(Bloomberg News) -- The U.S. Securities and Exchange Commission's internal watchdog has castigated the agency for missing the Bernard Madoff fraud, spotlighted employees who viewed online pornography and called for a criminal probe into the ethics of the SEC's former top lawyer.

His blunt reports have won Inspector General H. David Kotz admiration on Capitol Hill, where lawmakers summon him to testify about his efforts to improve what they have criticized as flawed management and oversight at the regulator.

At the SEC, it's a different story. While inspectors general are rarely beloved, a backlash against Kotz among staff and managers has grown in intensity and spread to the legal community outside the agency. Now critics led by former SEC Chairman Harvey Pitt say Kotz is undermining the market regulator's effectiveness.

"For those who may be unaware of what is going on at the SEC, there is a reign of terror in effect," Pitt, who has represented several people involved in Kotz's investigations, wrote to securities lawyers last month in an e-mail obtained by Bloomberg News.
Kotz's supporters say he's a zealous investigator who arrived when the SEC's lapses in the run-up to the credit crisis called for a tough in-house cop. His critics say that some of Kotz's reports lacked evidence of wrongdoing and unfairly damaged the reputations of those he accused.

In reports to Congress, Kotz has said his office referred 28 cases to the Justice Department from October 2007 to March of this year, leading to two prosecutions, one agreement not to bring charges and no convictions so far. He said in a statement yesterday that only about 10 were formal referrals and one resulted in a conviction.

'Drop of a Hat'

Pitt, who participated in the e-mail exchange about Kotz with about 90 other securities lawyers, said the inspector general's activities have put the agency on edge. "People are afraid to write anything down, make decisions or even take notes of telephone conversations, because the current IG monitors everyone's e-mails, including the chairman's, and starts investigations at the drop of a hat," Pitt wrote.

In interviews, almost three dozen current and former SEC staff members, speaking on condition of anonymity to avoid reprisals from Kotz, raised concerns similar to Pitt's.

Kotz, 45, disputed his critics in an e-mailed statement, saying his work has had "an extremely positive impact" on the SEC.
"Whenever an inspector general is doing his or her job properly, there is naturally some level of apprehension on the part of agency employees of a possible investigation," Kotz said. "However, we have made efforts to be very thorough, detailed and fair in our reports."

Million Messages

The current and former staff members interviewed, who include managers, senior appointees and non-supervisors, said their fear of Kotz's probes has caused them and others to change work habits in ways that have unintended consequences.

Kotz has reviewed millions of internal messages in some investigations. That has prompted many in the agency to rely largely on private e-mail accounts and cell phones, rather than their government-issued devices, the people said. As a result, staff conduct is harder to monitor. Some managers have bought legal insurance to pay attorney's fees in the event they wind up embroiled in a Kotz probe, according to three people with direct knowledge of the matter.

George Canellos, a former federal prosecutor who oversees the SEC's enforcement and inspection work in New York, was asked at a legal conference this month about Kotz's impact on the agency. Telling the group that he needed to "tread very softly," Canellos said that "there's an influence on the SEC culture that flows in part from active IG scrutiny that I never observed in nine years in the Justice Department."

Reluctant Lawyers

Canellos said that some of Kotz's probes -- at times driven by requests from Congress or SEC Chairman Mary Schapiro -- have looked broadly at whether employees are doing their jobs rather than focusing on whether rules were broken. That approach, combined with public scrutiny of the SEC's failures in the Madoff and R. Allen Stanford Ponzi cases, has made enforcement lawyers reluctant to formally close files even when they believe there's no case, he said.

"Right now if you close an investigation and, god forbid, you've missed something, you could be subject to significant criticism," Canellos said.

"There's arguably a positive upside, in the sense that people are very vigilant and constantly attentive to the fact that they're sort of being watched and that any of their activity could be scrutinized, but that can also have a chilling effect, and distorting effect on some activities," he said.

Canellos, in response to questions from Bloomberg News, said in an e-mail this week that his comments reflect general pressures on the SEC staff and were not personal criticisms of Kotz or his investigations.

Kotz, who declined to comment on specific cases, said in his statement that since he took over the job in 2007 his office has issued 52 audit reports and 140 investigative reports. He said he is unaware of any material error in any of them, which he termed "an extraordinary record." The SEC's management agreed with 95 percent of the 685 recommendations in those reports, he said, and has put 73 percent of them into place.

"My staff and I have developed an extremely constructive and collaborative working relationship with agency management, and in particular, Chairman Schapiro and her staff," Kotz said.
To Kotz's supporters, his critics are largely disgruntled people who've gotten caught up in his reviews.

'Disciplinarian'

"Too many IG's are picked to be wallflowers and not do anything," said Harry Markopolos, the whistleblower who tried without success to interest the agency in Madoff's activities before the scandal broke in December 2008. Kotz "brought in accountability and no one likes a disciplinarian," Markopolos said.

Kotz's reports have provided fuel for Republican lawmakers critical of the SEC's operations under Schapiro, who was appointed by President Barack Obama. Senator Charles Grassley of Iowa and Representatives Randy Neugebauer of Texas and Darrell Issa of California have helped propel his investigations with public statements and hearings.

In addition, some lawmakers have featured Kotz's reports in arguments to cut the agency's budget, including the SEC's bungling of a $557 million lease for new office space and the revelation that employees accessed online pornography at work.

'Sugar Coating'

Kotz has "shown independence in his willingness to take on controversial topics and present findings without any sugar- coating," Grassley said in a statement. "Agencies with active inspectors general tend to function better than those without."

Asked if Schapiro wanted to make a statement on the inspector general, SEC spokesman John Nester said in an e-mail: "Chairman Schapiro recognizes the important role of inspectors general in promoting integrity and efficiency in government, but it would not be appropriate for the chairman to discuss personnel matters."

Kotz was named inspector general in December 2007 by Christopher Cox, a Republican selected by President George W. Bush as SEC chairman. Kotz had been doing the same job at the Peace Corps since 2006; he joined that agency in 2002, working in the general counsel's office. Kotz also was a lawyer at the U.S. Agency for International Development.

Previously, Kotz, who earned his law degree from Cornell University in 1990, was in private practice at three firms, including in the Washington office of Pepper Hamilton LLP.

'Zealous Advocate'

Kotz is a "zealous advocate," said Carl Sosebee, who worked with him at the development agency and later reviewed Kotz's investigative reports while serving in the general counsel's office at the Peace Corps.

"I never felt that he wrote anything unfair or inflammatory," said Sosebee, now a senior adviser to the Peace Corps director. "He's a guy of integrity."

Pitt, who was appointed to head the SEC by President George W. Bush in 2001, resigned in November 2002 during the Enron and WorldCom accounting scandals after lawmakers raised questions about his previous business ties to the biggest auditing firms.

Pitt's campaign was prompted in part by Kotz's probe of former SEC general counsel David Becker, who worked for Pitt when he ran the agency. Kotz last month called for the Justice Department to conduct a criminal investigation of Becker. The inspector general's 119-page report concluded that Becker's work on Madoff policy while at the SEC was improper because he had inherited profits from the fraud through an account held by his late mother.

'Beyond the Pale'

Becker had alerted Schapiro about the matter and sought and followed advice from the SEC's ethics counsel. In the e-mail, Pitt said Kotz's decision to seek a criminal probe is "far worse than beyond the pale" and a "classic example of what is destroying the esprit at the SEC."

Becker has said he didn't violate the law because he had no financial interest in the SEC's Madoff policy. Schapiro, who has said that in hindsight she wished Becker recused himself, took part of the blame for the matter and told lawmakers she was overhauling procedures for vetting conflicts of interest.

Stanley Sporkin, a former SEC enforcement director and federal judge, said that while "everyone could have used better judgment" in the Becker matter, it's unlikely to end in criminal charges.

"For them to charge him criminally and get a jury to convict would be the most difficult thing," said Sporkin, who was also general counsel of the Central Intelligence Agency. He was one of 52 lawyers who signed a letter to lawmakers supporting Becker.

At a hearing last month, Becker told lawmakers that while he was working at the SEC, Kotz routinely sent cases to the Justice Department to "get lots of publicity" for his reports, and said from a legal standpoint, a number of the referrals "were laughable."
Becker, 64, declined to comment for this story, pointing to the February going-away speech he gave to SEC staff for insight into Kotz's probe.

"It's riskier to work here than it used to be," Becker said in the remarks. "I've had more than a few people in my office weeping with fear about what might happen to them because one person or another was looking into their behavior. I've been shocked by that."
Some of Kotz's internal critics said in interviews that the Becker case added to their distress over previous criminal referrals made by Kotz that didn't lead to charges.

Reporting to Congress

Kotz's semiannual reports to Congress covered the period from October 2007 -- two months before his appointment -- through March of this year. The 28 cases he said were referred in that time exceeds the number sent by peers. For example, A. Roy Lavik, inspector general of the Commodity Futures Trading Commission, told Congress he referred none, and John Seeba, internal watchdog for the Federal Trade Commission, reported sending one matter to a U.S. Attorney's office that resulted in a guilty plea, according to their congressional reports.

The gap in numbers may reflect in part a difference in what each inspector general considers a reportable referral. For the purposes of the congressional reports, Kotz lists cases he discusses with Justice lawyers as referrals even if he doesn't send them over in the end.

"Approximately 10" of those cases led to a "formal" referral to federal prosecutors, and many of them are too recent to expect that they'd result in charges, he said in the statement.

Employees investigated by Kotz have been identified by name in press reports or inside the agency. In cases the Justice Department ultimately declined to pursue, there haven't been public exonerations.

In one 2009 probe, Kotz accused two SEC employees, Glenn Gentry and Nancy McGinley, of possibly violating insider trading laws. In one instance highlighted by Kotz, McGinley, an enforcement attorney who joined the agency in 1981, traded shares of Schlumberger Ltd. in early 2008 around the time the SEC was exploring a possible foreign bribery case against the company, which already had disclosed that the Justice Department had a criminal probe underway. McGinley testified that she had no idea the SEC was looking at the Schlumberger matter.

In his report, Kotz wrote that Justice "accepted the referral and is conducting a comprehensive investigation together with the Federal Bureau of Investigation."

'Nothing'

According to Adam Augustine Carter, McGinley's attorney, federal prosecutors dropped the case after a review showed that the employees didn't trade on material non-public information, the legal standard for insider trading.

"They looked at this and determined that there was nothing to prosecute," said Carter, a principal at The Employment Law Group in Washington. "Not that there wasn't a felony or it wasn't worth it, but that there was nothing."

David Gourevitch, a former SEC enforcement lawyer now based in New York, reviewed Kotz's report and said it lacks proof that a crime was committed. "There is no evidence," Gourevitch, who has prosecuted and defended insider trading cases, said in an interview. "Where's the beef?"

Gentry and his lawyer didn't return calls seeking comment.

McGinley and Gentry, who still work at the agency, haven't been publicly vindicated. While their names were blacked out in the report, it contained other details that made it easy for others to identify them, including their gender, the division where they worked and the length of time they had been at the SEC.

Kotz "is happy to grab headlines when it suits him, suggest that there is something wrong at the SEC and then have other people suffer the fallout," Carter said.

Alleging Improprieties

In another case, Mayra Toledo, a longtime manager in the SEC's technology office, was accused by Kotz of improprieties including attending a meeting with a contractor at another agency. During his probe, Kotz urged senior SEC officials to fire her, warning that she was going to be indicted, according to two people who heard Kotz. When the officials called the Justice Department, they were told it had no interest in bringing a case.

Toledo, who has left the SEC, declined to comment. Laura Sweeney, a Justice Department spokeswoman, declined to comment.

In his statement, Kotz said that the Inspector General Act requires him to refer evidence of violations of criminal law and that he has "limited discretion in deciding whether matters should be referred." He added that "the decisions on which names or other information should be redacted from our investigative reports are made by SEC management, not by my office."

Some SEC employees have pushed for their union to speak out against the inspector general, according to a 2009 e-mail to Jeffrey Risinger, the SEC's then-head of human resources.

The e-mail came from the union's chief, Greg Gilman, an enforcement lawyer in the SEC's Boston office, who was forwarding a complaint from an unidentified employee, according to a copy of the e-mail traffic obtained by Bloomberg News. The worker told Gilman that the union needed to publicly raise the issue of the IG's conduct to the commission for what the worker called the mistreatment of individuals singled out in some of Kotz's reports.

Risinger, in turn, sent the e-mail to four of Schapiro's top aides, noting that it wasn't the first complaint the labor group, which is part of the National Treasury Employees Union, had received about Kotz. "At some point soon, the union will defend the reputation of its members," Risinger wrote.

Whistleblower

A year earlier, in 2008, the SEC's chief administrative law judge, Brenda Murray, was asked by then-SEC chairman Cox to review two of Kotz's probes because they involved one of his direct reports, enforcement director Linda Thomsen. Murray, in written opinions, was critical of Kotz's investigative findings.

In one case, Kotz had faulted David Nelson, former head of the SEC's regional office in Miami, for improperly closing a probe into Bear Stearns Cos. pricing of certain financial products. Kotz said the probe should have led to an enforcement action.
Murray disagreed, noting in a written opinion that, "none of the materials the IG cites provides a legal basis for his recommendation."

The second case Murray reviewed involved an investigation into an insider trading matter and the firing of a whistleblower where Kotz had recommended that the SEC discipline Thomsen herself for disclosing non-public information. Murray concluded that while Thomsen did give out the information, it was legally allowed because it was necessary to carry out her job.

"There is no evidence that the disclosure impeded enforcement's investigation, that it assisted the person being investigated, or that Thomsen expected to benefit personally from the disclosure," Murray wrote. Thomsen left the SEC in 2009 and is now in private practice at Davis Polk & Wardwell LLP in Washington.

Neil Barofsky, the former special inspector general who monitored the financial bailout, said criticisms of an activist watchdog are inevitable.

"There have been a lot of attacks against David, and that's usually a pretty good sign he's doing his job," said Barofsky, now teaching at New York University's law school. "If you want to be an IG and do the job right, you're not looking to make friends."

Lynn Turner, a former chief accountant at the SEC who still pays close attention to the agency, says that when it comes to the assessments of Kotz, "the truth is somewhere in the middle."

Kotz has done top-notch investigations, including those looking at the Madoff, Stanford and leasing matters, Turner said. Kotz also has a prosecutorial style that leads him to sometimes leave out facts that go against his case, Turner said.
"He detracts from the good work he's done when it starts to look like the Salem witch trials," Turner said.