SEC’s Get-Tough Attitude Tests the Limits of Its Power

In the war against corporate fraud, the Securities and Exchange Commission has aimed some of its newest, most powerful weapons at former health-care executive Richard Scrushy.

Regulators, who suspected Scrushy of involvement in accounting misdeeds while chief executive at hospital operator HealthSouth Corp., moved with unusual speed in March to freeze his personal assets, estimated at more than $100 million. They played for a federal judge part of a secretly recorded tape made by the FBI, a byproduct of new teamwork among the federal agencies that police financial misconduct. Behind the scenes, a parade of Scrushy’s co-workers poured out their stories to investigators in a desperate bid to avoid jail time under strict new federal guidelines.

Then, on May 7, U.S. District Judge Inge P. Johnson lifted the freeze on Scrushy’s assets, declaring that the SEC’s evidence was insufficient.

It was a notable setback but didn’t appear to daunt enforcers at the increasingly get-tough SEC. Indeed, SEC officials say they ultimately expect to prevail in their civil case against HealthSouth. Meanwhile, 14 company executives have admitted wrongdoing as a result of the Justice Department’s related criminal probe, including two last week.

The HealthSouth case underscores both the pros and the cons of the agency’s confrontational style: It is moving quickly and forcefully in response to suspicions of corporate wrongdoing, but it also is drawing fiercer, less accommodating reactions from suspects and their defense attorneys.

“It’s kind of a shock-and-awe strategy,” said Thomas V. Sjoblom, Scrushy’s lawyer and a former SEC enforcement official. “Hit hard, hit fast, do what you’ve got to do. And later on figure out if there was anything really there.”

The SEC was created during the New Deal to police the nation’s securities markets and provide investors with a measure of protection from fraud. Yet the agency’s approach to enforcement has varied markedly over the years depending on political priorities and public opinion.

These days, with scandals having swept corporate America and corruption in the executive suite a popular political issue, the SEC has embarked on an aggressive campaign that is prompting legal battles and testing the limits of its powers.

“They’re being much, much tougher across the board,” said Darryl P. Rains, an attorney with Morrison & Foerster in San Francisco who often defends high-tech executives facing federal scrutiny. “In these negotiations now, the government is much more likely to threaten enforcement proceedings with a case that would previously be too weak to bring. And they will no longer compromise.”

To some extent, the SEC had little choice but to ramp up its enforcement efforts, given the outcry against misconduct at Enron Corp., WorldCom Inc. and other public companies. What’s more, the agency was in danger of losing the regulatory spotlight to aggressive state officials such as New York Atty. Gen. Eliot Spitzer, who spearheaded last year’s headline-grabbing investigation of big Wall Street brokerage firms.

For its part, Congress signaled that it expected the SEC to take a tougher stance toward corporate crime by passing last year’s landmark Sarbanes-Oxley corporate reform law. Sarbanes-Oxley increased the SEC’s budget by nearly 50% to more than $700 million and enhanced its power to freeze the assets of people it is investigating. The law also raised the penalties for wrongdoing, putting new pressure on corporate employees to cooperate with investigators.

Beyond that, the SEC has marshaled its powers in an effort to move harder and faster when cases arise. Asset freezes, lifetime bars preventing individuals from serving as corporate officers and directors, and financial sanctions in which the accused must give back money to investors all reached record levels last year, according to SEC data and agency officials.

Now, the SEC is asking Congress for even greater powers, including the authority to impose fines on executives, corporate lawyers and auditors without first getting approval from a federal judge. The agency also wants increased access to grand jury evidence gathered by criminal investigators and the ability to subpoena financial records without informing the target of the probe.

The first hints of a backlash may be emerging.

As the SEC presses ahead, a growing percentage of the accused are refusing to reach settlement agreements, the preferred -- and cheaper for the government -- method of resolving cases. The number of cases in which at least one defendant resists settling has grown from 34% in 2001 to 42% so far this year.

“I expect there will be fewer settlements and more trials, at least in the short run,” SEC Commissioner Harvey Goldschmid said.

Senior SEC officials say they aren’t just being reactive. They also hope their strategy will prove a deterrent. “One of the ways to prevent misconduct is sending a message to the world at large that if you do stuff like this, you’re going to be punished,” Stephen Cutler, the SEC’s director of enforcement, said in a recent interview.

The SEC is sending that message in a variety of ways:

* Long criticized for concentrating its resources on small-time targets, the agency is beginning to go after bigger prey. Currently, formal and informal investigations, which may result in enforcement cases, involve 75 of the Fortune 500 companies, SEC officials told The Times.

* The SEC increasingly is trying to have wrongdoers barred from serving as top corporate officers or directors -- sometimes for life. In 2001, it sought such bans just 51 times. The number jumped to 126 last year and hit 124 in the first nine months of the current fiscal year, which ends Sept. 30. Targets range from Martha Stewart, accused in an insider-trading scandal involving ImClone Systems Inc. stock, to individuals at Enron, WorldCom and Tyco International Ltd.

* Offenders are being required to return more money than ever, and some of it is going into special funds to compensate shareholders. Last year, defendants in SEC cases were ordered to repay $1.3 billion in ill-gotten gains, double the amount in 2001.

* Parallel investigations, in which the SEC pursues civil violations while the Justice Department goes after criminal offenses, are up sharply. Last month, SEC Chairman William H. Donaldson and Deputy Atty. Gen. Larry Thompson touted the administration’s corporate fraud task force, saying it had obtained more than 250 fraud convictions or guilty pleas during its first year of operation.

Helping aid the SEC in its crackdown are new federal sentencing guidelines. Under them, corporate criminals face up to 20 years in prison, a prospect that even civil enforcers such as the SEC can wield like a club over white-collar suspects.

But parallel SEC-Justice investigations come with potentially serious pitfalls. Unlike criminal prosecutors, who tend to try to methodically develop their cases, the SEC finds itself moving swiftly to keep assets from being hidden or squandered.

Tensions flared early in the joint effort against Scrushy and Birmingham, Ala.-based HealthSouth. In a March 19 civil complaint, the SEC accused Scrushy and HealthSouth of committing a “massive accounting fraud” designed to inflate the company’s profit. The next day, a federal judge in Birmingham granted the SEC’s request to freeze Scrushy’s assets. Scrushy, who hasn’t been charged criminally, has denied wrongdoing.

At that point, law enforcement officials were touting the effort as a model of post-Enron cooperation between the SEC and the FBI. But the cooperative approach soon produced headaches for the government.

Arguing in court to keep a lock on most of Scrushy’s assets, the SEC used an FBI-supplied tape recording in which Scrushy appeared to tell a colleague: “We just need to get those numbers where we want them to be. You’re my guy. You’ve got the technology and know-how.”

Scrushy’s lawyer challenged the recording and raised other issues that prosecutors feared would derail their case -- prompting the Justice Department to request that the proceeding be postponed. The request was turned down, and when Judge Johnson lifted the freeze on Scrushy’s assets, she said the cooperation between the SEC and the FBI may have jeopardized Scrushy’s ability to defend himself in the civil case while the criminal investigation was underway.

It was during the tenure of former SEC Chairman Harvey L. Pitt, widely viewed as a friend to business, that the agency stepped up efforts at “real time” enforcement. This put new emphasis on reacting quickly to safeguard investor assets. The real-time doctrine was linked to a carrot-and-stick tactic, in which companies were rewarded for cooperating with investigations and punished for resisting.

In April 2002, the SEC hit Xerox Corp. with the stick, scolding the company for its “lack of full cooperation” in a probe and imposing a then-record civil penalty of $10 million on the company.

Several months later, when the SEC filed fraud charges against three former executives of Homestore Inc., it spared the Westlake Village-based firm from financial sanctions because of what the agency called “swift, extensive and extraordinary cooperation” by the online real-estate company.

Even with the increase in its budget this year, the SEC has to pick and choose its targets. Recently, the agency turned its attention to questionable practices in the mutual fund industry and signaled to outside corporate directors that they may be held accountable for wrongdoing that occurs on their watch.

“Part of the calculus is what kind of message will this case send?” said Cutler, the SEC’s enforcement chief. “And does it justify the resources and time and effort that are going to be required to pursue it?”

One message SEC officials don’t want to send is that settlements are sometimes overly gentle -- a view that has gained currency because of the traditional terms in which defendants agree to settle “without admitting or denying” guilt. Such language has helped make deals possible because it can help protect defendants from private lawsuits and criminal charges.

Recently, regulators have taken limited steps to put teeth into settlements. Starting with a sweeping deal with Wall Street firms in April, which grew out of the Spitzer-led inquiry, the SEC has been insisting as a condition of such accords that individuals pay their fines out of pocket, rather than rely on insurance or tax deductions to ease the pain.

Just last week, the SEC took a step to see that settlements wouldn’t undermine subsequent enforcement proceedings. In a case involving a North Carolina investment advisor, the agency said alleged wrongdoers who agreed to settlements in federal court wouldn’t be allowed to deny the SEC charges later if the agency chose to follow up with disciplinary proceedings.

It will be years before it’s clear whether the SEC’s hardball strategy has succeeded or unleashed such fierce legal resistance that the agency’s goals will have been undermined, said Stanley Sporkin, who served as the SEC’s enforcement chief in the 1970s. But Sporkin sounded wistful as he talked about the agency’s new aggressiveness -- and the expanded crime-fighting authority it is seeking.

“I never had these powers,” he said. “I think it would have been a lot of fun if we had them. We’d have used them.”