Speech by SEC Staff:
Remarks Before the District of Columbia Bar Association
Stephen M. Cutler
Director, Division of Enforcement,
U.S. Securities and Exchange Commission
February 11, 2004
The SEC, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of the author and do not necessarily reflect the views of the Commission or the staff of the Commission.
Thank you for that kind introduction. It’s a pleasure to be here. At the outset, let me remind you that the views I express today are my own and do not necessarily represent the views of the Commission or its staff.
Things are moving pretty quickly at the SEC these days, especially in the enforcement arena. Not only have the last few years been a time of intense activity for us, it has been a period of substantial change. As you know from your own legal practices, when issues are whizzing at you from all directions, you seldom have an opportunity to step back and look at the big picture. But I’d like to use my time with you today to do just that, to step back and discuss what we’re doing differently in our enforcement investigations these days. Although these changes have occurred incrementally and intermittently, taken together they affect how our investigations start, what happens along the way, and perhaps of most interest to you, how they conclude. With that in mind, I’ll start at the beginning.
Enforcement, traditionally, indeed, almost by definition, has been thought of as a reactive function. But, in the last couple years, thanks in part to the actions of the New York Attorney General, expectations, as well as our aspirations in this area have changed. It is no longer considered sufficient to simply jump on violations of law and mete out appropriate sanctions. These days, the concept of effective enforcement necessarily includes “seeing around the corner.” What that means to us is identifying trends, practices, and risks within our capital markets that could be exploited to the detriment of investors. Ideally, if we are able to spot these issues in their infancy, we can prevent them from growing into full-fledged, confidence-eroding scandals.
At the SEC, we’ve taken a number of steps in an effort to achieve this goal. As you can imagine, there is expertise of great breadth and depth within the Commission staff when all Divisions and Offices are taken together. One of the questions we’ve grappled with of late is how we in Enforcement can take full advantage of the substantive knowledge of those in the operating divisions and offices. Here are a few ideas we’ve implemented in an effort to harness that resource.
Late last year, we formed an inter-divisional committee with representatives from the Divisions of Enforcement and Investment Management and the Office of Compliance Inspections and Examinations. The Committee was asked to review investment company and investment adviser referrals that the exam program has made to Enforcement. In particular, the Committee was charged with taking a fresh look at the referral process, including assessing the types of referrals that have been made and how they have been handled, and how the enforcement referral process could be improved. After this look-back has been completed, this Committee will continue to meet periodically to ensure that exam referrals of investment companies and investment advisers are pursued as appropriate. In addition, we are undertaking a parallel initiative, along with staff of OCIE and the Division of Market Regulation, with respect to exam referrals relating to broker-dealers.
A similar effort at cross-pollination in the corporate fraud area has been ongoing for considerably longer. To help identify potentially problematic trends in the financial reporting area, the chief accountants of the Divisions of Enforcement, Investment Management, and Corporation Finance and the Chief Accountant of the Commission meet regularly. From these meetings, Enforcement staff can learn of those areas in which OCA staff are getting frequent requests for guidance or areas on which Corporation Finance or Investment Management are frequently finding it necessary to comment in the filings they review. This information can potentially help us identify high-risk areas in the financial reporting arena.
Our efforts in this area follow the lead of Chairman Donaldson, who has undertaken an agency-wide risk assessment effort. A new Office of Risk Assessment will coordinate and manage risk assessment activities across the agency and report directly to the Chairman. To ensure this work isn’t done in a vacuum, the work of the Office of Risk Assessment will be complemented by a Risk Management Committee, whose primary responsibility will be to review the implications of identified risks and recommend an appropriate course of action. As the Chairman has explained, this initiative will enable the Commission to analyze risks across divisional boundaries, focusing on early identification of new or resurgent forms of fraudulent, illegal or questionable behavior or products.
We’re also looking to use the expertise of our colleagues in another way, and that is to provide training on certain technical areas of the securities business. Our examination staff spends weeks and weeks each year on-site at broker-dealers and investment advisers, inspecting internal controls, supervisory procedures, books and records, compliance functions, and so on. They acquire a real-world view of how firms work that many of our enforcement staff lack, especially early in their careers. With an eye toward accelerating our staff’s learning curve in these areas, we have started a pilot program under which several of our enforcement staff will work on an examination. Members of our staff will, in effect, be detailed to OCIE for the course of a single broker-dealer or investment adviser exam. We believe this experience will deepen our understanding of how these firms operate and better enable us in our investigations to spot practices that may disadvantage investors. We are supplementing this pilot program by offering our staff in the Home Office the opportunity to take the Series 7 training course, which helps prepare securities industry participants for their initial licensing exam.
To further bolster our knowledge-base within Enforcement, we’re in the process of recruiting and hiring into the Enforcement Division three “subject matter experts” – one in accounting and corporate disclosure; one in trading and markets; and one in investment adviser and mutual fund operations. By bringing in individuals with more focused expertise we will gain another window into the business practices in these areas. Among the responsibilities of these new staff will be to closely monitor the relevant literature, be it academic or trade, so that we can incorporate the ideas and debates of these observers into our thinking as well.
In addition, we have recently re-organized our Chief Counsel’s office – which is really the “in-house general counsel’s office for the Enforcement Division -- into substantive sections that mirror the specializations of our new subject-matter experts. Thus, the existing staff within that office will have the opportunity to develop greater expertise by focusing on particular types of cases, such as broker-dealer or mutual fund matters.
We are also making better use of a virtual tidal wave of information that comes to us daily. As of late, our Enforcement Complaint Center is receiving over 20,000 communications a month from a wide variety of investors and whistleblowers. While each email we receive has always been individually reviewed, we are now making a greater effort to expedite follow-up on communications from whistleblowers and others who raise enforcement issues. We’ve also taken steps to centralize and streamline our handling of telephone complaints made to the Division, and instituted a monthly review of the disposition of each enforcement-related call by the Division's senior management.
In addition to these more concrete reforms, we’re also fostering a subtle cultural change within the enforcement program to encourage more risk taking. By risk, I mean pursuing investigations where, at the outset, it is not clear that a securities violation has occurred. We need to reach beyond investigating the cause of every announced restatement, to probe industries or practices about which we have concerns or suspicions, but no clear roadmap to wrongdoing. I recognize that taking such risks is not costless. Inevitably, in more of these situations than in others we investigate, we will conclude that there is no case to be brought. Nevertheless, if we can develop a culture that encourages taking the well-reasoned risk – including the risk that the Commission will bring fewer but more important cases each year – I think the enforcement program will be more effective in protecting the investing public.
Finally, we are also asking firms that we regulate to be more proactive and forward-looking. Particularly regulated entities, with their compliance and supervisory obligations, are in a position to both help us and help themselves by aggressively policing their own conduct. Indeed, last September, I challenged all financial services firms to undertake a systematic top-to-bottom review of their business operations with the goal of addressing conflicts of interest of every kind. In addition to their identifying such conflicts, I urged that they address them, and inform us of any violative conduct. What, you may wonder, is the incentive for them to do so? As I’ll discuss in more detail later, if we find the violations on our own, the consequences will surely be worse.
The amount of time I’ve taken here describing our efforts to see around the corner is a reflection of the high priority we place on this task. Now that I’ve addressed changes in how we’re starting investigations, I’d like to discuss two differences that arise during the course of our investigations, both of which highlight the importance of how you and your clients conduct yourselves once an investigation has begun.
Increasingly, the Commission is acting aggressively to protect the integrity of our investigative processes. That means the Commission is bringing more cases for failures to preserve or produce required documents and records, and we’re encouraging criminal authorities to back us up in appropriate situations with obstruction of justice prosecutions. What such cases illustrate is that, no matter how bad the underlying conduct, you can always make things worse. Think here of Arthur Andersen. Let me give you a few recent examples.
When a recipient of a Commission subpoena for documents fails to comply by producing all responsive documents, the Commission has the option of seeking a court order enforcing the subpoena. In the last three fiscal years, the Commission has done so on a total of 46 occasions. One recent example involved Ken Lay, former Chairman and CEO of Enron. Lay had refused to produce documents subpoenaed by the Commission on the grounds that his act of producing them would violate his Fifth Amendment rights. The Commission sought a court order requiring Lay to comply with the subpoena and requiring him to produce the requested documents. Our subpoena enforcement proceeding was resolved when the Court approved a Stipulation and Order requiring Lay to produce, within three days, all documents subpoenaed by the Commission that had been withheld by Lay on Fifth Amendment grounds.
While this example occurred in the context of a highly publicized long-running investigation, many subpoena enforcement actions serve as the first public disclosure of a person or entity’s involvement in an otherwise non-public SEC inquiry. So, while this may be a situation where, at first glance, your client might think – what’s the worst that can happen? I’ll just be ordered to produce the documents – you should keep in mind that when we go to court to enforce a subpoena, it typically results in unwelcome publicity concerning your client’s entanglement in an SEC investigation. And it will also factor into the Commission’s willingness to settle an action – and the terms of any such settlement the Commission will accept – at the end of the day.
I’d be remiss if I didn’t mention to an audience of lawyers this compelling example of what can happen when documents are not properly produced in an SEC enforcement action. In August 2003, the Commission obtained a $2 million payment from law firm Gardere Wynne Sewell LLP for violating a court order to, among other things, produce documents in a pending SEC civil lawsuit against one of the law firm's former clients. Gardere had represented the client and negotiated the terms and language of the court’s order, which required all nonprivileged documents to be “immediately” produced to a court-appointed Special Master. Nevertheless, Gardere failed to turn over to the Special Master and the Commission staff 27 boxes of records until 18 months after the entry of the order. As a result of Gardere's failure to timely deliver these records, the Special Master's efforts to administer the assets maintained for investors were significantly impaired.
We’re going to continue to be active in this area. I think you’ll soon see another case where the Commission will sue an entity for failing to produce documents in a timely fashion, so stay tuned.
The situations I have discussed thus far relate to the consequences of failing to produce documents – and promptly – in connection with our investigations. But that’s merely one facet of the issue. The Commission is also acting aggressively when confronted by failures to preserve required documents and records.
For example, in December 2002, the SEC, New York Stock Exchange and NASD filed joint actions against five major broker-dealers for violations of record-keeping requirements concerning e-mail communications. The firms consented to the imposition of fines along with a requirement to review their procedures to ensure compliance with record-keeping statutes and rules. The firms agreed to be censured and to pay fines of $1.65 million each. In addition to the penalties imposed, what’s noteworthy about this case is that we discovered the respondents' failure to preserve e-mail communications and\or to maintain them in an accessible place during the analyst research investigations, yet the Commission did not wait to bring these charges along with those relating to the underlying conduct we were investigating. In the Commission’s view, the document preservation failures were of such importance that they warranted immediate, independent action against these firms.
The Commission is also cracking down on failures to preserve documents outside the regulated entity context. Recently, the SEC instituted Rule 102(e) proceedings against a former Ernst & Young audit partner, audit manager, and senior manager, for altering E&Y’s work papers for its audit of the company NextCard. Among the allegations are that the respondents altered and destroyed copies of work papers months after completing the audit, including making the work papers appear as though E&Y had thoroughly considered all relevant issues and changing the dates on the computers to make it appear as though the altered work papers were created at the time of the original audit work. In addition, in testimony before the SEC staff, the former audit partner allegedly concealed the alteration and destruction of documents when he was questioned about his role in the production of work papers to the banking regulators. He is awaiting a criminal trial.
Similarly, in May of last year, the SEC filed a settled action against PricewaterhouseCoopers in connection with its audit of SmarTalk TeleServices’ financial statements. The Commission censured PwC for engaging in improper professional conduct pursuant to Rule 102(e) for PwC’s failure to comply with Generally Accepted Audit Standards (GAAS). As the Commission’s order also details, however, the Commission found that after the audit was completed PwC, with the knowledge of several partners with firm-wide responsibility, made revisions to its working papers and disposed of the relevant Desk Files. The SEC also found that when PwC voluntarily produced documents to the SEC staff in February 1999, PwC did not tell the staff until nine months later that some working papers and other documents had been revised, created, and discarded.
To resolve this action, PwC agreed to pay $1 million and to undertake certain remedial measures. What the Commission’s order says about the penalty is noteworthy. Although the Commission did not charge the document destruction and alteration as a separate, stand-alone violation of law, the order explains that the Commission thought it appropriate to sanction and seek other relief from PwC for its personnel’s substantive audit failures because PwC made undocumented changes to its audit working papers and discarded other documents relevant to its audit. This case illustrates two points. The narrower point is that the Commission can reflect concerns about document preservation and production in the sanctions it ultimately seeks or settles for.
The larger lesson is the continuing importance of what we refer to as cooperation, a term that incorporates preventive and remedial activities, as well as the degree to which parties are forthcoming during our investigations. While giving credit for cooperation is a longstanding practice at the agency, I distinguish the Commission’s more recent focus on cooperation in two ways. First, I believe the Commission is placing a greater emphasis than ever before on assessing and weighing cooperation when making charging and sanctions decisions. Thus, I have recently directed the staff to keep an ongoing log recording parties’ cooperation, or lack thereof, throughout each investigation. Second, I think the Commission is using a more graduated scale when it assesses cooperation. There are cases in which the Commission has found cooperation early in an investigation to have been inadequate, and taken that into consideration, even if the conduct of the same party was later exemplary. In other words, the Commission no longer begins and ends its assessment by asking, “did this party cooperate, yes or no?” Now, it routinely goes on to consider, if the party did cooperate, how much? How often? You should expect that we will seek to reflect the answers to these sorts of questions when we resolve investigations and actions.
That brings me to my final subject – what is different about how the Commission is resolving our investigations and actions. The short answer is, with higher penalties and tougher prophylactic measures. Let me start with the money. The penalties the Commission is routinely obtaining these days, against both entities and individuals, were simply unheard of ten years ago. At the top of the list, of course, is the $750 million penalty the Commission obtained against WorldCom. Even if you set that one aside as truly exceptional, the SEC recently obtained a $100 million penalty against Alliance Capital Management, a $65 million penalty against J.P. Morgan Chase, a $57.5 million penalty against Citigroup, and a $50 million penalty against MFS. All of these were in addition to substantial disgorgement payments. And, just before the end of the year, the Commission obtained a $50 million penalty from Vivendi. To think, our $10 million penalty against Xerox only two years ago raised eyebrows at the time. As for individuals, the Commission obtained several $1 million-or-greater penalties in the last year.
Put simply, the stakes have gotten much, much higher. In part, I think, this reflects a sense that the large-scale frauds that have been revealed recently warrant meaningful sanctions. As an aside, we’ve taken other steps, such as dictating that penalties cannot not be paid by insurers or written off as tax deductions, to heighten their effects. In addition, however, Congress’s enactment of the Fair Funds provision of the Sarbanes-Oxley Act, which enables us to return penalty monies to harmed investors rather than to the U.S. Treasury, suggests that Congress intended that the Commission use its penalty authority to maximize investor recompense. Believe me when I tell you, we intend to do so.
Finally, the Commission is also making more frequent use of certain prophylactic measures, like officer and director bars. In fiscal year 2003, the SEC sought 170 O&D bars, compared to only 38 in fiscal year 2000. As these numbers suggest, the Commission is seeking this remedy in new situations. This is consistent, again, with the message of the Sarbanes-Oxley Act, which lowered the standard for imposing such bars from “substantially unfit” to “unfit.” So you can expect us to continue to use this remedy aggressively.
You invited me here to discuss where the SEC enforcement program is headed. I think the changes I’ve described to you today -- some already in place and others, works in progress point to the answer. We are working to become more proactive, to develop deeper expertise within the Division, and to take greater risks. You can expect to see the Commission react quickly and aggressively when we detect a failure to comply with our subpoenas or a similar effort to frustrate the investigative process. In addition, the civil penalty scale clearly has been ratcheted up, and may not have topped out yet. And these higher penalties will frequently be accompanied by tough prophylactic measures. Although one thing that will always remain the same is our attention to fairness and due process, we recognize the need for the enforcement program to change and evolve in response to events and developments around us. Rest assured that the changes I’ve discussed today, and others we may make in the future, reflect our commitment to continue to make the Commission’s enforcement program a critical advocate for the interests of investors.