Behind the SEC's New 'Broken Windows' Enforcement Strategy

A tectonic shift in the Securities and Exchange Commission's approach to enforcement is currently underway, with the Commission vowing to leave no stone unturned in its pursuit of securities lawbreakers.

In a speech this month at the Securities Enforcement Forum, SEC Chairman Mary Jo White declared that one the new goals of the agency is to be an omnipresent cop on the beat, “pursuing all types of violations of our federal securities laws, big and small.” White likened the SEC's enforcement approach to the so-called “broken windows” strategy of zero tolerance employed in the 1990s by former New York City Mayor Rudolph Guiliani and Police Commissioner Bill Bratton, who similarly declared that no crime is too small to be left unpunished.

With limited resources and large budget increases from Congress unlikely, however, some are wondering if the agency can make good on the strategy. “They say they want to be everywhere, but they can't be,” says Michael Rivera, chair of the securities enforcement and compliance practice of law firm Venable. “They just don't have the resources to do that.”

The “broken windows” strategy is based on the theory that when a window is broken and immediately fixed, it sends a signal that disorder will not be tolerated, while a broken window left unrepaired suggests an environment of disorder that encourages more serious crimes to flourish.

“The same theory can be applied to our securities markets,” said White. “Minor violations that are overlooked or ignored can feed bigger ones, and, perhaps more importantly, can foster a culture where laws are increasingly treated as toothless guidelines—and so, I believe it is important to pursue even the smallest infractions.”

The SEC wants to send a message that even the small cases are “just as important as the headline grabbers,” says John Reed Stark, a managing director of forensic and risk management consultancy firm Stroz Friedberg. “I don't know that there has ever been a message from the top down that these kinds of cases are important.” Historically, much of the agency's focus has been on the larger, high-profile cases that cause the most harm to investors or grab the biggest headlines. In the past, the SEC has pursued cases against Martha Stewart, Mark Cuban, baseball greats Eddie Murray and Doug DeCinces, and even Daniel Ruettiger, the Notre Dame football player who inspired the movie “Rudy.”  

The SEC's motivation behind its new enforcement tact comes from the need to restore its public image, which remains tainted ever since the financial meltdown and the Bernard Madoff Ponzi scheme, says Michael Trager, senior partner and chair of the securities enforcement practice for Arnold & Porter. White's speech suggests the “return to the SEC's core mission of protecting investors and the market,” he says.

That is not to say that the SEC intends to pursue smaller cases at the expense of the bigger ones. “Quite the opposite, it is critical that we continue to focus on the larger, tougher, and more complicated cases,” White said.

Limited Resources, Leveraged Technology

The practical reality, however, is that the SEC cannot be everywhere at once, simply because the agency's resources, to White's own admission, aren't “nearly sufficient to the enormity and scope of the responsibility we have.” For fiscal year 2014, the SEC is requesting a budget of $1.67 billion to fund 4,638 full-time employees.

No SEC Commissioner will ever have a sufficient amount of resources to keep pace with the agency's broad responsibilities, says Thomas Gorman, a partner at law firm Dorsey & Whitney. The agency oversees the regulation of more than 35,000 entities, including public companies, investment advisers, broker dealers, mutual funds, exchange traded funds, and others. To improve its tough cop image, the agency must first “establish a credible track record in court of winning major cases,” he says. Without winning the bigger, high-profile cases, “it really undercuts your credibility.”

SEC Commissioner Luis Aguilar reiterated this point in an Oct. 25 address at the Annual Securities Litigation and Regulatory Enforcement Seminar. “It is no exaggeration to say that the SEC's reputation is largely based on how well, or poorly, the Division of Enforcement performs,” he said.

For the SEC's Enforcement Division to achieve its goals, it's all comes down to perception. “How do you create the perception that you're everywhere?” says Rivera.

One way the SEC is achieving its enforcement efforts is through the use of new data analytic tools and other technologies that are assisting the agency in spotting anomalies and streamlining investigative efforts.

The SEC's Advanced Bluesheet Analysis Program, for example, analyzes data provided by market participants on specific securities transactions to identify suspicious trading. “We plan to step up our use of this program,” said White.

The SEC's Division of Economic and Risk Analysis is also “continuing to develop additional risk-based initiatives, including the Accounting Quality Model, which will be used to assess the degree to which financial statements filed by issuers appear anomalous,” said Aguilar.

The wider message here is the renewed emphasis by the SEC on financial statement fraud, “an area of the SEC that's been neglected for a while,” says Gorman. Other areas of focus will continue to include insider trading, market manipulation cases, and Foreign Corrupt Practices Act violations.

“Companies will want to make sure their internal controls are in order and that their financial reporting systems are operating efficiently and correctly so they don't get tripped up in an accounting fraud case,” says Rivera.

“They say they want to be everywhere, but they can't be. They just don't have the resources to do that.”

—Michael Rivera,

Chair of Securities Enforcement & Compliance Practice,

Venable

In addition, the SEC has created a new Center for Risk and Quantitative Analytics within the SEC's Division of Enforcement. “This Center will employ quantitative analysis to profile high-risk market behavior and will otherwise support and coordinate the Division's risk analytic initiatives,” said Aguilar.

Another mechanism that can extend the SEC's enforcement arm far beyond the reach of its own investigators is the Whistleblower office that opened in 2011 created by the Dodd-Frank Act. Last year, the SEC reported that it received more than 3,000 credible tips from whistleblowers. This month, the SEC issued a $14 million award—its largest award yet—to a whistleblower whose information led to an enforcement action that recovered substantial investor funds.   

For its fiscal year 2014 budget, the SEC has requested an additional $56 million to improve its technology systems, “including enhancements to the system for receiving tips, complaints, and referrals,” the report stated.

Overly Broad Subpoenas?

These enhanced surveillance and detection capabilities are creating new concerns for companies, including worries of false positives and requests for piles of data. In the past, the last thing the SEC staff wanted when they issued a subpoena was to have to review a truckload of documents. “Nowadays, it's the opposite,” says Stark, who was former chief of the SEC's Office of Internet Enforcement before joining Stroz Friedberg. “They want as many documents as possible.”

As a result, the SEC's subpoena powers have become “extraordinarily broad,” raising concerns of overreaching by the SEC, says Stark. For example, the SEC in some cases has now begun to subpoena full hard drives from the companies and individuals it investigates, “which I'm not sure they have the authority to do,” he says. “I hope the SEC would be more surgical in their investigatory powers, but I have my doubts.”

With millions of transactions taking place every day, technical violations are bound to occur, says Rivera. Bringing too many enforcement actions for such violations could create the opposite intent of having a “chilling effect” on the market, if the SEC starts to overreach its enforcement powers, he says.

STRIVING TO BE EVERYWHERE

Below is an excerpt from SEC Chairman Mary Jo White's infamous “Broken Windows” speech.

In today's fast moving, complex and changing markets, it is important that we strive to be everywhere to enforce our securities laws and to protect investors. It is important because investors in our markets want to know that there is a strong cop on the beat – not just someone sitting in the station house waiting for a call, but patrolling the streets and checking on things. They want to know that would-be fraudsters are spending more time looking over their shoulders, and less time stepping over the line.

Investors do not want someone who ignores minor violations, and waits for the big one that brings media attention. Instead, they want someone who understands that even the smallest infractions have victims, and that the smallest infractions are very often just the first step toward bigger ones down the road. They deserve an SEC that looks at its enforcement mission in exactly that way.

This approach is not unlike the one taken in the nineties by then New York City Mayor Rudy Giuliani and Police Commissioner Bill Bratton, back when I was the United States Attorney for the Southern District of New York.

They essentially declared that no infraction was too small to be uncovered and punished. And, so the NYPD pursued infractions of law at every level – from street corner squeegee men to graffiti artists to subway turnstile jumpers to the biggest crimes in the city. The strategy was simple. They wanted to avoid an environment of disorder that would encourage more serious crimes to flourish. They wanted to send a message of law and order.

The underpinning for this strategy was outlined in an article, which many of you will have read or heard of, titled, “Broken Windows.” The theory is that when a window is broken and someone fixes it—it is a sign that disorder will not be tolerated. But, when a broken window is not fixed, it “is a signal that no one cares, and so breaking more windows costs nothing.”

The same theory can be applied to our securities markets—minor violations that are overlooked or ignored can feed bigger ones, and, perhaps more importantly, can foster a culture where laws are increasingly treated as toothless guidelines. And so, I believe it is important to pursue even the smallest infractions. Retail investors, in particular, need to be protected from unscrupulous advisers and brokers, whatever their size and the size of the violation that victimizes the investor ...

… But this does not mean we will not continue our vigorous pursuit of the bigger violations. Cases like the ones we brought recently against the likes of SAC Capital, Harbinger, J.P. Morgan, Oppenheimer, and the City of Miami not to mention the scores of significant financial crisis cases have always been, and will continue to be, important cases for us.

I believe the SEC should strive to be that kind of cop—to be the agency that covers the entire neighborhood and pursues every level of violation. An agency that also makes you feel like we are everywhere. And we will do our best not to disappoint.

Source: SEC.

All of these factors mean that companies have a much higher chance of facing an SEC inquiry. “Companies are going to see a lot more preliminary inquiries from the SEC seeking explanations for the various red flags that they've identified,” says Rivera.

The challenge for the SEC is that it doesn't always know what it's dealing with until an investigation has began, says Trager. That means the agency must perform a careful balancing act between knowing when to back off an investigation that won't lead to charges, or when to aggressively pursue those that will, he says.

White acknowledged this concern in her speech. “[A] critical part of a strong enforcement program is also to act only when the evidence justifies acting and to always go about our investigations and cases fairly, and with the mindset of doing the right thing in the right way,” she said.

Collaboration Efforts

The SEC's close collaboration with other regulatory agencies has also enabled the SEC to cast a wider net with its enforcement efforts. Last month, for example, the SEC fined 23 firms for violating Rule 105 of the Exchange Act, which prohibits short-selling prior to investing in a public offering, after working closely with the self-regulatory body, the Financial Industry Regulatory Authority.

The result of these particular enforcement actions signals a departure from past practice where the SEC would pick and choose referrals it received from FINRA that “would make the biggest splash,” says Stark. Now, the agency has indicated that it will be looking a lot more closely at all referrals, even those that “might not on their face involve big dollar amounts or outrageous frauds,” he says.

Gorman surmises that the SEC will continue to replicate that approach going forward “by bringing several cases together on one day to try to create this omnipresence in the marketplace.”

From an enforcement standpoint, that means the SEC will continue to bring cases that don't require proof of intent, cases in which the SEC only has to prove that a certain violation occurred, securities experts say. Examples of such cases include not only Rule 105 violations, but books and records violations, as well.

Every new SEC Chairman “wants enforcement to be an important aspect of their program,” says Stark, but with White being “the most experienced law enforcement chairman in history," that goal is all the more significant, he says. 

A lot of what the SEC's Enforcement Division wants to achieve, however, will come down to credibility, concludes Gorman. The agency will first have to win a couple of solid cases involving some big companies in order to establish their program. “If they can't do that, then all the tough talk will just be seen as little more than that, tough talk.”