The Inside Story on the Breakdown at the SEC

Historians looking for an early sign that the worst financial crisis since the Great Depression might be deeper than expected could do worse than listen in on a predawn teleconference one Friday last spring. Top Treasury and Federal Reserve Bank officials hunched over their phones in a last-ditch bid to bail out the giant investment bank Bear Stearns Cos. But a crucial voice was missing from the emergency conference call: Christopher Cox, chairman of the Securities and Exchange Commission.

And it was not the only time the nation’s chief securities regulator was absent during that critical weekend. On Saturday, as bailout talks continued, Cox dropped out to give a speech at the birthday party of a securities-industry overseer. On Sunday, Cox was a no-show once again, this time for a key conference call dealing with the multibillion-dollar sale of Bear Stearns’ remaining assets to JPMorgan Chase. Less than a week later, the SEC chairman slipped away for a long-planned Caribbean holiday.

The man who should have played a major role in sounding the alarm about–and perhaps preventing–America’s financial meltdown now stands accused by critics of being asleep on the job. While Cox did participate in some of that weekend’s deliberations, federal officials involved in the process say he was a bit player, and Cox himself notes that he was skeptical about the bailout. Though he left the SEC on Jan. 20, he has emerged as a symbol of much of what went wrong at the small but crucial federal agency, from ignoring evidence of a massive Ponzi scheme set up by investment guru Bernard Madoff to the passive supervision of giant investment banks that went under on his watch. Partly as a result of this lax supervision, the future of the 75-year-old agency is in jeopardy.

Long an evangelist for deregulation, the affable 56-year-old conservative former California Congressman took a custodial approach to a job that called for muscular leadership. The mismatch between Cox and the world he was meant to police became such an embarrassment to the Republican Party that GOP candidate John McCain publicly called for the firing of the SEC boss in the heat of last fall’s presidential campaign. Indeed, longtime observers say, Cox allowed complacency and drift at an agency that was created to issue warnings and limit the potential for wider damage from financial malfeasance at publicly traded companies. “The fact that business as usual continued under chairman Cox might have been because he didn’t try hard enough to change things, because he didn’t really seek reform,” says Senator Charles Grassley, the senior Republican on the Senate Finance Committee. “But once the wrong culture takes hold of an agency, it takes a real crusade to change it.” Cox was not that crusader. A prominent SEC historian is more pointed: The Cox years represent “one of the most significant periods of dysfunction in the history of the commission,” says Joel Seligman, president of the University of Rochester.

An Agency on Autopilot

Franklin Roosevelt created the SEC during the Great Depression to clean up financial scandals and rebuild investor confidence. For three-quarters of a century, the agency waged high-profile wars against insider trading, corporate bribery and fraud in cases ranging from junk-bond king Michael Milken to Enron. Cox took charge in August 2005 after 17 years of representing Orange County, California. A Harvard-trained lawyer, he was a key leader of Newt Gingrich’s Republican revolution, helping enact a provision of the GOP’s Contract with America that restricted investor lawsuits against companies accused of securities fraud.

At the SEC, Cox initially sought consensus by soliciting the opinions of two Democrats on the five-member body. But his desire for harmony played into the hands of the most conservative Republican commissioner, Paul Atkins, who opposed aggressive enforcement. Not that the Democratic commissioners offered much resistance: one stepped down in 2007, the other in early 2008. President Bush didn’t fill either of the vacant seats until last summer, giving the Republicans more latitude. Meanwhile, the world the SEC regulated was turning upside down.

In 2007, Cox pushed through a rule requiring SEC staff to get authorization from commissioners for financial penalties before settling a case. Cox says the rule was an experiment designed to streamline the process.

In fact, it quickly created delays and obstacles, so much so that SEC officials often stopped seeking penalties. “It wasn’t worth it,” a former commissioner says. “All they got was abuse every time they went before the commission and asked for penalties.” Some investigations didn’t get even that far. Gary Aguirre, a senior SEC lawyer, sought to question the chairman of Morgan Stanley in a fraud investigation but was denied permission before Cox arrived. He later told Congress that his superiors, fearing the banker’s “very powerful political connections” in Washington, had delayed the probe, dooming any chance of making a case–allegations that a Republican Senate report later found credible.

Eventually, enforcers at the SEC grew demoralized. One by one, key officials left the agency; Aguirre was fired under Cox. Sensitive cases seemed to lag. Cox has admitted that his staff brushed off “credible and specific” reports of fraud committed by Madoff over the past 10 years and did not seek subpoena power or bring tips to the attention of commissioners. Although 2008 saw the second highest number of enforcement actions in the agency’s history, many involved smaller cases, as the value of penalties dropped. Critics say the SEC wanted to avoid upsetting the powerful securities industry.

A Voluntary Approach

But the SEC was missing the much bigger and more important game. Those lost penalties–which can reach hundreds of millions of dollars–amounted to peanuts compared with the multibillion-dollar stakes in play at investment banks like Bear Stearns and Lehman Brothers. While their brokerage businesses remained under SEC control, their parent corporations–huge holding companies with far-flung interests in hedge funds and other financial services–answered to no one but shareholders. It is a measure of the industry’s comfort level with the SEC that investment banks, when faced with the demand that they open their books, lobbied for the commission to conduct the oversight. In 2002, the European Union threatened to impose its own rules on Europe-based affiliates of the big U.S. investment houses. The U.S. firms pleaded for the opportunity to find a regulator at home. To avoid prying European eyes, five banks–Bear Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch and Morgan Stanley–offered to subject their parent companies to SEC oversight. Under Cox’s predecessor, William Donaldson, the SEC agreed to create a voluntary supervisory program that didn’t extend to the holding companies the debt limits that the commission had once imposed on brokerages owned by the banks. The program had no teeth, but it did permit some government oversight of an otherwise unregulated industry–that is, if SEC supervisors properly performed it.

In theory, it was only a matter of time before hyperleveraging came unraveled. A pair of hedge funds managed by Bear Stearns collapsed in June 2007 as a result of huge losses in subprime mortgages. Despite more bad news–a federal investigation into the hedge-fund collapse, two consecutive quarters of declining profits and a dropping stock price–Bear Stearns’ chief executive, James Cayne, announced on Oct. 4 of that year, “Most of our businesses are beginning to rebound.” Investors who wanted to reconcile the numbers with the company’s conflicting explanation got no help from the SEC. Its voluntary program had given the agency a window into the secretive industry, revealing Bear Stearns’ rising concentration of subprime mortgages, its questionable risk management and its yawning ratio of debt to capital, according to a later inspector general’s report. But the SEC failed to warn the public and didn’t urge the bank to improve most of its practices, the inspector general reported.

Cox insists that he too was in the dark, adding he was never informed of the problems at Bear Stearns and was surprised by the bank’s fall. He certainly sounded lost at the time: five days before Bear Stearns collapsed, Cox told reporters, “We have a good deal of comfort about the capital cushions at these firms.”

Critics say Cox either never really understood his job and its powers or simply wasn’t interested in flexing the agency’s muscles. With investment banks and Wall Street in trouble, he should have sought regular reports from his staff and demanded changes, says former SEC commissioner Harvey Goldschmid, whose term preceded Cox’s. The chairman, Goldschmid says, should have “gone in and pounded on the table and said, ‘Look, there are all these red flags. Why are you still leveraged? We want you to have more capital.’ There’s never been a time when those firms were not going to respond to demands by the SEC chairman.” Cox, Goldschmid adds, “was the primary regulator. He should’ve been there earlier to try to avoid these things from happening.”

But Cox kept his distance from the investment banks. He says the SEC chairman “typically does not” jawbone CEOs of those firms. Other observers say Cox simply checked out. “They never heard from him. They never saw him,” says another ex-commissioner. “He was never a factor. Even when things got bad, it took a long time before he got on the phone to find out from these firms what their exposures were and what they were doing about it.”

A New Leader

Some experts argue that the origins of America’s financial crisis are far larger than Christopher Cox. “If you want to cast blame, there are many regulators, agencies and Congress that are as much, or more, at fault than Cox or SEC,” says Joseph Grundfest, who was an SEC commissioner in the 1980s.

But the SEC’s failure under Cox now has some members of Congress working to shrink the commission’s authority and hand some of its most important duties to the Federal Reserve and other agencies. It will fall to 53-year-old Mary Schapiro–a former SEC commissioner and a former head of the Financial Industry Regulatory Authority, whom Barack Obama named to replace Cox–to prevent that from happening.

Since taking over on Jan. 27, Schapiro has launched an aggressive campaign to beef up enforcement and reverse a number of Cox-era practices. She has already canned the rule requiring staff to obtain approval from the SEC’s commissioners before resolving cases against violators. She is studying new technology to cope with the estimated 700,000 tips the SEC gets from informants annually–like those it received but ignored in the Madoff case. And she has quickly filled senior SEC jobs, selecting a variety of candidates who have been prominent Cox critics. For immediate impact, Schapiro has unleashed a spectacular new case, charging R. Allen Stanford and three of his companies with an $8 billion investment fraud.

But Schapiro’s steps are overdue and may not be enough to save the SEC. Grassley recently demanded to know what Schapiro will do about 4,000 e-mails and other documents that suggest there was insider trading at Lehman Brothers, the investment giant whose 2008 bankruptcy marked a turning point in the financial crisis. The whistle-blower in that case, a Lehman Brothers employee, was fired and last spring spent many hours with senior SEC staffers. Cox told TIME that he was uninformed about the case. The former chairman, who isn’t sure about his next career move, believes that much of the criticism leveled at him is uninformed or tendentious. “I take full responsibility for the actions of the SEC during my chairmanship,” he said in an interview. “And I have tremendous pride in the extraordinary, around-the-clock efforts of the SEC staff in attempting to avert the crisis.”

That is not a view, as they say about securities, that is widely held.