Speech by SEC Commissioner:
Remarks at Vanderbilt University
Commissioner Paul S. Atkins
U.S. Securities and Exchange Commission
October 20, 2006
Thank you, Angelo, for your kind introduction. I am honored to be back here at my alma mater. It is hard to believe that more than 23 years that have passed since I graduated from law school. Some of you were not even born then! Before I begin, I must remind you that the views that I express here are my own and do not necessarily represent those of the Securities and Exchange Commission or my fellow commissioners.
As Angelo mentioned, I am now in my second stint at the Securities and Exchange Commission since graduating from law school. I first worked at the SEC 15 years ago. In those days, it was very different. At that time, the SEC was far from being a household name. Every call I made required an awkward introduction in which I would tell the person at the other end of the telephone that I was from the SEC. “FCC, you say?” “No, the SEC.” “Oh the FEC.” “No, I said “SEC.” “Oh, you are from the FTC.” In the alphabet soup of Washington, I learned quickly that I needed to enunciate S-E-C clearly or, better yet, say the complete name. Once that issue was cleared up, I would be asked: “Is that a government agency?” Once I explained that the SEC is part of the federal government, I would be asked: “Are you based in Washington or New York?”
Well, times have changed. I became convinced that the SEC had gone mainstream when it was featured on the Simpsons a couple years ago.1 Homer unwittingly gets caught up in a company gone bad. The SEC swoops in and arrests him, and he gets sent to prison. But, unlike the depictions on this and other shows, we do not carry M-16s, chase down yachts of inside traders in SEC police boats, or parachute James Bond style into illicit corporate board meetings. It is much tamer than that. We don’t carry guns; we have no boats; we have no planes. We do not even have authority to arrest people.
Although the SEC appears in the headlines a lot more than it used to, the structure and functions of the SEC remain a mystery to most, so I will give you a bit of background. I am one member of this five-member commission. Each of us was appointed by the President and confirmed by the Senate. The SEC is one of the many so-called “independent agencies,” which means that it performs a mix of executive, legislative and judicial functions. The SEC has civil (not criminal) enforcement powers against people who violate the securities laws and our rules; it has power to write rules pursuant to statute; and it acts like an appellate court in reviewing appeals from sanctions that the stock exchanges and the professional organization of brokers levy against their members.
Like many other administrative agencies, the SEC has grown in influence over recent years. This is attributable in part to the rapid growth of the financial markets and the increasing participation of retail investors in the markets. Earlier this week, the Dow Jones Industrial Average topped 12,000 for the first time. Changes in technology and attitudes have opened up world financial markets to one another. In dealing with changes in the financial markets, the SEC has a responsibility to regulate in a manner that both protects investors and fosters innovation, competition and growth in the financial sector.
I encourage those of you who are students, whether law students or business students, to consider pursuing a career in the financial services sector. Securities law is a growing, challenging, and rapidly-changing field. The financial sector also offers many exciting opportunities for business students with an innovative or analytical bent. Regardless of whether you choose to pursue a career in the financial sector, a working knowledge of securities issues is important.
One of the lessons that even a cursory familiarity with securities issues will teach you is that it pays to choose your employer carefully. Take to heart the old adage that you can judge a person by the company he keeps. A firm’s ethical culture is very important. It is set primarily by a firm’s executives and is reflected by the firm’s organizational structure, strategic goals, compensation incentives, and the degree of oversight activity by gatekeepers such as directors, auditors, and attorneys.
Once you have taken a job, be willing to ask questions and exercise your judgment. Hapless corporate employees who have gotten into situations over their heads may find themselves the subjects of SEC enforcement actions. During my 4 years on the Commission, I have seen numerous examples of this. What do you do if, after having moved yourself and your family across the country to take a new job, you begin to suspect that your boss is crooked? What if she tells you to do something against your better judgment, but you don’t know enough about the company yet to be sure whether it is wrong? You are excited about the new job, want to be loyal to your boss and your colleagues, and want to think the best of the situation. With the benefit of 20/20 hindsight years later, however, it is easy for a government official to argue that you should have seen the clear warning signs, blown the whistle, and quit. Would you be brave enough to do that? What if you are wrong? What does that do to your career? Asking questions will serve to protect you, your career, and potentially your new employer well.
The Sarbanes-Oxley Act, of course, contained a provision regarding so-called “reporting up” of securities law violations. This provision requires public companies to have policies and mechanisms for employees, especially lawyers, to notify higher-ups if problems are not satisfactorily addressed by the immediate supervisor.
Given the important role that individual integrity plays in stopping fraud, I was disturbed to hear the results of a survey of business school students that was released last month.2 The study found that 56% of the more than 5,000 graduate business school students who were surveyed said that they had cheated during the last academic year. One of the professors who authored the study gleaned from student comments that students were justifying their behavior by looking at it as practice for the business world.3 (Since I know that most of you are law students, you will probably want to know the results for law students, which were also not very heartening -- 45% had cheated within the last year.4)
This survey comports with the admittedly unscientific sample that my wife had in business school. When her ethics professor asked the class if they would feel any compunction about taking money from petty cash for personal uses, most of her classmates said no, because they said that everyone does it. Professional services firms and companies have had to fire people for falsifying claims for reimbursable expenses, fabricating resumes, and lying about academic credentials. During my third year of law school, my classmates and I went through a wrenching, blatant case of plagiarism on the Vanderbilt Law Review that ended my dreams of a tranquil, golf-filled third year for me.
Of course, law schools and business schools are taking steps to instill ethical considerations into their students before they are confronted with them in the business world. The bar exam in each state has an ethics component, albeit any standardized test on ethics tends to be rather formulaic. I was especially encouraged to read, in the Business Week article reporting on the survey that I just mentioned, that Vanderbilt’s Owen Graduate School of Management is one of the schools that is taking the issue of ethics seriously through its Honor System.5
Ethics are equally important in the public sector. Some of you might go into public service right out of law school or business school. Others might enter through what is sometimes derided as the “revolving door.” Rather than looking at the revolving door as a negative phenomenon, I see it as a good way of combating regulation in blissful isolation from the real world. Without a revolving door, we are left with the alternative of a class of career government employees, with no industry experience, relying only on what they have read about. This is a troubling proposition. People with private sector experience bring into government knowledge about how things are done and an appreciation for the practical implications of regulatory actions. By the same token, people with government experience can bring into the business world a finely-tuned sense of the distinctions between lawful and unlawful behavior to head off bad conduct before it happens.
Those of you who end up in public service will come to appreciate the difficulty of wielding the extraordinary power of the government effectively and fairly. Even seemingly insignificant actions or inactions by a government bureaucracy can be tremendously significant to the people and firms with which it interacts.
This concept is illustrated most starkly in the enforcement context. The subjects of SEC enforcement investigations often live in a state of personal and professional limbo while the examination is ongoing. If the enforcement staff finds misconduct, even though the Commission cannot impose a prison sentence, it can impose sanctions that affect the person and her career for years to come. That is why protections surrounding the enforcement process are so important.
As you all know, deference to attorney-client privilege is one such protection. Twenty five years ago, a unanimous Supreme Court explained that the attorney-client privilege, along with the work product doctrine, serve “to encourage full and frank communication between attorneys and their clients and thereby promote broader public interests in the observance of law and administration of justice.” 6 Attorney-client privilege arguably makes the government’s job harder. Waivers of privileged material can help speed up and streamline investigations. This is particularly true if a corporation has hired a law firm to conduct an internal investigation. As convenient as this shortcut would seem to be, due process protections do not attach in internal investigations, and the findings could be wrong. Also, invariably the knowledge that internal investigations really are not ultimately privileged could undermine their effectiveness and usefulness.
Public policy concerns aside, full or partial waivers of the privilege in SEC and Department of Justice investigations have become commonplace. Recently, the Department of Justice, after coming under criticism in the press, by the bar, and on Capitol Hill, began requiring all U.S. Attorneys to adopt written waiver request procedures. I understand that the U.S. Attorney or a senior supervisor now must approve requests to corporations for waiver of privilege or work product protection. More importantly, after months of hearings and testimony, the U.S. Sentencing Commission, which had added waiver to its cooperation guidelines in 2004, recently voted to drop waiver as a determinative factor in the evaluation of cooperation. This was a significant step forward in the fight to mitigate the “culture of waiver.”
Given the high stakes in criminal investigations, the privilege waiver “limelight” has focused on the Department of Justice rather than the SEC. The SEC’s practices and policies, however, have not escaped scrutiny entirely. Don’t get me wrong -- none of the criticism that I have heard suggests that there are systemic abuses of respondents’ due process rights by our staff. It makes sense, however, to take a fresh look at our waiver policies even while outside criticism is relatively muted.
Traditionally, many respondents in SEC actions have chosen to waive privilege without any formalized expectation of cooperation credit. In 2001, the SEC formalized the factors for determining whether to afford cooperation credit to respondents. The culmination of that effort, the so-called “Seaboard” report, did not list waiver separately as one of the thirteen factors in the cooperation analysis.7 The report stated in a footnote, however, that “the Commission does not view a company’s waiver of a privilege as an end in itself, but only as a means (where necessary) to provide relevant and sometimes critical information to the Commission staff.” 8
I was not a member of the SEC in 2001 when the Seaboard report came out. Five years later, however, I strongly believe that the Commission should not view a company’s waiver of privilege as a factor that will afford cooperation credit. It might be time for the Commission to revisit this issue in a formal way and to clarify that waiver or fundamental rights and protections will not result in lesser allegations and/or remedies. Likewise, maybe it is time for the Commission to review our internal policies and procedures governing staff requests -- whether enforcement or examination -- for protected information. We might strengthen the process by, requiring for example, that any request for waiver be vetted in advance by senior personnel, such as the General Counsel.
Enforcement might be the most obvious context in which the government’s actions affect people and corporations, but it is not the only context. Much of what the administrative state of today does occurs through the rulemaking and the interpretation of those rules outside of the enforcement context. The SEC and the many other agencies that dot the regulatory landscape are charged with making specialized and often technical decisions that are deemed to be more appropriately handled by experts than through the political process. The complexities of securities law, for example, lend themselves well to expert deliberation. There are, however, dangers to this decentralized, non-political approach to government decision-making, especially for those of us who believe in the democratic process, and not a government of mandarins. Of great concern is lack of transparency and accountability.
Congress, appropriately, has directed agencies to think about process. This directive is called the Administrative Procedure Act or the “APA”. It is a rather dull piece of legislation and has given birth to an entire practice of its own. Many of you have already studied this in an Administrative Law course, so I will be brief in my description. (I avoided this class in law school, thinking that I would never need it – the joke is on me now.) The APA provides basic due process protections that regulatory agencies must follow. We are required to give adequate notice to the public of the rules that we are thinking of putting in place, ask for comment, and then, when adopting the rule, explain how those comments were acted upon. Investors and the regulated community can monitor us more easily if our actions are taken in the public eye.
I know that Dean Rubin has called for a rethinking of the Administrative Procedure Act.9 I agree with him that we cannot turn back the clock on the intensely administrative nature of the government and our time is better spent on “reconcil[ing] ourselves to its existence, understand[ing] its underlying structure, and mak[ing] it work.”10 I commend the Dean for taking a fresh look at the system of accountability for administrative agencies. My years at the SEC have solidified my view that when agencies attempt to operate without public accountability, their regulatory effectiveness suffers. I would like to use a few examples from recent SEC experience to illustrate this point.
The DC Circuit Court of Appeals recently vacated the Commission’s rule that required hedge fund advisors to register with the Commission.11 I dissented from the hedge fund rule for a number of reasons, not the least of which is that I do not believe it necessary for the Commission to allocate its limited resources for the oversight of a sector that is the province of a relatively small number of investors who can carry out their own due diligence about an advisor or hire someone else to do so.
Because of the contrived way that the rule was structured, it negatively affected many hedge fund investors too. The rule did not apply to hedge fund advisors with lock-up periods of longer than two years. Accordingly, some advisors extended their lock-ups in response to the rule. Amaranth was one of these. Longer lock-up periods mean less accountability for hedge fund advisors since they know that it is harder for disgruntled investors to take their money and run.
Of course, the SEC has in the past and will continue to bring enforcement actions against perpetrators of securities fraud, whether or not they are registered with us. That is clearly within our jurisdiction under current law, and it is one of the reasons that I thought the hedge fund registration rule unnecessary. Some have advocated that we also monitor the systemic risk to the financial markets posed by hedge fund activities. Our registration rule would not have accomplished that at all. In fact, other more economist-based agencies, like the Fed, are much better situated to look after that sort of risk, than is the SEC, which I like to say is of, by, and for lawyers.
In overturning the rule, the Court of Appeals deemed it to be arbitrary and faulted the SEC for inadequately justifying its departure from its own prior statutory interpretation.12 In no uncertain terms, the Court explained: “That the Commission wanted a hook on which to hang more comprehensive regulation of hedge funds may be understandable. But the Commission may not accomplish its objective by a manipulation of meaning.”13
It took two decisions from the Court of Appeals to make the Commission realize that our process for adopting another rule -- the mutual fund governance rule -- was deeply flawed. The rule effectively would have mandated that mutual fund boards have independent chairmen and no less than seventy-five percent independent directors. I dissented for a number of reasons, including a belief that it is inappropriate for the government to mandate the adoption of one particular corporate governance structure by a whole sector of the economy. In a June 2005 opinion, the Court of Appeals found that the Commission had violated the Administrative Procedure Act in adopting the rule by failing to consider adequately the costs of and alternatives to the measure.14 A mere eight days after the Court’s decision and with only a perfunctory nod to the flaws that the Court had pointed out, the Commission readopted the provisions that had been struck down. In a second opinion, in which it vacated the contested provisions, the Court made it clear that it was not moved by the Commission’s argument that it had needed to readopt the provisions within days of the Court’s initial decision because two of the rule’s major proponents, including former SEC Chairman Donaldson, were about to leave the Commission.15 After the second decision, under the leadership of our new chairman, Chris Cox, we decided to seek public comment on the rule before deciding how to proceed.
Chairman Cox has turned these two judicial reprimands into an opportunity to look with fresh eyes at our Commission processes to see how we can improve them. He has directed the SEC’s General Counsel to review the Commission’s process for complying with our statutory mandates to conduct an economic analysis of rule proposals.16 The General Counsel’s review will help to temper the lawyer-centric nature of the SEC that I mentioned before.
So this leads me right back to Dean Rubin. I understand that he is in the process of establishing the program in law and economics that is to be launched at Vanderbilt next year. With professors like Kip Viscusi and Joni Hersch on board, the program is sure to be a strong one. The integration of law and economics will serve law students and the profession well. A lack of appreciation for economic principles has hampered the efforts of well-intentioned attorneys in many practice areas. In a field like securities, the problem is particularly acute. What sounds like a good regulatory approach can easily end up costing more than the benefits that it will produce. Economics teaches us to ask whether we are employing our scarce resources for their highest and best use.
Underestimating the costs of a regulatory action can have serious ramifications. One example that comes readily to mind arose out of the Sarbanes-Oxley Act. Section 404 of the Act requires that management complete an annual internal control report and then have the company’s auditor attest to, and report on, management’s assessment. The goals of Section 404 – strengthening and tightening controls over financial reporting – are, without question, laudable.
Unfortunately, everyone greatly underestimated the costs. When the SEC first released its implementation rules for 404 we estimated aggregate costs of about $1.24 billion or $94,000 per public company. The SEC is not the only regulator in the picture. The Public Company Accounting Oversight Board is the entity that grew out of Sarbanes-Oxley Act to oversee public company audits. Although operated as a nonprofit corporation, it possesses powers that look very governmental and salaries that don’t, because they are intended to rival those in the for-profit private sector. Their salaries even eclipse those of the President, although they don’t travel by helicopter or motorcade. Not yet anyway. Because the Board’s name is a bit of a mouthful and even the initials don’t roll off the tongue, I use the friendly shorthand – Peekaboo. PCAOB put in place a 300 page, intensely prescriptive audit standard to guide auditors in their work under Section 404. It caused audit costs to balloon. By some counts, actual costs incurred for Section 404 compliance exceeded our estimates by twenty times. As a consequence, external consulting and audit costs have ballooned.
In the real world, of course, resources are limited. The more that companies spend on things like internal controls, the less they can invest in developing and marketing products, hiring and retaining talent, and embracing new technologies. Some companies have avoided new acquisitions, delayed or cancelled upgrading their computer systems, or not added a new product line lest they set off a new flurry of internal control documentation. I spoke with the chief financial officer of an issuer that spends more on its auditors than it does on the folks in the finance department who actually prepare the financial statements. That does not mean that internal controls and other organizational costs are not important. They are; but, there must be a balance.
The SEC and the PCAOB are working now to overhaul the Section 404 guidance for auditors and management. I am hopeful that these efforts will bring reason back into the implementation of the statute. This should allow the objectives of Section 404 to be met without unduly burdening the companies whose shareholders Section 404 was designed to help.
Thank you very much for your attention. If Vanderbilt students and faculty are anything like they were when I was here, I know that you all have things to say. I would be happy to address any issues that you would like to discuss.