Four Ways to Improve SEC Enforcement

The enforcement program at the Securities and Exchange Commission has been the subject of severe criticism in recent years, and occasional changes to the system have not begun to root out the deeper, structural defects in the investigation and charging process at the SEC.  Reforms going to the essence of the way the Division of Enforcement operates are needed.

The three fundamental problems with SEC enforcement are that the Commission and the Division of Enforcement (1) advance legal theories that are outside settled boundaries, (2) misunderstand or mischaracterize the factual record, and (3) fail to accord fair and impartial treatment to persons being investigated.  The result is an unacceptably high number of cases that lack merit, meaning either that the extensive evidence collected by the SEC does not support the alleged violation or that the case relies on a legal theory that is not likely to be accepted by a court.

The SEC can do better and be more effective.  It can extend more fairness and consideration to those being investigated without any damage to tough enforcement.  A recent paper publicly available on SSRN here and summarized below describes four ways to improve SEC enforcement.

1. The first is for the Commission to assert violations of law based only on well established and widely accepted legal principles and not to base claims on new or extreme legal theories.  The SEC too frequently asserts a theory of liability during an investigation or in a charging document that is beyond or inconsistent with existing precedent or settled interpretations of statutory or regulatory language.

Although sometimes successful, the SEC has a long series of losses on its efforts to persuade courts to adopt new and more expansive legal standards.  For example, in case after case, such as Janus Capital Group, Inc. v. First Derivative Traders, Morrison v. National Australia Bank, and Aaron v. SEC, the Supreme Court rejected the legal standard for liability that the SEC, working with the Department of Justice, proposed.

Enforcement based on expanding legal rules raises serious issues for both the private party and the system as a whole.  Once the government charges a private party, even on a new legal theory, the person is labeled publicly as a law breaker and faces severe and frequently career or business ending sanctions.  The private party must incur the costs, distress, and adverse publicity associated with a defense or succumb and settle, and the pressure to settle is over-powering even when the SEC case lacks merit.

The threats to the overall system are equally grave.  An agency must take care to stay well within the legal boundaries set by Congress or it acts as lawlessly as those who really violated the securities laws.  In addition, enforcement agencies must exercise their power within established rules so regulated persons may act accordingly and so that those enforcing the law do not act arbitrarily.

One way to improve the SEC enforcement process therefore is to reward the staff for recommending cases based on established and accepted legal doctrines and to eschew over-reaching legal positions.

2. A second way to improve SEC enforcement is for the staff to collect and evaluate evidence of a possible violation neutrally and fairly.  The investigating staff must bring an objective and open-minded approach to the collection of evidence.

Many times the staff starts with a predisposition that the person under investigation violated the securities laws.  It is just a matter of finding the evidence of the violation.  The staff is committed to “winning,” which means having the Commission authorize a proceeding, and that will-to-win warps the fact-gathering process.

The attitude causes the staff to misunderstand legitimate market practices, misinterpret or distort emails and other evidence, and ignore the larger, often far more benign, picture conveyed by the evidence.  As a result, the staff builds an evidentiary record that succeeds in persuading the Commissioners to approve an enforcement case but that forms a flawed basis for the enforcement charges.  The paper gives several examples of courts faulting the SEC’s evidentiary support for a charge.

The solution to this set of problems is tighter internal management and discipline.  From the beginning, the investigating staff should gather evidence with a view to both wrongdoing and innocent explanations.  The key factual assertions supporting a violation must be tested and potential alternative explanations must be discussed.

3. A third way to improve SEC enforcement is to apply neutral standards on the merits when beginning a formal investigation or an enforcement case.  Over the years, enforcement decisions have been susceptible to undue influence from factors other than the merits, particularly pressure from the press, Congress, and other regulators.

When enforcement activity results from external pressures, the system and private parties suffer.  The SEC shifts resources away from higher priority areas selected by its more traditional criteria.  Weak cases are brought.  Conduct that could well have been lawful and socially beneficial is condemned.  The effect of an investigation or proceeding on private parties can be devastating.  The need to respond to SEC requests distracts management from productive activity, and leaks or disclosure of an investigation can harm reputations and end careers and businesses.

Because of this potential for damage, the SEC should guard against inappropriate influences when beginning an investigation or an enforcement case.  The staff should have evidence indicating a possible violation and should consider existing enforcement priorities before starting an investigation.

After an investigation, the Commissioners should not authorize a proceeding unless they believe a reasonable person would conclude that the SEC is more likely than not to prevail on the facts and the law.  A proceeding also should serve broad and legitimate enforcement goals.

If a case is a close call, the Commission and the staff do not have sufficient confidence that the defendant’s conduct was a violation.  In those cases, the SEC should not proceed.  Suing is not being “tough” or “aggressive”; it is being arbitrary and tyrannical.  Close calls must go to the private party and not to the government.

4. Another area worth attention is the time SEC investigations take.  Potential wrongdoing must be investigated promptly and charges, when justified, must be brought promptly to serve a range of important interests.  Unfortunately, investigations lasting for many years are the norm, and long investigations mean that trials, when they occur, reconstruct old events and depend on aged evidence.

Extended investigations disserve the enforcement process and the persons being investigated.  The delays increase the costs of defense and the burdens on private parties.  Lengthy investigations can harm reputations, stall careers, and postpone investments, research, and product development.

The delays also seriously harm the quality of justice.  Anyone experienced with the extended SEC investigation and litigation process knows that documents are lost, data are misplaced, and memories degrade.  The passage of time blurs an understanding of what happened and raises serious questions about the accuracy of the factual foundation used to determine whether a violation of law occurred.

Possible solutions are available, but they depend on more disciplined internal management.  During the periodic internal reviews of the inventory of investigations, senior Enforcement officials must be more discerning about terminating or accelerating investigations.  All staff should make decisions about things not to do.  They should narrow requests for documents and reduce the number of individuals called for testimony.  They should limit testimony and should set and stick to internal deadlines to keep things moving along.

The preceding post comes to us from Andrew N. Vollmer, who is Professor of Law, General Faculty, and Director of the John W. Glynn, Jr. Law & Business Program at the University of Virginia School of Law.