Courage is Part of the Fraud Examiner's Job Description

Cressey Award recipient and securities regulation expert Prof. John C. Coffee encourages fraud examiners to persevere in the wake of the global economic crisis, but also take advantage of the new Dodd-Frank Act. 

"For fraud examiners, courage is part of the job description," said John C. Coffee Jr., Adolf A. Berle Professor Law at Columbia Law School, recipient of the ACFE's 2011 Cressey Award, during a recent Fraud Magazine interview. "Remember that at WorldCom it was the internal auditors who caught the fraud and brought it to the board's attention when the outside auditors missed it." 

Coffee, a U.S. securities regulation and white-collar crime expert, helped draft parts of the new U.S. Dodd-Frank Wall Street Reform and Consumer Protection Act and the Sarbanes-Oxley Act, and he has testified before Congress numerous times. The National Law Journal has listed him as one "The 100 Most Influential Lawyers in the United States." He is the director of the Center on Corporate Governance at Columbia University Law School and is frequently quoted and interviewed by major media outlets. He teaches course on white-collar crime, securities regulation, corporations and complex corporate litigation.

Coffee, 66, and his wife of more than 40 years, Jane, a professor of mathematics, live in New Jersey, and have one daughter, a physician.

"Under most compliance programs, internal auditing staff should have immunity and protection for information that they bring to the board. If there is ambiguity on this score, reform must begin with protection from internal retaliation."

The Dodd-Frank Act, passed in the wake of the economic meltdown, does strengthen protections for internal auditors. "Also under Dodd-Frank's whistleblowing provisions, internal compliance staff can become whistleblowers — and profit — if the corporation covers up — or ignores — misconduct that they have found or reviewed. Anonymous hotlines to the audit committee are common and should be universal," Coffee said.

"Corporate bonuses should be paid for uncovering fraud or abuse, and formulas should be crafted and communicated to employees that offer corporate-paid bounties to fraud examiners for their success. If executives are paid for performance, so should fraud examiners," he said.

The Cressey Award is the ACFE's highest honor, given for a lifetime of achievement in the detection and deterrence of fraud. The award memorializes the late Dr. Donald R. Cressey, a renowned fraud researcher and an ACFE founding father.

Why did you decide to pursue law studies?

I felt then - and even more so now - that lawyers are the engineers of policy planning. Whatever particular policy the social scientists or regulators may want to pursue, it is lawyers who design and implement that policy. Law — at least as an academic discipline — is applied social science.

You were in private practice as an attorney for six years until you became a professor at Georgetown University Law Center and then at Columbia Law School. Why did you decide to make the switch? How did that come about?

For me, it was an easy choice. It gave me the chance to focus on the problems that interested me, rather than the problems that faced my clients.

What fascinates you about securities law?

I have a number of overlapping interests, and they all come together within the context of securities law. These interests include: public and private enforcement, complex litigation, misconduct and internal control within organizations, disclosure and transparency and consumer protection. I continue to believe in [Supreme Court] Associate Justice Brandeis' dictum that "sunlight is said to be the best of disinfectants; electric light the most efficient policeman." Although that idea remains true today, it is increasingly under attack.

You are a prolific author and thought leader on legal matters. Can you explain some of the ways theses occur to you? Do you have another book in the works?

Often, there is an ongoing debate, and I am simply taking a side. Sometimes, I am attempting to apply "law and economics" insights. I also find it useful to trace the early histories of governance practices (such as dispersed ownership) to see how they developed. Recently, the 2008 financial crisis has dominated the attention of scholars in my field, both because its causes need to be identified and adequate reforms defined. For the future, I am working on a book about the American system of "entrepreneurial litigation" — i.e., lawyers representing large classes with relatively little client control — and its alternatives.

What should fraud examiners know about U.S. securities regulation?

Securities regulation is based on the concept of full disclosure. But it is not enough to show that material information was omitted from a disclosure. The major difficulty in proving most securities law violations is showing a fraudulent intent. Both Congress and the Supreme Court over recent years have repeatedly raised the barriers in this area. Often that intent can be shown through contemporaneous private statements —such as email or wiretapped conversations. Federal prosecutors may also seize computer hard drives, looking for such admissions of knowledge. Through plea bargaining, prosecutors may compel such defendants to turn against and testify against their confederates. But generally, the key requirement is proof of "scienter" (or fraudulent intent) and not just the failure to disclose material information.

For fraud examiners, the key tactic normally is to "follow the money." But within investment banks and similar institutions, the money comes in the form of bonuses and stock options, and side payments or bribes are unlikely. Thus the "smoking gun" is evidence showing that the individual knew that material information was being withheld.

What kinds of hedge funds will the SEC focus on in the future? How do you think the SEC's risk-based approach will affect its plans for examining hedge fund managers?

Their risk-based approach makes sense. A hedge fund specialized in over-the-counter derivatives and making a directional bet on the market (such as by short selling) does take on greater risk and will probably face more frequent examinations than one investing primarily in equity securities. Illiquidity will also make one a greater target.

You have written that you agree with the view that the SEC's enforcement staff has been reorganized into a flatter, less bureaucratic structure and can now devote more resources to actual litigation. However, you have written that many believe that the SEC pulls its punches whenever there is a chance that they might lose — either settling cheaply or "allowing the settlement to be indemnified in a manner that produces a hollow, bloodless victory." Do you think that the SEC settlements are deterring fraud?

Yes and no. I agree with [U.S. District] Judge [Jed] Rakoff [for the Southern District of New York] who criticized the SEC's settlement with Bank of America as being both too opaque (because there was no discussion of who made the decisions) and because the penalty fell only on the corporation (and thus would be borne by its shareholders). When the SEC is suing on the theory that shareholders were defrauded — as in the Merrill Lynch/Bank of America merger — it is a curious policy to punish shareholders in order to protect shareholders. I also feel the SEC settled too modestly with Angelo Mozilo, the former chairman of the board and CEO of Countrywide Financial. More recently, the SEC has responded to Rakoff's criticisms and given greater attention to including individual defendants in their enforcement actions, and I think that is a desirable step.

Dr. Joseph T. Wells, CFE, CPA, founded the ACFE in 1988 based on the precept that it is better and cheaper to prevent and deter fraud than to deal with the aftermath. Can you elaborate on your views on the possible deterrent effects of anti-fraud regulations?

I agree with Dr. Wells. Moreover, in the securities industry, we are dealing with people who are uniquely good at calculating costs and benefits (and do so professionally). Insider trading is not a crime of passion nor the product of drug addiction. Thus, it is deterrable. The behavior of white-collar offenders changes as antifraud laws are enforced, and I think we are seeing that today in the insider trading area.

What are the implications of the new Dodd-Frank whistleblower provisions? Why are corporations so concerned about the provisions?

Over time, Dodd-Frank's whistleblower provisions will result in increased SEC actions and penalties. Once, whistleblowers faced a bleak future and near-certain retaliation. Now, they can profit. Corporations want the whistleblower to go first through internal compliance procedures — possibly in the hopes of heading off a whistleblower complaint and at the least because it gives them advance notice and time to prepare a defense. The SEC compromised by not requiring prior disclosure to internal compliance officers, but indicated that higher bounties would normally be awarded by it if such internal disclosure is made first. While the early experience with the SEC's new whistleblower rules has not shown any significant spike in filings by whistleblowers, the SEC is telling the bar that the complaints they receive are better documented and corroborated. I would attribute this to the impact of plaintiffs' law firms that are now more prepared to work with whistleblowers because there is a payoff. I can imagine law firms that represent whistleblowers are hiring fraud examiners.

Many of the rules mandated by the Dodd-Frank financial regulatory law have been delayed. Do you believe that some of the players are encouraging the delays to attempt to kill much of the implementation? What could be other results of the delays?  

Delay is partly the product of intense lobbying and partly the product of the complexity of the task and the need for multiple regulatory agencies to reach a common (and hopefully consistent) position. Also, Congress can threaten retaliation and reduced budgets if an agency goes beyond what they want. Clearly, Congress has delayed and sidetracked the Consumer Protection Agency, and The White House knows it cannot get Elizabeth Warren confirmed as head of the agency.

You have seen the ebb and flow of regulation for years, but is this latest spate of laws as unique as the economic meltdown that preceded it? 

The U.S. political climate is today more polarized than at any time in my lifetime. Traditionally, most issues of securities regulation were analyzed on a bipartisan basis, and SEC Commissioners were respected professionals. Today, the SEC is as divided and partisan as Congress. Although Dodd-Frank is the most important financial regulation in 50 years, Sarbanes-Oxley was similar in also being the response to scandals and a collapse. Indeed, since the South Sea Bubble in roughly 1719-1720 (and I was not around for that), all significant regulation of the securities markets has come in response to a market collapse (usually as the result of a bubble).

Inevitably, deregulation and the pendulum swing toward heavier regulation are tied to political issues. Have you seen a period in U.S. history when the involved parties were able to rise even slightly above the political fray?

Remember that Sarbanes-Oxley passed the U.S. Senate in 2002 with a unanimous vote. Later, it became controversial. None of the major federal securities statutes — the Securities Act of 1933, the Securities Exchange Act of 1934 nor the major amendments creating the National Market System in 1964 — were highly controversial.

Do you see regulators in Europe and Asia creating similar standardized rules in coordination with ours? 

Basel III [a global regulatory standard agreed by the members of the Basel Committee on Banking Supervision] and similar proposals for higher capital adequacy standards for banks will need consensus support to become effective. Britain has in some respects been tougher than the U.S., but I do not see Europe (and particularly not Asia) restricting executive compensation or adopting the Volcker Rule [which places trading restrictions on financial institutions]. Still, [at publication] the Greek crisis has not fully played out, and Europe may face a continuing challenge that will provoke it to address the "too big to fail problem."

You have talked about Wall Street's new need to "race to the top" (rather than their usual race-to-the bottom behavior) because of the shock wave of insider-trading prosecutions and the federal government's renewed emphasis on FCPA enforcement. Do you think that hedge funds' and investment banks' conversions, due to fear of investor redemptions because of even investigation rumors, is a short-term phenomenon?

Hedge fund managers do fear that any enforcement action by the SEC could cause redemptions and a run on the bank. Will this be a "short-term phenomenon"? Possibly, but not if strong SEC enforcement continues. Public enforcement motivates the private sector to take compliance seriously.

The Department of Justice, the SEC and other federal agencies are now using wiretaps — once the tool of investigators of organized crime — to catch insider traders and others. Do you believe that this method will be challenged in the courts? Will it become a staple federal investigative method?

Because wiretaps are very expensive (both in money and personnel), they will not be used in every case. There is no serious constitutional issue involving their use, but there are high statutory requirements. Of course, defendants will appeal, but probably not successfully. The Rajaratnam appeal will be based primarily on the wiretap issue, and if his conviction is upheld (as I believe it will be), wiretaps will continue. The U.S. federal government is also using search warrants to seize hard drives (and has done so at several hedge funds). This technique will also yield contemporaneous statements (but somewhat less vivid) that can document fraud.

You told ACFE annual conference attendees that Wall Street firms and national corporations are trying to signal they are like Caesar's wife — above suspicion. They are investing in strict compliance programs, whistleblower hotlines and enforceable codes of ethics. The ACFE has preached this sermon from its inception. Are corporations finally realizing that anti-fraud plans and strong internal controls are money savers not wasters?

The ACFE has long preached strict compliance, but in the past, U.S. Attorneys' Offices or the Department of Justice weren't threatening indictments or the SEC (sometimes) bringing suit. My point was that serious public enforcement motivates stronger compliance efforts. But the new interest in compliance may fade if public enforcement wanes. There is a symbiotic relationship here.

You said that this new emphasis on compliance and enforcement could be a major boon for fraud examiners. Can you elaborate on that?

In response to whistleblower complaints, compliance departments will conduct more and better investigations, possibly using fraud examiners. The SEC will frequently settle cases on the basis of elaborate internal investigations, generally conducted by outside law firms, who may come to employ more fraud examiners. And U.S. Attorneys' Offices will similarly demand more efforts at compliance and internal investigations as a part of deferred prosecution agreements. Once again, the internal corrective response waxes and wanes with the strength of public enforcement, and Dodd-Frank should encourage a stronger internal auditing and compliance function.

You have said the good news is that this is the best of times for anti-fraud professionals. But the bad news is that "the empire will strike back." Who, to you, is the "empire"?

Both the financial industry and other firms affected by FCPA enforcement will seek relaxation of some rules through lobbying, will seek to delay the promulgation of new rules and will encourage Congress to restrict funding to enforcement agencies. Evidence of these pressures lies in the inability of the Treasury Department and The White House to launch (or even staff) Dodd-Frank's new Consumer Protection Agency and in the SEC's current budget crisis.

You have said that the empire will not attack the SEC on its merits but on the level of funding. Can you elaborate on that?

The SEC is woefully underfunded and has had to delay the opening of its new bureau dealing with credit rating agencies. I seriously doubt that the SEC has the staff to read carefully or consider seriously all the whistleblower complaints that it is beginning to receive. It is inundated with new responsibilities and faces budgetary foot-dragging in the House.

You have also said that the future of anti-fraud efforts depends on strong governmental enforcement, and fraud examiners should support enforcement legislation. How do anti-fraud professionals do that?

The ACFE is a perfect vehicle. I do not suggest that it lobby. But in its conferences, it can (and has) featured the principal enforcement agencies. And it can recognize those in Congress who do support stronger enforcement.

How do you respond to those even in the anti-fraud community who say that legislation such as Sarbanes-Oxley and Dodd-Frank are actually overbearing, costly and counterproductive?

Nothing is more "overbearing, costly and counterproductive" than the failure of a "too big to fail" financial institution. And they will fail again because the pressure to increase profits leads to more leverage and risk-taking. Any major bill — SOX or Dodd-Frank — is a potpourri because Congress must blend the ideas of many to pass anything. Thus, there may be some waste and excess in Dodd-Frank (as there has been in all major legislation). But the real danger is that Dodd-Frank will be only weakly and equivocally implemented. I see signs of that already. If that happens, another 2008 becomes predictable. In Yogi Berras words, it will be "déjà vu, all over again."

So, do you have any predictions on how the enforcement and compliance efforts will shake out with the conflicting factions? When the furor has died down due to the economic meltdown will we fall into usual patterns of neglect (similar to the aftermath of the savings & loan debacle), or we have created a "new normal"?

I do think that Dodd-Frank is being only weakly implemented. To some extent, this is because of lobbying pressure and the shift in Congress. To some extent, it is also because the Federal Reserve and other federal banking agencies are very closely aligned with the interests of the banks and often function more as cheerleaders than as the "tough cops of Wall Street." And in part, it is because regulators are overly focused on what went wrong in 2008 and not on what new could go wrong in the future. The next financial crisis will come from an unanticipated direction (just as the 2008 crisis did).

What simple, non-political economic truths must the general public know in the aftermath of this monumental recession?

The fastest way to increase the profitability of a financial institution is to increase its leverage. The fastest way to cause a new financial crisis is to encourage increased leverage at financial institutions. Thus there will be an enduring tension between the financial community and regulators.

There is a "Regulatory Sine Curve." The farther we move from a recession in the direction of "normalcy," the more that regulatory vigilance is dulled, and the cycle starts over.

Executive compensation can produce moral hazard unless pay is tied to long-term performance.

Dick Carozza is editor-in-chief of Fraud Magazine.

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