In June 2005, William H. Donaldson was forced to resign
as Chairman of the Securities and Exchange Commission
(SEC). The reason? As the New York Times put it:
"criticism that his enforcement was too heavy-handed".
President Bush chose California Rep. Christopher Cox, a
Republican, to replace him.
Gary Langan Goodenow is an attorney licensed to
practice in the State of Florida and the District of
Columbia. The Webmaster of
www.RealityAtTheSEC.com, he worked at the Miami
office of the SEC for about six years, in the Division of
Enforcement.
His experience is varied. As a staff attorney, he
investigated and prosecuted cases enforcing the federal
securities laws. As a branch chief, he supervised the work
of several staff attorneys. As a Senior Trial Counsel, he
was responsible for litigating about thirty enforcement
cases at any one time in federal court. As Senior Counsel,
he made the final recommendations on which cases the
office would investigate and prosecute, or decline.
He describes an experience he had after he left the SEC.
"I represented an Internet financial writer with a Web
site that touted stocks, Mr. Ted Melcher of SGA Whisper
Stocks. The SEC sued Ted because as he was singing
the praises of certain stocks in his articles, he was selling
them into a rising market. He got his shares from the
issuers in exchange for doing the promotional
touting. Unfortunately for him, the SEC and the
Department of Justice made an example of his case, and
he went to jail".
Q. The SEC is often accused of lax and intermittent
enforcement of the law. Is the problem with the
enforcement division - or with the law? Can you describe
a typical SEC investigation from start to finish?
A. The problem lies with both.
At the SEC, the best argument in support of a proposed
course of action is "that's what we did last time". That will
inevitably please the staff attorney's superiors.
SEC rules and regulations remind me of an old farmhouse
that has been altered and adapted, sometimes for
convenience, other times for necessity. But it has never
been just plain pulled down and rebuilt despite incredible
changes around it. To the uninitiated, the house is
rambling with hidden passages, dark corners, low ceilings,
folklore and horror stories, and accumulations of tons of
antique rubbish that sometimes no one - not even some
SEC Commissioners - can wade through.
Wandering from room to room in this farmhouse are the
SEC staff. Regretfully, I found that many are ignorant or
indifferent to their mission, or scornful of investors'
plight, too addicted to their petty specializations in their
detailed job descriptions, and way too prone to follow
only the well-trodden path.
They are stunned by the rapidity, multiplicity, immensity
and intelligence behind the scams. Their tools of research,
investigation and prosecution are confusingly changed
periodically when Congress passes some new "reform"
legislation, or a new Chairman or new Enforcement
Director issues some memo edict on a "new approach".
Staff attorneys typically bring investors only bad news
and are numbed by the latters' emotional reactions, in a
kind of "shell shock". The SEC lost one quarter of its staff
in the last two years. The turnover of its 1200 attorneys, at
14%, is nearly double the government's average.
One SEC official was quoted as saying "We are losing our
future - the people who would have had the experience to
move into the senior ranks". Those that stay behind and
rise in the ranks are often the least inspired. At the SEC
enforcement division, one is often confronted with the
"evil of banality".
The SEC is empowered by the Securities Act of 1933
and the Securities Exchange Act of 1934 to seek
injunctive relief where it appears that a person is engaged
or about to engage in violations of the federal securities
laws. This is a civil remedy, not a criminal law
sanction. Under well-settled case law, the purpose of
injunctive relief is deterrence, rather than punishment, of
those who commit violations. Investors do not know that,
and are uniformly shocked when told.
The "likelihood requirement" means that, once the
Commission demonstrates a violation, for injunctive relief
it needs only show that there is some reasonable
likelihood of future violations. "Positive proof' of
likelihood, as one court demanded, is hard to provide. At
the other extreme, I had one former Commissioner tell me
that, as he understood the law, if the person is alive and
breathing, the Commission enforcement staff can show
likelihood of future violations.
The broad powers of the federal courts are used in
actions brought by the Commission to prevent securities
violators from enjoying the fruits of their misconduct. But
because this is a civil and not a criminal remedy, the SEC
has a unique rule where defendants can consent to an
injunction without "admitting or denying the allegations
of the complaint". This leads to what are called "waivers",
and I submit that "waivers" are the fundamental flaw in
U.S. securities laws enforcement.
In a nutshell, here is the problem. A "fraudster"
commits a fraud. The Commission sues for an injunction.
The fraudster consents to the injunction as per above. The
Court then orders the fraudster to "disgorge" his "ill gotten
gains" from the scam, usually within 30 days and with
interest.
In most cases, the fraudster doesn't pay it all and the
Commission moves to hold him in civil contempt for
disobeying the Court's order. The fraudster claims to the
Court that it is impossible for him to comply because the
money is gone and he is "without the financial means to
pay". The Commission then issues a "waiver" and that's
the way many cases end. Thus both sides can put the case
behind them. The fraudster agrees to the re-opening of the
case if he turns out to have lied.
This procedure is problematic. The Commission
typically alleges that these fraudsters have lied through
their teeth in securities sales - but is forced to accept their
word in an affidavit swearing that they have no money to
pay the disgorgement. So the waivers are based on an
assumption of credibility that has no basis in experience
and possibly none in fact.
Moreover, the Division of Enforcement has no
mechanism in place to check if the fraudster has, indeed,
lied. After the waiver, the files of the case get stored. The
case is closed. I don't know if there's even a central place
where the records of waivers are kept.
In the six years I was at the Commission, I never heard
of a case involving a breach of waiver affidavit. I doubt if
one has ever been brought by the Commission -
anywhere. UPI ought to do a Freedom Of Information Act
Request on that.
Something similar happens with the Commission's
much vaunted ability to levy civil penalties. The statute
requires that a court trial be held to determine the
egregiousness of the fraud. Based on its findings, the court
can levy the fines. But, according to some earlier non-
SEC case law, a fraudster can ask for a jury trial regarding
the amount of the civil penalties because he or she lack
the means to pay them. U.S. district courts being as busy
as they are, there's no way the court is going to hold a jury
trial.
Instead, the fraudster consents to a court order "noting
the appropriateness of civil penalties for the case, but
declining to set them based on a demonstrated inability to
pay". Again, if the fraudster lied, the Commission can ask
the Court to revisit the issue.
Q. Internet fraud, corporate malfeasance, derivatives, off-
shore special purpose entities, multi-level marketing,
scams, money laundering - is the SEC up to it? Isn't its
staff overwhelmed and under-qualified?
A. The staff is overwhelmed. The longest serving are
often the least qualified because the talented usually leave.
We've already got the criminal statutes on the books for
criminal prosecution of securities fraud at the federal
level. Congress should pass a law deputizing staff
attorneys of the Commission Division of Enforcement,
with at least one-year experience and high performance
ratings, as Special Assistant United States Attorneys for
the prosecution of securities fraud. In other words, make
them part of the Department of Justice to make criminal,
not just civil cases, against the fraudsters.
The US Department of Justice does not have the person
power to pursue enough criminal securities cases in the
Internet Age. Commission attorneys have the expertise,
but not the legal right, to bring criminal prosecution. The
afore-described waiver system only makes the fraudsters
more confident that the potential gain from fraud
outweighs the risk.
I'd keep the civil remedies. In an ongoing fraud, with no
time to make out a criminal case, the Commission staff
can seek a Temporary Restraining Order and an asset
freeze. This more closely resembles the original intent of
Congress in the 1930s. But after the dust settles, the
investing public deserves to demand criminal
accountability for the fraud, not just waivers.
Q. Is the SEC - or at least its current head - in hock to
special interests, e.g., the accounting industry?
A. "In hock to special interests" is too explicit a statement
about US practice. It makes a good slogan for a Marxist
law school professor, but reality is far subtler.
By unwritten bipartisan agreement, the Chairman of the
SEC is always a political figure. Two of the five SEC
Commissioners are always Democrats, two Republicans,
and the Chairman belongs to the political party of the
President. I am curious to see if this same agreement will
apply to the boards established under the Sarbannes-Oxley
Act.
Thus, both parties typically choose a candidate for
Chairman of impeccable partisan credentials and
consistent adherence to the "party line". The less
connected, the less partisan, and academicians serve as
Commissioners, not Chairmen.
The Chairman's tenure normally overlaps with a specific
President's term in office, even when, as with President
Bush the elder following President Reagan, the same party
remains in power. SEC jobs lend themselves to lucrative
post-Commission employment. This explains the dearth of
"loyal opposition". Alumni pride themselves on their
connections following their departure.
The Chairman is no more and no less "in hock" than any
leading member of a US political party. Still, I faulted
Chairman Pitt, and became the first former member of
SEC management to call for his resignation, in an Op/Ed
item in the Miami Herald. In my view, he was
impermissibly indulgent of his former law clients at the
expense of SEC enforcement.
Q. What more could stock exchanges do to help the SEC?
A. At the risk of being flippant, enforce their own
rules. The major enforcement action against the
NASDAQ brokers a few years ago, for instance, was
toothless. Presently, Merrill Lynch is being scrutinized by
the State of New York, but there is not a word from the
NYSE.
Q. Do you regard the recent changes to the law -
especially the Sarbanes-Oxley Act - as toothless or an
important enhancement to the arsenal of law enforcement
agencies? Do you think that the SEC should have any
input in professional self-regulating and regulatory bodies,
such as the recently established accountants board?
A. It remains to be seen. The Act establishes a Public
Accounting Oversight Board ("the Board"). It reflects one
major aspect of SEC enforcement practice: unlike in many
countries, the SEC does not recognize an
accountant/client privilege, though it does recognize an
attorney/client privilege.
Regrettably, in my experience, attorneys organize at least
as much securities fraud as accountants. Yet in the US,
one would never see an "attorneys oversight board". For
one thing, Congress has more attorneys than accountants.
Section 3 of the Act, titled "Commission Rules and
Enforcement", treats a violation of the Rules of the
Public Company Accounting Oversight Board as a
violation of the '34 Act, giving rise to the same
penalties. It is unclear if this means waiver after waiver,
as in present SEC enforcement. Even if it does, the Rules
may still be more effective because US state regulators
can forfeit an accountant's license based on a waived
injunction.
The Act's provision, in Section 101, for the membership
of said Board has yet to be fleshed out. Appointed to five-
year terms, two of the members must be - or have been -
certified public accountants, and the remaining three must
not be and cannot have been CPAs. Lawyers are the
likeliest to be appointed to these other seats. The
Chairmanship may be held by one of the CPA members,
provided that he or she has not been engaged as a
practicing CPA for five years, meaning, ab initio, that he
or she will be behind the practice curb at a time when
change is rapid.
No Board member may, during their service on the Board,
"share in any of the profits of, or receive payments from, a
public accounting firm," other than "fixed continuing
payments," such as retirement payments. This mirrors
SEC practice with the securities industry, but does little to
tackle "the revolving door".
The Board members are appointed by the SEC, "after
consultation with" the Federal Reserve Board Chairman
and the Treasury Secretary. Given the term lengths, it is
safe to predict that every new presidential administration
will bring with it a new Board.
The major powers granted to the Board will effectively
change the accounting profession in the USA, at least with
regards to public companies, from a self-regulatory body
licensed by the states, into a national regulator.
Under Act Section 103, the Board shall: (1) register public
accounting firms; (2) establish "auditing, quality control,
ethics, independence, and other standards relating to the
preparation of audit reports for issuers;" (3) inspect
accounting firms; and (4) investigate and discipline firms
to enforce compliance with the Act, the Rules,
professional standards and the federal securities
laws. This is a sea change in the US.
As to professional standards, the Board must "cooperate
on an on-going basis" with certain accountants advisory
groups. Yet, US federal government Boards do not "co-
operate" - they dictate. The Board can "to the extent that it
determines appropriate" adopt proposals by such groups.
More importantly, it has authority to reject any standards
proffered by said groups. This will then be reviewed by
the SEC, because the Board must report on its standards to
the Commission every year. The SEC may - by rule -
require the Board to cover additional ground. The Board,
and the SEC through the Board, now run the US
accounting profession.
The Board is also augments the US effort to establish
hegemony over the global practice of accounting. Act
Section 106, Foreign Public Accounting Firms, subjects
foreigners who audit U.S. companies - including foreign
firms that perform audit work that is used by the primary
auditor on a foreign subsidiary of a U.S. company - to
registration with the Board.
I am amazed that the EU was silent on this inroad to their
sovereignty. This may prove more problematic in US
operations in China. I do not think the US can force its
accounting standards on China without negatively
affecting our trade there.
Under Act Section 108, the SEC now decides what are
"generally" accepted accounting principles. Registered
public accounting firms are barred from providing certain
non-audit services to an issuer they audit. Thus, the split,
first proposed by the head of Arthur Anderson in 1974, is
now the law.
Act Section 203, Audit Partner Rotation, is a gift to the
accounting profession. The lead audit or coordinating
partner and the reviewing partner must rotate every 5
years. That means that by law, the work will be spread
around. Note that the law says "partner", not
"partnership". Thus, we are likely to continue to see
institutional clients serviced by "juntas" at accounting
firms, not by individuals. This will likely end forever the
days when a single person controlled major amounts of
business at an accounting firm. US law firms would never
countenance such a change, as the competition for major
clients is intense.
Act Section 209, Consideration by Appropriate State
Regulatory Authorities, "throws a bone" to the states. It
requires state regulators to make an independent
determination whether Board standards apply to small and
mid-size non-registered accounting firms. No one can
seriously doubt the outcome of these determinations. But
we now pretend that we still have real state regulation of
the accounting profession, just as we pretend that we have
state regulation of the securities markets through "blue
sky laws". The reality is that the states will be confined
hence to the initial admission of persons to the accounting
profession. Like the "blue sky laws", it will be a revenue
source, but the states will be completely junior to the
Board and the SEC.
Act Section 302, Corporate Responsibility For Financial
Reports, mandates that the CEO and CFO of each issuer
shall certify the "appropriateness of the financial
statements and disclosures contained in the periodic
report, and that those financial statements and disclosures
fairly present, in all material respects, the operations and
financial condition of the issuer". This may prove
problematic with global companies. We have already seen
resistance by Daimler-Benz of Germany.
Act Section 305: Officer And Director Bars And
Penalties; Equitable Relief, will be used by the SEC to
counterattack arguments arising out of the Central Bank
case. As I maintained in the American Journal of Trial
Advocacy, the real significance of the Supreme Court
decision in Central Bank was that the remedial sanctions
of the federal securities laws should be narrowly
construed.
Well, now the SEC has a Congressional mandate. Federal
courts are authorized to "grant any equitable relief that
may be appropriate or necessary for the benefit of
investors". That is an incredibly broad delegation of
rights, and is an end run around Central Bank. I was
surprised that this received no publicity.
Lastly, Act Section 402, Prohibition on Personal Loans
to Executives, shows how low this generation of US
leadership has sunk. President Bush has signed a law that
makes illegal the type of loans from which he and his
extended family have previously benefited.
Tacitly, the Act admits that some practices of Enron were
not illegal inter se. Act Section 401, Study and Report on
Special Purpose Entities, provides that the SEC should
study off-balance sheet disclosures to determine their
extent and whether they are reported in a sufficiently
transparent fashion. The answer will almost certainly be
no, and the Board will change GAAP accordingly.
Q. Does the SEC collaborate with other financial
regulators and law enforcement agencies internationally?
Does it share information with other US law enforcement
agencies? Is there interagency rivalry and does it hamper
investigations? Can you give us an example?
A. The SEC and other regulators - as well as two House
subcommittees - have only very recently begun
considering information sharing between financial
regulators.
This comes too late for the victims of Martin Frankel,
who, having been barred for life from the securities
industry by the SEC and NASD in 1992, simply moved
over to the insurance industry to perpetrate a scam where
investors have lost an estimated $200 million dollars.
Had the state insurance regulators known this person's
background, he would have been unable to set up multiple
insurance companies. Failure to share information is a
genuine problem, but "turf" considerations generally
trump any joint efforts.