Robert Khuzami: Master distracter

January 17, 2013

I blogged recently in support of Columbia Law professor John Coffee’s proposal for the SEC to hire outside expert attorneys to prosecute complex cases. He called the performance of the current SEC enforcement division lackluster, and wrote that it is “an overworked, underfunded agency that is subject to severe resource constraints.”

The soon to retire head of the SEC’s enforcement division, Robert Khuzami, blasted Professor Coffee’s idea in the National Law Journal last week with a piece titled “Unfair claims, untenable solution.” The New York Post nicknamed Khuzami the “master blaster” with a “poison pen” for going after Coffee.

In his rebuttal to Coffee, Khuzami lauds the number of settlements the SEC has achieved under his tenure. But the number of settlements under Khuzami and former SEC Chairman Mary Shapiro has actually declined from post-Sarbox-era SEC Chairmen William Donaldson and Chris Cox. NERA Economic Consulting shows this in its recently released SEC Settlement Trends: 2H12 Update (page 19):

Overall, the number of settlements per year declined from 751 in the pre-Schapiro era to 680 in the Schapiro era. The decline was both for settlements with companies and individuals.

However, using settlement data from the entire pre-Schapiro era obscures the fact that the Schapiro era average of 680 settlements per year is virtually unchanged from the average of 682 settlements per year observed in three years immediately prior to the Schapiro Chairmanship.

We note that FY 2012 saw a significant increase in settlements compared to prior years, jumping to 714 settlements, the highest level since 2007. Because of the lengthy gestation period for many cases, it may be that many of the settlements in the first years of the Schapiro era simply reflected the inherited pipeline of cases that were working their way towards resolution. If so, the settlement figures for 2012 may turn out to reflect enforcement priorities and efforts initiated during the Schapiro era, particularly for cases originating during the financial crisis of 2008.

On a quantified basis, Khuzami barely surpassed the efforts of the prior administration, which had a reputation of regulatory neglect. Most Americans would find these numbers disheartening given the massive economic damage suffered in the United States during those years. It would be logical for the number of settlements arising from the financial crisis to be closer to the level of prosecutions after the savings and loan crisis of the 1980’s, which was in the thousands.

Americans are not interested in the small players of the crisis, rather the high level bank executives who have avoided prosecution. Khuzami was questioned about this by Richard Walker, managing director and general counsel of Deutsche Bank, at the SIFMA Compliance and Legal Society monthly luncheon in June of 2011. Khuzami previously held the position of Deutsche Bank’s U.S. general council. The law firm Sidley Austin reported on the talk:

The next question addressed the press’ criticism of the Commission for not holding senior executives accountable in some cases. Mr. Walker noted that the SEC has charged about 50 individuals, but asked what accounts for the gap between charging low- and high-level individuals.

Mr. Khuzami offered that the SEC has had a pretty impressive record of charging mortgage originators, including IndyMac, Countrywide, Schwab, State Street and Evergreen, to name a few. Although the Commission has not yet charged heads of investment banks, which Mr. Khuzami noted is a barometer for success by some critics’ measure, he commented that criminal authorities have also not brought cases against these high level executives, even after taking long, hard looks at these potential cases.

Additionally, in Mr. Khuzami’s view, the fraudulent activity is not necessarily happening at the highest levels of an organization, especially in the structured products sector; rather, the activity is happening two and three levels down, where products are manufactured and sold. Accordingly, it is difficult to reach into the highest levels of organizations unless there is tangible evidence of fraud there.

Since the SEC can only prosecute civil cases, which have a much lower standard of proof, Khuzami’s explanation that criminal authorities had not brought cases is disingenuous at best. The most egregious instance of the SEC not pursuing litigation is the case of Lehman Brothers. In this case, the bankruptcy examiner, Jenner Block’s Anton Valukus, provided a two thousand page “roadmap” for the activities that had led to the collapse of the firm. Steve Kroft of CBS’ 60 Minutes conducted an interview with Valukus on his examination:

Valukus, writing in his examination report, (page 20) lays out his findings of “colorable claims.” Basically, Valukus asserts that Lehman management was cooking the books and materially misrepresenting their financial position to investors:

Lehman’s failure to disclose the use of an accounting device to significantly and temporarily lower leverage, at the same time that it affirmatively represented those “low” leverage numbers to investors as positive news, created a misleading portrayal of Lehman’s true financial health.

Colorable claims exist against the senior officers who were responsible for balance sheet management and financial disclosure, who signed and certified Lehman’s financial statements and who failed to disclose Lehman’s use and extent of Repo 105 transactions to manage its balance sheet.

Valukus later said that since officials from the SEC and Federal Reserve Bank of New York had been onsite since March 2008, Lehman defendants may have a defense that regulators were aware of their actions. But as Valukus’ report (page 20) shows, Lehman was engaged in using accounting maneuvers (repo 105) to misrepresent its balance sheet to investors since 2007, a year or more before regulators were onsite.

The Lehman case speaks directly to Professor’s Coffee’s suggestion that the SEC outsource its most complex cases. It is astounding that the SEC never prosecuted the senior management of Lehman Brothers, and it would have lost nothing to let contingent attorneys prosecute the case. The SEC needs new ideas and more effective tools. Defensive articles in law journals pushing back on members of academia will not improve the prosecution of our securities laws.

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