The U.S. Securities and Exchange Commission, long known for settling enforcement actions without having to prove its case in court, is struggling to cope with a a surge in the number of executives and companies willing to go to trial to defend themselves.
The SEC’s office in Washington is actively litigating about 90 cases, up more than 50 percent in the past year, Matthew Martens, the SEC’s chief litigation counsel, said in an interview. At the same time, Martens’ trial unit staff has stayed relatively flat at about 36. He recently added three more lawyers to his group and is looking to hire more.
'If you don’t have a legitimate trial threat, if you don’t communicate to the targets of your investigation that you’re prepared to go to trial, then you can be exploited', SEC Enforcement Director Robert Khuzami said.
Martens said its critical that his unit present a credible threat. 'At the end of the day, if we can’t win cases, then people don’t settle. That’s the reality', he said.
The wave of litigation has two main sources: more complex cases stemming from the 2008 financial crisis and a related increase in lawsuits filed against individual executives.
The collapse of the housing market and resulting financial turmoil involved complex securities for which there was little legal precedent. In addition, the agency has brought more financial crisis lawsuits against executives -- more than 50 so far -- and individuals are often inclined to fight claims that could damage or end their careers.
Those cases, which have required years of investigation, are central to the agency’s effort to restore its reputation after being battered for more than three years by lawmakers, judges and investors who claimed it hasn’t been tough enough in holding Wall Street to account.
Prolonged courtroom battles could sap resources from the SEC, which has said funding gaps have already diminished its ability to regulate securities markets. That puts regulators in a bind: They need to demonstrate to Congress that they need more resources while not showing any weakness to defendants.
'If you don’t have a legitimate trial threat, if you don’t communicate to the targets of your investigation that you’re prepared to go to trial, then you can be exploited', SEC Enforcement Director Robert Khuzami said in May 17 testimony before the House Financial Services Committee. 'Defendants will simply hold out for a softer settlement and not fear the alternative'.
The SEC is litigating at least four cases related to complex financial products linked to residential mortgages. While firms including Goldman Sachs Group Inc. (GS), Citigroup Inc. (C)and JPMorgan Chase & Co. (JPM) have settled the SEC’s claims, executives named in the suits are fighting them in court.
'It doesn’t take many cases to eat up limited resources', said Mark Schonfeld, the former head of the SEC’s regional office in New York who is now a partner at law firm Gibson Dunn & Crutcher LLP. 'It’s not just an expenditure of resources in the near-term; these cases go on for years and years'.
Fabrice Tourre, the London-based Goldman Sachs executive sued over his role in selling a mortgage-linked security called Abacus, has fought an SEC lawsuit since 2010 and the judge recently extended a deadline for taking testimony from witnesses outside the U.S. The SEC has about 10 attorneys involved in the litigation, according to court documents.
In some cases, the SEC has taken the once-rare step of suing executives over claims they were negligent. Historically, the agency had refrained from suing individuals if the evidence didn’t support a stronger claim, such as intentional fraud or recklessness.
'It can be hard to persuade a judge and jury that a person should be punished for something they did 10 years ago, when they have had an exemplary career before and since', said Schonfeld. 'When you add on top of all that that the worst thing you’re saying about a person is that they acted negligently, that’s not a very compelling case'.
Brian Stoker, a former Citigroup employee who the agency said was responsible for structuring a deal at the center of the SEC’s lawsuit against the bank, and Edward Steffelin, a collateral manager for a collateralized debt obligation faulted in an SEC settlement with JPMorgan, are both fighting negligence-based claims.
'When the SEC is being more aggressive in the enforcement context and using more creative theories, breaking new ground, that can lead to more litigation because people feel they have a greater chance of prevailing', said David Kornblau, the SEC’s former chief litigation counsel who is now a partner at law firm Covington & Burling LLP in New York.
The SEC has become increasingly vocal in recent months about the resource drain of prolonged litigation after U.S. District Judge Jed Rakoff rejected a $285 million settlement with Citigroup. Rakoff criticized the agency for its practice of settling cases without requiring an admission of wrongdoing.
'The cost of trials, both in terms of the thousands of staff time hours and other out-of-pocket costs such as expert witnesses, can be exorbitant', Khuzami said in his May 17 testimony. 'It is wiser to save our resources by demanding settlements approximating what we could expect to achieve at trial and spending those saved resources on fighting other frauds or litigating when a settlement doesn’t meet our standards'.
Spencer Bachus, the Alabama Republican who leads the Financial Services panel, said in last week’s hearing that 'a policy that has judges micromanaging federal agencies’ exercise of their enforcement authority and requiring the government to engage in lengthy and expensive trials in every instance would not serve the best interests of taxpayers or investors'. Bachus has questioned whether Congress should increase the SEC’s budget.
80 Percent Success
Much of the burden of burnishing the SEC’s courtroom credentials has fallen to Martens, a former federal prosecutor in North Carolina who was tapped in 2010 to become the SEC’s chief litigation counsel. During his tenure, the agency has prevailed in more than 80 percent of the matters that went all the way to trial, according to his calculations.
After graduating first in his class from the University of North Carolina School of Law, Martens, 39, began his legal career as a clerk to Judge David Sentelle at the U.S. Court of Appeals in Washington D.C. in 1996 followed by a one-year clerkship with then-Supreme Court Chief Justice William Rehnquist.
Martens later worked for about three years as a litigation associate at law firm Latham & Watkins before joining then- Assistant Attorney General Michael Chertoff at the Justice Department, ultimately becoming his chief of staff for the criminal division.
Martens 'was like a one-man dynamo', Chertoff, who later served as secretary of Homeland Security and is currently chairman of a security management firm called the Chertoff Group, said in an interview. 'Matt is not a guy who’s going to be afraid to take a case to trial'.
At the SEC, Martens has pushed to insert his trial attorneys earlier in investigations to avoid inheriting cases that wouldn’t play well in court. He’s also taking an active role in reviewing legal briefs before they’re filed.
While Martens directly oversees the trial lawyers in Washington, litigators in the SEC’s regional offices don’t report directly to him. Still, Martens is responsible for ensuring continuity in the SEC’s litigation nationwide, including briefs on the agency’s position on the Supreme Court’s ruling involving Janus Capital Group Inc. (JNS) Martens said that he personally reviews all of the SEC’s briefs on the Janus decision, which effectively narrowed the universe of people who can be sued for making false statements in financial filings.
Also on the docket is a raft of subprime disclosure cases against executives who the agency claims made misleading statements about their firms’ exposure to souring home loans. The ongoing litigation includes lawsuits against six former executives of Fannie Mae (FNMA) and Freddie Mac, three executives from IndyMac Bancorp Inc, the ex-CEO and chief financial officer of Franklin Bank Corp (FBTXQ), and three former executives of Thornburg Mortgage Inc.
The trend is likely to continue. In a congressional hearing in March, SEC Chairman Mary Schapiro said the agency will need to focus more resources on the trial unit.
'The expectation is that as we bring more and more cases, we will have to litigate more of them', Schapiro said, adding that the agency needs 'experienced trial counsel' to handle the load.
'They can never be seen to lack litigation capacity because otherwise some people will try to steam roll them', said Steve Crimmins, a partner at law firm K&L Gates who used to be deputy chief litigation counsel at the SEC. 'If they show weakness, if they show understaffing, if they show the inability to go to trial, they won’t get the settlements they need'.