November 5, 2009, was a good day for the Securities and Exchange Commission. At a press conference with the U.S. attorney’s office in Manhattan, new SEC enforcement director Robert Khuzami announced that his agency was bringing civil charges against 13 people associated with the Galleon Group insider trading scandal. In the post-Madoff era, it was a chance for the SEC to show that it is back on the beat aggressively policing the securities markets. And it was an opportunity for Khuzami, who can mix financial crime gravitas with Jon Stewart–age ironical detachment, to set a different tone.

“There should be a moment–hopefully before you’re holding a bag of cash delivered to you by somebody code-named ‘the Octopussy’–that causes anyone in a position to tip or trade on inside information to think twice before taking such a misguided step,” Khuzami said in his prepared remarks. “And if you find yourself chewing the memory card in your cell phone to destroy any record of your misconduct, something has gone terribly wrong with your character.”

Khuzami is a leader for the media age. Since taking office last March, the 53-year-old former federal prosecutor and corporate lawyer has delivered dozens of speeches, making him the most visible enforcement director in a generation. His dry sense of humor, genial demeanor, and resume–11 years in the Southern District of New York, including a stint as head of the securities fraud unit–have helped him bring about the most sweeping changes at the 1,200-person division since the 1970s. In the past year he eliminated an entire level of management, formed national units to concentrate expertise in five major areas under the agency’s purview, and created a new system to handle tips and complaints. Recently he borrowed pages from the prosecutorial playbook, extending cooperating-witness immunity to informants, and creating an SEC version of a deferred prosecution agreement.

These initiatives were meant to restore confidence in an agency blamed for failing to sound a warning on the risky practices that led to the biggest financial collapse since the Great Depression, and for its botched effort–detailed in a damning 477-page report by the SEC’s own inspector general–to stop Bernard Madoff, arguably the greatest criminal fraudster of all time. The reforms were also meant to bring a measure of prosecutorial muscle and streamlined process to an enforcement division that has seemed defined, in the past few years, by its labyrinthine bureaucracy.

But as Khuzami reaches his one-year anniversary on the job, Congress, investors, and the industry his agency regulates are waiting to see whether structural changes and a beefed-up docket—enforcement actions are up under Khuzami–will lead to real change. Will there be more significant cases like the Galleon investigation, conducted in tandem with the U.S. Department of Justice? Or will there be more embarrassments, such as the rebuke from Jed Rakoff, the Manhattan district court judge who scuttled the agency’s initial settlement with Bank of America Corporation? Khuzami was hired to shake up the division. So far, he has done just that. Those looking for him to remake the enforcement arm in the image of a U.S. attorney’s office, though, are likely to be disappointed. In interviews, he preaches reform, not revolution. “You can’t just airlift a model from one organization to another,” he says. “You have to customize to reflect the realities of the organization.”

Will measured change be enough to restore faith in the SEC?

On a cold day in January, Khuzami settles into a seat on the top floor of the restaurant America in Washington, D.C.’s Union Station. From here he has a commanding view of the grand old railroad depot, but he chose the spot for a more pragmatic reason. SEC headquarters is next door, accessible through a little-known passage. In his first six months on the job, when he was working 18-hour days and commuting home to New York on weekends, Khuzami ate lunch at Union Station every day. This, still, is as far as he likes to range.

In interviews, Khuzami comes across as even-tempered and cerebral, subject to long, discursive answers to policy questions. He gamely replies to questions about his past, though he is rarely the hero in his own stories. Friends attribute this general lack of ego to a working-class background and education that was quite different from most of his white-shoe peers.

Khuzami was born in Brooklyn in 1956, the son of professional dancers. His father, a Lebanese immigrant (the family name is Persian), managed two Arthur Murray studios. Later, the family moved upstate to Rochester. As the dance craze faded, and the studios closed, his parents turned to teaching lessons in middle schools. Eventually, to make ends meet, his father, who dropped out of school after the eighth grade, went on the road, selling correspondence courses, and taking odd jobs at department stores over holidays.

After high school, Khuzami worked for a year tending bar and painting houses, and then enrolled at the State University of New York at Geneseo. He transferred to the University of Rochester before his junior year, in part because his mother’s secretarial job there provided a partial tuition waiver. To make ends meet, he worked the 10 p.m.-to-6 a.m. shift three days a week unloading freight for a trucking company. “I was committed to the notion of convincing the Teamsters I worked with that I wasn’t some wimpy college kid,” Khuzami recalls. One night he tried to pick up a box that was covering a skid with a piece of heavy machinery in it, and spent the next week in bed with a ruptured disc.

After college, he went back to painting houses. “I got a contract to paint 200 townhouses,” Khuzami recalls. “They were identical down to the layout. I grabbed a five-gallon bucket and a roller and brush, and did the same thing every day. It was like The Twilight Zone. I realized I didn’t want to be doing this for the rest of my life.”

A star student at Rochester, he was accepted to Boston University School of Law, where he edited the American Journal of Law and Medicine. In 1984 he went to work at Cadwalader, Wickersham & Taft. As a litigation associate, he made friends with partner Richard Walker, who was later SEC enforcement director, from 1998 to 2001, and who is now global general counsel at Deutsche Bank AG. Walker remembers Khuzami coming in to the office at 4 p.m. on a Saturday, after spending the day moving from one apartment to another, to write a complicated Racketeer Influenced and Corrupt Organizations Act claim to help defend the target of a potential takeover. They remain close. Walker describes Khuzami as “simply unflappable” and “the world’s cheapest man” (this after recounting a story about how Khuzami refused to replace an old Honda until his wife, Julie, who was pregnant, demanded that he do so). Khuzami and his wife have two young daughters.

Khuzami joined the Southern District’s office in 1991. He quickly impressed Andrew McCarthy, a more experienced prosecutor, who second-chaired one of Khuzami’s first trials. “I was a potted plant,” McCarthy recalls. “I didn’t have to do anything. He was already a very polished litigator.” (At Cadwalader, Khuzami had tried a prisoners’ rights case and negotiated many securities arbitrations.)

Mary Jo White met Khuzami on her second day on the job as the new Manhattan U.S. attorney. “I was taken with his sense of humor and maturity,” she recalls. “He had a fine reputation as one of the smartest people in the office.” In 1993 she assigned him to a career-changing case, the prosecution of Sheik Omar Abdel Rahman—the Blind Sheikh—and his associates, who had plotted to blow up New York landmarks, bridges, and tunnels. In his book Willful Blindness, McCarthy, who along with Patrick Fitzgerald would prosecute the case with Khuzami, described the opportunity to try such a high-profile case as akin to being asked to pitch the seventh game of the World Series. (Years later, Fitzgerald led the investigation of the Valerie Plame imbroglio.)

As head of the securities and commodities fraud task force, from 1999 to 2002, Khuzami brought a case involving a mob union pension fraud and Ponzi scheme that led to 121 arrests in one day. Andy Applebaum, who ran the general crimes unit at the same time, and shared an office with Khuzami early in their careers at the U.S. attorney’s office, credits his former colleague with being able to manage up and down. “Mary Jo White is a very tough person, and very demanding of her unit chiefs,” Applebaum says. “He handled that well. He made her look good. He shaped the next generation of white-collar prosecutors in that office.”

In 2001 Khuzami was awarded the Henry Stimson medal, named for the former Manhattan U.S. attorney who served as secretary of War for two presidents, and who oversaw the Manhattan Project to build the first atomic bomb. In typical Khuzami fashion, he used his acceptance speech to poke fun at himself. He began by listing all of Stimson’s accomplishments. “I, on the other hand, have spent the last one-and-a-half years trying to extradite a stripper from Canada in an old insider trading case,” Khuzami said.

Three years later, Richard Walker hired him to head regulations and investigations at Deutsche Bank. When Timothy Mayopoulos, then the general counsel, left for Bank of America in 2004, Khuzami was named his successor. “It was a big step up for him,” Walker says. “Before that, he was in his comfort zone. Stepping into the role of GC, he had to become more involved in transactional work.” It was also a job, Walker says, that requires “mindless administrative patience.” Walker later recommended Khuzami to SEC chairman Mary Schapiro for the enforcement job.

Khuzami joined the agency at what was, arguably, its lowest point. A month before he arrived last spring, in a moment that is enshrined on YouTube, Representative Gary Ackerman, a Democrat from New York, told Khuzami’s predecessor Linda Thomsen and other SEC officials testifying before his committee that they were “inept,” that their value to the American people was “useless,” and—the kicker—”We thought the enemy was Mr. Madoff. I think the enemy is you.”

Given this reality, Khuzami might have the toughest mandate of any enforcement director in agency history. He must reform the division to the satisfaction of Congress and investors, while also boosting morale. His investigators must get a handle on the new technologies that allow traders with inside information to take advantage of incremental changes in the market. And he must win cases, lots of them, a point he acknowledged on his first day, when he gave a speech laying out the division’s priorities.

What constitutes a “win,” though, in the SEC lexicon, is a moving target. In the seventies and eighties, the division had few tools to pursue wrongdoers, save the threat of injunction—judicial orders to stop future violations—and, when appropriate, restitution. Yet, under legendary enforcement director Stanley Sporkin, enforcement officials used injunctions to force major governance changes at companies accused of violating securities laws. Publicly traded companies took notice and voluntarily instituted some reforms that were being foisted on their competitors. It is standard practice now, for example, that audit committees be composed of independent board members.

In 1990 Congress passed a law that added considerable muscle to the division, most notably the power to ask courts to impose civil monetary penalties on violators. In the post-Enron era, especially, the agency has relied on big penalties and fines as its chief means of deterrence. In fiscal year 2009, violators paid $345 million in penalties, a 35 percent increase over 2008. Almost all of this money came into the agency through settlement agreements.

Given that financial penalties are the agency’s biggest cudgel, many of Khuzami’s reforms are intended to make the process that leads to a settlement agreement more efficient. At the front end, Khuzami has created the Office of Market Intelligence, in an attempt to better analyze and sort the hundreds of thousands of tips, complaints, and referrals that the agency gets each year.

At the investigative stage, he revived an old idea to make enforcement generalists into subject-area experts, creating national units in asset management, market abuses, structured and new products, the Foreign Corrupt Practices Act, and municipal securities and public pensions. He has hired several Wall Street veterans, who understand how the markets are supposed to function, to advise the lawyers in the more specialized units. (Simona Suh, for example, the staff attorney assigned to the Madoff investigation, later told the SEC inspector general that she did not know the “particular steps that needed to be taken when you do a Ponzi-scheme case investigation.” Suh had worked at the agency for less than two years when she was assigned to the case.)

Khuzami also convinced the commission to decentralize authority so that formal orders of investigation, with their accompanying subpoena power, can be issued by senior enforcement division officers. (Previously, investigators often waited half a year or longer for approval, which had to come from the five SEC commissioners.) “You lose part of the message and you lose part of the deterrent effect, if there is a long gap between conduct and accountability,” Khuzami says.

Starting an investigation is easier; bringing formal charges still requires clearing several internal hurdles, much to the frustration of the enforcers. Commissioners must approve every charging decision and all elements of settlements. “What that means is that you need an enormous infrastructure to vet information and create memos so that every decision can be made by five people,” says one division lawyer. “If you are criminally charged, do you think Eric Holder, the attorney general, even knows about it?”

The BofA bonus deal seemed to fit well into Khuzami’s vision for a streamlined, faster enforcement division. In late 2008, investigators started looking into allegations that BofA failed to notify shareholders about $5.8 billion in bonuses for Merrill Lynch & Co., Inc., bankers in a proxy disclosure. Less than a year later, in August 2009, the SEC asked Judge Rakoff to approve a $33 million settlement.

Then the wheels fell off. Rakoff, perhaps empowered by outrage over the financial crisis, refused to approve it. (The settlement “does not comport with the most elementary notions of justice and morality,” Rakoff said.) He wanted to know why, if the bank relied on advice from outside counsel, no individuals were charged ["Showstopper," December 2009].

On February 4 the parties offered up a new $150 million settlement for Rakoff’s approval. Under this deal the bank agreed to a series of new oversight provisions, including hiring an independent auditor and outside counsel to monitor financial statements and disclosure, and a requirement that only independent directors serve on its compensation committee. (Still, the deal didn’t include any enforcement actions against BofA executives or advisers.)

At a hearing on the settlement the next week, Khuzami, his deputy Lorin Reisner, and George Canellos, head of the SEC’s New York office, all made personal appearances. As of press time, Rakoff hadn’t said whether he would approve the new settlement.

The settlement-as-primary-remedy model, though, doesn’t sit well with everyone. Brian Cartwright, a former SEC general counsel now at Latham & Watkins, says that when the division is confident it’s on solid legal ground, it needs to go after individuals. “The division has to be prepared to litigate more often and be tested in court, and not be afraid to lose on occasion,” he says. (Khuzami has promised to boost staffing in the 107-lawyer trial unit. The SEC had mixed results in 2009, winning at trial three times, and losing twice.)

And it has to go after the high-impact cases, says Thomas Gorman, a securities litigator from Porter Wright Morris & Arthur who runs the SEC Actions blog. Gorman says the division needs to pursue cases that “bring a new ethic to the marketplace.” That means taking Wall Street to task for the reckless practices that led to the financial crisis.

Khuzami says his division is doing just that. Last summer the SEC charged Angelo Mozilo, the former head of Countrywide Financial Corporation, with securities fraud and insider trading. Earlier this year the agency charged three former top officers of New Century Financial Corporation with securities fraud for misleading investors as the company’s subprime mortgage business was collapsing in 2006. In early February the agency announced a $313 million settlement with money manager State Street Bank and Trust Company, which was accused of misleading investors about their exposure to subprime mortgages.

In the course of reporting this story, The American Lawyer interviewed more than two dozen current and former SEC officials. If there is a shared conventional wisdom, it is that the enforcement division needed an outsider to shake up some of its traditions and correct bad habits, and that Khuzami has done just that. SEC veterans interviewed for this story were also generally inclined to give Khuzami more time to make his mark. They say that the internal reorganization, though it may seem like micromanaging, could pay big dividends. “With more cops on the beat, and if the specialized units pan out, we should see a far more effective division and agency in a few years,” says Cartwright.

That’s the view from the inside, too. “We are our people,” SEC chair Schapiro says in response to a question about whether the internal changes are substantive. “If people are not organized in ways to do their jobs efficiently, there isn’t any output for investors to measure. You don’t get the output without a well-oiled machine behind it.”

How effective are the SEC’s people? Well, that, too, is subject to debate, and, as the Madoff case showed, could ultimately pose the biggest challenge to reform. At the top, Canellos, who joined from Milbank, Tweed, Hadley & McCloy, and Reisner, who joined from Debevoise & Plimpton, are well-credentialed lawyers with corporate securities litigation experience. Both men are also veterans of the Manhattan prosecutor’s office; Reisner in the early 1990s and Canellos for eight years, from 1994 to 2002. (Canellos worked directly for Khuzami on the securities fraud task force and later ran the major crimes unit.)

Many current and former SEC lawyers interviewed for this story describe the talent level elsewhere in the division, however, as uneven. A common complaint is that agency lawyers, as compared to those who tend to work as assistant U.S. attorneys in “glamour” offices such as the Southern District, aren’t as driven to succeed. “[Khuzami's] experience is with bright kids out of Harvard or Yale who are loaded with ambition and want to work on big splashy cases, then move on,” says a former SEC lawyer. “Lawyers at the SEC have the best-paying job in government. Many of them want to make a career there, working 9:30 a.m. to 5 p.m., and taking every other Friday off. They lose their edge.”

Enforcement lawyers acknowledge that not everyone at the agency pulls his or her weight, but attribute most of the blame to poor leadership and congressional negligence. (Congress froze the SEC’s budget from 2005 through 2007, and approved only a small increase in 2008 and 2009. For 2010 the SEC got a 16 percent boost in funding, to $1.13 billion, and President Barack Obama has proposed an 11 percent increase, to $1.23 billion, in 2011, which would include $419 million for more than 100 new enforcement staffers.)

If Khuzami follows the lead of most of his predecessors, he will serve for four years or so and then return to private practice. In the final analysis of his tenure, few outside of Washington, D.C., and Wall Street will care much about how the enforcement division is organized, or how much money it won in disgorgements. The investing public, and even Congress, most of the time, only pay real attention to the SEC’s enforcement arm when it screws up. And if that happens, to some degree, it may be beyond Khuzami’s control.

William McLucas, a partner at Wilmer Cutler Pickering Hale and Dorr, served as enforcement head for eight years, longer than anyone in its history. He, more than anyone, knows that Khuzami’s success or failure isn’t entirely in his own hands. McLucas says that when he was director, he drove home every evening preoccupied by one single fear. “God,” he thought, “I hope someone working on one of the 2,000 cases isn’t doing something incredibly stupid or missing something incredibly important today.”



Walking The Talk

Enforcement division activity, which picked up steam at the end of 2008, continued through 2009 under Khuzami.

2008

2009

Increase

Disgorgements

$774M

$2.09B

170%

Formal orders of investigation

233

496

113%

Temporary restraining orders

39

71

82%

Penalties

$256M

$345M

35%

Penalties

$256M

$345M

35%

Source: The SEC