Speech by SEC Commissioner:
Remarks before the U.S. Chamber Institute for Legal Reform
Commissioner Paul S. Atkins
U.S. Securities and Exchange Commission
February 16, 2006
Thank you, Lisa, for that gracious introduction. Before I start with the substantive portion of my remarks today, I would like to take the opportunity to recognize the recent work of the Chamber of Commerce under Tom Donohue. The Chamber has certainly demonstrated leadership and activism in Washington under Tom's guidance. To some, this may be disquieting. But, most of us appreciate the addition to the debate regarding the proper role of government in our economy, the balance of costs versus benefits of new laws and regulations that government imposes on corporations and on working men and women, and the reach of its powers. You certainly cannot say that the Chamber or Tom have been AWOL from the debates of the past few years: Whether it is focusing on the structural problems in the marketplace, such as excessive emphasis on the short-term by Wall Street, or attempting to hold government agencies accountable to their mission. The Chamber has brought a new spirit of intellectual rigor to political debate in Washington. One recent example is the constitution of a committee, led by Bob Steele and Bill Daley, to look into issues in the financial services industry. I will be very interested to see what this distinguished group will suggest.
Of course, not everyone at my agency may share these views of the Chamber, particularly since you are suing us, so let me hasten to say that the views I express here are my own and do not necessarily represent those of the Securities and Exchange Commission or my fellow commissioners.
I think that it is safe to say that everyone in this room, including me, has a common concern: Namely, that we must not allow the American economy to be encumbered by a web of excessive regulations that fail the cost/benefit test. Simply put, the benefits of our laws and regulations must outweigh the burdens placed on corporations - and ultimately on investors and consumers - to comply with the rules. Otherwise, we have a tragic result for American workers, investors, and consumers.
Just about one year ago, the Wall Street Journal and the Heritage Foundation released their 11th annual "Index of Economic Freedom." For the first time in the decade-long history of the index, the U.S. is no longer among the top ten "most free" countries. I will be interested to see how we fare in the 2006 survey. Although it is wonderful to see other countries becoming more free, I do not like to see the U.S. losing its reputation for being a great place to do business. President Bush said it very well last year when he reminded us that "it's very important not to get [the system] out of balance when it comes to [ ] government reach."
We do not have much room for error. The world markets are incredibly competitive. And, we must remember that it is not only the direct costs of regulation that affect the attractiveness of the United States as an investment destination, or as a place in which to build a future and do business. Perhaps the number one concern that I hear when I speak to foreign business leaders about their willingness, or un-willingness, to do business in the United States is our culture of litigation. Government officials, political leaders, entrepreneurs, and corporate executives see the specter of what they describe to me as a "lottery system of justice." This is a disincentive for them to view the United States as an attractive investment destination. In their view, the potential costs of doing business in our marketplace have exceeded the benefits.
Of course, litigation reform has been an important cause for the Chamber of Commerce. The problem was decades in the making and is susceptible to no easy solutions.
In recent years, the seminal act in litigation reform was the PSLRA. It is an honor to be here to talk to you about private securities litigation issues ten years after the enactment of the PSLRA. The SEC has long recognized the important role that properly motivated private securities litigation plays in the protection of investors. The government, after all, cannot be everywhere. By contrast, untempered and predatorial private securities litigation can have a crippling effect on American business and also on investors. I will talk today about several areas in which SEC action affects private securities litigation.
I am sure that there has already been a lot of discussion this morning about the trends in private securities litigation since the PSLRA went into effect in 1995. You no doubt have heard that, based on the recent Cornerstone Research report of class action filings in 2005, the number of traditional securities class action suits in 2005 fell 17% from the 2004 total, and is approximately 10% lower than the average number of filings from 1996 to 2004. These statistics are very encouraging. After the last several years of scandal-induced securities class actions, it appears that things may be taking a turn for the better. As former SEC commissioner, now Stanford Professor, Joe Grundfest likes to say - and please forgive me if you've already heard the phrase this morning, but it's too colorful to pass up - "the pig may have passed through the python."
I am happy to say that there is a positive trend at the SEC these days too. As you know, Chairman Cox came to the SEC in August of last year after a distinguished career in the House of Representatives - a career that included the sponsorship of the very statute that drew you here today, the PSLRA. Chairman Cox has brought to the SEC a new spirit of leadership, collegiality, and a sense of cooperation and mutual goal-setting that he honed through years of working in the House. Under his leadership, the Commission has already achieved a number of significant milestones.
One SEC milestone that is especially relevant to today's gathering is the Commission's recent statement setting forth certain principles for the imposition of penalties against corporations.1 The penalty statement was issued to provide "the maximum possible clarity, consistency, and predictability in explaining the way that [the Commission's] penalty authority will be exercised."2
Less than four years ago, in April 2002 (I might add, before I arrived at the Commission), the SEC imposed a then-record penalty of $10 million against Xerox in a financial fraud case. Believe it or not, that was only the third time that the SEC had ever imposed a monetary penalty of more than a million dollars on a corporation that we do not directly regulate - that is, an issuer of securities as opposed to a broker-dealer or investment advisor. That is because the SEC had only gotten the power from Congress in 1990 to fine corporations and had used the power sparingly, precisely because of the concern that fines against corporations are ultimately paid by shareholders. Things have changed in four years. Today, a $10 million SEC penalty would probably be considered a "victory" for most entities settling SEC fraud charges -- multi-million dollar SEC settlements have become almost commonplace over the last few years.
As the PSLRA was designed to reign in improper securities litigation and the attendant costs to corporations and their shareholders, the Commission's penalty statement should help us avoid the imposition of excessive, misplaced corporate penalties. Don't get me wrong -there will continue to be large penalties when the facts warrant it, but with application of the guidelines in the penalty statement, there will need to be a case-by-case showing by the Enforcement staff that the penalty is not inappropriately harming shareholders.
In the penalty statement, which was unanimously approved by the Commissioners, we stated that a determination on the appropriateness of a corporate penalty would turn principally on two considerations: (1) the presence or absence of a direct benefit to the corporation as a result of the violation, and (2) the degree to which the penalty will recompense or further harm the injured shareholders.3
We recognized that, "If the victims are shareholders of the corporation being penalized, they will still bear the cost of issuer penalty payments (which is the case with any penalty against a corporate entity)."4 That is a critical acknowledgement that has been all too often lost in recent years. In financial fraud cases, shareholders, who are the ultimate owners of the corporations on which we impose these penalties, may already have been punished through reputational and stock-price damage. I am pleased that the Commission, true to congressional intent behind the Remedies Act of 1990, has now publicly committed itself to a more rational and systematic approach to deciding whether to impose penalties on shareholders.
The scandals of the last few years ushered in a new era of massive regulatory penalties and recoveries in private litigation. It seems the large regulatory penalties did not diminish the size or frequency of the private class action recoveries. At least for the last few years the SEC has had the statutory authority, in certain instances, to distribute penalties to those who were harmed.
Buried amongst other, perhaps more controversial provisions of the Sarbanes- Oxley Act of 2002, is the Fair Funds provision, Section 308. This provision authorizes the Commission, in certain circumstances, to distribute the civil money penalties it obtains from securities law violators to the parties harmed by the violations. Because penalties can be added to disgorgement amounts collected by the SEC, the Fair Funds system has enabled the SEC to increase the amount of money available to compensate harmed investors. Prior to the enactment of Section 308, the Commission was required under the Securities Exchange Act of 1934 to remit penalties to the U.S. Treasury.
One concern I have, however, is the potential for double dipping by investors when they receive money from both a Fair Fund and a private lawsuit. This potential problem has been raised recently by Kenneth Lehn,5 and the Commission should pay close attention to this issue.
There is a terrific parallel between the PSLRA and the Fair Funds provision of Sarbanes-Oxley -- both of them can put more money in the pocket of defrauded investors. When talking about the importance and effectiveness of the lead plaintiff provision of the PSLRA, Chairman Cox likes to point to the Enron class action suits. As you know, under the PSLRA a judge, not the plaintiff's lawyers, chooses the lead plaintiff -- the plaintiff who best represents the class. In the Enron litigation, the court chose the Regents of the University of California as the lead plaintiff. One of the first moves made by the UC Regents was to negotiate a significantly reduced legal fee that resulted in hundreds of millions more dollars for injured investors.
Along those same lines, I am reminded of the revolutionary decision by Judge Vaughan Walker 15 years ago in the Oracle class action suit to select plaintiff's counsel in a competitive bidding process prior to litigation. Judge Walker's theory was that market forces could be harnessed to help select the most efficient and effective counsel for the class. You can imagine the look on the faces of the lawyers from the 29 plaintiff's firms vying for the lead counsel spot when Judge Walker told them to submit their bids and to do so without colluding among themselves! As I understand it, long after the enactment of the PSLRA, several courts continue to use the competitive bidding process.
With the benefits of Fair Funds, however, have come certain burdens for the Commission. The SEC staff must create and implement a detailed plan of distribution for the funds. To distribute the funds, the SEC can either appoint a distribution agent, or, if available, contribute the funds to a class administrator in a parallel private class action proceeding. Of course, when we choose to have the funds disbursed by a class administrator we do not allow any of the funds from the SEC action to be paid to private lawyers.
Although I see the efficiencies of using the private class action administrator to distribute money collected in Fair Funds, I wonder if that is the best approach to distribution? I have stated before that I am concerned the SEC could gradually, inadvertently align itself with the strategies and tactics of private class action attorneys, creating a conflict in certain cases with our mission as law enforcer, overseer of the capital markets, and general protector of investors. Some have suggested as an alternative that the SEC should have Congressional authority to become the lead plaintiff in certain kinds of class actions. The SEC almost plays this role in some bankruptcies involving financial fraud, because the SEC is the biggest unsecured creditor. Private securities lawyers might not necessarily like that approach, and I certainly have concerns as to whether the SEC's interests would necessarily be aligned with the interests of shareholders in particular cases. But, I think it is important that we regularly recognize and evaluate alternatives for a more time and cost efficient method of returning money to harmed investors.
As I have said elsewhere, it is time for us to revisit Section 404 of the Sarbanes-Oxley Act or, more precisely, the manner in which it has been implemented. Section 404 requires public companies to provide an assessment of their internal controls in their annual reports and, importantly, requires the public accounting firms preparing or issuing the annual reports to attest to the companies' assessment. The goals of Section 404 are laudable -- management should be accountable for the integrity of financial information, and shareholders should have a gauge to help them assess to what degree they should rely upon a company's financial statements.
But it is indisputable that everyone greatly underestimated the costs involved in the 404 process. When the SEC first released its implementation rules for 404, we estimated that the aggregate costs of the rule would be about $1.24 billion or $94,000 per public company. In the SEC's defense, we made this estimate before the PCAOB released its 300 page Auditing Standard No. 2. Unfortunately, surveys indicate that actual costs incurred for 404 compliance were TWENTY times higher than what we estimated.
Our rule adopting the internal control provision provides that the control process must give "reasonable assurance" regarding its control structures. It also states that records should be maintained in "reasonable detail" and that a company's policies and procedures provide "reasonable assurance" that transactions are recorded accurately in accordance with GAAP. Despite our attempt to emphasize reasonableness, people in the trenches - both corporate managers and external auditors -- are taking an excessively granular approach. As a result, in some companies, tens or hundreds of thousands of key internal controls have to be documented and audited.
The biggest problem seems to be the fact that accountants and companies fear being second-guessed. I don't think it's a stretch to believe that this fear is driven as much by the possibility of private litigation as it is the fear of SEC or PCAOB enforcement action. Interestingly, it appears that in their quest to avoid missing any possible theoretical internal control weakness, the accounting firms may actually be assisting private litigants as they struggle to meet the heightened pleading standards of the PSLRA. Talk about the proverbial rock and hard place for public companies! I would be very interested to hear about any real world experience you may have with these issues.
One area in which the Commission becomes directly involved with private securities litigation is the Amicus Curiae process (or "friend of the court" process for the non-lawyers or non-Latin scholars in the audience). Since the PSLRA's enactment in 1995, the SEC has filed approximately 14 Amicus briefs on lead plaintiff and lead counsel issues, and has participated as Amicus in several other cases involving PSLRA issues. Normally, the SEC will file a friend-of-the-court brief only in an appellate court. In PSLRA cases, however, the SEC has filed many of those Amicus briefs at the district court level, because the Commission recognized that the issues presented to the trial court might never reach the court of appeals.
Notably, the Commission also successfully participated as Amicus, jointly with the Department of Justice, in the Dura Pharmaceuticals Supreme Court case that was decided last year. In that brief, we urged the Supreme Court to overturn a Ninth Circuit decision that allowed a pleading standard for plaintiffs in securities class actions that was much more relaxed than the standard Congress prescribed in the PSLRA. In a unanimous opinion, the Supreme Court agreed with the Commission's and DOJ's arguments, and held that a plaintiff cannot just rely on the fact that a stock's price was higher than it should have been when alleging fraud under the PSLRA. This decision has been widely viewed as another curb on inappropriate private securities litigation, and I hope it is having that effect.
Although the Commission is frequently invited by the courts, as well as plaintiffs and defendants, to submit Amicus briefs, we are selective in choosing the appropriate opportunities to participate as Amicus. If you think there are ripe issues on which the Commission should be participating as an Amicus in particular cases, I invite you to tell us. The Commission will not shy away from a good fight if it makes sense! And, under Supreme Court doctrine, judges should accord the SEC's opinions a great deal of deference as we are the expert government agency in this area.
The next topic I'd like to talk about does not fit squarely within the realm of private securities litigation issues, but it does raise interesting civil liability issues. The issue is premature disclosure of SEC settlement negotiations.
It has become a common occurrence lately that I see public companies disclosing an agreement, or settlement, "in principle" with the SEC. I can't tell you how frustrated this makes me. To understand my frustration, you must understand the context in which these situations arise.
Often in the SEC enforcement process, public companies, or sometimes their regulated subsidiaries such as broker-dealers, decide to pursue a settlement with the Commission. In the settlement process, the settling party deals directly with our enforcement staff, but the staff does not have the authority to bind the Commission to the terms of a settlement. Simply put, the settling party is offering to the enforcement staff to settle the matter based on certain violations of the securities laws, with certain remedies such as bars, penalties, or disgorgement, and in return the enforcement staff is agreeing to recommend to the Commissioners that they approve the settlement as offered.
At this stage nothing is final, and because of that lack of finality I find it hard to believe that the agreement by the staff to recommend settlement to the Commission is, by itself, necessarily an event that must be reported to shareholders. Although we Commissioners have deep respect for the work of enforcement staff, I can assure you that the next step in the process is not a rubber stamp approval by the Commission.
In fact, this Commission has shown that it does not own a rubber stamp! Proposed settlements have been, and will continue to be, disapproved or modified by the Commission when they do not meet the policy objectives of investor protection, as well as other factors. Those of you who follow closely the workings of the SEC or who practice before us know very well what I am talking about.
So, I think you can start to see the source of my frustration - there simply isn't clear guidance for public companies faced with a disclosure decision regarding settlement negotiations with the SEC. And, as with most disclosure issues, companies typically err on the side of extreme caution. When public companies determine that disclosure of a "settlement in principle" with the SEC is appropriate, and when they then make such a disclosure, they assume a risk. There is the possibility that the statement will, in hindsight, appear inaccurate or misleading if the Commission disapproves or requires a material modification of the terms of the settlement. The trouble is that the public does not typically understand the nuances, and the press does not always sufficiently convey them. Thus, the disclosure that is disseminated to the public can be materially misleading.
I have seen all types of "settlement in principle" disclosures, and some are dramatically better than others. For example, a 2004 press release disclosed a settlement offer made to the enforcement staff and, without any disclaimer of the need for Commission approval, proceeded to speak in terms of what "will" happen in connection with the settlement.
You can tell how I feel about a disclosure like that, but I am not here to prescribe language in these situations. I believe a company should disclose an unapproved SEC settlement agreement only in the rare instance in which the company deems it to be required and appropriate under the circumstances.
The last thing I want to do is chill the desire of public companies to make full and fair disclosure. Indeed, the SEC's mission is premised on the notion that full and accurate disclosure is the best form of investor protection. But, I have a keen interest in making sure that when disclosure is made, it is made for the right reason, and that it is accurate.
All of this leads me to conclude that public companies need some guidance in this area. I understand that many companies have a default instinct to disclose matters such as a turning point in an SEC investigation, and I believe that inclination may derive from a fear that failure to disclose will open the floodgates to subsequent private litigation. Although it would be nice, the SEC cannot unilaterally grant issuers immunity for private causes of action in connection with specific types of disclosures. You will need Congress to help with that. But, the SEC can provide clear guidance for companies that will enable them to make the right disclosure decisions and provide some level of comfort with respect to subsequent lawsuits.
I intend to work with the staff to see if we can craft such guidance, and I hope we can get something out in the near future. Some pertinent questions are: (1) At what point is the existence of an SEC investigation a disclosable event under current rules and guidance? (2) Should a Wells notice be a triggering event for disclosure? (3) Can a company choose to make an initial disclosure of an SEC investigation and in that disclosure state that no update will be made until there is a final resolution (for example, a Commission-approved settlement)? I am very interested in hearing from issuers, outside counsel, and others regarding this issue.
An issue closely related to disclosure of settlements is disclosure of SEC investigations. This has become big news in the past few years because rumors of SEC investigations, along with increasing short positions, can contribute to downward pressure on stock prices in what has become a hyper-sensitive market environment. Unscrupulous operators thus find it very tempting to try to manipulate the SEC's enforcement process. There has been a lot of publicity lately - most notably in the Wall Street Journal op/ed pages and from the Washington Legal Foundation - calling for the SEC to look into allegations of complicity between short sellers, namely hedge funds, and plaintiff's lawyers.
As the story goes -- and I have personally seen instances of this before I came to the Commission -- the two groups can act in concert to systematically drive down the price of a company's stock, to their mutual gain and the company's and its shareholders' loss. A recent Wall Street Journal opinion provided detail into a couple of these alleged schemes, stating that hedge funds take short positions in a company, then embark on a campaign to drive down the price of the company's stock.6 Allegedly, the hedge funds enlist the help of plaintiff's lawyers, and together they use the media, and even referrals to the SEC enforcement staff, to create and disseminate negative news for the company. When the stock price falls, the hedge funds cover their short positions, and the plaintiff's lawyers swoop in with a class action suit. In one example, the hedge fund was actually the lead plaintiff in the class action until the judge disqualified the fund due to its short selling activity! Talk about double dipping! If true, these stories are examples of both unethical legal conduct and hedge fund tactics at their worst.
Of course, this is not the first time we have heard allegations of attacks on American companies and their shareholders by unscrupulous players. The SEC has a long history of bringing enforcement actions against the perpetrators of similar fraudulent enterprises, such as "pump and dump," "cybersmear," and "boiler room" market manipulation schemes.
These issues are tremendously important to the integrity of the capital markets, and we should be careful to ensure that the appropriate amount of enforcement resources are directed to the type of activity described in the Journal piece, as well as the separate but no less important issue of illegal naked short selling. Have we, perhaps inadvertently, over the past few years allowed too much of our attention to be diverted to other, supposedly "sexier" financial frauds where the lines are greyer, potential settlements are eye-popping, and newspaper headlines are guaranteed? The basic market manipulation cases, such as pump and dump schemes, are the types of cases in which outright criminals directly victimize innocent investors. We have plenty of power and authority to take more of these cases on (with or without the controversial hedge fund registration rule that is before the courts as we speak).
You have been a very patient audience, and I appreciate your attention. I welcome your active involvement in the issues I discussed today, and all of our issues. My phone and office are always open to you. Please call or stop by if you have any comments or concerns. Thanks again for your time and attention.