Speech by SEC Commissioner:
Address to the Institute for Legal Reform's Annual Legal Reform Summit
Commissioner Kathleen L. Casey
U.S. Securities and Exchange Commission
October, 24, 2007
Thank you, Lisa, for those kind words. And I also want to thank the Institute for Legal Reform, the National Chamber Foundation, and all of the distinguished guests here today for their focus on this most important topic.
Before I go further, I must remind you that my comments today are my own and do not necessarily reflect the views of the Commission or my fellow Commissioners.
I am pleased that you asked me to speak with you today because, as this conference invites us to do, assessing the state of our legal and regulatory environment, and particularly the role it plays in the United States' overall competitiveness, is a worthwhile exercise. Further, your summit on legal reform raises questions that we, the Securities and Exchange Commission, should be considering both in service of our market efficiency and capital raising objectives, and as we press the interests of the investors that we serve.
As you know, the Commission is charged with a tripartite mission: protecting investors, facilitating the formation of capital, and ensuring fair, efficient and orderly markets. We are often best known for our work in service of the first prong of our mission, investor protection; and like each of my fellow Commissioners and the staff of the Commission, we take this duty very seriously. Rigorous investor protection requires ensuring adequate transparency in our markets, and forcefully confronting harmful behavior by those who would do wrong by investors.
But investor protection means much more than ferreting out fraud and fostering full disclosure; indeed, as more and more Americans invest their wealth and seek to secure their futures in our markets, protecting these investors requires ensuring that our markets remain vibrant and deep.
Protecting the interests of investors and ensuring a competitive marketplace are therefore clearly not mutually exclusive; indeed, they go hand-in-hand. Investors want healthy markets that are free from unnecessary regulatory burdens. And investors want a swift and firm response to those who would violate the trust they place in them. For this reason, we should be having, and we should be taking seriously, this public discourse about the competitiveness of our markets.
Now, perhaps at a pace unparalleled in recent history, capital markets are expanding and changing. And, markets abroad are growing and strengthening exponentially. Everyday, retail investors are joining institutional investors in seeking and gaining greater access to investment opportunities and markets abroad. This globalization of our markets, fueled by technological innovation, continues to diminish the relevance of geographical boundaries that have historically defined and dictated our approach to regulation.
As regulators, if we are to maintain our effectiveness, we must be nimble in our regulatory approaches, vigilant in our enforcement efforts, and increasingly collaborative.
In the last year, three major studies have called into question U.S. competitiveness. Each concludes that America is losing ground to foreign markets. They suggest that these trends may be caused by foreign markets developing and evolving in integrity, liquidity and sophistication — no more than maturation in markets abroad. But they also question whether America's regulatory climate, rather than fostering innovation and the kind of risk-taking investors seek to reward, dissuades investment in our markets.
The reports raise concerns about our immigration policies, legal system, tax laws, economic policies, and regulatory approach. And all of the reports urge various suggestions for reform. As you know, the study commissioned by the Chamber has attempted to take a complementary approach, seeking to urge reform in areas not emphasized by the other reports, such as assuring auditor strength and addressing the use of earnings guidance.
In response to these reports, some argue that we must act now, or we will forever lose our competitive edge. Others warn that the concern is overblown, and that any reforms would be a 'rollback' of investor protections. I know that many in this room have added their voices to this debate; I encourage you to continue to do so because you bring important views to this national discussion.
For my part, I do not believe this is necessarily a binary choice that requires either rejecting or embracing the conclusions of these reports. On the one hand, the sky is not falling — America's capital markets remain deep, vibrant and attractive; and while we may be losing global market share, there are likely many reasons for this trend, not all of our own making. On the other hand, doing nothing to analyze and consider these very noteworthy trends would be perhaps the worst thing we could do, and would almost certainly further erode our ability to compete internationally. A runner may not win the race by running faster; but she will surely lose it by standing still.
And so, although the emergence of other significant foreign capital markets could be seen as a threat to the central role U.S. markets have historically played in global commerce, I see it as an opportunity for growth and productive change. We can all benefit from competition, whether at home or abroad.
I believe we should always be asking ourselves whether and how we can do better, but this is especially so given today's fast-changing and competitive markets. Do we have the proper emphasis on enforcement? Can state and federal regulators improve legal certainty so that market participants can manage risk? Are our economic and tax policies properly balanced to foster innovation? Does our civil justice system effectively complement our regulatory enforcement efforts? And do our financial reporting rules promote useful and informative disclosures without undue complexity? These are questions we should all be asking and trying to answer. This national discussion invites the attention of legislators, regulators, and other policymakers.
Each of the three competitiveness reports expresses concern that our separate state and federal regulatory systems create uncertainty and complexity which can turn businesses away from our markets. They call for greater communication, coordination and cooperation among regulators. Even if one does not agree with their conclusions, it is clear that greater cooperation and coordination are critical to leveraging resources. Many have placed particular emphasis on the importance of communication between the various state and federal regulators overseeing our markets so that market participants obtain improved clarity and certainty.
As you know, the Treasury Department has taken a leadership role in this regard. Most recently, Treasury began the process of examining our regulatory structure and plans to release a blueprint for reform next year. Pursuant to this effort, just a few days ago, Treasury invited the public to provide comments on several broad policy questions they have posed that should assist in their review.
On the same topic, many have called for better coordination between the CFTC and the SEC. The SEC and CFTC enjoy a strong working relationship and we continue to work collaboratively in addressing cross jurisdictional issues raised by innovative new products in the marketplace. Despite these cooperative efforts, we are somewhat constrained by statute, so the Congress necessarily has an important role in ultimately rationalizing our regulatory roles and mandates if we are to achieve more seamless, efficient and clear market regulation.
In response to this changing marketplace, the Commission has been doing its part to ensure that American investors and companies have the tools they need to compete. I would like to highlight some of our activities in this regard, some of which began long before these competitiveness reports.
Last December the SEC liberalized the deregistration regulations for foreign companies listed in the U.S. The concerns that had been raised focused upon the reluctance of foreign issuers to list in the United States given the difficulties posed by our deregistration rules. The unanimous vote by the Commission demonstrates a bipartisan recognition of the need to rationalize our approach and reduce unnecessary regulatory barriers that can diminish the attractiveness of our markets.
Over a year ago, the Commission and the PCAOB embarked on a process to address the undue costs and burdens associated with the implementation of Section 404 of the Sarbanes Oxley Act — the internal controls provisions of the law that have been a lightening rod for criticisms of the U.S. approach to regulation. 404 has taken on even greater symbolic significance, sometimes becoming a euphemism for all that is perceived wrong with U.S. regulation.
SOX has a great many virtues and has been important to restoring needed confidence in our markets following the scandals we all know so well. Nevertheless, critics — in particular small business owners — have concluded that the costs of 404 as implemented threaten to dramatically outweigh its benefits. This summer, the Commission released management guidance and the PCAOB released a new audit standard, both designed to alter the 404 internal controls audit process from a costly, and often unnecessary, rules-based audit, to a more principles-based internal controls review.
But this effort is just one step that we must take. I am committed to pressing my colleagues to continue to monitor implementation of 404, especially as its requirements apply to small businesses in the coming years, to ensure that costs do not disproportionately burden small businesses, and that 404's objectives are achieved. To that end, it is critical that the Commission and the PCAOB, through our examination and enforcement activities, set the right tone in light of our request for a more principles-based application of 404. I will continue to work with our staff to ensure that this happens.
As global markets continue to expand, investors seek greater and more timely access to high quality financial information, driving a demand for a more common reporting language. The development and acceptance of IFRS around the world has helped foster this drive to convergence of differing accounting systems. And it has questioned the continued effectiveness and value of the U.S. GAAP reconciliation requirement for investors, instead perhaps acting more as an unnecessary cost and disincentive to list in the U.S. for market participants who can now just as readily tap capital around the world. With the ultimate goal of creating a single set of high-quality global accounting standards, the Commission is currently considering eliminating the reconciliation requirement of IFRS to U.S. GAAP.
The Commission is also actively developing a mutual recognition framework that would facilitate greater cross-border access for investors and market participants. Recognizing the realities of the market today, the challenge for the Commission will be continuing to strike the right balance between fostering choice for investors, and protecting investors from unknown perils that could lie in far away markets.
For just as surely as U.S. investors seek and demand greater investment opportunities, they also expect high standards of investor protection. This is a significant initiative that promises great benefits for U.S. investors and our markets.
The Commission has also recently announced several broader study initiatives to be considered over the coming year. This summer, the Chairman formed an advisory panel to look at ways to eliminate unneeded complexity in U.S. financial reporting. This is a concern touched upon by many reports, such as the Chamber's recommendation that companies discontinue earnings guidance.
This initiative seeks to tackle a difficult problem: ensuring meaningful disclosure for sophisticated institutional investors who demand detail and depth in financial reports, but also assuring accessible disclosures for retail investors lacking the time, expertise, or resources to work through lengthy filings. The panel has all critical interests represented by distinguished professionals. If successful, the effort should result in recommendations that reduce regulatory burdens while improving disclosures for investors — and I look forward to their findings.
One of the questions raised by the competitiveness reports is whether the uncertainty created by our regulatory and legal systems is chasing capital from our markets. The focus is upon the unpredictability of our market oversight system, a system involving fifty different state legal systems and a federal system, multiple securities, insurance, banking and criminal regulators at the state and federal levels, multiple SROs, and thousands of laws, regulations and rules. The results of these disparate oversight functions are often, not surprisingly, uneven. So it can be hard to discern clear standards of conduct, and the sanctions for violating those standards.
I believe that the SEC has the responsibility to set clear standards and enforce them consistently.
The public expects us to be vigorous and vigilant in enforcing the securities laws, but it also expects us to be fair. And so, although people rightly criticize the Commission when our enforcement efforts are unnecessarily prolonged, when lengthy enforcement investigations are the result of thoroughness, it can foster fairness and horizontal equity. While not always possible, I strive for consistent results in our enforcement activities. For if we are consistent, we are predictable. And if we are predictable, market actors can know how to do the right thing, and know what to expect if they fail.
The objective of clarity and consistency was a significant driver, I believe, in two somewhat recent initiatives in our enforcement program: our statement on corporate penalties, and our corporate penalties pilot program. In early 2006, before I arrived at the Commission, the SEC announced a series of factors for determining whether to issue a penalty against a public company. This corporate penalty policy recognizes the unique circumstances presented by corporate misconduct: innocent shareholders, not the wrongdoers themselves, often bear the cost of a corporate penalty. But it also acknowledges that, consistent with Congressional intent, corporate penalties are an appropriate deterrent in the right case.
So in service of these concerns, the Commission considers whether the shareholders benefited from the misconduct, whether the current shareholders would be further victimized by a penalty, the pervasiveness of the misconduct within the company, and several other factors designed to weigh the utility of a penalty's deterrence impact against the harm such a penalty could inflict on shareholders. This was an incremental step, but an important one, I believe, toward a more rational enforcement program.
Under a new pilot program for reviewing corporate penalties, the staff consults with the Commissioners prior to engaging in settlement discussions with certain issuers. This process is not a marked departure from custom or policy at the Commission; instead, it is a return to a process that was once used for all cases. Although still in its early stages, the pilot program should improve consistency because it will allow the Congressionally-accountable Commissioners to evaluate the appropriateness of a penalty at an earlier stage, bringing to bear our broad programmatic perspectives, and it will put issuers on notice that the staff's position in settlement talks has the full backing of the Commission.
Thus, the Commission remains loyal to its responsibility of vigorously protecting investors through its enforcement efforts, but sensitive to the needs of corporate citizens who seek nothing more than to understand the rules, and the consequences of their violation of those rules.
The Commission represents just one part of the equation, but our responsibilities require us to examine our capital markets if we are to give due allegiance to our tripartite mission. In recent months, the Commission has been asked to evaluate the interplay between our private securities class action system and the Commission's enforcement efforts. This summer, several Members of Congress asked us to consider whether the securities class action system adequately complements our enforcement efforts. And in August, a group of 6 noted professors asked us to explore a purely economic consideration: does the private litigation system achieve an efficient wealth redistribution objective, or are the transactions costs unnecessarily high? Much has been written on this subject, and the debate is hardly new.
Over a decade ago, Congress passed the Private Securities Litigation Reform Act seeking to address perceived problems with the private securities class action system; a system that many believed was benefiting plaintiffs attorneys as much as, if not more than, the investors they sought to represent, and crippling the sometimes innocent companies in which those investors placed their wealth.
The PSLRA had three major components: more tightly defining securities fraud in an effort to weed out what were considered to be frivolous or extortive suits; empowering lead plaintiffs in an effort to ensure that victims of fraud, not plaintiffs lawyers, control important litigation decisions; and improving the ability of judges to sanction lawyers for frivolous tactics. Whether the PSLRA has achieved its objectives is a dynamic analysis.
According to at least one study, the lead plaintiff provision may have effectively reduced some 'pay to play' behavior.1 Criminal interest in the conduct of some plaintiffs lawyers may also have had an effect on the ability of lawyers to drive litigation adverse to the financial interests of their clients.
Further, the Supreme Court recently clarified the standard for pleading a fraud case under the PSLRA — and while the standard that was articulated was not the most stringent defined by the circuits, neither was it the least stringent.2 So it remains to be seen whether this newly-defined standard, one that will now be employed by all district judges, will further the PSLRA's goal of ferreting out frivolous suits that needlessly waste shareholder value. Given the tendencies of our civil justice system, the true impact of the Tellabs decision may take years to fully appreciate, and may result in additional visits to the Supreme Court. But it is an important step in the right direction if it helps weed out frivolous lawsuits.
Of course, the PSLRA confirmed the Commission's authority to bring aiding and abetting cases against third parties in light of Central Bank, the Supreme Court decision confirming that no such private right of action exists. A few weeks ago the Supreme Court heard arguments in the Stoneridge case to consider whether a private right of action for primary liability against a third party exists. In public remarks I have explained my position on this matter: I believe it is the role of Congress, not the courts, to decide whether a private right of action against third parties exists; the legal theories for third party liability advanced by the plaintiffs in Stoneridge, in my view, expanded and confused the Congressional scheme for private actions in such cases. I am hopeful that the Supreme Court will render a clear and definitive statement that recognizes this Congressional framework.
But in any case, it appears that securities litigation — whether meritorious or not — has not meaningfully reduced in the twelve years since enactment of the PSLRA. Securities class actions continue to represent almost half of all class actions pending in federal court.3 According to a recent survey, sixty percent of US companies have at least one class action case pending against them.4 Almost twenty percent have 20 or more class action cases pending against them.5 In 1995, the year that the PSLRA was enacted, class actions resulted in $150 million in settlements; in 2005, that number was $3.5 billion.6 Today, officer and director insurance in the United States is six times more expensive than in Europe — I don't believe, however, that we should necessarily conclude that this differential reflects that American executives are six times more likely to be negligent than their European counterparts.7 Perhaps there are logical reasons for these statistics.
And so, after over a decade, it is right to evaluate how the system is working, and whether investors are benefiting. These questions about our civil justice and enforcement efforts do not invite a simplistic response: one need not be either for our class action system or against it; that would invite a false choice. Few would question the value of meritorious lawsuits, and few would argue that frivolous suits improve corporate governance.
Indeed, these questions are being raised by non-partisan and bi-partisan groups. Bright, thoughtful commentators have noted the unique character of securities suits and the special difficulties they present to our legal system. In a typical securities class action award, the victims, innocent shareholders who sold after the wrongdoing deflated the market price, are effectively compensated by other innocent shareholders who happen to hold the stock at the time that the company pays the award — these shareholders may even be victims themselves. The actual wrongdoers are often covered by insurance or indemnified by the company so, in either case, the current shareholders are covering that cost. And the intermediaries, lawyers and distribution agents, exact a large piece of any award, often 25 to 35 percent.8 It's a curious situation that begs the value of deterrence and compensation in such cases.
These questions call upon us to examine the importance of balance in our system. Early next year, the Commission will hold roundtables to explore these issues, and the public discourse that should follow will be important and valuable.
I want to briefly touch upon some of the questions that have been raised by legal scholars and other distinguished commentators that I find most provocative. Initially, few would disagree that transactions costs in private litigation are high, with plaintiffs and defense lawyers, receivers and administrators often taking significant portions of settlements and judgments. I look forward to considering whether our legal system adequately incentivizes lawyers and investors to pursue legitimate cases, or whether the system facilitates rent-seeking conduct that diverts money from those who are injured.
I am also intrigued by the studies that suggest that diversified institutional investors gain from fraud as much as they lose because their portfolios are highly diversified, such that their losses from securities sold after the discovery of frauds offset their sales at highpoints during a fraud. I would be interested to see the Commission's growing cadre of economists consider this significant question.
Whatever the empirical evidence, deterrence remains an important purpose for our enforcement activities and for private securities actions; but understanding whether the compensation objective of private litigation — a system that sometimes produces just pennies on the dollar — is working, would certainly inform policymakers.
And one matter of particular interest is whether judges adjudicating private actions against issuers should employ an analysis similar to the Commission's analysis — which was derived, by the way, from the Remedies Act — and consider whether the company tangibly benefited from the fraud, and whether current shareholders are harmed. Such an inquiry would necessarily explore whether the events theory can be consistently and appropriately applied.
Finally, I look forward to exploring the relationship between the Commission's use of fair funds and the distribution of judgments in private securities class actions. I think now is the time to evaluate the interplay between government and private compensation efforts.
I should note that whatever the conclusions of the Commission's fact-finding exercise, solutions may be outside of our jurisdiction. Nevertheless, there is no question that the Commission can offer important contributions to the process. So, I am pleased that the Commission is undertaking this meaningful review.
These are just a few examples of the Commission's efforts to evaluate and reevaluate our rules and practices, in service of our mandates, in an increasingly global, competitive marketplace. At the Commission, we remain keenly focused on corrupt influences that weaken our markets, and are prepared to act swiftly and surely to root out and sanction them. We also remain engaged in assuring that investors continue to benefit from our historically rich, deep and vibrant markets. We can do both. This is a fair debate; regulators should listen carefully and engage actively. I believe that if we do so, our markets and investors will be better for it.
Thank you for your work in expanding and informing this debate, and for allowing me to speak with you today.