SEC's 'broken windows' policing of Wall Street 'deeply flawed' or necessary?

At times, Mary Jo White sounds almost like Wyatt Earp, or some other law enforcer from the Old West … only without the gun.

“You have to be tough” has been White’s motto since taking over the Securities and Exchange Commission from Mary Schapiro in spring 2013.

“The SEC is a law enforcement agency,” she told the Wall Street Journal. “You have to try to send as strong a message as you can, across as broad a swath of the market as you regulate, and that’s pretty broad.”

On the surface, she has followed through. The SEC filed 686 enforcement actions in its 2013 fiscal year. In its 2014 fiscal year, White bragged that the number soared to 755, “the highest number of cases in the history of this commission”. Moreover, she has noted that the agency levied a whopping $4.1bn in penalties as part of those actions.

It all sounds great. But is it?

Securities lawyers – understandably enough – haven’t been big fans of the SEC’s saber-rattling, perhaps because it’s giving their clients a tough time, often for issues that they consider minor.

Hanging on to law enforcement terminology, the SEC is cracking down on “broken windows” offenses: stuff that previously might have warranted only a rap on the knuckles. In the 2013 fiscal year, for instance, 132 of those 686 cases involved the relatively plain vanilla issue of failing to report a change in stock ownership or a stock sale by a corporate insider, like a director or CEO, in a timely manner.

These are a far cry from what we usually think of when we think of “SEC enforcement actions”: they aren’t accounting irregularities, fraud, or market manipulation. In 2014, 107 of 755 cases were delinquent filing actions. The securities team at Cooley LLP pointed out in a review of the SEC’s enforcement actions that some of these “crimes” actually could be no more accidental oversights.

In other cases, the transactions didn’t go unreported – the individuals just didn’t meet the SEC’s deadlines. (In other words, the lawyers argue, it’s a bit like when we pay our credit card bills late.) Then, too, they argue that this is a real departure in the SEC’s traditional approach to cracking down on late filings only when it’s part of a bigger problem – part of a broader fraud. And why charge a company for “contributing to filing failures” by a director or other insider?

For Urska Velikonja, a law professor at Emory University, the answer is easy: the SEC is padding what she believes to be “deeply flawed” enforcement statistics. In a study slated for publication in the Cornell Law Review, she calculates that the way the agency has counted the number of cases it has pursued has made it looked like a far fiercer and more effective sheriff than it may actually be.

Velikonja’s data and her arguments are compelling, if not altogether new: they simply offer a more objective and unbiased view of the same argument previously advanced by securities lawyers like Marc Fagel, a partner in the San Francisco office of Gibson Dunn & Crutcher. In an analysis of the 2014 data, Fagel noted that 80% of the cases came from five big, targeted actions that resulted in a large number of individuals being charged simultaneously for reporting-related violations that didn’t rise to the level of fraud.

Those are some of the cases that Velikonja criticizes as “padding”, since they don’t require much investigation. She also takes aim at double counting (where the agency counts actions that are taken aginst the same individuals two or three times in different venues, or counts the enforcement against, say, a CEO and his or her company as separate enforcement action) and other forms of creative mathematics.

Velikonja’s survey of the data will provide lots of fodder for the SEC’s critics – of whom there are many. The study hit the news within days of the end of the agency’s 2015 fiscal year on 30 September; within weeks, White will take the podium to reveal and discuss the agency’s enforcement track record for the last 12 months.

Perhaps White and the SEC shouldn’t have been as triumphalist as they have been in past months, pointing over and over again to those 755 cases as evidence that the sheriff has been successful in organizing her posse and is riding out in pursuit of the stock market’s black hats.

On the other hand, should they now have to vigorously defend every enforcement action they’ve taken, and every strategic measure to patrol the markets, as rigorously as they will have to in the wake of Velikonja’s provocative conclusions? Probably not.

While there is legitimate criticism to be levied against the way in which the SEC presents and discusses enforcement data, it might be dangerous to cross the line and start querying whether or not these are pointless exercises.

Sure, they boost the enforcement division’s stats and make them look effective. But as Marc Fagel of Gibson, Dunn pointed out, the big enforcement “sweeps” that generated some of those cases about which Velikonja writes dismissively draw attention early to precisely the kind of companies that history suggests are most ripe for future frauds: those without current financial reports.

Moreover, what the SEC has done doesn’t necessarily tell us what it is working on or will work on in future: an active and aggressive enforcement division (even if it’s only writing the equivalent of parking tickets today) might be in the early stages of developing a complex fraud or insider trading case, or be better prepared to spot a rogue trader in the early stages of his shenanigans as a result of their small-scale enforcement activities.

Big, dramatic cases obviously appeal most – what’s not to like about really sticking it to an evil insider trader or a bankster? But the fewer of these there are, or the more time and effort required to build those cases, the more White needs to rely on big overall numbers when testifying to Congress and justifying her budget and the size of her staff, which has grown from 1,266 in 2014 to nearly 1,340 (budgeted) in 2015.

The risk now is that SEC critics will seize on Velikonja’s data to push for cuts to the agency’s budget, just as it is trying to come to grips with new challenges, like the role of high-frequency trading, to its enforcement operations. In the years leading up to the 2008 financial crisis, morale and resources at the SEC was at a particularly low ebb, making it strikingly ineffective. Do we really want to remove whatever fangs it is in the process of re-growing today because of the way data is reported?

By all means, let’s focus on what the enforcement division is doing, and ask for an explanation of why the agency is pursuing this “broken windows” policy. And let’s ask why the SEC has levied record fines, but has done such a notably bad job when it comes to collecting and disbursing those penalties that the nonpartisan Government Accountability Office has told it to clean up its act. Every watchdog organization needs to be scrutinized, in its turn; transparency is a great thing.

But let’s remember that just because the SEC’s enforcement division isn’t marching the wolves of Wall Street off to jail in handcuffs each week on the nightly news doesn’t mean that we don’t need the agency and its resources on the job, putting cases together piece by piece. Let’s make sure they have the resources to keep doing that.