Speech by SEC Staff:
The Benefits of an Enforcement Division
Director, Office of International Affairs
U.S. Securities and Exchange Commission
Comissão de Valores Mobiliários
(Brazilian Securities Commission)
30th Anniversary International Seminar
Rio de Janeiro, Brazil
September 5, 2006
Boa tarde a todos e feliz compleano a la CVM. I am honored and privileged that Chairman Trindade and Eduardo Gomes invited me to contribute to the 30th anniversary of the Brazilian Securities Commission. I would like to thank them for giving me the opportunity to speak on the “upsides and downsides” of a Division of Enforcement and share observations with you from my experience at the United States Securities and Exchange Commission. And congratulations to them on what has proven to be an extremely successful seminar.
Lest you mistake my musings as SEC gospel, I am required to inform you that the views I am about to express are my own, and do not necessarily reflect the views of the Commission, its Commissioners, or other members of its staff. But I hope not to stray to far afield.
I. Theories of Securities Regulation
There are two theories of human nature. For Jean-Jacques Rousseau, mankind is perfectible and noble — inside each and every one of us there is an unbounded capacity to do good, and each and every one of us would choose to do good if only the circumstances permitted. For Thomas Hobbes, on the other hand, mankind is imperfect and fallible — we simply cannot resist the temptation to lie, cheat, and steal. According to Hobbes, in the state of nature mankind’s life is “nasty, brutish, and short.”
From the perspective of government, Hobbes would seem to have the better of the argument. One might say that Rousseau focused on the possiblities and Hobbes on the realities. And governments must cultivate human potential but they must also deal with human reality. As one of our early presidents, James Madison, noted, “If men were angels, no government would be necessary.” And if government is necessary, it therefore follows that men and women are not angels. And if men and women are not angels, the question then becomes, what to do about it?
Describing the law from a behavioralist perspective, the distinguished American jurist Oliver Wendell Holmes wrote that “if you want to know the law and nothing else, you must look at it as a bad man, who cares only for the material consequences” he can predict. In other words, you should not look at the law through the eyes of a good man, “who finds his reasons for conduct, whether inside the law or outside of it, in his conscience” For me, the perspective of Holmes’s “bad man” yields powerful insights on both the drafting of securities regulations and enforcement. We draft regulations not for those who find the reasons for their conduct “in their conscience.” Those folks have no need of regulation. And these certainly aren’t the people we think of when we bring enforcement actions. No — it’s Holmes’s “bad man” that captures our attention.
Our job as regulators is to help Holmes’s “bad man” to predict those “material consequences” that will encourage him to act better than he otherwise would — sanctions, fines, and in some cases, jail time. In short, we need an enforcement program that deters would-be wrongdoers. Former SEC Chairman Harvey Pitt pithily summed up the essence of an effective enforcement program in one sentence: “People need to believe that we are everywhere, and that if you risk violations of law, you will get caught.”
So to my mind, whether it is better to have a separate division of enforcement turns on whether having a separate division fosters this belief. But there are other issues we should consider as well.
II. Some General Observations: Lessons from Organizational Theory
Creating a separate division of enforcement may make sense from the perspective of organizational theory. Indeed, I would posit that there are three advantages to centralizing enforcement.
First, there are obvious benefits to be realized from specialization. Investigating and prosecuting securities violations is a highly specialized skill, ranging from collecting and reviewing documents, interviewing witnesses, and — if necessary — bringing cases to trial. To the extent that you can create a specialized cadre of individuals with these skills, the efficacy of your enforcement efforts increases. Or to put this a bit differently, by placing the responsibility and authority for enforcement in a specialized unit, you can free up your regulators to . . . well, regulate.
You may think I’m being facetious, but regulation — that is, issuing regulations that are designed to address problems before they arise — is vastly different from investigating conduct that has already taken place. When you are crafting regulations, you want to discuss the concerns, the alternatives, the benefits, and the costs with as many stakeholders as possible. You want to be sure that the regulations that you adopt are realistic, effective and cost-justified.
Investigation and enforcement, however, focus on what an individual has already done. Rather than looking toward the future, enforcement looks to the past, and focuses on one, or a small handful of, individuals and firms, rather than on an entire industry. That’s not to say that regulation shouldn’t inform enforcement, and enforcement shouldn’t affect regulation. These are complementary activities. But they are different activities, with different purposes, using different techniques. Putting regulation and enforcement in different shops is recognition that it is difficult to serve two masters.
The second advantage to creating a separate and specialized division of enforcement is that it makes it easier for the regulator to manage investigations and enforcement. The regulator can identify particular enforcement issues, set priorities, and ensure that these priorities are met across all of its operating divisions and regional offices. That’s not to say that having enforcement authority dispersed throughout a commission makes this sort of oversight impossible. But I believe that centralizing enforcement authority in one division certainly makes managing that authority much, much easier. If you don’t believe me, think about how much easier it is to set a budget for investigations and enforcement when that function is consolidated in one division than it is if you have to set that budget as a percentage of several divisions’ budgets.
The third advantage to creating a separate and specialized division of enforcement stems from what I will call — for want of a better word — “branding.” We want to create in the mind of the “bad man” the impression that enforcement is swift, certain, and unforgiving. And in order to create that impression, our “bad man” has to know that securities regulations will be enforced. As former Chairman Pitt noted, “an essential predicate for any effective enforcement program is its visibility.” I can’t think of any better way to make an enforcement program more visible than to make it a separate division, with its own budget, its own staff, and perhaps most importantly, its own director. Well, I can assure you that when the Director of the SEC’s Division of Enforcement speaks, people really watch and listen.
III. Lessons from the SEC’s History
In puzzling through this question, it might be useful to step back and look at the U.S. SEC’s experience. You probably already know that the SEC was established in 1934, in the shadow of the 1929 Stock Market Crash and the Great Depression. But you may be surprised to learn that it was not until 1972 that the SEC established its Division of Enforcement. In other words, despite the really good reasons that I’ve just given you, it took us some 38 years before we got around to setting up a separate Division of Enforcement.
How did the SEC carry out its enforcement function before 1972? In the years preceding 1950, much of the SEC’s enforcement efforts were concentrated in the various regional offices. These efforts were focused on boiler rooms, fraudulent penny stocks, and exploitative broker dealers. By the late 50s, the Commission’s operating divisions developed their own enforcement branches. For example, what was then known as the Division of Trading and Exchanges had its own “Office of Special Investigations.” The Division of Corporation Finance and the Division of Corporate Regulation also conducted their own investigations.
In 1972, the SEC undertook a sweeping review of its enforcement operations and restructured its operating divisions, creating the Division of Enforcement. Although there is little that is publicly known about the deliberations that led to its creation, it is known that there was a perceived need for a stand-alone division that would provide a more complete picture of the SEC’s nationwide enforcement activities. It was thought at the time that the SEC would have an easier time identifying, establishing, and following through on national enforcement priorities. And some were concerned that enforcement activities had become so demanding on the staff’s time that resources were being diverted from the tasks of oversight and rulemaking.
But it’s worth noting that although the Division of Enforcement was created in 1972, the SEC has been focused, from its inception, on enforcement. The SEC was created at the conclusion of the Senate Banking and Currency Committee’s investigation into the causes of the stock market crash of 1929, in which the value of all stocks listed on the New York Stock Exchange shrank from $90 billion to just under $16 billion. One might well describe this as the moment that the U.S. Congress called for ordem e progresso in the U.S. financial markets. In 1937, William O. Douglas, the third chairman of the commission, set the tone for the newly-created SEC when he declared it to be “the investor’s advocate,” defending investors against the unscrupulous and the unprincipled. And quite recently, Chairman Cox again reiterated that “first and foremost, the SEC is a law enforcement agency.” So the lesson may well be that although there may be advantages to centralizing enforcement authority in a stand-alone division of enforcement, the most important element of success is not the structure of your organization but your organization’s commitment to enforcement.
IV. Lessons from History Revisited
Of course, history never points in one direction, and for every lesson learned, there is an opposite lesson, equally plausible. Look before you leap; but he who hesitates is lost. Many hands make late work; but too many cooks spoil the broth. And my favorite: buy low, sell high; but remember, you get what you pay for.
I note these contradictions because the creation of a separate division of enforcement may not be for all. What may make the SEC’s experience unique are the specific historical circumstances in which it was created. The SEC was created in response to a specific problem: the collapse of the financial markets in the United States and the need to restore investor confidence. Given the collapse, it was all but inevitable that investor protection — and therefore enforcement — would lie at the heart of the SEC’s mission. What we sometimes forget is that the U.S. financial markets preceded the SEC by some two hundred years. Put differently, the SEC’s mandate — though tremendous — did not include creating financial the markets.
Other commissions, however, may be confronting this very issue. For those countries in which the most pressing issue is market development, investor protection may not appear to be the highest priority. For those charged with developing financial markets, the question ultimately becomes the extent to which enforcement will get a share of the scarce resources that a commission can bring to bear on securities regulation. But I would maintain that successful market development today calls for robust investor protection. And a separate division of enforcement would seem to be the most effective way to achieve this goal and articulate a commitment to enforcement.
Perhaps I am a pessimist, but I think the history of the financial markets has demonstrated, time and time again, that President Madison is right, and that whatever its capacity for good, mankind is simply prone to do wrong. A separate, vigilant, and active Division of Enforcement gives us in the United States some comfort that honest investors can have confidence in the integrity of the financial markets. Obrigado.