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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Remarks before the The Bond Market Association's
2004 Ninth Legal and Compliance Conference


Giovanni Prezioso

General Counsel, U.S. Securities & Exchange Commission

New York, New York

February 2, 2004

As a matter of policy, the Securities and Exchange Commission disclaims responsibility for any private publication or statement of any SEC employee or Commissioner. This speech expresses the author's views and does not necessarily reflect those of the Commission, the Commissioners, or other members of the staff.


Good evening and thank you for the kind introduction.

It is not just a formality when I say that it is a pleasure for me to be here this evening. As many of you know, before joining the SEC, I spent a great deal of time working with the Bond Market Association and many of the individuals in this room. As perhaps a smaller number of you know, my link to this group goes back to my very first project as a lawyer - literally assigned to me the first day at the office after the bar exam - when I worked with the Association, the Federal Reserve and the SEC in drafting and obtaining passage of the repo bankruptcy amendments. (If there any film buffs in the room, I would be happy to let you see the original "Repo Man" posters that my wife gave me when the movie came out.) In the many years since that project, a great deal has changed, including the name of the Association, which was then the Public Securities Association. But throughout that time, one thing has not changed: the widespread recognition in the financial community of the Association's professionalism and commitment to strong bond markets, as well as the high quality of the legal and compliance officers representing its members.

Now this is probably a good time to remind you that the views I express tonight are solely my own and do not necessarily represent those of the Commission or my colleagues on the staff.

Having made that disclaimer, I want to turn to a more difficult subject - the legal and ethical failures uncovered in our securities markets in the past few years, beginning with the collapse of Enron and extending through recent scandals involving mutual funds. There has been a great deal of commentary on these events and their causes, including in particular on the failures by financial market gatekeepers - not only accountants, but also investment banks and attorneys. Rather than add to the general commentary trying to explain how folks seem to have gotten comfortable with lower and lower ethical standards, I will just mention an old story they used to tell in Abruzzi. There were two peasant farmers sitting around talking. One said to the other, "Carminuccio, I bought a new goat." Carminuccio replied, "But where will you keep it?" "In the house." Carminuccio was puzzled: "But what about the smell?" "Oh, he'll get used to it."

With the background of recent market failures and the decline of the old-fashioned "smell test" in mind, I would like to focus on my topic for the evening - a topic that I think is particularly important, and that I hope will be of interest to this group: the responsibilities of financial intermediaries - and the lawyers who work for them - when entering into structured transactions with public companies.

After reviewing some of the cases the Commission has brought recently, I would like to talk a little bit about the law governing intermediaries when structuring transactions involving public companies. I would also like to discuss some of the factors that, in my view, the Commission has used, and will continue to use, in evaluating these activities - with the hope that they will be useful to you in thinking about how you might approach these transactions in the future. This is a serious and complex topic to cover at a dinner event, but this is a sophisticated audience and these are serious times for securities lawyers, so I hope you won't mind.

At the outset, let me make the following observation: I have heard that many are nervous about their potential liabilities in this area and are concerned about the Commission's posture on intermediaries' responsibilities in structuring transactions. Candidly, there may be good reason for some people to be nervous - and I am not going to try to disabuse you of all concern. At the same time, I do hope to persuade you that the Commission is taking a reasonable and principled approach to these questions, especially given the gravity of the misconduct that we have seen in the markets. I also hope to persuade you that the rewards of careful and rigorous lawyering and compliance efforts in connection with structured transactions are substantial, and merit your full attention and resources.

Recent Commission Cases

As you all know, the Commission has engaged in an aggressive enforcement and rulemaking program over the past few years to address failures in our financial markets. This has included bringing enforcement actions against corporate officers participating in financial fraud, as well as their accountants. Perhaps of greater interest to this group, it also has included a number of important enforcement actions against financial intermediaries that structured transactions with issuers engaged in fraud.

In the past year, in connection with the Enron matter alone, we brought settled enforcement actions against Canadian Imperial Bank of Commerce,1 JP Morgan Chase & Co.,2 Citigroup, Inc.,3 and Merrill Lynch & Co.4 These cases resulted in remedial cease and desist or injunctive orders, and in very substantial monetary relief - ranging from $80 million to $135 million. In some cases the Commission also charged individuals, and sought relief including bars against service as an officer or director of a public company. The litigation is still pending as to some individuals.

The Commission's focus on intermediaries is not limited to the collapse of Enron - which notably was one of the first, and thus oldest, of the major scandals to unfold in our markets. For example, in September of last year, we brought a settled action that resulted in a $10 million penalty against American International Group, Inc. for its primary role in an accounting fraud committed by Brightpoint, Inc.5 And I do not think you will be surprised to hear that there are more cases in the pipeline. Currently, the Commission staff is actively investigating a number of intermediaries who entered into transactions that gave rise to financial fraud or other securities law violations - this includes not only firms that structured and marketed transactions, but also lenders that financed them. From an enforcement perspective, I think we are closer to the end of the beginning than the beginning of the end.

The Rules of the Game: Applicable Law

Now, I have heard people ask, isn't this all really unfair, hasn't the Commission somehow changed the rules of the game in response to media and political furor? The answer to that, I believe, is a quite categorical "No." The rules of the game have actually been clear for some years, even if the Commission has not always had the evidence or the resources to enforce them as aggressively as it would have liked.

Let me take a minute to elaborate on this point - because it is so fundamental to how I believe the Commission approaches these questions. The legal doctrines that the Commission applies to financial intermediaries entering into structured transactions are not new and they are not particularly arcane - they are very well established and basic securities law principles that have existed for decades.

What are these legal principles? First, the Commission looks to the antifraud provisions of the securities laws: Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act and Rule 10b-5 under the Act. The elements of these core proscriptions of the law are well known to all of you. They prohibit material misstatements and misleading omissions, or other schemes or practices to defraud, where committed with the requisite intent. The intent standard varies depending on the provision invoked, but always will pick up intentional or reckless conduct, and sometimes negligent conduct, that results in fraud. The Commission has routinely brought actions against public companies under these provisions where they have engaged in fraudulent accounting activities, whether in the form of off-balance sheet vehicles or other types of transactions, if those transactions resulted in materially inaccurate or misleading financial statements or other disclosures. The Commission also has often brought actions against public companies under the provisions of Section 13 of the Exchange Act and related rules under that section requiring the maintenance and filing of accurate financial reports - regulatory violations with notably lower intent requirements.

How does a securities firm, bank or other financial intermediary get into this picture? Well, there are two possibilities: it can either become secondarily liable by taking actions that aid and abet or cause the violation, or it can become so involved that it actually becomes primarily liable as a principal in the activities.

"Aiding and abetting" liability has not generally been in the forefront of lawyers' minds since the Supreme Court's 1994 decision in Central Bank6 - the case that eliminated private rights of action based on "aiding and abetting" theories. But it is important to keep in mind that, promptly after that decision, Congress made clear that the Commission retains the authority to bring enforcement actions against those who aid and abet violations of the Exchange Act.7 This was well before the recent market "bubble" started, much less burst.

What does it take to establish aiding and abetting liability? The Commission requires: (1) a violation by another party, (2) a general awareness or knowledge by the aider and abettor that his actions are part of an overall course of conduct that is improper, and (3) substantial assistance by the aider and abettor in the violative conduct.8 The aider and abettor does not necessarily have to have specific knowledge of every aspect of a fraudulent scheme - general knowledge of the fraud may be sufficient.

Let me just dwell on this standard for a moment and restate it in non-technical terms. Three elements: somebody breaks the law, you are generally aware that something improper is going on, and you do something significant to help the person pull off the violation. This is not a complicated legal question. It is not like the esoteric fiduciary duty issues that sometimes come up in insider trading law; it is not like parsing complicated questions about whether a derivative is a "security;" it is not even like determining the margin requirements under Regulation T. There may be difficult factual questions about how the law applies in a particular case, but the legal issue is straightforward: if you sleep with dogs (or at least if you feed them), you will catch fleas.

The Commission's allegations in a number of the Enron-related cases involving intermediaries were based on aiding and abetting theories. These include the Merrill Lynch, J.P. Morgan Chase, and CIBC cases. In other cases, the Commission has brought enforcement actions under a similar "causing" theory available in administrative proceedings. This theory encompasses any person who caused a violation of the Exchange Act through an act or omission that the person knew or should have known would contribute to the violation.9 The Commission applied this "causing" theory in its case against Citigroup, which involved alleged primary violations at both Enron and Dynegy.

Of course, when the facts warrant it, the Commission will also pursue cases against financial institutions for primary liability. This can occur if the conduct of the intermediary goes beyond mere general awareness and assistance to the primary violator - in some cases, the intermediary's involvement, whether in structuring or packaging or executing the fraudulent transaction, is so great that it actually becomes part of the fraud itself. This can be true even where the intermediary did not itself "make" the misrepresentation or omission. An example of a case involving allegations of primary liability is the Commission's recent enforcement action against AIG. In that action, the Commission alleged that AIG sold a public company a new "insurance" product that AIG had developed and marketed for the specific purpose of helping issuers to report false financial information to the public.10

The line between primary liability and secondary liability (for aiding and abetting or causing a violation) is sometimes a difficult one and subtle to discern. It has been the subject of private litigation since the Central Bank decision. But in the end, whether the liability is primary or secondary does not change one essential point: in either case the conduct violates the law.

Commission Perspective

Now you are probably starting to ask yourselves, why am I taking so much time talking about pretty basic legal points? The reason is precisely because they are basic - and fundamental to understanding the Commission's perspective on the role of financial intermediaries. In my experience, sophisticated bankers, traders and marketers spend a lot of their time, together with legal and compliance personnel, working on immensely complex and difficult transactions, typically under intense time pressure - and I should note that the public often does not fully appreciate the remarkable energy, doggedness and intelligence that it takes to make our capital markets function. To make these transactions and markets work, legal and compliance personnel need, among their many skills, to be problem solvers of the first order who can find the right way through a maze of securities, commercial and other legal issues, many of which have an esoteric tax and accounting overlay. And believe it or not, most people at the Commission actually understand this.

At the same time, the Commission is a government agency, charged with enforcing the law - and it typically will only be reviewing your conduct after something terrible has happened. More importantly, the Commission's job is looking out for investors. This includes, particularly after the Sarbanes-Oxley Act, calling for greater accountability by all categories of gatekeepers, including securities firms, banks and other financial intermediaries. As Chairman Donaldson has regularly emphasized, the Commission would like to see high ethical and legal standards become part of the DNA of all participants in our financial markets. And if you step back and put yourself in the Commission's shoes, you are likely to evaluate an intermediary's responsibilities in a different light.

What will the Commission consider? Well, as I have said, the law itself. Did the transaction result in fraudulent disclosures by a public company? Was the intermediary generally aware that the conduct was improper? Did the intermediary substantially assist in the fraudulent transactions? These are the basic legal requirements. From a broader policy perspective, based on my experience, the Commission will look at the egregiousness of the conduct and the extent of the harm. Was the primary violation substantial and obvious, far from any plausible innocent explanation? Did the violation result in substantial harm to investors - who after all, are the constituency that the Commission is charged with protecting? Is there evidence that the intermediary set aside customary compliance limits in the interests of obtaining a quick or unusually large profit? These considerations will be supplemented, of course, by the mitigating factors such as self-reporting and cooperation that the Commission considers more generally in the enforcement context.

And here I want to pause to make a point that you may find reassuring. The Commission is not, I believe, attempting to use aiding and abetting or similar theories, coupled with 20/20 hindsight, to punish intermediaries who simply did fancy transactions with companies that later blew up. On the contrary, there are instances where a careful review of the evidence has shown that, even though an intermediary entered into transactions that facilitated a violation, it did not have sufficient awareness of improper conduct to merit an enforcement action. Put another way, the Commission is not stretching for cases involving innocent bystanders - we have more than enough to keep the Enforcement Division busy.

The Commission also recognizes that many financial intermediaries are concerned about compliance issues and want to ensure that their internal controls are as robust as they can be - to keep from straying into dangerous territory that threatens substantial legal and reputational risk. In this connection, the staff is consulting with other federal regulatory agencies - the Federal Reserve Board and the Comptroller of the Currency - and considering whether additional guidance would be helpful to financial intermediaries in adopting strong procedures and controls.

More generally, you should keep in mind that the Commission, in my experience, takes very seriously its obligations as an independent agency to listen to those it regulates, to analyze their cases impartially, and to provide fair notice of its actions. But do not misunderstand me, none of this will detract from the Commission's willingness to impose appropriately harsh sanctions when it identifies serious violations of the law.

Practical Considerations

What does all this mean, in practice, for legal and compliance professionals at securities firms, banks and other intermediaries? You are in a better position to assess that than I am. But I would offer a few observations.

First, when analyzing transactions, try to step back and think about the big picture-how a sensible and disinterested observer would apply the relevant legal principles. This is a straightforward point-really a variant on the "how would it look in the New York Times" test. I am not ordinarily a big fan of role playing games, but it probably would not hurt once in a while to imagine yourself in the position of someone in the Enforcement Division who comes in to look at the transaction, or of someone in the General Counsel's office reviewing the case, or a Commissioner at the table analyzing the staff's recommendation. In that light, a lot of legal "arguments" and business "necessities" that you probably hear about all day long will not seem very compelling. In fact, in many cases, a firm will settle a case even before raising these arguments or circumstances in its defense.

Second, an intermediary's conduct will be analyzed based on all the facts known to it - so it really is essential for the legal and compliance team to understand those facts correctly. It may seem unfair, and occasionally you will be asked why you are your brother's keeper, but this really is not anything more than the legal and compliance component of "knowing your customer" - a familiar issue that goes back as long as I can remember, at least to the Drysdale failure that led to the repo bankruptcy amendments. One of the things that has struck me in reviewing some enforcement matters recently is that the intermediaries in fact acquired a great deal of information as part of their diligence process to assess counterparty credit risk - including information about the accounting, tax and revenue impact of a transaction. Yet that information was never shared with, or it was overlooked by, lawyers who might have identified the potential legal risks that the transaction posed.

Third, do not use your competitors' practices as a legal and compliance benchmark. You never want to have lower compliance standards than they do, but it should be fairly obvious by now that the Commission is not going to give you any credit simply because "everybody is doing it."

Fourth, while you need good procedures and checklists, they are not a substitute for good judgment. In this connection, I cannot underscore enough that compliance with GAAP is not sufficient, in the Commission's view, to assure that a public company's financial statements satisfy the securities laws. If a company shrinks its balance sheet by 90% two days before quarter's end, only to blow it back up to the same level a week later, it is possible that the company's CFO may tell you that the balance sheet complies with GAAP - but you should probably be asking a lot more questions. In the same vein, materiality is not merely a numerical concept. There are some transactions - think of illegal transactions with insiders - that may not be large in dollar terms, but whose omission could be quite material to a reasonable investor reading the company's SEC filings.

Finally, let me turn to a legal point that I think has critical practical implications. While the basic antifraud and aiding and abetting principles that the Commission applies have been around for some time, there are some new requirements under the Sarbanes-Oxley Act that have a direct impact on legal and compliance professionals working for financial intermediaries. Among these are rules under Section 303 of the Act strengthening the prohibitions on misleading auditors, including in some cases where that conduct is merely negligent. But even more important for this discussion, I think, you need to consider the Commission's attorney conduct rules under Section 307 of the Sarbanes-Oxley Act.

Those rules, as you know, require attorneys appearing and practicing before the Commission on behalf of a public company to report "up-the-ladder" within their firms if they become aware of evidence of a material violation of the securities laws, a material breach of fiduciary duty, or a similar material violation. While an attorney representing a financial intermediary does not necessarily fall within this rule simply by working on a transaction with a public company, you should keep in mind that it will apply to you, if you are an attorney for a financial intermediary that is itself a public company, in cases where you encounter evidence of a material violation by the intermediary. And, as I have just discussed at some length, the financial intermediary may be directly exposed to liability under a variety of aiding and abetting and other theories, even where the primary violation is by a public company counterparty. That liability, I should add, will often be material, even at large firms, particularly in light of the monetary relief I mentioned earlier.

Let me underscore this point, to make sure I am being clear. If you represent a financial intermediary that is a public company, and that intermediary aids and abets a violation by another company, the Commission's "reporting up" rules may well apply to you. And remember - now it is personal: it is you and not just your firm that has potential liability.

Before you throw food at me, I want to mention that this obligation comes, in my view, with a silver lining. The obligation to report up the ladder - because it falls upon you personally - cannot simply be dismissed as a legal risk that the head banker or trader is willing to take as a business matter. It is your personal obligation as a professional - and you are the ultimate arbiter of how to comply. This will, I hope, strengthen your ability to exercise professional judgment - the old fashioned "smell test" - to stop unsavory transactions, particularly when coupled with the ability to "report out" violations where the Commission's permissive disclosure rules apply. I suppose you will probably view this as at best a mixed blessing, and I won't belabor the point. If I were a motivational speaker, though, I would summarize the impact of the new rules by saying: "You've got the power."

Let me close by turning the tables on myself. I have asked you to look at these issues from the Commission's perspective. You should recognize that I also consider it important for us at the Commission to try to understand your perspective. While I cannot speak for the Commissioners or others on the staff, I do not believe that I am alone when I ask that you keep us informed of your views on the legal issues that you face as intermediaries in our markets today. We recognize that, if they live up to their responsibilities, the legal and compliance professionals at securities firms can be our strongest allies in serving investors and the public, particularly in the context of structuring derivatives and complex transactions that play an important role in our financial markets. I hope that we will hear from you in many settings, including at this conference over the next two days.

Many thanks for taking the time to listen to me tonight.

1 Litigation Release No. 18517 (Dec. 22, 2003).

2 Litigation Release No. 18252 (July 28, 2003).

3 Exchange Act Release No. 48230 (July 28, 2003).

4 Litigation Release No. 18038 (Mar. 17, 2003).

5 Litigation Release No. 18340 (Sept. 11, 2003).

6 Central Bank of Denver v. First Interstate Bank of Denver, 511 U.S. 164 (1994).

7 See Securities Exchange Act Section 20(e), 15 U.S.C. § 78t(e).

8 Robert L. McCook, Exchange Act Release No. 47572 (Mar. 26, 2003).

9 Securities Exchange Act Section 21C, 15 U.S.C. § 78u-3.

10 Litigation Release No. 18340 (Sept. 11, 2003).



Modified: 02/17/2004