S.E.C. No Evil
by Scot Paltrow October 2008 Issue
Under chairman Christopher Cox, the commission has undermined and demoralized its enforcement staff. For the next administration, restoring the agency's role as market watchdog won't be easy.
Christopher Cox
THE BOSS Christopher Cox, chairman of the S.E.C., in his office in February 2007.
For months, Christopher Cox, the chairman of the Securities and Exchange Commission, has been under fire for a belated response to market upheavals stemming from the subprime fiasco and for being soft on big corporations. He’s eager to dispel his critics. In his 10th-floor office, with a postcard view of the Capitol, Cox appears fit and buoyant despite a recent bout with a rare cancer of the thymus gland. He denies any suggestion that he has oriented the S.E.C. away from tough enforcement and investor protection. “I spend more time on enforcement than on any aspect of my job,” he says.
But a look at his record since he became chairman in 2005 suggests that, behind the scenes, Cox has engineered a series of procedural and tactical changes, effectively reducing the S.E.C. enforcement division’s power. The division, one of four in the S.E.C., investigates and litigates violations of securities laws. Under the new rules, enforcement staffers no longer have the freedom to negotiate fines against public companies in a select group of cases. Instead, the commissioners—three Republicans and two Democrats—dictate the maximum penalty the enforcement division can seek. Since the rule was imposed, penalties have dropped. For example, in March, the commission approved a fine of $10 million against pharmaceuticals manufacturer Biovail, significantly less than the enforcement staff had sought.
At the S.E.C., which has come under fire from Congress for its apparent lack of vigilance in the subprime mess, such tensions between frontline investigators and the politically appointed commissioners to whom they report have become commonplace. Former senior enforcement officials say Cox has used his control over the commission’s calendar to delay major cases and water down others. Cox and other commissioners have shifted the agency’s focus away from strong enforcement action against big public companies and Wall Street firms, instead emphasizing what S.E.C. lawyers consider petty-fraud cases, such as small Ponzi schemes. Penalties against companies, individuals, and brokerage firms have sunk from a high of $1.5 billion in 2005 to $507 million last year.
In the coming months, the S.E.C. will be expected to sort out whether malfeasance contributed to the current economic crisis—and if so, whose. But the fundamental changes at the enforcement division will make this all the more difficult. The division has been significantly weakened by the exodus of top supervisors and is hamstrung by the new limits on its powers. Even if a new administration in the White House replaces Cox, whose term expires in 2009, it is not as though a switch could be flipped to begin more aggressive prosecution. Gearing up would require restoring the depleted ranks and finishing pending cases, both of which could entail substantial delays at a time when the market needs to quickly regain the confidence of battered investors.
Cox did not accomplish these changes on his own. Internal agency politics, critics say, played a major role, with Cox’s Republican colleagues, particularly Paul Atkins, pressing him to roll back enforcement and rein in the division’s independence. Beginning in late 2007, the White House, which nominates S.E.C. commissioners, helped clear the way for retrenchment in enforcement by delaying the replacement of two Democratic commissioners whose terms had ended. From January through July 2008, the commission had just three members, all Republican. This gave Atkins and Kathleen Casey de facto veto power over the more moderate chairman.
The perceived absence of support for major investigations has alienated many staff members and prompted some of the enforcement division’s senior officials to quit. Since Cox took office in 2005, the staff count in the division has dropped 9 percent, to 1,124 people this year. His predecessor, William Donaldson—like Cox, a Republican—long declined to speak publicly about changes at the S.E.C. He told me recently, though, that he was aware of a “high degree of frustration” among the staff. “With the kind of problems we have now,” he said, “any attempt to reduce the effective role of the S.E.C. as a policeman has been a mistake.”
At the time President Bush named him S.E.C. chairman, Cox had served 17 years in Congress, where he stood out as one of the most effective pro-business representatives in a strongly pro- business class of House Republicans. He took the helm at the S.E.C. during a period of corporate backlash against the agency and the stringent regulations imposed by the 2002 Sarbanes-Oxley Act. The departing chairman, Donaldson, was a Bush family friend who had been appointed by the White House with the expectation that he would temper the S.E.C.’s activism. Instead, he embraced the agency’s role as cop. The business community felt “that Donaldson was too tough on corporate America and Wall Street,” says a former enforcement official. “Cox was brought in to chill it out.”
Besides pulling back on enforcement, Cox also cut back on the S.E.C.’s new risk-assessment office, created under Donaldson to help the agency do a better job of anticipating financial upheavals. After the head of that office left, Cox didn’t replace him for nearly two years. Although Donaldson had authorized and filled eight positions and planned to expand the staff to 15, by 2007 the office was staffed mainly by part-timers, who in federal budget records were regarded as the equivalent of only two full-time workers. Cox says in response that he has allocated staff to other departments that he contends perform similar functions.
Also, under Cox, the commission loosened a key limit on short-selling in 2007, scrapping what’s known as the uptick rule, which is meant to forestall plunges in share value by allowing short-selling only when a stock is rising. A year later, after heavy short-selling threatened the survival of certain large financial companies, the S.E.C. temporarily restricted the short-selling of 19 mortgage-company and bank stocks.
Cox and other S.E.C. officials have said that it wasn’t possible to anticipate the effects of the real estate bubble’s bursting. And Cox has said he’s able to do more with less by prioritizing enforcement and oversight efforts. The S.E.C., he told Congress in July, has more than four dozen pending investigations into the credit crisis. Some relate to whether improper short-selling and insider trading spurred the Bear Stearns collapse. But some members of Congress and the federal government clearly aren’t impressed. The Treasury Department has proposed grabbing for itself and the Federal Reserve some of the S.E.C.’s most important powers, including enforcement authority over brokerages and investment banks. At a Senate hearing in May, Senator Richard Durbin, a Democrat from Illinois, faulted Cox for endorsing the White House’s request for only a minor increase in the S.E.C.’s budget for 2009. Durbin noted that Cox’s budget request would mean the loss of at least 94 more staff positions throughout the S.E.C. “Developments and trends in the market call for more, not less, vigilance, to protect investors,” Durbin stated in a press release following the hearing.
Cox, in an interview that he allows to go well beyond the allotted hour, defends his record and dismisses repeated interruptions from a secretary. He is adamant that he has stepped up enforcement: “We are redoubling our efforts in every way that we know how.” He attributes the decline in penalties to an inevitable shift in the mix of cases after the resolution of big accounting scandals in the first half of this decade.
Under his leadership, Cox says, the S.E.C. has become forward-looking “in ways that traditionally we might not have been.” And he takes great pains to present himself as a champion of the small-time investor.
After we’ve shaken hands and I’m nearly at the elevator, Cox summons me back to examine a column of framed mementos on his office wall. He’s often mentioned these items when testifying before Congress as symbols of his personal commitment to regulation. They relate to Samuel Insull, the Chicago electricity magnate whose company went bust in 1932, wiping out hundreds of thousands of investors and helping prompt the establishment of the S.E.C. in 1934. The display includes a photo of Insull and a check for $3.36 made out to Cox’s grandfather—all that he got back on a $6,000 investment in the company.
Almost from the moment Cox took office, former enforcement officials say, he began chipping away behind the scenes at the S.E.C.’s enforcement division—the largest and most high-profile of the agency’s four divisions. Approval of the enforcement division’s requests to initiate investigations, which was an expeditious process under former chairman Donaldson, turned into a logjam, as the commission closely scrutinized each one. “It was like someone poured molasses on the enforcement division,” says a former enforcement division supervisor.
When the commission was divided over cases, Cox would simply take them off its agenda. The same supervisor says, “You had cases where the enforcement staff had worked hard for three years. It was finally done, on the calendar. The general counsel has reviewed it. The day arrives for your hearing before the commission, and you’re told that morning it’s been pulled. Taken off the calendar. When’s it going back on? We don’t know.” By mid-2006, this had become routine. “Cases are held up, pulled, held up, pulled,” the supervisor says.
Cox’s treatment of Linda Thomsen, the S.E.C.’s first female enforcement director, was seen by staffers as a sign of the division’s declining clout. A longtime S.E.C. lawyer, Thomsen had been named director by Donaldson just prior to his departure. Her predecessor, Steve Cutler, who had worked closely with Donaldson and several earlier enforcement directors going back to Stanley Sporkin, who held the job in the 1970s, told me that this kind of open-door relationship was the norm. Several former senior S.E.C. staffers say Thomsen had far less access.
Thomsen defends her boss. “This chairman has an extremely busy schedule,” she says. “I can get to him if I need to.” But she acknowledges that “sometimes it can take days.” Cox says, “She has complete and total access to me.” An S.E.C. spokesman says the two met as often as eight times a day during recent settlement negotiations with banks over auction-rate securities. The banks agreed to repay nearly $27 billion to investors.
Some former S.E.C. staffers say Thomsen complied too easily with the push to restrict enforcement. Cox boasts that the commission approves “99.999 percent” of the enforcement division’s recommendations. But some former S.E.C. enforcement officials say he maintains that high percentage by prevailing on Thomsen to water them down. Thomsen confirms that she has revised recommendations “from time to time” but denies that the commission has curbed enforcement efforts. “Everybody’s pro-law-enforcement” among the commissioners, she says. “Nobody likes crooks.”
Demoralized, key enforcement staffers started heading out the door. Veteran S.E.C. lawyer James Coffman left in 2007 after he was passed over for a promotion. He says that Thomsen told him he didn’t get the job because he was viewed as “too tough.” Thomsen, noting that toughness is one of the qualities necessary for an enforcement job, dismissed the notion that anyone would be denied a promotion for being “too tough.”
A budget shortfall led the S.E.C. to impose a hiring freeze in 2005. The enforcement division’s staff is divided into groups, and ordinarily 15 lawyers report to an assistant director in each one. But as the freeze dragged on, some groups dwindled to seven or eight lawyers. An S.E.C. spokesman says that if one group is overburdened, cases are reassigned to a different group.
Enforcement staffers cite two cases as examples of the agency’s retreat from tough prosecution. One is the Biovail case. When eight women died after their bus smashed into a truck loaded with Biovail antidepressant pills, the pharmaceutical maker attributed a revenue decline to inventory lost in the crash. S.E.C. enforcement lawyers charged that not only was the company’s explanation false, but Biovail had also set up a company in Barbados to inflate reported profits and was in cahoots with a pharmaceutical distributor to stage a sham sale of pills, according to the S.E.C. complaint. Although an outside expert retained by the S.E.C. recommended a much larger fine, the commissioners decided on $10 million. Biovail accepted the penalty without admitting or denying wrongdoing. Cox says the commission relied on the advice of the agency’s chief economist.
The other case involved Tenet Healthcare, a hospital company that had allegedly boosted earnings through Medicare fraud. In March 2007, the S.E.C.’s settlement talks with Tenet nearly collapsed over whether the company would be granted a “safe harbor” provision, which protects a company from liability for financial projections that are made in good faith. The S.E.C. had routinely denied this protection in fraud settlements. Accordingly, enforcement lawyers refused to make an exception for Tenet. But on the night before they were set to appear before the commission, Tenet’s lawyer fired off an appeal to the S.E.C. commissioners.
The next day, a majority of the commissioners, including Cox, made it clear that they would grant Tenet safe harbor, according to several people who attended the meeting. The enforcement staff drafted a settlement. (The company paid a $10 million penalty.) The commission’s break with precedent on this and other cases caused consternation among the enforcement staff and helped spur the departure of Randall Lee, the veteran head of the S.E.C.’s Los Angeles office, which had handled the case. Cox says the commissioners took into consideration that Tenet had new management.
A January analysis by the law firm Morgan Lewis found that S.E.C. penalties have dropped by a “staggering degree” and that “the numbers suggest a philosophical shift by the Cox commission in what constitutes an appropriate penalty.”
A spokesperson for the S.E.C., in an email statement, insists that “by any objective measure, the S.E.C.’s enforcement division has never been more effective or enjoyed greater support from the commission. The commission’s unparalleled support has brought unparalleled results from investors.”
While major cases were bogged down, commissioners quickly approved minor ones involving penny stocks, boiler-room operators, and Ponzi schemers who fleeced groups of small investors. According to former S.E.C. officials, this apparent shift in agenda was pushed in large measure by former commissioner Atkins, who stepped down in August after his term expired. One former S.E.C. official claims to have heard Atkins remark that he believed that the S.E.C. was “unconstitutionally constituted.” Atkins denies this, saying that if he had believed the S.E.C. was unconstitutional, he would not have served on the commission. But a friend of Atkins’ says, “If you surprised Paul and asked him what he really thinks of the S.E.C., he’d probably say, ‘Blow it up.’ ”
Atkins, whom one former commissioner describes as “probably the most effective commissioner in the history of the S.E.C.,” benefited from Cox’s desire to build consensus. Cox shunned divided votes, delaying important matters until he could engineer a majority. Atkins wasn’t inclined to compromise. He castigated the enforcement division in speeches around the country and filed detailed public dissents in response to some of the agency’s decisions.
Atkins says the push against small-scale fraud cases has not come at the expense of large investigations. He suggests that by emphasizing such efforts, the S.E.C. adopted a strategy similar to one that former New York mayor Rudy Giuliani employed to reduce the city’s crime rate—cracking down on quality-of-life offenses and securing arrests for minor violations. “You have to concentrate on the muggings and graffiti because that builds up respect for the rule of law,” Atkins says.
But demoralized staffers don’t agree. In one instance, after commissioners had approved penalties in a microcap fraud case, Atkins says an enforcement lawyer came up to the colleague who had conducted the investigation, slapped him on the back, and said sarcastically, “Congratulations on your small case.”
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