SEC 'broken windows' policy draws new critics

New research analyses the SEC's so-called "broken windows" enforcement policy. But is the regulator's goal of trying to be everywhere feasible on their budget, and is it even beneficial for the health of the markets and for investor safety?

US regulator the Securities and Exchange Commission (SEC) has a tough job on its hands. Regulating the securities markets within the world's largest economy, while looking out for the interests of millions of potential investors, poses a unique challenge for a historically underfunded agency.

And since the financial crisis times have been hard for the regulator. A string of high-profile court losses and allegations of complacency have dogged the SEC in recent years. The appointment of Mary Jo White as chair in 2013 appeared to signal a new, hardline stance for the commission – a stance that was further underlined when she announced a new and controversial "broken windows" policy for the agency in October 2013.

White said her objective was that the SEC would be "felt and feared in more areas than market participants would normally expect". The policy – styled after the zero-tolerance approach to police enforcement of former New York mayor Rudy Giuliani in the 1990s – has generated significant debate, with critics questioning the value of clampdowns on what are deemed by some to be minor infractions.

Joining the dissenting voices has been SEC commissioner Michael Piwowar, who warned in a 2014 speech to the Securities Enforcement Forum that a broken windows approach to enforcement might not achieve the desired result. "If every rule is a priority, then no rule is a priority," he said.

Meanwhile, a New York-based law firm, Morvillo Abramowitz, has begun publishing regular reports analysing the SEC's enforcement data in light of the agency's apparent policy shift. The law firm separates cases into core and non-core categories, designating cases as non-core where the case is a follow-up to an investigation already under way or the infraction is based on legally required disclosure forms not being delivered to the SEC on time (so-called "delinquent filer" cases). According to this methodology, nearly half of cases were core in 2013 but that figure had dropped to 30% of cases in the first quarter of 2014 (see chart 1).

Among those worried by the trend is John Coffee, professor of law at Columbia University. "The SEC has shifted its approach to bringing a lot more small cases," says Coffee, adding that the commission seems willing to bring cases for a lesser offence even where a more serious instance of fraud might have been committed. "They will reduce cases to non-fraud charges in order to get settlement," says Coffee, who points out that cases including an allegation of fraud are much more difficult to prove than mis-filing or other lesser charges.

Low-hanging fruit

One suggestion is that the SEC wants to stack up some easy wins as it tries to repair its reputation after a string of high-profile failures. The commission has come under fire for embarrassments including its failure to identify Bernie Madoff's multibillion dollar Ponzi scheme in 2008. Another high-profile loss was the verdict in favour of businessman and NBA franchise owner Mark Cuban in an insider trading case in 2013.

"Losing is humiliating," Coffee says. "Their reputation and pride have been injured by the cases they have lost, so they may be less willing to bring the more challenging cases that could be lost, and where they could face first rate lawyers with unlimited budgets."

"They will tell you they've had a successful rate on trials this last year," he adds, but points out the trial rates don't offer insight into the relative difficulty of cases, nor the importance and legal muscle of the defendants. "I don't think they have brought the more difficult, demanding and challenging cases. I'm not trying to say that they don't want to go after fraudsters. I'm saying I think they have been reluctant to bring more challenging, higher risk cases."

The SEC, headquartered in Washington, DC, failed in its insider trading prosecution against Mark Cuban

 

Another suggestion is that the broken windows policy is partly motivated by the need to present impressive enforcement statistics to Congress to help the SEC secure a larger budget.

The agency presents a budget justification document to the US Congress each year, with the report including statistics and performance data for the previous 12 months. The agency has complained in the past that it is underfunded compared with the size of the markets it polices. In a speech last year, for example, White said the SEC's funding fell "significantly short of the level we need to fulfil our mission".

"One of the SEC's concerns is to be able to justify an increased budget from Congress," Coffee says. "To justify an increased budget, they may want to show they are bringing more cases. The way you bring more cases with fairly limited manpower is by focusing on smaller cases and less difficult cases. So we give out parking tickets rather than pursue homicide."

Some are sceptical that a strategy of increasing the number of successful prosecutions will give the SEC the necessary leverage to extract a budget rise from Congress. As a senior partner and expert in US banking regulation at a UK-based law firm says: "Congress won't be fooled by beefed-up statistics based on an uptick of purely minor offences being punished."

The number of cases is certainly trending up. In 2014 the SEC announced a record year for enforcement penalties and boosted its enforcement actions by 10% on the previous year. The enforcement division has also requested a budget of $498 million from Congress for 2015, representing an increase of 11% on the budget for 2014. This is compared with a small cut in budget between 2013 and 2014 (see chart 2).

"One of the big risks is that it is a lot easier to enforce small infractions, particularly against institutions that are pretty much law abiding," says the senior partner. "They're not hiding stuff from you. It's a lot easier to crack down on that than go out hunting and investigating your Madoffs.

"One of the concerns is: if you've got limited resources, the focus will shift from the really important threats to investor protection, to things that are to some extent more ministerial."

A broken windows policy is meant to deter larger infractions by cracking down on smaller violations. But not everyone agrees that what worked for 1990s New York will necessarily translate to modern securities markets.

"Is somebody intent on creating a Ponzi scheme going to say, 'well, I'd better think twice because the SEC is even nabbing people for failing to file a form'?", says the senior partner.

Ground cover

Is the SEC on the wrong track, then, with its broken windows approach? Not according to Michael Sullivan (pictured), a former counsel at the SEC and now a director at Promontory, a US-based consultancy. Sullivan argues that cracking down on small rules will encourage compliance by showing that the SEC is not afraid to enforce any of its regulations.

Part of the story is that improved technology means the SEC can now cover more ground, he explains. "The goal is to let everyone know the SEC is going to use technology and data tools, and take a more proactive role."

Sullivan also questions the validity of the decision by Morvillo Abramowitz to split cases based on their perceived severity. Even though penalties may differ, rule-breaking is rule-breaking, he argues.

"A common criticism is that these are technical rule violations," says Sullivan. "I don't know what that means, because these are rules in the books. They're important rules, if not in and of themselves, because of the greater conduct they relate to."

"Does [the approach] further the mission of the commission, which is, among other things, to protect investors and secure fair and orderly markets? Done well and done the right way, it will certainly further that mission," he says.

In Washington DC, at the SEC, director of enforcement Andrew Ceresney rebuffs the suggestion that a policy adjustment is leading to a focus on smaller cases.

He argues the SEC's enforcement policy is not to take a blanket zero-tolerance approach, as Michael Piwowar warned against. Instead the Commission focuses on one rule, concentrates its resources on sanctioning rule-breakers in that area and then moves on to scrutinise compliance in other areas one at a time, Ceresney explains.

"What we're talking about here is not turning every securities violation into an enforcement action," he says. "The idea is to target certain types of violations – including strict liability-type violations – that represent important rules that really haven't received sufficient attention or compliance, areas where we're seeing repeated violations.

"What we're trying to do is to use minimal resources to target those areas, bring a bunch of different cases in those areas, and send a message about compliance in those areas."

Ceresney disputes the application of the broken windows label to official enforcement policy at all.

"We're not directing significant resources now towards the smaller violations," he says. "We have investigations in priority areas such as financial reporting, market structure, investment adviser fraud, FCPA [Foreign Corrupt Practices Act] and the like, where we are allocating significant resources. What we're trying to do is use our resources wisely by sending messages through the expenditure of minimal resources in these particular areas that have seen repeated violations."

New technologies are enabling the SEC to process more cases than ever, he says. This allows the organisation to pursue smaller violations without compromising more labour-intensive investigations.

"Our use of big data, our ability to use data in ways that identify violations and then to streamline the investigation – that's been pretty critical," he says.

"We've been successful in the quality of cases we have brought across a broad range of areas in the last couple of years," says Ceresney. "The idea that we are turning away from being aggressive and that we are trying to pump up our numbers is just wrong."

Back at Columbia University, Coffee remains sceptical. "I could see the SEC [pursuing a broken windows policy] for a brief period to get the industry back into compliance in some area where there was non-compliance," he concludes. "But with respect to fraud cases I think the SEC should be bringing major fraud cases. Those are the cases most likely to have real deterrent value."

Ceresney, though, is happy to wait and see whether results show the approach has worked or not.

"In a year, when we try to redo a particular sweep, we will have to see whether we find the same volume of violations. If we find a reduction then clearly we will have had an impact," he says. "But I think it is clear from the attention these cases are already getting that we have had a significant impact."