What the Future of S.E.C. Enforcement Holds Under Jay Clayton

A frequently told story about the Securities and Exchange Commission’s adoption of Rule 10b-5, the principal antifraud rule used in hundreds of cases every year, is that after the five commissioners reviewed the proposal, the only one to speak was Sumner Pike, who simply said, “Well, we are against fraud, aren’t we?”

That captures well the approach of Jay Clayton, President Trump’s nominee for chairman of the S.E.C., at his hearing before the Senate Banking Committee last week. His prepared statement asserted that “I am 100 percent committed to rooting out any fraud and shady practices in our financial system.”

Anything less would have been heresy, furthering the view that he is simply a tool for the Wall Street titans he represented as a partner at Sullivan & Cromwell, one of the leading law firms for large banks and investment firms. As chairman, Mr. Clayton recognizes that he can no longer be an advocate for former clients if he wants to be successful.

A good portion of the hearing focused on the potential conflicts of interest that might arise from his law practice that included representing Goldman Sachs and Deutsche Bank, both of which have run afoul of the commission, along with Volkswagen and Valeant Pharmaceuticals International, both currently under investigation for possible securities law violations.

In addition, Mr. Clayton’s financial disclosure form states that he could not disclose the names of four individuals and five corporate clients because of confidentiality rules for lawyers, including two corporate clients that “are the subject of a pending nonpublic investigation.” It will be interesting to see if those investigations develop into enforcement actions, indicated by Mr. Clayton’s recusal from any decision on them.

For someone with an extensive practice involving the capital markets, the conflicts are unsurprising and will require him to avoid matters involving former clients for two years. Mary Jo White, the former chairwoman of the S.E.C., had a similarly extensive private practice that included representing JPMorgan Chase and UBS, knocking her out of any cases involving them.

Although recusals can make life more difficult in deciding whether to pursue a case, many enforcement matters that come before the commissioners are not controversial and do not divide them along ideological or political lines. Under Ms. White, divisions among the commissioners were often about the appropriate penalty in a settlement or whether waivers from certain restrictions would be granted, and less frequently about whether the matter involved a violation that should be pursued.

Nor does the chairman have any hands-on role in an investigation, so once the commissioners authorize the filing of a case they do not deal with the litigation or dictate strategy to the trial lawyers, except to approve a settlement if one is reached. Unlike a typical client who foots the bill and often helps formulate the approach to a case, the S.E.C.’s lawyers — like most government attorneys — have a much greater measure of independence in pursuing a matter once given the authority to proceed.

The larger question is what tone Mr. Clayton will set for enforcement, and how aggressive he wants the S.E.C.’s staff to pursue cases that involve major Wall Street financial institutions.

The important first step, assuming he is approved by the Senate, will be the appointment of a new director of the enforcement division.

Since 2009, two of the three directors were former federal prosecutors who worked under Ms. White in the United States attorney’s office in Manhattan. They adopted policies reflective of the approach of the Justice Department, like requiring some defendants to admit to violations and granting deferred prosecution agreements in exchange for cooperation.

As the S.E.C. recovered from the debacle over the failure to detect the Ponzi scheme perpetrated by Bernard L. Madoff, aggressive enforcement became the watchword. This was reflected in annual increases in the number of enforcement actions filed — even though some involved minor transgressions — and large corporate penalties that were promoted as signs of the agency’s renewed vigor in enforcing the securities laws.

Mr. Clayton told the senators that “there is zero room for bad actors in our capital markets.” Yet, he also pointed out that the penalties imposed on companies in settlements should be reduced because “shareholders do bear those costs and we have to keep that in mind.” He noted that greater deterrence was possible by pursuing individuals rather than seeking large payments from corporate violators.

The focus on individuals is similar to the policy adopted in 2015 by the Justice Department that conditioned credit for a company’s cooperation on providing evidence of individual wrongdoing by employees and executives.

The challenge in this approach will be that scaling back corporate penalties could send a message to corporations and Wall Street that they have little to fear from the S.E.C., which cannot pursue criminal cases, because they face only modest financial exposure if violations are uncovered. Without the threat of a significant monetary penalty, it will be an open question whether there will be real cooperation from organizations or just lip service about providing assistance while avoiding disclosures that might implicate current management.

Since the Justice Department adopted its new approach to corporate cooperation, there have been few individual prosecutions for violations inside companies. Even the indictment of six Volkswagen employees over their role in the rigging software to thwart emissions tests did not reach the upper levels of the company, and five of the defendants remain in Germany and so are outside the reach of the United States government.

Stressing the need to pursue individuals rather than corporations sounds like an effective enforcement policy, but it may not produce significant results. Unlike companies, which often settle cases rather than run the risk of negative publicity, individuals are much more likely to fight charges that can result in a rejection of the charges by a jury or judge.

In an organizational setting, it is often difficult to assess who is responsible for corporate decisions when authority is diffuse and no one is fully responsible for misconduct. Top management often has little involvement in day-to-day decisions, so executives can claim ignorance of wrongdoing despite a “toxic culture” described in The New York Times that developed at companies like Wells Fargo and Volkswagen that led to multiple violations.

Another challenge Mr. Clayton faces is whether the S.E.C. will have the resources to pursue an aggressive program to police the markets. In November 2016, shortly after Mr. Trump’s election, Ms. White submitted a budget request to Congress seeking a $445 million increase for the agency from its current funding of about $1.6 billion — a proposal that had no possibility of being approved.

The S.E.C. did not rate a mention in President Trump’s budget blueprint released recently, but the proposed cuts to most departments indicate that the funding available for the agency will most likely be reduced, perhaps substantially. The enforcement division is the largest at the S.E.C., totaling about 1,400 employees, so it can be expected to absorb a good portion of the budgetary impact.

It will be interesting to see how Mr. Clayton distributes any likely funding reductions the S.E.C. is facing and whether he will seek to increase its appropriations in future years. Although it may be fashionable to talk about “doing more with less,” as a practical matter a significant budget cut will affect enforcement more than any claims about rooting out wrongdoing.

As the S.E.C. faces a potential reduction in the resources it can devote to enforcement, choices will have to be made about what types of violations will be investigated and whether to file cases that may involve a significant expenditure of time and energy, especially if there is not a high probability of success. For Wall Street, the message may be that the agency will have to police a little less even though everyone is against fraud.