nature of the problem makes this inevitable. As 2009 unfolds, the SEC will focus on three broad categories of cases. First, it will investigate subprime lenders. Second, it will investigate various players involved in securitizing subprime obligations, including investment banks, credit rating agencies, insurers and others. Third, it will look at banks and broker-dealers involved in selling subprime-related investments to the public.7
Facing a situation of unprecedented complexity, the SEC has so far brought just two cases. In June 2008, the SEC sued two Bear Stearns portfolio managers following collapse of two hedge funds and charged they had deceived investors and counterparties about the financial state of the funds and their over-exposure to mortgage-backed securities. In September 2008, the SEC sued two brokers and charged that they had misrepresented that the auction rate securities they sold were safe and liquid and backed by federally guaranteed student loans, when they were actually backed by subprime mortgages, collateralized debt obligations and other collateral.8 With more than 50 investigations already underway, some involving multiple entities and individuals, the SEC will likely file a substantial number of cases in this area during 2009.
Ponzi and Other 'High Impact' Frauds
There will be a huge fallout from the alleged Madoff Ponzi scheme that will extend well beyond prosecuting Bernard Madoff and marshalling what may be left of the missing $50 billion. According to press reports, the SEC is already investigating certain Madoff associates to explore what involvement, if any, they may have had in the scheme. More broadly, the SEC will examine the roles of numerous independent advisers and intermediaries who in various ways may have facilitated investments in Mr. Madoff's enterprise. The Madoff situation may also further fuel the SEC's ongoing general enforcement interest in the activities of hedge funds.
Having failed to catch the alleged Madoff fraud before it collapsed, it is certain that ferreting out other possible Ponzi schemes will be high on the SEC's radar in 2009, and tough economic conditions will make it harder for such schemes to keep out of sight. During just a two-week period beginning not long after its Madoff announcement, the SEC announced cases involving no less than four additional Ponzi schemes. Like the alleged Madoff fraud, these schemes inflicted substantial losses on large groups of victims - $23.4 million raised from thousands of moderate-means investors for purported trading of stocks and options; $50 million raised from 80 investors for purported securities futures trading; $4 million from 200 investors for purported investment in "high quality" residential mortgages; and $25 million raised from 120 investors for purported trading of U.S. and Japanese currency contracts.9
In looking for similar broad-impact cases, the SEC will likely also focus on so-called "affinity" frauds that target members based on religious, ethnic or other cultural connections. One of the SEC's recent Ponzi cases allegedly preyed on Haitian-American investors and promised to make investments that would benefit the Haitian community in the United States and Haiti. Another allegedly targeted Catholic clergy and religious orders, while still another allegedly targeted Orthodox Jewish investors.10
Foreign Corrupt Practices Act
In fiscal 2008 (ending Sept. 30, 2008), the SEC brought 15 Foreign Corrupt Practices Act (FCPA) cases, and since 2006 it brought 38 such cases, more than in the entire prior history of the FCPA since its adoption in 1977.11 In recent bar panels, senior SEC enforcement officials have been promising that FCPA will be a centerpiece of the SEC's enforcement efforts during 2009.
This 2009 focus on FCPA is already off to a strong start. On Dec. 12, the SEC filed against Siemens AG what is by far the largest FCPA case in history. The SEC charged that Siemens, a German company listed on the NYSE, had paid $1.4 billion in bribes over a six-year period to government officials around the world to win business. To resolve the matter, Siemens agreed to pay $1.6 billion, including $350 million in disgorgement to the SEC, $450 million as a criminal fine to the Justice Department, and hundreds of millions to a German prosecutor.12
The Siemens case came just three months after another landmark FCPA case against Albert Jackson Stanley, the former CEO of Kellogg, Brown & Root Inc. That case charged payment of $180 million to obtain contracts for LNG-facility construction projects in Nigeria. Mr. Stanley settled with the SEC and the Justice Department, and promised to cooperate with the government's ongoing investigation.13
SEC enforcement actions for insider trading are trending significantly higher. The SEC brought more insider trading cases in fiscal 2008 than in any past year, and such cases were up 25 percent over the year before. Among its most notable were a $24 million insider trading case against a Dow Jones board member and three other Hong Kong residents, and a $30 million case against the former chairman of an Enron division.14 During 2009, the SEC will continue to be tough on insider trading, and it will likely continue to test pleading limits by bringing such cases on circumstantial evidence that is not much stronger than a conversation of unknown content with an insider followed by a profitable trade.15
Cooperation With Other Enforcers
The SEC's relationship with other securities regulators has not always been smooth, as shown when the New York State Attorney General's Office used the criminal-sanction muscle of its state securities statute to race ahead of the SEC in the mutual fund trading probes a few years ago. Times have changed. The SEC recently demonstrated the ability to team with the New York Attorney General after the freeze-up of the auction rate securities market. SEC and state enforcers cooperated on testimony-taking and other investigative efforts to hammer out settlements with large banks designed to quickly restore liquidity for retail and small business investors.16
New SEC Chairwoman Schapiro can be expected to do everything possible to coordinate enforcement efforts with the New York Attorney General, the multiple U.S. Attorney's Offices active in securities matters, and the array of other securities regulators whose reach overlaps the SEC's. In this spirit, SEC Commissioner Aguilar has recently called for the SEC to develop a "strong, collaborative relationship" with state and Canadian provincial regulators and to consider forming a permanent joint enforcement task force "to monitor financial activity across North America, consider the accumulated risk, and share and discuss recommendations for appropriate action."17
Finally, with trading and markets now globally interconnected, the SEC will continue its ongoing process of forging ties with foreign regulators. Following a 2003 European Union directive, securities regulators across the EU now target substantially the same misconduct as the SEC, and regulators now strive to share information and bring cross-border enforcement cases.18 For its part, the SEC is upgrading its memoranda of understanding with foreign regulators to allow broad sharing of information for market oversight and supervision of financial services firms, and not simply case-specific requests for information.19 In the coming year and beyond, we will likely see European securities regulators behaving more like the SEC, and see the SEC working with foreign regulators to bring more multijurisdictional enforcement cases reaching across national boundaries.
Enforcement and Consolidation
President Obama and congressional leaders are considering whether to merge the SEC with the CFTC and possibly other financial services regulators. In her confirmation hearing, Ms. Schapiro laid out the enforcement challenge she will face in "any regulatory overhaul that may be undertaken" - the need to "ensure" that consolidation preserves the SEC's commitment to "investor protection, transparency, accountability, and disclosure." Days before, SEC Commissioner Aguilar urged that any SEC-CFTC combination hew to "the SEC's model of regulation," and not the CFTC's.
In contrast, the Treasury Department last March appeared to endorse the "principles-based" CFTC model for a combined agency "by imbuing the SEC with a regulatory regime more conducive to the modern marketplace."20 If regulatory consolidation proceeds in the present crisis environment, Ms. Schapiro will likely win this tug-of-war over regulatory philosophy.
During most of the SEC's history, presidents have chosen securities industry executives, defense lawyers and politicians as their SEC chairmen. President Obama has instead appointed an SEC chairwoman with decades of experience managing securities enforcement programs. In the present national crisis, the public and their elected representatives are calling for vigorous enforcement, and all signs are that Mary Schapiro and her "reinvigorated" SEC will deliver. A challenging 2009 lies ahead for SEC defense counsel.
Reprinted with permission from the February 9, 2009 edition of New York Law Journal © 2009 Incisive Media Properties, Inc. All rights reserved. Further duplication without permission is prohibited.