Speech by SEC Staff:
Remarks at the 2007 Corporate Counsel Institute
Linda Chatman Thomsen
Director, Division of Enforcement
U.S. Securities and Exchange Commission
March 8, 2007
Thank you, John, and thank you everyone for attending this important and informative conference.
1939 was a memorable year in American history. For a very small number of people, it is memorable as the year Congress enacted the Trust Indenture Act. For the rest of us, minus those two people, it is much more memorable as "the greatest year in film history," marked by the release of "Gone With the Wind," "The Hunchback of Notre Dame," "Mr. Smith Goes to Washington," "Of Mice and Men," and my first favorite movie—"The Wizard of Oz." In the 1950s it was shown at least annually on television and it was in that decade when it became my first favorite movie. It tells the story of the red-haired girl with the red sparkly shoes who runs away from home after a dust-up over her dog biting the town grouch, ignores all signs of terrible weather, and finds herself in the magical world of Oz. Like many runaways, having managed to get away, she is desperate to go home and implores just about everyone she meets to get her back to Kansas. Eventually, with a little help from her friends the wise Scarecrow, the compassionate Tin Man and contrary to standard moniker, the oh so brave Lion, as well as a good, if somewhat squeaky-voiced, witch and a largely incompetent wizard, she figures out that she has the power and ability to get herself home.
I think I loved this movie so much not because of all the magical non-humans but because of that all too human Dorothy. Like most of us, she had a hard time coming to terms with her own role and responsibility for the jams she found herself in. After all, I'll grant you that the town grouch, Miss Gulch, was a pill, but was it so irrational to take umbrage at being bitten by a dog? And, if someone killed your sister by dropping a house on her and then took your inheritance (the aforementioned red shoes), wouldn't you be a little peeved? And Dorothy, like most of us, would much rather leave the responsibility of getting herself out of the jam she at least helped get herself into to someone, just about anyone, else.
And on the personal responsibility front, let me be clear that my views are my own and do not necessarily reflect the views of the Commission or any other member of the staff.
So why, you ask, am I talking about this film classic? It came to mind as I thought about some of the discussion over the last few months about the continuing competitiveness of the U.S. capital markets. Several prominent reports have been issued regarding perceived threats to the success of the U.S. markets and financial services industry, the sources of those perceived threats, and what should be done about them. While these reports raise a variety of issues, among the recurrent themes are one, the United States is losing business to the rest of the world, and two, our regulation and law enforcement are among the causes. But what do these reports have to do with Dorothy? Two things. First, it does seem there is a bit of blaming everyone else for business's issues and looking to anyone else to fix them. Second, when Dorothy finally heads back to Kansas, she declares that if she ever goes looking for her heart's desire again, she will look no further than her own backyard. Maybe many of the competitive advantages we're looking for in the worldwide financial markets are already here, and to find them we need look no further than our own backyard.
As to the reports themselves, the Interim Report of the Committee on Capital Markets Regulation and the similar McKinsey Report, which was commissioned by Senator Charles Schumer and Mayor Michael Bloomberg to assess the state of the financial markets in New York City, both claim that the U.S. is losing its competitive position to other market centers, putting at risk continued new investments in U.S. markets and, ultimately U.S. jobs.1 Among other things, they claim that over-regulation is making the U.S. markets less competitive, and that unless regulation and enforcement are curbed, the U.S., and particularly New York City, will lose preeminence as the foremost financial center in the world. Among the evidence they cite is the state of the IPO market, especially the declining number of IPOs launched by foreign companies in the United States. They cite statistics showing that foreign companies are increasingly listing their IPOs on exchanges outside the United States, particularly London and Hong Kong.
In reaction to these studies and otherwise, alternative explanations have been advanced. Some disagree with the premise—arguing that the United States has not lost its position and is doing quite well; others seem to agree with the premise but argue the cause is not regulation and the legal climate but something else—globalization, different cost structures, etc.; and others suggest that even if it is true, it's worth bearing in mind that the businesses in the financial world are themselves global these days and that Wall Street is not so much a location as a state of mind. Some commentators point out that Wall Street just had its most successful year in history, as demonstrated by the unprecedented level of bonuses paid throughout the industry.2 Some point out that the decline in foreign IPOs listing in the U.S. began in 1996, six full years before the adoption of Sarbanes-Oxley, and cite counter-evidence suggesting that the level of foreign IPOs in the U.S. has risen dramatically in the years since the enactment of Sarbanes-Oxley.3 Many say the decline in foreign IPOs is attributable to factors other than the level of securities regulation and enforcement in the United States. Among the other factors cited are the fact that some of the largest recent IPOs have been of state entities that are being privatized in their home countries and that IPO costs in London and Hong Kong are much lower than here, with fees that are only about half what an issuer would pay in the U.S.4 More generally, many commentators have noted that the decline in foreign IPOs in the U.S. is a natural result of the growing globalization of the financial and securities worlds.5
I have no intention of trying to resolve these issues. Indeed, the debate about where we are, how we got here, and where we are going is undoubtedly healthy. There is, however, one recurring theme built into some of these studies and debates that I would like to talk about: the role of law enforcement. Baked into some of the recent studies is a suggestion that overzealous law enforcement has contributed to the concerns about competition, and therefore we might be better off with less law enforcement. You know what? Those of us in law enforcement want less law enforcement too. Not as an end in itself, though, but rather as the natural consequence of less law-breaking. Put another way, I am not so cynical as to believe that the success of American business depends on turning a blind eye to illegal behavior. And, I believe, when we list our hopes, our aspirations, our hearts' desires, surely we can do better than wish for mediocre law enforcement.
So let's for the moment assume that what we really want is an environment in which business can flourish, hard work can lead to success, and opportunities abound. How does law enforcement contribute or detract from those goals?
First, there is substantial evidence that financial markets succeed because of strong enforcement and regulation not in spite of it. One academic study stated that the U.S. securities regulatory system that has evolved since the 1930s "has proven itself the most successful in the world."6 In my view, it should be self-evident that stopping fraud makes our markets better and stronger.
The merits of the existing U.S. securities regulatory and enforcement model are demonstrated by the ongoing trend toward the adoption of U.S.-type standards in other countries. As we speak, our regulatory and enforcement regimes are being adopted and emulated in other countries all over the world.7 If imitation is the sincerest form of flattery, then our securities regulation and enforcement regime is being honored with the highest possible accolades.8 The E.U. countries, along with China, Korea and other Asian countries, have recently adopted new or stronger anti-fraud regulations and have strengthened their enforcement systems. In general, transnational studies have found a strong correlation between the maturity and size of financial markets and the aggressiveness of the enforcement efforts on behalf of investors.9 While the U.K. and France have long prohibited insider trading, an E.U. Directive in 1989 required that all member states adopt laws against insider trading. By the year 2000, virtually all developed countries had enacted insider trading prohibitions consistent with U.S. law. Further evidence of the positive economic effects of a strong regulatory and enforcement environment has been found by numerous empirical studies concluding that in countries with stricter enforcement of securities laws there is a lower cost of equity and more liquid capital markets.10
Taking a more focused look at the situation here in the United States, a recent Wall Street Journal editorial by Joseph Grundfest discusses data showing a dramatic decrease in the number of securities class action suits.11 Professor Grundfest is a former SEC Commissioner who is now a professor of law and business at Stanford University and co-director of its Rock Center on Corporate Governance. As you may know, Stanford maintains a comprehensive database of all securities class action suits filed in the United States. After discussing and dismissing some explanations for the recent drop in class action filings, Professor Grundfest writes:
"The remaining explanation is more interesting and profound: Perhaps fewer companies are being sued for fraud because there is less fraud. Under this theory, the government's aggressive criminal and civil enforcement strategy following the Enron and WorldCom frauds has caused corporate boards and management to "get religion" when it comes to complying with the securities laws. Executives are acutely aware that a major accounting or disclosure fraud is more likely than ever to leave them fired or indicted. They respond to this new regime like rational economic actors: If you increase the penalties for engaging in fraud then you reduce the incentives to commit fraud. Nothing complicated here at all."12
The flip side of the economic benefits of effective enforcement is the economic harm of fraud. Here too the evidence is compelling: securities fraud imposes significant costs on an economy. It reduces managerial accountability, increases verification costs for analysts and others, raises liquidity costs, and distorts capital allocation.13 Ultimately, if investors refuse to invest because they believe the markets are rigged against them, the economy will suffer.14 In the absence of meaningful securities regulation, the likelihood of fraud in the markets results in economic inefficiencies because it is difficult for investors to accurately adjust the stock price they pay to account for the risk of fraud.15
Whatever one might think of the costs of the new regulatory requirements, our financial markets cannot afford the costs of the widespread corporate malfeasance we saw in Enron and other recent financial frauds. Just one timely example illustrates this point. A recent estimate puts the total cost of the options backdating scandal alone, including the costs of financial restatements, legal fees and penalties, at more than $10 billion.16 Costs of this magnitude have led at least one commentator to remark that "[t]he greatest threat to any publicly traded company is a well-publicized scandal."17
Let's get a little more specific about what we do in the SEC's Division of Enforcement and ask is it too much? Do we go after the wrong things?
On the numbers, we bring, on average, about 600 enforcement actions a year. Is that too many? Surely every defendant thinks it's at least one too many. Let's put our numbers in context. There are today in the U.S. approximately: 6,000 registered broker-dealers, 660,000 registered representatives, 10,400 registered investment advisers, 8,000 mutual fund portfolios, 9,000 hedge funds and 13,600 companies that file reports with us. And these numbers reflect those who are the presumptively legitimate actors in our markets; these numbers do not capture the scam artists, ponzi schemers, insider traders and manipulators who prey on our markets and investors. Against those numbers, its hard to say 600 is too many. Of course, even one case would be too many if it were baseless or arbitrary, but given our richness of process, with every case subject to numerous reviews and, ultimately, authorization by the Commission, as well as our success record, it's hard to credibly argue our cases are baseless or arbitrary.
On the specific cases, do we bring the wrong ones? The vast majority of our civil actions filed in federal court involve intentional fraud charges and most of those cases are filed on a settled basis. To us, the high percentage of settled fraud charges suggests we're making the right choices. It also suggests that the people and institutions we sue, who are more often than not very ably represented, are persuaded of that too. On the other hand, some argue that our settlements suggest only that the cost of pursuing vindication is too high and defendants have no choice but to settle. So let's look at our litigated matters, the cases we take to independent fact finders—judges and juries—and see how we do. It's fair to assume that the litigated cases are among the hardest for the SEC to prove because those are the ones taken to fact finders. Last fiscal year we tried ten cases in federal district courts. All of them involved fraud charges, most of them lasted weeks, most also had defendants represented by some of the best legal talent this county has to offer, and the SEC prevailed in all ten. Ten for ten is fairly persuasive evidence that we are, in fact, making reasoned and reasonable choices. And the trend continues. Yesterday, after a 3-week trial, a federal jury in San Diego delivered a verdict in the SEC's favor on all charges against the former CFO and former controller of Gateway, Inc., the personal computer manufacturer. They were held liable for engaging in a fraudulent revenue and earnings manipulation scheme to meet Wall Street analysts' expectations, and for concealing from the investing public important information about the success of Gateway's PC business.
Let's look at a few recent examples of cases we've brought. Lately, as you all know, we have been spending a fair amount of time and attention on investigations involving the use, or more accurately misuse, of stock options. Since last summer we have filed cases involving option abuses at Brocade Communications Systems, Comverse Technology, McAfee, Monster Worldwide, Take Two Interactive Software, and Engineered Support Systems. Are we overreacting? You tell me: these cases have involved secret slush funds; forgery; grants to fictitious employees, former employees and unknown future employees; falsified corporate documents; cancellation of legitimate grants that had fallen out of the money and substitution of illegally backdated grants that were already in the money; self-dealing; self-enrichment; attempted cover-ups; and lying to the auditors. When, as is the case here, the alleged conduct involves senior management, it's hard to argue that we should not address it.
On another front, a week ago today we filed the largest insider trading case against Wall Street professionals since the days of Ivan Boesky and Dennis Levine. Our complaint alleged two overlapping insider trading schemes: One involved trading ahead of upcoming UBS analyst upgrades and downgrades, where the center of the scheme was a senior professional who served on a powerful internal committee dedicated to reviewing and approving UBS's proposed analyst recommendations. The other scheme involved trading ahead of corporate acquisition announcements using information stolen from Morgan Stanley. At the center of that scheme was a lawyer in Morgan Stanley's global compliance department, whose duties included safeguarding confidential information. All told, the case alleged unlawful conduct by 14 defendants, including 8 Wall Street professionals, 3 hedge funds, 2 broker-dealers and a day-trading firm. We allege conduct that occurred over five years and involved hundreds of tips, thousands of trades and millions of dollars in illegal profits.
From my vantage point, it seems to me greed and money continue to be powerful, powerful motivators that aren't going away. It should come as no surprise that we are not going away either. We've got plenty to do and we're doing it.
Let's turn for a moment to sanctions. To be sure, they are costly in the short term, which to a certain extent, is the point. All law enforcement theory supports the concept that sanctions have to be high enough that people want to avoid them. As we just discussed, Professor Grundfest's analysis suggests our sanctions have done exactly what sanctions are supposed to do—deter and reduce incidents of illegal behavior. In recent years our efforts have been increasingly focused on the future. We look at the steps taken, and in some instances we insist that steps be taken, to avoid similar misconduct in the future. Some argue this amounts to regulation by enforcement—changing the rules. I submit we aren't changing rules, we're changing conduct to comply with existing rules. That's what deterrence is all about. Today, at least in part due to our efforts, companies and individuals are increasingly coming forward to report wrongdoing instead of waiting for us to find it. They are cooperating with law enforcement and are taking proactive remedial steps. More importantly, they are adopting systematic prophylactic measures to detect and deter violations. The stock option backdating area provides clear evidence of this trend, as companies across the country have commenced internal investigations and self-reported to the SEC, fired wrongdoers and revised their options-granting practices. In many cases, all this has happened without so much as a phone call from the SEC. And this is as it should be: no legitimate business should tolerate illegitimacy within its walls, and neither should any legitimate market.
I assume you want still less law enforcement. I will assume you, like me, want it for the right reason—because fewer companies and individuals are violating the law. How do we get there? One way, the direct way, is the way Dorothy got herself back to Kansas. She took matters into her own hands. Put more bluntly, if you don't break the law, no one can enforce it. That seems self-evident. But good compliance has benefits that go beyond just preventing legal violations.
For one thing, good compliance is good business. A great example of putting this principle into practice is the proactive measures taken by anesthesiologists in the last twenty years to reduce errors and control malpractice insurance costs.18 While many groups of doctors at the time were blaming increased malpractice costs on greedy plaintiffs' lawyers and capricious juries and focusing on legislation as the remedy, the anesthesiologists decided to take matters into their own hands, to pay attention to what they controlled and focus on patient safety. The group launched a patient safety foundation that analyzed closed malpractice claims to determine the causes of patient deaths and, based on the results, instituted significant improvements in procedures and technologies. The result? A drop in patient deaths to one death per 200,000-300,000 cases from one for every 5,000 cases 20 years earlier. Malpractice rates for anesthesiologists fell, as did the percentage of total malpractice suits filed against anesthesiologists and the size of payments made in successful malpractice suits.
There are other advantages. One significant consequence of high-profile corporate scandals is, as we all know, a call for increased regulation. Investors feel cheated, Congress and regulators feel obligated to take action to seek to prevent a recurrence of the factors that led to the scandals, and often the result is additional law and regulations. Sarbanes-Oxley is a case in point. While these additional laws and regulations often have beneficial effects, as Sarbanes-Oxley is widely acknowledged to have had, there is no doubt they also impose costs on companies. A critical point that often gets lost in the debate, though, is that financial scandals are preventable—if companies don't engage in illegal conduct, no one is going to be clamoring for more laws or more regulations. Pause for a moment and think about the airline industry—I doubt anyone would be talking about a passengers' bill of rights, if airlines hadn't left passengers sitting on tarmacs for hours on end.
Now we've heard and seen airline executives expressing great remorse for what they put their customers through and a commitment to do right by them. I hope it's true. I also hope that those anesthesiologists, delighted though they are at reduced malpractice premiums, are a little more excited about the dramatic drop in patient deaths. Because at bottom, I submit it's a matter of ethics, culture and belief. You have to embrace, as all citizens in all contexts need to embrace, the concept that complying with the laws we've decided upon, whether or not we quibble or disagree with some of the specifics, is simply right and important.
And that includes buying into the big picture—no line-drawing, edge-skating, pretzel-twisting or distinction-making among shades of grey. On that topic, let me share a current example. In 2000, the SEC enacted Rule 10b5-1 in order to clarify the law about when executives who may come into possession of inside information can legally trade. Rule 10b5-1 allows corporate executives to make a plan, at a time when they are not in possession of inside information, to make prearranged trades at specified prices or dates in the future. The idea was to give executives "a safe harbor" to proceed with these prearranged trades without facing charges of insider trading. The Rule was intended to give executives regular opportunities to liquidate their stock holdings—to pay their kids' college tuition, for example—without risk of inadvertently facing an insider trading inquiry. However, recent academic studies suggest that the Rule is being abused.19 The academic data shows that executives who trade within a 10b5-1 plan outperform their peers who trade outside of such a plan by nearly 6%; it ought to be the case that plan participants should be no more successful on average than those who trade outside a plan. The difference seems to be that executives with plans sell more frequently and more strategically ahead of announcements of bad news. This raises the possibility that plans are being abused in various ways to facilitate trading based on inside information. We're looking at this—hard. We want to make sure that people are not doing here what they were doing with stock options. If executives are in fact trading on inside information and using a plan for cover, they should expect the "safe harbor" to provide no defense.
Returning to the larger point about corporate behavior, John Mackey, the Chairman, CEO and co-founder of Whole Foods Market recently remarked:
"The world is getting more and more transparent. You're in a fishbowl these days. . . . When there are fewer secrets, there is greater motivation to do the right thing. That's driving business. There's great accountability, and more businesses are getting leadership that recognizes that we can't hide. So we better do the right thing. I think this is part of a larger trend, toward business having a greater responsibility in society than just maximizing profits. Customers want that, employees want that, and shareholders want that: They want businesses to be good citizens."20
Professor Lynn Sharp Paine of Harvard Business School analyzes this trend in her book on the role of values in business. She recognizes that ethics doesn't always pay in the short-run, and advocates a longer-term perspective in order to recognize the benefits to a business of consistently behaving according to high ethical standards. These benefits go beyond the bottom line, and include the advantages that flow from increased employee and customer loyalty, enhanced credibility, and an excellent reputation. Professor Paine notes that "ethics counts" is a better slogan than "ethics pays" because it "recognizes that corporate strategies must make both moral and financial sense. Ethics counts—and so does strong, sustained profitability."21
I realize that aspiring to create a corporate culture that is consistent with these higher standards of accountability is a challenging undertaking. Going back to Oz for a moment, remember that Dorothy needed a little help from her friends to find her way back to Kansas—she needed their brains, heart, and courage. Despite my day-to-day view of American business where I am exposed to its less attractive attributes and actions, I have to say American business has an abundance of just those strengths and then some. And it is those very strengths, in my view, that will prove to be the key to success as American businesses navigate their way in our increasingly global marketplace. Thank you.