SEC ENFORCEMENT TRENDS 2011: Analysis and Conclusions

This is the final installment in a series of articles that has been published periodically analyzing the direction of SEC enforcement.

The Division of Enforcement is critical to the overall mission of the SEC. To bring a new ethics to the market place it is essential that the enforcement program effectively monitor that market and halt malfeasance. Equally critical, the program must deter future violations through its presence, the actions it brings and the remedies obtained in those cases.

When SEC Enforcement began its historic reorganization the program was at a cross-roads. Once it was well respected and considered one of the most effective in government. Scandals and malfeasance tarnished that reputation, leaving many viewing the agency as ineffective or perhaps worse. Some critics suggested it be merged while others thought it should be abolished.

Yet not only has it survived but Congress has fortified the Commission with new weapons, broadening the reach of the antifraud provisions and strengthening its remedies. At the same time new inter-agency task forces have broadened and fortified its reach. All of this should place the newly streamlined program in a good position to achieve its goals. Yet many question whether the agency has moved past the cross-roads.

To be sure, in recent months the enforcement program has compiled impressive statistics. In the most recent fiscal year the SEC opened more investigations, filed more cases and secured more orders for more dollars than in the prior year. Although once criticized for not brining actions against major players, in recent months cases have been initiated against Wall Street titans such as Goldman Sachs, Citigroup and Bank of America. Others were brought against market place giants General Electric, Dell Inc. and Johnson & Johnson.

The SEC has also notched significant settlements in large, headline grabbing cases. Wall Street icon Goldman Sachs made an unheard of admission of error in settling with the Commission while consenting to a fraud injunction and agreeing to pay a record setting civil penalty. The SEC also obtained significant settlements in actions against the key former officers of sub-prime lending giants Countrywide and New Century Financial while bringing its first enforcement action against a state.

There are troubling signs however. The settlements in Bank of America and Citigroup, both major enforcement actions, raise serious questions. In both cases the court initially declined to enter the proposed settlement. In both cases the complaints contain allegations of intentional misconduct which belied by the terms of the proposed settlements, causing the courts to balk at executing the proposed consent decrees. In Bank of America the court went so far as to call the Commission’s investigation a sham. Despite the fact that the judge in each case acknowledged it was not their position to second guess the SEC, neither would sign off on the settlements without revisions to the agreements.

Equally disturbing are the results in the courtroom. While the agency has won cases at trial, it has also lost a significant number, an usual occurrence for a prosecutor. More disturbing however, are comments from the bench noting not just a failure of proof but at times inappropriate tactics such as an argument totally lacking in evidentiary support or the misinterpretation of proof such as misreading an order ticket for the purchase of a security. Every program has a few difficulties. Here there are enough to be called a red flag.

The program is, nevertheless, moving forward, if only in fits and starts while at times still dodging the scandals of the past. An analysis of the Commission’s recent cases in key areas suggests its future course:

• The market crisis cases: The action against Goldman Sachs is not just the most significant market crisis case but the most notable action brought in some time by the Commission. Built on exceedingly complex transactions, the case is at the center of what many believe caused or at least greatly contributed to the market crisis. The Mozilo and Morrice cases against, respectively, executives from Countrywide and New Century were also significant. Unfortunately the difficulties with Citigroup raised significant questions while Bank of America was nothing short of an embarrassment. In view of the depth and breath of the market crisis and the huge amount of resources expended on the ensuing investigations, it would seem that there should be more cases.

• Insider trading: The headlines in this area go to the Manhattan U.S. Attorney. The conviction of Raji Rajaratnam, the aggressive investigation of the expert networks and the wholesale use of blue collar tactics on a scale not seen before in this type of investigation are significant. The Commission however has been equally aggressive but in a manner which many have overlooked by many. In selected cases the SEC is gradually pushing out the edges of insider trading law. Cases such as Cuban and Onubus present issues about the nature of the agreement under which confidential information is obtained and the obligation of its recipient. Others such as Steffes and the recently filed Carollaction (here) raise questions about the viability of the mosaic theory and the use of what can appear to be routine information observed by employees. These trends, together with a renewed emphasis on Reg FD, may eventually rewrite insider trading law into a kind of parity of information standard which was rejected by the courts years ago. In the long run this trend will have a more significant impact on the market than the headline grabbing blue collar tactics. It should also be of concern to compliance officers.

• FCPA: This is an area in which the SEC aggressively took charge years ago. While FCPA enforcement today continues to be a Commission priority, DOJ dominates the scene. This is not to say that the SEC is not playing an important role. The Commission’s approach and settlements however often belie the statements of its officials. In the beginning the focus was on self-reporting and preventing future violations. Initiatives like the 1970s volunteer program encouraged and rewarded self-reporting. The settlements of that era were remedial and focused on future prevention. Today DOJ and the SEC both emphasize these same themes. Yet it is DOJ which frequently highlights the cooperation of a company in an FCPA investigation and points out its benefits in the settlement papers. The SEC, in contrast, frequently says little about the cooperation of the company while imposing settlement terms in cookie-cutter fashion. While there is no doubt that the threat of criminal charges will always be a key focus for any company, the SEC needs to return to its roots and embed in its program the notion of compliance which prevents violations and cooperation which aids in effectively resolving them. The recent announcement that the Commission entered into its first non-cooperation agreement and that the underlying mater in an FCPA case, may signal the beginning of such an effort (here). At the same time, issuers would do well to revisit their compliance procedures, ensure that they are fully integrated with internal controls and extend to agents who are all too frequently at the center of FCPA charges.

• Financial fraud: Many of the recent financial fraud actions have evolved out of the market crisis. Cases like Citigroup, Mazilo and Morrice center on disclosure claims which key to financial fraud. Some cases such as Krantz, the action against the outside directors of bullet proof vest manufacture Point Blank, may suggest a new level of scrutiny for corporate directors. At the same time the settlements in cases like Citigroup and Dell, where the conduct as described in the complaints appears intentional but the resolution is based on lesser charges, suggest an evolving claim of failure to monitor by corporate officials reminiscent of a kind of Caremark duty. In re Caremark Derivative Litigation, 692 A. 2d 959 (Del. Ct. Ch. 1996). At the same time the SEC has made it clear that it will aggressively assert Section 304 of Sarbanes Oxley, demanding repayment from CEOs and CFOs of certain incentive based compensation where there is a restatement tied to wrongful conduct despite the fact that the executives were not involved in any malfeasance. The evolution of a failure to monitor approach should encourage vigilance by corporate officials and perhaps foster cooperation. In contrast the SEC’s administration of Section 304 can only be viewed as counter productive, discouraging incentive compensation, restatements and self-reporting. These conflicting trends should be carefully monitored and assessed by issuers when evaluating incentive based compensation, considering a restatement or faced with a self-reporting decision.

• Regulated entities: The recent key cases in this area, which are largely tied to the market crisis, center on undisclosed conflicts of interest, overreaching and not disclosing the impact of the market crisis on the firm. Others are tied to self-dealing at the expense of the clients.

The trends from these cases clearly indicate a program which is moving forward and should be carefully monitored by issuers and their directors and officers. Equally clear are the red flags of troubles within the enforcement program. Lurking in the background seems to be the never quite gone scandals of the past. Together these trends represent a program in transition. In the end whether it continues to move forward and once again becomes a highly effective and respected regulator and enforcer may well a function of the final results from the on-going market crisis investigations and the ability to move past old scandals.