Speech by SEC Staff:
Remarks before the Directors’ Education Institute at Duke University: Staying the Course
Stephen M. Cutler
Director, Division of Enforcement
U.S. Securities and Exchange Commission
March 18, 2005
Much has been said and written over the last several months about the rising tide of opposition to recent corporate reform efforts, including, most notably and notoriously, the Sarbanes-Oxley Act of 2002. In that spirit, I was recently directed to an article in Fortune magazine railing against newly enacted securities legislation that, in the author's view, would increase the cost of capital, make independent directors reluctant to sit on corporate boards, push companies off shore and away from U.S. regulatory requirements, and increase the number of shareholder strike suits brought as a form of legal blackmail.
I should like to respond to the critic who made these charges. Unfortunately, I can't. And that's not just because I can't speak for the Commission or other members of the staff (which I can't and won't do today). It's because the man who wrote them is long deceased.
These criticisms, you see, were leveled against the Securities Act of 1933 - the key law governing our securities offering process - just a few short months after its passage. The historians among you will recall that the 1933 Act, like Sarbanes-Oxley, was passed with resounding support in the wake of a financial crisis and subsequent Congressional findings of corruption and wrongdoing in the securities markets. I suppose the statements of this critic, an esteemed Wall Street attorney of the time, may represent one of the first efforts to force the pendulum of securities law reform to swing in a contrary direction. They're eerily reminiscent of some of today's criticisms of Sarbanes-Oxley and the accompanying crescendo of support for regulatory retrenchment. Of course, what may have seemed to some like a major calamity for business in 1933 quickly became a widely accepted standard for market fairness.
Part of me wonders whether that's how we'll look back on Sarbanes-Oxley a generation or two from now: as a statute we could hardly imagine doing without - as a set of rules indispensable to accurate and complete financial disclosure.
The passage of Sarbanes-Oxley was a powerful statement on behalf of investors who had been victimized by corporate misconduct. With some of the alleged wrongdoers still to be brought before the bar of justice, it is simply too soon, in my view, to renounce that statement. All one need do is look at recent episodes of multi-billion dollar restatements and insiders selling large blocks of stock prior to the release of negative news to see that we are not out of the woods yet. Ask any cop on the beat if he can retreat to the station house after a street corner roundup. He will tell you that it's essential to stay on the beat, to keep wrongdoers from regaining their foothold.
The vocal campaign currently being mounted by opponents of the Commission's recent reform efforts takes two tacks. The first focuses on the burdens imposed by new regulatory requirements - not just by Sarbanes-Oxley, but by new rules requiring the registration of hedge fund advisers, the appointment of independent mutual fund chairmen, and fair disclosure of material nonpublic information. The second tack focuses on the Commission's enforcement of the requirements already on the books.
I don't intend to spend too much of my time on the first of these tacks. But whatever one might think about the costs of new regulatory requirements (and I know they're not small), one can't overlook the costs of the sort of corporate malfeasance we have seen in the last several years - not just in market cap declines, eviscerated pensions and lost savings, but in diminished investor confidence and a loss of faith in the integrity of our markets. I don't think anyone wants a return to the environment that allowed the scandals of Enron, WorldCom, Tyco and Adelphia to take seed and flourish. In answer to the question - usually asked in another forum - "are we better off today than we were four years ago?" I would say, categorically, "yes." There's more independence and oversight in the boardroom. There's higher quality work coming out of auditing firms. There's more transparency in companies' financial statements. There are better accounting and disclosure controls. I think it would be a profound mistake to retreat from the fundamental tenets of Sarbanes-Oxley that have contributed to this improved environment for today's investor. Should we make sure that we're implementing the Act's requirements sensibly? Do we need to ensure that we've got the regulatory dials calibrated correctly? Of course - and that's what the Commission is doing with its 404 Roundtable and its Small Business Advisory Committee. But we shouldn't act too hastily to unwind the core of recently enacted requirements.
That brings me to the second tack - the claim that our enforcement efforts need to be dialed back. On this subject, given what I do, I want to say more than just a few words. But let me try to sum it up succinctly: the notion that we should turn back the clock and ease up our enforcement efforts is sorely misguided. Vigorous enforcement of the federal securities laws is an integral part of what it takes to maintain safe and efficient markets.
Certainly, Main Street investors trying to safeguard their futures want to see us go after the proverbial bad guys. But, if you think about it, so too do corporate citizens looking to compete on a level playing field. Honest companies and their executives want us to make sure that everyone is playing by the same rules they are. You know, there's a financial services firm that is famous within the halls of the SEC for applying every now and then for a "no action" letter that it really doesn't want to get and expects to be denied. A "no action" letter, for those of you who aren't SEC aficionados, is a written representation from the Commission staff that it will not recommend enforcement action on a particular set of facts. The staff's no action letters are published for the world to see. Now from afar, it might look to some like this firm wishes to engage in some pretty questionable practices. In fact, however, the firm has a very different objective: to level the playing field by ensuring that others aren't doing those things. The firm wants all of its competitors to know that the Commission will not countenance certain conduct-and at the same time ensure that its own business is not disadvantaged by rival firms that would otherwise engage in the practices.
In the same way, small business interests often tell me that they want vigorous enforcement in the microcap market. It's difficult for struggling new companies to raise capital, and all the more difficult if investors are concerned that the company may be a fraud. When fraudulent issuers are weeded out of the microcap marketplace by enforcement action, not only are investors protected from unscrupulous promoters, but legitimate microcap companies reap tremendous benefits as well.
In short, strong enforcement is good for all participants in our capital markets: the small investor, the institutional investor, the financial intermediary, the small company and the big company.
Some have suggested that we are using enforcement to make new rules. Recently, I attended a Wells meeting during which we told defense counsel we were troubled by a company press release that in our view was misleading. Defense counsel agreed that the release didn't tell the whole story and may have conveyed an impression contrary to reality, but urged us not to hold her client to the standards of 2005 for conduct that occurred in 2001. Of course, it was against the law in 2001, just as much as it is today for a company to issue materially false and misleading press releases. Some of the claims that we've engaged in rulemaking by enforcement are being made by those who don't want us to enforce the laws that have been on our books for decades: laws against fraud, against manipulation, against inaccurate financial reporting, and against undisclosed conflicts of interest.
Take, for example, the mutual fund revenue sharing cases we've recently brought. In these cases, mutual fund complexes agreed to pay certain brokers millions of dollars for promoting their mutual funds by, for instance, putting them on the brokers' "preferred lists." Some critics objected to our enforcement actions on the grounds that such revenue sharing agreements had been a common practice in the industry for years and that the Commission had never indicated that there was anything wrong with them.
But the fact is that a failure to adequately disclose these agreements violates long-standing rules designed to protect investors against undisclosed conflicts of interest and misleading representations. Under existing law - law that was in effect long before we brought our first revenue sharing case - brokers are required to disclose to their customers any compensation they receive in connection with a securities transaction, which would include revenue sharing payments. And, of course, when making representations to their customers about securities, brokers are always prohibited from making material misrepresentations or omitting material information necessary to make their representations not misleading.
In most of our revenue sharing cases, the brokers chose to rely on the disclosures made in the fund prospectuses - which they were entitled to do - but the disclosures were often woefully inadequate. The prospectuses typically said something like: "The fund may compensate certain brokers for certain services, which may include, among many other things, sales of fund shares." These disclosures were so vague that they told the customer almost nothing. They did not disclose known facts about the nature of the existing arrangements the brokers had, or sufficient information for customers to appreciate the dimensions of the conflicts of interest the brokers faced. Some brokers went so far as to tell their customers that the recommended funds were selected as the most appropriate for the customers, when in fact they were selected, in part, on the basis of how much the mutual fund company had been willing to pay the broker for its selling efforts. In short, the revenue sharing cases arose out of failure to disclose conflicts of interest, omission of material facts and misrepresentation of material facts - all classic violations of the securities laws.
People have also singled out for criticism the stiffer sanctions we've sought and obtained in recent years. Some of these sanctions have been prophylactic, or forward-looking, in nature: officer-and-director bars, for example; or securities industry bars; or suspensions from appearing before the Commission as an attorney or accountant. In some cases, we've required companies to hire independent compliance consultants to evaluate and improve their compliance systems, to spend money on training and to create "inspector general" or corporate ombudsman positions to whom employees could report potential ethical violations. In one case, we even prohibited an audit firm from accepting business from new clients for a period of six months. We recognize that these sorts of forward-looking requirements can be very costly, but we believe they will go a long way to preventing a recurrence of the sort of misconduct we've seen.
Of course, our sanctions aren't just prophylactic; they're also meant to punish. During each of our last two fiscal years, the Commission has obtained judgments providing for over $2 billion in civil penalties. These numbers, startling as they may be to veteran SEC-watchers, reflect the proliferation of wide-ranging, large-scale frauds involving billions of dollars of ill-gotten gains and investor losses and egregious wrongdoing by companies and their employees.
You know, until 1991, the Commission didn't even have the power to impose civil money penalties in most cases. The Commission's bread-and-butter remedy was the injunction - an order to engage in no further violations of the securities laws. As a neophyte defense lawyer, I remember being struck by this. "Let me get this straight," I said to the partner (a former senior SEC official) who was spearheading the defense of a company being investigated by the SEC for misconduct, "We're going to spend the next year or two - and a whole lot of the client's money - reviewing and producing hundreds of thousands of documents, interviewing, preparing and defending dozens of witnesses, and otherwise trying to convince the Commission staff of the merits of our position, and at the end of all that, the most that the Commission can do is get a piece of paper saying, 'Don't violate the law again!?'" "That's right," replied the partner. "Well," I said, "maybe we should just give them that piece of paper right now." Okay, I was young and naïve. Certainly, the partner with whom I was working thought so. But maybe, just maybe, while the prospect of an injunction was the subject of intense interest among securities lawyers, it wasn't really grabbing attention where it was most needed: the executive suite. If one of the primary goals of law enforcement is deterrence, I'm just not sure we were achieving our goal with injunctions alone. Civil money penalties speak loudly in a language that every defendant and respondent can understand. And in so doing, they help achieve deterrence.
But penalties aren't simply about turning heads. In each and every case, the compliance and other undertakings we've required and the penalties we've imposed have been tied to specific wrongdoing by specific parties and tailored and proportionate to the unlawful conduct alleged. In short, the punishments have fit the crimes. And indeed, in many of these cases, the conduct was a crime -- so the criminal authorities had their own parallel investigations and cases. In short, to put the thought another way, the misdeeds we have seen have merited nothing less than a tough response.
To be sure, toughness isn't the only measure of an enforcement program. I've always thought that the highest compliment one could pay a prosecutor was to say, "He's tough but he's fair." Well, I think that the sanctions sought and obtained by the Commission have always been governed by principles of fundamental fairness. If you look at any case we've brought, and consider the egregiousness of the conduct and the economic harm caused, the accusations of overzealousness just don't stand up.
Maybe that's because our actions are the product of more due process than any government prosecutor anywhere in the world gives to putative defendants: Wells meetings, Wells submissions, approval by senior management of the Enforcement Division, review by the policy-making divisions of the Commission and the Office of the General Counsel and, most importantly, Commission approval. Every action we take is painstakingly analyzed, reviewed and re-reviewed at multiple levels of the Commission. Mind you, I'm not complaining (though sometimes my staff does): it's part of the proud tradition of the SEC - a tradition that I think has served us very well. We have a responsibility to get it right, and that's a responsibility we take very seriously.
What's really gratifying to me is that our enhanced enforcement efforts and stiffer sanctions appear to be having the desired effect. Throughout corporate America there are signs of fundamental change - a profound shift to a corporate culture of cooperation and compliance. The Wall Street Journal recently observed that "there seems to be a kind of sea change going on here - a maturation of American corporate governance." Boards of directors are becoming stronger and more independent. They are starting to take decisive action in response to ethics and compliance failures. Recently, after a significant accounting restatement, one company announced that the responsible executives were returning the bonuses they had received based on the original financial data. As one observer told the New York Times, "Boards are flexing their muscles and beginning to take on the role they are supposed to take on, and that is very healthy for American business."
At the Commission, we have seen other evidence that our heightened efforts are working. For example, companies and insiders are now coming forward to report wrongdoing to the Commission's staff, rather than waiting for us to find it. To avoid the prospect of substantial penalties, more companies and their employees are fully cooperating with our investigations. More importantly, they are putting proactive systems in place to deter and detect wrongdoing. To date, no fewer than a dozen major Wall Street firms have engaged in top-to-bottom reviews of their businesses to identify and address conflicts of interest and have come in to discuss their findings with the Commission staff. All of these measures help investors. Faster detection and faster investigative work help us do our jobs and minimize investor harm in the short run, while the implementation of preventive and remedial measures work to maximize investor benefit in the long run. In sum, at least in part due to our enforcement efforts, many companies are creating and reinforcing a culture of compliance, and that is a very positive development for American investors.
So that may lead one to ask where we go from here. Are we going to be bringing more and more cases? Are our sanctions on a never-ending upward spiral? I don't think so. While we can't afford to relax or retreat, I do believe our enforcement approach is about where it needs to be - and is producing real results. As a consequence, and I hope this isn't my glass-half-full side getting the best of me, I don't think we'll be seeing an enforcement docket three to five years from now that looks anything like the enforcement docket we have today. Of course, we're not just going to assume that's the case; we're going to work to make it the case.
Those who fear that the Commission is overstepping its authority and penalizing wrongdoers too harshly may have too quickly forgotten the major frauds that rocked the U.S. markets to their foundations only a few short years ago. In the wake of the devastating damage wrought by recent scandals, we have strengthened our enforcement efforts and raised the cost of securities law violations in order to prevent the recurrence of such frauds. With the hard knowledge we've gained from recent tribulations, we can't just declare victory and go home. Our capital markets are among the best in the world, but they aren't free. And the price we pay for them is constant vigilance.
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Before I close, I would just like to say a few words about Regulation FD, as in Full Disclosure-which was adopted before Sarbanes-Oxley and even before Enron. It is one of the rule reforms that has come under attack by certain critics in the business community. But I should hasten to add that these critics, even the most outspoken of them, do not represent all of America's business interests. Recently, the Business Roundtable, which is comprised of the CEOs of 160 leading corporations, wrote to Chairman Donaldson: "Now that it has been in place for over four years," the Roundtable wrote, "[we] believe that Regulation FD has been successful in accomplishing the Commission's goal of promoting full and fair disclosure. We also believe Regulation FD has had the important and beneficial effect of enhancing investor confidence in the marketplace. For these reasons," the Roundtable concluded, "[we] continue to support Regulation FD." So too does a group of distinguished securities law professors-who, as you might imagine, rarely agree on anything. They wrote a compelling amicus brief defending the Commission's authority in this area and decrying the distorted picture of the Rule's requirements painted by its critics.
Regulation FD, as much as any rule we've ever enacted, embodies our commitment to information transparency, to fair markets where the average investor can feel he is not being victimized by whispers between the denizens of Wall Street club rooms. And those who would oppose Regulation FD and its requirements are advocating precisely what can't and shouldn't be done: returning to the days when corporate chieftains could favor members of the club by selectively doling out vital information. One business association recently wrote that FD is a "threat to a free, robust, orderly and democratic society." But to my mind, there's something more than a little bit chilling and Orwellian about calling a rule designed to ensure equal access to information a threat to "democracy."
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Stronger enforcement, rules mandating equal access to corporate information . . . these are all of a piece. These developments herald a new mindset among Main Street investors. There is a cry from the public - along with a mandate from Congress - demanding responsibility and accountability on Wall Street and in our executive suites. Investors want to be treated not as afterthoughts, but as owners. They may not always have paid spokesmen or high-priced lobbyists, but we hear them.
In the long run, the work we are doing to protect those investors will benefit all of the participants in our marketplace; it will make our public companies and the markets on which they trade stronger, sounder and more resilient; and it will ensure that we have the deepest, most liquid and safest markets anywhere in the world. That's why, despite the current sound and fury, we need to stay the course - to preserve the important investor protections put in place by Congress and the Commission in the last few years and to continue to pursue and punish wrongdoing fairly and unrelentingly.