• People familiar with the matter say Republican Commissioner Kathleen Casey questioned the SEC staff Thursday on their decision to abandon the strongest fraud charge and strike a settlement involving a lesser allegation, and given that, how the SEC could justify such a large penalty on a lesser charge.

Her complaint about the penalty is no big surprise.  It should be remembered that Commissioner Casey was one of the commissioners responsible for the policy during the Cox era that utterly hobbled the Division of Enforcement by requiring pre-approval of penalties imposed on issuers.  She's opposed to them but fortunately that era has passed.  

The negative vote is no great surprise for another reason.  Commissioners Casey and Paredes opposed the case from the very beginning, essentially arguing that it lacked merit.  Had the Commission been handed its head in litigation, they could have uttered a conclusive "I told you so."  Instead, the Commission has won a rich settlement, extracting a half a billion dollar penalty in the process.  Their prior position and characterization now looks embarrassingly wrong.  So does the continued opposition.    

So, in this context, its not accurate, as the WSJ writes, to contend that the "dispute also raises fresh questions about how strong a case the SEC had against Goldman."  It reflects the views of two Commissioners who have a deregulatory philosophy that was emphatically rejected with the adoption of FinReg by the Senate.  It does not reflect on the merits of the case.  

The problem is, thankfully, a temporal one.  Commissioner Casey's term expires in 2011, leaving Commissioner Paredes very isolated until the expiration of his term in 2013 (although its not uncommon for commissioners to resign before a term is completed).   The Commission cannot have more than three persons of the same party but the Chair, Mary Schapiro is typically labeled an independent so that means when Casey resigns, there is room for a third Democrat. 

Even if the appointment goes to a Republican (something the Senate minority might try to force), it will at least have to be a Republican that President Obama is willing to nominate.  Suffice it to say that someone with the views of commissioners Casey and Paredes will not qualify.

This type of information is highly confidential and ought not to leak to the press.  When there were leaks that the Goldman case had been authorized by a 3-2 vote, we criticized the leak and recommended that the Commission rely more often on executive sessions. 

The article in the WSJ noted that the 3-2 vote occurred in a "30-minute closed-door session," an apparent reference to an executive session.  Executive sessions are closed to most of the staff and typically open only to those who are in a must know situation.

Despite the precaution, the leak occurred.  Given the smaller number of officials aware of what transpired at the meeting, the Agency should conduct an investigation and attempt to identify the source of the leak.  Indeed, we think that is an appropriate function for the Inspector General and a better use of his time than investigating whether whether the Goldman case was politically timed.

The interpretive issue arose because the same statute also allowed the NLRB to delegate authority to committees and in these committees, two members could be a quorum.  The NLRB used the committee authority to effectively reduce the quorum for all matters (something like 600) by delegating all of the Board's powers to a committee.  Justice Stevens characterized the approach as a "Rube Goldberg-style delegation mechanism."  

The case got us to thinking about the quorum requirements for the SEC.   After all, the problem at the NLRB arose out of the failure of the political process.  Membership had fallen to two commissioners and the "Rube Goldberg-style delegation" was an attempt to allow the Board to continue to function.  The same thing could, of course, happen to the Commission.  Indeed, back in 1995, Commissioners Levitt and Wallman were the only members of the Commission.  Towards the end of the Bush administration, the Commission for a time consisted of three members. 

These are addressed in the Commission rules and provide:

• A quorum of the Commission shall consist of three members; provided, however, that if the number of Commissioners in office is less than three, a quorum shall consist of the number of members in office; and provided further that on any matter of business as to which the number of members in office, minus the number of members who either have disqualified themselves from consideration of such matter pursuant to § 200.60 or are otherwise disqualified from such consideration, is two, two members shall constitute a quorum for purposes of such matter.

17 CFR § 200.41.  In other words, the Commission does not have to go through the Rube Goldberg approach and create a committee but can simply rely on the two remaining commissioners to provide the quorum.  Of course, the rule goes further and provides that a single commissioner will constitute a quorum, at least in cases where only one commissioner remains on the board.   See Exchange Act Release No. 35548 (March 30, 1995)("To provide adequate flexibility in this unlikely situation, the Commission is providing that one commissioner would constitute a quorum if no other commissioners are in office."). 

Given the Court's ruling in New Process Steel, however, one might reasonably ask whether the SEC's rule is valid.  There are some significant differences in the two cases.  Most noticeably, the determination of the SEC's quorum requirement is not set out in the enabling statute.  One lower court concluded that as a result, the agency had broad discretion to determine its own quorum requirement.  See Falcon Trading Group v. SEC, 102 F.3d 579  (DC Cir. 1996)("If not otherwise constrained by statute, an agency sufficiently empowered by its enabling legislation may create its own quorum rule."). 

Second, the creation of a two person quorum in New Process Steel was by resolution.  The SEC has done it by rule.  Of course, as a precedural rule, the SEC did not submit the change for notice and comment.  See Exchange Act Release No. 35548 (March 30, 1995)("Therefore, the provisions of the Administrative Procedure Act ("APA") regarding notice and comment are not applicable.").  As such, it is unlikely to receive any deference under Chevron.

While the SEC's situation is different enough, the presence of a one person quorum does raise questions.  The Commission was created as a collective body with collective decision making authority.  One has to wonder whether a one person Commission is consistent with this approach. 

There was considerable publicity around the Inspector General's decision to investigate the timing of the Goldman case after receiving a request from several Republican congressmen.  We know he started an investigation in response because he announced it on Fox News.  Well, he is at it again

Senator Grassley, the Ranking Republican on the Senate Finance Committee sent a letter demanding that Kotz look into the so called revolving door problem at the SEC.  The Letter was not sent by the entire committee (which would require bipartisan support) or by the entire Republican component of the Committee (which would at least require organization and suggest that it wasn't a "shoot from the hip" kind of letter).  Instead, it was sent only by the Senator from Iowa.

The Letter included little more than a handful of anecdotal examples of SEC personnel leaving the agency and suddenly representing clients with business before the Agency.  There is nothing in the Letter that suggests anything particularly untoward or anything particulalry unusual.  Indeed, the Letter specifically noted that:

• "Trading and Markets Division Associate Director Elizabeth King recently left the SEC to work for a leading high frequency trading firm, Getco, LLC. Given her former position at the SEC, this raises a number of questions about:

• (1) the extent to which Ms. King was personally involved in the SEC’s review of last month’s “flash crash” and related rulemaking activities on high frequency trading,
• (2) when she first had contact with Getco, LLC about the possibility of employment there and whether she recused herself from matters related to the SEC’s inquiry and rulemaking after that point, and
• (3) the extent to which SEC and government-wide ethic rules will limit her communications with her former colleagues at the SEC on behalf of Getco, LLC going forward.

In other words, Senator Grassley had nothing more than the fact that an SEC employee left the Agency and went to work for a company in a relatively high profile area.  Indeed, according to the WSJ:

• Ms. King spent 17 years at the SEC. She was associate director for market supervision and oversaw the options and single-stock futures markets, a commission spokesman said.

• People familiar with her responsibilities said she "did not have a meaningful role" in the SEC's examination of high-frequency trading.

In short, Senator Grassley had nothing to go on other than an employee left and took a job with a regulated entity.  In his letter, he nonetheless asked the Inspector General to:

• please (a) provide a summary of the matters your office has reviewed that raise similar revolving door issues, and (b) conduct a review of the circumstances surrounding Ms. King’s departure from the SEC and disclose the results so that Congress and the public can more accurately assess the integrity of the SEC’s operations?

The response? Mr. Kotz had already opened an investigation into Ms. Kings' circumstances and he would be "pleased to share the results" of this investigation with Senator Grassley.  One has to wonder why Ms. King is already under investigation.  But the tone of Mr. Kotz's letter is clear enough.  Had she not been under investigation, he would have started one.  And when he has a report, irrespective of its confidentiality or findings, he will turn it over to the Ranking Member of the Senate Finance Committee. 

The job of the Inspector General should be less focused on political considerations and more focused on the needs of the Agency.  That does not include investigating every employee who leaves to take a job with a regulated entity or every request made by a lone minority member of a committee. 

GovernanceMetrics has produced a fascinating report on gender diversity, Women on Boards, A Statistical Review by Country, Supersector and Sector, GovernanceMetrics International®, March 11, 2010.  The firm follows more than 4200 companies worldwise.  How many women are there in total?  9.4%, up from 9.2% in March 2009. 

The study uses a number of metrics.  One of the tables ranks countries based upon the percentage of companies that have at least one director on the board. The other looks at the number of women as a percentage of total directors. 

With respect to the number of companies with at least one woman on the board, the percentage in the US is 68.93%.  In other words, 31% of the 1754 companies followed by GovernanceMetrics have no women on the board.  That's high enough, however, to be ranked 14th.

The higher ranked top countries?  Finland (96.3%); Sweden (93.88%); Israel (93.75%); Norway (91.30%); South Africa (90.70%); Philippines (83.33%); Thailand (81.82%); Denmark (80.77%); Ireland (75.00%); Canada (72.79%); Spain (71.74%); Egypt (71.43%); France (68.93%). 

How about some of the low performers?  The UK can only muster about half (51.11%).  Japan comes in at a dismal 9.41%.  Others include South Korea (13.58%), Russia (33.33%), Italy (35.71%), and Australia (43.50%). 

As for the percentage of total directors?  The US comes in at 12.21%, or 10th.  This is behind Norway (34.25%), Finland (23.41%), Swedan (23.89%), Phillipines (19.05%), South Africa (15.53%), Israel (14.13%), Denmark (14.40%),  Netherlands (13.70%), and Canada (12.49%).   As for the bottom of the list?  South Korea (1.53%); Japan (0.89%); and Morocco (0.00% but only three companies).  In twomen represent only 8.46% of the total number of directors.

How can this be anything but a form of market failure?  Is it really the case that the pool of qualified women is so small that only 9% of directors are women?  In effect the nominating process is controlled by the board itself.  Directors nominate a slate and usually run unopposed.  As a result, the fault rests with this process.  While legal reforms such as those in Norway (that now require boards of large companies to have at least 40% of both genders) can redress the imbalance, a more market oriented approach is to take some of the authority away from incumbents.  One way to do that is through the increased election of directors nominated not by the board but by shareholders.  In the United States, the most immediate way to advance that task is by providing shareholders with access to the company's proxy statement for their nominees. 

With respect to the SEC, Mr. Kotz, the Inspector General, has apparently agreed to look into the matter.  In a highly professional manner, however, this information was not revealed in a public statement or in some inflammatory manner.  Mr. Kotz apparently delivered the information to counsel individually.  Moreover, when asked for comments, he declined to provide any.

This is a far cry from a similar situation last month.  Mr. Kotz revealed on Fox News that he was undertaking an investigation into the timing of the case brought by the Commission against Goldman Sachs.  Some in Congress had accused the Agency of deliberately timing the case to influence the financial reform process.

Mr. Kotz correctly handled this one.  The professionalism is appreciated.

Having said that, we note a timely speech by Commissioner Aguilar about diversity (or lack thereof) at the staff level.  Earlier this month (May 3), Commissioner Aguilar spoke at the Attorney Career Roundtable and titled his remarks: Recruiting the Best and the Brightest Means Striving for a Diverse Applicant Pool.  In his talk, he gave the stats on diversity at the "senior officer" level.

• As of fiscal year 2009, the agency's senior officers were approximately 89% White, 4% African-American, 3% Hispanic, and 2% Asian. The gender breakdown among these officers is 67% male and 33% female.

Its not quite clear exactly what "senior officer" level encompasses (presumably it includes all managers from the branch chiefs on up, but that's not clear).  Nonetheless, the statistics are revealing.  The Commission has not done an adequate job making sure that all communities are adequately represented.

One can hope that with the current hiring binge underway, the Agency will reach out to underrepresented communities.  Most officers rise from the staff.  To ensure adequate representation among the officer corps means ensuring strong representation at the lower levels. 

The current Commission has been decisive and has corrected a number of the weaknesses left over from the prior administration.  Increasing diversity is another one that requires substantial attention. 

Reports quote him as opposing presidential appointment.   In a statement issued by the Center for Public Integrity, he provided his reasons:     

• “If I were to be an inspector general that was appointed by the president and cleared by the White House, it might be difficult to convince the public that I could conduct an independent or credible investigation into alleged improper connections between outside forces, including the White House, and the SEC,” SEC Inspector General David Kotz said in an interview with the Center for Public Integrity.

He also noted upon enactment, he would immediately "become a lame duck” that could have "a significant impact on our ongoing investigations.”  

Both are weak arguments.  The comment about the conduct of the investigation is steeped in irony.  He is arguing against any step that might compromise the post and make it difficult to "convince the public."  Yet he did exactly that when he announced the investigation on Fox News.  If he finds evidence of improper connections, it will look political.  If he finds evidence of no connections, he will be criticized for having undertaken the investigation to begin with.  Either way, it will be tough under current circumstances to "convince the public."

Unfortunately, there is nothing in the comment that speaks to the difficult structural issues involved in the decision.  In short, it does little to help the SEC resolve this issue in a manner best for the Agency.

His proposal, according to reports, would essentially allow for an Inspector General without accountability.  He would create a position that was accountable to no one, the President, Congress, or the Chair of the Commission.  Once appointed, the Inspector General could only be removed for cause.  While the Grassley Amendment apparently has a provision for "peer" review, this would be no substitute for actual oversight.   

The approach in this case, unfortunately, reeks with political overtones.  Senator Grassley, a Republican, is taking a position that would protect the job of the Inspector General at the SEC, an individual who just announced an investigation undertaken at the request of a Republican congressman.   But it is a short term perspective.  In the longer term, its just as likely that it will be a Democratic chair who appoints an Inspector General who will embarass a Republican Administration.

Whether subject to removal by the President or the Chair of the SEC, either is better than removal by, and accountability to, no one.

At some level, it hardly matters.  The President has the power to appoint the chair of the SEC.  Thus, in most cases, the President's interests and those of the Chair will be in rough alignment.  To a small degree, it gives the President a modest amount of additional influence over an independent agency.  It also probably makes dismissal for benign reasons like non-performance a bit tougher since it is probably more difficult to get the attention of the White House on these types of mundane issues. 

Finally, dismissal for non-benign reasons is less likely when it is up to the President.  Most investigations within the SEC will not matter to the President, even if they result in embarassing disclosure.  Kotz had publicly embarassed the SEC on a number of occasions, whether the invesigation into Pequot or staff Internet habits.  These types of things would not likely raise the ire of the President but could result in dismissal by the chair.  In short, presidential appointment and removal would increase the ability of the Inspector General to act in a manner that was unpopular within the SEC.

Are their costs in moving the appointment power?  Absolutely.  For one thing, the President can sweep out the Inspector Generals upon a change of Administration and make sure that no holdovers are left in place.  Under this approach, Kotz, an appointee of the prior administration, might have been ousted when President Obama took office. 

Having said that, however, the new chair of the SEC (in this case Mary Schapiro) already had the authority to do so.  That she did not reflects the historically uneventful nature of the post.  After all, Kotz is only the second Inspector General to serve at the SEC.  Yet his actions have demonstrated that this is not the case.  On a going forward basis, any new Chair, at least when appointed by a new administration, will no doubt need to take a hard look at the Inspector General and consider seriously his/her removal.   So giving appointment/removal authority to the President is not likely to result in any significant change in practice.

What presidential appointment does do, however, is increase the authority of Congress with respect to the Inspector General.  Congress must approve the appointee and must be provided with advance notice of removal.  It will help politicize the position.    

There are currently 69 Inspector Generals.  Many are appointed by, and subjected to the removal of, the President.  With respect to appointment, an Inspector General must be "appointed without regard to political affiliation and solely on the basis of integrity and demonstrated ability in accounting, auditing, financial analysis, law, management analysis, public administration, or investigations."

With respect to removal, the President may remove the Inspector General but must "communicate the reasons for any such removal to both Houses of Congress."  Moreover, Congress must be notified at least 30 days before any removal or transfer.   See Section 3 of the IG Act. 

The theory behind presidential appointment and removal is obvious.  The purpose is to increase not decrease the independence of the Inspector General.  The alternative -- one currently applicable to the SEC as well as other agencies -- is to put appointment and removal authority in the hands of the agency head that will be subject to investigation.  Under the existing system, it is hard to call the Inspector General independent, although the term is nonetheless tossed around.  See SEC Watchdog: Becoming Political Appointee Would Jeopardize White House Probe, John Solomon, May 11, 2010 ("Some, especially those at Cabinet agencies, are presidentially appointed and confirmed by the Senate. Many others are hired independently by their agencies."). 

This would suggest that presidential appointment/removal is preferable.  Yet the issue is more complicated, as we will address in the next post.

As a result, his credibility as an "independent" arbiter of the facts has been unalterably damaged.  Future reports issued by his office will be seen in a partisan light.  This hurts the Commission.  The Commission needs someone in that position who is beyond reproach, who when he/she exonerates or blames carries irreproachable integrity.  Kotz no longer fits that description.

The need for a credible Inspector General is particularly acute right now.  The Inspector General at the SEC is currently appointed by the Chairman, one of only a handful of similar positions not appointed by the president.  Legislative proposals floating around, however, would transform the position into a presidential appointment, requiring the approval of the Senate. 

Such legislation has already passed the House of Representatives (HR 885) and would extend to the Inspectors General of the Commodity Futures Trading Commission, the Board of Governors of the Federal Reserve, the Securities and Exchange Commission, the National Credit Union Administration and the Pension Benefit Guaranty Corporation.  The legislation would, by the way, give the Inspectors in these agencies subpoena authority.  Similar language has apparently has been just added to the Dodd Bill. 

At the same time, Senator Grassley is trying to gain support for a proposal that would leave the position as an appointee of the agency but restrict removal to cause.  In addition, he wants to require that the Inspector General report to the entire board or commission (and, presumably not just the chair) and that the Inspector General be subject to an annual "peer review."  The Grassley proposal would, as we'll discuss, do serious damage to the current structure for the post of inspector general. 

This is a serious issue and one that requires careful thought.  It requires a strong position by the Commission, one way or another.  The voice of a non-partisan Inspector General would likely carry considerable weight.  While we will discuss this further, we note at this point only that anything Kotz could say on this issue will now be viewed entirely in political terms.  Thus, while he opposes the efforts to make his position a presidential appointee, the statement has no credibility.   It may be a position carefully developed on the merits or it may be political rhetoric.

In any event, the escapade over Goldman has cost the Commission an advocate. 

First, he was asked about the relationship between the SEC and the criminal authorities.  Recall that Mr. Reisner did a term at the US Attorneys Office.  One thing is clear from his comments:  The number of criminal cases is increasing.  He indicated that relations with criminal authorities had never been better.  Intriguingly, he noted that there were 80-90 cases at the Commission that were of “national importance” and that 60% of them had parallel criminal investigations. 

He was also asked if the SEC had any intention of altering the traditional approach of settling cases with the defendants neither admitting nor denying the charges.  He responded by saying that there is “no current plan in any broad and systematic way to change the practice,” although he noted there would always be exceptions.  The comment hinted that there will be an increase in the number of cases where defendants are not allowed to rely on the "neither admit nor deny" standard but that it will not be systematically abandoned.

The five new units include:  Asset Management, Market Abuse, Structured & New Products, Foreign Corrupt Practices and Muni Securities and Public Pensions.  Staff (there are Unit Chiefs, Deputies,  assistant directors and staff attorneys in each specialty unit) has been culled from all of the SEC’s offices, not just those in Washington.

At the Rocky Mountain Securities Conference, Julie Lutz, the Associate Regional Director with the Division of Enforcement in the Denver Regional Office described logistically the effect of the five new specialty units on the SEC’s regional office in Denver.  As with all SEC offices, Denver was reorganized to eliminate branch chiefs, a step now complete.  The number of assistant regional directors in the office increased from three to five.  Two of assistants have become part of specialty units:  Market Abuse (under Jay Scoggins) and Structured Products (under Laura Metcalfe).  According to Ms. Lutz, approximately 25% of the office staff will be involved in these units, consistent with the agency wide percentage.  Specialized training in the units has already begun and includes members of the trial team. 

Residential mortgage backed securities (“RMBS”), according to the SEC’s recent complaint, provides investors with payments “out of the principal and interest on the underlying [pool of residential] mortgages.”  Simply put, RMBS allows a mortgage holder (i.e., lender) to sell its risk and income stream in mortgages to an investor.  Generally, the buyer pays cash to the seller in exchange for a debt instrument that entitles the buyer to recover its original investment plus interest through a series of periodic payments.  Thus, a buyer likely invests in RMBS for exposure to interest rates normally associated with mortgages. 

Mortgages of different quality, as determined by credit rating agencies, underlie RMBS.  Lower quality loans, known as mid to subprime, have a higher propensity to experience adverse credit events.  That is, for example, the mortgagees declaring bankruptcy; this ultimately hinders the buyer’s ability to receive payments from the RMBS.  Simply put, high mortgage default rates in RMBS can render a buyer’s investment worthless.  Not surprisingly, however, a buyer receives higher interest income on a RMBS containing lower quality mortgages.  As such, some buyers are willing to risk higher default rates for exposure to increased return on investment generally offered by long exposure to mid and subprime RMBS.           

The SEC’s complaint describes a Credit Default Swap (“CDS”) as a “derivative contract under which a protection buyer makes premium payments and the protection seller makes a contingent payment if a reference obligation experiences a credit event.”  Restated, a buyer makes payments to a seller over a fixed period of time in exchange for the sellers promise to pay the buyer a predetermined amount (i.e., CDS’s notional amount) if an issuer defaults on the referenced credit obligation (i.e., underlying).  This transaction resembles insurance.  CDS insures against, among other things, corporate defaults, government defaults, RMBS defaults, and other indices’ losses.  Notably, and unlike traditional insurance, neither CDS purchasers nor sellers must have an insurable interest in the underlying credit obligation. 

The SEC’s complaint further explains a Synthetic Collateralized Debt Obligation (“SCDO”) as a “debt . . . [security] collateralized by debt obligations including RMBS,” where the SCDO is not actually backed by the underlying debt obligations, but instead references a portfolio of those securities (“reference portfolio”).  A CDS written against the reference portfolio completes this derivative structure.  Then, if an agreed upon credit event occurs, the CDS triggers resulting in the seller making a required payment to the buyer.  

Simply put, the protection buyer makes CDS premium payments in exchange for the contingent right to receive payment if a specified credit event, such as default, occurs.  On the other hand, the protection seller receives periodic interest payments, but must pay the buyer if a credit event occurs.  Consequently, a seller likely believes the reference portfolio will not experience a credit event, and thus, has an effective long position in the reference portfolio.  On the contrary, a buyer likely believes a default will occur, and thus, has an effective short position in the underlying.  Notably, this derivative generally uses a third-party trustee (“trustee”) to manage the transfer of funds between parties.    

A SCDO operates as follows.  First, a seller will deposit their initial investment (“collateral”) with the trustee.  Then, the buyer will make periodic CDS premium payments to the trustee.  If no credit event occurs, the payments collected from the buyer are used to make periodic interest payments to the seller, and the trustee eventually returns the collateral to the seller.  If, however, a credit event occurs, the buyer has a right to receive payment from the collateral.  Restated, payment to the buyer upon default comes out of the seller’s initial investment.  Thus, a seller can potentially lose their entire initial investment.