SEC Enforcement Quandary: Where Do We Go From Here?

Still in the thick of the recent financial turmoil, the Securities and Exchange Commission began its new fiscal year Oct. 1, with as much uncertainty about its future as there has been in many years.

There are far more questions than answers right now. What should be its priorities? Cleaning up the sub-prime mess? Financial fraud? Insider trading? Foreign corrupt practices? Manipulation by hedge funds? All of the above? More fundamentally, what is even the proper mission for the SEC—an after-the-fact “policeman” for violations like those mentioned above, or an aggressive regulator that identifies and prevents problems before they arise? And, finally, will the SEC have the budget and the manpower to do everything expected of it in the year to come?

Start with the SEC’s priorities for 2009—which in the quickly shifting financial environment, is not as simple a task as it sounds. As recently as June 2008, in a speech at the Compliance Week Conference, SEC Division of Enforcement Director Linda Chatman Thomsen offered some startling comments on the state of the SEC’s battle against insider trading and foreign corrupt practices. Thomsen stated that she was “profoundly dismayed at the extent to which the Commission’s insider-trading actions in the past year have involved securities industry professionals at the highest levels.” She added that this wave of insider-trading cases involving securities professionals has risen to levels “not seen since the days of Ivan Boesky and Dennis Levine in the late 1980s.” Thomsen echoed earlier comments from Chairman Christopher Cox that targeting insider trading by securities professionals was a top priority.

Thomsen also singled out the SEC’s focus on cases alleging the bribery of foreign officials in violations of the Foreign Corrupt Practices Act, which are now being brought in record numbers. Although the FCPA has been in been in effect for 30 years, Thomsen stated that the Commission had filed more FCPA cases in the last two years than in all preceding years combined.

As late as mid-September of this year, Michael Dicke, the new associate regional director for enforcement in the SEC’s San Francisco Regional Office, stated that he believed that financial fraud cases needed to be the top priority for the Enforcement Division and that his office was specifically looking at cases where companies were manipulating their expenses to improve their reported earnings.

Well, the sub-prime crisis threatens to make all those other SEC priorities take a distant backseat. Under harsh criticism from some for being too passive on this front, the SEC has repeatedly emphasized the huge amount of resources that it is now devoting to the sub-prime crisis. Chairman Cox testified before Congress on Sept. 18 that the SEC now has dozens of staff professionals working on auction-rate securities matters throughout the country. In August, Cox stated that the SEC had more than a dozen pending investigations into the ARS market and that “nobody is getting a pass” for misconduct. On top of that, the Enforcement Division’s Subprime Working Group is said to be conducting more than 50 investigations in the sub-prime area, exclusive of ARS, concerning sub-prime lenders, others involved in the securitization process, and those banks and broker-dealers who sold mortgage-backed investments to the public.

Speedy investigation and enforcement in all of these “top-priority” cases will be a huge challenge for the SEC in 2009. Such work, however, has historically been the SEC’s core function. As Cox often reiterates, “first and foremost, the SEC is a law enforcement agency.”

Even this role, however, has been second-guessed as part of the finger pointing that has inevitably accompanied the current financial crisis. Critics say that the SEC does not get in front of problems, but rather just acts as a policeman for blatant violations. Howard Schiffman, formerly in the SEC’s enforcement division himself, told Business Week in September that the SEC “hasn't been leading the charge, as much as they’ve been following it. The house burns down, and then they do a really good job to say, ‘Whose fault is that?’”

Here’s the truth, however: Asking the SEC in its current form to anticipate and head off problems before they occur is unrealistic, and counter to the way that the SEC’s enforcement function has been carried out for decades now. As a “law enforcement agency,” the SEC is trained and experienced in gathering facts about what has occurred, determining whether the law was violated, and taking enforcement action where appropriate to punish wrongdoers. By definition, this is a backward-looking exercise that punishes fraud that has already occurred.

The one formal foray that the SEC has attempted in the area of prevention and risk—the “Office of Risk Assessment” that it launched in 2004—has been largely ineffective. ORA’s stated mission was to “to see over the hills and around the corners of problems that may be looming in the distance” and “head off major problems before they occur.” To date, ORA does not appear to have made much, if any, publicly recognized effect on the SEC.

Indeed, when the first ORA Director, Charles Fishkin, left the SEC at the beginning of 2007, the SEC took more than a full year to replace him. The reality is that identifying and heading off complex risk in the financial markets simply is not the SEC’s strength. As Donald Langevoort, a law professor at Georgetown University, recently commented to Time Magazine about whether the SEC should be blamed for not detecting the trouble brewing at investment banks: “I’m not sure the SEC had the manpower or internal expertise to quickly ramp up to being able to spot highly sophisticated risk that, as far as we can tell, no one was good at spotting.”

One more important question as the SEC heads into its 2009 fiscal year is whether it is adequately funded to handle the avalanche of high-priority and important work now facing it. The SEC’s overall budget for 2009 is set to rise less than 1 percent in 2009, going from $906 million to $913 million in 2009. Perhaps more significantly, the number of SEC enforcement personnel is actually budgeted to decline in 2009, from 1,209 this year to 1,177 in 2009. Overall, the SEC expects to have 3,771 employees next year.

A recent article in U.S. News and World Report made the interesting point that the SEC’s 2009 budget and employee numbers seem to show very little respect from Congress for the SEC’s daunting mission, when you consider that, for example, the Smithsonian Institution budget for 2009 includes funding for 4,324 employees, and Congress allocates five times as much money for corn subsidies ($4.9 billion in 2006, the most recent year for which data are available) as it does for the SEC.

In short, 2009 looks like it will be a defining year for the SEC in its priorities and overall mission, as well as the resources that the United States is willing to invest in the SEC to permit it to carry out its job.