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SEC's Schapiro Sees 'Overwhelming' Task Amid Dodd-Frank Curbs

Mary Schapiro, chairman of the U.S. SEC
Mary Schapiro, chairman of the U.S. Securities and Exchange Commission (SEC), speaks at a Senate Banking Committee hearing on the fiscal 2012 budget request for the SEC in Washington, D.C., U.S., on Thursday, March 10, 2011. Photographer: Andrew Harrer/Bloomberg

On a stormy night in October 2009, Mary Schapiro, the newly appointed head of the U.S. Securities and Exchange Commission, returned to her alma mater, Franklin & Marshall College in Lancaster, Pennsylvania, to be inducted into the hall of fame for student athletes. Receiving her award, she grasped the podium, confessed she was near tears and spoke of how she had never even seen a lacrosse game before attending college.

“But I knew if I worked hard and persevered, I might ultimately play,” she said. She competed for four years and served as captain of the team in her senior year, when it went 7-4. She also lettered in field hockey, Bloomberg Markets magazine reports in its May issue.

Today, Schapiro, 55, faces challenges a good bit nastier than a muddy lacrosse game. As she hits the halfway point of her five-year term as head of the SEC, she must deal with a sprawling legislative mandate to rewrite regulations affecting the financial industry while, at the same time, trying to erase the stain of the SEC’s failure to uncover Bernard Madoff’s Ponzi scheme.

Oh, yes, and Congress has effectively frozen her budget.

Not since Joseph Kennedy was appointed the first SEC chairman by President Franklin D. Roosevelt in 1934, in the shadow of a stock market crash that had shattered investor confidence, has the agency’s leadership faced such a broad call to action. Kennedy might have been speaking for Schapiro when he described his challenge as “one of the most difficult and one of the most delicate tasks ever given to a governmental agency.”

‘A Bit Overwhelming’

Taking stock of her lot, Schapiro is more understated.

“It can feel a bit overwhelming at times, but we just have to take it one step at a time and get it done,” she says. She has tempered that can-do attitude with warnings that the volume of work and the lack of additional funding will cause the SEC to miss deadlines as it writes up to 100 new rules designed to curb fraud and excessive risk taking in the financial industry. And it could get worse from there.

“The real crunch comes after the rules are in place and we have to operationalize them,” she told the Senate Banking Committee in late February. “We lack the resources to do that.”

Representative Scott Garrett, the new Republican chairman of the House subcommittee on capital markets, counters that the commission, like every federal agency, is already bloated. He wants to reduce, not increase, its budget.

Representative Barney Frank, the Massachusetts Democrat who was chief sponsor of the financial regulation bill together with former Senator Christopher Dodd, says the real goal of Garrett and the other Republicans who took charge of the House in January is to derail Dodd-Frank.


“They are looking to de-reregulate the financial markets,” Frank says.

Limited resources aside, Schapiro and her enforcement chief, former federal prosecutor Robert Khuzami, have kept the SEC in the news by filing lawsuits against high-profile financial players. SEC lawyers helped the Justice Department build its insider-trading case against hedge-fund mogul Raj Rajaratnam, now on trial in federal district court in Manhattan. While the SEC doesn’t have the power to bring criminal prosecutions, agency lawyers can appear in the courtroom to help question witnesses.

Days before the trial of Rajaratnam started in early March, the SEC filed a civil suit against Rajat Gupta, former head of McKinsey & Co. and former Goldman Sachs Group Inc. director, alleging that Gupta had funneled inside information about Goldman’s finances to Rajaratnam. Gupta denies wrongdoing.

Goldman Sued

Goldman itself was the object of an April 2010 SEC suit, alleging that it had committed fraud when it sold investors a mortgage security without disclosing that bearish hedge fund Paulson & Co. helped pick the loans. Goldman paid a record $550 million fine and acknowledged that its marketing materials contained incomplete information.

Schapiro also announced on March 2 that the SEC was writing regulations that would allow it to challenge the bonuses paid to the top executives of Wall Street banks, brokerage firms and hedge funds.

Lynn Turner, former chief accountant at the SEC, says that however tough Schapiro is on bonuses and inside traders, she can’t overcome her failure to sue the executives he holds responsible for the market crash.

“Name me one executive at Merrill Lynch the SEC has held accountable, or name me one at Bear Stearns or at Lehman Brothers,” Turner says. “Here you have the worst financial crisis in history and you can’t name one.”

Fannie, Freddie

The SEC isn’t finished pursuing top executives from the financial crisis. In mid-March, Daniel Mudd, the former CEO of Fannie Mae, confirmed that he had received a Wells notice from the SEC, indicating a pending enforcement action. Richard Syron, former CEO of Freddie Mac, also got a notice, according to two people briefed on the matter.

The two government-backed mortgage giants have stayed afloat only with the help of more than $150 billion of bailout money.

The bonus controls are another measure mandated by the Dodd-Frank financial regulatory law, passed in July 2010. Formally called the Wall Street Reform and Consumer Protection Act, Dodd-Frank also foisted onto the SEC a mandate to conduct studies on 20 open-ended questions, including whether or not to have credit ratings on structured financial instruments such as securitized mortgage loans.

‘An Imperfect Law’

As the SEC staff works to implement the law, the agency’s commissioners are highlighting the challenges.

“The act is an imperfect law,” Commissioner Kathleen Casey, one of two Republican Party members on the five-member commission, told an audience of corporate directors in January. “It is vague in some areas; it sets forth timelines that are in some cases unrealistic. And in some areas, the law is unworkable.”

Her concerns include new SEC rules expanding shareholders’ right to challenge management.

Harvey Pitt, SEC chairman from 2001 to 2003 under President George W. Bush and now head of Washington-based consulting firm Kalorama Partners LLC, doesn’t mince words on what Dodd-Frank means for the commission.

“The SEC has been set up for failure,” he says. “Congress was eager to say, ‘We’ve addressed the financial crisis,’ and they didn’t worry about how effectively they had addressed the crisis. We needed smarter regulatory reform than we got.”

He says Dodd-Frank’s requirement that the SEC write rules to regulate the derivatives market by September 2011 is unnecessarily rushed, and he calls a mandate that it set up an investor advocate office superfluous.

New Trading Rules

“The SEC is the investor advocate, so why do we need a special office for that?” he asks.

Schapiro has also had to address long-standing SEC issues not covered by Dodd-Frank. She made it a high priority to formulate a new series of trading rules and limitations to prevent a repeat of the May 2010 market meltdown, when 340 stocks listed on the New York Stock Exchange dove more than 60 percent in minutes, for reasons no official could immediately explain, before recovering later in the day.

Schapiro is also overseeing a broad reorganization of the commission’s enforcement division, which had wilted under restrictions imposed by her predecessor, Christopher Cox. He ruled that the division’s lawyers had to seek approval from the commissioners before negotiating agreements on corporate fines, which delayed resolution of some cases for many months.

Penalties Under Cox

During Cox’s tenure, the dollar value of penalties decreased every year, falling from $1.5 billion in 2005 to $256 million in 2008.

Schapiro and Khuzami have portrayed the insider cases as the tough new face of an SEC determined to root out financial crime. Khuzami himself led the March 1 press conference announcing the suit against Gupta, who was also a director of Procter & Gamble Co.

“Gupta was honored with the highest trust of leading public companies, and he betrayed that trust by disclosing their most sensitive and valuable secrets,” Khuzami said.

“The SEC allegations are totally baseless,” says Gupta’s lawyer, Gary Naftalis. “Mr. Gupta has done nothing wrong and is confident that these unfounded allegations will be rejected by any fair and impartial fact finder.”

The insider-trading cases have done little to mute the continuing cry from Congress and media commentators for punishment of the executives who brought down the financial system through the manufacture of high-risk debt instruments.

Insider Trading

“Insider trading is really flash,” says Peter Henning, a former SEC enforcement attorney and Justice Department prosecutor who now teaches law at Wayne State University in Detroit. “If you look at some of the biggest numbers, like Raj, you’re talking about $50 million. But Lehman is the biggest bankruptcy in history, and it alone has cost over $1 billion in legal and other professional fees.”

The public anger reached as far as the February Academy Awards ceremony, where a film about the financial meltdown called “Inside Job” won the award for best documentary. In his acceptance speech, director Charles Ferguson lamented that Wall Street hadn’t really been held to account.

“I must start by pointing out that three years after our horrific financial crisis caused by financial fraud, not a single financial executive has gone to jail, and that’s wrong,” he said.

Schapiro and enforcement chief Khuzami say the government is restricted both by the law, which requires knowledge and intent to file fraud charges, and the agency’s continued funding constraints.

Quashing a Budget Rise

The Dodd-Frank law authorized the SEC budget, which was $1.1 billion in 2010, to rise to $1.3 billion in 2011 and $2.25 billion by 2015.

House Republican leaders are determined to quash any increase.

In mid-February, President Barack Obama requested $305 million more than last year’s SEC budget even as he agreed to freeze or cut spending across most other agencies. Congressman Garrett says neither the SEC nor its sister agency, the Commodity Futures Trading Commission, needs more money.

“A dramatic spending increase to fund the SEC and the CFTC, as envisioned by the authors of the Dodd-Frank legislation, would further the mindset that our nation’s problems can be solved with more spending, not more efficiency,” Garrett said in a January statement.

House Disagreement

Garrett has proposed to reduce the SEC budget to the 2008 level of $906 million.

He won’t necessarily get his way. Fellow Republican Jo Ann Emerson, head of a House appropriations subcommittee considering the SEC’s budget, said at a March 15 hearing she opposed a rollback in the SEC budget to 2008 levels.

“They’ve got a huge mission here,” she said. “They need the tools to do their job.”

The SEC has given ammunition to its funding opponents. In April 2010, the office of Senator Charles Grassley, Republican of Iowa, said it was investigating a report that 33 SEC staff had been disciplined over five years for watching pornography on their office computers. Then in July of the same year, the agency signed a 10-year lease for an additional 900,000 square feet (83,600 square meters) of office space in downtown Washington, even though it didn’t yet have the funds to expand its staff.

Becker Controversy

In March, Schapiro landed before the House Oversight Committee over her decision to allow the SEC’s general counsel, David Becker, to participate in deliberations about how Madoff victims should be compensated, even though his mother had amassed $2 million in a Madoff account that he and his brothers inherited.

“I wish that Mr. Becker had recused himself, absolutely,” Schapiro told the committee.

Becker, who has been sued by Madoff fraud trustee Irving Picard, left his post in late February.

A Dodd-Frank-mandated review of the SEC by Boston Consulting Group Inc., released in March, finds that the SEC is about 400 employees short of what it needs to manage its new workload, which includes oversight of hedge funds, derivatives, credit-ratings firms and municipal bonds.

“Without sufficient human resources, the agency will be unable to complete the requirements of Dodd-Frank while maintaining its current activities,” the report says.

Staff Pressures

The SEC staff, which numbers 3,800, is already showing the strain. A survey by the U.S. Office of Personnel Management, released in late February, says that when employees were asked in 2008 whether they had sufficient resources to do their job, 59 percent said they did. In the new survey, only 44 percent said they had such resources.

Henry Hu is one person who got a close-up view of the overworked SEC. In September 2009, Schapiro appointed Hu, a professor of business law at the University of Texas Law School, to head the SEC’s new division of Risk, Strategy and Financial Innovation, known as Risk Fin. Hu, who left the SEC to return to academia in January 2011, gave a December speech on his experience at the Hedge Funds New York conference sponsored by Bloomberg. He described the frenetic pace of work as reminiscent of the famous skit from “I Love Lucy,” in which Lucy and Ethel work on a chocolate candy production line and frantically try to keep up with the conveyor belt.

“The SEC is doing the best it can under very challenging conditions,” Hu says. “It was already faced with tight resource limitations and then Congress imposed new rules and studies on top of that without giving any additional money.”

Schapiro Too Quiet

Arthur Levitt, who led the SEC from 1993 to 2001, the longest run for any SEC chairman, says Schapiro, while smart and accomplished, has been too quiet as support has waned in Congress for stronger regulation.

“I wish Mary had had the personality to create the broadest possible public and political engagement as soon as the administration and the Congress began to backtrack almost a year ago,” he says.

Adds former SEC Chairman William Donaldson, “It’s just not her style to cry bloody murder.”

Levitt sits on the board of Bloomberg Inc., the general partner of Bloomberg LP, parent of Bloomberg News.

Brooksley Born, who was chairwoman of the CFTC from 1996 to 1999, sees parallels between Schapiro’s situation and the time she tried to push forward legislation to make over-the-counter derivatives more transparent. She says the effort failed due to pushback from Treasury Secretary Robert Rubin, Federal Reserve Chief Alan Greenspan and Levitt. She thinks gender bias may have played a role then and now.

Gender Issues

“The financial services industry is male dominated still, and it may be a little easier to discredit a female voice because of that,” she says.

Born, now a partner in the Washington office of law firm Arnold & Porter, served last year on the Financial Crisis Inquiry Commission, created by Congress to examine the financial breakdown.

If it’s possible to be a born regulator, Mary Schapiro fits the bill. After graduating from Franklin & Marshall with a degree in anthropology, she attended George Washington University law school, where she met her husband, Charles Cadwell, now an attorney at the Urban Institute, a Washington think tank. They have two teenage daughters, Anna and Molly.

Schapiro’s first job after law school was as a staff attorney with the CFTC. In 1984, she jumped to the Futures Industry Association, where she worked until President Ronald Reagan made her a commissioner of the SEC in 1988. She was 33. She served until 1994.


In 1995, President Bill Clinton appointed Schapiro head of the CFTC, a job she held until 1996, when she joined the National Association of Securities Dealers as president. In 2007, she led NASD into a merger with the NYSE’s regulatory arm to form the Financial Industry Regulatory Authority, or Finra, the largest nongovernment securities industry regulator in the country.

Schapiro’s total compensation in her final year at Finra added up to $3.26 million. When she left in 2009 to head the SEC, she got a lump sum pension distribution of $7.6 million.

At NASD and Finra, Schapiro had a reputation as being soft on enforcement, says Turner, who was chief accountant at the SEC around that time. Fines levied by Finra declined in each of the last three years she was there, from $125.4 million in 2005 to $28 million in 2008, according to Finra data. Turner says her weak enforcement record didn’t hurt her career at all.

‘Smart and Tough’

“It’s probably why the financial industry liked her for the SEC job,” he says.

That wasn’t the impression President-elect Obama gave when he nominated her in December 2008.

“Mary is known as a regulator who is both smart and tough, so much so that she’s been criticized by the same industry insiders who we need to get tough on,” he told the press on the day she was nominated.

When she returned to the SEC after 15 years -- at a government salary of $163,000 -- Schapiro says she saw quickly that the agency was ill-equipped to attack what Obama in his nomination speech called Wall Street’s “culture of greed.”

“I was a bit taken aback when I returned by how far we had fallen behind the financial industry’s technology,” she says.

The agency, for example, had very limited knowledge of real-time trading action taking place off the exchanges -- a fact that became clear in the May 6, 2010, market plunge. A report later concluded that the incident was caused by the abrupt sale of shares via programmed trades and high-frequency traders.

Real-Time Information

Schapiro has since moved to create a consolidated audit trail that would give the SEC real-time trading information for both the NYSE and electronic platforms.

Schapiro’s other important focus when she took over the SEC was enforcement. She hired Khuzami to take over the biggest division less than two months after Madoff confessed that he’d operated a giant fraud under the SEC’s nose for more than 15 years.

Khuzami was brought in to change the culture.

“We have retooled the division to make it more targeted, quick, insightful and proactive,” he says.

Khuzami also joined hands with the Department of Justice to offer suspects in financial wrongdoing deferred prosecution in return for cooperation.


“Chairman Cox did a pretty good job of demoralizing parts of the agency, and I think Khuzami has lifted things up,” says James Cox (no relation), professor of corporate and securities law at Duke University.

Khuzami also moved to create specialized units within the division, including teams focused on “market abuse” and structured products, which Schapiro says have been highly effective.

“We look back on it now and it seems obvious,” Schapiro says. “Rather than having an enforcement attorney work on insider trading one month, then market regulation the next month, let’s help them build expertise in one area, get them tools and training, bring in outside experts. It’s really been quite transformational.”

By traditional metrics, the changes are paying off. In 2010, penalties collected by the enforcement division were up $800 million over 2009, while disgorgements -- the surrender of ill-gotten gains -- rose $200 million. And, as Schapiro likes to point out, the SEC is, in effect, a great deal for taxpayers. In 2010, she says, the SEC paid $2 billion in penalties and disgorgements to wronged investors.

Two Dollars for One

“That’s two dollars for every dollar the agency costs the taxpayer,” she says.

Most of that money was collected from institutions such as Bank of America Corp., Citigroup Inc. and Goldman Sachs. As Turner and other critics point out, the commission’s record against individuals involved in the financial crisis is less impressive.

In October, the SEC settled a case against Angelo Mozilo, former head of mortgage bank Countrywide Financial Corp., hitting him with $22.5 million in penalties and $45 million in disgorgement for misleading investors as the subprime-mortgage crisis emerged. It turned out that Mozilo had been indemnified by Countrywide, which in July 2008 was bought by Bank of America. The bank will pay more than half of Mozilo’s tab.

“There have been attempts over the years to deny similar indemnification rights in our settlements, and those efforts didn’t fare well in the courts,” Khuzami says. “That’s a fact of life we have to live with.”

Rattner Case

The SEC was also criticized for being too soft on Steven Rattner, former head of the hedge fund Quadrangle Group LLC, who the agency sued over his alleged involvement in a New York scandal in which investors paid middlemen for the chance to manage money for the state pension fund.

Rattner settled with the SEC for $3 million in penalties and $3.2 million in disgorgement, without admitting or denying wrongdoing.

New York Governor Andrew Cuomo, who was the state’s attorney general at the time, refused to join the settlement, saying the SEC terms were far too lenient.

“This is not justice,” he said.

Cuomo pressed his own suit against Rattner under New York’s powerful Martin Act and settled for $10 million.

The SEC has also had bad luck in the courts. In September 2009, the agency moved in federal court to conclude a case in which Bank of America was accused of failing to disclose to its shareholders bonuses that Merrill Lynch & Co. had agreed to pay to its executives just prior to its purchase by BofA in 2008.

‘Façade of Enforcement’

When the $33 million settlement was presented to Judge Jed Rakoff in U.S. District Court in New York, he rejected the terms, calling it “a contrivance designed to provide a facade of enforcement.”

Six months later, the SEC went back to court with a revised $150 million penalty and the judge approved it.

In August 2010, a proposed SEC settlement with Citigroup over its failure to disclose its exposure to subprime mortgages was rebuffed by New York U.S. District Judge Ellen Huvelle. The SEC later went back to court, spelling out specific corrective measures Citigroup was taking, and the judge approved the settlement.

The public’s appetite to punish the nation’s financial kingpins is based on anger and emotion, Khuzami says.

‘A Nation of Laws’

“But we are a nation of laws, and that often means proving knowledge and intent. Our task is to distinguish that which is illegal from that which resulted from bad judgment or poor investment decisions or faulty risk management,” he says.

While taking its licks over its enforcement effort, the agency soldiers on with its attempt to fulfill its Dodd-Frank obligations. The legislation calls for 243 separate sets of new rules and 67 studies, divided among various agencies, including the CFTC, the Federal Reserve and the Federal Deposit Insurance Corp. More of that work falls on the SEC than any other agency, with many of the rules to be completed by mid-July and to take effect in September.

The SEC is required to come up with a dozen new rules related to credit-ratings companies alone, reviewing and recommending changes in the firms’ methods for evaluating structured financial instruments and other arcane products of the investment banking industry. Each rule is opened for public comment, then undergoes multiple revisions before being voted on by the commission.

Derivatives Challenge

Schapiro says the agency’s most daunting task is to write new rules governing derivatives -- financial instruments such as futures contracts and credit-default swaps whose value is derived from that of an underlying commodity or security. Dodd-Frank requires that many derivatives previously traded privately, or over the counter, be placed on exchanges and regulated like other securities.

“It’s the biggest challenge,” Schapiro says. “It’s a massive undertaking, where you are really creating a whole new regulatory regime from a blank slate.”

The SEC currently has about 75 people working on the new derivatives rules, and Schapiro expects to have about 10 finalized by the end of 2011.

“As challenging as the rule-writing phase has been, I think it will pale in comparison to the implementation challenges -- both to the agencies and the regulated entities,” says Annette Nazareth, a former SEC commissioner who departed a year before Schapiro arrived.

Whistleblower Conundrum

One new Dodd-Frank creation, the whistleblower program, is already in effect. Informants who blow the whistle on wrongdoing in their financial firms are entitled to 10 to 30 percent of the amount recovered. While the law went into effect in July 2010, the SEC’s poverty has prevented the agency from staffing the office.

Schapiro named a coordinator only in February, and he will rely on existing SEC staff.

Former SEC Chairman Pitt worries that the SEC will be overwhelmed with tips from employees of financial companies trying to collect multimillion-dollar government rewards. (A whistleblower in the $550 million Goldman Sachs case could have collected as much as $165 million.)

“Somebody has to separate the wheat from the chaff,” he says. “Somewhere, somebody has to step back and say, ‘We’re piling all these responsibilities on, creating all these new provisions, but how do we expect the agency to cope?’”

Four Deadlines Missed

While the budget battle rages, the SEC struggles. It has already missed four rule-related deadlines and is also late on two studies. Schapiro is busy seven days a week.

“I work on weekends, but from home,” she says.

That’s an improvement over her first year as chairman, when, she says, “I got home for dinner no more than six or seven times.”

Now she spends more time with her family. She says that when CFTC Chairman Gary Gensler came to her office for a derivatives-related meeting on his birthday, Schapiro and her daughters baked cupcakes for him.

The relentless pace of work is taking a toll on the SEC staff. Barbara Roper, director of investor protection at the Consumer Federation of America, who makes frequent visits to SEC headquarters, sees troubling signs.

“They are working under enormously challenging conditions,” she says. “You go over there and the people look exhausted.”

As the deadlines arrive for dozens of additional Dodd-Frank provisions, the staff will lose more sleep. If help doesn’t arrive soon, Schapiro says, investors could wind up losing something more precious: fair and honest markets.

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