Khuzami Remarks at SIFMA’s Compliance and Legal Society Annual Seminar


New York – Yesterday, Robert Khuzami, Director of the SEC’s Division of Enforcement addressed the SIFMA Compliance and Legal Society Annual Seminar. Some of his remarks are excerpted below, especially where they touch on the SEC’s recent enforcement actions and where they spell out future enforcement priorities.

Speech by SEC Staff:
Remarks at SIFMA’s Compliance and Legal Society Annual Seminar

The overview of recent cases is a helpful recap of the SEC’s recent activity, where there seems to have been a great deal of focus on statements that mislead customers, as well as violations of fiduciary duty by board members, senior executives, and employees.

I also want to highlight other cases we have filed that might be of interest to this audience, including significant actions against broker-dealers, hedge funds, investment advisers, and financial advisers.

In January, Merrill Lynch paid a $10 million penalty because while representing to customers that their order information would be maintained on a strict need-to-know basis, the firm’s proprietary trading desk obtained information about institutional customer orders from traders on the market making desk, and used that information to place trades on Merrill’s behalf after executing the customers’ trades. We determined that Merrill failed to establish and maintain written policies and procedures designed to prevent the misuse of material nonpublic information.

In September, we charged Pinnacle Capital Markets with failing to have an adequate Customer Identification Program to verify the identities of all of its customers. Although it had a CIP program on paper, it failed to comply with those procedures for a six-year period. This violation had real consequences, since Pinnacle marketed its direct market access business to foreign customers, thus presenting real AML risks.

In addition, we have held accountable those firms and individuals that failed to accurately describe product risk – especially the widely-held mutual funds that are the bread-and-butter investments of retail investors.

In February, we charged TD Ameritrade for failing to reasonably supervise certain registered representatives who misled customers when selling shares of the Reserve Yield Plus Fund – a mutual fund that “broke the buck” in September 2008. We found that these representatives mischaracterized the Fund as a money market fund, as safe as cash, or as an investment with guaranteed liquidity.

In January, we charged Charles Schwab affiliates and individuals with making misleading statements regarding the Schwab YieldPlus Fund – formerly the largest ultra short bond fund in its class – including statements concerning the pace of redemptions in the Fund. The Schwab Entities agreed to pay more than $118 million. Our suit against the individuals, including the former CIO for fixed income and the former President of the investment adviser, is ongoing.

We have also brought several recent cases against investment advisers who violated basic fiduciary principles. In the AXA Rosenberg case, we charged an investment adviser with concealing an error in the computer code of the quantitative investment model that they used to manage client risk, resulting in the firm paying $217 million to harmed clients and a $25 million penalty. We charged Aquila Investment Management and two former portfolio managers with defrauding a mutual fund that invests primarily in municipal bonds issued by the State of Utah by improperly charging municipal bond issuers more than a half-million dollars in undisclosed “credit monitoring fees” that they secretly pocketed for themselves.

We also have stepped up our enforcement activity against those who misappropriated investor funds or otherwise engaged in illicit schemes, including through the use of “side pocket” investments. These cases include Baystar Capital Management, where we charged a San Francisco Bay Area hedge fund manager with concealing more than $12 million in investment proceeds owed to investors through the use of a “side pocket” into which investors had limited visibility; and Hunter World Markets, where we charged two securities professionals, a hedge fund trader, two firms and a Chief Compliance Officer in connection with a scheme that manipulated several U.S. microcap stocks and generated more than $63 million in illicit proceeds through stock sales, commissions and sales credits, and allowed them to materially overstate by at least $440 million the hedge funds’ performance and net asset values (NAVs) in a fraudulent practice known as “portfolio pumping.”

At the same time, we continue to vigorously enforce insider trading laws. Earlier this month, we charged Rajat Gupta, former director of Goldman Sachs and Procter & Gamble, for illegally tipping Galleon Management founder and hedge fund manager Raj Rajaratnam with inside information about the quarterly earnings at both firms as well as an impending $5 billion investment by Berkshire Hathaway in Goldman. This case also represented the first use by the SEC of its new authority under Dodd-Frank to obtain penalties in an Administrative Proceeding against persons not associated with a regulated entity.

In addition, in the Expert Network Insider Trading Cases, we charged hedge funds and four technology company employees who, while moonlighting as consultants or “experts” without the knowledge of their employers, abused their access to inside information about such technology companies as AMD, Apple, Dell, Flextronics, and Marvell and passed it to the funds.

We also remain focused on the conduct of boards and senior executives in contexts other than insider trading. For example, in addition to charging the Company and senior executives, we recently charged three outside directors and members of Audit Committee for ignoring obvious signs of the fraud at DHB Industries, including inappropriate management involvement in the internal investigation, resignation of the law firm conducting the internal investigation, and termination of the outside firm looking into allegation of unauthorized expenses by the CEO. Last year in the InfoUSA case, we similarly brought charges against senior executives based on the misappropriation of assets by the former CEO and we also charged an outside director and chair of the Audit Committee for failing to respond to obvious red flags relating to the CEO’s misappropriation of funds.

Khuzami also spelled out some new areas of focus, including actions involving the municipal securities market, its aim to exercise powers enabled by Section 304 of the Sarbanes Oxley Act and the Dodd Frank Act, and an upcoming focus on high-frequency and algorithmic trading, data feed latency issues, and large volume trading:

We also have brought cases concerning the growing municipal securities market. In December, we charged Banc of America Securities, LLC (BAS) for repeatedly paying undisclosed gratuitous payments and kickbacks to various bidding agents and affirmatively misrepresenting that certain bidding processes were proper. To settle the SEC’s charges, BAS agreed to pay more than $36 million in disgorgement and interest and another $101 million to other federal and state authorities.

Another new area is actions under Section 304 of the Sarbanes-Oxley Act. Passed in the wake of the Enron and WorldCom accounting scandals, this provision seeks to incentivize CEOs and CFOs to implement strong internal financial reporting and accounting controls by authorizing the SEC to clawback their incentive compensation and personal stock profits when their companies are required to prepare an accounting restatement as a result of “misconduct,” even to clawback such compensation where the CEO or CFO are not personally charged with wrongdoing. We filed the first of these so-called “stand alone” cases against former CSK Auto CEO Maynard Jenkins, seeking that he reimburse the company for bonuses and stock sale profits that he received while CSK was committing accounting fraud. In another 304 case filed earlier this month, Ian McCarthy, the CEO of Beazer Homes USA, agreed to reimburse the company more than $6 million in bonuses and stock profits that he received while Beazer was issuing false and misleading financial results.

Dodd-Frank Act

I also would like to mention two provisions under Dodd-Frank that impact our program.

First is collateral bar authority, where we now can impose industry-wide bars for securities laws professionals who violate the law, meaning if the misconduct arises out of activity associated with a broker-dealer, the person can be barred not only from association with a broker-dealer, but from all regulated entities, including investment advisers, municipal securities dealers, municipal advisers, transfer agents and nationally rated securities rating organizations.

Second, we now have new whistleblower authority which authorizes the agency to compensate individuals who provide the SEC with useful information suggesting securities law violations. We have received and studied many comments to the proposed rules, and adoption of the rule is set for April. The proposed rule has provoked some passionate views, particularly on the issue of the role of internal corporate compliance programs. In the proposed rule, we have worked hard to strike the right balance between incentivizing and protecting whistleblowers who want to report suspected misconduct, but at the same time acknowledging the value and obligation of corporate compliance programs to identify and remediate misconduct in the company’s operations. We look forward to implementing the whistleblower program in a way that factors in the important role of corporate compliance programs while providing whistleblowers a direct path to the SEC in appropriate circumstances.

Upcoming Priorities

There are no shortages of challenges to the enforcement program. We must be current with market developments. For example, in the market abuse area, we need the expertise to understand and analyze new trading technologies such as high-frequency and algorithmic trading, data feed latency issues, and large volume trading, as well as systemic insider trading and manipulation schemes. In the asset management area, we must increase our understanding of issues related to valuation of illiquid portfolios, false performance claims, preferential redemptions, and high-risk emerging products.

In the municipal securities markets, we must be up-to-date on pension liability disclosures, valuation issues, and tax-arbitrage activities. These examples are just part of a broader array of challenges stemming from the fast-paced change and increasing complexity apparent in the financial products, markets, transactions, and practices that the Division confronts.

To give but one example of the technology challenges we face, critical to our mission is increased capacity to analyze large volumes of information, including both structured and unstructured data. The Division receives each month approximately three to four terabytes of electronic data. As a comparison, 20 terabytes is often noted as the equivalent to the printed book collection of the U.S. Library of Congress. The capacity and functionality of our systems to handle this volume is not what it should be.

But despite these limitations, I see every day the incredible talent and commitment of the staff, and I am confident that we will continue to bring new energy and vision to the critical task of policing our financial markets.

Source: Speech by SEC Staff:
Remarks at SIFMA’s Compliance and Legal Society Annual Seminar


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