RUDE AWAKENING AT THE SEC

...The line attorney has little incentive to do this promptly, so that the investigation may linger on the shelf for months, or sometimes years, while the attorney who initiated it pursues cases more likely to be productive and career-enhancing...

...It is important to note, however, that although the approval of a senior enforcement division official was necessary to open a MUI, no approval is necessary for a MUI to roll over into an informal investigation...

...A MUI can be opened at the request of any line attorney, and must be approved by a senior manager, usually someone at the associate director level...

...This public rebuke to the staff of the enforcement division is important...

...The willingness of Chairman Cox publicly to admonish the enforcement staff is a good sign...

...On February 7, 2006, without the approval of the chairman or the commission, the enforcement division's San Francisco office issued a subpoena for the e-mails and phone records of two Dow Jones reporters who had been in touch with a stock-analyst firm and a hedge fund about the future prospects of a public company, Overstock.com...

...Such requests, however, are not without risk...

...9 The commission should appoint an ombudsman with authority to investigate complaints about staff violations of the procedures established by the commission, or the commission's inspector general should be given the authority to investigate public complaints about staff violations of the commission's rules for enforcement actions...

...MAY 2006 THE AMERICAN SPECTATOR 23 RUDE AWAKENING AT THE SEC The subpoena issued to the Dow Jones reporters is, of course, only one example of the heedless way with which the staff can proceed...

...For this, the staff needs the approval of the commission...

...More than that, because its principal objective has been to encourage disclosure, the SEC has served a central principle of conservative economics: its principal regulatory thrust has helped to empower individuals...

...ity with restraint...

...Thus, the Levitt and Donaldson regimes seem to have resulted in an enforcement division mindset that finding, pursuing, and winning cases was the most important objective, and that concern about the damage done to regulated companies, issuers, and investors was distinctly of secondary importance...

...If a party publicly named in a formal or informal investigation is no longer a subject or a witness in that proceeding, the party should be promptly notified...

...They suffer a decline in the value of their shares as the possibility of an SEC enforcement action--now actually abandoned-hangs over the market...

...But meanwhile, the market-which at any given moment includes all the information known about a company-continues to carry a somewhat reduced stock price, reflecting the risk that the informal investigation will eventually turn into something more serious...

...This distorted process can also lead to an appalling irony...

...One familiar tactic of recent vintage is to ask the company to waive attorney-client privilege, so that the division can represent to the commissioners that the company has been "cooperative," purportedly to induce the commissioners more readily to accept the settlement involving a lesser charge...

...it signals the chairman's awareness that something has gone seriously off the tracks in that staff, and may indicate that the commission will now pay sustained attention to how that division conducts its business...

...This is especially true in the small and mostly procedural ways in which government agencies pursue their basic functions, because these get little attention, either by the heads of the agencywhich may not even be aware that the agency's power is being abused-or by the public...

...MUIs should not automatically roll into informal investigations without any staff consideration...

...Lawyers representing companies are justifiably reluctant to ask about investigations that seem to have been abandoned, because they know that such an inquiry might induce the enforcement division to look into the matter again...

...9 Parties should not be asked to waive attorneyclient privilege unless they assert advice of counsel as a defense-and even then only as to the facts disclosed to counsel and the substance of advice imparted...

...But the matter did not end there...

...9 As long as the decision to proceed with a charge is made by the commission in a closed meeting, the staff will always have considerable leverage to extract settlements from companies and other parties in cases that could not be won in court...

...The SEC now has new leadership...

...This is a familiar prosecutor's tactic, but the SEC staff is able to take it somewhat further...

...Issuing a subpoena to journalists is highly unusual for the SEC, or any other government agency, and it appears that shortly after the subpoena became publicly known the SEC decided to withdraw it...

...The general counsel currently has the responsibility to advise the commission whether, in the general counsel's view, the case can be won...

...A well-placed "tip" to the SEC may be just the ticket...

...The "Wells," as it is called, is an opportunity for a party to present a written statement to the commission as to why it should not be formally accused of wrongdoing...

...The agency's sense that it had to compete for sensational cases with New York Attorney General Eliot Spitzer also loosened the controls from the top, giving the division extraordinary latitude in choosing its targets and wielding the commission's authority...

...Rapid advancement within the division seems to depend on finding and bringing dramatic cases, so there is considerable incentive for a staff member to be the first to open what is called a "matter under inquiry" (MUI, or "muey" in SECspeak...

...Because the staff is in control of the information presented to the commission-and the defendant company may be unaware of what the staff is presenting-the staff is also able to force disclosures from parties that even prosecutors cannot Most presentations to the commission by the staff result in actual charges...

...MUls and Other Investigations A N SEC ENFORCEMENT ACTION f r e q u e n t l y begins with a newspaper article, investor complaint, or anonymous "tip" about a company, which may attract the attention of a staff lawyer in the enforcement division...

...However, there is no opportunity for oral argument, and the defendant is not present when the matter is taken up by the commission...

...The staff knows of the companies' vulnerability, and is thus in a strong position to force parties to settle cases that the commission might not otherwise be able to win, or win completely, in court...

...9 In connection with every Wells submission, the party making the submission should be advised of the specific facts that will be presented to the commission by the enforcement division...

...Government officials should constantly ask themselves whether they are using their power responsibly, or abusing it...

...This results in a letter, or sometimes a simple phone call, asking an individual or a company to provide information to the staff that would be relevant to determining whether a violation of the law or regulations has occurred...

...However, if the informal investigation now underway does not turn up violations of law or related SEC regulations, the line attorney who originally opened the MUI must spend a lot of time to terminate it-including an extensive closing memorandum that includes such things as summaries of witness interviews and recorded testimony...

...Charges, Wells Submissions, and Settlements S OMETIMES, OF COURSE, an investigation turns up something worth pursuing, and reaches a point where the staff is ready to issue a formal charge...

...The major and dramatic steps of the SEC and other agencies are covered in the press and occasionally challenged in court, but it is the day-to-day actions that reveal whether an agency is observing the rules of fair conduct or has succumbed to the arrogance of power...

...This process can cost a The eagerness of the staff to find and pursue sexy cases makes them susceptible to manipulation by a d ishonest short-seller seeking to drive down a stock's price...

...After that initial high-level review, however, things often spin out of control...

...To be sure, some conservative economists argue that the agency should not exist at all...

...9 If an informal investigation has been abandoned, that is, not actively pursued for a period of, say, 60 days, it should be deemed automatically abandoned, and may not be pursued by the staff without specific commission approval...

...this is true in every administration, but certainly in a conservative administration...

...It is noteworthy that the National Association of Securities Dealers (NASD) has an entirely separate organization-independent of its enforcement section-that advises the board on whether the NASD's case is substantial enough to prosecute...

...Speeches by the head of the division frequently seemed to be or became the policy of the agency without any approval by the commission itself...

...Of course, counsel for a company or individual may always ask the staff whether an investigation is over...

...In fact, the enforcement division's policy is not to advise companies concerning the termination of informal investigations-apparently for fear that the company or others will cite the termination notice as proof that they are law-abiding...

...26 THE AMERICAN SPECTATOR MAY 2006...

...E-mails and similar items must be read to ensure they are actually responsive to the request and do not, for example, involve privileged material...

...If so, the commission will find much to criticize and change...

...It seems that no one is good enough to deserve that modest honorific...

...The MUI then becomes an informal investigation, is disclosed by the company on advice of counsel, and the shortseller gets his wish...

...Some mechanism must be put in place that ameliorates the unfairness of this situation...

...The SEC's division of enforcement-over the years, and likely without the knowledge of the commissioners-has developed a set of procedures that seem heedless of the cost of their actions and reflect a desire to win at any cost...

...Thus, in effect, although an investigation may have been abandoned, the company involved may not have been so advised...

...In a large bureaucracy, what is known at the top, and what is actually going on down below, are two entirely different things...

...William Donaldson has been replaced as chairman by former Congressman Christopher Cox, a conservative who, with Bush appointees Paul Atkins and Cynthia Glassman, is unlikely to pursue the unwarranted and unnecessary regulatory initiatives that cost Donaldson his job...

...A well-placed "tip" to the SEC may be just the ticket...

...MUI requests are often drafted very broadly, without regard to the likely economic cost of full compliance...

...The general data in this r e p o r t - without including the names of parties-should regularly be made public by the commission...

...More troubling, the defendant is not always aware of what evidence the enforcement division will use to seek the commission's approval...

...often obtain...

...The next step is to redeem the principle of conservative governance by assuring that the SEC staff, and particularly the enforcement division, understands the need for selfrestraint...

...9 Certainly not to protect wrongdoers or to weaken the ability of the SEC to enforce the securities laws by legitimate and responsible means...

...Consultations with the ombudsman should remain confidential, even if the complainant is ultimately charged with wrongdoing...

...The existence of the subpoena and its withdrawal were reported in the Wall Street Journal on Saturday, February 25, and on Monday, February 27, Chairman Cox issued a press release that stated in part: "Until the appearance of media reports this weekend, neither the Chairman of the SEC, the General Counsel, the Office of Public Affairs, nor any Commissioner was apprised of or consulted in connection with a decision to take such extraordinary action...

...Defendants know this, and frequently prefer to settle rather than suffer the adverse publicity associated with both the formal charge and any protracted litigation...

...Most presentations to the commission by the staff result in actual charges...

...At this point, private counsel usually advises the affected company that the informal investigation must be publicly disclosed-with adverse consequences for the company's stock price-even though it may not have been based on any more information, or on any greater SEC staff consideration, than the original news article, complaint or tip that stimulated the MUI...

...Although informal contacts between the enforcement staff and defense counsel can provide some sense of what facts are important, there is no requirement that the staff reveal all the salient facts that it will present to the commission, so that the defendant preparing the Wells submission is often handicapped in determining what issues it should address...

...The commission is both the prosecutor and grand jury in these cases, an obviously unfair situation that led the commission in the early 1970s to develop a procedural form known as the Wells submission-named after a prominent New York lawyer, John Ashley Wells, who headed a committee that advised the commission on its procedures...

...Victims of this process say it has actually happened...

...Defendants know this, and frequently prefer to settle rather than suffer the adverse publicity associated with both the formal charge and any protracted litigation...

...But like any other agency that wields the monopoly power of government, the SEC must use its authorby Peter J. Wallison 22 THE AMERICAN SPECTATOR MAY 2006 Under Christopher Cox, the Securities and Exchange Commission may finally be ready to take control of its enforcement staff...

...An active investigation should be defined so that the public can determine whether investigations that are no longer active are being closed...

...The eagerness of the staff to find and pursue sexy cases makes them susceptible to manipulation by a dishonest short-seller seeking to drive down a stock's price...

...Peter J. Wallison is a resident fellow at the American Enterprise Institute...

...The commission itself apparently exercises no control over this process, and may not be aware of how enforcement cases originate...

...It shows that he has recognized some of the problems that his predecessors allowed to fester...

...But when government officials are given monopoly power to pursue their authority they must act responsibly, understanding that their power also involves a public trust...

...From a purely economic point of view, the enormous waste of assets that flows from excessive and unnecessary actions by the SEC's enforcement staff is a deadweight loss to the economy and a specific loss to investors in a company that is investigated but never charged with wrongdoing...

...In these proceedings, the enforcemerit division provides a written "Action Memorandum" to the commission and division representatives orally present their case...

...Where the request calls for years of e-mail messages or other documentation, it can entail significant and costly efforts by lawyers inside and outside the affected company...

...Still, there are indications that Chairman Cox has begun to realize that the enforcement division must be brought to heel...

...It is important to note who gets hurt by all of this: investors, the very people the SEC is supposed to protect...

...Necessary Reforms T HESE PROCEDURES ARE NOT WORTHY of an agency that operates according to standards of elementary procedural fairness, or is truly concerned about protecting the interests of investors...

...But as government agencies go, the SEC, until recently, has had a creditable record of allowing markets to function relatively freely...

...It's not clear how seriously the general counsel takes this role, and the commission should take steps to assure that the general counsel is aware that he or she has just as important a role in the enforcement decision as the enforcement division itself...

...There are, as a result, very few litigated cases involving SEC charges against public companies or regulated entities such as broker-dealers...

...firm millions of dollars in legal fees and tie up a significant portion of senior staff time...

...Thus, informal investigations can be, and often are, opened without ever being touched by human hands...

...A few procedural reforms would go a long way toward rectifying this situation: MAY 2006 THE AMERICAN SPECTATOR 25 RUDE AWAKENING AT THE SEC _9 Senior officials who approve MUIs should be charged with assuring that these highly preliminary requests for information are not costly fishing expeditions...

...An ambitious stafferhoping to have found the Enron of his tenure-may 24 THE AMERICAN SPECTATOR MAY 2006 PETER J. WALLISON open a MUI on the basis of the tip, find nothing worth pursuing, and fail to close it...

...The Wells procedure, as it has now developed, is therefore only a partial remedy for the inherent unfairness of a process in which the prosecution holds all the cards...

...9 The commission currently receives staff reports on the number of investigations open and the number that are active...

...Better, they have learned through experience, to let sleeping dogs lie...

...W HY SHOULD THESE THINGS BE DONE...

...During the chairmanships of Arthur Levitt and William Donaldson, the power of the SEC's enforcement division grew considerably...

...9 As MUIs age toward 60 days, the written approval of the associate director who originally approved the MUI should be required before the matter becomes an informal investigation...

...If it turns out that the staff's initial suspicions do not warrant further review, the MUI can be terminated easily, but if this is not done within 60 days the SEC's computerized case tracking system automatically escalates the MUI to the status of an "informal investigation...

...One of the most important protections of our legal system is thus often denied to companies and individuals because of a procedural advantage exploited by the staff...

...9 If a party publicly named in a formal or informal investigation is no longer a subject or a witness in that proceeding, the party should be promptly notified...

...what started as a quick look for a potential violation has now become a disclosure item for the affected public company...