Speech by SEC Commissioner:
Remarks to the Leadership Health Care Delegation to Wall Street
Commissioner Paul S. Atkins
U.S. Securities and Exchange Commission
New York, New York
September 20, 2007
Thank you very much, Duncan [Niederauer], for that wonderful introduction. I congratulate both Leadership Health Care and the Nashville Health Care Council on your inaugural delegation to Wall Street. It is a privilege for me to be with you today at this historic venue, the New York Stock Exchange.
I have fond memories of Nashville from my law school days at Vanderbilt. I first arrived there in 1980, when Nashville was quite a bit smaller. For most of the nation, Nashville was known mainly for being the home of country music, Maxwell House coffee, and (at least nearby) Andrew Jackson. But since then, Nashville has grown dramatically, both in terms of the diversity of its population and its economic base.
When American General launched its hostile tender offer for NLT, at the time probably the largest financial services company in town with the tallest skyscraper, many people thought that Nashville would die as a financial and commercial center. Today, not only do major Fortune 500 corporations call Nashville home, but large foreign companies base their U.S. operations from there — and the city can boast about both of its professional football and hockey franchises. It is now the healthcare industry, not the music industry, that provides the largest economic impact in the Nashville region. So I think it is very appropriate for you to be visiting Wall Street today.
Before proceeding further, I must note that the views that I express here today are my own and do not necessarily reflect those of the Commission or of my fellow Commissioners.
The fact that Leadership Health Care and the Nashville Health Care Council have organized this delegation recognizes that the relationship between Main Street and Wall Street has never been tighter. The development of new financial products, transaction structures, and methods of financing are critical to further improving the capabilities of, and productivity in, the healthcare industry.
The ability of our financial markets to efficiently allocate billions of dollars in capital is a crucial component to continued economic growth and our nation's financial health. Nonetheless, the financial markets are globally integrated and difficulties in one market or sub-market can easily affect another.
The financial markets have been quite volatile in recent months. The problems started with sub-prime mortgages and asset-backed securities supported by sub-prime debt. Because of the inter-relation of our capital markets, August certainly was not a slow month in Washington and on Wall Street. The changes in the supply and demand of these instruments caused holders to check valuations and re-examine investment strategies, leverage levels, and long-held assumptions about market behavior and synthetic instruments.
This re-examination has real-life effects in traditional industries such as health care. For instance, some companies are re-assessing their approach to the capital markets, including their capital structure, sources of capital, and balance sheet components. Virtually all market participants are re-evaluating their stress-testing and making modifications to their methodologies.
All of this activity is a normal and ultimately healthy reaction to changing circumstances. There is a natural tendency for people to hope for some level of consistency and predictability in the markets. But, is that realistic? Does history support such a view? Periods of volatility are to be expected and are a natural process of sorting out supply, demand, and expectations.
Volatility can also give rise to demands for action. We at the SEC, along with our colleagues at other federal and state financial regulatory agencies, such as the Commodity Futures Trading Commission and the Federal Reserve, and indeed at financial agencies around the world, are closely following the situation. We are also looking at disclosure practices and conflicts of interest of rating agencies and other market participants. Political bodies will soon be studying the situation, as well.
As a regulator, I would strongly caution against over-reaction. The events of the past few years have clearly taught us that financial markets are very closely inter-related. No one wants unilateral, uncoordinated action. This is especially true for the United States, as the world's largest and most liquid market.
The SEC's mission to maintain market integrity is based on a very simple premise: if investors believe that they will be treated fairly in the capital markets, they will be more willing to invest their money. Thus, our role as policeman to protect investor's property from theft.
It is precisely during times of market volatility that we must resist the temptation for excessive regulation or enforcement merely to show that the SEC is "doing something" about the problem. Pleas for government solutions come all too frequently and from all too many corners. But government solutions are generally cumbersome and imprecise because of their wide application. So we must be quite careful to avoid taking action just for the sake of action. As the legendary UCLA basketball coach John Wooden was fond of saying, "never mistake activity for accomplishment."
The actions of government by nature are coercive. We enact laws and implement regulations. We expose persons to criminal, civil, and third-party liability — and frequently it is done with the notion that any costs of over-regulation can be easily absorbed by the business community. But, the full brunt of these costs is not borne by business; rather, they are shouldered by investors. Once a government mandate is in place, investors generally cannot opt out of it, and it is the investors who pay for regulation through lower returns, reduced growth, and diminished investment opportunities. Thus, achieving the appropriate regulatory balance is crucial.
Government securities regulators should be acutely aware of the regulatory costs that they impose on the market. It is important to note that these costs are cumulative. Perhaps each individual mandate may not be particularly significant in general or in any given year, but over twenty years or more, the aggregate costs may be significant. Of course, the real question is not one of cost, but one of value: what are the benefits obtained by the markets as a result of these regulatory costs? If the benefits to the market are greater than the costs, then I would say our regulatory approach has added tremendous value. But if these regulatory costs are not adding value, then it would be prudent to pare back those non-value added aspects of regulation.
Therefore, we should look first to the marketplace and those who shape it to develop and implement solutions of their own. My own overriding philosophy when approaching regulatory policy issues is rooted in a belief in our free market system. Government should not judge the merit of products or business models, set prices, or select as between competitors. Government should keep barriers to entry low so that new entrants can test their ideas in the marketplace.
Risk taking is an inherent component of investing in the financial markets, and this is well-recognized by government regulators. In 1999, the President's Working Group on Financial Markets — which is made up the heads of the Treasury, the Federal Reserve Board, the CFTC, and the SEC — issued a report in response to the collapse of the hedge fund Long Term Capital Management. The report noted that "in our market-based economy, market discipline of risk taking is the rule and government regulation is the exception."1 The report further cautioned, that "[a]ny resort to government regulation should have a clear purpose and should be carefully evaluated in order to avoid unintended outcomes."2
In the past couple of years, these principles of regulatory restraint have been re-affirmed as the market has continued to demonstrate a capacity to minimize and absorb systemic risk. In February, the President's Working Group issued a policy statement supporting a market-based approach regarding private pools of capital. The statement acknowledged the valuable role that private pools of capital play in the financial markets and recognized that "[m]arket discipline most effectively addresses systemic risks posed by private pools of capital."3
We are reviewing the activities of many participants in the sub-prime markets — with a particularly watchful eye towards structural issues and disclosures. To the extent violations are uncovered, appropriate remedial actions will be sought. To the extent improvements can be made, appropriate statutory or regulatory changes will be proposed.
But it is important to note that the most important players in regulating the behavior of the marketplace are the market participants themselves. They take risks because they are looking for returns consistent with those risks. In the absence of fraud, those investors who failed to properly evaluate or judge the inherent risks in holding securities backed by sub-prime mortgages should rightfully absorb the losses. They cannot have it both ways — enjoying the upside benefits, but being bailed out from downside consequences. This would set up a true moral hazard, encouraging people to take on ever more risk.
I know that many members of the delegation work for publicly traded corporations and are still absorbing the full impact of the Sarbanes-Oxley Act.4 Earlier this summer, the SEC made some significant adjustments to the implementation of Section 404 of that law. In June, the Commission issued guidance that is intended to provide management with a risk-based, top-down, tailored approach to complying with their obligations under Section 404.5 In July, the Commission approved the Public Company Accounting Oversight Board's new Audit Standard 5, which replaced the prior Audit Standard 2.6 AS 2 was prescriptive, encouraged auditors to focus on items that were not material, and discouraged auditors from using the work of others.
The new standard is intended to refocus the manner in which auditors carry out their responsibilities under Section 404. Under the new standard, auditors should direct their efforts to identifying any material weaknesses in internal control without getting diverted by looking for immaterial internal control issues. As both the Commission and the PCAOB have acknowledged, we will not be able to judge the effectiveness of the new audit standard and management guidance until we see how they are implemented. It is my hope that these improvements will be properly utilized by issuers, auditors, and regulators alike and will go far in improving the regulatory environment for publicly traded companies.
However, any gains from the improvements to Section 404 may be tempered by a potentially expansive concept of primary liability for securities law violations. In a few weeks, the U.S. Supreme Court will decide the extent of primary liability in securities litigation under the Securities Exchange Act of 1934 in a case called Stoneridge Investment Partners LLC v. Scientific-Atlanta, Inc.7 Under the anti-fraud provisions of that act, which lawyers know as Section 10(b) and Rule 10b-5, private parties can sue those whom they believe defrauded them in buying or selling securities. One way of bringing these kinds of actions is through the shareholder class action lawsuit. In 1994, the Supreme Court ruled that a person may be subject to a private lawsuit if he commits a "primary violation," but not if his actions only amounted to "aiding and abetting" someone else's fraud.8
So the case before the Supreme Court next month will involve deciding the scope of a primary violation. As you may have read in some press reports, there has been some disagreement both within the SEC and the federal government as to the appropriate position to take before the Supreme Court in Stoneridge.9 However, when appearing before the Supreme Court, the United States speaks through the single voice of the Solicitor General. In this role, the Solicitor General must thoughtfully consider the interests and concerns of many parties and not exclusively those of any single agency. After reviewing the amicus brief of the United States, I believe that the position taken by the Solicitor General is the appropriate one.
When the SEC considered Stoneridge a few months ago, the Commission separated its consideration into two distinct issues. The first issue was whether someone can be sued for fraud based solely on deceptive conduct. On this issue, the SEC unanimously decided that deceptive, non-verbal conduct alone is sufficient; there does not have to be some written or oral statement. You can imagine how someone's nodding his head can have the same effect as saying or writing yes. We asked the Solicitor General to reflect this position in his Supreme Court brief, and he did.
The second issue was a bit more complicated. To be precise, the question was "whether a person may be liable in a private action under [the anti-fraud rules] for engaging in a transaction with the issuer of a security on the ground that the transaction constituted 'deceptive' conduct, when the plaintiff did not rely on that conduct but at most relied only on a subsequent misstatement by the issuer concerning the transaction."10 In other words, can someone — who engages in a transaction with a company that improperly accounts for it — be held primarily liable to a third party who relied on the improper accounting? This matters because a private securities suit cannot go forward unless it alleges a primary violation.
Only a bare 3-2 majority of the Commission answered this question in the affirmative, saying that a person can be deemed to be primarily liable for the issuer's fraud if he engages in deceptive conduct in the course of a transaction with an issuer. This is called "scheme liability," because you can be held liable for the entire scheme even if you were only a bit player. I voted against taking this position. The Solicitor General also rejected this expansive notion of primary liability under the anti-fraud provisions as had the federal circuit court of appeals that had considered the issue.11 He instead urged the Supreme Court to continue to apply the traditional requirements for antifraud liability, including reliance and loss causation. I will put those terms into context in a minute.
The position that the Solicitor General advocated has caused consternation in some quarters, but I believe that those complaints are misguided. So what is the real issue here? Do the Solicitor General and I believe in providing free passage for those who assist corrupt individuals to loot corporations for their personal gain at the expense of innocent shareholders and the integrity of the capital markets? Absolutely not.
The problem with private securities lawsuits — especially class actions — is that they impose tremendous costs. Even if a suit lacks merit, it is often cheaper to settle it than to defend it. The merits of settled cases never get tested in court. Indeed, in some cases, class action lawsuits do nothing more than shift wealth from one group of shareholders, the owners of the corporation being sued, to another group of shareholders who held shares during an often arbitrarily defined period — with, of course, a hefty chunk reserved for the plaintiff's lawyers.
Congress has recognized the significant potential of unchecked private class action securities litigation to harm the economy and the capital markets. In the mid-1990s, Congress specifically considered — and rejected — legislation that would have restored the right of private plaintiffs to bring actions against aiders and abettors of securities fraud, so-called "secondary actors."12 Instead, Congress clarified the SEC's authority to take enforcement action against aiders and abettors. Thus, secondary actors can be held responsible for their facilitation of a fraud, but the SEC (not private parties) is charged with going after them.
Congress went further and — overturning a presidential veto in the process — tightened pleading standards in an attempt to eliminate baseless suits without curbing meritorious suits. Nonetheless, the lure of potentially enormous payouts for successfully settled class action lawsuits has encouraged creativity by the class action plaintiff's bar, including the development of new and expansive theories of liability.
Needless to say, you cannot obtain multi-million dollar judgments and settlements from companies that are insolvent or bankrupt. Under the "scheme liability" concept that the SEC majority advocated, plaintiffs would be able to reach into the deep pockets of customers, vendors and other firms that simply do business with issuers. Firms would face liability when those issuers make misrepresentations to investors about transactions involving those firms. Given the costs of litigating, these firms might prefer to settle even in instances in which their own conduct was not deceptive. Privately held companies and foreign companies, who would never otherwise have thought about having securities liability for entering into commercial transactions, would not be immune from suit.
Talk about a chilling effect! Can you imagine the amount of documentation and investigation that you would have to undertake to protect yourself from liability that far outstrips any gain you might earn from the transaction? Any liability would be determined years later, by others judging you in retrospect according to the supposed "red flags" that you might have missed alerting you to what your counterparty was actually up to. The size and materiality of the transaction to you or to the other party would not necessarily matter because under some concepts of so-called "qualitative materiality," the last dollar of your transaction could put the other side over the top in its quarterly estimates to Wall Street, thus keeping its stock price up and fooling investors. You always would have to be extra careful to get representations from the other side as to the propriety of their accounting and look behind those representations to protect yourself.
Perhaps the underlying subtext lurking beneath Stoneridge is the spate of corporate scandals that occurred in the early part of this decade. Investors were left high and dry. Lives were destroyed by the implosion of firms that engaged in massive financial and accounting fraud. Nevertheless, a desire to see these investors made whole does not justify resorting to attenuated theories of liability in order to force people to bear responsibility for fraud that they did not commit.
How so? Let me give you a hypothetical example, based on a fact pattern that occurs often in real life. What if a newspaper published a full page advertisement in its business section for a company called Best Ever Stock Transaction (that would make BEST its ticker symbol). The ad raves that the company is "an incredible investment opportunity" and is positioning itself to "help re-invent the health-care industry as we know it." Many of these kinds of advertisements are part of what we call "pump-and-dump" schemes, where stocks are hyped in order to generate investor interest and then the promoters dump their holdings, taking their profits, and causing the price of the stock to collapse. We devote a good part of our enforcement resources to this kind of market manipulation, and we see a growing incidence of it on the Internet.
If the statements in the ad are false and misleading, could the newspaper be subject to a private lawsuit under scheme liability if the company turns out to be part of a fraud? Perhaps, if you follow the scheme liability rationale. After all, the newspaper published an advertisement that contained false statements in support of a fraudulent scheme. The newspaper even made money off of publishing the advertisement. The plaintiffs would claim that the newspaper either knew or was reckless in not knowing that the statements were false and allowed itself to further the scheme. Many newspapers have published news reports discussing how these "pump and dump" schemes work and how the SEC and others are making efforts to stop them. Can the knowledge of the journalism and editorial side of the newspaper be imputed to the business side? Thus, the plaintiffs' would claim that the newspaper willingly turned a blind eye in pursuit of advertising revenue. Furthermore, because it is an advertisement, it would be considered commercial speech and subject to a lower level of First Amendment protection.13
One could argue that the newspaper would ultimately prevail in litigation. But prospects of success at trial would be beside the point if the cost of litigation and the risk of losing tilt the balance in favor of settling without admitting or denying any liability. The real question, then, is whether such a lawsuit would survive a motion to dismiss and thereby raise the incentives of the newspaper to settle. Under scheme liability, it very well could.
A further unintended consequence of scheme liability would be the potential vastly to expand the global jurisdiction of our federal securities laws through private class actions. Transactions that occur entirely abroad — and which are completely legal in the place where they occur — could be potentially subject to securities class actions if the results of such transactions are incorporated into the financial statements of an issuer that files reports in the United States. Recent reports on the competitiveness of the U.S. capital markets note that foreigners regard the lottery-like aspect of the U.S. litigation system as a significant negative factor to doing business in the United States.14
Thank you again for your invitation to be with you today here in New York. I wish you all the best in your visit and in your discussions. We have many issues facing us in the capital markets — some within our control and many outside our control. Please remember that we at the SEC depend on commentary from people like you. I would welcome your active involvement in our issues. My phone and office are always open to you. Please call or stop by if you have any comments or concerns. Thank you for your time and attention.