SEC enforcement boost paying dividends

A reorganization of the SEC’s enforcement division is starting to pay off with some high-profile cases, and agency executives promise that many more are in the pipeline.

“It’s become more obvious that [the division] is up and running, and really doing things,” said a securities law attorney, who asked not to be identified. “They’ve been extremely active.”

For its first enforcement division reorganization in 30 years, the Securities and Exchange Commission announced in January 2010 the creation of five units that enforcement director Robert S. Khuzami promised would bring a “strong, swift and strategic” approach to enforcement: structured and new products, asset management, municipal securities and public pensions, market abuse and foreign corrupt practices.

So far, it has.

CDO SETTLEMENTS

The structured- and new-products unit settled several high-profile cases involving failed collateralized debt obligations, including a $550 million settlement with The Goldman Sachs Group Inc. in July 2010, a $153 million settlement with J.P. Morgan Securities a year later and, this month, a $285 million settlement with Citigroup Global Markets Inc., with fees and penalties going to investors.

The asset management unit was responsible for the $240 million settlement with Axa Rosenberg Group LLC in February over SEC charges that the firm had concealed a significant computer coding error in its quantitative investment model.

In August, the structured- and new-products unit teamed up with the municipal securities and public-pension group to go after RBC Capital Markets and brokerage firm Stifel Nicolaus & Co. Inc. for what the SEC considered unsuitable CDO investments. They were pitched to five Wisconsin school districts that were looking for money to pay pension benefits but wound up losing $200 million in borrowed money. RBC agreed to pay $30.4 million to settle the case; the civil case against Stifel Nicolaus is still active.

In August 2010, the municipal-securities and public-pension unit announced charges against the state of New Jersey, the first-ever securities violation case against a state, for misrepresenting and failing to disclose underfunding of its two largest pension plans during 79 municipal bond offerings between 2001 and 2007. The state agreed to end the practice and to implement stronger disclosure procedures.

In addition to the creation of the units, the reorganization launched an “enforcement cooperation initiative,” with incentives for witnesses to come forward, including leniency or deferred prosecution.

Like other Washington financial regulators, part of the commission’s motivation was figuring out what — and who — contributed to the financial crisis. Critics also noted that getting tougher would help repair a reputation damaged by the Bernard Madoff scandal and other market failures.

Another motivation was to get ahead of trends.

“We try to keep on top of whatever new products Wall Street is pitching, including by attempting to understand how banks are making money and where risks to investors lie,” said Kenneth R. Lench, director of the structured- and new-products unit. “There may be no problem at all with a particular product, but we at least want to learn about it. What are the risks to investors? Who are the big players?”

One move that helped accelerate the learning curve was the hiring of industry experts to complement staff attorneys. That is particularly true for Mr. Lench’s unit on new products, he said. “At times, they are like translators of a foreign language. They have given the investigative lawyers a lot of insight.”

The new expertise lets the units function like a “mini think tank” that does more than just enforcement, and works closely with people in the offices of compliance and investment management, as well as other investigators, Mr. Lench said. “It’s nice to have people steeped in these issues so that when new matters come in, we don’t have to reinvent the wheel.”

From the industry’s perspective, having more sophisticated investigators is a case of “be careful for what you wish for,” noted the securities attorney who declined to be identified.

“In the past, there were enforcement people that really didn’t understand the business. The downside for the industry is that there is a likelihood there will be more cases. The upside is that cases that shouldn’t have been brought won’t be. At the end of the day, you’d rather be dealing with someone who understands the industry,” the attorney said.

It’s also good for good players, noted a hedge fund consultant, who also asked not to be identified. “We don’t want bad guys in our business.”

The asset management unit, the largest, with 60 attorneys in Washington and eight regional offices, also tapped former portfolio managers and market experts to help in target areas, including the growing trend of pension fund investment in alternatives.

“Pension funds need to be careful in selecting their alternative-investment managers and conduct appropriate due diligence,” said Robert Kaplan, co-chief of the asset management unit. “They need to make sure that they understand — and can tolerate — the risks inherent in the strategies employed.”

The case against Axa Rosenberg “was a way to learn what was going on with the quant funds,” said one insider, who requested anonymity. A confidential report from the independent compliance consultant mandated by the settlement should increase that understanding and give SEC compliance examiners more guidance, as well.

The asset management unit is also taking a close look at how hedge fund managers represent themselves.

WATCHING FOR DRIFT

“Offering documents often give hedge fund managers significant discretion in implementing their investment strategies, and they sometimes deviate from their stated objectives,” Mr. Kaplan said. “The unit is concerned when managers engage in improper or unauthorized style drift.”

Another concern, he said, is that “some hedge fund advisers treat the funds like a piggy bank and borrow capital for unauthorized purposes, including to satisfy the obligations of other commonly managed funds or, in some instances, to meet their own personal financial obligations. We are concerned that the improper use of fund assets occurs with some frequency.”

That has led the asset management unit to bring several high-profile enforcement cases, including:

• A $14 million settlement in March against Baystar Capital Management LLC and hedge fund manager Lawrence R. Goldfarb in Larkspur, Calif., for concealing proceeds from illiquid “side pocket” accounts and diverting the funds.

• October 2010 charges against two Georgia hedge fund portfolio managers at Palisades Master Fund LP alleging side-pocket account valuation fraud. The case is now headed for court.

Thanks to the asset management unit’s Aberrational Performance Initiative, which uses quantitative and qualitative risk analytics to track hedge fund managers “with suspicious performance patterns over time … we’re optimistic about cases in the pipeline,” Mr. Kaplan said.

Staff training in industry-specific practices is a top priority with the municipal-securities and public-pension unit, said unit chief Elaine C. Greenberg, who is also a regional director based in Philadelphia.

“One of our major areas of focus is public-pension-fund liabilities — how states and municipalities are accounting for them, what kind of disclosures they’re making in bond-offering documents and whether they are misleading,” Ms. Greenberg said, referring to the 2010 action against New Jersey.

As pension fund asset values drop, it “may present a scenario for possible fraudulent activity,” Ms. Greenberg said. “We are actively investigating.”

Mr. Lench said another goal in bringing high-profile cases is to develop both legal precedent and deterrents. “The “cop on the beat’ element of what we do is important. It lets the market know that somebody is looking.”

Message received, according to one hedge fund executive. “The SEC is clearly ramping up. If you don’t get it, you’re not paying attention,” the executive said.

Hazel Bradford is a reporter for sister publication Pensions & Investments.

Related Topics: Securities and Exchange Commission