SEC Inspector General Finds Staff Misconduct in Investigations of Wall Street Firms. Reports Will Increase Pressure on SEC to "Get Tough"
Significant disruptions in the market invariably lead to an increase in SEC enforcement activity, as regulators seek to determine whether those negative events resulted from violations of the federal securities laws. The aggressiveness of the SEC’s efforts in this regard will likely be further enhanced by two new reports from the SEC’s Inspector General (“IG”), H. David Kotz, that are highly critical of the Enforcement Division’s prior conduct of investigations involving major Wall Street firms. In each report, the IG raised questions about the Enforcement staff’s appearance of impartiality and recommended that disciplinary action be taken against the staff members involved, including the Director of the Enforcement Division and the head of the SEC’s Miami Regional Office.
The Enforcement Division has publicly, and in strong terms, contested the findings of at least one of the IG’s reports. Nonetheless, the IG’s charges of lax enforcement and the appearance of favorable treatment for major participants in the financial services industry seem certain to result in an even tougher and more difficult enforcement environment in the context of the SEC’s response to the current financial crisis.
Aguirre termination. The first report, issued on September 30, stemmed from charges by a former SEC Enforcement staff attorney, Gary Aguirre, that his supervisors gave improper preferential treatment to Morgan Stanley Chairman and CEO John Mack, and terminated Aguirre’s employment, when Aguirre sought to take Mack’s testimony as a possible tipper in an insider trading investigation involving hedge fund Pequot Capital Management. See “Re-Investigation of Claims by Gary Aguirre of Improper Preferential Treatment and Retaliatory Termination,” SEC Office of Inspector General (Sept. 30, 2008), available at http://finance.senate.gov/press/Gpress/2008/prg100708.pdf. An initial IG investigation in 2005, conducted by the current IG’s predecessor, exonerated the Enforcement staff. Congress held hearings, and in August 2007, the Senate Finance and Judiciary Committees issued a report critical of the Enforcement Division’s conduct of the Pequot investigation, and faulting the IG for failing to conduct a credible investigation into Aguirre’s charges. Following the Senate report, the IG retired, and Kotz was appointed as the SEC’s new IG in December 2007.
Importantly, the Kotz re-investigation did not find that Mack received any favorable treatment regarding the taking of his testimony. The IG received testimony from numerous past and present Enforcement officials that Enforcement cases are not affected by political considerations or the prominence of particular individuals. The IG also found that there had been reasonable strategic reasons for delaying Mack’s testimony.
Notwithstanding these findings, the IG went on to conclude that Enforcement staff supervisors had “conducted themselves in a manner that raised serious questions about the impartiality and fairness of the Pequot investigation.” Further, the IG determined that “there was a connection between the decision to terminate Aguirre and his seeking to take Mack’s testimony,” and that Enforcement “allowed inappropriate reasons to factor into its decision to terminate him.” The IG went on to directly criticize Enforcement Director Linda Thomsen and recommended that the SEC Chairman take disciplinary action against her for disclosing non-public information about the evidence against Mack to counsel for Morgan Stanley’s board of directors. In response to a request for information (because Morgan Stanley’s board was considering hiring Mack as CEO), Thomsen told the board’s counsel that the investigation had uncovered “smoke,” but no “fire,” concerning Mack.
Bear Stearns Investigation. In a second report, the IG found that the Director of the SEC’s Miami Regional Office had “failed to administer his statutory obligations and responsibilities to vigorously enforce compliance with [applicable] securities laws” in connection with an investigation into Bear Stearns’ role in valuing certain collateralized bond obligations and collateralized loan obligations that a client purchased from Bear Stearns. See “Failure to Vigorously Enforce Action Against W. Holding and Bear Stearns at the Miami Regional Office,” SEC Office of Inspector General (Sept. 30, 2008). The report was prepared in response to a request from Senator Charles Grassley (R. Iowa), ranking member of the Senate Finance Committee, seeking information as to why the SEC had closed the investigation without any enforcement action.
According to the IG’s report, the head of the Miami office “abruptly” closed the investigation in 2007 after the staff had made progress negotiating several settlements. Further, the IG found that the fact that two of the defense counsel involved in the case were longtime friends of the head of the
The IG went on to fault the Miami office staff for not coordinating its investigation with the Department of Justice, which was investigating a similar matter involving another Bear Stearns employee. The IG found that “[a] significant opportunity to coordinate with the U.S. Attorney’s Office and uncover evidence of a systematic problem at Bear Stearns was also lost through neglect.” The IG recommended that the SEC Chairman take disciplinary action against the Director of the Miami office.
In a strongly worded response, the Enforcement Division characterized the IG’s report as “misleading,” filled with “speculation and innuendo,” as ignoring testimony showing that the decision to close the investigation was a sound one, and failing to comply with the IG’s “fundamental obligation to conduct a fair and impartial fact-finding.”
Likely impact of the IG reports. Against the backdrop of existing criticisms of the SEC for regulatory failures that contributed to the current financial crisis, the IG’s reports may provide the impetus for a period of unusually difficult, contentious, and highly critical oversight of the SEC’s enforcement function. Regardless of whether the IG’s conclusions in these cases were sound, the IG’s reports are likely to fuel critics in Congress and elsewhere who seek to contend that the Enforcement Division has failed in its responsibility to pursue aggressively misconduct at large banking firms.
To cite just one such example, Sen. Grassley has commented that the IG’s report on the Bear Stearns investigation provides “yet another example of the lack of vigorous enforcement at the SEC,” and “demonstrates the culture of deference at the SEC in dealing with big players on Wall Street.” http://finance.senate.gov/press/Gpress/2008/prg101008.pdf. Similarly, on October 21, Sen. Grassley wrote to SEC Chairman Cox concerning anonymous allegations he has received that, during the negotiations earlier this year that led to JP Morgan Chase’s (“JPMC”) takeover of Bear Stearns, Enforcement Director Thomsen disclosed information concerning the status of various investigations involving Bear Stearns to JPMC’s General Counsel, Stephen Cutler, who preceded Ms. Thomsen as Director of the Enforcement Division. Sen. Grassley wrote to Chairman Cox that “Such conduct would reinforce the appearance that Enforcement decisions, and disclosures of information about them, are sometimes based not on the merits, but rather on access to senior officials by influential representatives of power brokers on Wall Street. In light of these allegations and the ongoing financial crisis, there has never been a more critical time to take swift action to restore confidence in the SEC Enforcement Division.” http://finance.senate.gov/press/Gpress/2008/prg102108.pdf.
The SEC’s Enforcement Division and the Commission thus are likely to feel pressure to demonstrate heightened aggressiveness and firmness in future investigations and enforcement actions, particularly where major participants in the financial services sector are involved. The Enforcement staff will likely seek even more rapid progress in priority investigations than in the past, and may curtail opportunities for meaningful deliberation and dialogue that have historically proven beneficial both to the staff and to the subjects of complex investigations. While the staff will undoubtedly maintain its high standards of professionalism, it would be unsurprising if there is less flexibility and less willingness to entertain sound arguments regarding factual and legal defenses in an environment where staff members may be concerned that any concessions they make may subject them to criticism or even disciplinary action if they are perceived to be insufficiently vigorous in their enforcement of the securities laws.
