The distorting incentives facing the U.S. securities and exchange commission

Harvard Journal of Law and Public Policy

Volumn 33, Issue 2, 2010, Pages 639-671

  Macey, Jonathan R ^a  

^a YALE UNIVERSITY   (United States)

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EID: 78049258959     PISSN: 01934872     EISSN: None     Source Type: Journal    
DOI: None     Document Type: Article

References (105)

1. See, e.g., WILLIAM NISKANEN, BUREAUCRACY AND REPRESENTATIVE GOVERNMENT (1971);
2. David D. Haddock & Jonathan R. Macey, Regulation on Demand: Spend Interest Groups and Insider Trading Law, 30 J.L. ECON. 311, 323 (1987);
3. Jonathan R. Macey, Administrative Agency Obsolescence and Interest Group Formation: A Case Study of the SEC at Sixty, 15 CARDOZO L. REV. 909, 914 (1994).
4. See Troy A. Paredes, SEC Comm'r, Remarks Before the Mutual Fund Directors Forum Ninth Annual Policy Conference (May 4, 2009), available at http://www.sec.gov/news/speech/2009/spch050409tap.htm.
5. See Riva D. Atlas, Spitzer Vows Legal Action Against Head of Fund Family, N.Y. TIMES, Oct. 30, 2003, at Cl;
6. see also Walter Hamilton, Strong Capital May be Indicted; Prosecutor says Criminal Charges Against the Mutual Fund Giant and Its Founder are Possible, L.A. TIMES, Oct. 31, 2003, at Cl (noting that "[t]he SEC has lagged behind Spitzer in uncovering mutual fund trading abuses").
7. See U.S. SEC. & EXCH. COMM'N, OFFICE OF INVESTIGATIONS, INVESTIGATION OF FAILURE OF THE SEC TO UNCOVER BERNARD MADOFF'S PONZI SCHEME (2009) [hereinafter MADOFF INVESTIGATION].
8. See Jed Horowitz, SEC commish: We need fewer lawyers and more economists, INV. NEWS, Sept. 24 2009, http://www.investmentnews.com/apps/pbcs.dll/article? AID=/20090924/FREE/909249990/-1/Topic;
9. see dso Paredes, supra note 2 ("For an agency that regulates the world's largest securities markets to be so dominated by lawyers is ill-advised.").
10. A notable exception to this general situation is the apparently successful effort by the investment banking firm Morgan Stanley to limit the SEC's insider trading investigation of a hedge fund called Pequot Capital Management. For a retelling of the story,
11. see 153 CONG. REC. S1381-91 (daily ed. Jan 31, 2007). The SEC's investigation was going to require taking testimony from- and perhaps investigating-dash; John Mack, Morgan Stanley's CEO who had worked with Pequot during the time period of the alleged insider trading. Maneuvering within the SEC delayed Mack's testimony until after the statute of limitations had lapsed. Congressional investigators found that: In June 2005, Morgan Stanley's Board of Directors hired former U.S. Attorney Mary Jo White to determine whether prospective CEO John Mack had any exposure in the Pequot investigation. White contacted Director of Enforcement Linda Thomsen directly, and other Morgan Stanley officials contacted Associate Director Paul Berger. Soon afterward, SEC managers prohibited the staff from asking John Mack about his communications with Arthur Samberg at Pequot.... SEC management delayed Mack's testimony for over a year, until days after the statute of limitations expired. After Staff Attorney Aguirre complained about his supervisor's reference to Mack's "political clout," SEC management offered conflicting and shifting explanations for blocking Mack's testimony. Although Paul Berger claimed that the SEC had always intended to take Mack's testimony, Assistant Director Mark Kreitman said that definitive proof that Mack knew about the GE-Heller deal was the "necessary prerequisite" for taking his testimony. The SEC eventually took Mack's testimony only after the Senate Committees began investigating and after Aguirre's allegations became public, even though it had not met Kreitman's prerequisite. The SEC fired Gary Aguirre after he reported his supervisor's comments about Mack's "political connections," despite positive performance reviews and a merit pay raise. Just days after Aguirre sent an e-mail to Associate Director Paul Berger detailing his allegations, his supervisors prepared a negative re-evaluation outside the SEC's ordinary performance appraisal process. They prepared a negative re-evaluation of only one other employee. Like Aguirre, that employee had recently sent an e-mail complaining about a similar situation where he believed SEC managers limited an investigation following contact between outside counsel and the Director of Enforcement. MINORITY STAFF OF S. FIN. COMM. & S. COMM. ON THE JUDICIARY, 110TH CONG., THE FIRING OF AN SEC ATTORNEY AND THE INVESTIGATION OF PEQUOT CAPITAL MANAGEMENT 5-6 (Comm. Print 2007).
12. Sec. & Exch. Comm'n., The Investor's Advocate: How the SEC Protects Investors, Maintains Market Integrity, and Facilitates Capital Formation, http://sec.gov/about/whatwedo.shtml (last visited Mar. 5, 2010).
13. Id.
14. Id.
15. John Sivolella, Bureaucratic Decision Making - SEC Enforcement and the Federal Courts' Ideology 29 (Apr. 2007) (unpublished manuscript), avdlable at http://www.allacademic.com/meta/p196843-index.html.
16. William E. Bealing, Jr., Actions Speak Louder Than Words: An Institutional Perspective on the Securities and Exchange Commission, 19 ACCT. ORG. & Soc'Y 555, 555-57 (1994).
17. Sivolella, supra note 10, at 30.
18. Oversight of the SEC's Failure to Identify the Bernard L. Madoff Ponzi Scheme and How to Improve SEC Performance: Hearing Before the S. Comm. on Banking, Hous. & Urban Affairs, 111th Cong. 22-23 (2009) (statement of Robert Khuzami, Dir., Div. of Enforcement, U.S. Sec. & Exch. Comm'n, & John Walsh, Acting Dir., Office of Compliance Inspections & Examinations, U.S. Sec. & Exch. Comm'n) [hereinafter Khuzami & Walsh Hearing], available at http://banking.senate.gov/public/index.cfm?FuseAction=Files. View&FileStore-id=64355cc6-d04c-4b4f-be96-ed0d4a93c244.
19. U.S. SEC. & EXCH. COMM'N, 2008 PERFORMANCE AND ACCOUNTABILITY REPORT (2008).
20. Zachary Kouwe, Judge Rejects Settlement Over Merrill Bonuses, N.Y. TIMES, Sept. 14, 2009, at Al.
21. See Jonathan R. Macey & Maureen O'Hara, Regulation and Scholarship: Constant Companions or Occassional Bedfellows?, 26 YALE J. ON REG. 82, 102-13 (2009).
22. See id.
23. Herbert Bless et al., Ease of Retrieval as Information: Another Look at the Availability Heuristic, 61 J. PERS. & Soc. PSYCH. 195, 195 (1991). In addition to the SEC, it also appears that the Financial Industry Regulatory Authority (FINRA) is evaluated on the basis of how many cases it brings and how big the fines are that it collects.
24. See Susanne Craig, Finra's Susan Merrill to Exit as Enforcement Chief, WALL ST. J., Mar. 18, 2010, at Al ("The executive hired by Wall Street to enforce its rules is stepping down after nearly three years in which the organization's disciplinary actions and fines against the brokerage industry have declined, the group said.").
25. Aaron Tversky & Daniel Kahneman, Availability: A Heuristic for Judging Frequency and Probability, 5 COGNITIVE PSYCH. 207, 208 (1973).
26. See Paredes, supra note 2.
27. Fraud Investigator Blasts SEC, WKRG.COM NEWS, Feb. 5, 2009, http://www.wkrg.com/politics/article/fraud-investigator-blasts-sec/23318/ Feb-05-2009-6-4-am.
28. Michael Lewis & David Einhorn, Op-Ed., The End of the Financial World as We Know It, N.Y. TIMES, Jan. 4, 2009, at WK9.
29. SEC. & EXCH. COMM'N, PAY PARITY IMPLEMENTATION PLAN AND REPORT (2009), http://www.sec.gov/news/studies/payparity.htm. During the eight-year period for which data is available (1994-2001) annual turnover rates for SEC attorneys averaged 14.05% while annual turnover rates for government attorneys generally averaged only 7.6%.
30. Id.
31. See, e.g., Macey, supra note 1, at 937, 948.
32. SEC. & EXCH. COMM'N, supra note 24.
33. SUSAN DUDLEY & MELINDA WARREN, REGULATORY SPENDING SOARS: AN ANALYSIS OF THE U.S. BUDGET FOR FISCAL YEARS 2003 AND 2004: 2004 ANNUAL REPORT 11-12, 16 (2003).
34. See Sec. & Exch. Comm'n, Frequently Requested FOIA Document: Budget History, http://www.sec.gov/foia/docs/budgetact.htm (last visited Mar. 6, 2010).
35. See Departments of Commerce, Justice, and State, the Judiciary, and Related Agencies Appropriations for Fiscal Year 2003: Hearing on S. 2778 Before a Subcomm. of the S. Comm. on Appropriations, 107th Cong. 226-27 (2002) (written statement of Harvey L. Pitt, Chairman, Sec. & Exch. Comm'n).
36. Vital Assets: Human Capital in Federal Economic Regulatory Agencies: Hearing Before the Subcomm. on Oversight of Gov't Mgmt, Restructuring, and the Dist. of Columbia of the S. Comm. on Governmental Affairs, 107th Cong. 73 (2002) (written statement of James M. McConnell Executive Dir., U.S. Sec. & Exch. Comm'n).
37. Investor and Capital Markets Fee Relief Act, Pub. L. No. 107-23, § 8, 115 Stat. 2390, 2398 (2002).
38. Kouwe, supra note 15.
39. Id.
40. Complaint at 1-2, SEC v. Bank of Am. Corp., No. 09 Civ. 6829 (S.D.N.Y. Aug. 3, 2009).
41. Id. at 2.
42. Memorandum Order at 3, SEC v. Bank of Am. Corp., No. 09 Civ. 6829 (S.D.N.Y. Sept. 14, 2009).
43. Id. at 3.
44. Id. at 2.
45. Id. at 4. The SEC defended making the shareholders pay for the company's fraud on the grounds that "[a] corporate penalty... sends a strong signal to shareholders that unsatisfactory corporate conduct has occurred and allows shareholders to better assess the quality and performance of management." Id. (alteration in original) (citation omitted). As Judge Rakoff noted, the SEC's justification makes no sense when applied to the facts here: for the notion that Bank of America shareholders, having been lied to blatantly in connection with the multi-billion-dollar purchase of a huge, nearly-bankrupt company, need to lose another $33 million of their money in order to 'better assess the quality and performance of management' is absurd.
46. Id.
47. Id. at 5.
48. Id. at 7 (noting that "even if this decision is arguably within [management's] purview, it calls for greater scrutiny by the Court than would otherwise be the case").
49. Id. at 8.
50. Id. at 11.
51. Khuzami & Walsh Hearing, supra note 13.
52. MADOFF INVESTIGATION, supra note 4, at 1-2.
53. Khuzami & Walsh Hearing, supra note 13.
54. MADOFF INVESTIGATION, supra note 4, at 20-21 (emphasis added).
55. Id. at 98.
56. Id. at 108-09 ("I can tell you we were always hesitant to get audit trail data because it can be tremendously voluminous and difficult to deal with and is a huge resource issue for us. It takes us a ton of time.").
57. Id. at 109.
58. Id. at 339. In all, the OIG investigation of Madoff cites the unwillingness or inability to devote resources to the investigation over thirty times.
59. MADOFF INVESTIGATION, supra note 4, at 244 n.167.
60. SEC. & EXCH. COMM'N, DIV. OF ENFORCEMENT, ENFORCEMENT MANUAL 20 (2010).
61. Ehsan H. Feroz, Kyungjoo Park & Victor S. Pastena, The Financial and Market Effects of the SEC's Accounting and Auditing Enforcement Releases, 29 J. ACCT. RES. 107, 111 n.6 (1991) (observing that former SEC Enforcement Division Chief Accountant Robert Sack believes that approximately one-third of SEC investigation leads are initiated by perusing the financial press).
62. Mark L. DeFond, Jere R. Francis & Xuesong Hu, The Geography of Auditor Independence and SEC Enforcement 5-6 (May 13, 2008) (unpublished manuscript), available at http://papers.ssrn.com/sol3/papers.cfm?abstract-id= 1132885.
63. Id. at 4-5.
64. The primary internal source is referrals to the Division of Enforcement from the Division of Corporate Finance. See Michael J. Kigin, Assoc. Chief Accountant, Office of the Chief Accountant, Sec. & Exch. Comm'n, Remarks to Business Issues and Audit Conference, The Institute of Internal Auditors: The SEC's View on Government and Enforcement Activities 3 (Oct. 25, 1993), available at http:// www.sec.gov/news/speech/1993/102593kigin.pdf.
65. See JOSEPH P. CHAMBERLAIN & PAUL R. HAYS, THE JUDICIAL FUNCTION IN FEDERAL ADMINISTRATIVE AGENCIES 76-78 (1970);
66. see also HARWOOD L. CHILDS, PUBLIC OPINION: NATURE, FORMATION, AND ROLE 298 (1965).
67. See George Priest & Benjamin Klein, The Selection of Disputes for Litigation, 13 J. LEGAL STUD. 1, 16 (1984).
68. Donald C. Langevoort, The SEC and the Madoff Scandal: Three Narratives in Search of a Story 8 (Georgetown Law Faculty Working Papers, Paper No. 116, 2009), available at http://scholarship.law.georgetown.edu/fwps-papers/116/#.
69. See Chevron U.S.A. Inc. v. Natural Res. Def. Council, Inc., 467 U.S. 837 (1984);
70. Skidmore v. Swift & Co., 323 U.S. 134 (1944).
71. Langevoort, supra note 60, at 8.
72. Joseph K. Tanimura, The Effects of Insider Trading Restrictions: Evidence from Dividend Initiations and Omissions (1935-1974), at 23 (Mar. 14, 2009) (unpublished manuscript), available at http://papers.ssrn.com/sol3/papers.cfm? abstract-id-1359679;
73. accord Louis Loss, History of S.E.C. Legislative Programs and Suggestions for a Code, 22 Bus. LAW. 795, 795-96 (1967). The defense of the SEC's refusal to formulate a definition of insider trading was that it was not possible to define this sort of illegal behavior and that any definition promulgated simply would create a "blueprint for fraud."
74. See Donald C. Langevoort, Seeking Sunlight in Santa Fe's Shadow: The SEC's Strategic Pursuit of Managerial Accountability 40 (Georgetown University Law Center, Working Paper No. 265144, 2001), available at http://papers.ssrn. com/sol3/papers.cfm?abstract-id=265144.
75. See SEC v. Cuban, 634 F. Supp. 2d 713 (N.D. Tex. 2009). The Author participated in writing and filing an amicus brief supporting the dismissal of the SEC's complaint.
76. Id. at 717.
77. Id. at 717-18.
78. See id. at 717.
79. Id. at 717-18.
80. See United States v. O'Hagan, 521 U.S. 642 (1997) (adopting the misappropriation theory of liability for insider trading).
81. Cuban, 634 F. Supp. 2d at 728.
82. Id. at 725.
83. Id. at 725-28.
84. 17 C.F.R. § 270.10b5-2(b)(1) (2009).
85. Cuban, 634 F. Supp. 2d at 730-31.
86. Market Timing, in A DICTIONARY OF BUSINESS AND MANAGEMENT 355 (5th ed. 2009). The efficient markets hypothesis (also known as the Efficient Capital Markets Hypothesis, or ECMH) predicts, among other things, that share prices adjust very rapidly to new information and already reflect historical information. A basic implication of the efficient markets hypothesis is that most market timing strategies cannot possibly succeed because they attempt to predict future share prices on the basis of historical patterns of share prices. This is fundamentally incompatible with the efficient markets hypothesis.
87. The NAV is the value of the mutual fund shares as calculated by the Mutual Fund Company's adviser divided by the number of mutual fund shares outstanding.
88. The European Central Bank may announce, for example, that it will lower interest rates because manufacturing is up and employment is down.
89. 17 C.F.R. § 270.22c-1(a).
90. 17 C.F.R. § 270.22c-1(b).
91. See Edward Sherwin, The Cost-Benefit Analysis of Financial Regulation: Lessons from the SEC's Stalled Mutual Fund Reform Effort, 12 STAN. J.L. Bus. & FIN. 1, 19 (2006) (describing "[t]he SEC's usually cooperative relationship with the mutual fund industry");
92. see also Paula Dwyer, Breach of Trust, Bus. WK., Dec. 15, 2003, at 98 (describing the close relationship between the SEC's mutual fund regulators and the mutual funds they were supposed to regulate and explaining how this relationship led to a situation in which illegal activity was condoned).
93. Landon Thomas Jr., Big Fine Over Trader's Mutual-Fund Moves, N.Y. TIMES, Sept. 4, 2003, at C1.
94. Id. As noted above, market timing and frequent trading are not illegal. Of course, mutual funds may not violate the terms of their own prospectuses by permitting frequent trading to the extent that such trading violates their prospectuses. And, others may not actively conspire with a mutual fund to violate the terms of its prospectus. The SEC is, in theory, supposed to police prospectus disclosures.
95. Sherwin, supra note 80, at 19-20.
96. Dimensional, News/Late Trading and Market Timing, http://www.dfaus.com/ news/late-trading/ (last visited Mar. 7, 2010).
97. Id.
98. As noted above, recently SEC alumni from the Division of Enforcement have placed themselves in senior positions at Deutsche Bank, JPMorgan Chase, and Morgan Stanley. See supra text accompanying note 23.
99. See Macey, supra note 1, at 946.
100. Id. at 948.
101. See GOV'T ACCOUNTABILITY OFFICE, SECURITIES AND EXCHANGE COMMISSION: GREATER ATTENTION NEEDED TO ENHANCE COMMUNICATION AND UTILIZATION OF RESOURCES IN THE DIVISION OF ENFORCEMENT 28 (2009).
102. MADOFF INVESTIGATION, supra note 4, at 366 (identifying administrative burdens facing the SEC staff attorneys charged with investigating Madoff).
103. Norman S. Poser, Why the SEC Failed: Regulators Against Regulation, 3 BROOK. J. CORP. FIN. & COM. L. 289, 289 (2009).
104. Preet Bharara, U.S. Attorney for the Southern Dist. of N.Y., Prepared Remarks for U.S. Attorney Preet Bharara: Hedge Fund Insider Trading Takedown (Oct. 16, 2009), available at http://www.justice.gov/usao/nys/hedgefund/ hedgefundinsidertradingremarks101609.pdf.
105. Complaint at 22, SEC v. Galleon Management, L.P., No. 09-CV-8811 (S.D.N.Y. Oct. 16, 2009).