More Executives to Face Court Reckoning as SEC Flexes New Power

Corporate executives are more likely to end up in court for their employees’ misconduct now that Congress has handed broader powers and more money to the U.S. Securities and Exchange Commission, former agency officials said.

Since the start of the financial crisis, lawmakers, investors and judges have criticized the agency for giving bosses a pass while accusing companies of wrongdoing, as in recent cases involving Citigroup Inc. and Bank of America Corp. The Dodd-Frank regulatory act lowers the bar for filing fraud lawsuits against individuals and authorizes the SEC to double its spending within five years.

“The SEC is going to cast a much broader net to include people on the edge of a fraud,” said Steve Crimmins, a former trial attorney at the agency who’s now at law firm K&L Gates LLP in Washington. “There will be legions more SEC cops on the beat and that will mean a lot more activity.”

Under Dodd-Frank, which was signed into law in July, the SEC can sue an individual who “recklessly” aids a fraud even if the person isn’t aware of the wrongdoing. Previously, lawyers had to show the person knowingly assisted the misconduct. The law also allows the agency to sue senior officers, directors or other people directly or indirectly accountable for the fraud.

Photographer: Andrew Harrer/Bloomberg

Robert Khuzami, director of enforcement with the U.S. Securities and Exchange Commission. Close

Robert Khuzami, director of enforcement with the U.S. Securities and Exchange Commission.

Close
Open
Photographer: Andrew Harrer/Bloomberg

Robert Khuzami, director of enforcement with the U.S. Securities and Exchange Commission.

Robert Khuzami, the SEC’s top enforcement official, is scheduled to answer for the agency’s progress tomorrow before the Senate Banking Committee after Senator Ted Kaufman, a Delaware Democrat, told him in December he was “frustrated” that regulators hadn’t been able to prosecute more executives and bankers.

Too Late for Crisis

While Dodd-Frank may make that easier, it may be too late for financial crisis cases, Crimmins said. “Had these standards been in place two or three years ago, we probably would have seen more individuals named in cases they’ve brought involving the financial crisis,” he said.

Generally, laws that change the substance of someone’s rights can’t be applied to previous conduct, said John Coffee, a securities law professor at Columbia University. The SEC hasn’t said whether it will try to apply the provisions retroactively.

The provisions “increase the likelihood of litigation” with fewer quietly settled cases, said David Kornblau, who was the SEC’s top prosecutor from 2000 to 2005, overseeing lawsuits against Enron Corp., WorldCom Inc. and Arthur Andersen LLP.

Regulatory lawsuits “can be potentially career-ending issues for individuals, whereas companies mostly can find a way to settle it and move on,” said Kornblau, who’s now an attorney at Covington & Burling LLP in New York.

Witnesses in the Courtroom

Under Dodd-Frank, SEC litigators can now haul witnesses into court from across the country, a power the agency has sought for years. Previously, trial attorneys generally had to videotape testimony of witnesses located more than 100 miles away from the court, sometimes months before the actual trial, instead of being able to grill them in front of a jury.

To be sure, the SEC has taken aim at some individuals for conduct related to the financial crisis, including Angelo Mozilo, the former Countrywide Financial Corp. chief executive officer, whom the agency accused of misleading investors about risks tied to the bank’s subprime mortgage holdings. Mozilo has denied the allegations.

The agency also sued former Bear Stearns Cos. hedge-fund managers Ralph Cioffi and Matthew Tannin in 2008 on claims they misled clients about pending losses and redemptions. Cioffi and Tannin were acquitted of criminal charges in November and deny wrongdoing in the SEC’s case.

Judges have questioned whether the agency avoided pursuing individuals in exchange for a quick resolution.

‘Who’s Responsible?’

“When you bring this long complaint and make it sound like there have been all these misdeeds, who’s responsible?” Judge Ellen Huvelle asked the SEC at an Aug. 16 hearing in Washington where she reviewed a $75 million settlement with Citigroup to resolve claims the firm misled investors about its exposure to subprime mortgages in 2007. “These things don’t happen without individuals.”

The two executives named in the matter paid “unimpressive” penalties, according to Huvelle. Former Chief Financial Officer Gary Crittenden agreed to pay $100,000 to settle claims he didn’t disclose the risk after getting internal briefings. Arthur Tildesley, the former investor relations chief, agreed to pay $80,000 to resolve claims he helped draft misleading disclosures. They didn’t admit or deny wrongdoing.

In the Bank of America case, U.S. District Judge Jed Rakoff in New York rejected a $33 million accord over the company’s disclosures about bonuses and losses while acquiring Merrill Lynch & Co. Rakoff, who later approved a $150 million settlement covering broader allegations, questioned why officers or directors hadn’t been sued.

Deterrence

“We’re likely to see continued pushback from the courts and a lot of trials in the future,” said James Cox, a professor at Duke University Law School. “If the SEC is serious about deterrence, sticking it to individuals is much more important.”

Under Dodd-Frank, the SEC could avoid the courts’ scrutiny by assessing penalties through the agency’s own administrative- law judges rather than going to court. Administrative cases are heard by a judge rather than a jury.

Khuzami, 54, took the enforcement division’s helm in March 2009 as the agency was being pilloried for missing Bernard Madoff’s multi-billion dollar Ponzi scheme and for failing to curb financial practices that helped spark more than $1.8 trillion in losses and writedowns. He has replaced senior staff, created specialized enforcement teams, streamlined probes and added front-line investigators.

‘Formidable Adversary’

“A deep and talented trial unit is critical to encouraging defendants to settle on appropriate terms, or face a formidable adversary in the courtroom,” Lorin Reisner, deputy director of the SEC’s enforcement division, said in a statement.

One source of new cases may be stock market abuse, as the SEC attempts to show it has a grip on trading that is increasingly fragmented and dominated by computers. Investigators are trying to determine what happened after stocks plummeted on May 6, temporarily erasing more than $1 trillion in market value, in a rout fueled by waves of computerized trading.

SEC lawyers are exploring novel legal issues, including whether traders’ algorithms should be preserved as communications for legal scrutiny, according to a person familiar with the matter who declined to be identified because the probe isn’t public.

“Because there’s such pressure on the agency to bring cases in new areas and deploy more creative theories to try to bring cases in all these substantive areas, litigation becomes more likely,” said Kornblau, who represents an investment bank in the SEC’s probe of the May 6 crash. He declined to identify the bank.

Enron and Tyco

The SEC has gone after individuals who became emblematic of past scandals, including Jeffrey Skilling for his role in accounting fraud at Enron, Dennis Kozlowski, who was jailed for stealing millions of dollars from Tyco International Ltd., and Ivan Boesky, the former takeover investor convicted of insider trading two decades ago. Cases stemming from the financial crisis, which may not include parallel criminal probes, may be more difficult to prove.

“There was certainly a desire to name individuals and push creative theories back then,” said Kornblau, referring to SEC accounting-fraud trials he led against Enron, WorldCom and Arthur Andersen. “But here we’re talking about totally new products and markets where there has been very little activity in the past. The pressure is magnified now.”

To contact the reporter on this story: Joshua Gallu in Washington at jgallu@bloomberg.net

To contact the editor responsible for this story Lawrence Roberts at lroberts13@bloomberg.net.

Bloomberg reserves the right to remove comments but is under no obligation to do so, or to explain individual moderation decisions.

Please enable JavaScript to view the comments powered by Disqus.