SEC’s New & Improved Enforcement Division

Corporate compliance and legal officers take note: You will not be dealing with the same Securities and Exchange Commission any longer.

So says Robert Khuzami, the SEC’s newly named director of enforcement. After six weeks on the job, Khuzami has outlined a range of reforms that the Enforcement Division will implement to improve its performance. His plans come on the heels of a scathing report from the Government Accountability Office, which recently flagged numerous weaknesses in the SEC’s enforcement program.

The GAO report was partly driven by the SEC’s failure to detect the gigantic Ponzi scheme run by the now-disgraced Bernard Madoff, despite numerous tips to SEC enforcement lawyers. Testifying before a Senate Banking Committee hearing on May 7, one day after the GAO report’s release, Khuzami said that he concurred with all of the concerns the GAO raised.

“The GAO report and its recommendations are timely,” he said, “and dovetail with our proposed initiatives to strengthen our Enforcement Division, maximize our resources, and meet the challenges that lay ahead.”

Following are the four biggest criticisms raised by the GAO and how Khuzami plans to address them:

1. Improved organizational structure for the Office of Collections and Distributions. The SEC established the OCD in 2008 as part of its effort to improve management of the Fair Funds program, which disburses money collected from fined companies to aggrieved investors. But the GAO said the office’s organizational structure may hamper efficiency and effectiveness, because it has a dual reporting structure where most of the staff don’t report to the OCD director.

Khuzami

Khuzami said he’s considering GAO recommendations to change that structure and reporting relationship. Among the solutions the SEC is considering is hiring a chief operating officer or business manager, to manage administrative, IT, 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,” Khuzami said during his Senate testimony.

2. Review of resource and workload imbalances. The GAO also noted that while overall Enforcement resources and activities have remained relatively steady in recent years, the number of investigation lawyers has decreased by 11.5 percent. Such shortages have meant that “some worthwhile leads cannot be pursued, and some cases are closed without action earlier than they otherwise would have been,” the GAO report said. Specifically, the report identifies the need for additional resources in enforcement devoted to administrative and paralegal support, IT support, and specialized services and expertise.

SEC SELF-ASSESSMENT

In the following excerpt from testimony before the U.S. Senate Banking, Housing, and Urban Affairs Subcommittee, Robert Khuzami outlines areas of consideration during the SEC’s Enforcement Division’s self-assessment:

[O]ur 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.

Source

SEC Enforcement Director Robert Khuzami’s Testimony (May 7, 2009).

Khuzami agreed and said he wants to remedy that manpower shortage as part of a broader effort to bring more resources to administrative and paralegal support, IT, and trial lawyers. The Division is also exploring how it can use specialized teams—say, one exclusively devoted to accounting fraud—“as a way to enhance our understanding of the areas we investigate and our ability to see patterns, links, trends, and motives,” he said. “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.”

3. Review of corporate penalty policies. In 2006 and 2007, the SEC adopted new policies for determining the appropriate size of corporate penalties. In its report, the GAO recommended that the Commission examine whether the 2006 corporate penalty policy and 2007 “penalty pilot” program are achieving their intended goals.

Schapiro

Much is already being done in this area. In February, SEC Chairman Mary Schapiro dismantled the Commission’s two-year-old penalty pilot program. In addition, to accelerate the approval of formal orders of investigation, Schapiro also called for the SEC to return to an older policy that allows the staff to use subpoena power to compel witness testimony and the production of documents without a full Commission meeting. Under the current program, many formal orders are made subject to full review at a meeting of all five Commissioners, requiring that they be placed on the calendar sometimes weeks in advance.

4. Address communication gaps. Related to the 2006 corporate penalty policy, the GAO report noted weaknesses in how the Commission communicates with its staff. “In particular, the Enforcement Division, which is responsible for implementing the policies, had only limited input into their development,” the report said. “As a result, enforcement attorneys say there has been frustration and uncertainty in application of the penalty policies.”

Moving forward, Khuzami noted that improvements in communication will continue to be a priority. “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.”

Other Changes

Concerns addressed by the GAO are not the only issues on the Enforcement Division’s agenda. Khuzami said he also wants to implement a stronger whistleblower program and would like to crack down on wrongdoing in the hedge fund and derivatives markets, which the SEC largely isn’t authorized to do right now. The SEC is already pushing for legislation to change that.

“These proposals will be aimed, in part, at ensuring we have sufficient authority and reach to combat fraud and other market misconduct,” Khuzami said.

In addition, the SEC also plans to follow through with other legislative measures discussed in the past, “which would provide important substantive and procedural tools to the Enforcement Division.” Some of those tools include giving the Commission the authority to seek penalties in cease-and-desist proceedings and authorizing civil penalties against aiders and abettors under the Investment Advisers Act, Khuzami said.

But many other potential weaknesses are also waiting to be addressed. One issue the GAO report did not address: the SEC’s inaction on abuses in the securities industry, instead leaving those responsibilities to state regulators and private litigants. Mercer Bullard, a University of Mississippi law professor who also testified before the Senate on May 7, said that delegation of authority has resulted in “a decline in public confidence in the markets, a reduction in investor protection, and an increase in uncertainty regarding applicable legal standards.”

Bullard offered an example in which the Commission has for years been aware that money management funds were compensating brokers for selling fund shares by directing brokerage business to the brokers’ firms. The funds didn’t ban this practice until state regulators cracked down on the practice. “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,” Bullard said.

“When known misconduct becomes widespread, it becomes difficult for compliance officers and legal counsel to persuade their clients that the misconduct is illegal,” Bullard added. Firms that seek to compete in a free enterprise market “are undercut by those who compete by breaking the rules.”

Concluded Bullard: “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.”