SEC enforcement: What has gone wrong?

A disturbingly persistent pattern has emerged in U.S. Securities and Exchange Commission enforcement cases that involves three key elements: (1) The commission rarely sues individual defendants at large financial institutions, settling instead with the entity only; (2) when it does sue individual defendants, it frequently loses; and (3) the penalties collected by the commission from corporate defendants are declining and, in any event, are modest in proportion to the profits obtained.

In November, the SEC sued and settled with JPMorgan Chase & Co. and Credit Suisse Group A.G. for a collective $417 million, but named no individual defendants. This continues a pattern under which the only senior executive at a truly major bank named as a defendant by the SEC in a case growing out of the 2008 crisis appears to be Angelo Mozilo, the former chief executive officer of Countrywide Financial Corp., who settled while under a threat of criminal indictment (which made going to a prior civil trial unthinkable). In sharp contrast, the Federal Housing Finance Agency (FHFA) also sued JPMorgan in a suit that similarly focused on the activities of Bear Stearns (which was acquired by JPMorgan) in packaging collateralized debt obligations (CDOs), and the FHFA named 42 individual defendants, including some high-ranking Bear Stearns executives. In a series of other cases against major banks, the FHFA has also sued a host of individual defendants.

On those occasions when the SEC has sued individuals at major financial institutions, it has generally named only low-ranking officers or associated consultants. For example, in the Goldman Sachs case, the SEC named Fabrice Tourre, a/k/a the “Fabulous Fab,” who was a virtual trainee. When the SEC sued Citigroup Inc., the only individual defendant named was Brian Stoker, a midlevel executive. In the case of JPMorgan, the SEC named Edward Steffelin, who did not work at JPMorgan but rather at an associated consulting firm that served JPMorgan as a collateral manager on its CDO offerings. To date, the case against Stoker resulted in an acquittal by a jury, which issued an unusual statement asking the SEC to bring more actions (but against more senior officials). Last month, the case against Steffelin was dismissed with prejudice at the SEC’s own request — an admission that it had bungled. The case against Tourre is proceeding slowly.

Also in November, a federal jury acquitted a father-and-son team — Bruce Bent and Bruce Bent II — of fraud charges brought by the SEC (although the jury did find one of them to have made negligent statements). The two defendants ran the Reserve Primary Fund, the first money-market fund, which “broke the buck” and closed its doors in the middle of the 2008 financial crisis. All in all, the SEC’s batting average is close to “zero for 2008” in the few cases that it has taken to trial stemming from that financial crisis.

Worse yet, although the SEC has collected billions of dollars in penalties from corporate defendants and is on pace for the largest number of settlements since 2005, the median value of SEC settlements with corporate defendants declined from $1.5 million in fiscal year 2011 to $800,000 during the first half of fiscal year 2012, and both years are well below the median corporate settlements a decade ago. The median corporate settlement in 2003 to 2005 was well over $50 million. See NERA Economic Consulting, “SEC Settlement Trends: 1H12 Update,” June 27, 2012, at 6. In short, the SEC is settling more, but for less.

What explains this pattern? First, the SEC is an overworked, underfunded agency that is subject to severe resource constraints. It knows that suits against senior executives will often drag on, consume considerable resources, and deprive it of manpower that could be employed elsewhere. In contrast, major financial institutions almost always settle with the SEC at an early point (as even Goldman Sachs did) to avoid reputational damage. Thus, the more the SEC needs quick, publicity generating settlements, the more it becomes inclined to forgo individual actions against executives who would be unlikely to settle.

Second, the SEC seems highly risk averse. Suits against high-profile executives who will resist fiercely could backfire, thereby interfering with the SEC’s broader program to repair the reputational damage it suffered as a result of the Madoff fiasco.

Third, the SEC needs to be able to use objective metrics to justify its request for budget increases. By bringing many actions and settling them cheaply, it can point to an increase in the aggregate penalties collected, even if the median penalty is at the same time decreasing. This may impress Congress, but from a deterrence perspective, it is similar to issuing modest parking tickets for major frauds. So long as the expected gain is not canceled, the incentive to commit fraud persists.

But none of these factors explains why the SEC is losing in court. In marked contrast, U.S. attorneys have been highly successful in prosecuting insider-trading cases, and they have to meet the higher standard of “proof beyond a reasonable doubt.” Here, three explanations seem plausible: (1) SEC attorneys (in contrast to federal criminal prosecutors) lack extensive trial experience and may be outmatched by the defense counsel in high-profile cases; (2) under pressure to identify and sue individual defendants, the SEC’s staff may not be screening their cases with the same high standards that federal prosecutors use (the Steffelin case seems such an example); and (3) the SEC does not have the resources to staff its cases as deeply as the defense bar, and this may leave it particularly vulnerable in the “big case,” where its adversary may use dozens of associates to review every document or email.

The dilemma then is that the SEC’s staff does not have the time, manpower or resources to investigate their cases as deeply as either defense counsel or the private plaintiffs’ bar. Federal prosecutors avoid this problem by screening their cases carefully, looking for “smoking guns” or cases with wiretap evidence. Because the SEC is under great pressure to name individual defendants and because it is accustomed to a world in which most defendants settle quickly, it may be tempted to bring half-baked cases that eventually lose.


What then is a feasible answer? The most logical response would be for the SEC to retain private counsel on a contingent-fee basis in those large cases that it cannot staff adequately itself. This is exactly what the FHFA has done in retaining Quinn Emanuel Urquhart & Sullivan to sue the major banks for the losses it sustained on toxic CDOs. Such a strategy kills at least three birds with one stone: (1) It allows the SEC to acquire highly experienced trial counsel for big cases (without having to pay their salaries for the long term); (2) it economizes on the SEC’s budget by paying the attorney fees only out of any recovery obtained; and (3) it enables privately retained counsel to invest greater time and effort, getting “deeper into the reeds” of a complex case (at least if the potential fee is large enough to justify such an effort).  Finally, the attorney-fee formula could be adjusted so as to encourage private counsel to pursue actions against individual defendants (for example, counsel might receive 30 percent of the recovery from individuals but only 20 percent of a recovery from the corporation).

Under such a system, the SEC’s enforcement staff members could then focus on what they are best at: insider trading, Ponzi schemes and smaller frauds not involving a complex institutional structure and multiple actors. Arguably, legislation may be necessary to authorize the retention of private counsel and use of contingent fees, and ethical rules would need to preclude such SEC retained counsel from also handling any resulting class action. But there is no policy reason why the SEC should not follow the FHFA’s lead.

The SEC is now on the brink of a major transition, and it is time for a reappraisal. Although the SEC is one of the strongest, smartest agencies in Washington, some tasks are beyond its natural grasp. The public at large wants accountability at large financial institutions, not the issuance of parking tickets for fraud. The Center for Audit Quality’s Sixth Annual Main Street Investor Survey has just found that 61 percent of investors “have no confidence in governmental regulators.” Some at the commission (particularly Commissioner Luis Aguilar) appear to be recognizing this problem and are calling for greater individual accountability. But the public’s confidence seems likely to be restored only if the SEC can find a way to staff the large “megacase.” That is precisely what the private bar can do well. If you cannot beat them, hire them!

This article was originally published in the National Law Journal on December 3, 2012.


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  3. Alex Rue

    While I agree with most of Professor Coffee’s analysis of the enforcement issues, I am troubled by his suggestion that the SEC hire outside counsel on a contingent fee basis to prosecute large, important financial market cases. I have no objection to the use of outside counsel if the SEC can afford to pay them in the appropriate case. But to pay counsel on a contingent fee basis is bad public policy akin to paying the police on a contingent or piecemeal basis. Justice requires something more.

    Professor Coffee hits the nail square on the head with his observation that the dismissal in Steffelin is an admission by the SEC that it had ‘bungled’ the matter. But where the ‘bungle’ occurred is important. In the investigation leading up to the recommendation to the Commission to sue? Or, in the preparation and trial of the case the Commission authorized to be filed?

    The SEC is not an ordinary litigant. The enforcement process begins as an investigation with administrative subpoena power to develop the evidence on which to base a recommendation that the Commission authorize a suit against named defendants under a particular legal theory. Discovery in an SEC case is the agency’s second chance to get it right. Private counsel may improve that chance, but if the underlying investigation is flawed even the best counsel cannot work miracles.

    Although the SEC may be one of the strongest, smartest agencies in Washington, how deep is its bench? Private counsel cannot supplant the work of the staff attorneys who actually conduct the investigations. And at the SEC as is the case elsewhere in the federal bureaucracy, your good hires are promoted and move on and your bad hires linger on until their retirement.

  4. John Nester, SEC Public Affairs Director

    There’s an interesting article on this topic in today’s National Law Journal written by SEC Enforcement Director Robert Khuzami and Deputy Director George Canellos. It starts like this:

    In his December 3, 2012, column, “SEC enforcement: What has gone wrong?,” Columbia Law School professor John C. Coffee Jr. makes a series of claims about U.S. Securities and Exchange Commission enforcement cases. These claims are inaccurate and paint a distorted picture of an enforcement program that has achieved record results in recent years. As a solution to the problems he sees, Coffee proposes that the SEC outsource its biggest cases to private contingency-fee lawyers — a suggestion that ignores critical differences between the SEC’s goals as a regulator and those of a litigant seeking monetary damages.

    Here’s the entire article:

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  11. jason gettinger

    Once, about 20 years ago, an SEC chairman said that in cases against individuals, losing defendants should be left homeless, naked, and without wheels. The chairman about ten years ago was very insistant that individuals be named, even trying to keep them from being indemnified fully. What has happened? It is possible that the SEC thinks it can establish group scienter in fraud cases against entities, but that proving individual scienter is more difficult. Also, post-Madoff, the staff is under pressure to bring more Ponzi and misappropriation cases, where typically (Madoff is atypical) the individuals have lived off the ill-gotten money for years, spending it on lifestyle rather than hard assets, so there is little or nothing left to collect and no money with which to pay a trustee or receiver. So, the ostensible disgorgement and penalties are waived away. Elements at the SEC have always favored hitting small fraudsters and Ponzi schemers rather than taking on officials of major corporations and investment banks: some because they think the staff was too agressive against corporate suites, some because they prefer to score statistics against what Coffee rightly calls low-hanging fruit. The justification is often: we are against securities fraud aren’t we? One question I do raise w/ Coffee: if the SEC is empowered to seek full restitution, will the courts require it to prove loss causation.

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