It’s a question often on the mind of corporate counsels: What is the Securities and Exchange Commission’s latest thinking on enforcement actions?
The Commission’s interest in corporate crackdown shifts from time to time, as budgets rise and fall or new scandals emerge and recede. Since the debut of the Sarbanes-Oxley Act in 2003, the trend has been decidedly downward: 574 enforcement actions in 2006, compared to 679 three years earlier.
For some types of wrongdoing, the number of enforcement actions has plummeted. For example, enforcement related to financial disclosure and reporting has dropped more than 30 percent since 2003; actions taken against broker-dealers are down 45 percent; crackdowns related to securities offerings are down about 50 percent from their peak in 2002, according to SEC statistics.
Latham
“I'm not surprised enforcement actions are down,” says John Latham, partner at the law firm Alston & Bird. “We have had a strong economy and market for the last few years. Enforcement actions tend to rise following economic declines.”
Other lawyers—many with previous experience in the SEC’s Division of Enforcement—say that public companies and broker-dealers have not exactly become more honest; the SEC still launched 914 investigations last year and 947 the year before that. Staffing in the enforcement ranks is up as well, from 835 in 2003 to 1,189 in 2006. And while the total SEC budget edged downward from $913 million in 2005 to only $888 million last year, that is still more than double the $423 million the Commission had in 2001.
Rather, SEC observers attribute the decline in enforcement actions to the changing nature of frauds and abuses the Commission investigates. Investigators are taking on more complicated cases, which require more staff and time to complete; others say the SEC’s increased determination to wrangle draconian settlements from offending companies has prompted more defendants to fight the charges.
Gorman
“Most people do feel that it is moving at a slower pace,” says Thomas Gorman, a lawyer with the firm Porter Wright and a former senior counsel in the Division of Enforcement.
One example: Brocade Communications Systems Inc. One year ago, Brocade said it had reserved $7 million for a proposed settlement with the SEC over backdated stock option grants. Likewise, last September, Mercury Interactive Corp. proposed paying a $35 million civil penalty as part of an SEC settlement for its own backdated options mess. The SEC, however, did not announce final settlements with the companies until the end of May.
“It took so long until they were approved by the Commission,” says Ivan Harris, of the law firm Morgan Lewis & Bockius and a former assistant regional enforcement director. He attributes the delay to a wider Commission policy to build a consensus on key issues. Finding consensus may usually be wise, he says, but “you run the risk of the balloon running out of air.”
Harris also criticizes the SEC for still winding down older cases from the prior decade. For example, in March, Banc of America Securities agreed to pay $26 million in disgorgement and penalties to settle SEC charges that the company did not safeguard the release of its nonpublic analyst reports between 1999 and 2001. Back in 2004, in connection with this investigation, the Commission censured BAS and ordered the firm to pay $10 million for failing to produce documents and engaging in dilatory tactics.
And in April, the SEC charged Tenet Healthcare and four former senior executives for failing to disclose that the company’s earnings growth from 1999 to 2002 was due largely to a Medicare reimbursement loophole.
Harris
“From the SEC’s perspective, the longer it takes, the less it has a prophylactic impact,” Harris says. “Real-time enforcement shows that misconduct is dealt with swiftly and effectively.”
Others say the decline in enforcement actions stems from the more complicated accounting cases the SEC has investigated recently, such as Enron and Fannie Mae. These days, probes into backdated stock options—the SEC reportedly is investigating nearly 150 companies—can require investigators to sift through millions of documents looking for minute details of meeting dates and option grants.
“They are more subtle and require more people,” says Nick Morgan, of the law firm DLA Piper and a former securities fraud prosecutor for the SEC. Such cases typically require two or three staff attorneys and a branch chief, he says, as opposed to what he calls “boiler room stock fraud,” which is much less demanding to chase down.
Morgan also believes the SEC is litigating more these days rather than settling, as the Commission seeks more of what he calls “career busting” remedies, such as bans against officers and directors. “This ties up resources,” he says, because the same attorneys and accountants who investigate cases also litigate them.
The SEC’s new policy for negotiating fines with companies might also slow down the process. Launched this spring as a pilot program, the new policy has enforcement lawyers confer with the five SEC commissioners before starting negotiations with the target company, rather than the usual practice of presenting a proposed settlement to the commissioners. Adding that extra step, Lapham says, “causes a lot of cases to stall until they work through this issue.”
On the other hand, the SEC wins plaudits for its ability to bring insider trading cases swiftly. In May the Commission filed charges against a Hong Kong couple who allegedly engaged in illegal insider trading before the public announcement of Rupert Murdoch’s bid for Dow Jones. The charges were filed just days after Murdoch’s bid became public. “Insider trading has always been the area where the Commission has moved quickly,” Harris says.
The SEC can move so quickly on those cases primarily because the stock exchanges monitor trading activity so closely, he adds. If, for example, the Chicago Board of Options Exchange notices unusual trading patterns before an acquisition is announced, the SEC can pounce on that information immediately. “As you get into more esoteric products, such as credit default swaps that do not trade on exchanges, it becomes more difficult for the regulators to move quickly. But unusual trading in your garden variety common stock or options-based case will be detected by the exchanges,” he says.
Lawyers do not seem concerned that enforcement actions have declined sharply among some categories of infractions. Theoretically that could indicate some underlying change in the nature of corporate misbehavior, but in reality, “What you see is the flavor of the month,” quips Gorman.
TAKING ACTION
Below is a breakdown of SEC enforcement actions in recent years, by type and number.
Enforcement Action Type
2001
2002
2003
2004
2005
2006
Financial Disclosure/Reporting
112
163
199
179
185
138
Securities Offering
95
119
109
99
60
61
Broker-Dealer
65
82
137
140
94
75
Insider Trading
57
59
50
42
50
46
Investment Co.
40
52
72
90
97
95
Market Manipulation
40
42
32
39
46
27
Delinquent Filings
N/A
N/A
N/A
N/A
N/A
91
Other
75
81
80
50
98
41
TOTAL
484
598
679
639
630
574
Source: SEC
For example, shortly after the Enron scandal in 2001, enforcement of financial fraud cases surged. When late-trading and market-timing scandals emerged in 2003, a spike of enforcement against investment advisers and hedge funds followed. And the steep drop in actions related to securities offerings merely reflects the overall decline in securities offerings in general since the late 1990s boom.
Looking ahead, corporate lawyers expect to see more insider trading cases, given the recent boom in mergers and acquisitions activity. They also plan on more enforcement for backdated stock options. “Two years ago, there was no inkling of options back-dating,” Latham says.
Harris believes the SEC will spend less time focusing on publicly traded companies and more on what he refers to as “the industry:” broker-dealers, investment advisers, and hedge funds. Pressure is coming from consumer advocates, Congress and even internal suspicions to look into alleged abuses, he says. “There is a feeling that Wall Street is not doing enough to assure the markets are operating fairly,” says Harris.
Morgan, however, cautions that the SEC promises every year to find the Next Big Fraud before it happens. Whether that’s possible is another question. Says he: “Some clever people bent on breaking the law will find ways to do it that are hard to anticipate.”
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