If there’s one thing Robert Khuzami learned from his experience prosecuting the first World Trade Center bombers in 1995, it’s this: “Whether you’re dealing with terrorism or securities fraud, it’s better to be in the prevention business than the cleanup business.”

As the top cop at the U.S. Securities and Exchange Commission, Khuzami has spent his first six months as the director of the Division of Enforcement tackling a cleanup of major proportions. He’s undertaken what many call the most sweeping changes of the division in 30 years, a top-to-bottom overhaul of how the agency detects and prosecutes wrongdoing in the financial marketplace.

He figures he’s succeeding, he said, if the SEC starts bringing cases that aren’t front-page news and involve small sums of money. “It means the conspiracies aren’t as far along,” he said in a lengthy interview. “We want to be better able to detect wrongdoing earlier in the cycle and minimize harm to investors.”

But the SEC isn’t there yet. The agency has faced sharp criticism over the collapse of the subprime-mortgage market, the demise of several major investment banks and, most of all, Bernard Madoff’s $50 billion Ponzi scheme.

For the thousands of people who lost their life savings as a result of Madoff’s scheme, the SEC’s failure has triggered profound anger and disappointment — not to mention a $2.4 million lawsuit against the agency for negligence filed by two victims last week. Now, under intense scrutiny from members of Congress and the SEC’s own inspector general, the agency has come to a watershed moment.

“There’s no denying the fact that the Madoff tragedy was a terrible event, a situation where we should have performed better,” Khuzami said. “We did not, and the best way to put meaning into our failure is to study the case and the outcome and determine how we can do better.”

Still, as a newcomer, it’s easy to apologize for something that clearly isn’t your fault. More crucial for Khuzami will be how the Enforcement Division performs going forward. Already he’s had one significant setback, when a New York judge issued a scathing decision rejecting the SEC’s proposed settlement with Bank of America Corp.

Nor is change easy within the agency, with staff reporting insecurity and doubt as they struggle to find their place in the new regime.

ENFORCEMENT REFORM

With the backing of SEC Chairman Mary Shapiro, Khuzami in the past two months has announced a series of initiatives to reorganize the 1,100-person division, which includes about 640 lawyers. He’s drawn on his experience as chief of the securities and commodities fraud task force in the U.S. Attorney’s Office for the Southern District of New York and, more recently, as general counsel for the Americas for Deutsche Bank A.G., to come up with the plans.

He’s formulating the first-ever standards for offering deals to individuals in return for cooperation and moving 10% to 20% of division staff into five new specialized units dedicated to specific areas of securities law.

Khuzami is also giving senior agency officials independent authority to open formal investigations and issue subpoenas and establishing an Office of Market Intelligence to handle the 700,000 tips and complaints the SEC receives annually.

There has also been a sharp uptick in the number of new cases being filed. According to an analysis by Gibson, Dunn & Crutcher for its clients, SEC lawyers brought 45% more enforcement actions in the first six months of 2009 compared to 2008, increasing to 167 cases from 114. More defendants were also charged — 527 compared to 317 a year earlier.

“The agency is filing many more cases at a much quicker pace, charging more individuals and filing more cases without settlements,” said Gibson Dunn partner Mark Schonfeld, who until 2008 was director of the SEC’s New York regional office and remains based in the city. “The more important test now will be whether the agency wins the cases it is filing.”

Khuzami said his top substantive priorities are cases related to the subprime credit crisis, Ponzi schemes and cross-market misconduct, plus accounting and financial statement fraud and insider trading.

As examples, he points to the accounting fraud charges against two former executives at American Home Investment Corp. filed by the SEC in late April, the fraud and insider trading charges brought against the ex-chief executive of Countrywide Financial Corp. in June, and an insider-trading case against a bond salesman at his old employer, Deutsche Bank, and a hedge fund manager at Millennium Partners in connection with credit default swaps.

But amid the flurry of new cases, the rejected Bank of America settlement stands as an embarrassing slap in the face to Khuzami and the division.

In September, U.S. District Judge Jed Rakoff of the Southern District of New York refused to approve a $33 million settlement between the SEC and Bank of America. The SEC alleged in August that the bank had lied to its shareholders prior to its takeover of Merrill Lynch by failing to disclose billions in bonuses owed to Merrill employees. In his order, Rakoff questioned why bank executives or their lawyers weren’t sued and said the proposed settlement was “neither fair, nor reasonable, nor adequate.” The case is set for trial in March.

Rather grimly, Khuzami noted, “The number of corporate-only penalty cases is quite low.” But he said, “I don’t think the [Rakoff] decision will change our way of thinking when it comes to negotiating future settlements.”

He explained, “Corporate penalties send the important deterrent message to managers and executives that their organizations will suffer financially and reputationally if they are not operated in a lawful manner.” Khuzami said, “We also recognize that shareholders will indirectly absorb the cost of those penalties. So there is a balancing that occurs in these cases, one that we always engage in and will continue to engage in.”

REWARDING COOPERATION

Securities lawyers seem most intrigued by Khuzami’s initiative to lay out standards for rewarding people for cooperating with the agency in investigations — in securities lawyer parlance, creating a “Seaboard” for individuals.

In 2001, the SEC released the Seaboard report (named after Seaboard Corp., which was under investigation) that detailed how it would credit corporations for self-policing, self-reporting, cooperation and remediation when making enforcement decisions. But no comparable standards exist for individuals. Khuzami aims to change that.

“I think it’s a wonderful idea,” said Treazure Johnson, a Washington-based Venable partner who until 2005 was senior assistant chief litigation counsel at the SEC. “If someone wants to cooperate, they should be rewarded. And it will be more productive for the investigation.”

Khuzami said his intention is “to secure higher-value evidence. There’s no substitute for witnesses who are on the inside of various schemes or who have first-hand knowledge, and we need to incentivize those persons to come forward.”

Individuals could face lesser charges or lighter sanctions in return for cooperation or, in extraordinary circumstances, get a free pass entirely.

The standards are almost finalized, and Khuzami said a policy statement will be published in the Federal Register in the near future.

“It has the potential to change the landscape,” said Jeff Robertson, a SEC enforcement partner in the Washington office of Mayer Brown. “Right now there is absolutely no incentive for individuals to come forward. Of course, the devil is in the details of what the policy says and how it’s implemented.”

THE WHITE SHEEP

Khuzami, 53, is the son of two professional ballroom dancers. His sister is an artist and his brother is a musician. “The family joke is that my parents would say, ‘He’s the white sheep of the family, where did we go wrong?’ ” Khuzami said.

He earned his law degree from Boston University in 1983, then clerked for Judge John Gibson of the U.S. Court of Appeals for the 8th Circuit. He joined Cadwalader, Wickersham & Taft as an associate, moving in 1990 to the U.S. attorney’s office in New York. Initially, he was assigned to the general crimes unit, then was promoted to major crimes, where along with Andrew McCarthy and Patrick Fitzgerald, he prosecuted Sheik Omar Abdel Rahman and nine followers for bombing the World Trade Center in 1993.

In 1998, he became chief of the office’s securities task force. One notable case involved more than 100 defendants, including members of New York’s five organized crime families, who were arrested in an undercover sting operation — the largest simultaneous arrest in a securities fraud case in Department of Justice history.

Khuzami moved to Deutsche Bank in 2002 and became general counsel for the Americas in 2004. Perhaps not coincidentally, his boss there, global general counsel Richard Walker, served as head of the SEC Enforcement Division from 1998 to 2001.

Khuzami said he accepted the enforcement director job because of the “professional and personal satisfaction that comes with working in the public sector that can’t be matched in the private sector.”

Still, in some ways, he was not an obvious pick for a new Democratic administration. Khuzami said he has “been a registered independent nearly my whole life,” but he gave $2,300 to John McCain in 2007 and spoke at the Republican National Convention in 2004 (his speech was about terrorism, he noted). “To the extent there was a perception that I was a Republican, it obviously didn’t hamper me in this job,” he said. “The job is itself is completely apolitical, near as I can tell.”

FLATTENING MANAGEMENT

As Khuzami has moved to implement his ideas, some employees of the division have expressed confusion and uncertainty about the new direction.

In a survey by SEC Inspector General H. David Kotz conducted in June and released on Sept. 29, more than 750 Enforcement Division staff gave their opinions on management effectiveness. When asked whether management clearly communicated workload priorities, 41% of staff said no, while 43% felt they did not have adequate guidance on how to achieve program priorities. In addition, 42% did not believe the division has an effective process in place for selecting cases.

One employee wrote, “Priorities change like the flavor of the day. Whatever’s ‘hot in the news’ becomes our priority. Often it feels like we’re the dog chasing its own tail.” Another wrote, “While management’s workload priorities are laid out, they are subject to constant change from day to day. Staff attorneys are not allowed to prioritize and manage their investigations as they see fit. Attorneys are constantly being pulled from one task to another at the whim of their manager.” A third said simply, “I don’t know quite what is expected of me.”

Within the Enforcement Division, one major change being felt in the day-to-day work of most staff is Khuzami’s plan to do away with the lowest level of supervisors, known as branch chiefs, who typically supervise three staff attorneys. Of the 115 chiefs, some are being assigned to work on front-line investigations, while others will be bumped up to the next supervisor level, assistant director. The assistant directors will each be put in charge of about six staff attorneys. There are currently 55 assistant directors, and another 46 positions will be added.

Khuzami described the move, which has not been fully implemented, as a way to “rebalance our staff to both reduce management levels and redeploy some of our most talented attorneys and investigators back to the full-time, mission-critical work of conducting investigations.”

But some agency veterans ­question the wisdom of the move. “I always believed the branch chiefs were very much value-added to the process,” said Randall Fons, a securities litigation partner in the Denver office of Morrison & Foerster.

Fons, who spent 18 years at the SEC and served as director of the central region as well as director of the southeast region, said he was concerned that assistant directors “might not have the bandwidth to understand what was going on in detail in each investigation. I understand the idea of wanting to flatten management, but they have to be careful not to lose some of the effective and truly knowledgeable supervision of specific matters.”

Along with the redeployment of branch chiefs, Khuzami also plans to launch five new specialized units. The largest, he said, is likely to be asset management, which will focus on investment advisers, investment companies, hedge funds and private equity funds.

Another will deal with large-scale market abuses and complex manipulation schemes. The third unit covers structured and new products, such as complex derivatives. The fourth focuses on Foreign Corrupt Practices Act (FCPA) cases, and the fifth handles municipal securities and public pensions.

“These units will have a significant focus on developing expertise, through both training and hiring market specialists, toward the goal of conducting faster investigations into newly developing and less transparent problems in the markets,” Khuzami said. “Specialized knowledge and greater familiarity with products and transactions and markets makes you a better investigator, and makes you better able to identify wrongdoing.”

To Kenneth Winer, a Washington securities partner at Foley & Lardner, the idea “obviously has some real benefits.” He said, however, that the division would have to address the danger that, if staff and supervisor training were too narrow, investigators might miss issues outside their speciality. “An investigation initially focused on FCPA anti-bribery issues might also implicate accounting and disclosure issues,” said Winer, who worked at the SEC from 1984 to 1988.

ANALYZING TIPS

Another move by Khuzami is giving senior officers the authority to issue formal orders of investigation with accompanying subpoena power rather than requiring them to seek preapproval from the commission. Also, senior officers around the country will be able to independently make routine case decisions.

“These are smart and experienced people who are fully capable of making these decisions,” Khuzami said. “And there will still be appropriate review, including review by the commission itself.”

Robertson of Mayer Brown said the “expectation and hope is that this will streamline the process.” But, he added, “It eliminates the check that is there when staff attorneys know they must get the commission’s blessing to open a formal investigation.” He also noted consistency could be an issue. He said, “An associate director in the home office no doubt has a different perspective than, say, the Los Angeles regional director of when opening a formal investigation is warranted.”

Still another new initiative is the creation of the Office of Market Intelligence.

As SEC Inspector General Kotz noted in his 477-page report released on Aug. 31 detailing the agency’s failure to detect Madoff’s Ponzi scheme, one of the key problems was the fact that the SEC did not properly investigate the tips it received about Madoff’s activities.

Between June 1992 and December 2008, the SEC received six substantive complaints and was aware of two articles which “should have led to questions about whether Madoff was really engaged in trading,” Kotz told the Senate Banking Committee on Sept. 10. Kotz recommended the SEC implement a system that captures the nature and source of each tip, how it was vetted, what was done in response and why.

Hundreds of thousands of tips each year flow into Washington and the 11 regional offices in all forms — phone, e-mail, fax, postal mail — but to date have not been compiled in a central repository.

“It’s an overwhelming number; we needed a better system of control and analysis,” Khuzami said.

The SEC has hired the Center for Enterprise Modernization, which is operated by the nonprofit MITRE Corp., to develop a system to “track complaints from cradle to grave,” Khuzami said. The system will rank the complaints, prioritizing those that are potentially the most serious, and will make connections among tips from different sources.

“We’ll be able to risk-weight these complaints and then start by first addressing those at the top of the list,” Khuzami said. “We’ll see the entire record of complaints and information on a particular person or entity.”

As Khuzami moves to establish the new tip system and implement his other initiatives as well, members of the securities bar are watching — and waiting.

“What’s happening now at the Enforcement Division really will determine whether the SEC resumes its stature as one of the elite government investigative agencies,” said Paul Huey-Burns, a securities litigation partner at Dechert in Washington who worked at the SEC from 1986 to 1998, serving as assistant director in the Enforcement Division for seven years.

“The future history of the division will be written based on how these decisions play out,” he said. “It’s sort of like rebuilding the Redskins. It’s not going to happen overnight. It’s a long process, but it has to start now.”

Jenna Greene can be contacted at jgreene@alm.com.