Fear and Loathing at the SEC

The agency’s tough inspector general is great at exposing wrongdoing—and terrifying the staff

The U.S. Securities and Exchange Commission’s in-house cop has castigated the agency for missing the Bernard Madoff fraud, spotlighted employees who viewed online pornography, and called for a criminal probe into the ethics of the SEC’s former top lawyer. His blunt reports have won Inspector General H. David Kotz admiration on Capitol Hill, where lawmakers summon him to testify about his efforts to improve the way the agency does business, and he is praised as a tough investigator who has been zealous in getting to the bottom of the SEC’s lapses in the runup to the credit crisis.

Inside the SEC, it’s not hard to imagine how he’s been received. While inspectors general are rarely beloved, a backlash against Kotz among staff and managers has grown in intensity and spread to the legal community outside the agency. Critics led by former SEC Chairman Harvey L. Pitt say Kotz is undermining the market regulator’s effectiveness. “For those who may be unaware of what is going on at the SEC, there is a reign of terror in effect,” Pitt wrote to about 90 securities lawyers in a September e-mail obtained by Bloomberg News. “People are afraid to write anything down, make decisions, or even take notes of telephone conversations, because the current IG monitors everyone’s e-mails, including the chairman’s, and starts investigations at the drop of a hat,” Pitt wrote. In an interview, Pitt—a lawyer who has represented several people involved in Kotz’s investigations—said he is speaking out because Kotz “has to be held accountable.” Kotz’s critics complain that some of his reports lacked evidence of wrongdoing and unfairly damaged the reputations of those he accused.

Kotz, 45, disputed his detractors in a written statement, saying his work has had “an extremely positive impact” on the SEC. “Whenever an inspector general is doing his or her job properly, there is naturally some level of apprehension on the part of agency employees of a possible investigation,” Kotz said. “However, we have made efforts to be very thorough, detailed, and fair in our reports.”

In interviews, almost three dozen current and former SEC staff members—including managers, senior appointees, and nonsupervisors—raised concerns similar to Pitt’s. Speaking on condition of anonymity for fear of reprisals, they said their wariness of Kotz’s probes has caused them and others to change work habits in ways that have unintended consequences. Kotz and his team have reviewed millions of internal messages in some investigations. That has prompted many in the agency to rely largely on private e-mail accounts and cell phones rather than their government-issued devices, making staff conduct harder to monitor.

George S. Canellos, a former federal prosecutor who heads the SEC’s New York office, was asked at a legal conference in October about Kotz’s impact on the agency. Telling the group that he needed to “tread very softly,” Canellos said that “there’s an influence on the SEC culture that flows in part from active IG scrutiny that I never observed in nine years in the Justice Dept.”

Some of Kotz’s probes—at times driven by requests from Congress or SEC Chairman Mary L. Schapiro—have looked broadly at whether employees are doing their jobs rather than focusing on whether rules were broken, Canellos said. That approach has made enforcement lawyers reluctant to close files even when they believe they have no case. “There’s arguably a positive upside, in the sense that people are very vigilant and constantly attentive to the fact that they’re sort of being watched and that any of their activity could be scrutinized, but that can also have a chilling effect, and distorting effect on some activities,” Canellos told the audience. In an e-mail, he said his comments at the conference reflect general pressures on the SEC staff and were not personal criticisms of Kotz.

Kotz, who was named SEC inspector general in 2007 after holding the same post at the Peace Corps, declined to comment on specific cases. In the statement, he said that since he took the job his office of almost 20 employees has issued 52 audits and 140 investigative reports and is unaware of any material error in any of them, which he termed “an extraordinary record.” The SEC’s management agreed with 95 percent of the 685 recommendations in those reviews, he said, and has put 73 percent of them into place. “My staff and I have developed an extremely constructive and collaborative working relationship with agency management, and in particular Chairman Schapiro and her staff,” Kotz said.

Schapiro declined to comment on Kotz’s tenure. In an e-mail, SEC spokesman John Nester said, “Chairman Schapiro recognizes the important role of inspectors general in promoting integrity and efficiency in government, but it would not be appropriate for the chairman to discuss personnel matters.”

Kotz’s defenders say his critics are largely disgruntled people who’ve gotten caught up in his reviews. “Too many IGs are picked to be wallflowers and not do anything,” says Harry Markopolos, the whistleblower who tried to interest the SEC in Madoff’s activities before the scandal broke in December 2008. Kotz “brought in accountability,” Markopolos says, “and no one likes a disciplinarian.”

One of the most vocal of those critics, Pitt, knows what it is like to come under heavy public scrutiny. He was appointed to head the SEC by President George W. Bush in 2001 and announced his resignation in November 2002, after the Enron and WorldCom accounting scandals drew attention to the agency’s shortcomings as a regulator. Pitt’s criticism of Kotz was prompted in part by the inspector general’s probe of David Becker, the former SEC general counsel who worked for Pitt when he ran the agency. In September, Kotz called for the Justice Dept. to conduct a criminal investigation of Becker. Kotz’s 119-page report concluded that Becker’s work on Madoff while at the SEC was improper because he had inherited profits from the fraud through an account held by his late mother. Becker had alerted Schapiro about the matter and sought and followed advice from the SEC’s ethics counsel. Becker declined to comment for this article. He has said he didn’t violate the law because he had no financial interest in the SEC’s Madoff policy. Schapiro told lawmakers she is overhauling procedures for vetting conflicts of interest.

Stanley Sporkin, a former SEC enforcement director and federal judge, says that while “everyone could have used better judgment” in the Becker matter, it’s unlikely to end in criminal charges. “For them to charge him criminally and get a jury to convict would be the most difficult thing,” says Sporkin, one of 52 lawyers who signed a letter to lawmakers supporting Becker.

One persistent criticism of Kotz is that employees he investigates sometimes wind up being named in the press but aren’t exonerated publicly if the prosecutors ultimately drop the cases. In 2009, Kotz accused an SEC enforcement attorney, Nancy McGinley, of possibly violating insider trading laws. McGinley traded shares of Schlumberger in early 2008 around the time the SEC was exploring a possible foreign bribery case against the company, which already had disclosed that the Justice Dept. had a criminal probe under way. McGinley testified that she had no idea the SEC was looking at the Schlumberger matter. In his report, Kotz wrote that Justice “accepted the referral and is conducting a comprehensive investigation together with the Federal Bureau of Investigation.”

Adam Augustine Carter, McGinley’s attorney, says federal prosecutors dropped the case after a review showed McGinley didn’t trade on material non-public information, the legal standard for insider trading. “They looked at this and determined that there was nothing to prosecute,” says Carter. Yet the government never publicly cleared McGinley, who still works at the agency. In his statement, Kotz said his reports “are internal in nature and not publicly released by my office.” The SEC’s management, he said, and not his office, decides “which names or other information should be redacted from our investigative reports.”

Neil Barofsky, the former special inspector general who monitored the federal financial bailout, says any activist investigator is going to make enemies: “There have been a lot of attacks against David, and that’s usually a pretty good sign he’s doing his job.” When it comes to Kotz’s work, “the truth is somewhere in the middle” between his supporters and his scolds, says Lynn Turner, a former chief accountant at the SEC. He has done meticulous investigations, says Turner, but his prosecutorial style sometimes gets in his way. “He detracts from the good work he’s done when it starts to look like the Salem witch trials.”


    The bottom line: SEC employees say they’re so fearful of Kotz’s scrutiny that they use personal cell phones and e-mail accounts for work.

    Before it's here, it's on the Bloomberg Terminal.