Columbia Law School Professor John Coffee has hit a nerve at the Securities and Exchange Commission (SEC).
In an article in the National Law Journal last month titled “SEC Enforcement: What Has Gone Wrong?” and in a PowerPoint presentation before the New York City Bar, Coffee argues that “the SEC is settling cheaply with entities and ignoring individuals — a policy of parking tickets for securities fraud.”
Coffee proposes that the SEC follow the example of other federal enforcement agencies — including the Federal Deposit Insurance Corporation (FDIC) — and retain private counsel on a contingent fee basis to pursue large complex financial fraud cases.
Outgoing SEC enforcement chief Robert Khuzami and deputy chief George Canellos don’t like Coffee’s criticism or his proposal and responded with their own missive in the National Law Journal this week titled Unfair Claims, Untenable Solution.
Khuzami and Canellos dismiss Coffee’s private litigation solution because it “assumes that the SEC’s general goal is to sue as many deep-pocketed parties, and collect as much in penalties, as possible.”
“But, as enforcer of the nation’s securities laws, the SEC’s goal is aggressively to uphold the law and serve the interests of justice,” they write. “That means evaluating each case fairly, suing only those whom the evidence shows violated the law, assessing relative culpability of different participants, and assessing a penalty that is appropriate for the particular violation — which could be anything from a serious fraud to an unintentional violation of a more technical requirement.”
In a response sent to Corporate Crime Reporter today, Coffee writes that “Khuzami and Canellos object that I would cause the SEC to abandon prosecutorial discretion.”
“Nonsense! The SEC would conduct the initial investigation and decide whether a suit was justified. But, it would now hold increased leverage in negotiations because it could credibly threaten suit by independent counsel — who would only take the case only if they judged it to be promising.”
“SEC discretion would remain because the case would go forward only if the SEC’s staff decided that it had merit,” Coffee says. “Such an approach would go far towards solving the SEC’s budgetary crisis, because attorneys’ fees would be earned only if a recovery was obtained and only out of the recovery — thus not depleting the SEC’s budget.”
Coffee cites the Chicago Booth/Kellogg Financial Trust Index for 2012, which finds that 79% of investors have “no trust in the financial system,” the Center for Audit Quality’s Sixth Annual Main Street Investor Survey, which finds that 61% of investors “have no confidence in governmental regulators,” and the 2012 Ethics and Action Survey, which finds that 64% of the American public believes that “corporate misconduct was a significant factor” in causing the 2008 economic crisis.
“The public’s dissatisfaction with SEC enforcement is not based on statistical data, but a sense that regulators have not held accountable anyone at the top of the major financial institutions that collapsed in 2008,” Coffee says.
“This was in sharp contrast to the savings and loan crisis in the late 1980s — where many went to prison — and WorldCom and Enron — where the CEOs were convicted and imprisoned.”
“The SEC did not even try to push the envelope,” Coffee says.
“In the case of Lehman, the Bankruptcy Examiner — Anton Valukas, now the chairman of Jenner & Block — prepared an elaborate and expensive report that argued with some force that the Lehman senior management had defrauded their investors through the Lehman 105 repo transactions — which hid the firm’s leverage through one day only transactions. Yet the SEC never sued.”
“Although the SEC asserts that they have sued individuals, almost none of them were executives at major financial institutions,” Coffee says. “The lone exceptions are Angelo Mozilo at Countrywide and, possibly, two senior executives at IndyBank.”
What explains the failure?
“One possible explanation is that the post-Madoff SEC is extremely risk averse and has learned that it can lose these cases against individuals,” Coffee says.
“Another is that an overworked, underfunded SEC cannot afford the resources to pursue individuals in lengthy litigations that will not yield major recoveries — no individual can settle at the level that Citigroup did. It may believe it more efficient to sue entities that typically settle early and for more.
“The SEC needs to justify budget increases and faces a skeptical House of Representatives that demands objective metrics to demonstrate the case for a higher budget. Settling many small cases — and some larger cases — cheaply may allow the SEC to seek a budget increase based on a record number of settlements — or a record amount collected—even if no one is deterred by small penalties.”
“Another explanation — favored by some judges — is that the SEC’s staff lacks the trial experience of U.S. Attorneys and cannot handle complex civil trials with elaborate discovery and messy facts. Corporations do not fight the SEC to the same extent as individual defendants because they suffer reputational damage from adverse publicity.”
“No judgment is here expressed,” Coffee says. “All could be true to some degree and overstated to some degree.”
Coffee says that while his proposal to hire private counsel to litigate major SEC financial fraud cases “may sound radical,” in fact “it is precisely what other agencies have done.”
“The Federal Housing Finance Agency (FHFA) recently sued a number of major banks for losses they suffered on toxic CDOs. They retained Quinn, Emanuel, Urquhart & Sullivan.”
“In the FHFA’s suit against JPMorgan over the activities of Bear Stearns, Quinn Emanuel named some 42 individual defendants.”
“It is not impossible to pursue individual defendants in civil cases, but it requires a major commitment of money and manpower.”
“Because SEC enforcement actions are not class actions, the fee awards to retained counsel in SEC actions should be entirely a matter of private negotiation.”
“Thus, if we want, we could award a higher fee for recoveries obtained from individuals than from entities. That would motivate the pursuit of individual accountability.”
Khuzami and Canellos say that Coffee definition of a major bank “apparently excludes institutions such as Citigroup Inc. (whose former CFO and former head of investor relations were charged by the SEC with causing the company’s misleading disclosures to investors about its exposure to subprime mortgage-related assets), New Century Financial Corp. (whose former CEO, CFO and controller were charged for similar conduct), American Home Mortgage Investment Corp. (whose former CEO, CFO and controller were also charged) and State Street Bank and Trust Co. (whose chief investment officer for the Americas was charged with misleading some investors).
“His definition of ‘senior executive’ appears similarly limited, since he makes no mention of the SEC’s actions against high-ranking managers at such firms as Credit Suisse and Bear Stearns for misconduct related to the credit crisis,” they write.
“Finally, Coffee ignores the SEC’s many actions against senior officers of nonbank financial institutions — such as mortgage giants Fannie Mae and Freddie Mac, whose top corporate officers have been charged with fraudulently concealing the companies’ exposure to risky mortgage assets.”
The SEC and its enforcement attorneys were surely stung by Coffee’s criticism.
But in his response, Coffee made it clear that he was not targeting any individual enforcement attorney.
“I want to emphasize that I am criticizing policies, not individuals,” Coffee wrote. “I have no doubt that both men are able lawyers who have worked hard to improve the SEC’s performance.”
Khuzami and Canellos point out that the SEC is suing more individuals than in the past.
“True, but actions against high-ranking senior executives of financial institutions remain conspicuous by their absence,” Coffee writes.
“Their attempt to list senior executives at major institutions ignores that no senior executive at Lehman, Bear Stearns, AIG or the other major players in the 2008 financial collapse were named.”
“The most important claim I make is that the nature of corporate litigation has changed, partly as a result of ‘ediscovery’ and the often millions of emails and related documents in the typical large case,” Coffee says.
“It is no longer feasible for a handful of SEC attorneys — even if all are diligent and able — to litigate effectively against the squadrons of associates that a large firm can throw at a complex case.”
“The result is a mismatch. Hence, when facing a major financial institution, the SEC tends out of necessity to settle cheaply or not sue at all — as in Lehman.
“My proposed answer to this problem is that the SEC should do what other financial regulators are already doing — including the FDIC — namely, hiring independent counsel on a negotiated contingent fee basis.”