Recent Criticism of the SEC: Fair or Unfair?

Jonathan N. Eisenberg is partner in the Government Enforcement practice at K&L Gates LLP. This post is based on a K&L Gates publication by Mr. Eisenberg and Shanda Hastings. The complete publication, including footnotes, is available here.

Over the last few years, the SEC has been criticized for (1) failing to “consistently and aggressively enforce the securities laws and protect investors and the public,” (2) obtaining sanctions that amount to only a slap on the wrist against major financial institutions, (3) settling rather than taking big banks to trial, 4) failing to name individuals in enforcement actions, (5) failing to require that companies admit guilt, (6) granting waivers from the collateral consequences of enforcement actions,6 and, most recently, (7) failing to prevent a prominent hedge-fund manager from getting back into the hedge-fund business.

We evaluate below whether the facts support those criticisms. We find that they support the opposite conclusions.

Lack of an Aggressive Enforcement Program

In its most recent fiscal year (FY 2015), the SEC filed 807 enforcement actions. Of the 807 enforcement actions, which was itself a record, a record 507 were “independent actions” for violations of the federal securities laws. In other words, the SEC brought more enforcement actions in its most recent fiscal year than it brought in any other year in its 82-year history.

The number of independent enforcement actions rose from 341 in FY 2013 (the year that Mary Jo White became Chair) to 413 in FY 2014 to 507 in FY 2015. In FY 2015 alone, it obtained orders for disgorgement and penalties of $4.2 billion, which equaled the largest amount ordered in SEC actions in at least the last decade. By comparison, the Consumer Financial Protection Bureau (“CFPB”), thought by many to be the most aggressive enforcement agency in the federal government and by some to be far too aggressive, reportedly brought 28 cases in 2013, 34 cases in 2014, and 70 cases in 2015.

“Slap-on-the-Wrist” Sanctions

Some have criticized the SEC, the Department of Justice, and other agencies for imposing only slap-on-the-wrist sanctions against banks that allegedly engaged in misconduct related to the financial crisis. But is that the case? The SEC itself has obtained orders for $3.76 billion in penalties, disgorgement, and monetary relief in actions arising from the financial crisis, and brought actions against 198 entities and individuals, including 89 senior officers, growing out of the financial crisis. But that is only a small part of the picture. The Committee on Capital Markets Regulation tracks “total public financial penalties imposed on financial institutions in the United States.” Between 2008 and 2011, those penalties averaged $945 million a year; over the next four years (between 2012 and 2015), they averaged a staggering $38.7 billion a year. Those are “historically unprecedented public financial penalties.” To our knowledge, no other country in the world penalizes its financial institutions to the degree the United States does, and in no other period has the government imposed such enormous penalties on financial institutions.

The notion that financial institutions, their executives, their employees, and their shareholders have not suffered from the financial crisis is contradicted not only by the massive size of penalties over the last few years but also by the declining value of their businesses. We looked at the stock prices of the ten largest investment banks in the United States, and compared their stock prices from January 2007 to the present, a period in which the Dow Jones Industrial Average rose by roughly 50 percent. Seven of the ten firms are still trading at well below half the price at which their stock traded nearly a decade ago. Those are huge losses for shareholders and for employees, many of whom are paid primarily in stock, rely on that stock for their life savings, and lost their jobs and their savings as a result of the financial crisis.

Settling Rather Than Taking Big Banks to Trial

One senator, at her first hearing as a member of the Senate Banking Committee, famously asked the major financial regulators to “tell me a little bit about the last few times you’ve taken the biggest financial institutions on Wall Street all the way to a trial.” None of the regulators could give an example. But the question might equally have been asked of the banks: in a period of “historically unprecedented public financial penalties,” why do the banks pay such large settlements without ever requiring the government to prove its case? The reality is that banks do not believe that they should litigate with their regulators, and the reason that regulators do not take banks to trial is that they can extract at least as onerous penalties in settlements as they could ever hope to achieve through litigation. It’s not a matter of weakness that causes regulators to forego trials; it’s a matter of negotiating leverage and common sense. That is not limited to the SEC. The CFPB, the Federal Reserve, and the Office of the Comptroller of the Currency, all of which bring settled enforcement actions against large banks, have uniformly found that they can achieve their enforcement objectives without going to trial with the banks that they regulate.

Failing to Name Individuals

The notion that the SEC ignores individuals is refuted by the data. A 2013 study found that the SEC names individuals in 93 percent of its cases and 96 percent of its fraud cases. Nor are those cases limited to junior employees. The same study found that the Commission named CEOs in 56 percent of its cases, CFOs in 58 percent of cases, and lower level executives in 71 percent of its cases. Among cases naming a top executive, “93 percent of cases result in such an executive receiving a severe penalty.” We are not aware of any agency that names individuals more frequently.

In connection with the financial crisis, the SEC brought actions against 89 CEOs, CFOs, and other senior corporate officers. To be sure, the SEC and other agencies sometimes bring cases against large banks without naming senior executives as defendants, but that is undoubtedly because the investigations failed to show that senior executives were culpable participants in the underlying conduct. That is not surprising because even misconduct that can give rise to substantial corporate liability under the doctrine of respondeat superior (the doctrine that a company is liable for the conduct of any employee, regardless of that employee’s seniority) often will not have come to the attention of senior executives of large institutions.

Failing to Require that Companies Admit Guilt

The SEC has obtained admissions of wrongdoing in more than 30 enforcement actions. To be sure, that is a small percentage of SEC enforcement actions. But outside the criminal context, the norm in both government and private litigation has been that settlements are made without admitting or denying guilt. That has been true across agencies and since time immemorial. The SEC is unique in that it sometimes requires admissions; almost all other civil enforcement agencies never seek admissions in settlements.

Granting Waivers of Collateral Consequences

Absent a waiver, which the federal securities laws authorize the Commission to grant, enforcement actions may result in automatic disqualifications from conducting business unrelated to the conduct giving rise to an enforcement action. For example, absent a waiver by the Commission, an investment adviser to mutual funds may no longer serve in that role if another entity, under common control, has been enjoined from acting in certain capacities. Similarly, absent a waiver by the Commission, an issuer that has been the subject of certain civil enforcement proceedings is ineligible to be treated as a “Well Known Seasoned Issuer,” which can result in substantial delays in communicating with shareholders and accessing the capital markets.

SEC Chair White has given a speech articulating a straightforward view on the waiver issue: the remedies for an enforcement action are the remedies set forth in the order resolving that action; whether an automatic disqualification should follow depends on whether “based on the nature and extent of the misconduct, a financial institution should not be permitted to conduct a particular line of business or avail itself of certain provisions of the securities laws….” The Commission considers “the proportionality of the impact of the disqualification on the institution in light of the nature of the misconduct, as well as any negative effects it could have for the markets, the institution’s clients, and the investing public.”

How does that compare to other agencies? To our knowledge, the general paradigm for non-securities enforcement agencies is to avoid the disqualification issue altogether. Outside the securities laws, their enforcement orders generally do not trigger automatic disqualifications and thus the waiver issue does not even arise.

Failing to Prevent a Sanctioned Hedge-Fund Manager from Getting Back into the Hedge-Fund Business

One senator recently criticized the Commission for permitting a prominent hedge-fund manager to get back into the hedge-fund business in a non-supervisory capacity, and stated, “It is the latest example of an SEC action that fails to appropriately punish guilty parties, deter future wrongdoing, and protect investors.” But the SEC settlement at issue reflected litigation reversals in the courts arising from the confused state of the law on insider trading, arguably due to Congress’s own failure to define the elements of an insider trading violation. The Commission brought the action in 2013, and charged the manager with failing to supervise two employees, who were subsequently convicted of criminal insider trading. In 2014, however, the United States Court of Appeals for the Second Circuit reversed the conviction of one of those traders on the ground that the government was required to show, but failed to show, that the person who traded knew that the person who “tipped” the information had done so for the tipper’s personal benefit, a benefit that the court held must be “consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature.” The Supreme Court rejected the government’s petition for certiorari, despite pleas by the government that the Second Circuit standard would make it impossible to prosecute large categories of insider trading cases. The second of the two traders is seeking to have his conviction reversed on similar grounds, and the Second Circuit is considering that request.

In short, litigation substantially weakened the SEC’s position by the time it settled with the hedge-fund manager in January of this year. Far from reflecting a failure to “punish guilty parties,” the settlement reflected that years of litigation had weakened the SEC’s position and that there was a substantial danger that it would lose the case completely. Had the SEC settled earlier rather than awaited the outcome of litigation, it would likely have been able to negotiate a tougher resolution.

* * *

By any objective measure, the SEC’s enforcement program is aggressive, and the government’s crackdown on banks is unprecedented in its severity. Public perceptions of the SEC have improved in recent years, but are still well below the pre-financial crisis levels. It’s unfortunate if those perceptions are shaped not by the facts but by criticisms inconsistent with the facts.

The complete publication, including footnotes, is available here.

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