POSTCRASH TRIAGE IN THE SEC EMERGENCY ROOM
Triage: the assignment of degrees of urgency to wounds in order to decide the order of treatment of a large number of patients or casualties.
Some days during my first years at the SEC (I ended up staying for five years), I felt like a trauma surgeon in the ER of the financial sector. In the wake of the financial train wreck of 2008 and the early casualties from the Madoff and Stanford scandals, patients kept getting wheeled through the doors of the SEC, and I was racing from table to table operating on the toughest cases. And while we juggled many priorities, we simply had to save as many investors as we could. The truth was, after decades of the SEC’s more or less enjoying widespread respect from the financial community, Congress, and independent experts, its spectacular failures revealed how much had gone wrong and how much the agency needed a major transformation to address the underlying weaknesses in its processes and culture.
In working with Carlo di Florio, who was a former management consultant with years of “doing change” at big companies, we frequently talked about what was happening at Exam and other SEC departments from the perspective of “change management”—that is, changing culture and getting people to buy into new roles and responsibilities as a result of a major failure of management.
Bestselling business author John Kotter and other experts cite key steps in making change work that include communicating a sense of urgency, building a coalition of leaders who support the change strategy, communicating principles and goals with a clear vision, reducing obstacles throughout the organization, and building ownership for this new way among employees at all levels.1 Carlo and I saw Exam as needing this kind of major change package. But we didn’t have an agencywide coalition or clear goals to talk about. It reminded me of a McKinsey case study. A Canadian hospital undertook a major change effort to reduce waiting times in the emergency room. A handful of managers piloted in-patient initiatives within the neurosurgery unit that cut waiting times and improved patient morale, but they failed when the time came to scale up those changes to other clinical units. Too few leaders across the entire hospital had bought into the initiative, and the rank and file showed widespread resistance to change. The consultant team had to start the entire program over from scratch.2
In New York, we were trying to make our ER work better, but the rest of the hospital required attention as well. As mentioned in Chapter 3, if Exam and the SEC were going to rediscover the value of their mission, we needed more converts at the national level.
A MEETING WITH ALL THE FACTIONS
Carlo decided early in 2010 to forge a national change plan for how Exam’s people would do their work for America’s taxpayers. It wasn’t enough for us just to improve the New York office. If we were going to shake up the culture of the SEC, Carlo knew, we needed a strategy for reform that included Exam leaders in every region. We called in associate and regional directors from every region for meetings in Washington, DC. (Each region has at least one associate director for exams, and New York and LA have two—one for investment management firms and another for broker-dealers.)
We not only wanted to make our case for modernizing how the SEC did its business; we needed to see who the regional players were. We had to find out who was strong and who was not. We needed to know who had innovative ideas for change, who would go along, and who would work against us behind the scenes. We had to try.
Soon divides appeared. Sometimes newer directors expressed far more support for change than the “lifers,” but some lifers advocated a great deal of change. (And I really mean lifers—some had been at the SEC for decades.) I didn’t hesitate to drive a lot of ideas and push the group to embrace reform. It wasn’t long before Carlo spoke to me one day in my office in New York.
“Norm,” he said, “I want you to become my deputy director. You should start coming down to Washington.”
“Carlo, I’d love to,” I told him. “But I can’t do it now. I just left 10 years of constant travel in the hedge fund business, and I am here in New York on a regular basis, and my family likes it.”
“All right, take your time,” he said. “I’ll catch up with you in a few months.”
We continued pushing for a national leadership idea, a set of operating principles that everybody in the Exam office followed. To do that, we needed cooperation from leaders in each department. That wasn’t a familiar role for them. Like New York, each of the other regions in Exam was doing its own thing. Nothing written down. No manual. Every region was convinced it was doing the right thing and the others were doing the wrong thing.
We introduced the classic five-part approach to strategic change: strategy, structure, people (including training), process, and technology.3 Then we formed teams around each aspect and charged them to come up with recommendations. I continued to take an active role in all the working groups, putting in monumental hours on top of trying to run the exam program in New York. Carlo came back to me late in the spring and said, “Look you’re the change agent in this crowd. You are leading all these different things. You have to be the deputy director.”
In June I finally agreed. “OK, Carlo, I’ll do it.” I enjoyed what I was doing in New York, dropping the kids at school, taking the subway to work, and not having to travel across too many time zones. But I’d come to relish the management challenges at the SEC and the opportunity to improve the agency for the staff. I knew if another major fraud scandal slipped through our process, it could be the SEC’s death blow.
So by July 2010 Carlo promoted me to deputy director of Exam. I now had responsibility for examinations and personnel problems all around the country. Soon after that I became caught up in new legislation aimed at reforming Wall Street and preventing another financial crisis. The Democratic-controlled Congress and the Obama administration passed a law, now known as Dodd-Frank, named after its sponsors Senator Chris Dodd and Congressman Barney Frank, that was the most sweeping financial services law our nation had seen since the original Glass-Steagall Act. It was our government’s answer to all that had happened, and it was also loaded up with many policy ideas that had little or nothing to do with the 2008 crisis, including requiring public companies to disclose whether they made payments for “extractive resources” like oil! Little did any laypeople (or even me to some extent) know at the time that it would be the SEC’s job to make a large part of this law work.
After all, until the SEC writes and implements revamped rules, financial legislation is only words in the United States Code. I found a talented SEC lawyer, Judy Lee, whom we asked to coordinate the effort to track the almost 50 Dodd-Frank rules in which Exam had data and experience to offer. Judy is at the SEC instead of a corporate law firm so she doesn’t spend long hours away from her two children, and yet she worked nonstop on this project.
Dodd-Frank became law in July 2010 just weeks after my promotion. One provision required the SEC to examine and report on the 10 credit rating agencies, such as Standard & Poor’s (S&P) and Moody’s, and assigned the task to the national exam group. It was time to get to work.
TIGHTENING THE LEASH ON THE CREDIT RATING AGENCIES
What exactly are credit rating agencies? (And I’m not talking about the consumer outfits that give you your credit score, though they too are quite important.) When people in and around the financial industry talk about credit rating agencies, they’re usually referring to Standard & Poor’s, known as S&P Global, Inc. at the time of this writing,* and Moody’s. These two agencies each control about 40 percent of the ratings business.4 Henry Poor began what became S&P in 1860 when he wrote a history of the finance of railroads and canals in the United States as a guide for investors. The Standard Statistics Bureau was founded in 1906 to examine the finances of nonrailroad companies. The two merged in the 1940s. John Moody started the company bearing his name in 1909 to publish his analyses of railway finances, grading the value of railroad stocks and bonds. Fitch is another ratings agency, established in 1913, with a much smaller share of the market.5
The agencies grade the issuers of bonds (loans that pay back the purchaser based on a fixed period of time), whether they are corporations or governments, from AAA down to CCC or lower, based on their analysis of the debt issuer’s ability to pay back its loan. The higher the risk of default, the higher the interest rate paid by the issuer. Michael Milken allegedly coined the notorious term “junk bonds” to describe the highest-risk paper offered by financially fragile or highly leveraged companies (or governments with very high debts and weak economies) and therefore that paid the fattest interest rates.6
The SEC’s relationship with rating agencies began in 1975 when it set up an endorsement system for rating agencies called Nationally Recognized Statistical Ratings Organizations, or NRSROs.7 The endorsement told investors and investment funds (some of which the SEC requires to carry only highly rated bonds) the agencies that could be viewed with the highest degree of trust and objectivity. The first three NRSROs were S&P, Moody’s, and Fitch. By 2008, however, the SEC had ten NRSROs on its approved list, including a Canadian and two Japanese agencies. Because of these endorsements, the SEC essentially placed the stamp of approval of the U.S. government on these agencies as objective referees of creditworthiness in the bond market.8
The 10 NRSROs at the time were A.M. Best Company, DBRS, Inc., Egan-Jones Ratings Co., Fitch, Kroll, Japan Credit Rating Agency, Moody’s Investors Service, Morningstar Credit Ratings, Rating and Investment Information, Inc., and Standard & Poor’s.9
This context makes it easier to understand the reaction of Congress and the regulatory agencies about the rating agencies’ role in the crash. In the aftermath of 2008, Congress grew enraged with the credit rating agencies for rating collateralized mortgage obligations—bundles of mortgage debt—and other complex housing debt instruments as AAA when such instruments were far riskier. The bundles’ value depended upon an overheated housing sector fueled by skyrocketing house prices and resulting increases in home values for mortgage holders.
Mortgage companies and to some extent banks were giving home loans to most anyone who breathed and who wanted one, often without documentation (“no doc” mortgages). “Lawmakers, regulators and investors have trained their cross hairs on S&P and its peers for assigning rosy ratings to thousands of complex securities that were later downgraded within the span of a few months, deepening the crisis,” one trenchant Wall Street Journal article by Jeannette Neuman and Jean Englesham reported in September 2011.10
Dodd-Frank called for two solutions. One created an office of credit rating agencies at the SEC to promulgate further rules for the agencies and require annual exams of the agencies and a public report on the findings of those exams. The second significantly increased the agencies’ liability for issuing inaccurate ratings and made it easier for the SEC to impose sanctions and bring claims against them for material misstatements and fraud.11
By the fall of 2010, the SEC’s new office hadn’t been created yet, but the statute did require the SEC to examine the credit rating agencies each year. Dodd-Frank directed no other requirements for our division other than the credit rating agencies’ exams. In a good example of how things go wrong between writing and regulating a law, Dodd-Frank required the SEC to examine and report on the agencies annually, but it didn’t say whether the report should be completed in the next fiscal year or the next calendar year. Since the statute passed in July, did that mean a report was due for 2010 or 2011? Calendar or government fiscal year? In the end, we decided to go with the government fiscal year; the statute passed in July 2010 so we made our deadline for the first set of exams to be completed by September 30, 2011.
Dodd-Frank charged the SEC with policing the raters to make sure they abided by their own procedures, but we were prohibited from meddling in the ratings process itself. Instead, we reviewed whether or not agencies complied with their own written procedures and policies and avoided conflicts of interest. This could include ensuring that agencies protected market-sensitive information and that their rating committees properly met to discuss any rating decision. The SEC was empowered to refer cases to enforcement authorities if it found problems.12
Now Exam had to get it done. When I met Jon Hertzke in August in my office in Washington, I felt great relief about our prospects. Jon brought a nice presence. He was big, was taller than I am, and had a thick beard and a ready open smile. He grew up in Utah, but as a gay man, he didn’t find Mormon culture was a great fit. After getting his law degree, Jon left Utah for the East Coast. At the SEC, Jon had starred in a number of staff roles including working as an examiner for the broker-dealer and securities markets exam groups.
Because a 2006 law that was passed when President Bush was in office gave the SEC some oversight tasks for the rating agencies, the SEC was ahead of the curve. Jon’s securities markets team at the SEC was among the first to see signs amid the smoking wreckage of the crash that the agencies had issued some questionable ratings. Had the big agencies become empires unto themselves? Was more oversight needed? To get the exams done in a year, I needed a team of examiners to start digging into the methods and potential conflicts at the ratings agencies. Jon volunteered to lead the examinations, a big leap for him at the time because he wasn’t known as a credit ratings expert and could have been second-guessed if he made any wrong moves.
As I got to know Jon, I understood his decision. Jon likes to take on new projects and grow into them because he is tremendously devoted to the mission. He’s fearless that way. Jon likes to be where the action is, and he didn’t give a lot of thought to how it would “sell” around the SEC.
“Look, we have to examine all of these credit rating agencies,” I told Jon at our August meeting. “This is the only thing that the exam program has been assigned out of Dodd-Frank. It is our responsibility. We are monitoring 50 of the rules, and Judy Lee is working on that whole thing. But this one is on us.”
The exam program was at the nadir of its existence, having missed Madoff and Stanford. We had 10 high-profile exams to complete, and our report would be read very carefully by many denizens of Capitol Hill and the media.
“Jon,” I went on, “we are not going to screw this up! If this has to be done within the year, we are going to do it within the year.”
“Sure,” he said, “I’m in. Got to be done.”
Oh, that was refreshing. This guy isn’t getting away from me, I thought.
Then our conversation yielded another example of the bizarro* decisions produced by the SEC bureaucracy. Jon told me that, in the wake of the 2008 crisis, the SEC actually hired several qualified analysts from the credit rating agencies. But the SEC required these examiners to move to Washington, DC, and operate from national headquarters. How absurd! These folks were overseeing three major credit rating agencies located within blocks of the SEC’s New York office. In fact, I used to walk past the Moody’s offices every day on my way to work. Shortly after the meeting I authorized the credit rating agency examiners to move back to the city if they wanted and work in the part of the New York regional office reserved for personnel who reported to groups actually located at the SEC’s Washington headquarters. In fact some of them did so, although one or two opted to stay in Washington.
As bizarro decisions tend to do, assigning the examiners to Washington eventually served up bad karma. The Republicans had recaptured the House of Representatives in the fall elections of 2010, riding the success of Tea Party candidates who ran on a limited-government platform. As a result, the House joined with the Senate in giving the SEC a “flat” budget—that is, the same dollar figure as the year before.13 This actually curtailed our spending, because items like the union’s collective bargaining agreement mandated steadily rising pay no matter what the budget situation was. As is common in many agencies, the SEC responded by redlining travel spending because it could control that cost. As the guy who had to carry out the credit rating agency exams with the few examiners we had located in Washington, a sudden ban on travel was a real issue. We were able to free up limited funds to send some of the examiners to New York for the exams. Nonetheless the decision to locate the examiners in Washington made our lives extremely difficult.
Given all of Exam’s failures relating to Madoff and Stanford, which we had to explain on nearly a daily basis to Congress or the press, I was determined we’d get these exams done and the public report issued in a timely manner. However, our team faced an unusually tough deadline conducting 10 exams and issuing a public report on them in a little over 12 months. Exam teams would need to visit all agencies, including the two in Japan, draft the report, and have the commission approve it. For high-profile assignments of this nature, Mary Shapiro’s office made sure we had the funding we needed to travel.
We borrowed examiners from the investment management and broker-dealer programs despite their other duties. As deputy director I had the authority to do this, but it wasn’t fun. Borrowing another group’s staff amounts to an act of bureaucratic warfare. My assistant directors were not happy that we took their people, which resulted in more work for them and everyone else. I would have felt similarly frustrated in their place. But there wasn’t a choice. Congress and the media were watching. If we screwed up, the entire country would be watching, in truth. It was our mission, and we were going to complete it.
Dodd-Frank charged the SEC with reviewing the raters on the following grounds:
• Did the raters ensure they follow policies and procedures regarding each rating?
• Are they managing conflicts of interest by making sure there is a separation between sales and people doing the ratings?
• Do they follow their ethics policies?
• Is their governance aboveboard?
• Are they allowing their designated compliance officer to perform his or her duties appropriately?
• Do they follow guidelines in managing conflicts and implications of postemployment activities for former staff?14
By the spring of 2011, our team did complete all 10 ratings agency exams. It took an all-out effort. We finished the report on time as well, and the SEC released it in September. You can find a link to the report on my website at http://www.normchamp.com.
THE CREDIT RATING AGENCIES STRIKE BACK
By early August 2011 my team was finishing the report on the raters. The exams were done, and we were getting the latest patient into recovery and ready for discharge. I remember it was a wet, windy August with many thunderstorms (which culminated when Hurricane Irene hit the New York and New England region late in the month with significant flooding). I was hoping things would slow down so I could get out to Martha’s Vineyard to join my family for our vacation. And that’s when the ambulance pulled up, and the next crisis came through the double doors. I was in the office early on Thursday, August 4, answering e-mails. My phone rang, and caller ID showed “Hertzke, Jon,” who by now had become one of my most trusted allies.
“S&P is going to downgrade the credit rating of the United States,” he told me. “The story’s going to be page one in all the papers.”
Oh, great. I didn’t think it would really happen. The roots of this went back to April 2011 when S&P announced a ratings review of the U.S. government, which is like saying we’re going to audit your taxes aggressively.15 As with most preliminary announcements of this kind, it barely drew a look from anyone except Treasury, the SEC, and some members of Congress. But during the summer of 2011, the Tea Party Caucus with the new Republican majority in the House of Representatives tried to get a handle on massive deficit spending by the Obama administration and Democrats by refusing to raise the debt ceiling. This is the legislative limit placed on the entire debt of the U.S. government in the form of bonds and securities. The administration and Congressional Democrats racked up massive annual budget deficits that necessitated the issuance of more government debt. The budget is in surplus or deficit each year depending upon the annual difference between the federal government’s revenue (taxes and fees) and its allocated expenditures for that year. The federal government’s debt is all of Uncle Sam’s obligations added together.
The debt ceiling controversy continued into the summer, and the Tea Party Caucus vowed as a protest to block any votes raising the debt ceiling limit. Raising the ceiling was necessary, many argued on the other side. Without a debt ceiling hike, not only could the United States be in default with its creditors, but the federal government wouldn’t be authorized to pay its bills, and all nonessential government operations would be closed. This is what led to the familiar “government shutdown” rhetoric of that time. S&P identified these events as significant enough to pose a threat of instability to the good credit of the United States—that is, S&P saw an increased risk to repayment of U.S. bonds, i.e., “Treasuries.”
Jon was right about the coverage the next day. There’s the New York Times headline: “S.&P. Downgrades Debt Rating of U.S. for the First Time.”16 The lead sentence in the Washington Post’s story read: “Standard & Poor’s announced Friday night that it has downgraded the U.S. credit rating for the first time, dealing a symbolic blow to the world’s economic superpower in what was a sharply worded critique of the American political system.”17 And the Wall Street Journal carried parts of S&P’s press release: “We lowered our long-term rating on the U.S. because we believe that the prolonged controversy over raising the statutory debt ceiling and the related fiscal policy debate indicate that further near-term progress containing the growth in public spending, especially on entitlements, or on reaching an agreement on raising revenues is less likely than we previously assumed and will remain a contentious and fitful process.”18
Behind the scenes (as we later learn) President Obama, his team, and Treasury secretary Tim Geithner were angry about the downgrade and had already told the folks at S&P that they’d made a mistake in their model that added $2 trillion to S&P’s claims about the U.S. deficit.19 (S&P disagrees it had made this error.) S&P and the U.S. government litigated for years afterward over whether a phone call Geithner made to S&P after the downgrade led to a lawsuit by the government against S&P for its failures in the crisis.20 But we didn’t know anything about this kind of acrimony. We were in the throes of finishing our new report on the exams of the rating agencies, and here S&P had taken a huge whack at the hornet’s nest of the Beltway budget fight, generating tons of controversy and news.
My thought was that we needed to go and talk to S&P. That’s what I told Jon, and he concurred. So I called Schapiro’s chief of staff in the afternoon.
“Look,” I told Didem, “we want to let you know that we are planning to visit S&P on Monday and talk to them. We want to ask about their policies and procedures in downgrading the rating. What’s behind this mistake in their model? Have you analyzed it?” The chair’s office agreed with what we were planning, and I called over to S&P to set up the meeting. Jon flew up Sunday, and we arranged to meet outside S&P’s offices at nine o’clock Monday morning.
Before I headed over, I got a call from a reporter asking about our plan to visit S&P about the downgrade. I nearly spit out my coffee. This was meant to be a no-drama sit-down just to understand what procedures S&P followed on the downgrade. You have to be kidding me! I told the reporter we had no comment. How the hell did this get to a reporter? Only a half-dozen people knew, and I doubted anyone at the SEC would have leaked this. It wasn’t our way.
We showed up at S&P at 55 Water Street. Jon and I walked in and went through security, got our badges, checked in, and headed upstairs.
We got off the elevator and walked into the hall that always seemed unusually long and quiet. I’d had a few meetings on this floor before with management, and the conference room was at the end of the hallway perhaps 50 yards away. Jon and I were a few strides from the door when a senior executive of S&P came out of the room, turned toward us, and started screaming: “How the hell can a reporter know that you are coming here this morning?! How was this meeting leaked?”
Jon and I stopped. “Listen,” I said, raising my hand in the universal palm-facing-out, chill-out-for-a-second gesture, “We didn’t leak this. Jon and I and Schapiro and a few other people knew about it, and we’d have no interest and no benefit in leaking this. We haven’t leaked anything about the agencies during the whole examination. So I don’t know what is going on. Let’s just go inside, and let’s just calm down.”
We crossed into the conference room. The upset executive had taken a seat, refusing to look our way. I saw S&P’s new CEO Doug Peterson getting up as we came in. The heads of S&P’s government ratings group were there as well as the head of European ratings and some of that group’s senior ratings people. Peterson came from Citibank as a steady, seasoned global financial manager, and I had grown to like him so far. He shook our hands and turned to say, “This is Floyd Abrams down here at the end of the table.”
There he is, indeed, the famous constitutional scholar on the First Amendment. I’d know him anywhere. S&P had hired one of the world’s name-brand lawyers to advise it on this meeting.
Peterson conveyed his concern that we were there to muzzle the credit rating agency based on S&P’s downgrade of the United States government’s credit rating.
Floyd Abrams looked up as we sat down. Abrams said, “We’re here to preserve their [S&P’s] First Amendment rights to say what they please.”
Once again, I gave the universal palm-out, calming gesture. “Look, can we just take a time-out here?” Keeping my voice calm though I’m getting aggravated, I went on: “As you know, we were charged by Dodd-Frank to regulate you and to conduct regular exams of you. We just finished the first exam. We saw your rating downgrade of the U.S., and we saw that there might have been a problem with the model. We are civil servants. We work for the government. We are following our statutory responsibility to dialogue with you about these issues.
“What are we going to do? Stay home? No. We are going to come, and we are going to talk to you. And we are going to ask you about whether you followed your policies and procedures. I don’t care if you downgrade or not. I don’t care what ratings you issue, but we do care about your process. We are not here to muzzle your First Amendment rights. But we are here to understand if you acted the way a regulated entity is supposed to act in these circumstances. That’s it.”
I saw heads nodding in agreement all around as the room calmed down. And then Peterson said, “How was this leaked to a reporter?”
I replied, “I had the same reaction. The only people at the SEC who know this is happening are me, Jon, Mary Schapiro, the chief of staff and a few others. We didn’t even tell the commissioners we were coming. There are maybe half a dozen people at the SEC. I doubt any of them are leaking it. So I don’t know where it is coming from.” Later I thought that S&P might have leaked it because it was under fire from Treasury, and it wanted to create the impression that it was being harassed. Or who knows? Perhaps someone in the SEC chair’s office leaked it to show the administration and Congress that the SEC was on the case. We never found out who it was.
But if Jon and I were caught leaking this kind of information, we’d lose our jobs. That’s it. I said to Floyd Abrams and his band of merry men, “You guys leaked this—or someone on our side did, someone way above our pay grade. I can promise you that Jon and I didn’t.”
Abrams shook his head slightly and half smiled, Peterson murmured something to him, and the meeting went smoothly after that. With his usual professionalism, Jon grilled the S&P leadership about its process, and we went back to the office satisfied with the answers. I must say that I am proud that S&P later countersued Treasury for harassment over the downgrade but not the SEC.21 We did our jobs under the law and did not overstep our responsibilities.
TRIAGE
The SEC chair’s office is headquartered in a sleek, white granite and curved glass building connected to Washington’s Union Station not far from the Capitol. It provides a spectacular view of the skyline of Washington and the Capitol dome. For SEC chair Mary Schapiro, the sight of the congressional building served as a daily reminder of the cost of further failures in the financial sector. “I like to tell the staff we are going to act like our hair is on fire,” Schapiro told reporters in the first weeks after she was appointed.22
Schapiro promised Congress during her confirmation hearing that she would take the handcuffs off the SEC’s Enforcement division and use them to apprehend fraudsters like Madoff before they could do further damage to the economy. The case of Allen Stanford particularly haunted Schapiro as an avoidable tragedy—and one that she would not allow to be repeated.23
The SEC’s examiners in Texas had suspected fraud at Stanford’s operation from as early as 1997, when examiners went to his firm for the first time. Stanford should have been an obvious outlier in that he purported to be able to make money for U.S. investors by investing in certificates of deposit issued by a bank in the Caribbean island nation of Antigua. Stanford himself was a prominent figure in Antigua, where he owned a cricket team and sponsored numerous sporting events. Stanford’s operation was just the latest variation on an old fraud scheme referred to as a “prime bank” scheme. While the scheme has taken many forms, essentially the wrongdoer sells investors on the idea that he has access to a bank instrument that is completely safe but that bears an interest rate far in excess of market interest rates. Like so many frauds, the prime bank scheme depends on a lack of sophistication by investors and a desire for risk-free returns that are not realistic.
There were obvious clues that Stanford’s operation was a fraud. For instance, why would banks in Antigua, a Caribbean island that enjoys prosperity, pay interest rates far in excess of the interest that U.S. and other banks are paying? Stanford’s con could not have worked without the skills of a master manipulator. Through his huge body frame and slick personality, Stanford intimidated and charmed associates and clients. As with many of these schemes, victims were taken in by the fraudster, and some continued to defend him even after he was arrested.
The troubling twist in the Stanford case? SEC examiners suspected early on that Stanford was a fraud, but they were unable to convince their enforcement colleagues to pursue the case. Examiners even wrote in a report in 1997 (12 years before his arrest) that Stanford was running a “possible Ponzi scheme.”24 However, they could not get the Fort Worth Enforcement staff interested in launching an investigation of Stanford that that would have shut the fraud down. Why? Allegedly because enforcement officials in Fort Worth worried about the difficulty of getting evidence from Antigua that might have made the case time consuming.25 This calamitous breakdown at the SEC led to the public testimony of examiner Julie Preuitt before Congress and the world that I wrote about in Chapter 1.
Unlike Madoff’s case, which dominated headlines and whose victims included many wealthy and powerful New Yorkers, the Stanford fraud was laced with the additional bitter salt that the more than 30,000 investors Stanford bilked recovered little money. Fortunately, a jury restored the scales of criminal justice with a guilty verdict, and the trial judge sentenced Stanford to 110 years in prison.
If I had to express Schapiro’s approach to running the SEC in three words, it would be these: No more Stanfords. His colossal crime hovered over us like a dark cloud whenever another potential fraud emerged. Not only had Stanford happened, but MF Global, the investment brokerage run by former New Jersey governor Jon Corzine, was in trouble because it couldn’t cover its bets on European bonds and had transferred customer funds to cover certain losses. SEC examiners were crawling all over that place. MF Global eventually declared bankruptcy on October 31, 2011, proving that you can be a big brokerage and still fail.*
Enter Dallas-based Penson Worldwide, Inc., which handled securities trades for U.S. brokerages and also ran a futures brokerage. It was huge, trading for over a million customers. It was a publicly traded company on Nasdaq. Penson disclosed in May 2011 that “it had accepted $42 million in bonds issued by an entity that controls the Retama Park racetrack as collateral from a number of customers.”26 The bad deal became even more toxic when Penson revealed that a member of its board was chief executive of the company that managed the racetrack and owned a large slice of the bonds.27 Not good, although the board member would later resign. Penson’s filing stated, “It is possible that the value of the collateral . . . might be impaired, resulting in a write-down of a portion of these receivables that could be material in amount.”
Indeed.
The racetrack bonds issue got the attention of market watchers, and Penson’s shares lost 50 percent of their value.
Julius Leiman-Carbia brought Penson to my attention in May. He had started as head of the broker-dealer exam program in April and was just starting to push for change.28 Julius gave me a call and told me he was watching this huge broker in Texas that had a big problem. I started looking at it and reached out to John Ramsay, who was deputy director of Trading and Markets (the policy division that sets the rules for brokers). The three of us realized after a few hours of analysis that Penson probably would fail.
It’s very simple if you are a broker holding people’s money: when all trades are netted out at the end of the day, you have to be cash positive or be able to borrow funds to be in the black. If you can’t do that, you’re out of business.
For a week or so we monitored whether Penson was capital positive at the end of the day for all its trades. As the movie cliché goes, I had a bad feeling about this. I got in touch with Julius and John.
“We have to get down there now,” I said. “Let’s reach out to the Fort Worth office and let them know.”
The staff of the Trading and Markets division culturally was cautious about stepping into a company’s operations and preferred monitoring the situation. But Julius and John saw how dangerous this was. So I called Fort Worth and told the staff that we had a real problem and needed a monitoring team on-site. Even after Stanford and MF Global, I could tell that the staff there were uncomfortable with a monitoring role that was not an exam.
I saw it differently. The collapse of another major trading firm could trigger a fresh episode of panic among investors, consumers, and Congress. We needed a trauma team of SEC staff watching the patient very closely. We needed to know if this massive broker-dealer was going to crash.
We had a meeting with Schapiro in early July.
“I don’t care about finding violations with an exam,” I told her. “I need to know every day if they’re going to make it to the following day. Their customers don’t know how bad this is—yet. So we don’t have a huge run on capital, but it could happen.”
Schapiro noted that another MF Global or Stanford could start an avalanche.
A few minutes later, she told us, “I want to do something now. This can’t happen.”
The Fort Worth folks still were dragging their feet. I got my own team together to monitor Penson. I assigned Valerie Bushfort, a terrific staffer, to lead the monitoring team on-site. (She has since left the commission and lives with her husband in Alaska, where they bought some land. Someone should bring her back—she’s that good.) She started talking to the Penson operations people and looking at the company’s accounts. Penson couldn’t be one penny in the red at 5 p.m. or it was over. We started learning more facts on the ground even as Penson was saying that the firm would survive the racetrack bond disaster and the firm’s lack of profitability.29 Penson’s cash position was even worse than we thought. As a publicly traded firm, its bankruptcy would be a major event.
We determined that John Ramsay and I would go to Texas and meet with Penson’s management and board. Schapiro wanted us to go as soon as possible. I was in Washington that day, so instead of returning to New York, I walked over to Union Station and bought an extra shirt at Andrew’s Ties, and we left for Texas that night.
We drove over to Penson in the morning. The offices are in downtown Dallas on Pacific Street, a boulevard of glass and steel corporate office rectangles and cylinders. I spotted a few nice cafés and drugstores nearby. We parked and went upstairs and joined the members of our monitoring team in the conference room. They were working well with Penson’s operations people, who were feeding us everything we needed. We knew what was happening with Penson’s cash pretty much minute to minute. Valerie briefed us that it was a very close call each night as to whether the company could stay open another day. Earlier she had picked up a valuable piece of intel that Penson was holding a board meeting that morning—which was part of the reason we wanted staff on-site—so we could learn these kinds of details.
So Ramsay and I started walking down the hall to the board meeting. The CEO intercepted us in the hallway.
“I want to talk to you before we go in the board meeting,” he said.
I said that was fine. And so Ramsay and I sat down with him in his office.
“What’s the issue?” he asked.
I told him, “As you know, Penson is barely passing its capital test every day. You are able to borrow, but people are nervous. We have a lot of issues, and we are very concerned about the firm.”
Forcing a smile, he told me the firm had been through these things before and would get through this.
“Well, we’re not sure you’ll get through this.”
Now I knew his name was over the door. Penson is an acronym of his name and the cofounder’s name. I knew he had a lot of pride and built this business. I respected that a great deal.
He repeated his view that the firm would get through.
“We are not so sure,” I replied. “I’m sorry. I wish it were otherwise.”
“We just had MF Global,” I told him, not to mention Stanford. “We cannot have you go down in a huge public flameout. The U.S. economy cannot have you go down. So we are going to talk to the board, and then we want you to get restructuring and bankruptcy lawyers. We want you to get a bankruptcy workout banker. We want you to make plans for whether you are going to have to go bankrupt or whether we can sell you to someone else.”
He reacted like a guy who came to the ER with chest pains only to have the surgeon tell him he has to have a triple bypass.
“What are you talking about! You can’t say that to the board.”
“Actually I am going to,” I said. “Look, you are our registrant. We have to hold you accountable, and we’ll come under fire if we don’t. We almost had a global economic depression a couple of years ago, your future is questionable, and you don’t get to do just ordinary business.”
So we went into the board meeting to meet with the directors of the corporation. I said all those things. I told them how we were worried about their capital and really didn’t know if the company was going to make it. I told them about Lehman and the stakes for the U.S. government. While Penson’s cash position wasn’t as public as Lehman’s, because it was a clearinghouse, many of the clients were not only leveraged day traders but small brokers on Main Street whose clients wouldn’t even know the name of Penson when its bankruptcy caused their portfolios to crash.
The board members were actually much more open to us than the CEO. They were scared. They realized the senior people from the SEC were sitting there saying you have a problem and the whole world could watch you go under. The board members had reputations outside Penson. Their names weren’t on the door, but their names would be in the lawsuits, the newspapers, and the prosecutorial briefs.
We could see they were uncomfortable and beginning to sweat (some of them literally). So we started calmly talking to them about what they needed to do, the next steps, how to handle this in full compliance. I told them we’ll have our team to advise them. A couple of the board members made a point to reassure us: “We will get advisors. We will get lawyers. We understand.”
John and I didn’t want any disputes about what we said at that meeting. So we sat down afterward and drafted a letter detailing our guidance to the board members. They needed not only to obtain restructuring lawyers and bankers but to look for a merger partner. They needed to prepare in case they had to go bankrupt, they had to think about what would happen to three million accounts if they went under, and they had to coordinate with us. You can’t walk out of a meeting like that and not have a written record of what was said. John and I knew that could be a nightmare. They could easily or even inadvertently twist what we said or misrepresent what we said. We knew we were vulnerable. We may have been the government, but if something went wrong, we’d take the blowback.
We agreed that the best course for Penson was to merge with a firm that had better capital. Mary, Julius, John, and I felt heartburn for investors if the brokerage behind a million customers vanished into bankruptcy. Now this wasn’t about saving Penson, because a merger was going to scoop up the accounts and assets and leave not much else of value. Penson was dying, only slowly.
By the fall I stepped back from a lot of the daily maneuvering but did help with finding a buyer. Penson talked to some huge firms, most of which didn’t like all the baggage that came with the company’s three million accounts (some customers had multiple accounts). In the fall we connected Penson with a prospective buyer, a well-known brokerage. Talks dragged on through the holidays and ultimately broke down.
At last in April 2012, Penson sold its securities-clearing operations to a company called Peak6Investments, Ltd., and later moved its futures brokerage business to Knight Capital Group. By January of the next year, Penson had gone gently into that good night, declaring bankruptcy for its remaining business, Nexa Technologies Inc.30 We spared investors the nightmare of the largest brokerage failure by number of customers and accounts in U.S. history. Despite the SEC’s byzantine ways, the agency had managed to intervene and prevent the public destruction of a major brokerage when consumer confidence in the economy hung by a thread. We’d established new oversight for the beleaguered credit rating agencies. With the issuance of the first Exam manual in January 2012, we had national standards and process in place for the previously autonomous regional offices. Sometimes the gang could shoot straight after all.
*At the time of the crisis, the McGraw-Hill Companies was the parent company of this book’s publisher and Standard & Poor’s. However, the educational and publishing divisions were spun off as a separate company long before my book was published. The publishing group and S&P have nothing to do with each other.
*Bizarro was a character created by DC Comics as a villain in the Superman/Superboy/Supergirl universes. As his creator, Alvin Schwartz, explains, “I was striving, you might say, for that mirror-image, that opposite. And out of a machine which would reveal the negative Superman, came the mirror image—always remembering that in a mirror everything is reversed . . .” “Bizarro,” DC Comics Encyclopedia, p. 631 (2008).
*As Stephen Gandel reported in Time, “But what is surprising and interesting about its failure is that MF Global doesn’t specialize in the credit default swaps type of derivatives that got AIG and others in trouble in the past. Instead, it specialized in more plain vanilla derivatives that are traded on exchanges. At least that was the case until March 2010, when the firm was taken over by a new leader, the former NJ governor Jon Corzine. In addition to having run New Jersey, Corzine was also a former head of Goldman Sachs . . . Corzine plunged the firm into proprietary trading—a risky business from which recent banking reforms have tried, perhaps unsuccessfully, to ban the big banks from doing.” See Gandel, “Understanding MF Global: Why the Bank’s Failure Matters,” Time, Nov. 1, 2011, http://business.time.com/2011/11/01/understanding-mf-global-why-the-banks-failure-matters/.