Sept. 21 (Bloomberg) -- Securities and Exchange Commission Chairman Mary Schapiro, overhauling an agency faulted for botching investigations of Bernard Madoff’s Ponzi scheme, is facing the first major setback of her own making.

The agency’s proposed $33 million settlement with Bank of America Corp. could have demonstrated a speedier approach to holding Wall Street accountable. The deal was reached nine months after the SEC said the bank misled shareholders while buying Merrill Lynch & Co. Instead, the effort backfired.

U.S. District Judge Jed Rakoff’s rejection of the deal last week exposed the pitfalls for the SEC after Madoff tarnished its reputation. Lawmakers including Democratic Representative Edolphus Towns echoed Rakoff, questioning why the agency didn’t punish executives and whether fining the bank unfairly compounds damage to investors. The case has prompted an internal inquiry into how the agency handles firms receiving federal bailouts.

“It’s a terrible blow,” leaving the agency “with a variety of bad choices,” said former SEC Chairman Arthur Levitt said, now a director of Bloomberg LP, parent of Bloomberg News. If the SEC pursues executives or lawyers, it may face challenges after conceding in filings that it lacks evidence to do so, Levitt said. If the agency drops the case, investigators will “look weak at a time they’re trying to look strong.”

Schapiro, 54, who became chairman seven weeks after Madoff’s Dec. 11 arrest, is defending SEC turf as lawmakers and President Barack Obama overhaul U.S. financial regulations. She is seeking to show that the SEC learned from Madoff and should win more resources and authority to police hedge funds and derivatives. Obama has proposed bundling some authorities from existing agencies to create a regulator for financial products.

‘Vigorously Enforce’

The SEC “will continue to vigorously enforce the securities laws,” agency spokesman John Nester said. He said he wouldn’t speculate on ramifications of Rakoff’s Bank of America ruling because every case has unique facts and circumstances.

Lawmakers including Senators Charles Schumer of New York and Ted Kaufman of Delaware also have pressed Schapiro on issues ranging from flash orders to high-frequency trading, while Representative Scott Garrett, a New Jersey Republican, asked the chairman about plans for dismissing workers involved in Madoff. All the issues predate Schapiro’s appointment as chairman.

Rakoff, 66, isn’t the only judge skeptical about the agency’s approach. In July, a federal judge in Texas dismissed a suit against billionaire Mark Cuban, disagreeing with the regulator’s interpretation of insider-trading laws. Lawmakers also plan a hearing this month on the settlement with Charlotte, North Carolina-based Bank of America.

Policies Repealed

Schapiro promised senators at a January confirmation hearing she would “move aggressively to reinvigorate” the agency’s enforcement division. Within weeks, she began repealing policies blamed for slowing inquiries and picked former federal prosecutor Robert Khuzami to lead the unit.

Khuzami, 53, on his first day urged staff to adopt a philosophy he dubbed “the four S’s” -- for strategic, swift, smart and successful. The goal is to build strong cases, then compel defendants to “settle quickly on the commission’s terms” or face evidence in court, he said in an Aug. 5 speech.

“A sense of urgency is critical,” he said. “Long gaps between conduct and atonement undermine the deterrent impact of our cases, and result in missed opportunities to achieve a permanent change in behavior and culture.”

Since late January, the division has opened more than twice as many formal investigations than in the same period a year ago, he said in the speech. Bank of America is among the first cases developed under Schapiro and Khuzami.

SEC Lawsuit

On Aug. 3, the SEC filed a lawsuit, claiming Bank of America had said in a proxy statement that Merrill wouldn’t pay year-end bonuses before the takeover without consent, according to the regulator. Shareholders were unaware that Bank of America had already told Merrill it could pay as much as $5.8 billion in bonuses, the SEC said. Merrill later paid out $3.6 billion, as the brokerage’s annual loss widened to a record $27.6 billion.

The SEC’s lawsuit didn’t identify executives or attorneys responsible for the decision on what information was disclosed. The suit didn’t deal with other issues already prompting congressional ire, such as whether the U.S. improperly pressured Bank of America to conceal from investors the brokerage’s mounting losses. The SEC said its investigation continues.

Bank of America, the biggest U.S. commercial lender, has said it did nothing wrong, telling the court it agreed to settle to avoid unwanted litigation with a key regulator.

Rakoff questioned both sides for weeks then refused to sign off on the accord, saying he still doesn’t understand why executives or their lawyers weren’t sued. On Feb. 1 the case will go to a trial that neither side wants.

‘Throws A Wrench’

“It definitely throws a wrench in their efforts” at rebuilding reputation, said Robert Hillman, a securities law professor at the University of California, Davis. “It’s a sign of the weakened stature of the SEC and a signal to the agency that it needs to get its act together.”

After the Madoff lapses and financial crisis, judges may view the agency with skepticism, said Hillman. In July, the agency lost the Cuban insider-trading case, which had been filed under Schapiro’s predecessor Christopher Cox. The agency still may appeal.

“The SEC has been one of the most highly respected federal agencies,” Hillman said. “Whether it’s fair or unfair, the general perception of the SEC is that it’s not been doing its job in the past several years. The SEC needs to re-earn its stripes.”

Rakoff’s rejection also shows the risk of seeking quick court action on problematic cases, said Donald Langevoort, a former SEC attorney who teaches securities regulation at Georgetown University in Washington.

Fast, Slow

“The SEC has in the past sometimes been too slow. Too fast is bad as well,” he said. “It sometimes truncates what needs to be a fairly deliberate, deep investigation.”

On Sept. 30, the House Oversight and Government Reform Committee will hold its fourth hearing on the Merrill takeover, taking testimony from Schapiro and Cox. Lawmakers will examine questions Rakoff raised about the settlement, Chairman Towns of New York said last week.

Separately, SEC Inspector General H. David Kotz agreed to examine potential punishments of banks getting aid from the Troubled Asset Relief Program, because taxpayers may absorb the fines. Representative Elijah Cummings requested the probe.

To contact the reporters on this story: David Scheer in New York at dscheer@bloomberg.net; Jesse Westbrook in Washington at jwestbrook1@bloomberg.net.

Last Updated: September 21, 2009 00:00 EDT