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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Regulation vs. Enforcement in an On-Line World

by Richard H. Walker

Director, Division of Enforcement,
U.S. Securities & Exchange Commission

The Bond Market Association's 6th Annual Legal and Compliance Seminar
New York

October 25, 2000

The Securities and Exchange Commission, 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 Mr. Walker and do not necessarily reflect the views of the Commission, the Commissioners, or other members of the Commission's staff.

Good afternoon. Thank you George for your kind introduction and for the elegant way that you handled the fact that Iíve bounced around the Commission for nearly a decade now without being able to hold down a single job for more than a couple of years. Iíve known George, and many of his colleagues at Merrill Lynch, since first joining the Commission. There are few who can match Georgeís efforts in promoting a culture where good corporate citizenship and compliance come above all else.

Iíd also like to thank the Bond Market Association for inviting me to this distinguished conference and for asking me to be your luncheon speaker. This is, in fact, the first opportunity Iíve had to attend this conference since becoming Enforcement Director and the first time Iíve addressed issues affecting the debt markets. In doing my homework for today, I was struck by how many different types of bonds there are Ė literally thousands. They come in all different shapes and sizes, including: the "Aircraft Carrier" bond which Iím sad to report is in default; the "Jonathan Lebed" bond, otherwise known as the "teenage stock manipulator" bond, which has no maturity; and -- Yankees fans, hold your lunch rolls -- the "Roger Clemens" bond which has no principle.

The fact that Iíve not previously talked about debt markets may not be such a bad thing for many of you. As Enforcement Director Ė a title some in the industry alternatively refer to as "the Prince of Darkness" Ė Iím not accustomed to spreading cheer among market participants when I speak. I take no offense when I hear people say, "Donít take this the wrong way, but I hope we never see each other again."

While it is true that each year the Enforcement Division brings many more cases involving fraud in the sale of equities, as opposed to debt instruments, no one should doubt our commitment to ensuring that the debt markets remain no less safe and fair than the stock market.

The reasons why the SEC cares about the debt markets should be clear.

First, a staggering number of investor dollars are at risk in these markets. Domestic issuance of fixed-income securities jumped to $10.9 trillion in 1999, a 6.6 percent increase over 1998 levels.

And, second, investor dollars in the debt markets are not simply at risk, they are also at work. The bond market touches all aspects of our lives Ė from the cost of building roads and schools to corporate investments in areas such as research and development, and plants and equipment.

The bond marketís muscle is perhaps even more evident in Washington than on Wall Street. While I have tried to avoid the "inside the Beltway" mentality that characterizes the thinking of many Washingtonians, I can tell you nonetheless that the bond marketís clout is clearly a fact of political life. After the bond marketís favorable reaction to President Clintonís first term economic program, democratic-adviser James Carville was quoted as saying, "I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody."

Weíve worked closely with the Bond Market Association to safeguard our debt markets. Our relationship with you provides a strong example of the effectiveness of a public-private sector partnership.

Of course, as with any partnership, we do not always see eye to eye. From an enforcement perspective, I think the topic on which we have differed most is how to strike an appropriate balance between enforcement and regulation.

The difficult task of determining how best to influence and shape conduct of market participants --whether through enforcement, by legislation, regulation, or by allowing free market forces to operate unimpeded -- is a subject that has been debated for decades. Itís also a subject that I have had the opportunity to consider in each of my different positions at the Commission. I would like to share some of my views on this topic with you today.

For those of you now contemplating a second cup of coffee, let me hasten to say in defense of this topic that there is a good reason why the time is ripe to revisit the issue.

We stand on the brink of a new millenium and our markets -- including our bond markets -- are experiencing explosive change, particularly as a result of technology. It is fair to ask how the new online markets fit into a structure of regulation originally designed for an off-line world.

Should we address these changes in our markets through a new regulatory scheme or through enforcement of existing rules in a manner that is consistent with their prohibitions yet responsive to evolving conditions?

This issue has come to the fore recently as people have questioned how longstanding principles such as the requirement of suitability or the prohibitions against market manipulation apply in an Internet marketplace. Such issues were showcased in the Internet report issued last year by Commissioner Laura Unger. In sharing my thoughts with you, I note that the views I express are my own and are not necessarily shared by the Commission or its staff.

Let me start with a little background. As you all know, our main antifraud weapon, Section 10(b), was signed into law in 1934. Congress deliberately provided expansive reach to Section 10(b). Thomas Gardiner Corcoran, a drafter of the Exchange Act, testified to Congress that Section 10(b) was "a catch-all clause to prevent manipulative devices." He went on to say that, "The Commission should have the authority to deal with new manipulative devices." While itís doubtful that Tommy the Cork had the Internet in mind, he clearly recognized that the world was not static and that the antifraud prohibitions had to be expansive in order to address the evolving world of manipulative schemes.

Congress vested in the Securities and Exchange Commission authority both to enforce the antifraud provisions, and to adopt regulations to prevent fraud and other misconduct. The seeds for the debate over how best to strike an appropriate balance between enforcement and regulation were sown at that time.

Over the years, the Commission has exercised its rulemaking authority under Section 10(b) sparingly. For the most part, we have attacked fraud through the enforcement process. While I suppose this will come as a shock to no one, I truly believe that the enforcement process offers advantages over rulemaking.

First, the Commissionís enforcement tools enable us to respond more nimbly to change. A new spin on an old fraud can be attacked quickly with our existing investigative and prosecutorial powers. Drafting and adopting effective rules, on the other hand, typically requires the accumulation over time of evidence of a particular type or pattern of misconduct, followed by a lengthy notice and comment period. Thus, rulemaking always leaves us a little behind the curve. Moreover, as technology and the markets evolve rapidly, we can only expect to lose ground more quickly. Specific regulatory prohibitions are static, and inevitably reflect assumptions Ė and limitations -- prevalent at the time of their adoption, but not necessarily at any time in the future.

Second, the enforcement process enables the Commission to take targeted action against those engaged in misconduct, without necessarily implicating the conduct of those engaged in similar, but legal, activity. Enforcement actions require the Commission to make far fewer difficult determinations about where to draw lines among types of conduct. These line-drawing decisions must be made particularly carefully in the rulemaking context because, like moths to a flame, parties subject to regulation are inevitably drawn closer and closer to the line. This tendency means that rulemaking can have the perverse effect of encouraging certain "close to the line" conduct. Furthermore, because rulemaking requires the Commission to draw lines among categories of conduct, rather than among the facts of particular cases, we incur the risk that our rules will be both over-inclusive and under-inclusive. As a result, we may burden conduct that otherwise would remain legal, while failing to curtail certain practices that we had hoped to stop.

Our approach to insider trading over the years is illustrative of our philosophy regarding enforcement and regulation. Certainly, combating insider trading has been one of the crowning successes of our enforcement program. And weíve achieved success in this area without a single rule or regulation, until two days ago. Even though insider trading is not defined, I believe that most people know what it is and understand that it is illegal. Adopting rules that prohibit precise types of trading would necessarily place beyond our reach other types of trading not covered Ė trading that may be just as unfair as that captured by a rule. The adoption of rules would also reopen for debate issues that have been long resolved by the courts.

The reason we acted recently to adopt two insider trading rules is equally instructive of our philosophy regarding enforcement and regulation. Rule 10b5-1 was adopted to eliminate the uncertainty that has arisen from various court cases as to whether it is necessary to prove that a person actually used inside information or whether it is sufficient simply to show that the person traded while aware of such information. The court decisions addressing this issue have reached different conclusions. We believed that a rule would provide greater certainty and save years of effort to clarify the standard in the courts. Rule 10b5-2 was adopted for similar reasons.

While some have said that we are too sparing in the use of our rulemaking authority and that we should identify prohibited conduct with greater specificity, others have asserted that the Commission is not sparing enough in its rulemaking efforts. This was the position taken by some of the opponents to our recent rulemaking initiative, Regulation FD. Such opponents asserted that we should proceed by bringing enforcement actions against those who engaged in selective disclosure, rather than imposing new regulatory requirements on all.

Finally, some of our critics appear to be just plain contrarians. Whatever approach the Commission takes Ė whether itís engaging in rulemaking or proceeding by enforcement Ė they say we should be doing the opposite.

Let me give you an example of what I am talking about, based on statements made a single day apart by that "other" securities industry trade association. In an April 5 amicus brief filed with the Ninth Circuit in the Rauscher yield burning case, that association, joined by this one, argues:

If the SEC feels that industry practices are insufficient, the solution is not to punish those who rely on those practices but to use the SECís rule-making authority to promulgate a standard that the SEC prefers.

In a comment letter filed the very next day pertaining to Regulation FD, the same association argued:

A governmental regulation is a blunt instrument.... The Commission [could] address more directly the specific abuses that concern it, including [by] vigorous enforcement of the existing insider trading prohibitions. This approach would be far preferable to imposing an oppressive regulation of all issuers in order to get a relatively small number of abusive cases.

The best way to sum up the juxtaposition of these arguments is the old "heads I win, tails you lose" line.

So where does this leave us? Iíve told you, not surprisingly, that my preference is to address misconduct in the marketplace through the enforcement process, except when controlling case law prevents us from doing so or conflicting case law creates unreasonable uncertainty. But it may surprise you to hear that I do not believe enforcement authority should be unfettered. True, a metal badge would be nice, but Iím not looking for a gun.

Probably the Commissionís most important consideration in bringing an enforcement action addressing novel conduct is whether the defendant was on notice that his or her conduct was illegal. Market participants are put on notice of illegal behavior under Section 10(b) by several sources, including: judicial and SEC precedents, SEC staff guidance, and NASD guidance, such as Notices to Members.

Sometimes the notice that we deem to be fair notice does not satisfy the desire of market participants for precise rules that provide absolute certainty. Take, for example, the standard governing mark-ups. Here, weíve provided broad guidelines that leave considerable room for individualized judgments in particular situations. Efforts by the Commission and other regulators to provide more specific guidance in the area of mark-ups have been derailed and illustrate the tensions that exist between rulemaking and enforcement.

In the wake of some recent enforcement actions charging violations arising out of material, but very small, undisclosed mark-ups, the call for regulation has again sounded. Some have urged us, in effect, to engage in rate-making and publish an elaborate and lengthy schedule of tariffs for each and every security imaginable. This does not seem particularly practical to me. In the first place, Iím not sure we have the expertise to do so. More importantly, however, our markets are dynamic and it is our responsibility to promote, rather than impede, competition. I fear that a schedule of published rates would set both a floor and a ceiling for mark-ups and could discourage further competition.

The Commission, on the other hand, has made a number of proposals that would, at least indirectly, address the issue of mark-ups, by providing greater transparency in the corporate bond market. These proposals would require the NASD to adopt transaction reporting rules for corporate debt that would make transaction prices available on a real-time basis. As previously mentioned, the more transparent our markets are, the more difficult it is to charge prices that are excessive or out of line with published quotations. Iím pleased that the Bond Market Association has been working with the Commission and the NASD to implement the rules necessary to achieve this goal.

Iíve discussed why I think the enforcement process more flexibly responds to ever changing conditions in the marketplace in most situations. But I should also spend a minute talking about when rulemaking is appropriate.

This brings us, logically, to Regulation FD, our new rule prohibiting selective disclosure that became effective two days ago. The reason we pursued rulemaking to prevent selective disclosure was because existing legal precedents Ė principally the Dirks case Ė placed barriers in the path of bringing enforcement actions to stop a practice universally regarded as unfair. Perhaps these barriers explain why opponents of the rule urged us to proceed by enforcing existing insider trading rules Ė they knew the rules were inadequate.

Another argument that was asserted in opposition to the rule was that there was insufficient proof that selective disclosure was occurring to the extent necessary to warrant a rule across the boards. This argument is frequently raised to block rulemaking initiatives. For example, the Big 5 accounting firms who oppose our auditor independence rules argue that there is no proof that the performance of consulting services for audit clients impairs the objectivity of auditors. In the case of Reg. FD, there was in fact proof that selective disclosure was occurring, including an entire Bloomberg website devoted to situations in which analyst conference calls have been closed to media and investors.

Regardless of whether there is demonstrable proof of wrongdoing or illegal behavior, the courts have made clear that the Commission is free to act prophylactically to prevent activity that it finds may harm investors or the markets. For example, in disposing of a challenge to Rule G-37 several years ago, the D.C. Circuit said: "Although the record contains only allegations, no smoking gun is needed where, as here, the conflict of interest is apparent, the likelihood of stealth great, and the legislative purpose prophylactic."

The task of striking an appropriate balance between enforcement and regulation is more difficult and controversial today than ever before. With technology transforming our markets, and an accompanying rise in Internet securities fraud, many have questioned whether the old rules fit in the new online world, and whether the Commission ought to proceed by regulation or enforcement of existing rules in these unchartered waters.

We have devoted significant resources to fighting Internet securities fraud and have brought over 200 actions since we began policing the Internet in 1995. Nearly all of these cases involve equities, and most focus on either illegal touting or "pump and dump" manipulation schemes. We have found, without exception, that wrongdoing we have witnessed on the Internet fits squarely within our existing statutory framework.

Nevertheless, some have argued that our statutes were never intended to cover Internet fraud. To one degree or another, defendants in several of our cases have all argued that the securities laws apply differently in cyberspace than in a bricks and mortar world. For example, we charged Tokyo Joe, a burrito restaurant owner turned web site operator, with several violations including touting securities on his web site. In defense, his lawyer was quoted as saying:

I would have hoped that the SEC would have dealt with these types of issues such as free speech and exchange of information over the Internet through regulation and not litigation.

I reject the argument that when fraud is perpetrated on a new medium, rulemaking is more appropriate than enforcement. The First Amendment has never protected fraud and it does not do so in cyberspace. Tokyo Joe quickly learned this lesson when his motion to dismiss was recently denied.

And Section 10(b) applies in the same way to conduct on-line and off. Its broad proscriptions address prohibited conduct and provide no exemptions based on the medium used.

Just because the Internet has spawned new techniques for facilitating traditional frauds does not mean that existing statutory prohibitions do not apply. No where is this more apparent than in the area of market manipulation Ė the intentional interference with the free forces of supply and demand to affect the price of a security.

The laws prohibiting manipulation require proof of both manipulative intent and effect. Historically, this has been evidenced by devices such as wash sales, matched orders or marking the close that have taken days, weeks or months to accomplish. But these indicia of a manipulation are not required to prove the requisite intent and purpose. And their absence does not give rise to a regulatory gap that precludes enforcement of the law where proof of manipulative intent and effect is otherwise present.

In an Internet world, the time it takes to manipulate a security has shrunk from days to minutes, and the techniques for accomplishing a manipulation have been simplified. A single mass e-mail or "spam" sent by the click of a mouse can more easily and cheaply reach investors and artificially influence trading than hundreds of cold calls from an old-fashioned boiler room or months of trading among confederates who control a stockís float. Yet the purpose and effect in both instances is the same, and the prohibitions against manipulation apply equally in both contexts as well.

This is a message that Jonathan Lebed, a 16 year-old stock manipulator who appeared on 60 minutes last Sunday, his parents, his lawyer, and various members of the media appear not to understand. And itís a message worth reiterating as people have asked whether the fundamental prohibition against market manipulation applies to conduct on the Internet. Trust me, it does.

Hereís what Lebed did. He purchased large blocks of thinly traded microcap stocks, often accompanying these trades with limit orders to sell. He then posted hundreds of identical messages, commonly known as "spam," to Yahoo! Finance message boards using multiple screen names. The messages typically touted the company by claiming, among other things, that the stock was about to "take-off," would be the next to gain 1,000%, and was "the most undervalued stock ever." In a number of postings, he made very specific price predictions, for instance, that the stock would go from $2 to $20, while at the same time placing limit sell orders at much lower prices. In at least one posting, he falsely claimed that the company was about to enter into a contract that would have generated large revenues. Lebed typically repeated the postings a second time early in the morning of the next day before going to school. In every instance, the price and volume of the stocks he touted increased, in some cases to 52-week-high levels. And he always sold out his positions at a profit, usually within 24 hours.

Lebed admitted that he authored and posted the messages in order to cause the stock price to rise so that he could make a profit, both of which, in fact, occurred. Indeed, he conceded on national television that he was manipulating the stocks. Itís not very often that we find stronger proof of manipulative purpose and effect. Nothing beats an admission.

And yet, for some reason Ė perhaps because this conduct took place over the Internet Ė even prominent financial newspapers have had a difficult time comprehending that the case involves market manipulation, plain and simple. Some of the press and others have gotten completely sidetracked and have attempted to defend Lebedís conduct by demonizing Wall Street and suggesting that what Lebed did is really no different than what Wall Street analysts do every day. Of course, to the extent an analyst intentionally manipulates a security, misleads investors through widespread Internet postings under multiple names, makes unsubstantiated price predictions or other statements that lack a reasonable basis, or scalps a recommendation by selling when the analyst is telling others to buy, the analyst has a serious problem. But to suggest that these are "standard brokerage house procedures" is sophomoric.

What is perhaps most disturbing about this case is the reaction weíve seen from the Lebed family and from others who seem to treat Jonathan as a cult hero. Both Lebed junior and senior have said, "Whatís the problem? There were no victims." Maybe the Lebeds should have used some of Jonathanís profits to buy a dictionary rather than a Mercedes. Just because you canít always see them or identify them does not mean victims donít exist. Those who unwittingly bought at an inflated price Ė only to be burned when the stock collapsed Ė meet any dictionary definition of victim.

Mr. Lebed also says he is "proud" of his son and distinguishes his sonís securities violations from smoking pot in the garage or stealing hubcaps. I wonder how many investors whoíve lost money as a result of Jonathanís manipulations would agree with this sentiment. A hubcap is worth about $20. Smoking pot -- as harmful and foolish as it may be -- does not injure innocent bystanders. Securities manipulation, by contrast, deprives people of hard-earned dollars needed for retirement, education and the like. So Mr. Lebed is right in saying his sonís conduct is different from smoking pot or stealing hubcaps. Itís worse.

The Internet continues to open up vast new horizons for all of us. I hope it will not cause us to compromise our moral principles and values, or lose the ability to differentiate between right and wrong.

While it may seem that Iíve traveled pretty far afield from talking about activities in the debt markets, I hope that my remarks will not be lost on this crowd as E*bond offerings and trading begin to arrive.

This past year weíve witnessed issuers and investment banks transform themselves into online merchants of all kinds of debt securities. We saw a number of firsts in this regard:

  • Freddie Mac launched the first-ever bond offering via the Internet, a $6 billion five-year issue;
  • Ford Motor Credit marketed the first corporate issue online, a $1.2 billion three-year bond; and
  • The first online municipal offerings arrived, including a $530 million offering by Puerto Rico.

We also began to see what I think will be a defining characteristic of online bond offerings Ė greater participation in this market by retail investors. In February, the World Bank launched a $3 billion deal, which marks the first online deal marketed not just to institutional investors but to retail investors as well.

As the online market for debt heats up, I think it only natural that more regulatory scrutiny and enforcement will follow. And if the past is any predictor of the future, Iím sure weíll be hearing the same arguments about the proper roles of regulation and enforcement that weíve heard in the past. Those selling debt securities online Ė or their amici Ė will likely argue that they could not have known how or if the securities laws applied to conduct online.

Let me set the record straight today Ė a markup that is excessive offline remains so online; an investment that is not suitable when recommended offline remains so online; and misleading risk disclosure in a paper prospectus remains misleading when presented in an electronic format.

So as we move forward to embrace technological advancements, make sure you remain true to the principles that have guided our markets for more than 60 years. These principles have served us well. As we like to say at the Commission, our markets maintain the reputation as being the fairest and safest in the world. Faithful adherence to these principles will ensure that our new online markets continue to provide benefits and protections to investors and issuers alike. Thank you.