The SEC Speaks 2011 Conference: The SEC Struggles to Manage Expanded Regulatory Mandates While Facing Budgetary Restraints From Congress
At this year’s annual “SEC Speaks” conference held on February 4-5, 2011, representatives from the U.S. Securities and Exchange Commission reviewed the SEC’s 2010 achievements and previewed upcoming 2011 enforcement initiatives. While last year’s program sent a strong message of aggressive enforcement and regulation, the theme that emerged this year was the growing tension created by the SEC’s expanded mandate to regulate in the face of enormous budgetary constraints that threaten its ability to carry out its mission effectively. In this regard, the message emerging from 2011’s SEC Speaks appears to be squarely directed to Congress, as the Commission plainly concedes that the bold possibilities created by the Dodd-Frank Wall Street Reform and Consumer Protection Act will require corresponding funding if the Commission is to succeed in meeting its mandate.
Over the past year, the SEC has had to reshape its priorities to respond to the aftermath of the financial crisis, and in doing so had to divert significant resources to the task of implementing the recently enacted Dodd-Frank Act. The Dodd-Frank Act provides enhanced enforcement authority and requires significant rulemaking on the part of the SEC. Various aspects of the expansive Act’s reach were explored and discussed frequently throughout the two-day conference, as well as the SEC's new responsibilities to regulate derivatives, hedge funds and credit-rating agencies.
This Client Update summarizes highlights from this year’s SEC Speaks.
Chairman Schapiro’s Opening Remarks
In her opening remarks, Chairman Mary L. Schapiro invoked the SEC’s mission as “the investor’s advocate” and highlighted the May 6 “flash crash” as an example of structural issues that caused volatility in the market. She stated that the SEC plans to address these issues this year by using circuit breaker rules and new regulations implemented by the SEC and the Financial Industry Regulatory Authority (FINRA). Chairman Schapiro also commented that the SEC is considering additional regulations such as "limit-up/limit-down" restrictions on trading,1 as well as implementing separate regulations and controls for high-frequency trading firms that make up over 50% of the market’s trading activity.
Chairman Schapiro also described the SEC’s efforts to implement new rules under the Dodd-Frank Act. Thus far, the SEC has proposed 24 rules, with six rules becoming final. The SEC is also currently working on proposed rules for over-the-counter (OTC) derivatives and new banking regulations under the Dodd-Frank Act, and it has already begun seeing the effects of the Dodd-Frank Act’s new whistleblower provisions.
Notably, Chairman Schapiro highlighted the SEC’s need for significant technological advancement to improve its ability to monitor increasingly sophisticated and high-frequency trading activities. While emphasizing the dire need for these improvements, Chairman Schapiro acknowledged that the SEC’s tight financial strains have rendered it nearly impossible to compete with the resources available to major Wall Street firms. Presenting a stark illustration, Chairman Schapiro described how some market participants’ Information Technology budgets alone surpass the entirety of the SEC’s operational budget.
Commentary by other members of the Commission staff highlighted the SEC’s plans to capitalize on its vastly expanded regulatory tools to achieve maximum impact on enforcement and deterrence.
Impact of Enforcement Actions
Commissioner Luis Aguilar, a member of the SEC’s Investment Advisor Committee, urged that market participants take seriously the threat of SEC sanctions and not view them as a mere cost of doing business. Commissioner Aguilar further noted that if the SEC’s enforcement actions do not instill changes in marketplace behavior, he thinks the SEC should revisit its practice of settling with defendants who neither admit nor deny the alleged conduct, presumably in order to increase the impact of SEC enforcement actions.
To bring home the impact of enforcement actions, SEC staff also reported that the SEC plans to continue using Section 304 “clawback” actions under the Sarbanes-Oxley Act to disgorge bonuses and stock profits from executives who are charged with wrongdoing. So far, the SEC has brought 20 such actions using this provision.
The SEC also noted that although it has not changed its interactions with defendants as a result of the increased judicial scrutiny its settlements have provoked, including high-profile resolutions with Bank of America and Citigroup, the SEC may implement measures to ensure that such judicial challenges are not due to any lack of information the court may have. The SEC may have to provide more information about a defendant’s underlying conduct and the reasons for the settlement, even if such disclosure goes against a defendant’s wishes. The SEC is also considering filing supplemental information or letters to the court as a matter of course in order to avoid unnecessary delays in the judicial approval of settlements.
Specialized Enforcement Units
Deputy Director Lorin Reisner highlighted the Enforcement Division’s specialized investigatory units. He commented that the specialized units are currently conducting dozens of investigations, with 25 percent of all enforcement activity originating from these units. The Enforcement Division has also hired 10 industry experts to assist the SEC in its investigations in “high-risk” market areas. For example, the Asset Management Unit has hired a former execution trader and former hedge fund manager, while the Structured and New Products Unit has hired a former credit analyst and former trading desk analyst.
Though it was announced just last year, the SEC’s Cooperation Initiative, which provides incentives for companies to cooperate in SEC investigations, has moved beyond its nascent stages. The SEC entered into its first cooperation agreement with Carter's Inc. in December 2010. SEC staff commented that the factors taken under consideration in deciding to give cooperation credit to Carter's included the isolated nature of the misconduct as well as the fact that Carter's self-reported its violation, conducted a thorough internal investigation and instituted extensive remedial actions.
Though the Carter’s agreement was the first publicly announced agreement under the Cooperation Initiative, it certainly does not stand alone. The SEC has now entered into a total of 20 cooperation agreements in a variety of areas including accounting fraud, insider trading, market manipulation and Foreign Corrupt Practices Act (FCPA) offenses. Thus far, the offices involved include Boston, Denver, Fort Worth, Los Angeles, Salt Lake City and Washington, D.C. Going forward, the SEC is considering new ways to be more transparent in communicating credit received for corporations who participate in the Cooperation Initiative.
The Dodd-Frank Act
The SEC expects that many of the new transparency requirements imposed by the Dodd-Frank Act will result in an increase in enforcement actions. Other significant provisions of the Dodd-Frank Act that may impact enforcement actions include:
Provisions clarifying that the standard for aiding and abetting liability is recklessness;
Provisions creating extraterritorial jurisdiction of the antifraud provisions of the federal securities laws;
Provisions providing the SEC with oversight and bar power over most regulated entities;
Provisions that enable the SEC to share information with other regulators without waiving privilege;
Provisions addressing vicarious liability for control persons; and
Provisions extending the SEC’s authority to impose monetary penalties in cease-and-desist proceedings.
The Dodd-Frank Whistleblower Program
The Dodd-Frank Act also ushered in a significant new whistleblower program. Since the Dodd-Frank Act’s effective date of July 22, the number of tips received by the SEC has markedly increased. Before the new program was implemented, the SEC reportedly referred about 100 tips for investigatory follow-up per year; post Dodd-Frank, whistleblower tips are resulting in one or two referrals per day. SEC staff also reported that these tips have been high quality, with some whistleblowers even providing documentary evidence at the time of submission. Thus far, whistleblower sources have included corporate insiders, competitors and even “jilted spouses.” The SEC is working on creating a Whistleblower Coordination Office that would process tips received by the SEC and administer the reward claims process.
The SEC has also released proposed rules for implementing the whistleblower program. Thus far, the biggest debate surrounding the SEC’s proposed rules has focused on whether they should mandate or otherwise encourage would-be whistleblowers to internally report violations to their corporate compliance department prior to filing a claim with the SEC. To that end, the SEC is currently considering whether the whistleblower reward program should be structured with an eye toward rewarding those who first tried to internally report violations through internal compliance programs. The SEC has also received significant public commentary relating to the proposed 90-day grace period that would allow whistleblowers to preserve their “place in line” at the SEC so they can first report their claims internally within their companies. Advocates on both sides of the debate want to increase the 90-day period to allow more time for whistleblowers to report violations internally and, in turn, for the corporation to investigate and address any such reports. SEC staff did not confirm whether a grace-period extension will be added to the proposed rules.
Judicial Developments Impacting Whistleblowers
The SEC addressed Johnson v. Siemens Building Technologies, a whistleblower case currently pending before the U.S. Department of Labor Administrative Review Board, concerning Sarbanes-Oxley Act (SOX) section 806 protections as applied to nonpublic subsidiaries’ employees. Although section 929(a) under the Dodd-Frank Act clearly establishes that SOX 806 protections cover any subsidiary or affiliate whose financials are consolidated with a public company, the conduct at issue in Johnson predates the Dodd-Frank Act. The Review Board invited the SEC to submit an amicus brief, following an administrative ruling that subsidiary employees are not protected whistleblowers. The SEC maintains that proper interpretation of SOX 806—even as it existed before the Dodd-Frank Act—should be read to cover employees of consolidated subsidiaries.
Attorney Client Privilege Concerns Raised by the Whistleblower Program
The SEC addressed several hot-button issues raised by the Dodd-Frank Act’s whistleblower program, particularly as they relate to the rules of professional responsibility for attorneys. The SEC’s proposed rules seek to safeguard against the unintended consequence of incentivizing attorneys to violate the rules of professional responsibility by providing information to the SEC that was obtained under the protection of attorney-client privilege and client confidences. The proposed rules provide that providing information obtained through communications subject to the attorney-client privilege will disqualify a would-be whistleblower from the reward program.
Another issue that has generated considerable commentary is proposed Rule 16(b), which provides that SEC staff may communicate directly with a whistleblower who is a director, officer, member, agent or employee of an entity that has counsel, without seeking the consent of the entity’s counsel. The proposed rule is believed by some to conflict with the Model Rule prohibiting communications with a represented party without consent of that person’s lawyer, unless “authorized by law” to do so. The SEC maintains that the Dodd-Frank Act provides the authorization contemplated by the Model Rule and that the SEC cannot adequately protect the anonymity of a whistleblower if it must first seek the consent of corporate counsel prior to speaking to the whistleblower about his or her claim.
Accounting Enforcement Priorities
SEC staff discussed several topics related to accounting enforcement actions—two of which address disclosures. The SEC emphasized that disclosure of reasonably possible losses should include litigation that may result in a significant settlement. The SEC also warned that a company that discloses a material weakness one year but does not disclose the same weakness the following the year will likely face scrutiny by the SEC, which will then investigate what measures the company implemented to correct the weakness in the interim.
The SEC placed greater emphasis on cross-border accounting, noting that many registrants perform almost all of their operations abroad, with an increasing trend of registrant formation through reverse mergers. The SEC cautioned that accounting personnel at these companies will be scrutinized for their knowledge of GAAP and that special attention will be paid to books and records of cross-border companies.
Other areas of focus for 2011 include revenue recognition, loan losses, valuations, impairments and individual accountability.
Foreign Corrupt Practices Act (FCPA)
Cheryl Scarboro, the head of the SEC’s FCPA investigations unit, commented that the SEC had brought a number of significant enforcement actions against 23 entities and seven individuals in 2010. These actions resulted in more than $600 million in disgorgement and fees. The SEC’s focus over the past year has been on foreign issuers, illustrated in cases such as Daimler, ABB and Alcatel. Going forward, the SEC plans to be more proactive in its actions, including targeting third-party agents involved in the facilitation of bribe payments. The SEC will continue its historically close coordination with the Department of Justice and continue to focus on industries and individuals.
Scarboro also noted that the Dodd-Frank Act’s whistleblower program has resulted in increased tips and referrals for FCPA violations, but she was also quick to note that among the SEC’s active inventory, one-third of cases originate from self-reporting. Thus, self-reporting remains the largest source of enforcement actions, followed by staff investigations and whistleblower tips. To encourage continued self-reporting, the SEC is evaluating ways to clarify exactly how credit is afforded to companies who self-disclose and cooperate with the SEC. Scarboro offered familiar examples of how the SEC might factor in cooperation considerations—such as whether a compliance monitor will be imposed, the assessment of a civil penalty or the decision to bring an action—but made no mention of any innovative developments or initiatives in this area.
With the U.K.’s new Bribery Act on the horizon, the SEC also expects to coordinate more closely with Britain’s Serious Fraud Office. The SEC did not address the latest delay in the implementation of the Bribery Act, news that has raised tremendous criticism from anti-bribery groups such as Transparency International. Kurt Gresenz, Senior Advisor in the SEC’s Office of International Affairs, highlighted 2010 achievements to foster cooperation among foreign securities authorities, including an expanded multilateral Memorandum of Understanding (MOU) that now includes 72 countries around the globe and enables regulators to obtain bank records, brokerage records and other evidence from foreign jurisdictions, as well as the April 2010 mutual legal assistance treaty (MLAT) with the European Union, which codified the SEC’s ability to avail itself of tools allowing an expanded reach to conduct witness interviews, obtain certain categories of documents and utilize other cross-border investigatory tools.
Mortgage Securities Fraud
The SEC continues to focus on mortgage securities fraud cases, with a focus on collateralized debt obligation (CDO) participants and broker-dealers. The SEC is also examining banking practices such as “robo-signing,” MERS (Mortgage Electronic Registration Systems) foreclosures, loan servicer foreclosures and bank misrepresentations regarding consumer loans. Citing the role of these loans in the mortgage-backed securities crisis, the SEC cautioned that banks should expect increased scrutiny in this area.
The SEC warned that the traditional framework of insider trading has changed, moving away from enforcement actions that have traditionally been focused on tips passed between neighbors and friends to a heightened scrutiny of communications between finance industry professionals. The SEC’s Market Abuse Unit promised to continue taking an aggressive approach to enforcement and to develop new investigation techniques to combat this type of insider trading. Part of the unit’s strategy will be to have the SEC surface later in undercover investigations so that it has more knowledge and evidence on the trading in question. The SEC pointed to the recent indictment and civil enforcement actions against six expert network services consultants who allegedly passed inside information to hedge funds. According to the SEC, many of the investigations into insider trading through expert network services have stemmed from the Galleon, Cutillo and MedImmune/Stephanos insider trading cases.
Although the SEC made clear its priority to aggressively protect investors from market abuse and fraud, it is impossible to ignore the implications of its plea for a more adequate budget to reach its goals. With what was frankly described as “draconian” cutbacks, the budgetary strain is having a very real impact on the SEC’s mission—as one conference presenter stated, even business travel requiring overnight stays has been all but eliminated. And with funding for the much-touted new whistleblower office delayed, along with four other offices created under the Dodd-Frank Act, the SEC’s budgetary battle with Congress appears likely to continue well into 2011.
While the circuit-breaker system halts trading in a specific stock if its price drops or rises by a certain percentage in five minutes, a limit-up/limit-down model does not freeze trading in the stock altogether; it prevents investors from trading beyond the parameters that currently trigger the circuit breakers.
© 2011 Perkins Coie LLP