Destruction at the SEC?

Thanks to Darcy Flynn, a longtime attorney at the Securities and Exchange Commission, we now have the ammunition to do what should have been done years ago: terminate the SEC, with extreme prejudice, and in its place construct a new regulatory watchdog for Wall Street that’s free of obvious conflicts of interest.

Flynn’s courage has almost been lost in all the recent apocalyptic talk of earthquakes and hurricanes, but a few weeks back he did something remarkable. After raising concerns internally at the SEC last year—and getting nowhere—Flynn went public and alleged in a formal whistleblower complaint that for at least 17 years the SEC “followed a policy of systematically destroying documents” related to what are known as matters under investigation, or MUIs, most of which were focused on possibly illicit or illegal behavior at Wall Street firms. MUIs are the first step in investigating a case that may lead to a formal SEC inquiry.

Flynn alleged that the MUI files were destroyed after the cases were closed when they should have been retained. He cataloged his complaints in a letter to Senator Charles Grassley, an Iowa Republican and the ranking member of the Senate Judiciary Committee. Grassley wrote to Mary Schapiro, the head of the SEC, asking her to respond to him about Flynn’s allegations by Aug. 31. By press time, she had not.

In his letter to Grassley, Flynn alleged that the SEC had destroyed documents related to MUIs involving Bernard Madoff; Goldman Sachs’s trading in the credit-­default swaps of insurer American International Group ; “financial fraud” at Wells Fargo and Bank of America ; and “insider-trading investigations” at Deutsche Bank, Lehman Brothers Holdings, and SAC Capital Advisors. “It doesn’t make sense that an agency responsible for investigations would want to get rid of potential evidence,” Grassley said in a press release that accompanied his letter to Schapiro. “If these charges are true, the agency needs to explain why it destroyed documents, how many documents it destroyed over what time frame, and to what extent its actions were consistent with the law.”

By itself, this case is reason enough to shutter the SEC and design a new agency worthy of its more than $1 billion annual budget. But there are many more instances of ineptitude. Top among them is the agency’s abject failure during the tenure of Christopher Cox (2005-09) to hold Wall Street the slightest bit accountable for its actions. Cox came to define laissez-faire regulation run amok, allowing the financial industry to get away with a string of abuses—from packaging questionable mortgages into securities, to allowing firms to bet against those same securities while they sold them—the extent of which may never be fully known, thanks partly to the SEC’s alleged document destruction.

Then there’s William H. Donaldson, Cox’s predecessor (2003-05) and one of the three founders of the investment bank Donaldson, Lufkin & Jenrette. How could Donaldson and the other SEC commissioners have blithely ruled in 2004 that the biggest securities firms could dramatically increase the leverage on their balance sheets without thinking through the possible ramifications of such enhanced risk—when a mere 2 percent decline in asset values could wipe out a firm’s equity cushion? Maybe because Donaldson was a tad too close to his old buddies on Wall Street? No doubt that decision helped lead to the downfall of Bear Stearns, Lehman Brothers, and Merrill Lynch, and to the near-failure of both Morgan Stanley and Goldman Sachs.

The SEC has long had a too-cozy relationship with Wall Street. Witness Robert Khuzami, the SEC’s director of enforcement, who used to be the general counsel for the Americas at Deutsche Bank in New York, a firm that issued one fatally flawed mortgage-backed security or collateralized debt obligation after another during the early part of the last decade. (A Senate subcommittee report on the financial crisis devotes 45 pages to Deutsche Bank’s squirrelly securities business and the role it played in fomenting the meltdown.)

Still, Khuzami set his sights on Goldman Sachs, rather than on his old company, in trying to create some accountability for the mortgage mess. Deutsche Bank was a bigger player in the mortgage-­securitization and CDO markets than Goldman Sachs was, yet it was Goldman that the SEC ended up going after in April 2010 when the agency filed—to great fanfare—a politically useful civil suit related to a synthetic CDO that Goldman created and sold in April 2007. (Deutsche Bank did similar deals, as detailed in the Senate report. One difference: Deutsche Bank lost billions.) Goldman Sachs settled the accusations in July 2010 for $550 million, more to make the bad publicity go away than because it did anything different from any other Wall Street firm. Goldman did not admit nor deny the allegations.

There’s no evidence of impropriety on Khuzami’s part, but it should hardly give investors confidence that someone with such an obvious conflict of interest could bring a suit against a competitor of his old employer. Schapiro, meanwhile, was previously head of the Financial Industry Regulatory Authority—Wall Street’s self-regulatory organization—and was paid almost $9 million by FINRA when she left to join the SEC.

It goes both ways: For years top SEC officials have been turning in their regulatory credentials for compensation bonanzas at the very companies they were once charged with overseeing. For instance, in the late 1980s, Gary Lynch spent four years at the SEC in the job now held by Khuzami. From there he went to Davis Polk & Wardell, the Wall Street law firm, before beginning a long march around Wall Street, including top legal jobs at Credit Suisse and Morgan Stanley. This past April, Lynch was named the global chief of legal, compliance, and regulatory relations at Bank of America. A May 2011 report by the independent Project on Government Oversight found that from 2006 to 2010 some 219 former SEC employees submitted letters to the SEC stating their intention to represent a client before the commission.

Then there’s the SEC’s ongoing obfuscation when it comes to Freedom of Information Act requests. The SEC is the black hole for such applications, hanging them up for years and ultimately ignoring them. A September 2009 60-page audit of the SEC’s compliance with FOIA found the agency had a “presumption of non-disclosure” and that “there are inadequate or incorrect procedures for determining whether potentially responsive documents exist.” This is a violation of trust that threatens our democracy and makes it difficult for journalists and historians to figure out what went wrong. Maybe that’s the point.

In Rolling Stone’s Sept. 1 issue, Matt Taibbi broke the story of Darcy Flynn’s complaint against the SEC. It’s worth reading for its rich detail about what Flynn alleges the SEC has been doing for decades. In a recent blog post following up on the article, Taibbi noted that the gist of the SEC’s response to him about Flynn’s charges was that the shredded documents involved unimportant cases. “The wave of corruption that blew up in 2008, and has since gone almost completely unpunished, belies this argument,” he observed. “We know that there was massive corruption on Wall Street during this time period involving the very companies tied to these MUIs. I can’t imagine anyone takes seriously the idea that none of these 9,000 or so files contained valuable intelligence. If even a hundredth of them contained the names of potential witnesses or sources, we’re talking about a treasure trove of lost leads.”

Taibbi’s reporting effectively rein­forces the idea that the agency is unsalvageable—and needs to be replaced. A new SEC would pay its top officials much higher salaries (in line with top private-sector attorneys) but not allow any of them to have previously worked on Wall Street or to go there for five years after they leave the agency. It would have genuine law-enforcement power, as opposed to the SEC’s referral or civil-suit-only mandate, and be able to indict a firm and its top executives for wrongdoing. In other words, the agency would have the chops to regulate a powerful industry badly in need of it, free of conflicts of interest.

It’s now crystal clear that the SEC stopped doing its job long ago. The agency needs to be rebuilt on a more secure foundation.

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