Review of SEC Enforcement in 2009 - 18 July 2009

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Review of SEC Enforcement in 2009

by Eduardo
Gallardo, Gibson, Dunn & Crutcher LLP,

Saturday, July
18, 2009 at 11:08 AM EDT

This post is by my colleagues Mark
Schonfeld, John Sturc, Barry
Goldsmith, Eric Creizman, Jennifer Colgan
Halter, Akita St. Clair, Ladan
Stewart and Matthew Estabrook.

Without question, the first six months of 2009 have been a period of
sharply
increased enforcement activity at the Securities and Exchange Commission. The
financial crisis, the new administration, new SEC leadership, increased
funding
and the focus of Congress and the media have all combined to encourage
heightened government scrutiny. And even though it has only been a few months
since a new Chairman took office, already there are tangible signs that the
SEC
has taken a more aggressive enforcement posture. In this alert, we review the
changes the new SEC leadership has instituted and is considering, the
observable impact of the new administration on enforcement activity and
significant cases in key areas that reflect the agency’s evolving
enforcement program.

I. Overview of Changes

A. The Backdrop

The events of 2008 led directly to the current enforcement agenda. The
collapse of the subprime mortgage market, the ensuing credit crisis, the
demise
of several major investment banks and, perhaps most of all, the Madoff case
led
to a loss of confidence in the agency’s ability to protect investors.
This loss of confidence was manifested in Congressional hearings and an
intensified media spotlight. At the same time, the SEC’s Inspector
General has issued a number of reports critical of the agency, and Congress
intensified pressure on the SEC and Department of Justice to bring cases in
the
wake of the financial crisis. At a March hearing of the Senate Judiciary
Committee on the law enforcement response to the financial crisis, Senator
Patrick J. Leahy declared, “I want to see prosecutions…. I want to
see people go to jail.”

B. The New SEC



Against this backdrop, the Obama Administration took office with a new
regulatory and enforcement agenda. Mary Schapiro was sworn in on January 27,
2009 as the twenty-ninth Chairman of the SEC. She wasted no time in
implementing changes to “reinvigorate” enforcement. In February, in
her first speech as Chairman, Ms. Schapiro announced two changes to the
enforcement process at the SEC intended to “empower” the staff of
the Enforcement Division. [1]

First, Chairman Schapiro ended a two-year “pilot” program,
implemented by the prior Chairman, which required the Enforcement staff to
seek
prior approval of the Commission before negotiating a civil money penalty
against a public company for alleged securities fraud. Chairman Schapiro
stated
that the pilot program had introduced significant delays into the process of
bringing a corporate penalty case, discouraged staff from arguing for a
penalty
and sometimes resulted in reductions in the size of penalties imposed.
Chairman
Schapiro further stated that the end of the program was designed “to
expedite the Commission’s enforcement efforts and ensure that justice is
swiftly served.”

Second, Chairman Schapiro provided for more rapid approval of formal orders
of investigation authorizing the staff to issue subpoenas by permitting
approval within a couple of days pursuant to the SEC’s
“seriatim” or “duty officer” procedures. As Chairman
Schapiro explained the change, “in investigations that require subpoena
power, time is always of the essence.”

In March, Chairman Schapiro announced an initiative to revamp the
SEC’s process for reviewing complaints and tips. The SEC retained the
Center for Enterprise Modernization, operated by the MITRE Corporation, to
assist with the creation of a more centralized process to identify leads for
potential investigations and inspections.

Chairman Schapiro has also initiated efforts to bring greater industry
expertise to the staff. In April, Chairman Schapiro announced a new Industry
and Markets Fellows Program to give industry professionals an opportunity to
work for two years in the Office of Risk Assessment and help identify and
assess risks in the financial markets. In addition, Chairman Schapiro created
new senior level positions within the examination program for individuals with
expertise in areas such as derivatives, valuation, securities trading, risk
management and forensic accounting.

C. New Director of Enforcement Division and More Changes



In February, Chairman Schapiro announced the appointment of Robert Khuzami, a
former federal prosecutor and investment bank general counsel, as the new
Director of the Division of Enforcement. In his May testimony to the Senate
Banking Committee, [2] Mr. Khuzami discussed proposals to
reallocate resources within the Enforcement Division to improve efficiency,
including:

• increasing the number of trial unit attorneys to present a
“credible threat” to defendants, improve the ability to win at
trial and increase settlement outcomes;

• increasing administrative, paralegal, and para-professional support,
to free up enforcement lawyers and accountants to focus on high-value
investigative tasks; and

• increasing information technology support for screening tips,
improving case and document management, analyzing market data and assessing
risks to investors.

Mr. Khuzami also outlined organizational changes under consideration with a
focus on making the Enforcement Division more “strategic, swift, smart
and successful,” including:

• creating specialized groups of attorneys along product, market or
transactional lines and increasing collaboration among staff across regions;

• flattening the management structure of the Division and reducing the
levels of review and approvals required for investigative steps to be taken;

• revising performance metrics to deemphasize quantitative factors,
such as the number of cases filed, and instead focus on qualitative factors,
such as timeliness, programmatic significance and deterrent effect; and

• increasing the rewards to individuals for cooperating in
investigations, including a potential request to Congress for an expanded
whistleblower program (beyond the existing statutory authorization for insider
trading cases) and greater use of agreements similar to deferred prosecution
agreements.

The appointment of Mr. Khuzami was followed by appointments of two other
former federal prosecutors to senior positions: George Canellos, as Director
of
the New York Regional Office, and Lorin Reisner, as Deputy Director of the
Enforcement Division. Both Messrs. Canellos and Reisner served in the U.S.
Attorney’s Office for the Southern District of New York earlier in their
careers. Most recently, news reports indicate that Mr. Khuzami has also taken
steps toward eliminating one entire tier of supervisors within the Enforcement
Division in an effort to reduce the levels of review.

D. Increased Enforcement Activity



Both Chairman Schapiro and Mr. Khuzami have cited a number of statistics to
demonstrate a significant up-tick in enforcement activity. [3] According to these statistics, between February and May
of this year, the number of emergency cases seeking temporary restraining
orders has nearly tripled (most likely due to the wave of Ponzi scheme cases
filed this year in the wake of the Madoff case) and the number of formal
orders
of investigation issued has more than doubled from the same period last year.

	Feb.-May 2008	Feb.-May 2009
TRO Cases	12	34
Investigations Opened	292	358
Formal Orders	74	188

Aside from the increase in TRO cases, the increase in the number of new
investigations opened and formal orders issued indicates a greater level of
investigative activity. But has there been an increase in the number of
enforcement cases being filed? The answer is a clear yes. We compared
injunctive actions filed in the first six months of 2009 and 2008. We found
that the number of injunctive actions filed and number of defendants charged
is
up significantly year over year.

	Jan.-June 2008	Jan.-June 2009
Injunctive Actions Filed	114	167
Number of defendants	317	527

Our analysis also reflected a noteworthy trend in the cases being filed.
While the number of cases filed and defendants charged is up, the percentage
of
defendants whose charges were settled at the time of filing is down
significantly year over year.

	Jan.-June 2008	Jan.-June 2009
Percentage of defendants settled at time of filing	32%	20%

This reflects not only increased enforcement activity, but particularly a
willingness by the SEC to file cases against defendants in the absence of
settlements. This may again be partly a result of the recent number of Ponzi
scheme cases that are typically filed on an emergency basis. But, as discussed
in more detail in the next section, it also likely reflects a priority on
bringing cases against individuals more quickly, without settlements and
without awaiting the result of possible parallel criminal investigations.

E. Significant Cases and Trends



More telling than the statistics, in the last few months, the SEC has filed a
number of high profile cases that demonstrate a more aggressive enforcement
approach and that are consistent with the themes that Mr. Khuzami has
articulated. Not surprisingly, the SEC has focused its attention on cases
related to the financial crisis. In addition, in an effort to bring cases more
quickly, the SEC has also more frequently filed these cases in the absence of
settlements and in the absence of parallel criminal cases. Moreover,
presumably
towards its goal of sending an “outsized message of deterrence,”
the SEC has charged senior level individual executives. As a consequence, the
SEC likely will face vigorous defenses and full litigation. The following
cases
illustrate these points: [4]

• SEC v. Mozilo, the SEC alleges that former executives of
Countrywide Financial misrepresented credit risks the company was undertaking
to maintain its market share; the SEC also alleges the former chief executive
officer engaged in insider trading despite having followed a 10b5-1 plan in
selling company stock.

• SEC v. Reserve Mgmt. Co., the SEC alleges that managers of
the Reserve Primary Fund money market fund failed to disclose material facts
about the fund’s vulnerability as Lehman Brothers sought bankruptcy
protection.

• SEC v. Strauss, the SEC alleges that former officers of
American Home Mortgage failed to disclose the company’s deteriorating
financial condition in 2007.

• SEC v. Rand, the SEC alleges that the former chief
accounting officer of Beazer Homes artificially reduced the company’s
income during the housing boom by improperly increasing reserves and
liabilities and then reversed those entries when the housing market declined
to
continue meeting analysts’ expectations.

• SEC v. Rorech, the first case to allege insider trading in
credit default swaps, the SEC alleges that a hedge fund manager traded in
credit default swaps on bonds based on nonpublic information from a bond
salesman at an investment bank that an upcoming restructuring of a bond
offering would impact the price of the swaps.

Note the following similarities in these cases:

• The cases touch on aspects of the financial crisis, demonstrating
the SEC’s emphasis on making this area a priority.

• With the exception of one defendant, the cases were filed without
settlements. This indicates an emphasis on bringing cases against individuals,
on bringing cases more quickly, and a greater willingness to litigate cases.
Going forward, it will be interesting to observe whether the SEC has
sufficient
resources to sustain the continued filing of cases that are likely to be
litigated to final judgment.

• The cases were also filed without any parallel criminal actions
against the individual defendants. This indicates a trend away from holding
off
on filing civil cases while waiting for criminal prosecutors to determine
whether to pursue criminal charges.

F. Increased Funding



Congress and the Administration have also provided additional money for
securities enforcement. In May, the President signed the Fraud Enforcement and
Recovery Act of 2009, which adds $265 million per year to the 2010 and 2011
budgets of the SEC, DOJ and other law enforcement agencies for the
investigation and prosecution of fraud involving financial institutions. In
addition, the Omnibus Appropriations Act of 2009 added $37 million to the
SEC’s 2009 budget which the agency is using to enhance enforcement. The
President’s 2010 budget proposal would increase the SEC’s budget by
13%, with the additional resources to be used to “increase staff and use
new technology to pursue risk-based approaches” to better detect fraud.
[5]

G. The Future of SEC Enforcement

This era of heightened enforcement will continue for the foreseeable
future.
In this environment, it is more important than ever that financial services
firms and public companies reinforce efforts to assure that their legal and
compliance infrastructure is identifying and resolving potential issues of
concern to regulators and positioning the company to respond effectively to
possible future regulatory inquiries.

II. Financial Reporting Cases

In the first half of 2009, the SEC has emphasized financial reporting cases
related to the collapsed subprime mortgage market. Other cases reflect the
SEC’s continuing prosecution of allegedly manipulative accounting
entries. The SEC also resolved outstanding stock option backdating claims that
arose beginning in the spring 2005.

A. Subprime and Financial Crisis Related Cases



In April, in SEC v. Strauss, the SEC charged three former executives
of American Home Mortgage Corporation, including the CEO, CFO and controller.
[6] The SEC alleges the defendants failed to disclose the
extent to which the company issued loans without income verification and the
impact that accelerating defaults were having on the company’s liquidity
in 2007. Pursuant to a settlement, the company’s former CEO consented to
$2.2 million in disgorgement, a $250,000 penalty and a five year officer and
director bar. Litigation continues against the other defendants.



In June, in SEC v. Mozilo, the SEC charged three former executives of
Countrywide Financial Corporation, including the CEO, the COO and the CFO. [7] The SEC alleges that the defendants presented the
company
as a lender of prime quality mortgage loans, different from competitors who
engaged primarily in riskier subprime lending, and did not disclose that the
company had actually developed a “supermarket” strategy that
widened underwriting guidelines to match products offered by its competitors.
The complaint cites to internal email messages that allegedly reflect
knowledge
of the increasing risks the company was undertaking. The CEO, Mozilo, was also
charged with insider trading.



On July 1, in SEC v. Rand, the SEC charged the former chief
accounting
officer of Beazer Homes USA, Inc. [8] The SEC alleges
that
the defendant artificially decreased the company’s income during the
housing boom by improperly increasing reserves and recording additional
liabilities and then reversed those entries when the housing market declined
in
2006 and 2007 in order to continue meeting analysts’ expectations. On the
same day, Beazer reached agreements to resolve criminal and civil charges with
the Department of Justice and the Department of Housing and Urban Development
alleging false mortgage originations and accounting practices. Pursuant to a
deferred prosecution agreement, Beazer will pay up to $50 million in fines and
restitution to home buyers. [9]

B. Vendor Payment and Inventory Management Claims



The SEC also resolved a number of financial reporting cases outside the realm
of the subprime mortgage market. The SEC announced a settlement with CSK Auto
Corporation alleging that the company overstated operating income from 2002 to
2004 by failing to write off uncollectible vendor allowances receivables and
recognizing vendor allowance receivables in the wrong time period. [10] The settlement with CSK followed similar charges in March
against several four former CSK employees. The litigation against the
individuals is continuing. [11]



The SEC also settled claims against several former employees of Cardinal
Health, Inc., alleging that they inflated the company’s earnings by
misclassifying bulk sales as operating revenue, selectively accelerating
recognition of cash discount income, and improperly adjusting reserves.
Pursuant to settlements, the defendants paid civil penalties ranging from
$50,000 to $100,000, and consented to officer and director bars and
suspensions
from appearing or practicing before the SEC as an accountant for three to five
years. [12]

C. Backdating Cases


The SEC continued to settle several outstanding stock option backdating
investigations that began in 2005. The SEC reached a settlement with Monster
Worldwide, Inc., with a $2.5 million penalty, [13]
Take-Two Interactive Software, Inc., with a $3 million penalty, [14] and Quest Software, Inc., with no penalty. [15] Former executives of Take-Two and Quest also reached
settlements. In addition, in May 2009, following a trial, Monster’s
former chief operating officer, James Treacy, was found guilty of criminal
charges for his role in options backdating at Monster.

III. Cases Against Broker-Dealers

The SEC’s enforcement actions against broker-dealers have addressed
the financial crisis, but have also encompassed sales practices, information
barriers, international business and market operations.

 

more...http://watchingthewatchers.org/indepth/95828/mid-year-review-sec-enforcement-2009