SEC ENFORCEMENT TRENDS 2011: MARKET REFORM
This is the second in a series of articles that will be published periodically analyzing the direction of SEC enforcement.
In recent testimony before Congress, SEC Chairman Mary Schapiro listed eight different areas in which rules had recently been adopted. They cover a variety of topics including custody and control of assets for investment advisers, proxy enhancements, short selling and failure to deliver, money market funds, central clearing for credit default swaps, credit rating agencies, pay-to-play and municipal securities disclosures. Other rules have been proposed relating topics which include asset backed securities, proxy access, large trader reporting, flash orders, sponsored access, dark pools, target date funds and an audit trail system for trading orders according to the Chairman’s testimony.
Under Dodd-Frank the SEC is required to write even more rules. That Act contains 95 provisions under which the SEC will issue rules. Those areas include swaps, investment advisers, securities lending, arbitration, credit rating agencies, securitization and corporate governance. The Act also requires the SEC to prepare seventeen reports presumably as the possible predicate for even more rules.
While many of these rules do not directly impact the enforcement division and its program, other provisions of Dodd-Frank add to its authority. Those include provisions: 1) an enhancement of the antifraud provisions under Exchange Act Sections 9, 10(1), and 15; 2) an expansion of the extraterritorial jurisdiction of the antifraud provisions; 3) extending aiding and abetting authority for the Commission under the Securities Act, the Investment Company Act and the Investment Advisers Act; 4) clarifying the SEC’s authority over formerly associated persons of regulated entities; 5) imposing joint and several liability on control persons in SEC actions; 6) authorizing nationwide service of subpoenas in SEC district court enforcement actions; 7) authorizing the SEC to impose collateral bars; and 8 ) expanding the Commission’s authority to impose penalties to all cease and desist proceedings.
While these provisions expand the authority of the enforcement division, there actual impact on its program is at present unclear. Provisions which many expect to have a far reaching impact on that program are the new whistleblower sections of the Act. Those provisions permit the Commission to pay potentially large bounties for tips which lead to successful enforcement actions. The provisions could spark a wave of tips and leads from corporate insiders on topics which range from FCPA violations to financial fraud.
While rules for the whistleblower program have been issued for comment, the vitality of the sections is in doubt. The program was to be administered by a new Associate Director of Enforcement. At present funding for that program, like others under Dodd-Frank, is in doubt. If insufficient funding is provided it could significantly impinge on its development.
Another important question is the impact of what may be a preference for rule writing by the Commission. To be sure many of the rules proposed and issued by the Commission will be beneficial. At the same time new rules are not always necessary. In some instances enforcement of those on the books is more than sufficient. The recent “window dressing” rules are an example. These arose out of reports from the Lehman Brothers bankruptcy proceedings that short term borrowings called Repo 105 were repeatedly used by the now collapsed investment bank at period end for reporting purposes. The transactions deceived investors by making it appear that the firm was far less leverage than was true. The Commission conducted a survey on the practice of “window dressing” last spring. Later in the year new disclosure rules were written.
In contrast the New York Attorney General recently brought an enforcement action against Lehman’s outside auditors centered on those transactions. The complaint charges securities fraud. It alleges that the auditors helped the firm defraud creditors by making it appear that it was far less leveraged than was true. At the heart of the case is a critical question about substance versus form in financial reporting. Lehman relied on the form of the transactions, according to the complaint, to defraud investors about the substance of its financial position.
To date the Commission has not brought such an action. Whether it will in view of the new “window dressing” rules appears doubtful. While the Commission has authorized controversial enforcement actions such as the case against Goldman Sachs, frequently this has been by a split vote of the Commissioners. The emphasis on rule writing, and in particular the new window dressing regulations, suggest that perhaps going forward the “tone at the top” may tend toward more rule writing.
Next: The reorganization of enforcement