Commentary: The SEC: This Watchdog Must Sharpen Its Bite

William H. Donaldson, the new chairman of the Securities & Exchange Commission, has come out of his corner swinging. Or at least, that is the message he would like to send Wall Street. On Mar. 17, in the first major enforcement action on his watch, the agency brought civil fraud charges against Merrill Lynch & Co. (MER ) and four top executives for their role in Enron Corp.'s scheme to inflate its earnings via off-balance-sheet transactions. The four execs are fighting the charges -- but not Merrill, which agreed, without admitting or denying wrongdoing, to pay an $80 million civil penalty.

That sounds like one heck of a lot of money -- and by current legal standards, it surely was. "We took an aggressive posture and succeeded," asserts one senior SEC official.

But don't start celebrating just yet. The Merrill settlement is far less draconian than meets the eye. And that's sobering news for investors, who are looking to the SEC to take an uncompromising stance against Wall Street transgressions in the post-Harvey Pitt era. What's more, the SEC is promoting the settlement as a model of the kind of justice it will mete out to other firms, such as Citigroup (C ) and J.P. Morgan Chase & Co. (JPM ), that fed at the Enron trough. If it turns out to be the gold standard for punishment of large firms, Wall Street can rest easy. Merrill dodged a bullet.

To be sure, the SEC gets an A for effort by moving against Enron's Wall Street partners. That certainly plows new ground. "This is the kind of case that would not have been pursued five years ago," says David U. Gourevitch, a former prosecutor who is now a partner with Stueve Helder Siegel LLP in New York.

But the feds get an F for impact. The settlement barely lays a glove on Merrill -- in contrast to the four execs, who face the possibility of immense fines and ruined careers. Even though the fine is a multiple of the $9.3 million Merrill earned from the transactions, it is chump change for a firm of that size. "The [$80 million penalty] falls in the category of 'less than significant,"' sniffs Thomas Ajamie, a veteran securities lawyer and partner at Schirrmeister Ajamie LLP in Houston. With net revenues of $18.6 billion in 2002, Merrill could recoup the sum in 1.5 days. That's the equivalent of a $200 fine for a $50,000 a year working stiff.

So what penalties would be more appropriate for a humongous firm that engaged in serious wrongdoing? One possibility advocated by New York securities lawyer Bill Singer, a former NASD official, is to suspend such firms, or one of their divisions, for a few days. That would be well within the SEC's powers. The agency also could go a long way toward restoring investor confidence by insisting that firms admit guilt and abandon the tiresome practice of permitting them to agree to penalties while not acknowledging culpability. Yes, it would expose the firms to shareholder suits. And what is wrong with that?

As the Merrill wrist-slap illustrates, current legal strictures don't permit fines that would be big enough to have a significant impact on major firms. Indeed, small brokerages have long complained that larger firms are treated far more leniently by regulators. "If the Internet [analyst] groups at some of these [big] firms were pulled out and dropped into the middle of Brooklyn, they would be considered boiler rooms," notes Ajamie. One example of disproportionate treatment, in Singer's view, is the penalty imposed by the NASD in April, 2002, on a small New York brokerage named Hornblower & Weeks Inc. The firm, accused of issuing overhyped analyst reports -- charges similar to those leveled against major firms -- was slapped with a six-month suspension of its research department. (The firm agreed to the penalty without, as usual, admitting or denying culpability.)

Large firms should no longer be immune to such punishment when circumstances warrant. Sure, it would take guts: Wall Street has immense political and economic clout. But if Bill Donaldson wants to have a meaningful impact on the Street's often pliable morality, he will have to hit firms with penalties they can feel. A hatchet is required -- not a pin prick.

By Gary Weiss

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