Speech by SEC Staff:
Speech to the Society of American Business Editors and Writers (SABEW)
Director, Division of Enforcement
U.S. Securities and Exchange Commission
Walter Cronkite School of Journalism and Mass Communication
Arizona State University, Phoenix, Arizona
March 19, 2010
Thank you for that kind introduction. It’s great to be here in Phoenix and I am grateful for this opportunity to talk about my first year as Director of Enforcement.
Before I describe some of the events of the last 354 days — we are 11 days shy of my first-year anniversary, I need to start with that usual headline-grabbing disclaimer — my views are my own and do not necessarily reflect the views of the Securities and Exchange Commission or any member of the Commission staff.
It has been an eventful year. On March 30, 2009, when I started, we were in a difficult and challenging place.
There was a steady stream of harsh criticism.
Some of it was directed at all financial regulators questioning why more was not done to prevent the credit crisis or mitigate its impact.
Other of it was directed at the SEC specifically, including that arising out of the egregious fraud of Bernard Madoff, and of our failure to take steps sooner to prevent it.
For a proud group of dedicated public servants, these criticisms — and the tragedy of investors who lost so much — were felt deeply and profoundly.
At the same time, regulatory reform was taking shape in Congress, and some were calling for the dismantling of the SEC or a significant cutback in its authority.
And I recall specifically, one of the most telling points — legislation was introduced in the Senate in mid-2009 proposing additional funds for law enforcement to fight financial fraud — the bread and butter of the SEC’s Enforcement Division — and designating more than a dozen federal and state law enforcement agencies to receive those funds.
But the SEC was left off the list.
It was, as I said, a difficult and challenging time in those early weeks and months.
But fast-forward ahead one year, and the Division of Enforcement, and the Commission as a whole, are in a very different place.
Congress has increased our funding for FY 2009 and hopefully will do so again in 2010, recognizing how underfunded we have been given the magnitude of our regulatory and enforcement task.
There is legislation before Congress that may result in hedge fund registration and the creation of a clearinghouse for derivatives, which together would increase the SEC’s authority and the availability of trade data to allow us to more effectively do our job.
There are new initiatives across the Commission and the Division, some of which we will talk about today.
The Commission is attracting a great deal of new talent, including those with significant expertise in the areas of risk management, derivatives, rating agency operations, portfolio management and others.
And the Enforcement Division has continued to investigate and file significant and high-impact cases across many different products and market practices.
So when I reflect on the past year, I think about how this turnaround happened.
The first reason is the Chairman, Mary Schapiro, who has reinvigorated the Commission with her leadership and high expectations.
The second reason is that we learned from the criticism rather than running from it.
In the Enforcement Division, we used it as a springboard to launch an intense, in-depth self-assessment, in which we set up ten Advisory Groups to study every aspect of our operations, structure and process.
The Groups were given only three mandates — no sacred cows, question everything, and come back in 10 weeks with concrete, realistic deliverables.
We listened to friends and enemies, supporters and critics, current staff and alumni, private sector and public.
We even spoke to business writers and editors, if you can believe that.
And we were shameless — we out-and-out stole ideas from other law enforcement agencies or the private sector if we thought they would work for us.
And mostly, we listened to the staff. The best source of ideas for improvement in an organization comes from those who labor every day under its flaws and imperfections.
Let’s go through some of these changes that the Advisory Groups delivered. The first is the move to specialization.
The Enforcement Division is a cop that walks the financial services beat.
It is a complex and dynamic neighborhood that we police, where products are complicated and evolve with increasing velocity, where markets execute with incredible speed, and where transactions are global in scope.
If you want to catch the bad guys who live and work in this neighborhood, you have to learn everything you can about how those markets, products and transactions operate, the economic substance of that activity, and how money is made and how it is lost in each product or transaction.
Don’t get me wrong, the Enforcement Division has done complicated and challenging cases throughout its entire existence.
One quick survey of the cases tells you that — complicated accounting and financial statement fraud, structured finance reinsurance transactions, insider trading in the CDS market, and many, many more examples.
But the fact remains that our staff has historically been generalists, often doing different types of cases over time.
This means that the expertise is diffuse throughout the Division and often allowed to dissipate as the staff member moves on to the next case.
And this requires the next staff attorney working on an investigation of the same nature to “reinvent the wheel.”
This is not an individual fault — these folks are plenty smart and dedicated. It was a failure of the organizational structure to capture and cultivate this expertise in a more meaningful way.
To do that, we established five specialized units, each a fixed point in our organization where persons could develop expertise, learn from others with a similar focus, receive specialized training, and then build on that expertise through repeated investigation into the same conduct.
What this does is bring us closer to the holy grail of law enforcement — stopping wrongdoing before it happens or shutting it down as early in the life-cycle as possible.
The fact is that when markets go up, fraud happens, and when markets go down, fraud is exposed.
But that is not an excuse for inaction.
The fact that we can’t prevent all frauds does not mean we should not strive with every breath to do better, and recognize that stopping early even a few more frauds sooner than you otherwise would have is a metric of success.
Specialization also gives us a better chance to catch those who would otherwise go undetected or against whom we cannot make a case.
These are often the masterminds, those who organize, devise, manage, and supervise the wrongdoing.
In white-collar crime, and securities fraud is no exception, the masterminds leave the fewest footprints, and they are often planning their defense at the same time they are committing the fraud.
To take a simple example, those who trade on insider information may well accumulate at the same time a stack of research reports on a company whose stock they just illegally purchased, and point to that file when law enforcement comes knocking.
They also use the complexity of products or the opaqueness of markets to conceal there misconduct — over-the-counter derivatives trading, accounting tricks, and difficult-to-value assets are just a few examples.
The best way to catch them is to be smart in the areas they operate — the more we know, the less likely these defensive strategies will be successful.
Lastly, specialization allows us to make informed decision about where to focus our enforcement efforts.
The SEC receives hundreds of thousands of tips, complaints and referrals each year.
In addition, there are spinoffs from existing investigations, referrals from other law enforcement agencies, and even suggestions from the articles all of you write and edit.
If all we did was passively sit back and pick through what comes in the door, everyone would have more than enough work, and we would bring complex and worthy cases.
But if we only did that, we would miss some of the riskiest behavior; miss the tidal wave heading to the shore, because by definition, the tips, referrals and headlines are often lagging indicators of fraud and wrongdoing.
In contrast, if we develop deep expertise about markets, products and transactions, consult with experts across the Commission and elsewhere, and then decide on an informed basis what rock to look under, we stand a much better chance of achieving that holy grail — deterrence and stopping fraud as early as possible.
So let me briefly describe the five Specialized Units we created.
The first unit is the Asset Management Unit.
This unit will focus on investment advisers, investment companies, hedge funds, and private equity funds — entities that account for an ever-increasing share of public and private investment funds.
Now, more than ever, effective enforcement requires a comprehensive approach to these entities.
Hedge funds can be particularly challenging.
They have undergone explosive growth, and they are not subject to the same rules as mutual funds with respect to liquidity, redemptions, conflict rules, pricing, disclosure, use of leverage, short sales — among other areas.
There is a lack of transparency to their trading that can be a source of concern — they trade extensively in less transparent markets, such as in credit and derivatives, utilize high-tech trading systems and techniques, and have close prime brokerage, cap intro and other relationships with investment banks, who themselves are sources of a great deal of private-side information that would be highly valuable to any trading entity.
Hedge funds also can have different fee arrangements across multiple structures and affiliates, which can create conflicts and incentives for improper activity.
The second unit is the Market Abuse Unit.
This unit will focus on large scale trading networks and rings — so called “organized” insider trading, as well as large-cap market manipulations, systems-based and platform-driven trading violations such as front-running, collusive trading, best-execution and abusive short-selling.
A particular focus of this unit will be on developing a proactive, trader-based investigative strategy, in which we will use improved technology to identify a core group of traders who trade in tandem under suspicious circumstances, and then deconstruct their social and other networks to identify common relationships or associations.
The third unit, the Structured and New Products Unit, will focus on complex financial instruments.
These include credit default swaps, collateralized debt obligations, securitized and other structured products.
It is also a group that can stay abreast of market trends and the development of new products, or new twists on old products.
For example, there is the so-called “Maturity Wall” that hits starting in 2012, beginning a 3-year period in which more than $700 billion in high-yield corporate debt issued as part of the past wave of private equity acquisitions comes to market.
There is concern that this may overload the debt market.
If that creates incentives to engage in some improper pricing, disclosure or offering practices, or some newly-devised or customized structure to sell it, you want folks keeping a close eye on such a development.
Next, the Foreign Corrupt Practices Unit will focus on proactive approaches to identifying violations of the Foreign Corrupt Practices Act, which prohibits U.S. companies from bribing foreign officials for government contracts and other business.
While we have been active in this area, we generally have relied on issuers to self-report their violations, after conducting internal investigations.
We intend to focus on being more proactive in investigations, learning of possible violations in advance of self-reporting, working more closely with our foreign counterparts, and taking a more global approach to these violations.
Last is the Municipal Securities and Public Pensions Unit.
The municipal securities marketplace has 50,000 issuers and $2.8 trillion in bonds outstanding, with $400 billion in issuance last year alone.
Large numbers of retail investors hold municipal securities, the infrastructure and other state and local financing needs are overwhelming, and the issuers of these securities — state and local governments and agencies — are under severe financial stress.
All of these developments concern us, as does the fact that it is a thinly-regulated market, as municipal securities are exempt from the registration requirements of the federal securities laws.
Thus, the anti-fraud laws enforced by the Enforcement Division play a significant role in the effort to police these markets, making a specialized focus even more important.
This unit will focus on five types of securities fraud: (a) offering/disclosure fraud; (b) tax or arbitrage driven fraud; (c) pay-to-play and public corruption violations; (d) public pension accounting and disclosure fraud; and (e) valuation/pricing issues.
These units are currently in formation, with management having been selected and we expect them to be fully staffed by mid-April or so.
They will also be national in scope, with staff located in various offices across the nation. This will help to encourage communication across regions and build more national “cartilage” across the entire Division.
The second initiative coming out of our self-assessment is the adoption of various witness cooperation tools.
The primary tool is the “Cooperation Agreement,” in which we agree that if a person provides timely, useful and thorough cooperation in an investigation, including full and accurate testimony, and we conclude that such cooperation constitutes “substantial assistance” in the investigation or prosecution of another, then we will agree to recommend to the full Commission that the cooperator receive reduced sanctions, or perhaps in some cases no sanctions, in exchange for that cooperation.
In common parlance, these are persons who have “flipped.”
These are commonly used tools in every criminal law enforcement authority in the nation.
Indeed, in many senses, cooperator testimony is the lifeblood of criminal prosecutions. A cooperator can provide the missing link to connecting someone to the wrongdoing, or allow an investigator to cut through efforts to obstruct the investigation and get to the truth.
Cases aided by cooperator testimony can be made quickly and efficiently, because cooperators are most often insiders who have seen and heard all that happened.
Charges supported by cooperator testimony can be resolved or litigated from a position of strength.
And finally, cooperating witnesses can be the master key that unlocks the intricacies of cases involving complex transactions that might otherwise escape detection, or enable authorities to apprehend the higher-ups whose culpability can be the most challenging to establish.
Streamlining Management and Internal Process
Some of our initiatives were more focused on structure and process.
These initiatives are not as substantive as specialization or cooperation. They are more like fixing the plumbing.
But they are critical — we all know what happens when the plumbing backs up.
The first is management flattening.
We had a too top-heavy management structure, for reasons that are entirely understandable — the Division wanted to reward its high-performers, and without an ability to do so with financial incentives, it was done with promotions and management responsibilities.
But that did not make it an optimal management structure.
So we reduced the number of managers, and re-deployed those persons — some of whom are our best and brightest performers — to the frontlines of conducting investigations.
This flattening of our management structure will increase the resources dedicated to our investigative efforts, and will operate as a check on the extra process, duplication, unnecessary internal review and the inevitable drag on decision-making that happens in any overly-managed organization.
In addition to management flattening, we have also delegated the authority to start formal investigations and issue subpoenas back to the senior officers in the Division, and no longer require these orders to be circulated to other Divisions and voted upon the Commission. This expedites the investigative process and allows us to respond quickly and forcefully to persons who are less than cooperative in our investigations.
We have hired the Division’s first-ever “Managing Executive,” who is assuming a COO-type role, and building out a business manager function throughout the Division. A 1,200-person Division, whether public or private, needs a COO.
In the past, many administrative, operational, and infrastructure tasks were handled by investigative personnel, who did not necessarily have the training or expertise to handle such matters, and for whom these tasks amounted to distractions from their investigation-related functions.
By hiring staff with workflow, information technology, and process skills, these tasks can be centralized, more efficiently handled, and provide better support for investigative functions.
Office of Market Intelligence
We have established an Office of Market Intelligence to oversee the handling of the tips, complaints and referrals that the SEC receives each year.
A Chief for this office has been selected, operations have started, and it is being staffed up.
Last year, the Commission received approximately 700,000 tips, complaints and referrals.
They come from investors, the public, regulated entities, issuers, self-regulatory agencies, other government agencies, foreign regulators.
They arrive by Web forms, emails, phone calls, mail, messengers and faxes.
And they come into multiple different offices within the Commission.
While all of these offices had their own polices and procedures for handling these tips, complaints and referrals, the process is obviously decentralized, and there was no centralized database to house the information.
In addition, because they were decentralized, we were losing an opportunity to harvest this information for leads, emerging trends and patterns of behavior that might inform our investigative efforts and priorities.
The Office of Market Intelligence will address these shortcomings.
It will centralize the intake and analysis of this information, risk-weight and triage the matters so that the most serious allegations receive the greatest initial attention, and then assign the matters for further investigation and tracking.
OMI will be staffed by persons with cross-discipline expertise, including accounting, IT, trading and markets, investment management, corporation finance and other disciplines, so that the right pair of eyes are focused on each matter.
Metrics is the next area of change.
We are looking to compliment our traditional quantitative metrics — the number of investigations started, the number of cases filed, and the amount of money returned to investors — with more qualitative ones.
These include the programmatic importance of enforcement actions, the timeliness of filed or instituted actions, the productivity of our staff’s work on each action, the use of litigation resources and the number of priority investigations and actions as compared to our total caseload.
Over time, the new measures should help us evaluate whether reforms now being implemented are achieving the desired results.
These are the main deliverables of our self-assessment.
The other initiative, perhaps the most important of all, concerns the recruitment of talent.
In the end, it is the most important variable in determining our effectiveness. And the Commission and the Division have been extremely fortunate in the quality of the talent we have been able to attract.
Chairman Schapiro started the first new Division in years: the Office of Risk, Financial Innovation and Strategy.
This group is an in-house think tank headed by Professor Henry Hu, the former University of Texas Chair of Law of Banking and Finance.
It is staffed with persons formerly in the private sector who collectively are experts in a variety of market disciplines, including risk management, market structure, derivatives, corporate governance and disclosure, M&A and finance.
The expertise in Risk Fin will be available to everyone in the Commission, and in particular we expect great synergies with the specialized units, including the market abuse, asset management and structured and new products units.
Risk Fin will also make better use of data and data analysis, and better integrate our existing economic analysis function into the work of the rest of the Commission.
Within the Enforcement Division, we are hiring and getting expressions of interest from persons of great talent and experience.
We have named a new Deputy Director, as well as heads of the New York, Miami and Atlanta offices.
These persons are all former prosecutors, but even more importantly also have a mixture of public-private experience that brings with it a deep understanding of the markets and practices in which we operate.
Combined with the great talent that already exists in the Division, we are well-placed to move forward in a smart and aggressive manner to fulfill our investor protection mandate.
There is one final reason I know that this first year has been a period of great success and even greater promise.
It is because while in the midst of the most profound reorganization in the Division’s history, the staff has continued to take on difficult and challenging investigations aggressively and intelligently, and in filing cases of great significance.
Let’s start with some numbers. Over the past year we have:
- Increased disgorgement orders by 170% ($2.09 billion, compared to $774 million in fiscal 2008)
- Increased penalty orders by 35% ($345 million, compared to $256 million in fiscal 2008)
- Sought 82% more emergency temporary restraining orders (71, compared to 39 in fiscal 2008)
- Sought 78% more asset freezes (82, compared to 46 in fiscal 2008)
- Issued more than twice as many orders opening formal investigations (496, compared to 233 in fiscal 2008).
Let me give you a sampling of the cases we have filed, starting with those related to mortgage-related frauds and misconduct, a high priority for us given the critical role these products played in the credit crisis.
In Countrywide, we charged former CEO Angelo Mozilo and two other former executives with fraud for allegedly deliberately misleading investors about the significant and increasing risks associated with its business model and mortgage assets. We also charged Mozilo with insider trading based on his exercise of stock options and sale of more than 5.1 million shares of Countrywide stock while allegedly in possession of material nonpublic information about Countrywide’s increasingly risky business model.
In American Home, we brought cases against former mortgage lending company executives for accounting fraud and allegedly making false and misleading disclosures relating to the riskiness of the mortgages originated and held by the company.
We sued officers at New Century for providing false and misleading information regarding the company’s subprime mortgage business, overstating the company’s financial results by improperly understating its expenses relating to repurchased loans, and failing to disclose dramatic increases in early default rates, loan repurchase and pending loan repurchase requests.
In Brookstreet, we sued executives and registered representatives of a broker-dealer firm for allegedly making false statements in marketing complex mortgage-related derivatives, such as IO and inverse IO securities, as safe and suitable for retirees and others with conservative investment goals.
In Evergreen, we charged a registered investment advisor and its affiliate with allegedly overstating the value of a mutual fund that invested primarily in mortgage-backed securities, and for selectively disclosing problems with the fund to favored investors, allowing them to bail out early to avoid losses.
In the derivatives space, we charged a former portfolio manager at a hedge fund and an investment banking salesman with insider trading in credit default swaps on an international holding company VNU. In a new derivative-oriented twist, bank employees allegedly tipped the portfolio manager about an anticipated change in VNU’s underlying bond structure. Once announced, that change substantially increased the price of the credit default swap. By purchasing CDS before the deal structure changed, the defendants profited when the restructuring was announced.
The lack of transparency in the derivatives markets adds a new and more dangerous dimension to misconduct such as insider trading.
We have pursued investment advisers to public pension funds for allegedly extracting kickbacks from investment management firms seeking to manage the assets of New York's largest pension fund.
We have charged hedge fund consultants with breaches of fiduciary duties for allegedly failing to perform the due diligence that they had advertised before they invested their clients’ money in hedge funds that turned out to be massive frauds.
Under the umbrella of accounting and financial statement fraud, General Electric agreed to pay $50 million to settle charges that it used improper derivative accounting methods to increase its reported earnings and revenues and avoid reporting negative financial results.
We are also keeping an eye on auditors; we charged Ernst & Young in connection with wrongdoing in connection with the $2.0 billion restatement of its client, Bally Total Fitness Holding Corp. We alleged that not only was E&Y aware of Bally’s fraudulent and improper accounting and disclosure practices, but that the firm also subsequently implemented a scheme to cover up the prior improper accounting and deficient audits.
E&Y settled the SEC’s action by agreeing to cease-and-desist from non-scienter fraud violations and making a payment of $8.5 million.
In two separate actions, we charged two broker-dealers and two options traders for "naked" short sale rule violations. Our complaint alleged that the respondents improperly claimed that they were entitled to an exception to the Regulation SHO requirements that broker-dealers must locate a source of borrowable shares prior to selling short and circumvented the requirement to deliver securities sold short by a specified closeout date.
In the pay-to-play area, we brought actions against J.P. Morgan Securities and two of its managing directors for their roles in an alleged unlawful municipal securities former pay-to-play scheme involving Jefferson County, Alabama.
We alleged that the firm and its two directors made more than $8 million in undisclosed payments to close friends of certain Jefferson County commissioners and that the commissioners in turn voted to select the firm as managing underwriter, and its affiliated bank as swap provider.
J.P. Morgan settled the case by paying $50 million directly to Jefferson County, forfeiting more than $647 million in claimed swap termination fees, and paying a penalty of $25 million.
In the executive compensation area, Section 304 of Sarbanes-Oxley is a powerful tool that is intended to deprive CEOs and CFOs from profiting when an issuer is required to prepare a restatement of its financials as a result of misconduct.
This section requires CEOs and CFOs to reimburse the company for any bonuses, or other incentive or equity based compensation, and profits from stock sales received in the 12 months after the initial filing that was later required to be restated.
Over the past two-and-a-half years, we have sought 304 reimbursements from 14 CEOs and CFOs in a total of 11 cases.
In the CSK Auto case, we sought for the first time reimbursement in a stand alone action against an executive. In CSK, we sought to claw back compensation from the CEO without alleging that the CEO himself had violated the law. We sued the CEO for violating 304 by failing to reimburse the company for a total of over $2 million in bonuses and over $2 million in profits from stock sales that he received in the 12 month period after the fraudulent filings.
Insider trading continues to be a priority for the Division.
We filed a complaint charging the former CFO of a San Francisco private investment firm and six relatives and friends who reaped more than $8.0 million in illicit profits based on tips about Tempur-pedic’s impending surprise pre-announcement on not meeting its earning forecast.
In the Galleon collection of cases, we have charged over 30 persons and entities with more than $70 million in illegal profits based on a massive insider trading scheme. This involved hedge funds that used the of paying bribes in exchange for inside information almost as a business model, and the case eventually ensnared corporate executives, consultants, rating agency personnel, proprietary traders, and public relations personnel.
There are many other cases beyond those I mentioned. But I think the point is made.
This level of enforcement activity, occurring simultaneously with a massive restructuring of the Division, means that this is one time when that overused analogy — changing the tires on a moving car — might actually be accurate.
And if past is in fact prologue, then I am very optimistic about what the future holds for the Enforcement Division and the SEC as a whole.
It is always a privilege to exchange ideas with a group such as this and I am happy to take any questions.