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Reasonableness Pants

Rutgers Law School, Camden, New Jersey

May 8, 2019

Thank you, Arthur [Laby]. Arthur and I worked together many years ago in the SEC’s Division of Investment Management, so it is an honor to be here with him and all of you this evening. I will begin with my standard disclaimer that the views that I represent tonight are my own and not necessarily those of the Commission or my fellow Commissioners.

Because Arthur is my host, I decided that a good place to start was his concise, but insightful comment letter on our proposed new standard of conduct for broker-dealers who provide advice. Arthur commented that it was indeed time to align the legal standard with expectations of investors[1]. Arthur, in his typical scholarly fashion, pulled out a dictionary. "Advise," he explained, carries with it an expectation that the advice is in the recipient’s best interest, whereas "convincing" and "persuading" are not necessarily motivated by the best interest of the person being persuaded or convinced. Arthur used a doctor as an example of a quintessential advice provider. The distinction got me thinking about my experience with those concepts. My interactions with doctors are as infrequent as I can make them, but I do remember visiting one doctor when I was experiencing severe dizziness. He advised me to stay away from the edge of the train platform—sound advice, clearly not motivated by anyone’s interest but my own. As unsatisfying as that prescription was for me at the time, it certainly did not generate much revenue for him. That I stand here today testifies to the fact that I took his advice and it worked. Contrast that with another doctor I visited who, instead of the standard medical school diplomas, proudly displayed on his office wall a Wikipedia entry on ulcers and a certificate of completion for a class on administering EKGs. He advised me to get an EKG, but I think that I might put him in the convincing and persuading category—rather than the advising category—since a significant motivator for the prescribed treatment seemed to be his desire to practice his newly acquired EKG skill. In short, I think I see Arthur’s point—there is a difference between advising, on the one hand, and persuading and convincing, on the other. I am not persuaded, however, that doctors always act in my best interest.

Arthur’s letter was one of many we received in conjunction with our proposed Regulation Best Interest and its two companion proposals. With the help of those comments, we are working on a set of adopting releases. Regardless of the details, I am hopeful that we can get to a place where investors are able to find a financial professional who works and is paid in a manner that works for them.

Arthur’s letter got us started, but I want to talk with you tonight primarily about enforcement at the SEC. To do that, I need to mention two more letters. Had I heeded a letter I received last week, I would not even be here. The author of that letter deemed me an inappropriate lecturer because of his disappointment about what he thought I thought about a recent enforcement action of note.

Perhaps with similar sentiment, a commentator, now cited on the SEC’s website as "anonymous", wrote to the SEC a month or so ago in response to a request for comment on earnings releases and quarterly reports.[2] This commenter had some particular thoughts about my work:

I would also like to thank Hester Peirce for her hard work towards dismantling the SEC. . . . Peirce is doing a splendid job of neutering @SEC-Enforcement as much as possible, and turning the SEC into the perfect tool for businesses to "hunt for profits" in pretty much any way that they see fit—especially those selling dreams that will come true in 3 months maybe, 6 months definitely.[3]

The commenter’s letter, which eloquently expresses concerns some others have voiced about my approach to enforcement, suggests that I need once again to take a moment to explain where I am coming from. I will advise you of my position, and we will see whether I am able to persuade or convince you that my approach is reasonable.

The "hunt for profits," when it is tied to meeting the needs of other people, is not, of course, a bad thing. To make profits, people have to find ways they can add value to other people’s lives. Part of the SEC’s mission is to facilitate capital formation, an objective that requires us to set up an effective regulatory framework, but avoid building unnecessary regulatory barriers to companies’ capital raising efforts. Capital formation is a key enabler of companies’ ability to serve their customers well and thus to earn profits. If we at the SEC do our job right, people with good ideas will be able to raise money to turn those ideas into products that make other people’s lives better.

A key way that we facilitate capital formation is by ensuring that companies that need money are disclosing to investors who have provided, or might be willing to provide, the money with the information they need to decide whether the company will make good use of the money. We want investors to get an accurate picture of the company’s long-term value. Periodically, it is important to revisit our regulations to make sure that they are achieving this goal. That is why we issued the request for comment on the need for quarterly reporting to which the commentator now known as "anonymous" responded, and that is why the Commission has undertaken a number of other initiatives to rethink disclosure obligations for public companies.[4]

Another way that we establish a regulatory framework within which our capital markets can flourish for the benefit of broader society is by running a strong enforcement program. A strong enforcement program requires us—to draw from the admonition a judge recently gave to us in a matter before her—to "put on [our] reasonableness pants."[5] The SEC ought always to wear reasonableness pants, and I would like to talk today about what those reasonableness pants look like on a regulator.

In outlining my views on enforcement in a speech a year ago, I explained that the SEC is not an enforcement agency, but rather a regulatory agency that uses enforcement as one tool[6]. Appropriate enforcement of the rules we have on our books protects investors and the integrity of our capital markets. Most enforcement recommendations the Commission receives from the staff are legally straightforward and not controversial, but a small subset causes me to ask whether we are wearing our reasonableness pants. In particular, I am not a fan of the so-called "broken windows" philosophy, a more-is-always-better, punish-the-small-violations approach to enforcement. Instead, I assess, when reviewing an enforcement recommendation from our staff, whether the recommendation is using our enforcement resources wisely. I ask, was there a meaningful violation? Is this a matter that could have been handled by our exam program? Are there other appropriate responses in lieu of an enforcement action, such as a rulemaking, interpretative guidance, or an educational bulletin for investors? Additionally, I consider due process principles when assessing our enforcement actions, for example by asking whether an action would constitute rulemaking by enforcement, push the bounds of the SEC’s authority, punish unduly aged conduct, or be based on an inappropriately induced waiver of attorney-client privilege. I also try to think about potential unintended consequences of our actions, such as whether they would inadvertently undermine the good faith efforts of chief compliance officers or impose costs on shareholders who already have suffered because of the securities law violations of company executives. These are some of the common considerations that drive my approach to enforcement, but tonight I would like to ask whether we were wearing our reasonableness pants in two specific instances.

As I alluded to, reasonableness pants are stitched together with due process threads. Due process concerns were front and center in my mind when, in March of this year, the SEC announced settlements with 79 investment advisers as the first fruits of the Division of Enforcement’s Share Class Selection Disclosure Initiative ("the Initiative").[7] The Initiative is a voluntary, self-reporting program open to investment advisers that, without disclosing it, had put clients into higher cost shares when lower cost shares were available.[8] Beginning in 2013, the SEC brought a number of cases that were forerunners of the cases in the Initiative.[9] The underlying theory behind these enforcement actions was that investment advisers[10] failed to disclose to their clients that their selections of particular mutual fund share classes resulted in the advisers or their related entities or individuals being paid a fee when a lower-cost share class for the same fund without the fee revenue for the adviser or its affiliate was available to the clients.[11] Our Office of Compliance Inspections and Examinations ("OCIE") also was finding related share class disclosure violations during its exams of investment advisers. OCIE issued a risk alert in July 2016.[12] The Division of Enforcement announced the Initiative two years later in February 2018.

The SEC announced the first settlements on March 11, 2019. Additional settlements may come in the future. Participating firms settled with the Commission to a cease-and-desist order, a censure, a payment of disgorgement and prejudgment interest which the firm would return to harmed investors, and, in some cases, certain undertakings. In return for participating in the Initiative, the firms did not pay a civil penalty.

Even though I supported many of the settlements announced in March, I do not view this Initiative as a high point in the Commission’s history. The 79 distinct enforcement actions were essentially one package produced by the Initiative. Admittedly, this aggregation helped to preserve precious staff resources and perhaps the participating advisers’ reputations. These benefits, however, came at great cost to the individual consideration these cases deserve. The public packaging of the cases obscured important distinctions. Some of these firms affirmatively lied; they accepted Rule 12b-1 fees, even though they said they did not. Other firms had disclosures that we deemed to be subpar, but, at least in broad strokes, disclosed the conflict at issue. These are two very different types of violations, but they were lumped together and presented to the public as if they were cut from the same cloth. More generally, an initiative like this one by its nature obscures the different facts and circumstances of each participant and emphasizes the similarities. The Enforcement Division made it clear that each firm that responded to the Initiative would be assessed on its own merits and demerits, but there is nevertheless a downside of lumping lots of firms together. In other words, the Initiative—in the name of efficiency— placed great tension on the due process threads of our reasonableness pants.

An even more fundamental concern is less about our enforcement function than what the Initiative says about our regulatory function. That numerous firms in the securities industry participated in the Initiative— including some very large firms —suggests that the SEC has fallen down on its job as a regulator. Yes, the fiduciary duty here belongs to the firm. In fulfilling that duty, we expect firms to exercise judgment. The Commission cannot spoon feed them the appropriate disclosure to use. Each firm, in fulfillment of its fiduciary duty, is responsible for telling clients in clear language what their conflicts are. The fiduciary duty is a firm’s duty to its clients, and indeed is a duty that firms often trumpet loudly in order to win clients’ trust.

That said, the SEC also has a duty. Our duty is to be clear with registrants about our interpretation of the fiduciary duty. If we see a wide-scale departure from the fiduciary duty as we interpret it occurring over numerous years, we owe it to the firms we regulate and—more importantly—the investors whom we are charged with protecting to be very clear that there is a problem. A regulator wearing its reasonableness pants tells the firms it regulates what their regulatory obligations are. When I say tell them, I do not mean bring a few enforcement actions and expect firms to find these actions on our website and revise their disclosures in light of what they can glean from those actions. I do not mean issue an OCIE risk alert, though such alerts are very helpful in giving a window into the problems our staff is seeing in the field. What I mean is that when we see a widespread problem that is affecting investors, we—the Commission—should issue our own guidance or promulgate a rule and put an end to the problem before it hurts investors further. Doing this is better for investors than waiting many years to bring a large enforcement initiative. It is also respectful of the due process of the firms we regulate by giving them notice of what the SEC expects from them. And yes, you guessed it, it is what the SEC does when it is wearing its reasonableness pants.

Sadly, that is not what happened here. We spotted a problem and let it fester without a definitive reaction from the Commission for five plus years. The delay meant that investors went years without the necessary disclosure to appreciate that they were not being put in the cheapest share classes available. Now firms know the disclosure formula we want, so I expect we will not see this precise violation again any time soon, but at what cost? Investors waited years to get back fees that they might not have paid if the Commission had timely issued a rule or guidance. Regulated entities that might have gotten the disclosure right if we had had guidance in place instead have an enforcement action on their record.

Reasonableness pants should not only be threaded with due process, but they also should fit properly. In other words, the SEC ought to take care in how it exercises its authority. The goal should not be for us to stretch our authority to its limits and beyond but instead to act carefully and cautiously. An example that I am watching now is how the SEC reacts to the recent decision by the U.S. Supreme Court, Lorenzo v. Securities and Exchange Commission.[13] Before offering my substantive thoughts of the case, let me provide you with an overview of the facts and procedural history.

Lorenzo was the director of investment banking at a registered broker-dealer. Lorenzo’s only investment banking client during the relevant time period was a company developing technology to convert solid waste into clean renewable energy. A big chunk of the company’s reported $14 million in assets was attributable to intellectual property Lorenzo knew to be worthless; the waste to energy technology was not ready for prime time. Shortly thereafter, Lorenzo, following his boss’s direction and using his boss’s words, sent two emails to prospective investors describing a debt offering by the company.[14] The emails trumpeted the assets that Lorenzo knew were worthless. Lorenzo signed the emails with his name, identified himself as "Vice President—Investment Banking," and invited the recipients to "call with any questions."[15]

In 2013, the SEC sued Lorenzo, along with his boss and the investment banking firm. The SEC charged Lorenzo with violating Section 17(a)(1) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder.[16] The SEC’s administrative law judge concluded that Lorenzo had violated these provisions by sending the emails with intent to defraud, ordered Lorenzo to cease and desist from violating the securities laws, barred him from the securities industry, and ordered him to pay a civil penalty of $15,000.[17] The Commission sustained the judgment of the ALJ.[18] The U.S. Court of Appeals for the District of Columbia affirmed the Commission’s decision in relevant part; the DC Circuit rejected the Commission’s 10b-5(b) charge, but held that, by sending the emails, Lorenzo violated Rule 10b-5(a) and (c), as well as Exchange Act Section 10(b) and Securities Act Section 17(a)(1).[19]

I give you all this background to set the stage for the Supreme Court case. Earlier this year, in a 6-2 decision, the Court held that by sending the emails with knowledge that they contained material untruths, Lorenzo "employ[ed]" a "device," "scheme," and "artifice to defraud" within the meaning of Rule 10b-5(a), Section 10(b), and Section 17(a)(1).[20] Additionally, the Court found that Lorenzo’s conduct made him primarily liable under Rule 10b-5(c) for "engag[ing] in a[n] act, practice, or course of business" that "operate[d] …. as a fraud or deceit."[21]

Why was this case a big deal? Under Lorenzo, scheme liability is broader than some of us believed it to be. Prior to the Lorenzo decision, I had read the provisions of the securities laws that involved a "device," "scheme," "artifice to defraud," "act," "practice," or "course of business"[22] to require something more than a misstatement. I looked for deceptive conduct such as running a Ponzi scheme, misappropriating investor funds, engaging in stock manipulation, or falsifying documents. In other words, I viewed conduct that is separate from the act of making a misstatement as a necessary basis for a violation of these provisions. Justice Thomas’ dissent in Lorenzo captures this distinction by noting that "[t]he act of knowingly disseminating a false statement at the behest of its maker, without more, does not amount to ‘employ[ing] any device, scheme, or artifice to defraud’ within the meaning of" Rule 10b-5(a) and Section 17(a)(1).[23]

Several years ago, in another Supreme Court case, Janus,[24] the Court held that only the maker of a false statement could be held primarily liable for it under 10b-5(b), which prohibits misstatements. In Lorenzo, the Court effectively gave an alternate route to primary liability for anyone who disseminates a false statement. The majority opinion concluded—relying on the fact that Lorenzo sent the emails directly to investors, the capacity in which he acted, and his offer to answer potential investors’ questions—this was not a "borderline" case, but acknowledged that these provisions "may present difficult problems of scope in borderline cases."[25] By way of guidance on the limits of its holding, the majority offered that a mailroom clerk would not be primarily liable for disseminating misstatements.[26] That is cold comfort given that I think not even the most expansionist reader of the case would have thought a mail clerk might be primarily liable for doing his job. There are a lot of people who fall somewhere between an investment banker and a mailroom clerk. Nevertheless, it is important that this case is limited to disseminators of misinformation with the intent to defraud.

The court’s opinion leaves many questions. Would the result have been different if Lorenzo had repeated his boss’s misstatements verbally instead of by email? If Lorenzo’s secretary, having overheard Lorenzo deriding the value of the waste to energy technology, had edited the two emails for grammar and sent them out on his behalf, would the secretary also be primarily liable? If Lorenzo’s two emails count as a "device," "scheme," "artifice to defraud," "act," "practice," or "course of business," what would not count? What, if anything, does the case say about conduct other than dissemination?

Justice Thomas read the majority opinion to mean that "virtually any person who assists with the making of a fraudulent misstatement will be primarily liable and thereby subject not only to SEC enforcement, but private lawsuits."[27] Justice Thomas further observes that the Lorenzo decision "eviscerates" the distinction, as articulated in the Janus decision, "between primary and secondary liability in fraudulent-misstatement cases."[28] His dissent notes that "the majority’s opinion renders Janus a dead letter"[29] because even though Lorenzo was not the maker of the fraudulent misstatements at issue, "[t]he majority nevertheless finds primary liability under different provisions of Rule 10b-5, without any real effort to reconcile its decision with Janus."[30]

It is awfully tempting for the SEC to read and attempt to apply Lorenzo as broadly as possible.[31] I hope we will instead keep in mind how unseemly it is when a regulator stretches its authority to its outer limits or beyond. Even in the wake of a Supreme Court win, restraint is the better approach. Reasonableness pants are always well-fitting, not stretched beyond decency. As we ought to do with any authority, we must exercise the provisions at issue in Lorenzo with wise discretion. We must respect the proper line between what primary and aiding-and-abetting liability is. Congress defined aiding and abetting liability to be the provision of "substantial assistance" to a securities law violator.[32] It is important for us and the courts not to ascribe primary liability to every violation and thus write aiding and abetting out of the statute. Instead, we have to think carefully about where the line between primary and secondary liability lies in particular cases. Even substantial conduct may not qualify as a primary violation. With that in mind, let us keep our reasonableness pants on and be judicious in how we exercise our authority to bring enforcement actions in the wake of Lorenzo.

In addition to being sewn with due process and fitting properly, reasonableness pants are not cool. They do not have holes in the knees the way my jeans did in high school and today’s fashionable jeans also do. Reasonableness pants are not an act of rebellion, as my ripped jeans were intended to be, or hip, as today’s holey jeans are; reasonableness pants are practical and not particularly fashionable.

Let me give you an example—this time from outside the enforcement context. Lots of people want the SEC to wade into a whole range of issues that are not properly within our purview. Increasingly, we are urged to tell companies how many women to have on their boards, to limit the ways companies and their shareholders may resolve disputes, to direct financial firms to avoid providing capital for certain industries, or to prohibit investors from getting access to certain products we think investors should not have in their portfolios.

We do not have the time, resources, or authority to do these things. We have other things to do that are not headline-grabbers, but are neatly within our core mission. Practicality demands, for example, that we work on updating our transfer agent rules, modernizing our disclosure requirements, strengthening the rules governing how financial professionals interact with investors, assessing fixed income and equity market structure, developing rules for finders, and ensuring that companies and investors across the country can participate in our capital markets. If we switch out our reasonableness pants for a trendy pair with strategically placed holes, subsequent generations will look back at us in disgust and wonder why we sacrificed the health of our capital markets for the chance to look cool for a moment.

To draw this to a close, I will remind you of the important role that you in the academic community have in scrutinizing our work and identifying instances in which you think we are wearing something other than reasonableness pants. I look forward to hearing your comments and questions now—or later by letter. If you are a letter-writer, you will be in good company. Thank you for your gracious attention.

[1] Letter from Arthur B. Laby, Professor of Law and Co-Director, Rutgers Center for Corporate Law and Governance, to Brent J. Fields, Secretary, U.S. Securities and Exchange Commission, Aug. 7, 2018, available at

[2] Letter from Anonymous to Brent J. Fields, Secretary, U.S. Securities and Exchange Commission, March 25, 2019 (received), available at

[3] Id.

[4]For example, we have twice in the last year adopted sweeping amendments to our Regulations S-K and S-X to streamline disclosures, eliminate redundancies, and harmonize our disclosures with U.S. GAAP. See FAST Act Modernization and Simplification of Regulation S-K, Release Nos. 33-10618, 34-85381, IA-5206, IC-33426 (March 20, 2019), available at; Disclosure Update and Simplification, Release Nos. 33-10532, 34-83875, IC-33203 (Aug. 17, 2018), available at We have also proposed changes to our rules regarding financial disclosures for acquired companies and for issuers and guarantors of guaranteed securities. See Amendments to Financial Disclosures about Acquired and Disposed Businesses, Release Nos. 33-10635, 34-85765, IC-33465 (May 3, 2019), available at; Financial Disclosures about Guarantors and Issuers of Guaranteed Securities and Affiliates Whose Securities Collateralize a Registrant’s Securities, Release Nos. 33-10526, 34-83701 (July 24, 2018), available at

[5] Matt Rosoff and Robert Ferris, "SEC, Tesla CEO Elon Musk seek one-week delay to resolve contempt motion," (April 18, 2019), available at (quoting Judge Alison Nathan).

[6] Hester M. Peirce, Commissioner, U.S. Securities and Exchange Commission, "The Why Behind the No: Remarks at the 50th Annual Rocky Mountain Securities Conference" (Denver, Colorado, May 11, 2018), available at

[7] U.S. Securities and Exchange Commission, "SEC Share Class Initiative Returning More than $125 Million to Investors" (March 11, 2019), available at

[8] U.S. Securities and Exchange Commission, "Share Class Selection Initiative," available at

[9] See e.g., In the Matter of Packerland Brokerage Services, Inc., Investment Advisers Act Rel. No. 4832 (Dec. 21, 2017); In the Matter of SunTrust Investment Services, Inc., Investment Advisers Act Rel. No. 4769 (Sept. 14, 2017); In the Matter of Envoy Advisory, Inc., Investment Advisers Act Rel. No. 4764 (Sept. 8, 2017); In the Matter of Cadaret, Grant & Co., Inc., Investment Advisers Act Rel. No. 4736 (Aug. 1, 2017); In the Matter of Pekin Singer Strauss Asset Management Inc., Investment Advisers Act Rel. No. 4126 (June 23, 2015); In the Matter of Manarin Investment Counsel, Ltd., Investment Advisers Act Rel. No. 3686 (Oct. 2, 2013).

[10] It should be noted that neither investment advisers nor investment adviser representatives are allowed to receive transaction-based compensation such as 12b-1 fees. The advisers and their representatives receiving these fees are dually registered as broker-dealers and registered representatives, respectively, or the adviser is an affiliate of a broker-dealer receiving these fees.

[11] U.S. Securities and Exchange Commission, "Share Class Selection Initiative," available at

[12] U.S. Securities and Exchange Commission, Office of Compliance Inspections and Examinations, "OCIE’s 2016 Share Class Initiative" (July 13, 2016), available at

[13] 587 U.S. ___, No. 17-1077 (U.S. Mar. 27, 2019).

[14] Id. at 3.

[15] Id.

[16] In the Matter of Gregg C. Lorenzo, Francis V. Lorenzo, and Charles Vista, LLC, Securities Act of 1933 Rel. No. 9385 (Feb. 15, 2013), available at

[17] In the Matter of Gregg C. Lorenzo, Francis V. Lorenzo, and Charles Vista, LLC, SEC Release No. 544 (Dec. 31, 2013), available at

[18] In the Matter of Francis V. Lorenzo, Securities Act of 1933 Rel. No. 9762 (Apr. 29, 2015), available at

[19] Lorenzo v. Sec. & Exch. Comm’n, 872 F.3d 578 (D.C. Cir. 2017).

[20] Lorenzo, 587 U.S. at 6.

[21] Id.

[22] Rule 10b-5(a) and (c), as well as Section 10(b) and Section 17(a)(1).

[23] Lorenzo, 587 U.S. at 4 (Thomas, J. dissenting).

[24] Janus Capital Group, Inc. v. First Derivative Traders, 564 U.S. 135 (2011).

[25] Lorenzo, 587 U.S. at 6.

[26] Id. at 7.

[27] Id. at 9 (Thomas, J. dissenting). The majority also acknowledged the potential breadth of conduct reached by these provisions. See also Id. at 6-7 ("These provisions capture a wide range of conduct. Applying them may present difficult problems of scope in borderline cases. Purpose, precedent, and circumstance could lead to narrowing their reach in other contexts.").

[28] Id. at 1 (Thomas, J. dissenting).

[29] Id. at 9 (Thomas, J. dissenting).

[30] Id.

[31] Howard Fischer, "‘Lorenzo’: What Happens Next and What To Do About It?" New York Law Journal (April 30, 2019) ("Indeed, soon after the opinion came out various SEC enforcement staff, giddy with a decision they see gifting them with an expansive writ, were widely reported to have stated at the annual ‘SEC Speaks’ CLE program that the Division of Enforcement anticipates the opinion will be applied ‘broadly’ – for example, not only to people who distribute a false statement but those that direct others to draft or distribute false statements."); Rachel Graf, "SEC Expects Lorenzo to Extend Beyond Dissemination," Law360 (April 8, 2019).

[32] 15 U.S. Code 78t(e).

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