Chapter 6 SEC Enforcement

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     Enron/WorldCom has had a dramatic impact on SEC enforcement.  The Commission already had a powerful arsenal of enforcement weapons (see Background) and the Commission historically has brought an impressive number of enforcement actions (see fiscal 2001 summary), but the Commission has a number of other responsibilities, and, as had been apparent to everyone other than Congress, limited resources with which to discharge them. The problem was compounded in part by the fact that for whatever reason our society produces year after year an unusually large number of individuals, often recidivist,  who commit blatant, often Ponzi like, securities fraud as well as those who live at the edge of the law. The Commission historically devoted considerable resources to blatant fraud, broker-dealer fraud, and to bringing actions alleging illegal insider trading.

     The Commission for the most part for years was cautious about taking action on the basis of false or misleading projections, financial reporting, or otherwise with respect to companies in the nationally traded securities category, and when it did so it often was several years after the event. See § 6:69. Former Commissioner J. Carter Beese, as a Commissioner and after leaving the Commission, made the point that many, if not most, of the private class actions filed involve cases the Commission would not bring.[1] His point being that many of the private actions should not have been brought. The Commission belatedly recognized that there was a problem. See § 6:70. Then Chairman Levitt on September 28, 1998 delivered “a major address on the state of accounting.” In the address he “expressed concern that the quality of financial reporting in corporate America is eroding" and he presented an action plan that calls on the entire financial community to remedy the problem.” Sounding like a class action lawyer, he attributed it to a “zeal to satisfy consensus earnings estimates and project a smooth earnings path,” Chairman Levitt accused “[t]oo many corporate managers, auditors, and analysts” of participating in a game of creative accounting to meet the analysts’ expectations." In the same vein, he charged such miscreant activities are undertaken “in order to grow market capitalization and increase the value of stock options.”[2] Richard H. Walker, then Director of the Division of Enforcement, on June 14, 2000 announced “zero tolerance for fraudulent financial reporting.”[3] There is no doubt that the Division of Enforcement was energized and placed a new-found emphasis on fraudulent financial reporting.  This is reflected by the fact that during fiscal 2001, financial reporting was the largest category (21%) of enforcement cases; 20% involved securities offerings (typically involving a large number of unregistered and blatantly fraudulent offerings); 13% broker-dealer cases' and only 12% insider trading cases. See TABLE.

     Chairman Levitt resigned as of February 1, 2001, to be followed within a short period of time by Richard Walker, and Lynn Turner, Chief Accountant. The three were the driving force behind the focus on accounting fraud. Commissioner Laura Unger, was appointed Acting Chairman by President Bush on February 1, 2001. She had been an SEC enforcement attorney early in her career and played a prominent behind the scenes role as a member of the staff of the Senate Banking Committee during the legislative process that led to the adoptions of the Private Securities Litigation Reform Act. She left the Commission at the end of 2001. On August 3, 2001, President Bush appointed Harvey Pitt, as Chairman of the Commission. Chairman Pitt early in his career had spent 10 years as an SEC attorney, the last three as the Commission's General Counsel. He had been a prominent SEC practitioner for 25 years prior to being named Chairman of the Commission.

     Enron began to unravel publicly on October 16, 2001. See ABOUT Enron. Six days later, Chairman Harvey Pitt, in his first major speech as Chairman, appeared before the Governing Council of American Institute of Certified Public Accountants (AICPA) and referred to his predecessor's SEC as a place that has not “always been a kinder and gentler place for accountants.”[1] He reminded them that for two decades he had represented the AICPA and that he had represented “each of the Big Five accounting firms.” A New York Times reporter highlighting the speech asked, “[c]an the new, friendlier Securities and Exchange Commission enforce the laws and assure investors that corporate financial reports are trustworthy?"[2] Chairman Pitt assured the AICPA that henceforth “the commission will make sound decisions, in a respectful, affirmative way, not in a demeaning, demanding or demonizing way.” He also cautioned in the same speech that “practices that reflect venality and disservice to public investors, however, will not be tolerated.” Chairman Pitt, soon realized, however, that Enron had changed the landscape and embarked on what he characterized as "an incredible journey to modernize securities regulation." See SEC Press Release 2002-12 welcoming Cynthia N. Glassman as a Commissioner, Jan. 23, 2002, available at  http://www.sec.gov/news/press/2002-12.txt. He also changed directions enforcement-wise and during his brief tenure as discussed in the Background to this hypothetical during his short tenure as Chairman the Commission exceeded all of its prior enforcement records. Although not the primary focus of Sarbanes-Oxley, the Act also strengthened the Commission's arsenal of enforcement weapons. See Background.

    Question 1: Does the Commission have authority to investigate violations of the Securities Acts. See § 6:1. What must the staff do, before staff members can issue a subpoena? See 6:40. See also Rules Relating to Investigations. Why was it necessary for the SEC to initiate a subpoena enforcement proceeding against Andrew Fastow, one of the principal players in the Enron drama. What sort of relief did the Commission seek? See Declaration of Douglas B. Paul, Branch Chief, filed in support of application to order obedience to subpoena in SEC v. Andrew S. Fastow (D.D.C. Misc. No. 01-) available at <http://www.sec.gov/litigation/complaints/comp3lr17270.htm>. Could Fastow have taken the Fifth Amendment and claimed the privilege against self-incrimination. If he planned to do that, why would the Commission still compel him to appear and force him to claim the privilege? Could his claiming the privilege be used against him in a criminal proceeding? In a civil proceeding? See CASES. See ALSO. Could he be compelled to produce corporate documents (as distinguished from personal records) in his custody or subject to his control? See CASES. If there are parallel criminal and civil proceedings involving the same defendants, are there are likely to be at some point in Enron, why might the Commission seek a stay or dismissal without prejudice in the civil proceeding? Why would a defendant/respondent oppose such a stay/dismissal without prejudice? What is the downside to permitting the civil proceeding to proceed before the criminal proceeding is disposed of? See CASES.

NOTE: Despite the Commission's impressive investigatory authority, it would like more. Be prepared to discuss the requests in this regard of Stephen Cutler, Director of the Division of Enforcement in testimony before Congress. Click HERE. The Senate on April 9, 2003 at the request of the Commission  included one special provision relating to SEC subpoenas in a completely unrelated bill that it passed on that date. Click HERE .

     Question 2: Assume that you have been engaged by a person who receives a subpoena to appear to give testimony in connection with an investigation being conducted by the SEC captioned In the Matter of ABC Corp.. Your client is the Chief Financial Officer of the company. Do you have a right  to view the Formal Order? Do you ask the SEC attorney in charge of the investigation for an opportunity to inspect or receive a copy of the Formal Order. Why? See Rules Relating to Investigations. Do you have the right to appear with your client and what are the limitations on your participation? See Rules Relating to Investigations. You know that several employees of ABC Corp. have been subpoenaed and given a deposition and others have been called to give a deposition at a future date. Do you have the right to view transcripts of the other witnesses? Do you have the right to receive a copy of the transcript of your client's testimony? What do you have the right to do in that respect? See Rules Relating to Investigations. What do you think would be the attitude of the SEC attorney in charge of the investigation if you appear as counsel for several of the individuals subpoenaed? Would it make any difference if you were also counsel to ABC Corp.?

NOTE: Assume that you are counsel to ABC Corp. and before there is a Commission investigation become aware of some aggressive accounting practices by the recently released Chief Financial Officer. You have suggested to the Board that there may be a serious problem and that it has to be corrected. The Commission has not initiated an investigation. What would you advise the company as part of a remedial process disclose and discuss the situation with the Commission. See § 6:71.

     Question 3: What are some of the choices of the Division of Enforcement in terms of proceeding against officers and directors that may be implicated in the filing by Enron of false financial statements over the relevant period of time Enron has acknowledged filing false statements. See Background. See also § 6:4, 6:20. Could the Division initiate an administrative proceeding naming some of the former officers or directors as a respondent to impose administrative fines (penalties). See § 6.:23. How would the Division proceed to impose a civil penalty? See § 6:8.Could the Division seek from the Commission a cease and desist order against such officers and directors? See § 6.:25. What may change if Congress adopts the CARE Act of 2003 in the form it passed the Senate on April9, 2003. Click HERE.

     Question 4: If the Division of Enforcement intends to proceed with a view to obtaining a cease and desist order against some of the officer/director prospective defendants/respondents, how must it initiate such proceeding? See § 6.:41. See also Rules of Practice.  What opportunity, if any, may it give the prospective respondents/defendants before initiating a proceeding? See § 6:40. If the Commission enters an order authorizing a proceeding to determine whether to issue a cease and desist order, willl this require notice and a hearing? See § 6:41. Before whom will such hearing be held? See § 6:49. See also Rules of Practice.  To what extent will respondents be entitled to discovery? See § 6:43. See also Rules of Practice.  What complications would this present from the Commission's perspective if there is (or there is likely to be) a parallel criminal proceeding against all or some of the respondents/defendants.? See CASES. To what extent will the initial decision be subject to review by the Commission? See § 6:53. The Commission's decision by the courts? See § 6:57.

          Question 5: Could the Commission prior to Sarbanes-Oxley take steps to bar an individual from acting as an officer or director of a public company? Could it do so in an administrative proceeding or was it required to initiate a civil proceeding? See § 6:12.  What it have to allege and prove to obtain such a bar order and how did Sarbanes Oxley change it. See § 6:13. How does it lower the standard? See 6:14. Chairman Pitt indicated he wants new legislation authorizing such bar orders in an administrative proceeding. Did Congress respond? See § 6:29.

             Question 6: Could the Commssion in an action to obtain injunctive relief and impose civil penalties, prior to Sarbanes-Oxley also seek to require defendants to disgorge ill-gotten gains. See CASES. See § 6:15. What are the gains derived by them individually from erroneous financial statements? Did the Commission prior to Sarbanes-Oxley have the authority in administrative proceedings to require officers of the company to disgorge ill-gotten gains? See § 6:28. Shortly after the President announced his Enron agenda, the SEC with much fanfare announced that it had initiated a proceeding against the CEO of another company relating to events the last of which occurred almost five years ago that it regarded as innovative in terms of the disgorgement sought. Click HERE. What was unusual about the relief sought? See § 6:16. Vis a vis the Commission's ability to obtain disgorgement, what did Sarbanes-Oxley add? See § 6:15? How effective has disgorgement been in making defrauded investors whole. See § 6:18. What has the Commission asked Congress to do to make disgorgement more effective? Click HERE.

          Question 7: The Commission has filed a civil action relating to Enron naming Andrw Fastow as a defendant. The complaint is available at http://www.sec.gov/litigation/complaints/comp17762.htm. Could Fastow file a motion to dismiss for failure to comply with the pleading provisions of the PSLRA? Rule 9(b) of the Federal Rules of Civil Procedure? In the event of a Rule 9(b) motion to dismiss,what are the issues. See § 3.01. See CASE.

           Question 8: The amended complaint filed in the Enron private litigation on behalf of lead plaintiff Regents of the University of California by lead counsel Milberg Weiss (available at
 <http://www.milberg.com/pdf/consolidated_complaint.pdf>) added two law firms and several investment banks as defendants. As we discussed previously, Judge Harmon denied the motion to dismiss of most of the so-called secondary defendants in that action. See § 1:15i.  In what respects would it be easier, if the Commission chose to do so, to establish violations of Rule 10b-5 by such defendants. See § 6:6 and § 1.08[1]. See also CASES.  Could the Commission proceed against the investment banks in administrative proceedings? See Background and § 6:20. Could the NASD also initiate a proceeding against the investment banks and would it be subject to review by the SEC. See § 6:58. Could respondents in the NASD proceeding assert the privilege against self-incrimination. See CASES.

       Question 9: The Commission now webcasts oral arguments on petitions to review initial decisions of administrative law judge.  Click HERE to hear oral argument, but before doing so as background HERE for the Initial Decision of the administrative law judge being reviewed and HERE for brief description of the hearing taking from the SEC News Digest. On what basis could the administrative law judge impose civil penalties on respondent? Disgorgement?

Respondent’s counsel in his argument attributed the drafting of the Securities Act to William Douglas. Was he correct?[1] Click on the footnote.

       Question 10: Who would you rather defend (and why)--Richard Scrushy, former CEO of HealthSouth, or Zacarias Moussaoui, the alleged 20th 9/11 terrorist? On the case against Scrushy, click HERE. What would be your strategy in defending Scrushy? For some ideas click HERE. Click HERE to read about the Scrushy personality . Asssume  a similar CEO and you learn in the course of your representation of the company of some of his misdeeds. Are you ready to go up-the-ladder?