In a report released publicly today, the Government Accountability Office said that policies put in place during the tenure of former Securities and Exchange Commission Chairman Christopher Cox were thought within the agency to have hampered investigations, discouraged staff from pursuing penalties against corporations, and created an adversarial relationship between the Division of Enforcement and the agency’s commissioners.

In at least one case, the GAO said, SEC attorneys claim the commission insisted on levying a lower penalty than one company had already agreed to pay.

The GAO’s review of the SEC began last August, when Cox was still chairman, and concluded in February, shortly after he left office. Many of the policies described in the resulting report were publicly disavowed and overturned earlier this year by current Chairman Mary Schapiro, who received a draft of the report months ago. “No one should be heard credibly to question whether enforcement is a priority at the SEC,” said a newly confirmed Schapiro in a February 6 speech.

In that speech, Schapiro announced that she was overturning a “penalty pilot” program requiring that staff in the Division of Enforcement seek approval from the commission before levying fines against public companies involved in securities fraud. The GAO report released publicly today says that policy, enacted in 2007, as well as an earlier 2006 policy, convinced managers and investigative attorneys in the Division of Enforcement that corporate penalties “were highly disfavored” by the commission, and frequently resulted in delays.  

Penalties fell 84 percent during the fiscal years roughly coinciding with Cox’s tenure, from a peak of $1.59 billion in fiscal-year 2005 to $256 million in fiscal 2008. Disgorgements fell 68 percent, from a fiscal-year 2006 peak of $2.4 billion to $774.2 million in fiscal-year 2008.

Before Cox joined the SEC in 2005, the four SEC commissioners, two Democrats and two Republicans, reportedly often split over corporate penalties. Former Republican commissioner Paul Atkins, in particular, had long complained that financial penalties against corporations represented a form of double jeopardy for shareholders already wounded by financial fraud.

Under Cox, in 2006, the SEC announced settlements with two companies, McAfee and Applix, but levied a penalty — $50 million — only against McAfee. (The SEC did file civil fraud charges against former Applix executives, including former CFO Walter T. Hilger.) At the time, the SEC explained, penalties would be assessed when a securities law violation improperly benefits shareholders, but that when “shareholders are the principal victims of the violations,” the commission “will seek penalties from the individual offenders” acting on behalf of the company.

In a subsequent 2007 speech, Cox announced that SEC enforcement staff would need to obtain approval from the commission for a penalty range before beginning settlement discussions.

The GAO report notes that both policies appear “neutral, in that they neither encourage nor discourage corporate penalties.” But according to GAO interviews with SEC staff, the policies were perceived as sending a message that the commission did not approve of corporate penalties. They also reportedly resulted in significant delays, and changes in the size of settlements. “[S]everal Enforcement attorneys told us that even when they presented cases in which a corporation had agreed to pay a penalty, the Commission might lower or eliminate the amount,” the report said.

According to the report, one SEC attorney told GAO auditors about a case “in which a company proposed a settlement with a higher penalty than was approved by the Commission, which required the attorney to return to the company and explain that the Commission wanted a lower amount.”

In other examples related to the GAO by SEC attorneys, “a company confessed and was willing to pay the penalty sought, but it still took more than 6 months to complete the settlement because the commissioners lacked consensus.” In another case, “a company agreed to a settlement, announced it publicly, and escrowed money for the payment, but the matter took a year to win Commission approval.”

SEC attorneys also complained to the GAO that the new penalty policies were accompanied by increasing difficulty in obtaining formal orders of investigation. SEC staff regularly question companies, an event sometimes characterized by companies in financial filings as “informal” inquiries. A formal investigation gives SEC staff the ability to issue subpoenas to potential witnesses. Companies almost always consider the launching of a formal investigation to be a material event requiring disclosure under securities laws.

According to the report, however, “obtaining approval of a formal order, once routine, lately had become more difficult and time-consuming . . . it could take months to obtain [full] Commission approval.” The GAO report notes that formal orders of investigation fell 14% from 272 in fiscal-year 2005 to 233 in 2008.

The GAO report notes that Cox himself cited the importance of formal orders when defending himself and the agency against severe criticism that it had missed the Madoff Ponzi scheme. “I am gravely concerned,” Cox said in a December 16, 2008 statement, “by the apparent multiple failures over at least a decade to thoroughly investigate these allegations or at any point to seek formal authority to pursue them. Moreover, a consequence of the failure to seek a formal order of investigation from the Commission is that subpoena power was not used to obtain information, but rather the staff relied upon information voluntarily produced by Mr. Madoff and his firm.”

However, the GAO report notes that “One [SEC] attorney said it took about 5 months and several rounds of comments on a supporting memorandum before a request seeking a formal order in a Ponzi scheme investigation was set for Commission consideration.”

In her February speech, Schapiro said the SEC would immediately revert to its former practice — in place when she herself was a commissioner 15 years ago — under which staff requests to launch formal investigations can be approved by a single commissioner acting as “duty officer,” or signed off on individually by each commissioner in turn.

The GAO said at least one former commissioner argued that it was not the 2006 and 2007 policies that accounted for declining amounts of penalties and disgorgement, or for less-vigorous pursuit of corporate penalties, but rather the quality of management. The report added that, “Another former commissioner said that, although some Commission actions may have caused Enforcement to feel constrained or that its authority was diminished, it was nevertheless important to understand that the division worked at the direction of the Commission, not as an independent entity.”

Current chairman Schapiro, however, took no issue with the report, noting in an appended letter that “[I] strongly agree that the recent reductions in enforcement staffing levels have seriously undermined the agency’s ability to effectively pursue violations of securities laws.” She added that the GAP report “provides important documentation” that the penalty pilot program contributed to unnecessary delays in the prosecution of cases and discourages staff from seeking corporate penalties.