Opposition playbook

Few federal agencies have come in for as much criticism in recent months as the SEC. The agency’s Division of Enforcement, in particular, has been in the crosshairs of Congress and the media ever since revelations first emerged last December that it overlooked red flags raised by the case of Bernard Madoff, who operated the largest Ponzi scheme in history undetected for decades.

Ironically, though, the commission under former chairman Christopher Cox had already begun laying the groundwork for significant changes in the way the agency operates, most notably by issuing its first ever ‘enforcement manual’ in October 2008. The 122-page document was aimed at standardizing procedures across the SEC’s 11 regional offices.

Though the agency has for years produced an internal book of enforcement policies and procedures called the ‘red book’, the new manual is much more comprehensive and provides an unprecedented look into the procedures the SEC will use to launch and conduct investigations. It spells out everything from the length most investigations should last before review, to what kind of documents may be made publicly available, to how immunity will be handled.

Setting out the rules
One of the manual’s larger purposes, however, was to help insulate the commission from exactly the kind of controversy that has now engulfed it. Among the manual’s most significant provisions, for instance, are best practices spelling out the proper level of contact high-level SEC staff members should have with defense lawyers and others involved in investigations, advising that ‘the senior official should be particularly sensitive that an external communication may appear to be or has the potential to be an attempt to supersede the investigative team’s judgment and experience.’

That provision, several long-time agency observers say, stems directly from another high-profile dust-up involving the SEC’s handling of an insider-trading probe of the hedge fund Pequot Capital Management. In that case, an SEC special counsel in the Division of Enforcement named Gary Aguirre claimed that his superiors hampered his investigation and finally fired him after he attempted to subpoena Morgan Stanley CEO John Mack.

A Senate panel held hearings on the matter and congressional investigators eventually accused high-level Division of Enforcement members of undermining Aguirre. SEC enforcement chief Stephen Cutler, according to a report, met with an attorney representing Pequot, and just two weeks later 17 possible violations were reduced to only three.

‘One of the catalysts for this manual was the Aguirre case,’ says Pravin Rao, a partner at Perkins Coie and a former federal prosecutor and SEC Division of Enforcement branch chief.

As the agency grapples with the much larger controversy created by the Madoff case, the manual will likely serve as the vehicle for other reforms in the months ahead. The agency, says Rao, is ‘exasperated’ by all the criticism it has received over Pequot, the economy and Madoff, creating a ‘perfect storm’ that makes significant reform highly likely.

Stephen Crimmins, a partner at Mayer Brown and a former deputy chief litigation counsel for the Division of Enforcement, says the manual ‘encourages the enforcement process to self-evaluate’ and that the commission’s new enforcement director has indicated that he will seek input from the staff and likely ‘turn to the enforcement manual to implement changes.’

In the meantime, the initial document is giving corporate America and its attorneys plenty to study. David Seide, a former assistant US attorney and partner at Curtis, Mallet-Prevost, Colt & Mosle, notes that in addition to providing a set of well-defined practices that staff are expected to follow as they investigate cases, the guide ‘gives the defense community a common language’ it can use while preparing cases and dealing with the agency. Defense attorneys are likely to have plenty of opportunity to test out the new procedures in the months ahead.

New SEC chairman Mary Schapiro has made it clear she intends to shake things up and aggressively pursue cases. After witnesses and lawmakers alike spent two days lambasting the SEC at congressional hearings on the Madoff fraud, Schapiro announced that ‘we are going to act like our hair is on fire.’

Playing hardball
Schapiro ‘comes in with a mandate and a wish to try and prevent additional issues from happening,’ says Deborah Meshulam, a former SEC assistant chief litigation counsel and now the head of DLA Piper’s national SEC enforcement practice. ‘She’s taking a hard look at how the enforcement division has been structured, bringing in new people and adding a new energy.’

Among Schapiro’s most significant hires is a new enforcement chief, Robert Khuzami, a former federal prosecutor who was working most recently for Deutsche Bank. He’s made little secret of his intent to get aggressive. In April, he told the Washington Post that he wants the SEC to ‘become more of a deterrent.’ He noted, the article said, that there are too many white-collar criminals who ‘feel emboldened to resist, litigate or attempt to hold out for a better deal’ with the commission.

Schapiro has also begun instituting significant policy changes that pave the way for more enforcement actions. For years, staffers could negotiate settlements with companies and then bring them before the commission for approval. Under Cox, however, enforcement staffers were required to first get pre-approval from commissioners before even beginning to negotiate settlements for penalties against corporations – an unappetizing prospect, since many on the commission were perceived as promoting a more laissez-faire approach to corporate America. The impact of the requirement, says Crimmins, was to make enforcement staffers ‘more cautious, because the message was that staff should be careful about imposing penalties.’ One of Schapiro’s first actions was to reverse that policy.

The commission is also discussing another significant policy that would likely result in much higher penalties. In 2006, the SEC issued penalty guidelines that said a case must meet two criteria before a penalty is imposed: did the company gain by violating regulations or laws, and would imposing a penalty harm present shareholders by damaging the wealth of the corporation? Most expect Schapiro to reverse this policy as well.

‘There was then a sense on the part of the Cox commission that maybe things were getting a little
too high,’ Crimmins says. Under Schapiro, however, ‘the volume of cases will increase, more cases will involve penalties, and when there are penalties they will be in greater amounts than before.’

For corporate America the majority of penalties are likely to continue to fall in the two areas the SEC normally enforces: cases that involve misrepresentations or omissions either pertaining to financial reporting or made about a company’s business or its prospects, intentionally or recklessly.

Holding directors responsible
Mercer Bullard, an assistant professor at the University of Mississippi School of Law who testified before Congress recently on SEC reform, says a big question of Schapiro’s tenure is whether she will also ‘hold directors’ feet to the fire’ with respect to internal procedures mandated under Sarbanes-Oxley, especially ‘in respect to disclosure.’ Though the SEC has brought some cases against ‘egregious violations’, Bullard expects the agency at some point to step up its investigation and enforcement of SOX.

‘Enough time has passed for these procedures to become ingrained in the corporate world,’ he says. ‘The SEC may well take a look at who has established meaningful procedures and who has not.’

So far, though, Bullard sees little sign that Schapiro intends to be any more aggressive in targeting independent directors for enforcement actions. In early May, the commission filed fraud charges against several entities and individuals associated with the Reserve Primary Fund, the money market fund that ‘broke the buck’ on September 16, 2008, when its net asset value fell below $1 a share. The complaint alleges that the fund managers failed to provide key material facts about the fund’s vulnerability to investors and trustees.

According to Bullard, the fund’s directors have a specific statutory responsibility to value illiquid
securities in good faith. Yet during the week of September 10, when Lehman Brothers’ stock price plummeted 75 percent, the board maintained its valuation of Lehman debt held by the fund at 100 cents on the dollar. The investigation ‘was a scenario in which the SEC could have brought a case against the independent directors and sent a message, but it didn’t,’ Bullard says.

Perhaps the biggest obstacle to any increase in aggressive enforcement is funding. The number of lawyers doing investigations in the Division of Enforcement has dropped from 654 in 2005 to 594 in 2008, and according to some reports the size of some enforcement teams has been halved. Meanwhile, the securities industry grew by ‘double-digit metrics’, according to Crimmins. In his budget blueprint, President Obama asks Congress to hike the agency’s budget 9 percent, which would allow it to hire 50 new staff members – but even if Congress adopts that number, staff would still remain below 2005 levels.

Still, most agree that Schapiro’s arrival heralds a much more aggressive approach than that of her predecessor. And that means Corporate America can expect a lot more action from financial regulators in Washington and New York.