The Securities and Exchange Commission’s failure to stop the largest Ponzi scheme in history, despite repeated warnings by investment professionals familiar with Bernard L. Madoff’s overblown promises to investors, has become a symbol of regulatory breakdown. The results of that breakdown have been catastrophic: shattered markets, broken financial structures, soaring unemployment, and state and local budget cuts.
Reconstructing the regulatory framework for the nation’s financial system is critical to preventing future crises and improving the landscape for institutional and individual investors.
President Obama acknowledged as much when he talked about the market in his inauguration speech. “Its power to generate wealth and expand freedom is unmatched,” Obama said, “but this crisis has reminded us that without a watchful eye, the market can spin out of control – and that a nation cannot prosper long when it favors only the prosperous.”
The president’s new appointees – Mary Schapiro as chairman of the Securities and Exchange Commission and Timothy Geithner as Treasury Secretary – also have indicated that greater regulation will be a priority for the new administration.
Berman DeValerio decided to put together its own wish list for the new president, his regulators and the Democratic Congress.
Restore SEC’s Vigilance
Regulation is not a dirty word, as revelations in recent months have demonstrated. The business lobby during the Bush administration pushed hard and successfully rolled back measures that were enacted following the corporate scandals at Enron, Tyco International and WorldCom. The agency also temporarily eased regulations on short selling in July 2007, a move that many market watchers believe fueled last year’s collapse. Many now view the SEC as a toothless tiger that lost sight of its central missions: protecting investors and ensuring the integrity of the financial markets.
The agency is bringing fewer stock fraud prosecutions than it did eight years ago. According to Syracuse University’s Trac database of federal information, the SEC initiated 145 securities fraud prosecutions in 2008, compared with 437 cases in 2000.
Only nine agency investigations led to Justice Department prosecutions in 2007, compared with 69 in 2000. Fines are down, too. Penalties dropped from $977 million in 2006 to $505 million in 2007, The New York Times reported last April.
SEC Chairman Mary Schapiro has spent most of her career as a regulator with the Financial Industry Regulatory Authority, the SEC and the Commodity Futures Trading Commission.
The laundry list of improvements she’ll need to implement inside the SEC is long. In addition to increasing fraud referrals, the SEC needs to carefully regulate growing markets for exotic securities such as credit default swaps. More enforcement staff is also badly needed, for example, to assist existing mutual fund examiners currently overwhelmed by work. While Schapiro is widely praised for her commitment to investors, some question whether any one person can bring the change required. It is an enormous undertaking.
Yet, in her first weeks on the job, Schapiro is off to a strong start. She reversed a three-year-old policy that required enforcement attorneys to obtain sign-off from SEC commissioners before assessing penalties on corporate wrongdoers. The requirement was widely viewed as dissuading enforcement. Schapiro also is examining proposals that would give shareholders more say on executive compensation and board elections.
And Sen. Charles Schumer last month introduced a bill to provide $110 million to the FBI, Justice Department and SEC to hire hundreds of new investigators and prosecutors for the sole purpose of cracking down on financial fraud. The Obama administration should support this as part of its broad economic recovery package.
Negate Stoneridge
The U.S. Supreme Court’s 2008 decision, Stoneridge v. Scientific Atlanta, gave corporations a get-out-of-jail-free card, making it almost impossible for investors to sue third-parties – such as banks, accountants or, in this case, suppliers – for assisting in securities fraud. The Supreme Court ruled that private investors can sue only companies and individuals that made misleading statements to investors.
Plaintiffs charged that Scientific Atlanta helped devise phony transactions that allowed its client, the cable company Charter Communications, to artificially inflate revenue. But the Supreme Court said that Charter’s investors could not hold supplier Scientific Atlanta liable because it did not make the false statements contained in Charter’s SEC filings. Not surprisingly, the decision was widely hailed as a victory by corporations and their defense attorneys.
The new Congress should pass legislation that negates Stoneridge and allows investors to hold companies responsible in clear-cut cases in which they were complicit in helping companies they do business with to cook the books – even if that outside party did not issue or sign the fraudulent financial statements.
Improve Corporate Governance
Institutional investors have long sought corporate governance improvements that will create stronger oversight inside corporate America. In recent years, institutional investors have managed to achieve some remedies through the courts, pushing for corporate governance reforms in securities litigation settlements. But more can be done at the federal level.
The SEC, for example, has blocked shareholder proxy requests that seek better disclosure of a company’s financial risks. In a December letter to then President-elect Obama, a group of investor rights advocates cited one rejected resolution that sought disclosure by Washington Mutual of its exposure to mortgage risks: WaMu was acquired by J.P. Morgan Chase in a federal bailout last fall. The investor advocates urged the president to “reverse a pattern of recent SEC staff decisions that have been closing the door to important dialogues between shareholders and management.”
To send a message that shareholder rights are paramount, the SEC could also include more corporate governance changes as part of its fraud settlements. The Council of Institutional Investors and nearly 50 union and government pension funds are urging Congress to include corporate governance improvements in any regulatory reform.
“Investors need stronger tools to hold managers and boards accountable,” the group said in a December letter to House Speaker Nancy Pelosi. “In our view, a number of key corporate governance reforms are essential to providing meaningful investor oversight of management and boards.”
Items on the Council’s wish list, which we would second, include:
- Majority voting for directors;
- Independent board chairs and independent compensation advisers;
- Advisory shareowner votes on executive pay and shareholder pay limitations;
- Stronger clawback provisions that require senior executives to return bonuses awarded due to fraud.
Curb Executive Pay
The collective outrage over excessive executive compensation grew more fervent last year as CEOs walked away from their ruined companies with hundreds of millions of dollars in pay and perks. The government’s bailout package includes provisions that restrict executive compensation for financial institutions that receive taxpayer funds, but the requirements do not have enough teeth.
The excessive compensation highlighted in the financial crisis is part of a larger trend of runaway pay at the top of corporate America. According to the Economic Policy Institute, the average CEO earned 275 times that of a typical worker in 2007. “Put another way, a CEO earned more in one workday than an average worker earned in a year,” President Obama said during the campaign. As Senator from Illinois, Obama once introduced a bill allowing shareholders a non-binding vote on CEO pay.
The Council of Institutional Investors urged Congress to stiffen requirements for reporting executive pay in its letter to Speaker Pelosi.
Runaway executive pay needs to be reigned in – whether through Congressional passage of a “say on pay” law or through shareholder proxy votes.
Amend the PSLRA
Securities litigators may not have liked the Private Securities Litigation Reform Act of 1995 when it passed, but we have learned to work with it. One positive outcome: the rise of institutional lead plaintiffs such as government and union pension funds seeking to recover assets lost to their beneficiaries through fraud. (See article on page 3.)
Yet in its attempt to limit frivolous lawsuits, the PSLRA raised the pleading threshold so high that even strong fraud cases are filtered out. Unlike any other type of litigation, securities fraud plaintiffs cannot interview witnesses and request documents until after a judge has ruled their case meets the PSLRA’s unusually high requirements. This “catch 22” – a tougher burden of proof without the ability to gather evidence – gives tremendous advantages to defendants.
Congress should revisit and amend the PSLRA to enhance discovery powers so that legitimate cases – and shareholders – get their chance in court.
Regulate Exotic Securities
The investment world has been transformed over the past decade. Mortgage-backed securities such as collateralized debt obligations, or CDOs, and exotic credit default swaps – insurance policies for investors – were largely to blame for the credit crunch. Had they been regulated, many argue, the nation might never have gotten into the current financial mess.
Congress and the SEC must completely rethink the new world of securities trading and investing and implement a sweeping overhaul of the regulatory framework to take these innovative new products into account. Wall Street is always evolving, and regulators in the future need to stay current with any new financial innovations that crop up. It is time to learn from the disastrous mistakes of the past.
*In August 2017, our firm name changed to Berman Tabacco. Case references and content published before that date may refer to the firm under our prior name, Berman DeValerio.