Remaking The SEC For Tomorrow

Many are raising questions about the future of the SEC – will it survive the current market turmoil and the restructuring of the financial regulatory landscape? Some proposals have called for the SEC to be merged with the CFTC or other agencies. Media stories have circulated claiming that the Commission will be stripped of its investor protection role. Many wonder if an agency born so many years ago in the aftermath of a huge market crisis of another era is so far out of date that it has passed its usefulness.

Despite what may be some surface appeal, on examination these ideas make little sense. At the same time, they ignore the long history of this agency and its accomplishments, apparently lost in the unfavorable headline of the moment. To be sure, the agency and its statutes were crafted in a different time and during a different financial crisis. Yet, over its long history, the SEC has been a protector of the markets and an effective advocate for the investor, typically with very limited resources. As markets and the environment changed, the Commissioners and the staff have evolved the regulations and practices, tailoring and retooling them to new conditions and challenges for the protection of investors and the markets.

There are many examples. The creation of the integrated disclosure system is one. This system improved the information available to investors by essentially giving them a flow of pictures or snapshots over time of the company in which they have invested. This resulted from the hard work of the Commission and the Division of Corporation Finance, bringing together two statutes through a series of regulations despite the differing focus of each statute: The Securities Act of 1933, centered on securities offerings and the Exchange Act of 1934, focused on exchanges and broker dealer regulation. This system continues to aid investors today.

The 1970’s volunteer program created by the Divisions of Enforcement and Corporation Finance helped usher in a new era of corporate accountability and ethics that is still critical today. Born of the Watergate scandal with its slush funds, the program helped bring accountability to the corporate marketplace. Hundreds of corporations participated in the program, rooting out bribery and the falsification of corporate books that was necessary to cover up the corrupt payments. The result was the passage of the Foreign Corrupt Practices Act – a statute which has been emulated by many countries around the world and which is currently a key DOJ and SEC enforcement priority.

The insider trading program, which helped bring a new era of accountability to Wall Street in the 1980s, is yet another example. Cases against the Wall Street titans of the 1980s helped clean up the markets while reassuring investors that they could get a fair shake because the Cop of Wall Street was on the beat. Insider trading enforcement, which was revamped last year with a new market monitoring arrangement, continues to be a key enforcement priority today.

In each of these examples, the agency and its staff tailored the depression era statutes many claim are now out of date to solve current problems. To be sure, along the way SEC has made errors and lately it seems to be making more. At the moment, it seems to be jumping from one scandal to another. In part, these stem from the serious neglect the agency has suffered in recent years. Its budgets have been essentially flat for years. While doing more with less is a popular slogan, in the end having less in terms of funding and resources while faced with an ever changing and expanding marketplace will eventually mean that there is less protection.

Deregulation also has not been kind to the SEC. For the Commission, deregulation translates to gaps in its regulatory statutes such as those involving derivatives, investment bank holding companies and hedge funds. Other problems have emerged from a simple lack of leadership, which in recent times seemed to have left the agency rudderless.

These and other difficulties have accumulated over the years to create what now appears to be an agency mired in one scandal after another. While its new Chairman is working hard to try and establish a new tone at the top and roll out new regulations, she must at times feel like the kid trying to plug a dam by sticking her fingers in the holes that appear – at some point there are no fingers left but holes keep appearing.

What the SEC needs is not to be merged into the CFTC – a shop-worn idea that has kicked around for years and failed because it is a bad idea. Nor should it be stripped of its role in favor of creating some new agency – starting over always seems appealing, but throwing out all the good programs because of a few difficulties makes little sense.

What the agency does need however, is a fundamental re-evaluation of how it does business. A piecemeal approach will not do. Only a comprehensive review of how the SEC does business will translate into the forward-looking regulator that is needed today and tomorrow. To facilitate this process the Commission should consider creating an advisory panel to give it independent advice and expertise in evaluating existing processes and procedures and to help design those which will be needed to move the SEC forward in the years to come. By undertaking this process now, the Commission takes the steps now which will ensure that it is effectively carrying out its mission in the future.

This Week In Securities Litigation (May, 22, 2009)

A new scandal added to the woes of the SEC this week with the release of a redacted version of an Inspector General report which sparked a criminal investigation into whether two enforcement attorneys engaged in insider trading. Subsequently, press reports suggested that the SEC may be stripped of much of its authority under forthcoming administration proposals. A challenge to the constitutionality of the PCAOB got new life this week when the Supreme Court agreed to hear an appeal from the DC Circuit which had rejected the claim.

SEC enforcement focused on option backdating, financial fraud and more investment fund fraud cases. Two more individuals pleaded guilty to criminal violations of the FCPA, while a former E&Y partner was convicted on insider trading charges.

The SEC

A new report, discussed here, from the SEC’s Inspector General, released in redacted form by Senator Charles Grassley, states that over the last two years two attorneys in the Division of Enforcement have engaged in suspicious trading. The matter has been referred to the U.S. Attorney’s Office for the District of Columbia who, along with the FBI, is conducting a criminal investigation. The IG’s report also concludes that the division has virtually no insider trading controls.

The Supreme Court

PCAOB: The Court agreed to hear a challenge to the constitutionality of the Public Company Accounting Oversight Board created as part of the Sarbanes Oxley Act. Free Enterprise Fund and Beckstead and Watts, LLP v. Public Company Accounting Oversight Board and U.S.A., Case No. 08-861 (S. Ct. Filed Jan. 8, 2009). The case presents two constitutional questions as discussed here. First, whether the SOX sections creating the Board violate the Constitution’s separation of powers. Second, whether those sections are contrary to the Appointments Clause. The district court granted summary judgment in favor of defendants. The court of appeals affirmed in a 2-1 decision and later declined to rehear the case or consider it en banc in a 5-4 ruling.

If Petitioners prevail, it could be the end of the PCAOB and the comprehensive regulation of public company auditors Congress crafted in the wake of the corporate scandals which dominated the headlines early in this decade. The case will be heard next fall.

Pleading standards: The Court reaffirmed and clarified its conclusion that Federal Civil Rule 8(a) requires a complaint to set forth sufficient facts to establish that plaintiff has a plausible claim. The “plausibility” standard was previously announced by the Court in Bell Atlantic Corp. v. Twombly, 550 U.S. 544 (2007). In reaffirming Twombly, the court rejected a decision by the Second Circuit which concluded that only a “flexible plausibility standard” was required. Under that standard, “a pleader could amplify a claim with some factual allegations in those contexts where such amplification is needed to render the claim plausible.” The court also noted that under Rule 9(b), which requires that fraud be pleaded with “particularity” but state of mind “generally,” there must still be sufficient facts to make a plausible claim regarding state of mind. Ashcroft v. Iqbal, Case No. 07-1015 (S. Ct. Decided May 18, 2009).

SEC enforcement

Option backdating: SEC v. Monster Worldwide, Inc., Civil Action No. 09 CV 4641 (S.D.N.Y. May 18, 2009) is the latest in a series of actions regarding option backdating at Monster Worldwide, Inc. discussed here. As in the earlier cases, the complaint alleges that options were backdated at the company resulting in a restatement of the historical financial statements for the periods from 1997 through 2005. The cumulative pre-tax amount of the restatement was $339.5 million to record additional non-cash charges for option related compensation expenses.

The company resolved the case by consenting to the entry of a permanent injunction prohibiting future violations of the antifraud, reporting and proxy provisions of the federal securities laws. The company also agreed to pay a civil penalty of $2.5 million. The SEC took into consideration the cooperation of the company.

Option backdating: SEC v. Ray, Civil Action No. CV 09-3430 (C.D. Cal. Filed May 15, 2009) is a settled option backdating case against Gary Ray, the former vice president of human resources at KB Home, Inc. The complaint is based on the option backdating scheme at the company which is discussed here. Mr. Ray received backdated options for 380,000 shares and made more than $480,000 from exercising those options. He settled the case by consenting to the entry of a permanent injunction prohibiting future violations of the antifraud, books and records and proxy provisions of the securities laws. In addition, he agreed to pay over $540,000 in disgorgement and interest and a civil penalty of $50,000. Mr. Ray also agreed to be barred from serving as an officer or director of a public company for five years.

Financial fraud: SEC v. Apogee Technology, Inc., Civil Action No. 09 cv 10286 (D. Mass. May 19, 2009) is a settled financial fraud case against the company, its former COO, David Meyers and controller, Annette Jaynes as discussed here. The complaint centers on a scheme to inflate the revenues of the company in 2003 and 2004 by improperly recognizing income in violation of GAAP using a variety of techniques. The improper techniques used included improperly recognizing revenue: a) on transactions with a right of return; b) where the shipment did not go out until the next quarter; and c) where the terms of the agreement were not certain. As a result, quarterly revenues were overstated by as much as 45% in one quarter.

To resolve the case each defendant consented to the entry of a permanent injunction prohibiting future violations of the antifraud and books and records provisions. Mr. Myers also agreed to pay disgorgement of $9,356 plus prejudgment interest representing his gains on the sale of company stock during the period. Payment however, was waived based on his financial condition. Mr. Myers also consented to be barred from serving as an officer or director of a public company for five years. Ms. Jaynes agreed to the entry of an order requiring the payment of a civil penalty of $30,000.

Financial fraud: SEC v. WellCare Health Plans, Inc., Civil Action No. 8:09 cv 00910 (M.D. Fla. Filed May 18, 2009), discussed here. Here, the complaint alleges that over a four-year period from 2003 through 2007 the company engaged in a fraudulent scheme which inflated its reported profits by $40 million by retaining funds it was contractually required to reimburse to agencies of the state of Florida. The allegations in the complaint centered on two Florida state programs under which the company received funds or premiums that were to be expended on certain health care programs. By failing to spend the funds or return them as required, the company overstated its income. In 2007, the company restated its financial statements for FY 2004 through 2006.

To resolve the case, the company consented to the entry of a permanent injunction prohibiting future violations of the antifraud and reporting provisions and the payment of a $10 million civil penalty by the company. The Commission acknowledged the cooperation of the company

Investment fund cases: The SEC continued to file investment fund cases this week:

• SEC v. Wealth Management LLC, Civil Action No. 1:09-cv-506 (E.D. Wis. Filed May 21, 2009) is an action against James Putman, the founder and majority owner of investment adviser Wealth Management, its CEO, the Chief Investment Officer and related entities. Wealth Management does financial planning for families and individuals. It has approximately $102 million in client assets invested in various pools. Over a two year period, Mr. Putman and the CEO took $1.24 million in undisclosed payments from certain investments made by the pools. In addition, the complaint claims that the defendants made misrepresentations regarding the stability and safety of the two largest pools. The complaint is based on claimed violations of the antifraud provisions and a breach of fiduciary duty. The Commission obtained an emergency freeze order. The case is in litigation.

• In SEC v. Sun Group, Civil Action No. SACV 09-399 (C.D. Cal. Amended complaint filed May 19, 2009), the Commission amended its complaint, adding as defendants Bich Quyen Nguyen, Johnny Johnson and two entities they control — Sun Group and Sun Investment Savings and Loan. The initial defendants are Empire Capital Asset Management and Sun Empire along with Delilah Proctor and Shauntel McCoy. According to the amended complaint, the new defendants raised more than $9 million from investors, promising guaranteed returns on high-yield instruments. The marketing pitch focused on individuals who were unemployed or recently bankrupt, promising them returns of over 19% with guarantees. Sun Investment Savings and Loan is not in fact a savings and loan, according to the complaint. The SEC obtained a freeze order as to the new defendants. Previously the Commission had obtained a preliminary injunction. The case is in litigation.

• SEC v. Driver, Case No. CV 09-3410 (C.D. Cal. Filed May 14, 2009) alleges a Ponzi scheme conducted by defendant Gordon Driver and his company, Axcess Automation, LLC. According to the SEC, Mr. Driver rose over $14.1 million from investors by promising them weekly returns of 1 to 5% resulting from trading in futures using a proprietary software program he developed. In fact only a small fraction of the money was used to trade futures. The bulk of the investor cash was used to pay other investors, while over $1 million was spent on Mr. Driver’s personal expenses. The SEC obtained a temporary freeze order. The CFTC has also filed an action. The case is in litigation.

FCPA

Juan Diaz and Antonio Perez each pleaded guilty to a one count information based on FCPA violations in connection with securing services from the Telecommunications D’Haiti as discussed here. Mr. Diaz admitted paying over $1 million in bribes to Haitian officials on behalf of three Florida based telecommunications to secure business advantages. Mr. Perez, formerly the controller of a company which paid over $674,000 in bribes to Haitian officials, admitted facilitating the payment of over $36,000 in bribes. The payments were channeled through a company owned by Mr. Diaz. Both men are awaiting sentencing. U.S. v. Diaz, Case No. 09-20345 (S.D. Fla. Filed April 22, 2009).

Criminal cases

Insider trading: In U.S. v. Gansman, Case No. 108-cr-00471 (S.D.N.Y. Filed May 27, 2008), former E&Y partner James Gansman was found guilty by a jury following a two week trial on six counts of securities fraud related to insider trading. Mr. Gansman, an attorney in charge of the human resource consulting services E&Y provided merger clients, regularly furnished inside information to Donna Murdoch. Ms. Murdoch in tern traded based on the information, yielding about $300,000 in profits. Ms. Murdoch previously pled guilty.

Financial fraud: U.S. v. Sulfridge, Case No. 3:09-cr-00119 (N.D. Tex. Filed May 6, 2009), the former vice president of corporate finance for Image Entry, Inc., Michael Sulfridge, pled guilty to a two count information charging conspiracy to commit wire and securities fraud and tax evasion. The charges stem from the acquisition of Entry by Sourcecorp, Inc. Under the terms of the agreement $33 million was paid at closing. An additional $11 would be paid if Entry hit certain earnings targets over three years. An additional amount of up to $25 million would be paid keyed to the amount by which Image exceeded the specified earnings targets. Mr. Sulfridge fraudulently increased the earnings of Image to obtain the additional payments and then failed to report on his tax returns about $592,393 in bonus compensation he received based on the inflated revenues. Sentencing has not been scheduled.