The Next Wall Street Scandal

It would be hard to find a worse resume for chairman of the Securities and Exchange Commission than that of Christopher Cox, who was confirmed in the job by the Senate last summer after hearings that The New York Times aptly described as a “love fest.” As a congressman from Orange County, California, since 1988, Cox closely allied himself with the most aggressive lobbies for weaker securities regulation -- accountants, the high-tech industry, and the U.S. Chamber of Commerce. For nearly 17 years, he was their loyal servant, weakening the SEC and faithfully burying pro-investor reforms that might have prevented faked balance sheets and overstated earnings from inflating a stock market bubble.

Lest we forget, from 2000 to 2002 the Standard & Poor's 500 Index fell 50 percent -- equal to the drop during the Great Crash of 1929. The smaller-stock NASDAQ fell a gut-wrenching 78 percent. Today's market is stuck at 1998's level, meaning it has delivered a cumulative zero to investors for seven years. It is fair to say that Cox did his very best to make the bubble and its aftermath as horrific as they were.

Had President Bush named him to the SEC in 2002, when the market was hitting bottom, the outrage would have been great. But today, reforms have been enacted, culprits have been sent to jail, and the market has at least risen from its lows. Even liberals such as Arthur Levitt, who ran the SEC under Bill Clinton, greeted Cox's appointment with a ho-hum, apparently reckoning that a period of consolidation -- not further reform -- is in order.

They should know better. Firstly, memories of the scandals already are starting to fade. It's always when investors lower their guard that the SEC should raise its own. Secondly, Cox inherits a vast unfinished agenda on matters ranging from corporate governance to accounting standards to hedge funds. Whether the Sarbanes-Oxley Act and other post-Enron reforms take hold will largely be up to Chairman Cox -- likewise defense of the SEC's budget. Even as the trial of former Enron Chairman Kenneth Lay is set to begin, Cox's old friends on K Street are circling the beleaguered agency, saying reform has gone too far. In fact, much remains undone. To cite the most glaring example, the average investor in a mutual fund still has little idea of the fees he is paying, or of the blatant conflicts of interest that are involved in determining them. Is Chairman Cox the man to correct such abuses?

A 53-year-old Harvard-educated lawyer uniformly described as bright, articulate, conservative, and ambitious, Cox had never worked directly in the securities business. But his career is littered with clues about his approach to regulation. The most disturbing occurred during his stint as a junior partner in the Los Angeles firm of Latham & Watkins. From 1984 to 1986, Cox defended William Cooper, a scam artist being pursued by state and federal regulators. According to Michael Aguirre, a lawyer who represented a group of pensioners that Cooper defrauded, Cox placated the regulators, and thus enabled the fraud to continue. Ultimately, Cooper and two confreres went to jail, but not before they had bilked their clients out of an estimated $130 million.

“His job was to dress up the portfolio for presentation to the (California) Department of Corporations,” Aguirre, today the city attorney in San Diego, says. “Cox was a key player in helping to keep the scheme alive. Since he doesn't believe in the concept of fraud, selecting him as head of the SEC is really a horrible appointment.”

This is a harsh judgment, and to the extent that it turns on Cox's work as a 30-something lawyer, it is hardly a complete picture of the man today. Cox has denied culpability in the Cooper case (of which more later) and since his selection in July, he has been working overtime to disabuse people of the notion that he is too reactionary to run a regulatory agency created by Franklin D. Roosevelt.

“So which is it? Business friendly or investor friendly?” Cox asked in his maiden speech to the SEC staff. His answer was encouraging: “Ladies and gentlemen, the Department of Commerce serves our country's businesses. We are the investors' advocate.”

Cox has surprised critics by promising to defend some, though not all, of the reforms sponsored by his immediate predecessor, William Donaldson. He has launched a novel inquiry into the Altera Corporation for allegedly blackballing a security analyst who had been negative on its stock. “I don't doubt that he had the wrong instincts for quite a good period of time,” says Harvey Goldschmid, a former Democratic SEC commissioner who returned to Columbia Law School in August. “But he has certainly made a moderate, and an encouraging, entrance.”

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Chris Cox grew up in St. Paul, Minnesota, the son of a businessman. He attended the University of Southern California. At Harvard, in the mid-1970s, he not only made Law Review but also got an M.B.A. His thesis advocated the then far-right notion that the recipients of corporate dividends should not be “doubly” taxed (a goal that President Bush would largely accomplish in 2003). After a stint as a federal law clerk, Cox joined Latham & Watkins and rapidly made partner. While at Latham, Cox sent a resume to Washington, where Peter Wallison, counsel to the Reagan White House, spotted him as a prodigy and fellow Reagan partisan. In the White House, Cox worked on a broad array of subjects. However, on a Monday in October 1987 he got a whiff of the issues that would later consume him at the SEC. The stock market had plunged 22 percent (still its worst one-day fall ever) and Cox was asked to help formulate a government response. One reason for the severity of the crash was the widespread use of a new derivative, known as “portfolio insurance,” which instead of protecting investors as advertised had led to chain-reaction selling and thus exacerbated the decline. One possible response would have been to clamp down on derivatives -- which would pop up in numerous future fiascos, including Orange County, Long-Term Capital Management, and Enron.

Cox was disinclined to propose new rules. According to another White House colleague, “he wanted to be sure we didn't use the crash as an event to drive a whole new securities act.” In general, this former colleague says, “he had a vision of vibrant markets” (even when they were tumbling 22 percent) and didn't want them “smothered” by regulation.

This fear has rallied conservatives ever since the SEC's tumultuous infancy. After the Great Crash, examples of notorious self-dealing on Wall Street were exposed by Congress and the New Deal created the SEC to assure the honesty of securities markets. Despite ideological opposition, it soon became a truism on Wall Street that capital markets in the United States were stronger than those overseas thanks to the confidence inspired by the cop on the beat. In Congress, bipartisan support for the SEC endured, auspiciously, for six decades -- until the sudden triumph of the Gingrich Congress. That was when Chris Cox, elected to a fourth term in 1994, found himself part of the first Republican majority in the House since the Eisenhower era.

Cox's singular contribution to the Gingrich agenda was the 1995 Private Securities Litigation Reform Act. Its purpose was to limit class-action lawsuits by investors. Historically, the threat of such suits was a powerful deterrent to the kind of fraud typified by Enron. Though many experts agreed on the need to modestly temper the power of class-action lawyers, Cox's bill was an immunization shield for corporate executives and their auditors. Alarmingly, the bill raised the threshold for proving damages from “recklessness” to “intent.” It would no longer be enough to show that a Dennis Kozlowski had behaved with reckless indifference to stockholders; a plaintiff would have to prove that Kozlowski intended to do them harm. This was a prohibitively high bar, which the former Law Review editor surely knew.

The provision was eliminated by the Senate, but another Cox provision, also quite damaging to investors, was included in the final act. After a case is filed, plaintiffs must pass certain hurdles to advance to the “discovery” stage, where they can take depositions from insiders and thus attempt to ferret out details of the alleged fraud. Cox's bill required plaintiffs, prior to discovery, to “state with particularity facts giving rise to a strong inference” of fraud. In other words, a plaintiff had to assert the details of who did what without the benefit of discovery. The pleading standards, which were toughened in this and other ways (much to the satisfaction of the high-tech and audit lobbies) set an impossibly high standard. President Clinton vetoed the bill, but Congress overrode him. According to John Coffee, a Columbia University law professor, “litigation against auditors dried up after the act.” Not surprisingly, auditing standards noticeably slipped; it was in the immediate aftermath that companies such as Xerox, Waste Management, and Enron began to stretch the limits of acceptable practice right under their auditors' noses.

The House also targeted the agency for punitive budget cuts. This would limit the SEC's manpower precisely when the Internet revolution was spawning scores of new technology firms, many of dubious character, and thus a higher workload for the agency.

It was in that hysterical context that Cox supported or joined fellow Republicans in three other efforts with deleterious effects on investors. First, they pressured then–SEC Chief Levitt to get the Financial Accounting Standards Board to back off from requiring companies to book stock options as expenses. Levitt, to his own later regret, caved. Secondly, Republican legislators, again with heavy lobbying from accounting firms, blocked Levitt's efforts to prevent auditors from getting too close to their corporate clients -- exactly the abuse that led Enron and Arthur Andersen to their mutual destruction. Thirdly, Cox sought to delay a rule to ban the “pooling” method of accounting in mergers, which helps acquiring companies such as Cisco obscure the cost of their acquisitions.

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This general crusade aside, the securities litigation bill that Cox championed also had a personal context. In 1995, as the bill was being drafted, Cox was added as a defendant to a lawsuit in California state court. According to The New York Times, Cox said his experience as a defendant led him “to sympathize with people who are victimized in these suits.” Cox, of course, was referring to the action brought by the defrauded pensioners in the Cooper case. In his Senate confirmation hearing, Cox was subject to patently softball questions on the Cooper scandal.

Sen. Richard Shelby: Congressman Cox, several press accounts have described your involvement in a lawsuit arising from your time when you were in private practice of law. I think the outcome, if I recall, of that lawsuit was in your favor. But would you just, for the record, clarify your role in this litigation, how it was resolved, and so forth?

Cox: I did preliminary work on a small SEC-registered public offering. However, that public offering was not the basis for the criminal indictment and ultimate guilty ruling and conviction of this individual. Furthermore, I did not work at the law firm at the time the lawsuit went forward. …

Shelby: Well, basically it terminated in your favor, is that correct?

Cox: Yes, I had the entirety of the complaint dismissed against me, and there was no settlement of the matter either. I prevailed on the claim in the court.

This testimony is astonishingly incomplete. William E. Cooper and a partner ran First Pension Corp. and a series of related companies that, in the early 1980s, sold investments to pension funds and people with retirement accounts, and also managed their portfolios. Cooper offered the investors a high interest rate, chiefly by lending money to poor credit risks in the form of second and third mortgages. Many of the debtors stopped making payments, but Cooper hid this fact from his investors. Eventually, he bundled their assets in a pool. This made the poor performance easier to disguise. However, pooling the assets made them subject to the securities laws, and Cooper neglected to register them with any of the relevant authorities. The SEC, the California Department of Corporations, and the Department of Labor were all on his trail in 1984, when Latham & Watkins assigned the case to two young attorneys, one of whom was Cox.

According to the complaint filed by Aguirre, Cox helped to draft or review numerous items of First Pension's or its related entities' correspondence to investors and regulators. The complaint alleges that virtually all were substantially misleading and went over the line of normal attorney advocacy. Exhibit A is a letter he wrote to state regulators in February 1985 describing the restructuring of First Pension, which was key to keeping it afloat, as “low-risk” and “fair, just and equitable” to investors.

The complaint alleges that the documents that Cox drafted or reviewed failed to mention Cooper's previous, and illegal, pooling; they supplied a specious reasoning for why Cooper did not seek to appraise the mortgages' value. And they were silent as to Cooper's central motivation, which was to hide the collapse of the underlying investments.

Cox has said he was unaware that his client was doing anything wrong. If the 300-page complaint can be believed, then Cox must have been the most naive lawyer ever to emerge from Harvard Yard. In one memo, quoted in the complaint, a Cooper associate, worried that investors will get wise and start bailing out, pointedly advises Cox: “Our objective is to inform our clients of the changes [in] the system that meet the proper fiduciary disclosure requirements without causing a run on the system [emphasis added].”

Cox's testimony that his work for Cooper did not involve the entity that later was the subject of the criminal indictment is technically true but beside the point. Cox did work on entities in which investors lost money. It is arguable that his testimony perpetuates a central fiction of the case -- that Cooper's various paper subdivisions operated independently.

And Cox's involvement was far greater than “preliminary work on … a small offering.” According to the complaint, Cox submitted at least 150 time entries to his firm for work on First Pension–related entities. Indeed, after Cox left, in 1988, Cooper complained to the law firm: “Our mutual work on the fund and the service provided through the initial period of time, was satisfactory. However, things changed when Chris Cox left the firm, leaving our very crucial project in the hands of people who have proved to be inexperienced.” Finally, Cox's testimony that he “prevailed on the claim in court” is, according to Aguirre, a misrepresentation. Attempts to win a dismissal of the charges against Cox failed. His testimony omits the fact that he was removed from the case when his law firm, Latham & Watkins, agreed that Cox's actions could be imputed to the firm. And the firm did settle out of court for a not insubstatntial amount. With the exception of the complaint, the record of the case and the details of the settlement have been sealed. Cox declined to talk to me about it.

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Arthur Levitt says hopefully of the new chairman, “Cox is smart and he's political. He understands that his legacy will depend less on what the Chamber of Commerce thinks of him than what investors think of him.” Recent history can be cited either way. Levitt's successor, Harvey Pitt, was undone by his closeness to industry.

But Cox's immediate predecessor, William Donaldson, proved to be a surprisingly tough regulator. Donaldson provoked the ire of the Chamber on three major initiatives. One was whether hedge funds, previously unregulated, should be compelled to register with the SEC. Another was whether to require mutual funds to name an independent chairman. Third was a proposal to let shareholders (of all companies) name a candidate or two for director -- after all, the shareholders do own the stock -- and break management's exclusive lock on picking directors.

The Business Roundtable, which represents CEOs, mounted such a furious protest against the last proposal that Donaldson retreated. Meanwhile, the Chamber repeatedly blasted Donaldson for being an “overzealous” regulator (only in today's political climate could a Wall Street eminence like Donaldson be made to sound like Ralph Nader). His two fellow Republican commissioners frequently voted against him, leaving him in the awkward position of having to form a majority with the two Democrats.

Cox has dashed the hopes of the extreme right that he will simply reverse everything accomplished by Donaldson. Cox has said that he accepts as settled that stock options must be expensed (reversing the stance he took in Congress). And Cox told The Wall Street Journal that hedge fund registration will go through. But the new rule allows a gaping exclusion for funds whose investors commit for at least two years.

On another charged issue -- a probe into a sale of stock by Senate Majority Leader Bill Frist -- Cox, who has contributed money to Frist, promised to recuse himself. This prudent move does not cost much, as the consensus thinking in Washington is that the Frist probe will not go very far.

And it is clear that, under Cox, the business lobby is expecting a gentler SEC. “We think he'll be a good addition … a calming influence,” David Chavern, an executive at the Chamber, says pointedly. Cox deserves credit for running a more consensus-driven SEC, a departure from the Donaldson years. But it's not hard to see why the Chamber is celebrating. With both his principles and his political future in mind, Cox appears to be charting a conservative course that nonetheless maintains a patina of Donaldson-style vigilance. He is going slow on some of Donaldson's reforms while preserving them in a legalistic sense; letting others (shareholder access) lapse; ignoring areas in which the reforms are incomplete (mutual funds); and winning points as a “moderate” by picking a superficial initiative or two that will please the crowd.

Cox has said, for instance, that he may press for more disclosure on executive compensation. At first blush, this looks bold. On second look, it is mostly public relations. There is already a tremendous amount disclosed on what CEOs earn; the trouble is, pay totals keep rising regardless. It is doubtful that more disclosure will reverse the trend. To do more than grab headlines, the SEC will have to reach the people who set their pay -- the boards. Donaldson's shelved proposal for letting shareholders pick directors is an obvious solution. Imagine how the calculus on CEO pay would change if the head of the compensation committee had to run against a candidate picked, say, by Calpers and other large outside shareholders. It would mean, in effect, real democracy. So far, Cox has said nothing to suggest that he favors it.

Another looming controversy from the Donaldson era is mutual funds. The Chamber of Commerce took the SEC to court to block Donaldson's initiative, which called for an independent chairman and a supermajority of independents on the board. According to the Chamber, mutual fund boards are fine just as they are.

That's a hoot. Little more than a year ago, numerous fund managements were found (by Eliot Spitzer) to have been “timing” their personal investments -- that is, trading against their own shareholders. Funds also make investors pay for marketing expenses. It is impossible to disassociate such abuses from the fact that fund advisors dominate their boards and, in effect, negotiate their own fees. As Dave Swensen, who runs Yale's endowment, has pointed out in a new book, Morgan Stanley charges a 1 percent marketing fee and a half percent commission on an index fund (whose investments are managed by a computer). “Tell me that board is looking out for shareholders,” Swensen says with justifiable sarcasm.

The chairman has yet to tip his hand on mutual funds or on hedge funds. Judging from the collapse of Bayou Capital Management, which somehow lost track of $440 million of its investors' money, the era of free rides for hedge funds should be over.

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Interestingly, Peter Wallison, who launched Cox's political career at the Reagan White House and is now a fellow at the American Enterprise Institute, has become a prolific crusader against securities reforms, including shareholder access and independent fund directors. The latter, he wrote “was emblematic of what was wrong with [Donaldson's] tenure.” According to Wallison, if shareholders don't like the board, they can always sell the stock, so simple disclosure should be all that's required. This dovetails with what we know of Chris Cox's early view of securities markets, as a sort of Edenic capitalist garden in which well-informed investors moot the need for “smothering” regulations. “I suspect the SEC under his [Cox's] watch will pay more attention to empirical data,” Wallison says hopefully.

Unfortunately, the view that disclosure alone will root out misbehavior is belied by Wall Street's every experience over 75 years, especially its recent experience. We cannot, of course, infer that Cox will side with his former mentor. But given that the average American today invests principally through mutual funds, this is probably the single issue on which the Cox SEC will have the greatest potential for good or harm.

Wallison has also been beating the drum against the principal post-Enron legislative reform, the Sarbanes-Oxley Act. Cox has sounded supportive of the Act's principles, but vague on its details -- and in this case, the details matter greatly. Passed in 2002, after revelations of fraud and/or accounting shenanigans at, among others, WorldCom, Adelphia, Rite-Aid, Qwest, Global Crossing, Xerox, Lucent, and Waste Management, Sarbanes-Oxley significantly toughened the standards for corporate auditors. The early returns suggest that Sarbanes-Oxley is working. According to Lynn Turner, a former SEC chief accountant now at Glass Lewis & Co., the number of companies restating their earnings due to accounting errors has tripled to more than 600 a year. Thanks to the new law, companies have had to live with tougher controls, and auditors are taking their mission more seriously.

The business lobby, however, has been wailing about the cost of implementing Sarbanes-Oxley, and relief is high on their agenda, especially for smaller firms (which, by the way, account for far more than their share of bad audits). Audit costs have risen, however; prior to Sarbanes-Oxley they were undoubtedly too cheap. Not only were audits often perfunctory, but accounting firms were undercharging for audits as a means of competing for more-lucrative consulting business. So an increase in audit fees was overdue.

In one of the SEC's first acts under Cox, the agency agreed to give small companies an extra year to comply with the law's audit standards. Then, an advisory panel recommended that small companies be exempt from having their internal controls certified by auditors. This raises the larger question of whether Cox will enforce Sarbanes-Oxley in the tough spirit that its framers intended. Equally worrisome, the SEC has proposed making it easier for foreign companies to deregister their shares in the United States. This would mean that Americans who bought shares in supposedly safe foreign stocks would wake up to discover that the issuers need no longer comply with U.S. rules.

Corporate accounting also needs reform on several fronts. The SEC staff has singled out “special purpose entities” (those off-the-books partnerships used so deftly by Enron) as needing more transparent treatment. Accounting for derivative deals is still abysmally incoherent. There are probably not a dozen people in America who can decipher the disclosures of, say, GE Capital. And accounting for pensions is simply nonsensical. Companies now book earnings based on the percentage gains they expect in their pension funds -- a number their treasurer pulls from thin air -- even if the actual performance is far better or far worse. Given the seriously underfunded condition of many pension funds today, Cox should be pressing the Financial Accounting Standards Board to rewrite such rules.

In 2002, investors lost confidence in corporate books, and markets tanked. Even President Bush, whose personal record in private business was darkened by self-interested and conflicted behavior, was moved to endorse a major securities reform, enacted as Sarbanes-Oxley. In an eerie echo, the job of institutionalizing Sarbanes-Oxley will fall to another man with a dubious prior record on corporate accountability. It will not be easy.

Securities reform is a neverending need, because it must keep up with the agile minds of Wall Street, which are forever devising new techniques to entice, and occasionally to gull, the public. But by the sixth year of a president's tenure, enthusiasm for new SEC initiatives tends to wane, according to Joel Seligman, president of the University of Rochester and author of The Transformation of Wall Street, a magisterial history of the SEC. “Cox is a very bright guy. Is he going to represent continuity or someone who represents a new direction?” -- meaning a slowing or even a reversal of the Donaldson-era reforms -- Seligman wonders. “He really hasn't put his cards on the table.”

Certainly, Cox has been talking the talk. “So why is it that our markets are the gold standard?” he rhetorically asked of his staff. “It boils down to trust. Investor confidence.” Such platitudes would be more reassuring if Cox had not discovered them so recently. But he now has the chance to make good on them. Whether he succeeds in doing so will depend on whether he can distance himself not only from his former friends and his ideological soul mates, but from his very own history.

Roger Lowenstein is the author, most recently, of Origins of the Crash: The Great Bubble and Its Undoing, and a frequent contributor to The New York Times Magazine and SmartMoney.

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