SEC Investigations
Report of the Task Force on SEC Rules Relating to Investigations
Task Force on SEC Rules Relating to Investigations, 42(3): 789–824 (May 1987)
The task force recommends the adoption of eleven proposed rules relating to investigations, which replace the existing rules in toto. It concludes that existing rules are inadequate to achieve the objectives of thorough investigations to be conducted with evenhanded fairness. In some instances, the existing rules are contrary to judicial decisions, and, in others, they are obsolete.
An Overview of Various Procedural Considerations Associated With the Securities and Exchange Commission's Investigative Process
William R. McLucas, Thomas D. Hamill, Catherine Shea, and Jay Dubow, 45(2): 625–94 ( 1990)
The SEC has responsibility for investigating possible violations of the federal securities law. During the course of the SEC's investigations, a number of issues may arise, some of which have been the subject of recent change by virtue of statutory, case law, regulatory, and policy developments. This special presentation examines certain of those issues, provides insights into the nature of the SEC's investigations, and discusses strategic considerations and collateral disclosure effects regarding the SEC's investigations.
Enron at the Margin
William H. Widen, 58(3): 961–1002 (May 2003)
This Article explains how Enron's officers, directors, and lawyers orchestrated violations of the margin regulations when they structured and implemented the now infamous Raptor transactions. Thus, the oft-repeated mantra Enron technically complied with existing law in structuring these transactions is exposed as false. This Article analyzes the Raptor transactions against the standard of conduct required by the Securities Exchange Act of 1934 and the margin regulations promulgated by the Federal Reserve Board under that Act. Significantly, a violation of the margin regulations does not require proof of scienter. Existing law and regulations are reviewed to outline possible criminal liability for the identified margin violations that do not rely on proof of scienter. The identified violations are linked to the harm that contributed to Enron's downfall. Although the Raptor transaction structures were, in detail and purpose, novel, they failed for traditional and foreseeable credit quality reasons. The over-leverage and resulting unstable credit of the Raptor structure, supplemented by a general purpose to deceive, emerge as the real culprits. Enron violated disclosure laws by falsely claiming high credit standing for its derivatives transactions (although the details of determining liability for disclosure violations are left to others). The Article concludes by suggesting that a decision to prosecute Enron and its enablers for technical criminal violations of law would signal a return to traditional notions of criminal liability. Such a return to basic principles of criminal law might be very effective medicine for what ails existing corporate and legal culture. By insisting that ignorance of law is no defense, even to technical violations of law, society directs that the business and legal communities should seek ethical standards for their communities elsewhere rather than in technical compliance with law.
Empty Voting and Hidden (Morphable) Ownership: Taxonomy, Implications, and Reforms
Henry T. C. Hu and Bernard Black, 61(3):1011–1070 (May 2006)
Most American publicly held corporations have a one-share, one-vote structure, in which voting power is proportional to economic ownership. This structure gives shareholders economic incentives to exercise their voting power well and helps to legitimate managers' exercise of authority over property the managers do not own. Berle-Means' "separation of ownership and control" suggests that shareholders face large collective action problems in overseeing managers. Even so, mechanisms rooted in the shareholder vote, including proxy fights and takeover bids, constrain managers from straying too far from the goal of shareholder wealth maximization.
In the past few years, the derivatives revolution, hedge fund growth, and other capital market developments have come to threaten this familiar pattern throughout the world. Both outside investors and corporate insiders can now readily decouple economic ownership of shares from voting rights to those shares. This decoupling—which we call "the new vote buying"—is often hidden from public view and is largely untouched by current law and regulation. Hedge funds, sophisticated and largely unfettered by legal rules or conflicts of interest, have been especially aggressive in decoupling. Sometimes they hold more votes than economic ownership, a pattern we call "empty voting." That is, they may have substantial voting power while having limited, zero, or even negative economic ownership. In the extreme situation of negative economic ownership, the empty voter has an incentive to vote in ways that reduce the company's share price. Sometimes hedge funds hold more economic ownership than votes, though often with "morphable" voting rights—the de facto ability to acquire the votes if needed. We call this "hidden (morphable) ownership" because under current disclosure rules, the economic ownership and (de facto) voting ownership are often not disclosed. Corporate insiders, too, can use new vote buying techniques.
This article analyzes the new vote buying and its corporate governance implications. We propose a taxonomy of the new vote buying that unpacks its functional elements. We discuss the implications of decoupling for control contests and other forms of shareholder oversight, and the circumstances in which decoupling could be beneficial or harmful to corporate governance. We also propose a near-term disclosure-based response and sketch longer-term regulatory possibilities. Our disclosure proposal would simplify and partially integrate five existing, inconsistent share-ownership disclosure regimes, and is worth considering independent of its value with respect to decoupling. In the longer term, other responses may be needed; we briefly discuss possible strategies focused on voting rights, voting architecture, and supply and demand forces in the markets on which the new vote buying relies.
Independent Directors as Securities Monitors
Hillary A. Sale, 61(4):1375-1412 (August 2006)
This paper considers the role of independent directors of public companies as securities monitors. Rather than engaging in the debate about whether independent directors are good or bad, important or unimportant, the paper takes their existence and basic governance role as a given, focusing instead on what recent statements from Securities and Exchange Commission officials indicating an increased focus on independent directors and their role in preventing securities fraud. The paper notes that the SEC believes that independent directors are on the board to act, at least in part, as securities monitors. This securities monitor role is another aspect of the information-forcing-substance disclosure model that the SEC has used to achieve improved corporate governance. Although directors face heightened risk when they draft or sign disclosure documents, they also have an ongoing responsibility to be informed of developments within the company, ensure good processes for accurate disclosures, and make reasonable efforts to assure that disclosures are adequate. Independent directors with expertise should be involved in reviewing and, sometimes, drafting statements. All directors, however, should be fully aware of the company's press releases, public statements, and communications with security holders and sufficiently engaged and active to question and correct inadequate disclosures. In addition to defining the role of independent directors as securities monitors, the article reviews the liability independent directors might face under private causes of action and contrasts it with the SEC's enforcement powers and remedies. The article describes some of the SEC's prior statements that emphasize the role of independent directors as securities monitors and the importance of their providing both guidance and check and balance.
Internal Investigations and the Defense of Corporations in the Sarbanes-Oxley Era
Robert S. Bennett, Alan Kriegel, Carl S. Rauh, and Charles F. Walker, 62(1): 55–88 (Nov. 2006)
Internal investigations long have been an integral part of the successful defense of corporations against charges of misconduct, as well as an important board and management tool for assessing questionable practices. With the heightened standards of conduct and increased exposure created by Sarbanes-Oxley, this essential instrument for safeguarding corporate interests has become even more crucial in identifying and managing risk in the enforcement arena. This article examines from a practitioner's standpoint when and how internal investigations should be conducted in order to protect the corporation in criminal, civil and administrative proceedings. Particular attention is paid to the issues created by a concurrent government investigation and in dealing with employees and former employees in the course of an investigation. The article also addresses the role of the Audit Committee under Sarbanes-Oxley, and the important issue of reporting the findings of the investigation to appropriate corporate officials. The subject of self-reporting by the Company to enforcement authorities is considered as well. In this context, the article explores the SEC's position on crediting self-reporting and cooperation as set forth in the Seaboard report; Department of Justice policy as embodied in the Thompson Memorandum; and the impact of the Federal Sentencing Guidelines for Organizations.
The Erosion of the Materiality Standard in the Enforcement of the Federal Securities Laws
Richard C. Sauer, 62(2):317-358 ( 2007)
The disclosure requirements at the heart of the federal securities involve a delicate and complex balancing act. Too little information provides an inadequate basis for invest¬ment decisions; too much can muddle and diffuse disclosure and thereby lessen its usefulness. The legal concept of materiality provides the dividing line between what information companies must disclose-and must disclose correctly-and everything else. Materiality, however, is a highly judgmental standard, often colored by a variety of factual presumptions. Recent years have witnessed an effort by the Securities and Exchange Commission to recast certain such presumptions to make the standard more inclusive. This article examines the practical effects of this development on corporate disclosure obligations and considers how well it squares with judicial pronouncements on the materiality standard.
Should the SEC Be a Collection Agency for Defrauded Investors?
Barbara Black, 63(2): 317–346 (February 2008)
One of the important functions of the U.S. Securities and Exchange Commission ("the SEC") is enforcing the securities laws and punishing violators. Collecting damages for defrauded investors was not, historically, an important part of the agency's mission; rather, that was the function of private securities fraud class actions. Section 308 (the "Fair Fund provision") of the Sarbanes–Oxley Act of 2002 gives the SEC a more prominent role in compensating investors and allows the agency, in some circumstances, to distribute civil penalties to defrauded investors. The SEC has established Fair Funds in a number of high–profile cases and has taken pride in the large amounts of money it has obtained for investors. Meanwhile, section 308 has become an instrument in the business community's campaign against private securities fraud class actions.
This Article reviews the background of the SEC's disgorgement and penalty powers, the history and language of section 308, and SEC enforcement actions against corporations in financial fraud cases and then looks at the business community's reaction to section 308 and recent SEC enforcement actions. The Article concludes that the SEC's increased emphasis on section 308 could lead to a weakening of its effectiveness as an enforcement agency and further erode support for private securities litigation—an unfortunate outcome for investors.
Disgorgement: Punitive Demands and Remedial Offers
Elaine Buckberg and Frederick C. Dunbar, 63(2): 347–382 (February 2008)
U.S. Securities and Exchange Commission ("SEC") enforcement actions against corporate executives accused of securities fraud have become more visible since the Sarbanes–Oxley of 2002 set new standards to ensure that executives are held individually responsible for corporate fraud. Although long available to the SEC, the disgorgement remedy gained greater prominence because of the Sarbanes–Oxley Act requirement that the chief executive officer and chief financial officer of any company restating its financials due to material non–compliance disgorge incentive or equity–based compensation and profits from sales of stock following the false reporting. The SEC may also seek disgorgement from other executives and of other benefits, including any increment to pension or other retirement plans. Traditionally, class actions were the primary means by which shareholders sued officers and directors for securities claims. But the deterrent value of such lawsuits is arguably compromised because these cases almost always settle—and the employer and its directors' and officers' liability carrier usually fund the full settlement.
Computing accurately the benefits to the executive from the fraud requires an analysis of causation similar to that performed by the U.S. Supreme Court in Dura Pharmaceuticals, Inc. v. Broudo. In the case of an executive benefiting from inflated shares, the approach to measuring the inflation per share at the time of the purchase and sale is the same one as would be used in a shareholder class action. If the wrongdoing included fraudulent accounting leading to higher executive pay, then a similar causation standard applies—namely, how did the defendant's compensation change as a direct result of the fraudulent financials. For some types of accounting violations, such as recognition of revenue in the wrong year, the gains in executive compensation in the year the revenue was recognized are offset, at least to some extent, by the loss in compensation in the year the revenue should have been recognized. The principles of proximate cause and offsetting in disgorgement are grounded in both economics and securities fraud case law.
The Clawback Provision of Sarbanes-Oxley: An Underutilized Incentive to Keep the Corporate House Clean
Rachael E. Schwartz, 64(1): 1-36 (November 2008)
The Sarbanes-Oxley Act of 2002, passed in the wake of corporate scandals involving misstated financial reports, included a provision for certain compensation and profits from the sale of company stock to be "clawed back" from chief executive officers and chief financial officers of companies that are required to restate their financials, due to material non-compliance with any financial reporting requirement of the securities laws as a result of misconduct. Courts have determined that only the Securities and Exchange Commission may sue to enforce this clawback provision. In the six years following passage of the law, there have been Sarbanes-Oxley clawbacks in only a small number of cases, each one an options backdating case involving allegations that the officer affected personally committed fraud. This Article takes the position that the clawback provision has no scienter requirement and its application should not be limited to officers who have personally engaged in misconduct. Rather, the wording of Sarbanes-Oxley, its legislative history, and the policies it serves call for the clawback to be applied to the chief executive officers and chief financial officers of companies that are required to restate their financials due to material non-compliance with any financial reporting requirement of the securities laws as a result of misconduct, regardless of whether those officers actively participated in the wrongdoing, knew of and failed to correct the wrongdoing, or were oblivious to wrongdoing by employees subject to their control. This general rule can be made subject to an exemption for circumstances involving certain misconduct by non-management employees.
Disclosure Obligations Under the Federal Securities Laws in Government Investigations
David M. Stuart and David A. Wilson, 64(4): 973-998 (August 2009)
With the prevalence of government investigations into corporate conduct, public companies frequently face decisions about whether, when, how, and where to disclose to investors the existence of such investigations and the facts learned in the course of, or as a result of, those investigations. While the federal securities laws (and the rules and regulations promulgated thereunder) require disclosure of specific events that may arise during an investigation, neither those laws nor the courts that have interpreted them provide clear guidance for many of the disclosure decisions that must be made over the course of an investigation. As a result, counsel must carefully analyze numerous facts and circumstances, understand the company's previous disclosures, make "materiality" assessments, and determine whether to make disclosure in a current report or wait until the next periodic filing. This Article seeks to present, through an analysis of precedent disclosures, caselaw, rules, and practical ramifications, the considerations counsel must take into account in evaluating disclosure decisions in the context of an investigation. These considerations can help counsel avoid having a disclosure decision worsen the already difficult circumstances posed by the investigation itself.
Nibbling at the Edges—Regulation of Short Selling: Policing Fails to Deliver and Restoration of an Uptick Rule
Douglas M. Branson, 65(1): 67–94 (November 2009)
For several decades, most commentators' mantra on short selling has been promotion of informational efficiency, which translated into minimal regulation. Individual investors, the U.S. Securities & Exchange Commission ("SEC"), and other groups of observers believe that escalating amounts of short selling, including naked short selling, have been a substantial cause of market volatility, investors' wholesale retreat from the stock markets, and severely declining market indexes and share prices, particularly in financial stocks. This Article reviews recent SEC proposals and enactments, including restoration of an uptick or similar "sales price restriction" rule, or installation of circuit breakers adding restrictions on short selling of stock following a precipitous price decline in the stock, and enactment of formerly temporary regulations requiring market participants (broker-dealers mostly) to close fails to deliver after three days rather than thirteen days. Open fails to deliver often are evidence of naked short selling and stock price manipulation, which the SEC has battled since adoption of Regulation SHO in 2004. The Article concludes that these are Main Street versus Wall Street issues. Damping down market volatility is more important to Main Street traders than is promotion of high degrees of informational efficiency, while for professional traders, hedge funds, and high volume short sellers, informational efficiency is more important. The SEC's objective is not to serve one goal rather than the other but to regulate so as to achieve a balance between the two policy objectives.
The SEC and the Financial Industry: Evidence from Enforcement Against Broker-Dealers
Stavros Gadinis, 67(3): 679 - 728 (May 2012)
The Securities and Exchange Commission plays a central part in the U.S. regulatory framework for the supervision of the financial industry. How hasthe SEC carried out this mission? Despite recurrent crises, systematic studies of SEC performance data are surprisingly scarce. As the SEC reforms itself to address the shortcomings revealed in 2007–2008, a systematic examination of the agency’s past record can help identify priorities and evaluate the agency’s renewed efforts. This study takes a first step in studying empirically SEC enforcement against investment banks and brokerage houses, examining the agency’s record in the period right before the 2007–2008 crisis. This data suggests that defendants associated with big firms fared better in SEC enforcement actions as compared to defendants associated with smaller firms in three important dimensions. First, SEC actions against big firms were more likely to involve corporate liability exclusively, with no individuals subject to any regulatory action. Second, big-firm defendants were more likely to end up in administrative rather than court proceedings, controlling for types of violation and levels of harm to investors. Third, within administrative proceedings, big-firm employees were likely to receive lower sanctions, notably temporary or permanent bars from the industry. These patterns have important implications for major debates concerning corporate liability, regulatory capture, and the public and private enforcement of securities laws.
General Counsel Buffeted by Compliance Demands and Client Pressures May Face Personal Peril
E. Norman Veasey and Christine T. Di Guglielmo,68(1): 57 - 80 (November 2012)
In the "New Reality" of the world of corporate general counsel, the challenges and tensions thrust upon one holding that office have intensified exponentially. Not only does the general counsel uniquely straddle the world of business and law in giving advice to the management and directors of her client (the corporation) but also she may find herself personally in the crosshairs of regulators, prosecutors, and litigants. So, as the rhetoric and real pressures increase to target the general counsel, she must have and use the skills, balance, independence, and courage to be simultaneously the persuasive counselor for her corporate client while being attuned to the need for self-preservation. The lessons from the past targeting of general counsel and other in-house lawyers are ominous. But the quintessential general counsel, acting as both persuasive counselor and a leader in setting the corporation's ethical tone, will do the right thing and thus be prepared to deal with these challenges and tensions.
SEC Enforcement Actions and Issuer Litigation in the Context of a "Short Attack"
Charles F. Walker and Colin D. Forbes; 68(3): 687-738 (July 2013)
Issuers faced with a short attack—short selling of the issuer’s stock combined with the spread of negative rumors—may contemplate defensive strategies such as litigation and contacting government regulators, in addition to the investor and public relations efforts that are typically utilized in the wake of negative media coverage. Precedent calls for caution in these circumstances, as the record shows that the results of such strategies are mixed, with the SEC often turning its investigative focus to the issuer, and with costly litigation frequently resulting in compromise. This article begins with a discussion of the recent history of regulatory and legislative efforts to address concerns around short attacks and “naked” short selling. It then turns to a discussion of the SEC enforcement cases and private litigation relating to short attacks, and concludes that the SEC has appropriately brought enforcement cases only in clear-cut instances of fraud, while policing the margins through enforcement of the technical requirements of Regulation SHO. The article shows that the SEC enforcement record in this area, and the proof issues generally attendant to these cases, present important considerations for issuers who perceive themselves under siege in a short attack.
Massey Prize for Research in Law, Innovation, and Capital Markets Symposium—Foreword
70(2): 319-320 (Spring 2015)
Financial Innovation and Governance Mechanisms: The Evolution of Decoupling and Transparency
Henry T. C. Hu; 70(2): 347-406 (Spring 2015)
Financial innovation has fundamental implications for the key substantive and information-based mechanisms of corporate governance. “Decoupling” undermines classic understandings of the allocation of voting rights among shareholders (via, e.g., “empty voting”), the control rights of debtholders (via, e.g., “empty crediting” and “hidden interests”/ “hidden non-interests”), and of takeover practices (via, e.g., “morphable ownership” to avoid section 13(d) disclosure and to avoid triggering certain poison pills). Stock-based compensation, the monitoring of managerial performance, the market for corporate control, and other governance mechanisms dependent on a robust informational predicate and market efficiency are undermined by the transparency challenges posed by financial innovation. The basic approach to information that the SEC has always used—the “descriptive mode,” which relies on “intermediary depictions” of objective reality—is manifestly insufficient to capture highly complex objective realities, such as the realities of major banks heavily involved with derivatives. Ironically, the primary governmental response to such transparency challenges—a new system for public disclosure that became effective in 2013, the first since the establishment of the SEC—also creates difficulties. This new parallel public disclosure system, developed by bank regulators and applicable to major financial institutions, is not directed primarily at the familiar transparency ends of investor protection and market efficiency.
As starting points, this Article offers brief overviews of: (1) the analytical framework developed in 2006−2008 for “decoupling” and its calls for reform; and (2) the analytical framework developed in 2012−2014 reconceptualizing “information” in terms of three “modes” and addressing the two parallel disclosure universes.
As to decoupling, the Article proceeds to analyze some key post- 2008 developments (including the status of efforts at reform) and the road ahead. A detailed analysis is offered as to the landmark December 2012 TELUS opinion in the Supreme Court of British Columbia, involving perhaps the most complicated public example of decoupling to date. The Article discusses recent actions on the part of the Delaware judiciary and legislature, the European Union, and bankruptcy courts—and the pressing need for more action by the SEC. At the time the debt decoupling research was introduced, available evidence as to the phenomenon’s significance was limited. This Article helps address that gap.
As to information, the Article begins by outlining the calls for reform associated with the 2012−2014 analytical framework. With revolutionary advances in computer- and web-related technologies, regulators need no longer rely almost exclusively on the descriptive mode rooted in intermediary depictions. Regulators must also begin to systematically deploy the “transfer mode” rooted in “pure information” and the “hybrid mode” rooted in “moderately pure information.” The Article then shows some of the key ways that the new analytical framework can contribute to the SEC’s comprehensive and long-needed new initiative to address “disclosure effectiveness,” including in “depiction-difficult” contexts completely unrelated to financial innovation (e.g., pension disclosures and high technology companies). The Article concludes with a concise version of the analytical framework’s thesis that the new morphology of public information—consisting of two parallel regulatory universes with divergent ends and means—is unsustainable in the long run and involve certain matters that need statutory resolution. However, certain steps involving coordination among the SEC, the Federal Reserve, and others can be taken in the interim.
Disclosure Reform—The SEC Is Riding Off in Two Directions at Once
Roberta S. Karmel, 71(3): 731-834 (Summer 2016)
The U.S. Securities and Exchange Commission (“SEC”) is being buffeted by diametrically opposing forces with regard to disclosure policy rulemaking. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 required the SEC to pass rules to compel public companies to make disclosures about conflict minerals, mine safety, and certain payments to foreign governments, all for the purpose of advancing societal goals. Proponents of sustainability metrics have been urging the SEC to adopt standards relating to environmental and other similar matters, and a petition on disclosure of corporate contributions and lobbying expenses by public companies would involve the SEC in another political quagmire. Yet, forces that would deregulate disclosure mandates are also pressuring the SEC, and the JOBS Act of 2012 included some such deregulatory measures. Also, the SEC has embarked on its own initiative for streamlining disclosure obligations. This article discusses these conflicting disclosure initiatives and some of the current academic papers and theories with regard to SEC disclosure policy. I suggest a few possible ways for the SEC to move forward, including scaled and tiered disclosure.
The Post Dodd-Frank Act Evolution of the Private Fund Industry: Comparative Evidence from 2012 and 2015
Wulf A. Kaal, 71(4): 1151-1206 (Fall 2016)
This comparative survey study examines the private fund industry’s reactions and adjustments to a rapidly evolving regulatory framework, three years after the first application of mandatory registration and disclosure rules for private fund advisers under the Dodd-Frank Act. Using two datasets (2012: N = 94; 2015: N = 69) for a population of 1267 registered investment advisers to add an historical time series perspective, the author analyzes and compares survey respondents’ short- and long-term estimations of industry effects. The data suggest that immediate and short-term concerns have given way to adaptation to the changes.
The Promise of Unfavorable Research: Ramifications of Regulations Separating Research and Investment Banking for IPO Issuers and Investors
Benjamin J. Catalano; 72(1): 31-60 (Winter 2016/2017)
The trend in Securities and Exchange Commission and Financial Industry Regulatory Authority rulemaking and enforcement to insulate research from investment banking influence has led to the removal of research analysts from the underwriting process with adverse consequences for new issuers and their investors. The approach conflicts with the congressional objective under the Jumpstart Our Business Startups (JOBS) Act to incorporate research fully in public offerings for emerging growth companies, which now comprise the vast majority of IPO issuers. Faced with these competing objectives, broker-dealers should have written policies and procedures that are carefully crafted to service their underwriting and investor clients appropriately and to take advantage of the JOBS Act privileges with respect to research.
Loss Causation and the Materialization of Risk Doctrine in Securities Fraud Class Actions
Richard A. Booth; 75(2): 1791-1814 (Spring 2020)
In the context of a claim for securities fraud under SEC Rule 10b-5, most federal circuit courts have ruled or recognized that loss causation can be proven by an event that demonstrates an earlier statement by a defendant company to be false. In other words, corrective disclosure need not take the form of speech. Rather, a statement can be shown to be false by the materialization of a risk that was concealed by the company, and investors can be compensated for any losses they suffer as a result. Although this doctrine is well established, its ultimate effect is to overcompensate investors, thus encouraging excessive securities litigation and chilling voluntary disclosure.