SEC monitor: Only "slam-dunk' enforcement cases were encouraged

Inspector general says prosecutions were driven by "stats'

Securities and Exchange Commission officials tried to assure Congress last week that the SEC's examination and enforcement divisions are working together more effectively to catch and prosecute rogue advisers such as Robert Allen Stanford, who allegedly bilked clients out of $8 billion.

In a hearing before the Senate Banking Committee, SEC Inspector General H. David Kotz said that the examination staff in the commission's Fort Worth, Texas, office raised red flags as early as 1997 about certificates of deposit that Mr. Stanford was offering with unusually high interest rates.

But the enforcement staff refused to pursue the matter.

“We found that senior Fort Worth officials perceived that they were being judged on the numbers of cases they brought, so-called stats, and communicated to the enforcement staff that novel or complex cases were disfavored,” Mr. Kotz said. “As a result, cases like Stanford, which were not considered "quick-hit' or "slam-dunk' cases, were not encouraged.”

Mr. Stanford's tangled web of alleged fraud included complex international dimensions, such as the purchase of part of a Caribbean island. The SEC finally filed a case against him in February 2009.

Among Mr. Kotz's recommendations to the SEC: Change the commission's mindset to ensure that potential harm to investors outweighs concerns about litigation risk in pursuing fraud cases and improve coordination between inspection and enforcement.

Robert Khuzami, director of the SEC Division of Enforcement, and Carlo di Florio, director of the Office of Compliance Inspections and Examinations, said that they are implementing reforms called for in Mr. Kotz's report.

“I am telling the rank-and-file that quick hits and numbers are not what drive the division,” Mr. Khuzami told lawmakers. “It's not the standard today, I assure you.”

Mr. di Florio and Mr. Khuzami, both of whom assumed their current positions after the Stanford case was filed, said that their divisions are working more closely.

“Both OCIE and enforcement are committed to reforms,” Mr. di Florio said.

In prepared joint testimony, Mr. Khuzami and Mr. di Florio said that they have expanded training programs, streamlined management, “put seasoned investigative attorneys back on the front lines” and improved examiners' risk management techniques.

The Stanford case is making the SEC more willing to take on big, complex cases with uncertain outcomes, according to Robert Mintz, a partner at the law firm McCarter & English.

“It was a major wake-up call to the SEC to act more like prosecutors and less like regulators, and to dig deeper and ask tougher questions as they execute their oversight,” said Mr. Mintz, a former federal prosecutor. “The message from the highest levels of the SEC is filtering down — to increase collaboration and to make sure that information about regulated entities is being shared more effectively.”

Mr. Kotz delivered his report to SEC officials in March. It was released April 16, the same day that the SEC filed a lawsuit against The Goldman Sachs Group Inc. for alleged fraud involving mortgage-backed securities.

The Senate hearing Tuesday gave lawmakers a chance to vent their frustrations with SEC lapses in policing securities markets.

Sen. Richard Shelby, R-Ala., the ranking Republican on the Senate Banking Committee, noted that unlike the $50 billion fraud perpetrated by Bernard Madoff, which caught the SEC unawares, one part of the commission had raised concerns about Mr. Stanford for years.

“I believe this should mark just the beginning of our review of this troublesome episode,” Mr. Shelby said.

“We need to know exactly why evidence of fraud was not more thoroughly pursued,” he said. “This is a colossal failure of the SEC.”

Senators on both sides of the aisle wondered why no one at the SEC had been fired in the wake of the Stanford episode and expressed dismay that the head of the Fort Worth enforcement division later tried to represent Mr. Stanford before the commission.

Sen. Christopher Dodd, D-Conn., chairman of the Senate Banking Committee, was more generous toward the SEC, saying that “there are thousands of people in the SEC who do an incredible job every day.” But he pressed Mr. Kotz on whether the statistics-oriented approach to enforcement is undermining potentially large fraud cases in other SEC regional offices.

“To what extent were examiners frustrated across the country?” Mr. Dodd asked.

Mr. Kotz said that he wasn't aware of specific cases but that the SEC's leadership is trying to move enforcement away from a focus on statistics toward one that emphasizes impact.

“It takes time for a culture to be changed,” he said. “We need to make sure that trickles all the way down the line.”