Speech by SEC Staff:
Remarks at AICPA National Conference on Current SEC and PCAOB Developments
Director, Division of Enforcement
U.S. Securities and Exchange Commission
December 8, 2009
Thank you, Scott Pohlman, for that kind introduction. I’m delighted to attend this gathering of one of the most important of the SEC’s constituencies.
As you have probably heard a number of times during your conference, I must begin my remarks with the disclaimer that my remarks today are my own, and do not necessarily reflect the views of the Commission or any member of its staff.
Let me start with the obvious — for the past two years, our financial markets have suffered the most devastating financial crisis since the Great Depression. The consequences are all too familiar — the bursting of the housing market bubble, the widespread default of subprime mortgages and related derivative securities, the demise of once-hallowed financial institutions and the survival of others only through the grace of government assistance.
Recovery will require coordinated efforts on a variety of fronts, including enhanced supervision of financial institutions and reform of our market and regulatory structures. Vigorous enforcement is a critical component of that recovery effort. That is because restoring investor confidence requires satisfaction of the public’s legitimate call to hold accountable those whose unlawful conduct caused such loss and hardship, and to vindicate principles fundamental to the fair and proper functioning of our markets — that no one should have an unfair advantage in our markets; that investors have a right to truthful and accurate disclosure; and that there is a level playing field for all investors. As the SEC is the only agency in the federal government focused primarily on investor protection, it has a special obligation to vindicate these principles through vigorous enforcement.
While statistics alone do not tell the whole story, recent data provide real evidence that we are fulfilling our core mission of investor protection. This past fiscal year, the SEC:
- Ordered wrongdoers to disgorge over $2.0 billion in ill-gotten gains (an increase of 170% over fiscal 2008);
- Ordered wrongdoers to pay penalties of $345 million (an increase of 35% over fiscal 2008);
- Sought 71 emergency temporary restraining orders to halt ongoing misconduct and prevent further investor harm (an increase of 82% over fiscal 2008);
- Sought 82 asset freezes to preserve assets for the benefit of investors (an increase of 78% over fiscal 2008); and
- Issued 496 orders opening formal investigations (an increase of over 100% over fiscal 2008).
II. Changes in the Enforcement Division
Not unlike the comparison to “changing the tires on a moving car,” this increased enforcement activity has occurred in parallel with a top-to-bottom self-assessment of all of the Enforcement Division’s structure, processes and operations. The question we asked ourselves was a simple one: what can we do better? As a result of our self-assessment, Enforcement is now implementing a broad slate of new initiatives designed to improve the Division’s expertise and efficiency. These changes constitute the Division’s biggest reorganization in at least three decades. Let me summarize a few of the high points:
First, Specialization. We are creating five new national specialized investigative groups that will be dedicated to high-priority areas of enforcement.
- The first is Asset Management, which will focus on investment advisers, investment companies, hedge funds and private equity firms.
- The second is Market Abuse, which will focus on large-scale insider trading and market manipulation.
- The third is Structured and New Products, which will focus on complex derivative and newly-developed products;
- The fourth is Foreign Corrupt Practices Act cases; and
- The fifth is Municipal Securities, which will focus on suspect activity in the market for municipal securities.
The rationale for creating specialized groups is simple — many market practices, products and transactions are highly-complicated, and effective enforcement requires that we be as savvy as those we are investigating. As you can see from the cases we have brought, a significant amount of expertise already exists in the Division — however, we were not taking full advantage of that expertise.
Having specialized units that are national in scope will facilitate our ability to do so, as we will be able to coordinate the activities of staff with similar expertise, provide them with focused training, hire and assign to the units outside experts with particular skills and talent, and better take advantage of the expertise in our sister Divisions. Members of the specialized units will acquire the investigative insights that can only be developed by conducting multiple investigations in the same subject area, which will lead to more effective, efficient investigations. This increased expertise will permit us to be more proactive, identifying troubling conduct and practices earlier, and hopefully stopping them before investors losses have mounted.
Second, Management Restructuring. We are adopting a flatter, more streamlined organizational structure that will eliminate an entire layer of management. Our self-assessment revealed a management structure that was too top-heavy — resulting in too much process and rework, slower decision-making, and a stifling of creativity, autonomy, and accountability. This flattening will allow us to redeploy our former first line managers — some of our most experienced and dedicated personnel — to the task of conducting front-line investigations, thus rebalancing the Division’s center of gravity more toward our core function.
Third, Streamlining. We are decentralizing certain decision-making in order to reduce bureaucracy and increase autonomy. Senior officers now have delegated authority to approve subpoenas for documents and testimony, without having to obtain advance approval from the Commission. Routine decisions in the opening of investigations, the decision to recommend charges, and settlement can now be made by those same senior officers without advance approval by more senior personnel.
Other Initiatives. We are also implementing a number of other initiatives designed to improve our processes and overall effectiveness.
- We are enhancing our training and supervision;
- We have hired the Division's first-ever Managing Executive, a COO-type function to focus on the Division’s operational, infrastructure and workflow tasks;
- We have established an Office of Market Intelligence, which will collect, risk-weight, triage, investigate, assign and monitor the hundreds of thousands of complaints, tips, and referrals the Division receives each year.
I am confident that these initiatives — and others to come — will reinvigorate our Division and enable us to even better fulfill our mission of investor protection.
Let me mention one last initiative, and a special challenge that it may present for witnesses in SEC investigations and their counsel. That is the cooperation initiative. We are developing a range of tools similar to those used by criminal law enforcement authorities to encourage individuals to cooperate in SEC investigations. Among these tools are so-called “cooperation agreements,” which will provide the possibility of reduced sanctions in appropriate circumstances, such as where an individual is “first in the door” and provides us with valuable information concerning wrongdoing.
This is the type of “inside information” that the SEC encourages. It will allow us to secure key witnesses and evidence early on in investigations. We will also bring cases more quickly and efficiently, as we can avoid some of the painstaking investigative steps and delays made necessary when we lack an “insider’s” knowledge of the case.
Cooperation will have other consequences, such as in the area of representation of multiple witnesses by a single lawyer or law firm. It is not uncommon for corporations and audit firms to hire a single law firm to represent multiple company employees in SEC investigations. When one law firm represents more than one witness, there is a risk of a conflict of interest between the clients — and this risk generally increases exponentially as the number of witnesses represented grows. Indeed, in some cases, we have seen one law firm represent up to 20 witnesses or more. The risk of conflict of interest is further increased where the witnesses occupy different positions, responsibilities, knowledge, and involvement in the conduct being investigated. For example, an engagement partner’s potential liability for a failed audit can be very different from a staff member’s.
Now, lawyers have an ethical obligation to zealously represent the interests of their clients. And let me be clear — most lawyers take that obligation seriously and fulfill that important obligation appropriately. However, the broader availability of cooperation credit will increase the risk of conflicts of interest in situations where counsel seeks to represent multiple clients. It may be in the interest of one client to be the first to report the misconduct to the Commission or offer his or her cooperation. But, obviously, only one client can be first. Similarly, it may be in the interest of one client to provide evidence that is not helpful to another client of the same counsel. Accordingly, this new program could pose heightened ethical concerns for counsel representing more than one person who could potentially benefit from cooperating in a Commission investigation. It is something that counsel and their clients should carefully consider.
III. Financial Statement and Accounting Fraud
Let me now turn to a topic most relevant to this audience. Financial statement and accounting fraud is central to our Enforcement program — routinely comprising nearly 25% of all enforcement actions we bring annually. This constitutes the single largest category of actions we file, and is a main artery of our Enforcement program. In many ways, we are already “specialized” in this area, and for that reason did not make it the subject of one of the new specialized units. We purposefully chose to initiate specialized units in discrete areas, particularly new areas of focus or emphasis with steep learning curves, where our existing expertise may not be comprehensive. We also determined not to be too ambitious with the number of specialized units we started at once, in recognition of the implementation risk associated with integrating these new structures in our existing regional configuration. But rest assured — financial fraud investigations are continually being pursued by large numbers of staff in every office across the country.
To underscore this point, let me now turn to some recent financial statement and accounting fraud cases. We continue to be aggressive in this area — consider GE’s recent $50 million penalty arising out of its improper derivatives accounting1 and the $25 million penalty against Zurich Financial Services for its role in improper finite reinsurance transactions.2
But not surprisingly, we are bringing more financial disclosure cases arising out of mortgage-related businesses and activity. Just yesterday, the SEC filed charges against three former officers of New Century Financial Corporation, once the third-largest subprime lender in the United States. Our complaint alleged misrepresentations regarding the company’s subprime mortgage business and for materially overstating the company’s financial results by improperly understating expenses relating to repurchased loans. Our complaint also alleged that New Century did not disclose known dramatic increases in early default rates, loan repurchases and pending loan repurchase requests. Finally, we further alleged that the company materially overstated its 2006 Q2 pre-tax earnings by 165%, and improperly reported its Q3 pre-tax earnings as a $90 million profit instead of an $18 million loss.3
In July 2009, the SEC charged the former Chief Accounting Officer of Beazer Homes, a homebuilder with operations in at least 21 states, with allegedly conducting a multi-year fraudulent earnings management scheme and misleading Beazer’s outside and internal auditors to conceal his fraud. This involved decreasing reported net income through improper reserves during a period of strong growth from approximately 2000 to 2005. Then, as Beazer’s financial performance began to decline in 2006, along with the housing market, Beazer reversed the improper reserves and increased its net income.4
In June of this year, the SEC charged Angelo Mozilo, the former CEO of Countrywide Financial and two other former executives with fraud for deliberately misleading investors about the significant credit risks Countrywide was taking in efforts to build and maintain the company’s market share. The SEC alleged that Countrywide portrayed itself as underwriting mainly prime quality mortgages, while CEO Mozilo privately described some of the loans it made as "toxic." The SEC's complaint also charged Mozilo with alleged insider trading for selling his Countrywide stock based on non-public information for nearly $140 million in profit.5
In April, the SEC also brought actions against three former executives at American Home Mortgage Investment Corp. for alleged accounting fraud and false and misleading disclosures regarding the risk of the mortgages originated and held by the company as the credit crisis began to unfold. The SEC’s complaint alleged that two of the executives fraudulently understated the company’s first quarter 2007 loan loss reserves by tens of millions of dollars, converting the company’s loss into a fictional profit. One of the executives, Michael Strauss, settled the SEC’s charges by agreeing to pay approximately $2.2 million in disgorgement and a $250,000 penalty, and accepting a five-year officer and director bar.6
IV. “Clawback” Under Section 304 of the Sarbanes-Oxley Act
Let me make one additional point with respect to financial statement fraud. Earlier this year, we filed the CSK Auto case, a significant event under Section 304 of Sarbanes-Oxley, the so-called “clawback” provision.7 Section 304 provides that when an issuer is required to prepare a restatement, the CEO and CFO may be required to reimburse the issuer for any bonus or incentive-based compensation received during the 12 months after the publication of the non-complying financial filing, and any profits from the sale of company stock during the same period.8 Section 304 reflects Congress’ intent that high-level executives should not personally profit from misstated financial filings, and also serves as an additional incentive for CEOs and CFOs to ensure the accuracy of the company’s financials.
Of particular note is that Section 304 does not require the SEC to prove any specific level of involvement or misconduct on the part of the CEO and CFO. In the CSK Auto case, we are seeking to clawback more than $4 million in bonuses and stock sale profits from the former CEO, despite the fact that he was not alleged to have personally participated in the underlying financial wrongdoing. Section 304 is for that reason a powerful enforcement tool, and one that corporate executives should understand Congress has authorized the SEC to use in appropriate circumstances.
V. Policy and Other Issues
Looking ahead, the Enforcement Division is considering several issues that will be of interest to this group. The Enforcement Division’s Associate Chief Accountant, Jason Flemmons, is here with me today to discuss some specific matters I know will interest you, but I would like to touch briefly on two.
The first concerns privileges. We have seen a number of audit firms withhold subpoenaed documents and assert work product privilege on behalf of an audit client. We are skeptical of such claims, especially after the recent en banc decision in Textron which held that tax accrual work papers prepared by in-house counsel were not entitled to work product privilege. As you may know, in that case, the IRS sought those work papers and the company refused, claiming work product privilege. The court rejected that argument, noting that the “work product privilege is aimed at protecting work done for litigation, not in preparing financial statements.”9 And the First Circuit’s common sense analysis is how we evaluate these types of assertions of privilege. We do not see how the audit documentation prepared by or relied on by an auditor in connection with an audit report can be privileged, or how any claimed privilege hasn’t been waived. Audit documentation is collected or prepared for the purpose of issuing an audit opinion, not for the purpose of litigation. And sharing the work product with auditors, who are supposed to be “public watchdogs,” strongly undermines any such claim.
B. Audit Committees
Another area concerns the duties and responsibilities of boards of directors and audit committees. Our investigations of financial fraud will continue to carefully evaluate whether directors and audit committees played any role in the matters under investigation. That includes investigating active participation in wrongdoing as well as recklessly ignoring red flags and other information. Sitting on a board confers both prestige and responsibilities, and we want to insure that board members have properly discharged their duties when significant financial frauds occur. We will want to know that board members were acting in good faith and exercising due diligence and were not mere figureheads or rubber stamps for management. For audit committees, this means an active role in the accounting and audit issues confronting issuers. It also means insuring that the “tone at the top” reflects intolerance for misconduct and a desire to produce accurate financial statements that reflect the true picture of a company’s performance.
In short, we want to make sure Audit Committee members do not ignore warning signs — and that they do ask for information and require good answers, drill down into key accounting issues, and understand their company’s reporting. We aren’t interested in second-guessing good faith efforts by board members, but we are interested in ensuring that directors do not ignore information with respect to improper acts.
VI. Hedge Funds and Derivatives — Concerns
I would also like to speak briefly about two separate sets of cases that together illustrate important new priorities for the Enforcement Division — hedge funds and derivatives.
Hedge funds have experienced explosive growth in recent years and now account for a large percentage of trading volume. They provide benefits to the markets through increased liquidity and price discovery. At the same time, given the required high net-worth and financial sophistication of their investor base, hedge funds are not currently subject to the same investor protection rules that apply to, for example, mutual funds, such as rules pertaining to liquidity, redemption, pricing, disclosure, use of leverage, short sales and conflicts of interest. In addition, there can be a lack of transparency concerning hedge fund trading, as they often trade through alternative trading systems, such as ECNs and dark pools, sometimes using complex and opaque algorithmic trading strategies. Hedge funds can also have significant connections to, and be the source of significant revenues for, large financial institutions, through prime brokerage, capital-introduction and other relationships. These relationships can lead to pressure to improperly disclose to hedge funds confidential, material nonpublic information held by these institutions.
Compounding those concerns is the fact that amost anyone can start a hedge fund — there are no mandatory qualifications such as securities industry certifications or experience — and many hedge funds are wholly independent from any institution that is subject to registration and regulation under the Investment Advisers Act. As a result, many hedge funds may lack a history of, or even a model for, a vigorous compliance culture.
Some of the same concerns exist with respect to the derivatives markets. These products trade in the largely unregulated over-the-counter markets in which there is an absence of transparency, even about the most fundamental aspects of a trade.
That is why two separate sets of recent SEC cases are significant. In the first matter, the Galleon and Cutillo cases, we filed charges against two complex insider trading rings allegedly involving hedge fund portfolio managers, Wall Street professionals, attorneys, and high-level corporate insiders, among others. 10 In actions against billionaire hedge fund adviser Raj Rajaratnam, his investment advisory firm, Galleon Management LP, and others, the SEC has filed charges against a total of 29 individuals and entities. We alleged that the schemes cumulatively generated more than $53 million in illicit gains. The Galleon and Cutillo cases are significant for a number of reasons. First, court-authorized wiretaps were used by our criminal law enforcement partners. The use of these tools underscores the view that large scale insider trading by industry professionals is as serious as organized crime, extortion and similar misconduct where wiretaps commonly are used. Persons involved in illegal insider trading schemes now must rightly consider whether their conversations are under surveillance.
Second, the Galleon and Cutillo cases involved the repeated and more systemic effort by hedge funds to obtain material non-public information, including the cultivation of sources within the issuer community who were willing to provide material nonpublic information about their companies. Extending beyond the “opportunistic” conduct that characterized many previous insider trading cases, Galleon and Cutillo suggest that the use of insider trading as a business model, particularly for funds with event-driven strategies, is not isolated and must be explored.
The second matter involves insider trading in the credit default swap market — though I am personally recused from the case, I can speak about it based on publicly-available information. In May, we filed the VNU case, in which we alleged that a former portfolio manager at hedge fund investment adviser Millennium Partners and an investment banking salesman engaged in insider trading in credit default swaps on international holding company VNU.11 In a new derivative-oriented twist on an old fashioned illegal play, a bank employee allegedly tipped the portfolio manager about an anticipated change in the financing of a leveraged buyout of VNU, knowing that once the change was announced, it would substantially increased the price of the credit default swap on certain VNU bonds. By purchasing CDS before the deal structure changed, the defendants profited when the restructuring was announced.12 The lack of transparency in the derivatives markets adds a new and more dangerous dimension to misconduct such as insider trading.
Together, these two sets of cases illustrate the concerns that we have with respect to both hedge funds and the derivatives markets, and in particular the intersection of both. That is one of the reasons we support recent legislative initiatives to require the registration of hedge funds, which would result in greater disclosure and transparency, data collection and recordkeeping and encourage greater compliance. For the same reasons, we support the establishment of a central clearing party for standardized derivatives transactions. In addition, the new specialized units we are developing, in the areas of Asset Management, Market Abuse, and Structured Products, will result in trained and focused enforcement personnel closely scrutinizing these growing areas for possible wrongdoing, and moving swiftly when it is identified.
Our mission to vigorously enforce the federal securities laws is critical. We are committed to continuing to revitalize and improve our programs, aggressively pursuing long-term improvements in our structure and processes, and working hard to bring timely and significant cases with the ultimate goal of investor protection. With the dedicated and talented men and women that I work beside each day in the Division of Enforcement, I am confident that we will successfully fulfill our mission.
1 SEC v. General Electric Company, Lit. Rel. No. 21166 (Aug. 4, 2009).
2 SEC v. Zurich Financial Services, Lit. Rel. No. 20825 (Dec. 11, 2008).
3 SEC v. Brad A. Morrice, et al., Lit. Rel. No. 21327 (Dec. 7, 2009).
4 SEC v. Michael T. Rand, Lit. Rel. No. 21114 (July 1, 2009)
5 SEC v. Angelo Mozilo, et al., Lit. Rel. No. 21068A (June 4, 2009).
6 SEC v. Michael Strauss, et al., Lit. Rel. No. 21014 (Apr. 28, 2009).
7 SEC v. Maynard L. Jenkins, Lit. Rel. No. 2114 9A (July 23, 2009).
8 Sarbanes-Oxley Act of 2002 §304(a), codified at 15 U.S.C. §7243(a).
9 United States v. Textron, Inc., 577 F.3d 21, 31 (1st Cir.)(en banc), Application No. 09A361 granted, ___ U.S. ___ (Oct. 20, 2009) (extending time to file cert. petition until Dec. 24, 2009).
10 SEC v. Galleon Management, LP, et al., Lit. Rel. No. 21284 (Nov. 5, 2009) and SEC v. Cutillo, et al., Lit. Rel. No. 21283 (Nov. 5, 2009).
11 SEC v. Jon-Paul Rorech, et. al., Lit. Rel. No. 21023 (May 5, 2009).
12 See SEC v. Jon-Paul Rorech, et. al., CV-09-4329 (S.D.N.Y. May 5, 2009), Complaint at 2.