Why Robert Khuzami Would Be a Terrible Choice to Head the SEC

Given that the Obama Administration appears to think that missing-in-action Attorney General Eric Holder has been doing a fine job, it probably isn’t surprising to see the SEC’s head of enforcement, Robert Khuzami, included on a short list of names rumored to be under consideration to head of the agency.

But if the object is to prove that regulators can’t regulate and it’s too hard to enforce securities laws, then Khuzami’s your man.

I am old enough to remember when the SEC was feared on Wall Street, and it was due to the effectiveness of its enforcement head, Stanley Sporkin. The SEC’s lousy reputation is the direct outcome of its terrible record on enforcement. Promoting Khuzami to lead the SEC would cement this institutional failure.

Let’s look at the SEC’s record of enforcement fiascoes under Khuzami. The only thing he can claims is getting some bigger fry than usual on the insider trading front: Raj Rajaratnam, Rajat Gupta, and closing in on the SEC’s big target, Steve Cohen. Well, I suppose it’s nice that the SEC is becoming a better one-trick pony. But the wake of the biggest financial crisis in three generations was the time for the agency to up its game, and the SEC has failed miserably. One indicator: in his latest column, the New York Times’ Joe Nocera snorted at the appointment of Elisse B. Waters as the interim chief (she’s expected to be a placeholder; †he plan is to replace her within a year. We’ll see if this is really just a scheme to keep the SEC hobbled while appearing to Do Something). One of the reasons was that anyone was currently at the agency is part of the problem.

We’ll s go through some examples of glaring Khuzami failures. Mind you, I’ve had to restrain myself; I could easily have written a post three times as long.

Khuzami’s overarching failure is the SEC’s embarrassing record in pursing fraud that was instrumental in causing the financial crisis. Khuzami has repeatedly claimed that it’s hard to go after these cases. Yes, if you aren’t competent, anything looks hard.

Let’s start with the first big crisis case the SEC tried making, that of a criminal suit against the managers of the two Bear Stearns hedge funds that ate too much subprime and died as a result (note that this case was filed in tandem with a SEC civil fraud lawsuit, which continued and was settled for what one observer called “peanuts”). This was a weird choice, since the hedge funds were VICTIMS of bad subprime packing/selling practices. But this was a classic example of “if the only tool you have is a hammer, every problem looks like a nail.” The SEC and DoJ conceptualized the case along the lines of an insider trading case: one principals was reducing his holdings in the fund even as he was twisting investor arms to stay in. And they thought they had some slam-dunk evidence in the form of damning e-mails of the two managers saying how awful the funds’ holdings looked

But the effort botched basic case development, as in doing sufficient discovery. Turns out the dubious-looking sale was part of a program; the timing was not market-driven. And the e-mails were taken out of context; there were contemporaneous ones that were far more positive. And many observers thought the case looked dodgy from the get-go:

The case against Messrs. Cioffi and Tannin “was pushing the envelope,” said Andrew Frisch, a former federal prosecutor in Brooklyn, echoing comments made publicly by numerous lawyers since the case was filed last year. The defendants “were not trying to swindle widows out of their future; they were mismanaging the crisis,” said Mr. Frisch, a defense attorney who wasn’t involved in the case.

Second is the SEC’s failure to use the biggest and best tool on offer against any of the probable fraudsters, that of Sarbanes Oxley. Remember that Sarbox was the result of the SEC’s last big win, that of its successful pursuit, in conjunction with the DoJ, of Enron. The law was designed to end the “I’m the CEO and I know nothing” defense by requiring the CEO and at a minimum, the CFO to certify the accuracy of financial records and the adequacy of internal controls. For a big financial firm, that includes risk controls. But if you make risk control subordinate to trading, which is how it works in practice, and you drop multi-billion loss bombs, wreck the global economy and need bailouts and years of artfully disguised subsidies, like ZIRP and multiple QEs, it should not be all that hard to establish that risk control was a really an exercise in blame shifting (“We did all the right things. Whocoulddanode?”) rather than a serious undertaking. And the other beauty of Sarbox is the criminal violations language tracks the civil. Thus the SEC could file a civil case, and if it prevailed, it would be fairly simple to proceed with a criminal suit.

There’s been only one time when the SEC made a Sarbox-related claim related to the financial crisis, that in its suit against Angelo Mozilo. We believe SEC was incorrectly deterred by a one sentence ruling. We’ve argued more recently that Jon Corzine’s mismanagement of MF Global is a classic case of poor oversight and controls and a prime candidate for a Sarbox suit. But it looks like Corzine is Too Connected to Prosecute.

Third is the SEC’s practice of filing cases against big financial perps, and rather than taking any to trial, of settling them with no admission of any facts. The well-respect jurist Jed Rakoff had finally had enough of that. He first took the SEC to the woodshed for its paltry settlement with Bank of America over allegations of inadequate disclosure in its acquisition of Merrill (and notice the SEC took up that case only because then New York attorney general Andrew Cuomo looked about to embarrass the SEC for its inaction). He then told them to go try a case against Citi. From a post exactly one year ago:

Judge Jed Rakoff’s latest ruing, nixing a $285 million settlement between the SEC and Citigroup over a billion dollar fund that came a cropper, has broader implications than simply embarrassing the securities regulator (which given the fallen standing of the agency, and low standards in Washington generally, is harder to do than it ought to be). Rakoff has effectively said judges have no business sanctioning settlements in which the accused party admits to nothing.

What has Rakoff’s dander up is that the allegations made by the SEC in its lawsuit were that Citigroup stuffed the fund full of crappy CDO tranches and went short against them, and got investors to buy it by telling them the assets were selected by an independent party. Citi was a typically inefficient looter, earning about $160 million while investors lost $700 million (note that Rakoff had to pry that information out of the parties). Citi is admitting only to negligence when the violations the SEC described its filing and in a related case amount to fraud, or in securities speak, scienter.

Rakoff’s ruling calls the entire process a sham:

Here, the S.E.C.’s long-standing policy – hallowed by history, but not by reason – of allowing defendants to enter into Consent Judgments without admitting or denying the underlying allegations, deprives the Court of even the most minimal assurance that the substantial injunctive relief it is being asked to impose has any basis in fact.

Rakoff’s job is to determine whether the ruling is “whether the proposed Consent Judgment … is fair, reasonable, adequate, and in the public interest.” Since Citi admits to essentially nothing, he has no factual foundation for determining the adequacy of the settlement. He also notes that this deal clearly helps the big bank, since it’s a screaming deal if Citi did the bad things the SEC claimed it did in its initial lawsuit, and is a mere cost of doing business if it didn’t. It isn’t obvious to him what the SEC gets, beyond a headline. And he notes it leaves investors worse off, since the SEC has not said whether or not it will give any of its fines to them, plus the settlement means they cannot pursue private securities law claims based on negligence, so they are actually worse off.

The settlement includes injunctive relief, which in this case is to permanently restrain and enjoin Citi from violating certain provisions of securities regulations, and for three years to implement certain internal programs to prevent staff from undertaking this fraud. Rakoff pooh poohed that, noting that the SEC showed Citi to be a recidivist.

The Rakoff ruling produced a great deal of consternation, since the SEC has been using this dubious practice for a long time. But that’s hardly a defense. As Forbes columnist Bill Singer noted, in analyzing Khuzami’s press release on the ruling:

Missing — absolutely missing — from his critique of Judge Rakoff’s rationale for rejecting the proposed Citigroup settlement is some commentary on the fact that the SEC’s settlement protocol is, indeed, decades old, and that flowing from that longstanding approach is the inevitable and troubling conclusion that the manner in which the SEC has drafted and discharged settlements with the too-big-to-fail on Wall Street has, in part, contributed to the recent failures of due diligence, of compliance, of supervision, and of prudent risk practices.

And it is not as if this ruling deprived the SEC of being able to settle cases. It could still continue to settle them for monetary damages alone; that doesn’t require a judge’s blessing. What does is the inclusion of “injunctive relief,” which is a court order to take certain actions or refrain from certain conduct. The New York Times looked into the matter as a result of the Rakoff ruing and ascertained these orders were frequently violated.

Khuzami tried to rationalize this process in House Financial Services Committee hearing that looked designed to give the agency air cover. Matt Stoller found him less than convincing:

Of all the regulators testifying, the Securities and Exchange Commission’s enforcement chief, Robert Khuzami, was the most embarrassing, announcing the SEC would be making a change to its practice of not forcing corporate actors to admit wrongdoing.

In light in the special situation where an SEC civil action may also involve a parallel criminal action, senior officials in the Division of Enforcement recently undertook a review of the “neither-admit-nor-deny” settlement policy. While reaffirming the policy more generally, as a result of this review, the Division, after consulting with the Commission, modified its policy to eliminate “neither-admit-nor-deny” language that could be construed as inconsistent with admissions or findings made in a parallel criminal proceeding.  In other words, it seemed unwarranted for there to be a “neither-admit-nor-deny” provision in those cases where a defendant had already admitted to, or been criminally convicted of, conduct that formed the basis of a parallel civil enforcement proceeding.

In other words, if the company has already admitted guilt in a criminal proceeding, where the evidence required is usually much heavier, then the SEC will ask the company to admit guilt in a civil proceeding.  Khuzami spent most of the hearing talking about how the SEC was getting most of what it wanted out of these settlements, anyway, without an admission of guilt.  This is, of course, nonsense.  I pinged Bill Black about why it’s important to make companies admit wrongdoing, and here’s what he said.

(1)  It demonstrates that what has occurred was a fraud (otherwise they deny it after the fact and insist they were simply being extorted), (2) the plea of guilty (as opposed to nolo contender) can be used by civil plaintiffs (and in administrative enforcement actions) to invoke “collateral estoppel.”  The defendant is estopped from denying their guilt in the civil action.  This makes it immensely easier for victims to recover, (3) offenders, particularly multiple offenders, are treated differently under the laws and rules.  The pleas can be used under RICO to establish a pattern of racketeering, under the sentencing guidelines to secure a tougher prison sentence, and to argue in favor of punitive damages and asset freeze orders.

Yves again. Now rather than adjust course in light of the Rakoff ruling, the SEC and Citi appealed. It went before a motions panel to ascertain whether the appeal should go forward, since Rakoff objected on procedural grounds. The motions panel ruling criticized Rakoff’s action, but a brief written on his behalf may still give the appellate court a way to avoid ruling on the merits of the case.

Third is Khuzami’s was complicit in some of the worst behavior during the crisis. He should have resigned when it became clear that CDOs were central to the crisis and the SEC would not be able to avoid dealing with them. The SEC appears to have taken a policy of suing on one CDO per major firm and settling. This is heinous, since each and every one of these firms sold more than one CDO and the bad practices were pervasive. From a December 2011 post:

So why has the SEC not pursued this area more vigorously? …

Look no further for an answer than the SEC chief of enforcement, Robert Khuzami… He was General Counsel for the Americas for Deutsche Bank from 2004 to 2009. That means he had oversight responsibility for the arguable patient zero of the CDO business, one Greg Lippmann, a senior trader at Deutsche, who played a major role in the growth of the CDOs, and in particular, synthetic or hybrid CDOs, which required enlisting short sellers and packaging the credit default swaps they liked, typically on the BBB tranches of the very worst subprime bonds, into CDOs that were then sold to unsuspecting longs. (Readers of Michael Lewis’ The Big Short will remember Lippmann featured prominently. That is not an accident of Lewis’ device of selecting particular actors on which to hang his narrative, but reflects Lippmann’s considerable role in developing that product).

Any serious investigation of CDO bad practices would implicate Deutsche Bank, and presumably, Khuzami. Why was a Goldman Abacus trade probed, and not deals from Deutsche Bank’s similar CDO program, Start? Khuzami simply can’t afford to dig too deeply in this toxic terrain; questions would correctly be raised as to why Deutsche was not being scrutinized similarly. And recusing himself would be insufficient. Do you really think staffers are sufficiently inattentive of the politics so as to pursue investigations aggressively that might damage the head of their unit?

We’ll finish with the SEC’s demonstration of gross incompetence on other cases. We’ll just look at some recent examples. It lost against Brian Stoker, a Citigroup employees who was charged with more heinous conduct than the bank itself (this was one of the curiosities that led Rakoff to take issue with the Citigroup settlement discussed above). This was such an abject failure that some attorneys wondered if the SEC threw the case to support the idea that it could never have won against Citi on the same CDO. The SEC is also pursuing a bizarre case against former Fannie Mae and Freddie Mac for whether they made adequate disclosure of how much subprime exposure they had (the fact that the Bank of Canada’s Mark Carney figured out that they were insolvent a full ten months before they were put in conservatorship suggests that public disclosure was plenty adequate). And then we have SEC request a dismissal of its own case against Ed Steffein of GSC, a CDO fund manager. Clearly planted stories depicted the agency’s embarrassing reversal as yet another proof of regulatory overzealousness (the corollary of course, is that No One is Really to Blame). Our reader, MBS Guy, had a different take:

I know Stefflin and he is a decent enough guy – very likable but also a bit of a follower (which is why he was in this part of the business). I could see him appearing to be a sympathetic case, for someone not too familiar with the facts. A skilled lawyer could make this seem like prosecutorial over reach.

But the reality is that the wrong-doing in CDOs had become very commonplace and everyday and regular people were being pulled into it, partly because “everybody was doing it” and partly because the money was really good. it seems like that would be a more interesting tale for a journalist – but not this time.

The big problem with the SEC case is they didn’t bring charges against an individual at the bank [JP Morgan]. Nonetheless, I think individuals at GSC knew what the deal was with Magnetar. In fact, the article says that Stefflin knew the Paulsen Abacus deal was problematic yet he still was ok with the Magnetar deal. Presumably, the thing that gave him cover was that Magnetar was “buying” the equity in the deal. We know that this was only a difference of form, not substance, so why is the SEC accepting this as a legitimate distinction? Also, does Khuzami have an interest in saying that this is a major distinction from the Abacus case (ie did Deutache Bank use the same structure as Magnetar, while Khuzami was there)?

Oh, and the SEC isn’t missing the boat only in financial-crisis-related conduct. For instance, it issued a mere no-action letter agains UBS after filing a case on fraudulent bidding in municipal bond guaranteed investment products when the underlying allegations looked both serious and not that difficult to substantiate.

Even the most cursory look at Khuzami’s tenure shows it to be a complete embarrassment. Thus the only reason for him to be allowed to fail upward is that a weak SEC serves the interests of parties near and dear to the Administration. Given that the power of the Rubin/Hamilton Project bank-loving wing of the Democratic party continues its cancerous growth, it’s quite plausible this toxic choice will get the nod.