The SEC's Top Cop

With a big budget and more lawyers, Enforcement chief Steve Cutler is playing hardball with wrongdoers in Corporate America and on Wall Street

Stephen M. Cutler was steamed. For nearly two years, Securities & Exchange Commission lawyers had been investigating charges that top managers at Banc of America Securities (BAC ) had traded shares with advance knowledge of potentially market-moving rating changes by the brokerage's analysts. But the Bank of America Corp. unit still had not turned over many e-mails and documents the SEC had requested.

Fed up with the runaround, Cutler, the normally mild-mannered SEC Director of the Division of Enforcement, called BofA 's then-general counsel, Paul J. Polking, last Dec. 3 and lambasted him. According to people familiar with the incident, Cutler said: "It's a shame if you don't know about [the stalling] and a shame if you do." Two weeks later, BofA Chairman and CEO Kenneth D. Lewis was in Cutler's Washington office trying to make amends. Even so, BofA paid a steep price. Cutler hit the brokerage unit with a $10 million fine -- a first fine in a standalone case for failure to cooperate with an SEC investigation. And BofA still faces possible charges of illicit trading, plus more stiff fines.

Cutler is on a tear. The 42-year-old attorney, named to head the Enforcement Div. just days after Enron Corp. revealed its first big loss in October, 2001, is retooling his division into an elite police force patrolling the boardrooms and corner offices of America Inc. Leveraging new laws and commanding a vastly larger budget than his predecessors, Cutler is using hardball tactics and stiffer penalties to put CEOs, directors, lawyers, bankers, and accountants on notice that a more aggressive SEC will hold them responsible for shoddy finances and hidden conflicts of interest. "We are trying to change behavior," says Cutler. "People have to get used to the new way of thinking."

His goal is nothing less than to make markets safer and more transparent for investors by sweeping away Wall Street's bad habits. Corporate lawyers will no longer be allowed to sign off on foggy reports to shareholders that conceal more than they reveal. Banks will have to ensure that clients aren't using their financial deals to create phony revenues or hide debt. And brokers will have to spell out how they are paid for their services and reveal conflicts that pit their wallets against those of their clients.

Cutler has the crucial support to make the effort work. Although by some accounts SEC Chairman William H. Donaldson, a Wall Street veteran, may be wavering on proposals to make it easier for dissident shareholders to oust company directors, he backs Cutler and his enforcement efforts to the hilt. That's critical: Enforcement directors have enormous freedom to set priorities, investigate, and develop cases, but they need the chairman on board to bring charges. The pair talk several times a week, and Donaldson calls Cutler periodically to ask about current cases and suggest new targets. Indeed, because the chairman shuns the limelight, Enforcement is often the public face of the SEC. Says Donaldson: "I have a great deal of confidence in the division and in Steve. He's an outstanding leader, and he has been very creative."

He's had to play catch-up. When the Wall Street scandals broke in 2002, the SEC was caught flat-footed. New York Attorney General Eliot Spitzer humiliated the feds twice in two years. His probes of analyst conflicts of interest and mutual-fund trading abuses -- areas that are central to the agency's oversight duties -- made the SEC look inept, and asleep at the wheel. Says a former SEC lawyer: "[Spitzer] embarrassed us."


Determined to restore the agency's preeminence, Cutler forged a working relationship with Spitzer and drove his troops hard to produce results. Now, SEC Enforcement is again leading the charge. Exhibit A is Cutler's big effort to force Wall Street to look critically at itself. Last September he challenged financial firms to do a top-to-bottom review of their operations to root out hidden conflicts that had become accepted practice and to report back to the SEC on how they manage them. If they don't 'fess up about and fix problems, they face added penalties. "Many bad practices evolve in a creeping sort of way," says Cutler. The review "requires firms to stop and reassess."

The self-exams are a clever way to stretch the SEC's resources. And securities firms are taking them seriously. Morgan Stanley (MWD ) assigned former Spitzer deputy Eric R. Dinallo to oversee its housecleaning. "It's a brilliant move," says a former SEC lawyer who now advises securities firms. "Everyone realized that if they didn't do it, and a problem surfaced down the road, they would be defenseless."

That's just the start. SEC insiders and defense lawyers say the agency has plenty more charges to bring against mutual funds and hedge funds. Cutler is also broadening the SEC's attack on gatekeepers -- the auditors, lawyers, and bankers who advise companies and sometimes aid their frauds -- by targeting directors and lawyers who counseled companies, such as Enron and WorldCom Inc., which melted down after accounting failures. He is training his sights on senior Wall Street execs who failed to police dealings between analysts and investment bankers. And his team is probing whether some firms' bond operations took bids from preferred customers after auction deadlines.

Cutler's zero-tolerance strategy has incensed many financial and legal mavens. Privately, Wall Streeters say they fear that if their self-exams miss something smelly, the SEC will sniff it out and punish them harshly. "This is the most ominous and threatening thing ever from the SEC," says a former SEC lawyer involved in one of the reviews. Corporate defense lawyers say Cutler and his troops are going too far: cutting corners, trampling on their clients' legal rights, imposing excessive fines, and making liberal use of lifetime employment bans on execs. "There's been a cataclysmic change," says one attorney. "The staff is unbridled and unreasonable."

SEC targets are increasingly fighting back. In the six months through Mar. 31, the agency had to sue in 45% of the cases it filed, up from 38% in the whole of 2003. Courts are no haven for Cutler's targets, however. In the same six months, the SEC won eight out of nine trials in U.S. District Court and all nine heard by administrative judges.

Cutler isn't fazed by his critics. With the nation revolted by financial crimes, he is seizing an historic opportunity to lead his 1,100-strong band of enforcers on a mission to overhaul the culture of Wall Street and Corporate America. In a string of lawsuits and settlements, Cutler is forging new legal tactics to make the SEC's rules stick. One example: His broad assault on gatekeepers to hold them responsible for the honesty of clients' financial statements. Last year, the SEC leveled charges against JPMorgan Chase (JPM ), Citibank (C ), Merrill Lynch (MER ), and Canadian Imperial Bank of Commerce for helping Enron defraud investors, winning $416 million in settlements.

Cutler also is exploiting fully the SEC's enhanced powers under the 2002 Sarbanes-Oxley corporate-reform act. And he hasn't hesitated to explore the outer limits of the law -- at times even making policy ahead of the SEC's five commissioners. In December, he used a creative reading of the law to bring charges of failure to supervise employees against the head of Marque Millennium Group Inc., an unregistered investment adviser to a hedge fund, even though the SEC has no authority over hedge funds.

It's a dramatic change from the 1980s and '90s, when corporate crime wasn't front-page news and Cutler's predecessors were a more cautious lot. "There was resistance by the enforcement staff to hit hard and make those who had done wrong really pay for it," concedes one agency insider. "That's not true anymore." Put it together and "Cutler has become one of the most effective enforcement directors in SEC history," says Joel Seligman, dean of Washington University School of Law.


Even so, Cutler is no Dirty Harry for the white-collar set. The son of two lawyers, he had a privileged upbringing in Los Angeles. He played varsity water polo at a private high school and earned B.A. and law degrees at Yale University.

What drives Cutler is the urge to make a difference. When he graduated from Yale Law School in 1985, Cutler interviewed for a clerkship with Judge Dorothy W. Nelson, a federal appeals court judge in Pasadena, who asked him what he wanted to be doing in 10 years. "He wanted a job where he would have a major impact on public policy," says Nelson. "I hired him on the spot." After clerking, Cutler spent a year representing minority oilfield workers in an employment lawsuit.

Cutler, whose government salary is a fraction of what he could earn in private practice, has been appalled by the greed and deceit his enforcers have uncovered. "When the WorldCom lawyers came in the night before the announcement" of the company's initial discovery of $3.8 billion in accounting fraud in June, 2002, "the prosecutor in me said: 'This is incredible,"' Cutler recalls. "And the public citizen in me said: 'This is depressing."'

Intense and thoughtful, Cutler has a reputation for fairness. In settling mutual-fund trading-abuse cases, for example, he refused to join Spitzer in forcing funds to lower annual fees, arguing that they are a separate issue from trading violations. "We worry over whether we are doing the right thing, reaching the right result," says Linda Chatman Thomsen, Cutler's deputy at the Enforcement Div.

No table-pounder, Cutler is more likely to squash an opponent's case with implacable legal logic. Just ask the attorneys for five New York Stock Exchange specialist firms accused of trading abuses. When talks bogged down in mid-February, Cutler walked into a meeting of lawyers for the firms, outlined the SEC's case, and said: "This is going to happen by 6 p.m. Tuesday or we don't want to talk to you again until we file a case in court." Recalls a lawyer for one firm: "He didn't raise his voice or get rattled. But he had [the misconduct] nailed and drove a very hard bargain." By Tuesday, the firms had agreed to a $240 million joint settlement.

Before joining the SEC in 1999, Cutler worked for 12 years at the Washington law firm now known as Wilmer Cutler Pickering Hale & Dorr LLP. (He's not related to founding partner and former White House counsel Lloyd Cutler.) There, he came under the wing of partner Theodore A. Levine, today a dean of the securities bar. "Steve is incredibly hard-working and incredibly fair," says Levine, now a partner at Wachtell, Lipton, Rosen & Katz. (And imaginative: When Cutler was asked to plan the firm's annual retreat in 1993, he loosened up his staid colleagues by having lawyers don inflatable suits for "sumo wrestling.")

Two years after joining the SEC, he was promoted to Enforcement director by then-Chairman Harvey L. Pitt. Six months later, Spitzer shamed the SEC by revealing explosive e-mails from Merrill Lynch & Co. analysts that lifted the lid on Wall Street's conflicts. Despite that rough start, the two prosecutors have forged a partnership that, while occasionally strained, seems genuine."I have only the greatest admiration and respect for Steve Cutler," says Spitzer. "We've handled many cases together, and we've always worked through our disagreements."

Spitzer credits Cutler's deft use of humor for defusing tension in their relationship. At an SEC Historical Society dinner last June, Cutler brought down the house when he read spoof Spitzer e-mails knocking the AG's penchant for stretching his authority. Sample: "Dear God: It's my understanding that you are everywhere, including, apparently, the State of New York. As I read the Stamp Act [of 1765] you are subject to regulation and taxation by the State of New York. While you are and should be the primary regulator of humanity, I have some ideas I'd like to share with you." Says Spitzer: "I laughed so hard, I cried."

But the last laugh will be Cutler's. While Spitzer is taking on other industries -- and tuning up for his expected 2006 run for governor of New York -- "Cutler is building a program that will last longer than anything Spitzer is doing," says one Wall Street official who is close to Spitzer. And the Enforcement chief is picking up new allies. The Justice Dept. -- long reluctant to try complex financial fraud cases -- now is eager for Cutler's team to refer cases to U.S. Attorneys. The greater prospect for criminal charges strengthens the SEC's hand in negotiating settlements. "Big financial frauds are the hottest thing around," says Cutler deputy Thomsen. "My phone is ringing off the hook." Here's how Cutler is reshaping Enforcement:


SEC guidelines promise companies and executives lighter penalties if they cooperate -- a message Cutler pushes hard. The flip side: The agency will slam those, such as BofA, who don't play ball. "That settlement is worth its weight in gold," says SEC Commissioner Harvey J. Goldschmid. "It sends a message that it's one thing to fight hard for your clients; it's another to pass ethical lines and improperly frustrate Enforcement's efforts." A BofA spokesman refused to comment.

Even after settlements are reached, Cutler's troops watch for signs of backtracking. Just ask Lucent Technologies Inc. (LU ). In May, 2003, Enforcement staff tentatively agreed to resolve the company's accounting-fraud charges without penalty. But then an outside lawyer for Lucent gave a magazine interview in which he downplayed the misdeeds. Lucent also agreed to pay the legal fees of employees who are contesting SEC charges of securities fraud. That was too much: On May 17, Cutler slapped Lucent with a $25 million fine.

Defense lawyers gripe that the SEC now treats any disagreement about a case as obstruction of justice. Enforcement, they say, is bullying targets with deadlines of as little as three days to respond to Wells notices -- letters from the SEC telling targets the agency intends to bring charges. "When you don't knuckle under to unreasonable requests, they say you're failing to cooperate," says Andrew W. Vollmer, a securities enforcement partner at Cutler's old firm. "Even the threat of being accused of failing to cooperate intimidates responsible clients."


Last year, WorldCom, now MCI (MCWEQ ), paid a $750 million fine for cooking its books. Alliance Capital Management forked over $250 million in penalties and disgorgement to settle mutual-fund trading-abuse charges, and JPMorgan Chase paid $135 million in penalties, disgorgement, and interest to settle charges that it helped Enron commit accounting fraud. To add to the sting, in these and other cases, the SEC bars offenders from seeking reimbursement for fines from insurers. Most of the money has gone into restitution funds to compensate investors for heavy losses.

Those payouts dwarf the $10 million the SEC fined Xerox Corp. (XRX ) in 2002 -- at the time, the record penalty for financial fraud. What changed? Until Sarbanes-Oxley, the SEC was reluctant to hit companies with big penalties, reasoning that fines paid to the Treasury would hurt shareholders already victimized by fraud. But the new law allows the SEC to use penalties to repay shareholders, so it began to jack up fines.

The sharp rise in penalties has defense lawyers seething. "The only principle [Cutler] follows is that the amount has to be higher than the last case," says one former SEC lawyer. "It's like doing business in a rug market."

The griping is especially strong in mutual-fund cases. The SEC found that Massachusetts Financial Services Co. reaped $175 million in ill-gotten gains from abusive trading; the company had to pay that much into a fund to compensate investors, plus a $50 million fine. When Putnam Investment Management LLC settled similar charges, the SEC calculated its illicit profits at just $5 million -- but Putnam, too, was hit with a $50 million fine. Even former SEC lawyers find the logic puzzling. "The economic sanctions being sought so far eclipse any real damage that people wonder what barometer the SEC is using," says one. But the SEC contends Putnam deserved a more severe penalty because senior executives knew about the abuses and hid them from the board.


Sarbanes-Oxley is a veritable hardware store for Cutler's troops. Before, the SEC had to show that accountants or executives were "substantially unfit" to bar them from practicing or serving as public-company officers or directors. Now the hurdle is simply "unfit." In 2003 the SEC booted 170 execs, quadruple the 38 it barred in 2000. The dishonor roll includes former Xerox CFO Barry D. Romeril and ex-Tyco International (TYC ) Director Frank E. Walsh Jr. -- both banned for life.

The law indirectly boosted the SEC's leverage over defendants by encouraging the U.S. Sentencing Commission to overhaul guidelines for prison terms for criminal securities fraud. Now defendants can get 20 years instead of 10 for willfully making bogus financial disclosures. Jaws dropped in legal circles in January when Jamie Olis, a former Dynegy Inc. (DYN ) executive, was sentenced to more than 24 years in prison for his role in a scheme to conceal a $300 million loan from investors. Says Helen R. Friedli, a partner at McDermott Will & Emery: "The Olis case made people look carefully at the potential benefits of early cooperation and resolution" with the SEC.

In some areas, the agency may have overreached. Consider its new authority to go to court to halt "extraordinary" payouts to departing executives while it is investigating possible fraud. The SEC has used its new powers to freeze payments totaling more than $200 million, including a $23 million check to former Vivendi Universal (V ) CEO Jean-Marie Messier. But on May 12, the Ninth Circuit Court of Appeals in San Francisco said the SEC went too far when it froze $38 million in severance to two former Gemstar-TV Guide International Inc. executives in May, 2003. The court said the amounts were not "extraordinary." The SEC has appealed.


In his zeal to clean up the markets, Cutler is stretching the SEC's jurisdiction and using case law to set new rules for the financial industry. Last November, Morgan Stanley shocked Wall Street when it agreed to pay $50 million to settle SEC allegations that it had failed to disclose payments from 14 mutual-fund companies for selling their funds. SEC policymakers had debated for years whether and how to require brokerage firms to disclose such revenue-sharing. With the Morgan Stanley charges, Cutler sliced that Gordian knot, even though top SEC lawyers say the legal precedents were not on their side.

Some fund lawyers are crying foul. "The [SEC] went too far," says Richard M. Phillips of the San Francisco office of Kirkpatrick & Lockhart LLP. Still, the settlement kicked the SEC's Investment Management Div. into high gear: Four months later it proposed banning another unsavory practice highlighted in the case, whereby mutual funds funnel stock trades to brokers who sell their products.


As the post-Enron cleanup winds down, Cutler is taking up Donaldson's campaign to detect abuses before they explode into scandals. He's recruiting specialists in trading, fund management, and accounting. "I want them to know what's in the popular press, academic literature, the industry buzz, and elsewhere in the [SEC] building," says Cutler. Enforcement is also launching industrywide probes to see if questionable practices by some companies are part of a broader problem. Among the SEC's current investigations are those into cable companies' possible manipulation of their subscriber numbers, into pension consultants' hidden deals with fund managers, and into food companies' accounting for vendor rebates. Says Cutler's mentor Levine: "They're committed to being out in front of problems rather than being reactive."

However much Cutler does, there are those who argue it's still not enough. Fines should be higher, says Donald C. Langevoort, a Georgetown University law professor. And in egregious cases, he adds, the SEC should force defendants to concede guilt -- which would make it easier for investors and others to sue. "The chances of getting caught are so low that for many it's still worth the risk," says Langevoort.

But the greater danger to Cutler's crusade may be that many Wall Streeters think the opposite. And they're looking for a chance to blunt his efforts by pressing the SEC's congressional paymasters to rein the agency in. Undoubtedly, some finance execs are holding their breath, waiting for the storm of scandal to pass and support for tough enforcement to wane.

They could have a long wait. Cutler isn't just changing the way corporations and financial institutions treat investors and clients. He's also transforming enforcement culture at the SEC. He's honing a team of top lawyers, including Paul R. Berger and Thomas C. Newkirk, who are experts in financial fraud. They are hiring hundreds of lawyers and accountants and instilling a new ethos: Don't just probe whether an arcane securities law has been broken -- ask whether companies have met their burden of honesty and transparency.

The game is no longer "catch me if you can." With higher standards for corporate compliance and the housecleaning Wall Street is being forced to undertake, it's more like "catch it yourself -- or else." The SEC may not be able to prevent new outbursts of greed and deceit across Corporate America. But it will be on guard as never before.

By Amy Borrus and Paula Dwyer

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