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Takeaway: Are we witnessing the coming of a tougher SEC?

This note was originally published July 23, 2013 at 15:18 in Compliance

The SEC’s new chair, Mary Jo White, was a high-profile prosecutor as head of the Office of the United States Attorney for the Southern District of New York (known to its occupants as simply “the Office”).  She then became a rock-star white collar defense attorney, heading the litigation practice at Debevoise & Plimpton, from whence President Obama plucked her in January and tossed her into the lions’ den of Congressional confirmation hearings  (see our piece on the nomination in Fortune).  There was hand-wringing aplenty over concerns she might be soft on her former clients.  Now there appears to be a glimmer of hope that she may be a tough sheriff after all.

"Miami Vice" Meets the SEC? - mjw

The Good Part

Last week the SEC accused the city of Miami of misleading investors in a series of muni bond offerings.  The SEC charged the city and its former budget director with fraud in three 2009 bond offerings totaling $153.5 million, saying budget director Michael Boudreaux made false statements and material omissions regarding the city’s finances, orchestrating fraudulent transfers of funds “to mask increasing deficits in the General Fund, which is viewed by investors and bond rating agencies as a key indicator of financial health.”  The SEC says this caused the bond offerings to receive favorable ratings from the rating agencies, until the city’s Office of Independent Auditor General flagged the improper transfers, causing them to be unwound.  This led in turn to an across-the-board downgrade of the city’s debt.

SEC Co-Director of Enforcement George Canellos says “we will hold accountable not only municipalities, but also individual municipal officials for fraudulent disclosures to investors.”

The Really Good Part

One short paragraph in the SEC release has sparked considerable interest: “The SEC’s action also charges Miami with violating a cease-and-desist order that was entered against the city in 2003 based on similar misconduct.  This is the first time the SEC has alleged further wrongdoing by a municipality subject to an existing SEC cease-and-desist order.” [Emphasis added]

One of the biggest criticisms of the SEC has been its rush to settle enforcement cases, rather than trying them (see our Hedgeye e-book Fixing A Broken Wall Street for detailed analysis of this, and of other nasty stuff about Wall Street you will wish you had never found out.)  In settlements, finance professionals who may have been guilty of fraud generally walk away unscathed.  Even under rough-and-tumble former federal prosecutor Robert Khuzami – himself a former White protégé at “the Office” – the SEC settled for some big numbers, from Goldman Sachs for example, but did little in the area of identifying bankers who had significantly contributed to the financial meltdown.

Enforcement settlements with individuals routinely contain the expression “neither admit nor deny,” while settlements with companies almost never name individuals, as though fraud, negligence and rampant greed arose like some mysterious vapor from the earth.  This has perpetuated an aura of invincibility around the very worst practices in our industry, protecting Bad Actors from ever having to pay the piper.

Alongside the “neither admit nor deny wrongdoing” bit, there’s routinely a clause that says, “Even though we don’t admit that we did anything wrong, whatever it is we’re not admitting to, we promise we will never do it again.”  A reasonable command of English should enable you to see that piece will never be applied.  How do you charge someone with a repeat offense when you accepted them “neither admitting nor denying” the first offense?

For the first time, the SEC is acting as though a prior cease-and-desist order had teeth.  Critics are saying White does not go far enough, that she should go after “a real Wall Street insider,” instead of a non-financial player like the City of Miami.  We recognize that wheels turn very slowly in the world of regulation.  Indeed, if Congress gets its way, those wheels are likely to turn not at all, as we saw White valiantly taking up the case for increased funding for the Commission – a case her predecessor made in vain to a Congress whose election campaigns are paid for by the investment banks.  (Yep, it really is that simple.)

We would like to believe this is a first engagement in what will become a revolution in the way the SEC approaches cases.  We have been highly critical of the SEC’s culture of compromise, the “rush to settlement” mentality, but we also realize that big changes must be wrought incrementally.  We agree with the on-line posters, bloggers and other commentators who say that, while she is about going after repeat offenders, White should withdraw the SEC’s objections to Judge Jed Rackoff’s ruling that ordered Citigroup and the SEC to try their case over a $1 billion fraud.  This case was put on ice when the judge rejected a proposed settlement, saying the lack of specificity – no individuals named, no admission of wrongdoing or even negligence – made it impossible to determine whether the settlement was in the public interest.  “You are asking me to exercise my authority, but not my judgment,” said Rackoff.  In an utterly bizarre turn of events, Citi and the SEC joined forces asking a higher court to set aside Judge Rackoff’s ruling, leaving Rackoff to watch from the sidelines, as judicial procedure prohibits him from appearing to defend his own ruling in the appeals court.

As we wrote at the time – and wrote, and wrote, and wrote – Citigroup was the deformed phoenix that rose from the ashes of Glass Steagall.  Under President Clinton, the law of the land was eviscerated to enable Sanford Weill to consummate a merger that created a financial behemoth.  In the heat of the financial crisis, FDIC chair Sheila Bair persistently railed that Citi was terribly managed and dangerously unstable and in need of being broken up to avoid further disaster.

The rationale for settlements in the legal system is judicial economy: you can’t throw all the resources of the courts at every case.  As slowly as the wheels of justice now turn, they would instantly grind to a halt if all the resources of lawyers, judges, juries and courtroom personnel had to roll into motion every time someone was accused of an offense.

In the Citi case, this makes no sense.  The courts push for settlements in order to save their resources for Really Big Cases with particularly high stakes, cases that will establish game-changing precedents.  If ever there was a case deserving of the court’s full attention, it is SEC v. Citi.  The nation’s securities watchdog pitted against a titanic financial firm – the very firm whose existence caused the protections of Glass Steagall to be shunted aside.  This is the very case for which judicial economy was created.  For all the inconvenience it may have created for Sandy Weill, Glass Steagall had the overwhelming advantage of being simple: do this, don’t do that.  Markets can live with unreasonable regulations, but they can’t live with uncertainty.  Dodd Frank is a recipe for a decade of haggling.  Glass Steagall is simple.

White should finish what she started, moving expeditiously from the City of Miami to the courtrooms of lower Manhattan.  The best thing that could happen to restore confidence in America’s ability to regulate its markets would be for the SEC to withdraw the objection and try the case.  With Ms. White at the head of the team, we have the utmost confidence that the government’s case will be well prepared.  And for all that we don’t much like Citi, we are by no means certain the SEC’s case would be a slam-dunk.

But whatever the outcome, it would send the message that the days of shadowy dealings between regulators and regulatees are over, that justice isn’t for sale, and that market transparency is more important that winning or losing big cases.

We strongly urge Chairman White to take on the Citi case.  Whatever the outcome, we must declare Too Big To Fail also means Too Big To Settle.

Moshe Silver

Managing Director / Chief Compliance Officer