Thank you, Linda [Thomsen], for your kind words. Through Linda's embrace of efficiencies, such as the automated case tracking system that is being introduced now, she has brought much-needed management improvements in the Division of Enforcement.
It is hard for me to believe, but I have known Linda now for almost 25 years! I first got to know Linda when we were colleagues at the same firm. I was a newly minted associate and came down on trips from New York to Washington to file securities registration packages. Now, for you youngsters in the audience, once upon a time, before EDGAR and e-mail, someone had to get on the airplane and fly to Washington to hand deliver the package to the SEC. That someone was always the junior associate who had been up all night at the printer. So I had to file the registration statement, deliver a courtesy package to the reviewer in Corp Fin, and call back to the lead underwriter's syndicate desk to tell them that the filing was effective. After doing that, I would go bleary-eyed to my firm's D.C. office. Linda was always the good-sport and organized lunches with other lawyers in the firm to celebrate my having escaped the fate of other junior associates who made it into the annals of associate lore — like the guy who did not get his registration statement filed because he checked it with his luggage, which got lost, or the guy who fell asleep and missed his flight. Linda's good nature and good humor continue to make it a pleasure to work with her more than two decades later.
It is an honor and pleasure to be a part of the nineteenth edition of "SEC Speaks." The idea for "SEC Speaks" program was conceived by Al Sommer, Alan Levenson, and PLI's Mary Mulé as a mechanism for private lawyers, accountants, and others to hear about the latest developments at the SEC, to get a glimpse into the minds of the commissioners and staff, and to share ideas in an informal setting. Before I begin, I must say that the views that I express here are my own and not necessarily those of the Commission or my fellow Commissioners.
I have noticed in my almost 10 years at the SEC — first working for two chairmen and then as a commissioner myself — that the audience of SEC Speaks seems to hang on every word that is said. Law firm associates take copious notes and then race back to their offices to see who can be first to get a newsletter out to advise clients on the current views. In recent years, the bloggers in attendance post what is said and opine on what it all means.
It is as if Hermes came down from Mt. Olympus to deliver the message from the Olympians. Well, unlike Greek mythology, there should be nothing mysterious about what we do. We should not require a Hermes to deliver our messages, although I know a few lawyers in this room who have made a rather good living trying to fill that role. Some sport Hermès scarves and ties to boot. The SEC is not Olympus, and we certainly are no Olympians. And besides, the last time I partied with the Greeks was in college!
I promise, that is as close as I will come to a joke. I began last year's speech with a series of jokes. I have been informed, however, that jokes could be too controversial given the current composition of the Commission. Therefore, I will wait until we get two more Commissioners before I joke again.
Seriously, there should not be anything mysterious about what happens at the SEC, but somehow we have allowed an Olympic-like cloud to shroud our workings. Investors, companies, brokers, advisors, attorneys, accountants, and others participating in our capital markets should be able to predict whether conduct is permissible or prohibited. Predictability is critical to protecting the rights of those with whom we interact and ensuring a fair and just process.
Predictability must exist both in procedure and substance. With respect to procedure, the SEC must follow uniform procedures both within headquarters and across divisions and regions. With respect to substance, the SEC must provide predictable outcomes, and the manner in which those outcomes are reached must be transparent. As a government agency, we owe the taxpayers, investors, and marketplace no less.
Unfortunately, I think we at the SEC could do a better job of providing predictability to you and your clients in the private sector. We need to implement more systems and procedures to ensure better predictability and transparency in how we operate. The SEC must respect the rule of law and the rights of those with whom we interact.
With that in mind, this seems like a perfect opportunity to suggest a few steps that I hope the SEC will consider in the coming months to ensure better predictability.
One of the most glaring examples of lack of predictability is determining what constitutes materiality. The crux of our federal disclosure system is that all material information must be disclosed — with an emphasis on material. Yet the age-old question is: What does it mean to be "material"?
Issuers, investors, and regulators have struggled with applying the materiality test since the enactment of the securities laws. Materiality is an objective test: the Supreme Court has said that something is material if "there is a substantial likelihood that a reasonable shareholder would consider it … as having significantly altered the 'total mix' of information made available."
It is not enough that some investors may view a fact as important; rather, it must be important to the reasonable investor. In coming to this standard, the Supreme Court in 1976 in TSC Industries v. Northway, specifically overturned a test applied by the Second Circuit — that material facts include all facts that a reasonable shareholder might consider important. Can you imagine what prospectuses and proxy statements would look like if that standard had prevailed? TSC Industries is an example of the Supreme Court showing judicial restraint by not expanding the securities laws. Does this sound familiar? We have seen similar restraint in recent Supreme Court decisions this year and last in the area of securities law.
In TSC Industries, the Supreme Court clearly understood the problem of materiality. In the unanimous opinion written by Justice Thurgood Marshall, the Court observed that "[s]ome information is of such dubious significance that insistence on its disclosure may accomplish more harm than good." The potential liability for a fraud violation can be great and, so Justice Marshall explained, "If the standard of materiality is unnecessarily low, not only may the corporation and its management be subjected to liability for insignificant omissions or misstatements, but also management's fear of exposing itself to substantial liability may cause it simply to bury the shareholders in an avalanche of trivial information — a result that is hardly conducive to informed decisionmaking."
The SEC allowed the waters to be muddied on the issue of materiality in 1999 with Staff Accounting Bulletin 99. Anyone who has tried to apply SAB 99 is left with little certainty. Regardless of how quantitatively tiny a disclosure might be, the answer to any materiality question seems to be "it depends." (Of course, too often it is said to be clear later in 20/20 hindsight.) And yet that bulletin has been cited by courts, SEC staff, and lawyers as authority for materiality. As a result of SAB 99, issuers feel compelled to inundate shareholders with "an avalanche of trivial information," which was precisely the fear of the Supreme Court almost 32 years ago. Often, when you read a 10-K, it is as if you are reading Greek. Maybe we do need Hermes, after all, to interpret the content!
Would it surprise you to learn that SAB 99 does not necessarily represent the views of the Commission? As the title implies, it is a Staff Accounting Bulletin. The process of issuing Staff Accounting Bulletins is organized to avoid "complications" with the Administrative Procedure Act. Is that how a full-disclosure agency should operate? The Commission never voted on the views espoused within any SAB, so it does not and cannot represent the views of the SEC. Worse yet, SEC staff developed SAB 99 without public input. Substantive policy ought not to be made by the staff in private meetings, and ought not to be made based solely on the wisdom and experiences of SEC staff.
Moreover, since SAB 99 was released, a lot has changed. We now have Sarbanes-Oxley and new case law and regulations. Some persons are promoting new disclosure requirements on topics such as state sponsors of terrorism, climate change, and global warming. As the Advisory Committee on Improvements to Financial Reporting will discuss at its meeting next week, the issue of materiality may need to be revisited. I support the work of that committee and appreciate Bob Pozen's leadership. When the SEC takes up this issue, we must approach it by returning to "first principles" — that materiality is determined based upon the objective "reasonable investor" standard. The Commission itself — after proceeding with public notice and comment — should clear up this issue with the full input of the investor, legal, accounting, academic, and business communities.
Another area where the SEC must provide more predictability is corporate penalties and settlements. Companies should have a clear understanding of what it takes to receive cooperation credit, and that credit should be fairly and evenly administered. And, as I have said in the past, in measuring cooperation, the SEC should neither credit nor debit a company for its decisions regarding waiver of the attorney-client privilege. Crediting waiver amounts to the inevitability of waiver, and the SEC should never adopt a position that leaves a person no meaningful choice on the waiver of such a fundamental privilege.
Resisting efforts to characterize waiving companies as cooperative (and non-waiving companies as non-cooperative) is particularly important after the SEC's January 2006 Statement Concerning Financial Penalties. Pursuant to the Statement, the extent of cooperation in an investigation is an element in determining how high civil monetary penalties against corporations could be set.
We have seen that the SEC's penalties statement already has had its challenges in implementation. Even after the penalty statement, too often our penalties seem to be justified on little more than that they "feel right." Companies, the shareholders that ultimately must shoulder a high penalty, and most importantly, the market place have little predictability when it comes to how much the SEC will seek in penalties. In most cases, one of the greatest economic uncertainties for a company under investigation is the penalty that ultimately will be levied against it.
That is not to say that the SEC's discretion should be eliminated in favor of rote application of a mathematical formula for calculating penalties. Discretion plays an important role in forgoing certain theories of liability where a company and its shareholders have been punished enough through other avenues. However, discretion in other areas such as formulating a theory of liability can be dangerous. For instance, discretion must not serve as a license to the SEC to test novel theories of liability and "push the envelope" of the law. Can you imagine how the SEC would respond to a company that claims merely to "push the envelope" of the law or accounting principles? If we are to enforce the rule of law, we must follow the rule of law in our approach.
One way we can achieve better predictability is through an internal Enforcement Manual, similar to the U.S. Attorney Manual. Such a manual is long overdue. One item that I would like to see in that manual is a written and uniform "open jacket" policy for Enforcement matters. This is not a novel idea. Those of you who practice in the area of criminal defense may recognize that phrase. That means the government shows defense counsel the evidence it has against the defendant. That is called due process. If we have a strong case and feel we can win in court under the "preponderance of the evidence" standard (which is far short of the "beyond a reasonable doubt" standard in criminal cases), should we not be open with our evidence? In addition to protecting the rights of individuals and companies, an open jacket policy has practical benefits to the SEC; defense counsel sees the evidence the SEC has against its client and, as a result, is less inclined to fight it out in court.
I understand that an open jacket policy is used by some in Enforcement, and it has not hurt their efforts. We should take every step to apply this policy across all the regions and headquarters — not only because it works, but because it is the right thing to do.
Speaking of Enforcement, I would be remiss if I did not mention some of the recent efforts of those in the Enforcement Division in combating fraud on investors. Last year, the SEC halted a massive pyramid scheme with as many as 70,000 victims in 64 countries. According to the complaint, the scheme involved the purported sale of English and Spanish language tutorials and preyed on Hispanic communities in Orlando, Florida, and Puerto Rico. The tutorials allegedly were merely a front for unregistered sales of pools of securities with promises of large returns. The SEC stopped the wrongdoing in its tracks through an asset freeze, emergency relief, and appointment of a receiver. I applaud the efforts of Eric Busto, Chad Earnst, Cecilia Danger, Jorge Riera, Tonya Tullis, Chris Martin, and Trisha Sindler in our Miami Regional Office in bringing this case and deterring other similar wrongdoers.
And just last month, the SEC brought an action to halt an alleged fraudulent investment scheme run by an Omaha, Nebraska man who promised investors — many of them seniors — that they would earn a sizable monthly return from their investment. According to the SEC's complaint, he paid the earlier investors with the money from newer investors, and he misappropriated over $3.5 million in funds to purchase luxury vehicles, renovate two homes and capitalize other businesses that he owned. The court already has frozen the assets and converted the temporary restraining order to a preliminary injunction. I congratulate the SEC Enforcement team of Scott Friestad, John Polise, Chris Ehrman (who also helped to apprehend the so-called "Bishop" bomber who was threatening to kill mutual fund executives), Alexis Palascak, and Paul Kisslinger on their continuing efforts to thwart this alleged fraud. Bringing cases like these also helps to foster predictability: would-be fraudsters should know with certainty that the SEC will bring the full weight of the government against them if they yield to their temptation to defraud investors. These sorts of cases deserve more public attention.
I have been speaking a lot about Enforcement, but the need for better predictability and transparency extends well beyond the Enforcement Division. Our Office of Compliance Inspections and Examinations (OCIE) must use its powers with prudence, caution, and measure. OCIE should tailor its information requests to avoid imposing unnecessary costs on firms, and should refrain from asking firms to produce documents and information that they are not required to keep. OCIE should continue and expand its initiatives to provide greater predictability through such programs as the CCOutreach program, the publication of Compliance Alerts, and efforts to make communications with firms more uniform regardless of which office transmits them.
The Division of Investment Management is working to restore predictability in the exemptive application process. Many applicants have expressed frustration at a process that can take years with long periods of inaction. Rather than risk delaying an application's processing further, applicants are likely to accede to any and all demands made on them. Because exemptive orders allow for innovation, creating unnecessary obstacles to their processing hinders developments that would expand the options available to investors.
Predictability is particularly lacking in areas in which cooperation among Divisions is required. For example, Investment Management may be on the way to approving a product only to find that Trading and Markets, the Office of Economic Analysis, Corporation Finance, or another agency such as the IRS or the CFTC has an eleventh-hour objection. These sorts of occurrences point to the need for a cross-divisional new products czar. That czar should be responsible for the process and be able to coordinate all of the relevant parts of the SEC to ensure that all aspects of the proposed new product are considered in an orderly, efficient and timely manner. Predictable, systematic, and efficient consideration of new product ideas is important not only out of a general sense of fairness but also because the first-mover advantage is often critical to the success or failure of the product. Firms with new product ideas need to know what to expect in the approval process and, if their products are going to get approval, need to have a sense of timing so that they can plan the marketing and other release-related activities.
In closing, I am reminded of Sir Thomas More's words from "A Man for All Seasons," "The law is a causeway upon which, so long as he keeps to it, a citizen may walk safely." The SEC must ensure that the causeway upon which its laws rests is well marked and well lit. We must provide as many road signs as possible, and we must encourage companies and individuals to keep to the causeway, rather than celebrate when we have caught them having gone astray.
Thank you for your attention and enjoy the remainder of SEC Speaks.