Remarks Before the Exchequer Club of Washington, D.C.
Commissioner Paul S. Atkins
U.S. Securities and Exchange Commission
July 16, 2008
Thank you, Karen [Thomas], for the warm introduction. I am honored to speak to the Exchequer Club of Washington, D.C. As you probably are aware, the views I express here are my own and not necessarily those of the United States Securities and Exchange Commission or my fellow Commissioners.
It is appropriate that we are meeting today only a few blocks from the White House. On this day in 1790, Washington, D.C. became the official seat of the United States government. In the Compromise of 1790, James Madison, Alexander Hamilton, and Thomas Jefferson agreed that the federal government would assume the Revolutionary War debt carried by the thirteen States on the condition that the new national capital would be located in the South.
On July 16, 1790, the Residence Act provided for a new permanent capital to be located where we are today, on the banks of the Potomac River. Both Maryland and Virginia designated land for the federal district. George Washington — who had his family plantation, Mount Vernon, conveniently located down the Potomac — chose the exact site for the city, and it was named in his honor the following year, on September 9, 1791.
Of course, some people were upset at the time that our nation's capital would not be located in one of the top economic centers: New York, Philadelphia, Boston, Charleston, or Baltimore. Although our founding fathers certainly did not realize all of the ramifications of their decision at the time, their choice in not trying to place the seat of government in the same city as a major commercial hub perhaps shaped national economic policy. By being separated physically from the major markets and being consigned to what essentially was a provincial city until relatively recently, our governing officials certainly lacked a day-to-day connection with the markets.
If you go to a dinner party and everyone else is also a government worker or otherwise connected to the government, your world view may be colored by that lack of diversity. On the other hand, the separation from being in a large commercial city may have decreased — at least to some extent — the interest of those government officials to interfere in our markets during the first century of our nation's existence. That may have been at least one reason that our free market system grew and flourished.
Today, the financial markets are going through some difficult times. I have heard some questioning of the President's optimism. The financial sector is in turmoil because of issues relating to the lack of available credit, the securitization of certain home mortgages, and business and investment decisions made by professionals. But, we must not lose sight of the fact that what goes on in Wall Street does not necessarily translate to Main Street. Corporate balance sheets remain strong, productivity remains high, unemployment remains low by historical standards, and exports are increasing. It is important not to lose sight of those facts.
Responding to the Current Economic Situation
The current economic conditions in the market have prompted calls in the United States and abroad for greater regulation and a new regulatory order. We must not immediately jump to the conclusion that failures of firms in the marketplace or the unavailability of credit in the marketplace is caused by market failure, or indeed regulatory failure. The reality is that companies will flourish and companies will fail, depending primarily on business judgments. Regulators cannot, and indeed should not, interfere with the marketplace to guarantee success or ensure against failure. Instead, the role of regulators is to enforce contracts, protect property rights, and to strive for a transparent marketplace free of fraud.
In addressing the recent problems in the credit markets, regulators also must be cognizant of other, longer-term challenges that face our capital markets. The longer-term issues include concerns about whether our current regulatory framework is preventing U.S. capital markets from performing efficiently; whether we are spending our resources wisely to protect investors not from the vagaries and risks of the market, but from lying, cheating, and stealing; and whether we need to make changes to maintain the international competitiveness of our capital markets. Of course, a strong legal structure that is designed to ensure fairness, predictability, and efficiency is a crucial prerequisite for any healthy capital market. Investors need and demand effective recourse to the rule of law and enforceability of contract. They rely on a system of integrity.
If, however, we get the balance wrong, regulation can become part of the problem rather than part of the solution. Central to the issue of attractiveness of our markets is regulatory effectiveness and efficiency. Investors ultimately pay for regulation. If regulations impose costs without commensurate benefits, investors suffer the costs of lack of effectiveness and efficiency, not only through higher prices but also through constrained investment opportunities. That ultimately hurts them in their investment performance, because it means less opportunity for diversification.
Some see regulation differently. Some proponents of a change in our regulatory philosophy say that a greater role for regulators is needed. Somehow, they argue, regulators should be smarter than market participants and be able to prick bubbles before they grow too big. It is easy to blame business decisions and regulation in retrospect when there are business failures. But this alternative — the classic bureaucratic "just say no" — has its own consequences, too.
This view means that regulators must be able to predict future market conditions. How can regulators, or any one else for that matter, have that ability? Equally problematic is to expect regulators to be able to predict where problems will hit the financial system hardest. Can regulators do the jobs of industry better than industry can?
Before 1996, initial public offerings of stocks in some cases had to be approved in certain states under a merit-based system, where the government decides if a security is a "bad" investment and thus not appropriate to be offered to its citizens. In fact, this is exactly what happened to Apple Computer when it first went public in 1980. The SEC approved Apple's registration statement under the federal Securities Act, but the offering was still subject to merit review in various states. Massachusetts prohibited the offering of Apple shares because they were "too risky." The joke among the investment bankers was that Apple was "banned in Boston." Texas approved the sale after an extensive review, but its securities regulator called his decision "a close call." And Apple did not even bother to offer its shares in Illinois due to strict state laws on new issues.
The Apple situation was one where government bureaucrats made the decision about the value of the offering, not the markets. The result? Investors in Massachusetts and Illinois could not buy in what became a very successful IPO and ultimately a successful company. Congress changed the law in 1996 and exempted from state approval offerings most national offerings under the rationale that sufficient disclosure and coverage would exist for these sorts of listings. For the national capital markets, the SEC's regulatory approach under the federal securities law is a combination of mandated disclosure and antifraud enforcement.
What if we did have the power and willingness to impose our judgment on the entire U.S. market — to second guess investment or business decisions? Would Apple have become the successful company that it is today? Could Apple have failed and the bureaucrats proved correct? Perhaps. But they were wrong! Think of the opportunity cost to investors and society if that bureaucratic view had prevailed nationally and prevented a good idea from going forward.
In his last book, The Fatal Conceit: The Errors of Socialism, Friedrich von Hayek, the Austrian-born economist, wrote about the dangers of a paternalist attitude toward regulating the economy.1 He labeled as the "fatal conceit" the idea that "man is able to shape the world around him according to his wishes."2 Hayek argued: "To act on the belief that we possess the knowledge and the power which enable us to shape the processes of society entirely to our liking, knowledge which in fact we do not possess, is likely to make us do much harm."3 As the current market turmoil shows, one cannot predict the mentality of the market — tens or hundreds of millions of people making billions of independent decisions every day with their money.
We had a major bank failure last week under what some charge are lax regulatory standards, but we have had many bank failures in the past under other regulatory regimes. Continental Illinois, at one time the seventh largest bank in the country, is the biggest bank failure in history and its downfall was due to business decisions that turned out to be incorrect and regulatory standards that hobbled its diversification. The bank had grown aggressively in the late 1970s under regulatory supervision. Was that the right amount of supervision? Can we ever be able to answer such a question, except in hindsight?
As Hayek teaches, at some point, we must recognize that businesses are better than governments at business. To suggest that regulators somehow know more than a company knows about its own business and the risks its faces is both egotistical and na´ve. In addition, by removing any risk management from firms and placing it in the hands of government, there is a danger that firms will become careless and take on additional risk, believing regulators are protecting them. This is the moral hazard that we all try to avoid. Simply put, the risk management function must remain in the hands of the firms that face the risk. The shareholders ultimately must bear that risk and the results of the decisions — good and bad — that their employees (corporate management) make.
No matter how many regulations there are, they are no substitute for market participants' making sound decisions based on good information. No one can guarantee success in any investment. I have now done more than forty town hall meetings with investors of all types — military, retirees, students, investment clubs, and others. The one message that I stress the most is to try to understand your risk — and diversify, diversify, diversify. That goes for everyone from the novice investor to the professional. Government can never substitute for these sound investment principles.
Securities Act of 2008
Congress is currently considering some additional legislation concerning the SEC. On July 9, 2008, the House Capital Markets Subcommittee reported favorably without amendment the Securities Act of 2008. The bill contains many provisions requested by the Commission in previous authorization bills.
Many of the provisions are designed to clean up or clarify existing legislation. For example, the legislation includes provisions to protect the confidentiality of materials submitted to Commission, and there are clean-up amendments relating to the repeal of the Public Utility Holding Company Act (PUHCA).
One provision, though, deserves some discussion. It would provide authority to the SEC to impose civil penalties against a broader group of defendants in cease-and-desist proceedings, including against public companies that issue securities. A cease-and-desist proceeding is a proceeding brought before one of the SEC's administrative law judges. In other words, it not a proceeding before a federal district court judge appointed pursuit to Article III of the U.S. Constitution. Under existing securities laws, the SEC may seek a penalty against a public company only in a federal district court action, not a cease-and-desist proceeding.
This is not the first time that this issue has come up. In the late 1980s as part of the legislation that eventually became the Securities Enforcement Remedies and Penny Stock Reform Act of 1990, the SEC first sought the power to impose civil penalties against public companies in cease-and-desist proceedings. The SEC's request, however, was coupled with very specific factors that the SEC suggested should be considered in determining whether to seek a civil penalty against a public company in an administrative proceeding.4
First, the SEC underscored that the proposed law would not "dictate" that the Commission must seek or impose a civil penalty against an issuer.5 Instead, as the SEC explained, the Commission could proceed against culpable individuals and exercise discretion in not seeking an issuer penalty.6 Second, the SEC stressed that it "may properly take into account its concern that civil penalties assessed against corporate issuers will ultimately be paid by shareholders who were themselves victimized by the violations."7 The SEC explained that penalties should be assessed against issuers only in the rare situation where the issuer received a "direct economic benefit" from the fraud.8 Third, the SEC stated that a civil penalty should be imposed on an issuer "only where the violation resulted in an improper benefit to shareholders," but that, even under those circumstances, the passage of time and resulting shareholder turnover may weigh against imposing a penalty.9 New shareholders should not have to pay for the deeds of past management.
Central to the SEC's analysis of the propriety of seeking a penalty against an individual or an issuer was whether the penalty would serve a "public interest."10 To that point, the Commission outlined several additional factors it would consider to determine if the penalty was in the public interest, such as the nature of the conduct and the extent to which any wrongdoer was unjustly enriched, taking into consideration any restitution paid to injured parties from settlements in private securities litigation.11
Before Congress ultimately passed the legislation in 1990, the SEC removed its request for the authority to seek civil monetary penalties against issuers in administrative proceedings.12 Therefore, the SEC would need to go to federal court in order to obtain a civil penalty against a public company.
Although Congress understood that imposing civil monetary penalties on issuers would harm shareholders,13 Congress expected that the SEC would exercise discretion and seek civil monetary penalties against issuers only when a violation had resulted in improper benefits to shareholders.14 Congress took comfort in the fact that federal judges would operate as an independent check on the Commission's decision to seek an issuer penalty and the amount sought to be recovered. The concern among members of Congress and internally at the SEC was that if the same remedies were available to the SEC under both judicial and administrative proceedings, then the SEC might be perceived to have an incentive to conduct more enforcement actions through its own administrative proceedings, rather than before a federal district court judge. The final legislation did not include penalty authority in administrative proceedings precisely because administrative proceedings do not afford the oversight by Article III judges that is present in civil proceedings.
Are the concerns that existed in 1990 still valid? Might the SEC find its administrative proceedings more convenient than federal court? Is that necessarily a bad thing? Is it more efficient for SEC matters to be decided in such a venue? After all, if a company litigates in an SEC administrative court, it still can appeal to the full Commission and then to federal court. Does the legislation need to include the specific factors to weigh in assessing a penalty that the SEC originally proposed to include in the late 1980s? I look forward to hearing the debate on this legislation.
These issues are not partisan, and as debates twenty years ago show, these are not new issues. Raising these issues does not make one "anti-enforcement." After all, the best enforcement program is one that is effective and fair.
Call for Evaluation of SEC Enforcement Program
Unrelated to the legislation in Congress, I recently called for the formation of an independent advisory panel to evaluate the SEC's enforcement program and to make recommendations for improving the system. A similar panel was formed in 1972 by then-Chairman Bill Casey. Shortly after he pulled together dispersed units to form an enforcement division, Chairman Casey asked New York attorney Jack Wells to lead an independent panel to review and evaluate the enforcement program in light of the agency's mission. Chairman Casey wanted to ensure that the SEC properly allocated resources, balanced regulation and enforcement, and protected the rights of defendants and others with whom the agency interacted.
In the 36 years since the Wells Committee set out its recommendations, financial markets have changed tremendously, and corporate scandals have rocked both Wall Street and Main Street. In response, Congress over the years gave the SEC significantly more enforcement powers, many of them punitive in nature. The SEC now can impose multimillion-dollar penalties against corporations and individuals, bar individuals from serving as officers and directors of corporations, and prevent professionals such as accountants and securities lawyers from practicing before the SEC.
It is time for the Commission to convene a new advisory committee, in a spirit similar to that of the Wells Committee, to conduct an independent review of the SEC's enforcement program and to recommend any needed changes to modernize enforcement practices. That would include, of course, an examination of the usage, effects, amount and appropriateness of corporate penalties in financial fraud cases, to determine if they are consistent with the SEC's mission to protect investors; maintain fair, orderly and efficient capital markets; and facilitate capital formation.
The SEC's 2006 Statement Concerning Financial Penalties was a significant first step in examining many of these concerns, but in its application the SEC has encountered areas not addressed by the statement. For example, if a penalty against a corporation is appropriate in a particular case, how should the amount of the penalty be determined? What sort of extenuating circumstances should be considered, such as a troubled business situation or private litigation settlements? The new advisory committee should examine these concerns with the input of economists, legal scholars and practitioners.
Moreover, as the 1972 Wells Committee did, this new committee also should examine whether the SEC is taking appropriate steps to protect the rights of defendants and to provide appropriate due process. Providing these protections to prospective defendants would not hinder our ability to prosecute wrongdoers. Indeed, by providing due process safeguards, we protect the integrity of our enforcement system and ensure that only those who truly have committed wrongdoing receive the appropriate sanctions.
I am pleased that my calls for an advisory committee have been echoed by members of the private bar and even by many within the Enforcement Division — the latter often behind closed doors.
But inevitably, some have questioned the need for any review. Some argue that an advisory committee for enforcement is not a high priority when we have other matters to tackle, such as investigating those who spread false rumors or amending the rules concerning credit ratings. Efficiency, fairness, and due process of law by a regulatory agency are not just luxuries for the fat years; they are essential for maintaining the public's respect and confidence in the legal process.
I agree that those other matters should be priorities, but I submit that an independent advisory committee should be given that same priority. And the beauty of an independent panel is that it will not take away from the current work of the Commission. We have had a very positive experience with advisory committees in the past, including most recently the SEC Advisory Committee on Improvements to Financial Reporting (CIFR), headed by Bob Pozen.
Now, more than ever, we need to receive a candid and critical review of the SEC's enforcement program to determine if we are allocating properly our resources and have proper supervisory and management procedures. A recent Senate report made some recommendations on improving the Enforcement Division. In addition, the Government Accountability Office recently conducted a review of our enforcement and examinations groups. As to the Enforcement Division, one finding was that the division was not closing out cases expeditiously enough. Some investigations were languishing for years, with unfair consequences to those under investigation, whose lives were on hold during that time.
To give you an example of how an investigation can affect a professional, there is the story of an insider trading case in which an investment banker with a large bank was seeking to sell a particular business. He shopped it, among others, to friend who was a private equity investor. The investor signed a confidentiality agreement, but decided not to buy. The investment banker eventually found a public company buyer. He contacted the investor one more time to make sure that he did not want to participate — again, the answer was no. However, the investor then traded on the information and was caught. The investigative trail quickly led to the investment banker, who was put on administrative leave for a few years. We eventually found that he did not do anything wrong, but that was after years of being sidelined from his career. Investigations take time, but facts like those, with real lives being affected, emphasize that we must ensure that we are being as expeditious as possible, managing our processes fairly, and choosing good cases to bring.
These questions are timely as we try to respond to matters in the marketplace, such as investigating persons for spreading false rumors about companies in an effort to manipulate the price of shares, promoting Ponzi schemes that prey on the hopes of distressed individuals, and conducting pump-and-dump schemes.
My service as a commissioner will end shortly. The decision to impanel an independent advisory committee will fall upon the shoulders of a future Commission. I urge the Commission to take to heart this suggestion. The Commission must be open to hearing constructive criticism. The Division of Enforcement has a proud history and many dedicated attorneys, accountants and other staff. But, as with any organization, it can benefit from an independent review. We owe it to the public to allow such a review.
Thank you for listening. I will be glad to answer your questions.
intends that a penalty be sought when the violation results in an improper benefit to shareholders. In cases in which shareholders are the principal victims of the violations, the Committee expects that the SEC, when appropriate, will seek penalties from the individual offenders acting for a corporate issuer. Moreover, in deciding whether and to what extent to assess a penalty against the issuer, the court may properly take into account whether civil penalties assessed against corporate issue[r]s will ultimately be paid by shareholders who were themselves victimized by the violations.