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U.S. Securities and Exchange Commission

Speech by SEC Commissioner:
Remarks at Advanced ALI-ABA Course of Study


Commissioner Paul S. Atkins

U.S. Securities and Exchange Commission

Washington, D.C.
January 9, 2003

At the risk of understatement, I can certainly tell you that last year was an extraordinary and tumultuous year for investors and the financial services industry, as well as for the SEC itself. While I have not seen a poll on this subject, I would bet that a very high percentage of Americans today know about the Securities and Exchange Commission.

It is not surprising that the SEC is better known these days. Last year, the SEC was in the unaccustomed position of being at the center of political controversy and almost weekly news of corporate accounting failures. With the CEO certifications behind us, the elections decided, and a new Congress convening this week, I hope for the sake of investors that we are past that period of playing politics with investor interests and can return our agency to its traditional non-partisan status.

But, these are unique times and the SEC has gone mainstream. Technological advances, such as the securities industry's use of the Internet to guarantee 10-second executions, have made it increasingly easy for the retail investor to join the professional speculator investing in the stock market. Arguably over the last couple of years, individual investors may have assumed that they were on a level playing field with professionals.

Predictably, though, as throughout history, many investors believed that the long bull market would not end, and too many assumed that those they relied on in investing their money were acting fairly. Over the past couple of years, investors have finally experienced the long-anticipated end of "irrational exuberance" in the stock market, seen on television corporate heads do the "perp walk," and wondered whether they can trust numbers from corporations and advice from Wall Street. The US capital market has lost approximately $7 trillion in market capitalization since its high in March 2000. I have noted before that this translates to approximately $60,000 per U.S. household. Here, I should hasten to note that these figures properly should be used as a measure of the 1990s bubble — that is, a measure of false expectations — since the market appears to have stabilized. These figures should not be used as a measure of investor losses. That is a fallacy that too many reporters, politicians, and plaintiffs' attorneys slip into, since the nature of a bubble means simply that not everyone can get out at the top, because that sort of run on the bank naturally bursts the bubble through simple supply and demand forces.

As in other periods of financial turmoil, the government is implementing additional regulation intended to address the ways in which the system has failed to protect the individual investor and to strengthen the systemic weaknesses that created misrepresentations and skewed the transparency in the market. All of this places an especially heavy burden on those in government to get it right — particularly the SEC given its central role in protecting investors.

Crises — especially of the financial variety — have yielded a legislative reaction many times in our past. Dr. Robert Higgs wrote a book in the late 1980s called Crisis and Leviathan. His primary thesis is that government's command-and-control system of resource allocation expands at the expense of the private-sector's cost-revealing market system when government responds to an insistent but ill-defined public demand that it "do something" about a crisis. He traces a number of crises in our history — some financial, some military — and reveals how the market sector has given way in those cases.

That is where we are today. In response to investor outrage and political pressure, Congress enacted the Sarbanes-Oxley Act. It is sweeping legislation intended to hold corporate executives and auditors more accountable to the shareholders of public companies. It calls for a re-examination of our corporate governance structure and seeks to fill in the holes that have left investors out in the cold.

Sarbanes-Oxley contains many essential advances for corporate governance, although it also represents what used to be an unimaginable incursion of the federal government into the corporate governance field. Audit committees and independent directors are recognized as fundamental components of investor protection. A new board has been created to bring accountability to accountants, who systematically failed to do it themselves. As the SEC addressed just yesterday in implementing part of Sarbanes-Oxley, the proper clients of auditors now are clearly audit committees, thus stockholders, not management. The SEC has been given clear authority over professional conduct affecting investors — that of auditors and lawyers, including auditor independence and lawyer conduct.

But, given these essential elements, morality and ethics cannot be legislated into existence. Government controls --- too often paternalistic --- will never be a solution if individuals and individual firms are not upholding their own end of simple business ethics through their own effective compliance. Internal controls and the culture of an organization are basic structural aspects to reinforce the inherent nature of most people to do the right thing. The culture of a firm is a function of organizational structure plus compensation incentives plus adequate oversight activity by gatekeepers.

If one considers that part of the function of the boards of directors and management is to act as gatekeepers on behalf of investors, in addition to the gatekeeping function of lawyers, accountants, and compliance personnel, Sarbanes-Oxley can be seen as a consistent effort to enhance the awareness of gatekeepers to their duty to investors. There has certainly been an effect on those who have to certify their company's financial statements and on directors who are all too aware of their personal liability.

As to the professional gatekeepers — lawyers and accountants — much attention has been focused on their repeated failures in the recent corporate scandals. Management often turns to the legal department for guidance on the appropriate course of action when making business decisions. This is particularly true in the securities industry where broker-dealers are subject to numerous, and often complex, securities regulations. This dependency should be an ideal opportunity for in-house counsel to help management develop a strong corporate culture that embraces the basic principles of investor protection.

For instance, regarding the research analyst conflicts that have been the subject of enforcement activity lately, a relationship was developed from inception that was flawed. Since the days when Charles Dow first tinkered with the technical analysis of individual securities, brokers realized that this information could be used as a form of advertisement to attract clients and encourage trading.

Corporate management lived with and built upon these inherent conflicts of interest to capitalize on existing business relationships between research analysts and investment banking activities. As firms exploited these relationships, research analysts enjoyed compensation levels that reflected the business generated by their activity.

It is perhaps all too easy to ask in retrospect, but why is it too much to expect investment banks to have recognized the inherent conflicts? Why could they not have established compliance programs to detect and correct these structural flaws? Should the compliance and legal groups of brokerage firms have been aware that this use of compromised research reports tainted their overall sales efforts? The duty of an attorney is to take the initiative to raise possible issues and design reasonable solutions. This duty will become increasingly important in the future due to the implementation of the attorney conduct rules provided for under Sarbanes-Oxley.

Some view these new SEC rules governing attorney conduct as unnecessary federal governmental encroachment into the necessarily private relationship between an attorney and his client. Others view them as a necessary step toward bolstering investor confidence by forcing attorneys appearing and practicing before the SEC to help ferret out misdeeds. Still others have called the Act's attorney regulation mandate a "wake-up call" to the profession, noting that enforcement of legal ethics rules has typically been directed at suppressing competition, as opposed to protecting the interest of clients.

These are critically important issues for attorneys. The Public Company Accounting Oversight Board was created because of deep failings in the accounting profession's ability to regulate itself. I think it is safe to say that the legal profession would not like to see an organization created to regulate it in a similar fashion.

Attorneys that have experience working for a broker-dealer are well aware of the liability associated with having knowledge of a securities law violation and failing to take the appropriate steps to address the matter. Historically, the SEC initiated disciplinary proceedings in such cases against attorneys for aiding and abetting the securities violation or failing to supervise the subject employees. In the past, an attorney could also be suspended or barred from appearing or practicing before the SEC if the SEC brought a disciplinary proceeding under 102(e) of the SEC's Rules, although the SEC rarely brought an action against an attorney under 102(e) due to controversy surrounding the SEC's authority to promulgate the rule. In fact, the SEC learned the hard way in the appellate courts just how controversial 102(e) is. Now, Sarbanes-Oxley requires the SEC to promulgate a rule establishing standards of conduct for attorneys representing issuers, including broker-dealers. The SEC may now suspend or bar an attorney from appearing or practicing before the SEC AND from associating with broker-dealers.

I believe that this part of Sarbanes-Oxley should be viewed primarily as a codification of a principle that is easily stated but often difficult to carry out: in the corporate context, an attorney's client is the corporation and its shareholders, not the management that hired and, in fact, can fire the attorney. I believe in this principle, recognizing that it forces attorneys to make difficult choices. But as professionals, attorneys must continuously ask themselves, "who is my client?" and "is this action in the best interest of my client?" What an attorney does while answering these questions is the more difficult issue before us as we try to fill in the gaps left by the Act.

Congress's mandate is misleadingly simple. To paraphrase it, we must set forth "minimum standards of professional conduct" for attorneys appearing and practicing before the SEC. These attorneys must report evidence of a "material violation of securities law" that they "reasonably believe" has occurred, is occurring, or is about to occur to the company's chief legal counsel or CEO. If the chief legal counsel or CEO does not "appropriately respond" the attorney has to make a report to the company's audit committee or full board of directors. I should note that the "noisy withdrawal" provision included in the SEC's proposed attorney rules triggered when a company does not appropriately respond to a complaint was not mandated by Sarbanes-Oxley.

Here is one of the crucial issues that face the SEC now as to implementation of Sarbanes-Oxley. Essentially, public broker-dealers get the proverbial double-whammy: under the proposed rules, attorneys working for a broker-dealer who become aware of securities law violations of that broker-dealer not only with respect to its public securities law filings as an issuer, but also with respect to its broker-dealer activities (essentially every day business), would have to comply with these requirements.

It is questionable whether the new attorney rules would have changed the conduct of individuals at the investment banks involved in the research analyst scandal that were also issuers. For example, one would have to answer the following "easy" questions to determine whether these rules would have brought the analyst issue to light. Did any attorney reasonably believe that the conflicts of interest between the research analysts and investment banking amounted to a material violation of the securities law? If so, should that attorney have reported it up the chain? If the company failed to properly respond, should the SEC have been alerted through a noisy withdrawal? Finally, would attorneys that did have knowledge of such behavior, and did not act on it, be subject to a suspension or bar from appearing or practicing before the SEC?

One might say that the SEC is trying to create the future even if it does not have control over the past. I rather doubt that additional technical rules will achieve their intended goal unless lawyers move from an overly technical approach to securities law compliance and instead adopt more of a principle-based approach that focuses on the fundamental spirit underlying the securities laws.

In response to the failure of the securities industry to rectify the analyst conflicts, the SEC approved an initial set of rule proposals for the NASD and the New York Stock Exchange in May 2002. These newly adopted rules prescribe restrictions on the compensation and trading activity of research analysts, as well as require additional disclosure for research reports. The SEC recently published additional amendments to both the NASD and New York Stock Exchange rule proposals that will further increase the record keeping burdens for broker-dealers and require analysts to register with the SROs by passing a qualification examination.

Just to make doubly sure that the new SRO rules will not fail, the SEC proposed last summer (before I arrived, I should add) Regulation AC (for Analyst Certification) to try to bolster public confidence in the objectivity of research reports. As proposed, Regulation AC would require the research analyst to certify that his personal views are accurately expressed in the research report and would require that the analyst indicate whether or not he received compensation in connection with those specific views. Again the new rule proposals increase the record keeping burdens for broker-dealers. One would hope that the individual investor will be able to locate the research report after sifting through clear and prominently placed attestations reflecting that the analyst believes in the contents of the report and was not paid to reflect the stated beliefs, but if he had received payment then he must provide the source and the amount of the payment and the effect upon the objectivity of the report.

One might say that it may be overkill for research reports to have more warning labels than a barrel of plutonium. Perhaps a picture of skull and cross bones on the front of the research report would provide a more effective warning than endless pages of mandated disclosures. My main concern is that all of the certifications and disclosures may add more credibility than warranted to this opinion-based sales literature. To be sure, I am a firm believer in the disclosure of personal conflicts and the analyst's track record, because this is essential for any determination of objectivity of the report. But an analyst's certification as to his views is not at all like the CEO certification of financial statements, which is judged against objectively verifiable standards. Doesn't the panoply of antifraud provisions under the securities acts address the potential misrepresentation of an analyst's personal views in a research report?

Again, as with the accountants and the lawyers, Congress stepped in to mandate regulation because the securities industry did not police itself and establish a remedy to the analyst conflict. Like the failure of accountants and lawyers in the financial fraud cases surrounding WorldCom and Enron, the failure of the internal culture and the compliance and legal departments in the securities industry led to the distribution of tainted research reports to individual investors.

As a supporter of the free market, it distresses me when business people do not react to perceived problems using a principle-based approach to guide the conduct of their organization and the industry. As Dr. Higgs described in reviewing historical financial crises, this inattention provides the fuel for government to react to perceived demand for increased regulation. Then, businesses and customers alike must bear increased costs and inefficiency. Thus, in a real sense, you in this room are the ones on whom the marketplace ultimately depends to keep these regulatory costs down and business efficient and responding to the demands of investors.

I also wanted take this opportunity to remind you to submit comments on all of the SEC's proposed rules. We depend on your knowledge derived from everyday work experience when adopting effective and efficient rules that will protect investors while maintaining a low cost business environment.

Thank you.



Modified: 01/13/2003