Kotz: IG Probes Could Result in Referrals to Criminal Authorities

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Information turned up by the Securities and Exchange Commission's Office of the Inspector General during investigations of misconduct by SEC employees can--and on occasion does--result in a criminal referral, IG H. David Kotz told BNA Dec. 15.

In a wide-ranging interview, Kotz said his investigative staff “work[s] closely” with the Justice Department, the U.S. Attorney's Offices, and the Federal Bureau of Investigation. “From time to time,” he added, “a small percentage of the matters that we investigate get referred.”

Currently, he disclosed, there are “several active matters”--“more than two but less than a dozen”--that the OIG is working on either with Justice or the FBI.

While Kotz did not reveal any case particulars, he did say that the OIG has made referrals regarding both current and former SEC employees. Moreover, if the office were to learn of wrongdoing by an individual who had never worked for the commission--someone who was involved in potential criminal conduct with an SEC employee, for example--“we would be obligated to refer the matter. However, we would normally not be investigating that type of individual so we would have to find out about it in an indirect way.”

Madoff Investigation.

Kotz said his most interesting investigation--“and in some ways, the most difficult”--was the OIG's inquiry into how and why the SEC failed to uncover Bernard Madoff's $50 billion Ponzi scheme. Why? “The enormity of the amount of the scheme, plus the fact that the investigation spanned almost 20 years.”

Office of Inspector General.

The Office of the Inspector General is an independent office within the SEC, and the IG is a commission employee. The office conducts audits of SEC programs and operations and investigates allegations of misconduct by staff or contractors. The OIG's mission is to detect fraud, waste, and abuse, and to promote integrity and effectiveness in the comapmission's programs and operations. Complaints can be submitted online, or by calling the OIG's Toll Free Hotline, (877) 442-0854.

The SEC was castigated both in the press and on Capitol Hill over its embarrassing failure to discover the fraud before Madoff himself confessed to his wrongdoing. Among other specifics, the commission was widely faulted for ignoring complaints by derivatives expert Harry Markopolos, who warned the agency as early as 2000 that Madoff was running a Ponzi scheme.

Working to ensure that that kind of situation does not recur, Kotz said his office reviews every complaint it receives. “Every complaint that's brought in, we review and analyze and put into different categories,” he explained. “Some complaints we immediately know must be investigated thoroughly. If so, we open an investigation.” Other complaints are less certain; in those cases, the OIG commences a preliminary inquiry to analyze the matter further. Some complaints, however, are clearly not within OIG's jurisdiction and will be sent to another office within the SEC--a complaint that a company is engaged in fraud, for example, would be sent to the Enforcement Division.

“Every complaint that's brought in, we review and analyze.”

Kotz said his office receives complaints from a variety of sources, both within and outside the commission. In the six-month period between April and September 2010, he noted, the OIG received 364 complaints, 117 of which were from internal sources. In addition, Kotz said, the office learns of matters warranting investigation through its audit work. There also are times “when our employees will bring to my attention certain issues they think we should look at.”

“It's hard to tell” whether 2011 will be as busy as the past few years have been, Kotz continued. However, he also noted that the number of complaints received by the OIG has risen over time: “So I certainly think we'll be busy. Whether … we will have a large-scale matter like Madoff, or even [R. Allen] Stanford, I don't know.”

Audits, Investigations.

There are 25 people in the OIG, Kotz recounted: 22 full-time employees and three contractors. Although the staff has grown considerably--there were only nine full-time employees when Kotz first became IG in late 2007--he acknowledged that he “could always use more investigators. … We have a lot of complaints … that need to be investigated.” However, Kotz also said he strives to have an efficient operation, and is satisfied that the office can meet its responsibilities with the staff it has now.

On the audit side, Kotz detailed, the OIG essentially creates a master list of potential issues--“programs and policies that we believe should be audited.” He said the list is compiled primarily through conversations with other SEC employees. The OIG, in turn, has monthly meetings at which it analyzes matters on the list and determines “what issues we should look at and when.” In addition, lawmakers sometimes ask the OIG to look into particular matters, Kotz observed.

“[I]f it's within our jurisdiction and it has the potential to be a significant concern, we will at least conduct an inquiry.”

There is no complaint too insignificant to warrant further inquiry, he continued: “Potential misconduct is potential misconduct.” Rather, the question is more whether the matter is within the OIG's jurisdiction. “We will get complaints sometimes that are not really related to what we do,” Kotz explained. However, “if it's within our jurisdiction and it has the potential to be a significant concern, we will at least conduct an inquiry.”

Reaching Out to Lawmakers.

Kotz joined the commission shortly after then-IG Walter Stachnik stepped down in the wake of criticism over his handling of an inquiry into an insider trading investigation. Asked how that circumstance affected his own approach to the role, Kotz said he felt it was important to “reach out to folks on Capitol Hill” to ensure that they had confidence in the office. “So I did make efforts in that regard.”

In particular, he told BNA, he believed it was important to ensure that there was sufficient staff to fulfill the obligations of the office, and for the OIG to include in its semiannual report to Congress the details of its audits and investigations. “I did feel like it was important for us to inspire confidence among our constituents both within and outside the agency.”

“I think people know that we are on the job, … and if there is misconduct or … failures on the part of the SEC, we will uncover it.”

Those efforts have “actually been received very well, especially outside the commission,” Kotz related. He said the OIG has been commended by various oversight committees with respect to its Madoff and Stanford investigations, among other matters. It also has received kudos from the investing public, Kotz added, citing “hundreds of e-mails and letters from victims thanking me for my efforts” concerning Madoff and Stanford.

In addition, Kotz related, he has received tremendous support from Chairman Mary Schapiro and the senior staff, “and from many folks within the agency who felt that there needed to be someone in this position who was engaging in appropriate oversight and thanked us for our efforts in that regard.”

Asked about the conflict inherent in his role as an SEC employee, Kotz said that even though he reports to the chairman, he makes a great effort to ensure that his office is independent of the commission. Neither Schapiro nor former chairman Christopher Cox has ever threatened the OIG's independence, he emphasized. Rather, he said he thinks that everyone at the SEC understands the importance of having an internal watchdog. “We … investigate employees that we see in the halls and folks that we have interaction with, and we find what the evidence shows and recommend that action be taken.”

Enhanced Reputation.

Moreover, Kotz suggested, the agency has benefited, both tangibly and reputationally, from the efforts of his office. For example, he noted that OIG made 69 recommendations stemming from its findings in the Madoff investigation, “all of which have been implemented.” As a result, the SEC's enforcement and compliance offices and divisions should be in a much better position to identify and uncover fraud. “So I do think there's been a great benefit by virtue of the implementation of our recommendations.”


H. David Kotz was named Inspector General for the Securities and Exchange Commission in December 2007. Before joining the SEC, Kotz served as the Inspector General for the Peace Corps, during which time he also served as Inspector General on a part-time basis for the U.S. Commission on Civil Rights. Prior to his government service, Kotz worked for Graham & James LLP, New York, and Pepper Hamilton LLP, Washington. After joining the federal work force in May 1999, he served in several capacities at the U.S. Agency for International Development, both in the Office of General Counsel and as head of all administrative and disciplinary investigations for USAID. Kotz also serves on the Inspector General Council of the Troubled Asset Relief Program, the Council of the Inspectors General on Integrity and Efficiency, and several other professional and charitable organizations. He is a graduate of the University of Maryland and Cornell Law School.

In addition, Kotz said he believes that the fact that Congress and the investing public are aware that there is an entity within the SEC conducting oversight enhances the agency's reputation. “I think people know that we are on the job, … and if there is misconduct or … failures on the part of the SEC, we will uncover it.”

“If we were to conduct an investigation and find that there was no wrongdoing, which we on many occasions do, I think there is confidence on the part of Congress and the public that there was nothing wrong. The fact that you know that there is a watchdog in place that is conducting real oversight enhances the SEC's credibility,” Kotz related. He also suggested that the presence of an IG's office that is fulfilling its responsibilities “create[s] an incentive for employees to ensure that they are following all applicable rules.”

Reflecting on his tenure, Kotz said many changes have taken place at the SEC as a result of problems his office uncovered. He said he hopes the effect of these changes causes the commission “to be more responsive and better prepared to perform its responsibilities.”

Where does Kotz go from here? “I don't know. I really enjoy this job.”

“At the moment I don't have any plans to go anywhere. … It's been a very interesting, rewarding three years and I'm planning to stay,” he concluded.

By Phyllis Diamond

Request Securities & Capital Markets on Bloomberg Law