The Future of the SEC
Interview with Gary Goodenow
By: Dr. Sam Vaknin
Also published by United Press International (UPI)
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Interview conducted August 2002
Updated June 2005
In June 2005, William H. Donaldson was forced to resign as Chairman of the Securities and Exchange Commission (SEC). The reason? As the New York Times put it: "criticism that his enforcement was too heavy-handed". President Bush chose California Rep. Christopher Cox, a Republican, to replace him.
Gary Langan Goodenow is an attorney licensed to practice in the State of Florida and the District of Columbia. The Webmaster of www.RealityAtTheSEC.com, he worked at the Miami office of the SEC for about six years, in the Division of Enforcement.
His experience is varied. As a staff attorney, he investigated and prosecuted cases enforcing the federal securities laws. As a branch chief, he supervised the work of several staff attorneys. As a Senior Trial Counsel, he was responsible for litigating about thirty enforcement cases at any one time in federal court. As Senior Counsel, he made the final recommendations on which cases the office would investigate and prosecute, or decline.
He describes an experience he had after he left the SEC.
"I represented an Internet financial writer with a Web site that touted stocks, Mr. Ted Melcher of SGA Whisper Stocks. The SEC sued Ted because as he was singing the praises of certain stocks in his articles, he was selling them into a rising market. He got his shares from the issuers in exchange for doing the promotional touting. Unfortunately for him, the SEC and the Department of Justice made an example of his case, and he went to jail."
Q. The SEC is often accused of lax and intermittent enforcement of the law. Is the problem with the enforcement division - or with the law? Can you describe a typical SEC investigation from start to finish?
A. The problem lies with both.
At the SEC, the best argument in support of a proposed course of action is "that's what we did last time". That will inevitably please the staff attorney's superiors.
SEC rules and regulations remind me of an old farmhouse that has been altered and adapted, sometimes for convenience, other times for necessity. But it has never been just plain pulled down and rebuilt despite incredible changes around it. To the uninitiated, the house is rambling with hidden passages, dark corners, low ceilings, folklore and horror stories, and accumulations of tons of antique rubbish that sometimes no one – not even some SEC Commissioners – can wade through.
Wandering from room to room in this farmhouse are the SEC staff. Regretfully, I found that many are ignorant or indifferent to their mission, or scornful of investors' plight, too addicted to their petty specializations in their detailed job descriptions, and way too prone to follow only the well-trodden path.
They are stunned by the rapidity, multiplicity, immensity and intelligence behind the scams. Their tools of research, investigation and prosecution are confusingly changed periodically when Congress passes some new "reform" legislation, or a new Chairman or new Enforcement Director issues some memo edict on a "new approach".
Staff attorneys typically bring investors only bad news and are numbed by the latters' emotional reactions, in a kind of "shell shock". The SEC lost one quarter of its staff in the last two years. The turnover of its 1200 attorneys, at 14%, is nearly double the government's average.
One SEC official was quoted as saying "We are losing our future – the people who would have had the experience to move into the senior ranks". Those that stay behind and rise in the ranks are often the least inspired. At the SEC enforcement division, one is often confronted with the "evil of banality".
The SEC is empowered by the Securities Act of 1933 and the Securities Exchange Act of 1934 to seek injunctive relief where it appears that a person is engaged or about to engage in violations of the federal securities laws. This is a civil remedy, not a criminal law sanction. Under well-settled case law, the purpose of injunctive relief is deterrence, rather than punishment, of those who commit violations. Investors do not know that, and are uniformly shocked when told.
The "likelihood requirement" means that, once the Commission demonstrates a violation, for injunctive relief it needs only show that there is some reasonable likelihood of future violations. "Positive proof' of likelihood, as one court demanded, is hard to provide. At the other extreme, I had one former Commissioner tell me that, as he understood the law, if the person is alive and breathing, the Commission enforcement staff can show likelihood of future violations.
The broad powers of the federal courts are used in actions brought by the Commission to prevent securities violators from enjoying the fruits of their misconduct. But because this is a civil and not a criminal remedy, the SEC has a unique rule where defendants can consent to an injunction without "admitting or denying the allegations of the complaint". This leads to what are called "waivers", and I submit that "waivers" are the fundamental flaw in U.S. securities laws enforcement.
In a nutshell, here is the problem. A "fraudster" commits a fraud. The Commission sues for an injunction. The fraudster consents to the injunction as per above. The Court then orders the fraudster to "disgorge" his "ill gotten gains" from the scam, usually within 30 days and with interest.
In most cases, the fraudster doesn't pay it all and the Commission moves to hold him in civil contempt for disobeying the Court's order. The fraudster claims to the Court that it is impossible for him to comply because the money is gone and he is "without the financial means to pay". The Commission then issues a "waiver" and that's the way many cases end. Thus both sides can put the case behind them. The fraudster agrees to the re-opening of the case if he turns out to have lied.
This procedure is problematic. The Commission typically alleges that these fraudsters have lied through their teeth in securities sales - but is forced to accept their word in an affidavit swearing that they have no money to pay the disgorgement. So the waivers are based on an assumption of credibility that has no basis in experience and possibly none in fact.
Moreover, the Division of Enforcement has no mechanism in place to check if the fraudster has, indeed, lied. After the waiver, the files of the case get stored. The case is closed. I don't know if there's even a central place where the records of waivers are kept.
In the six years I was at the Commission, I never heard of a case involving a breach of waiver affidavit. I doubt if one has ever been brought by the Commission - anywhere. UPI ought to do a Freedom Of Information Act Request on that.
Something similar happens with the Commission's much vaunted ability to levy civil penalties. The statute requires that a court trial be held to determine the egregiousness of the fraud. Based on its findings, the court can levy the fines. But, according to some earlier non-SEC case law, a fraudster can ask for a jury trial regarding the amount of the civil penalties because he or she lack the means to pay them. U.S. district courts being as busy as they are, there's no way the court is going to hold a jury trial.
Instead, the fraudster consents to a court order "noting the appropriateness of civil penalties for the case, but declining to set them based on a demonstrated inability to pay". Again, if the fraudster lied, the Commission can ask the Court to revisit the issue.
Q. Internet fraud, corporate malfeasance, derivatives, off-shore special purpose entities, multi-level marketing, scams, money laundering - is the SEC up to it? Isn't its staff overwhelmed and under-qualified?
A. The staff is overwhelmed. The longest serving are often the least qualified because the talented usually leave.
We've already got the criminal statutes on the books for criminal prosecution of securities fraud at the federal level. Congress should pass a law deputizing staff attorneys of the Commission Division of Enforcement, with at least one-year experience and high performance ratings, as Special Assistant United States Attorneys for the prosecution of securities fraud. In other words, make them part of the Department of Justice to make criminal, not just civil cases, against the fraudsters.
The US Department of Justice does not have the person power to pursue enough criminal securities cases in the Internet Age. Commission attorneys have the expertise, but not the legal right, to bring criminal prosecution. The afore-described waiver system only makes the fraudsters more confident that the potential gain from fraud outweighs the risk.
I'd keep the civil remedies. In an ongoing fraud, with no time to make out a criminal case, the Commission staff can seek a Temporary Restraining Order and an asset freeze. This more closely resembles the original intent of Congress in the 1930s. But after the dust settles, the investing public deserves to demand criminal accountability for the fraud, not just waivers.
Q. Is the SEC - or at least its current head - in hock to special interests, e.g., the accounting industry?
A. "In hock to special interests" is too explicit a statement about US practice. It makes a good slogan for a Marxist law school professor, but reality is far subtler.
By unwritten bipartisan agreement, the Chairman of the SEC is always a political figure. Two of the five SEC Commissioners are always Democrats, two Republicans, and the Chairman belongs to the political party of the President. I am curious to see if this same agreement will apply to the boards established under the Sarbannes-Oxley Act.
Thus, both parties typically choose a candidate for Chairman of impeccable partisan credentials and consistent adherence to the "party line". The less connected, the less partisan, and academicians serve as Commissioners, not Chairmen.
The Chairman's tenure normally overlaps with a specific President's term in office, even when, as with President Bush the elder following President Reagan, the same party remains in power. SEC jobs lend themselves to lucrative post-Commission employment. This explains the dearth of "loyal opposition". Alumni pride themselves on their connections following their departure.
The Chairman is no more and no less "in hock" than any leading member of a US political party. Still, I faulted Chairman Pitt, and became the first former member of SEC management to call for his resignation, in an Op/Ed item in the Miami Herald. In my view, he was impermissibly indulgent of his former law clients at the expense of SEC enforcement.
Q. What more could stock exchanges do to help the SEC?
A. At the risk of being flippant, enforce their own rules. The major enforcement action against the NASDAQ brokers a few years ago, for instance, was toothless. Presently, Merrill Lynch is being scrutinized by the State of New York, but there is not a word from the NYSE.
Q. Do you regard the recent changes to the law - especially the Sarbanes-Oxley Act - as toothless or an important enhancement to the arsenal of law enforcement agencies? Do you think that the SEC should have any input in professional self-regulating and regulatory bodies, such as the recently established accountants board?
A. It remains to be seen. The Act establishes a Public Accounting Oversight Board ("the Board"). It reflects one major aspect of SEC enforcement practice: unlike in many countries, the SEC does not recognize an accountant/client privilege, though it does recognize an attorney/client privilege.
Regrettably, in my experience, attorneys organize at least as much securities fraud as accountants. Yet in the US, one would never see an "attorneys oversight board". For one thing, Congress has more attorneys than accountants.
Section 3 of the Act, titled "Commission Rules and Enforcement", treats a violation of the Rules of the Public Company Accounting Oversight Board as a violation of the '34 Act, giving rise to the same penalties. It is unclear if this means waiver after waiver, as in present SEC enforcement. Even if it does, the Rules may still be more effective because US state regulators can forfeit an accountant's license based on a waived injunction.
The Act's provision, in Section 101, for the membership of said Board has yet to be fleshed out. Appointed to five-year terms, two of the members must be - or have been - certified public accountants, and the remaining three must not be and cannot have been CPAs. Lawyers are the likeliest to be appointed to these other seats. The Chairmanship may be held by one of the CPA members, provided that he or she has not been engaged as a practicing CPA for five years, meaning, ab initio, that he or she will be behind the practice curb at a time when change is rapid.
No Board member may, during their service on the Board, "share in any of the profits of, or receive payments from, a public accounting firm," other than "fixed continuing payments," such as retirement payments. This mirrors SEC practice with the securities industry, but does little to tackle "the revolving door".
The Board members are appointed by the SEC, "after consultation with" the Federal Reserve Board Chairman and the Treasury Secretary. Given the term lengths, it is safe to predict that every new presidential administration will bring with it a new Board.
The major powers granted to the Board will effectively change the accounting profession in the USA, at least with regards to public companies, from a self-regulatory body licensed by the states, into a national regulator.
Under Act Section 103, the Board shall: (1) register public accounting firms; (2) establish "auditing, quality control, ethics, independence, and other standards relating to the preparation of audit reports for issuers;" (3) inspect accounting firms; and (4) investigate and discipline firms to enforce compliance with the Act, the Rules, professional standards and the federal securities laws. This is a sea change in the US.
As to professional standards, the Board must "cooperate on an on-going basis" with certain accountants advisory groups. Yet, US federal government Boards do not "co-operate" - they dictate. The Board can "to the extent that it determines appropriate" adopt proposals by such groups.
More importantly, it has authority to reject any standards proffered by said groups. This will then be reviewed by the SEC, because the Board must report on its standards to the Commission every year. The SEC may – by rule – require the Board to cover additional ground. The Board, and the SEC through the Board, now run the US accounting profession.
The Board is also augments the US effort to establish hegemony over the global practice of accounting. Act Section 106, Foreign Public Accounting Firms, subjects foreigners who audit U.S. companies - including foreign firms that perform audit work that is used by the primary auditor on a foreign subsidiary of a U.S. company - to registration with the Board.
I am amazed that the EU was silent on this inroad to their sovereignty. This may prove more problematic in US operations in China. I do not think the US can force its accounting standards on China without negatively affecting our trade there.
Under Act Section 108, the SEC now decides what are "generally" accepted accounting principles. Registered public accounting firms are barred from providing certain non-audit services to an issuer they audit. Thus, the split, first proposed by the head of Arthur Anderson in 1974, is now the law.
Act Section 203, Audit Partner Rotation, is a gift to the accounting profession. The lead audit or coordinating partner and the reviewing partner must rotate every 5 years. That means that by law, the work will be spread around. Note that the law says "partner", not "partnership". Thus, we are likely to continue to see institutional clients serviced by "juntas" at accounting firms, not by individuals. This will likely end forever the days when a single person controlled major amounts of business at an accounting firm. US law firms would never countenance such a change, as the competition for major clients is intense.
Act Section 209, Consideration by Appropriate State Regulatory Authorities, "throws a bone" to the states. It requires state regulators to make an independent determination whether Board standards apply to small and mid-size non-registered accounting firms. No one can seriously doubt the outcome of these determinations. But we now pretend that we still have real state regulation of the accounting profession, just as we pretend that we have state regulation of the securities markets through "blue sky laws". The reality is that the states will be confined hence to the initial admission of persons to the accounting profession. Like the "blue sky laws", it will be a revenue source, but the states will be completely junior to the Board and the SEC.
Act Section 302, Corporate Responsibility For Financial Reports, mandates that the CEO and CFO of each issuer shall certify the "appropriateness of the financial statements and disclosures contained in the periodic report, and that those financial statements and disclosures fairly present, in all material respects, the operations and financial condition of the issuer". This may prove problematic with global companies. We have already seen resistance by Daimler-Benz of Germany.
Act Section 305: Officer And Director Bars And Penalties; Equitable Relief, will be used by the SEC to counterattack arguments arising out of the Central Bank case. As I maintained in the American Journal of Trial Advocacy, the real significance of the Supreme Court decision in Central Bank was that the remedial sanctions of the federal securities laws should be narrowly construed.
Well, now the SEC has a Congressional mandate. Federal courts are authorized to "grant any equitable relief that may be appropriate or necessary for the benefit of investors". That is an incredibly broad delegation of rights, and is an end run around Central Bank. I was surprised that this received no publicity.
Lastly, Act Section 402, Prohibition on Personal Loans to Executives, shows how low this generation of US leadership has sunk. President Bush has signed a law that makes illegal the type of loans from which he and his extended family have previously benefited.
Tacitly, the Act admits that some practices of Enron were not illegal inter se. Act Section 401, Study and Report on Special Purpose Entities, provides that the SEC should study off-balance sheet disclosures to determine their extent and whether they are reported in a sufficiently transparent fashion. The answer will almost certainly be no, and the Board will change GAAP accordingly.
Q. Does the SEC collaborate with other financial regulators and law enforcement agencies internationally? Does it share information with other US law enforcement agencies? Is there interagency rivalry and does it hamper investigations? Can you give us an example?
A. The SEC and other regulators - as well as two House subcommittees - have only very recently begun considering information sharing between financial regulators.
This comes too late for the victims of Martin Frankel, who, having been barred for life from the securities industry by the SEC and NASD in 1992, simply moved over to the insurance industry to perpetrate a scam where investors have lost an estimated $200 million dollars.
Had the state insurance regulators known this person's background, he would have been unable to set up multiple insurance companies. Failure to share information is a genuine problem, but "turf" considerations generally trump any joint efforts.
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