Featured Faculty Opinion: John C. Coffee, Jr.
by John C. Coffee, Jr.*
Twice in two years - - first with securities analysts and now with mutual funds - - New York State Attorney General Eliot Spitzer has grabbed the brass ring, found the smoking gun, and stolen a march on the SEC. Only Tiger Woods has experienced a similar level of success - - and not recently. Predictably, two reactions are now evident to his success: First, he is attracting imitators from among his peers, who are eager to follow in his footsteps and hopefully reap similar fame; second, the securities industry is lobbying Congress to clip his wings and restrict the prosecutorial reach of state attorneys general. While the SEC has not joined in this call for preempting the state attorneys general, it has also not leaped to Spitzer's defense. Rather, SEC Chairman William Donaldson has just called for greater cooperation among state and federal regulators, but has also criticized New York and Massachusetts for not disclosing in advance to the SEC their recent major initiatives against mutual funds.(1) In short, only a guarded cooperation seems likely, with competition for headlines and credit appearing inevitable.
But is this bad? The real issue thus here is how much competition is desirable between federal and state regulators. Viewed in the light most favorable to the state attorneys general, competition is efficient and desirable. For example, if a federal agency either decides not to enforce a particular law or, more typically, is overwhelmed by other priorities, state regulators can act to fill the void. This may well describe what happened in 2002 when the SEC was preoccupied with accounting irregularity cases (e.g., Enron and WorldCom) and seemingly responded slowly to the revelations unearthed by Mr. Spitzer that securities analysts were deeply conflicted and compromised. From this perspective, competition among state and federal enforcers ensures that a failsafe remedy is available and so promotes law compliance.
Success also breeds success. While we do not know how Mr. Spitzer discovered the late trading by Canary Capital Partners, the hedge fund which has now agreed to a $40 million settlement, the natural inference is that a whistle-blower came to him (possibly instead of the SEC) because he had acquired a reputation as an aggressive enforcer. Whatever happened in that case, it is increasingly likely that the next whistle-blower will also come to Mr. Spitzer, because his office has now shown that it can and will respond quickly.
But the other side of the coin comes into view when we consider the implications of the recent decision of the Oklahoma Attorney General to indict WorldCom and its former CEO, Bernard Ebbers. In so doing, Oklahoma Attorney General Drew Edmondson has created a major problem for federal prosecutors and arguably crippled their ability to offer an effective plea bargain to potential defendants. Once a WorldCom defendant now pleads guilty at the federal level, that defendant seemingly becomes a sitting duck for a state prosecutions and, in addition, may have waived his or her Fifth Amendment privilege against self-incrimination. Even if the Oklahoma Attorney General agrees to abide by the federal plea agreement, or to agree to a joint plea, there is no telling who else may enter the field - - Massachusetts, Idaho, or Guam, as WorldCom operated everywhere. Simply the prospect of a state prosecution may have harmful consequences, as it may pressure federal prosecutors to rush the development of their cases for political reasons, rather than to develop them painstakingly. Last week's federal plea bargain under which Enron's Treasurer, Ben Glisan, agreed to, and began serving, a five year sentence has all the earmarks of a case in which the defendant was given a more favorable plea agreement than had been previously intended in order to secure a guilty plea at a politically opportune and sensitive moment. In short, competition does not always provide a protection against prosecutorial underenforcement, but may sometimes instead perversely impede enforcement, at least to the extent that plea bargains are recognized to be a necessary tool by which prosecutors flip defendants in order to gain witnesses who can implicate those higher up on the corporate ladder.
Another variation on this problem of competition among state and federal regulators is the "Balkanization-of-the-market" theme stressed by the securities industry: if every state can impose its own rules, at least locally, the efficiency of a single national market is lost. Indeed, a particular state attorney general might be able to insist on an idiosyncratic governance remedy that necessarily applied nationally but that defendants felt compelled to accept because of the threat of an indictment if they did not. Thus, one jurisdiction might be able effectively to overrule all others, thereby interfering with the SEC's ability to determine the structure of the national market system. Here, the example used by the industry is the original proposal made by Mr. Spitzer (and quickly dropped) that underwriting firms spin-off their securities analysts into a separate subsidiary that would be distributed as a stock dividend to their shareholders, thereby achieving a complete separation between analysts and underwriters. Such a proposal struck many as unduly prophylactic for a variety of reasons, including the poor economic prospects for independent analysts in such a spun-off firm. Yet, even though it was quickly abandoned, it has been used as the justification for proposed legislation, introduced in the House by Congressman Richard Baker (R-La.), chair of the Subcommittee on Capital Markets of the House Committee on Financial Services, as part of a proposed Securities Fraud Deterrence and Investor Restitution Act. Section 8(b) of this legislation would amend Section 15(h)(1) of the Securities Exchange Act of 1934 to read, as follows:
"(1) Capital, Margin, Books and Records. Bonding, Disclosure and Reports. - -
(A) IN GENERAL. - - No law, rule, regulation, judgment, agreement or order, or other action of any State or political subdivision thereof shall establish capital, custody, margin, financial responsibility, making and keeping records, bonding, or financial or operational reporting, disclosure or conflict or interest requirements for brokers, dealers, municipal securities dealers, government securities brokers or government securities dealers that differ from, or are in addition to, the requirements in those areas established by the Commission or by any national securities exchange or other self regulatory organization...." (emphasis added).
Today, Section 15(h)(1) omits the underscored language in the above text and basically only establishes uniform net capital, bonding and record keeping standards for broker dealers, thereby protecting them from higher or more specialized standards established by any state. The key addition in the proposed legislation would be the new reference to "disclosure or conflict of interest requirements." Seemingly, its impact would be to bar state attorneys general from establishing higher such standards than are required either by the SEC or, by the NYSE or Nasdaq. While this provision seems to have been drafted with a view to curbing efforts by Mr. Spitzer to require additional disclosures by investment banking firms about their securities analysts, it would seemingly apply as well to the Spitzer investigation of late trading and making timing by mutual funds. Brokers have allegedly assisted customers in some cases by filing misleading reports indicating that late trades were made before 4:00pm. Or, brokers may have participated in the selective revelation to favored clients of a mutual fund's daily portfolio positions, which enables the market timer to gain arbitrage profits that come at the expense of other shareholders. Any attempt by a state to adopt a prophylactic rule against market timing would seeming rub dangerously close to the proposed preemption of "disclosure or conflict of interest" rules that were more demanding than those of the SEC.
State attorneys general and the North American Securities Administrators Association, Inc ("NASAA") have been quick to protest this proposed revision to Section 15(h)(1). They point out that it would restrict long-established practices, such as the practice of many states of requiring more detailed disclosures in excess of SEC requirements from broker-dealers with a troubled regulatory history.(2) In effect, such broker-dealers are effectively placed on probation or denied the ability to enter a new state, unless they disclose more about their trading practices or recommendations than the SEC requires.(3) Ironically, denying the states such a power might lead state regulators to give up on probation and shut the firm down or bar it from entering a new jurisdiction. The states have also used the example of special disclosures for unorthodox securities, such as viatical settlements, where they have more elaborate disclosure requirements than the SEC requires. This is probably because viatical settlements, tend to be marketed locally and to fall below the SEC's radar screen; in effect, there is no national market to protect. But the states, having more experience, have more detailed disclosure requirements for such offerings.
Beyond the issues identified by NASAA, another quirk embedded in the proposed legislation seems even more anomalous: it permits both the NYSE and Nasdaq, both private bodies, to preempt state regulation. Let us suppose that a given state adopts a suitability requirement stronger than that of the NYSE and Nasdaq. At least to the extent that suitability rules can be viewed as disclosure and/or conflict of interest regulations, the higher state regulation is seemingly preempted - - by a private organization's rules. Of course, the proponents of such preemption would argue that this is necessary to protect a national market against interference by a host of provincial regulators. But the irony here is that NYSE and the NASD's suitability rules are not identical;(4) hence, there is no uniform national standard.
Even from the industry's perspective, the proposed legislation has ambiguities that may undercut its utility to them. For example, if under the threat of indictment for a traditional antifraud offense, a defendant agrees to a plea bargain containing a broad prophylactic prohibition that would normally violate Section 15(h)(1), it is not clear that it can always later challenge this agreement. After all, rights can be waived, and private parties other than the defendant probably lack standing to challenge such an agreement.
For state regulators, however, the greatest problem with the proposed legislation is that a defense under Section 15(h)(1) might be raised in a vast number of cases - - even if only frivolously. According to NASAA, the states filed 360 criminal actions, 78 civil actions, and 2,579 administrative actions for securities law violations during fiscal year 2001-2002,5 the most recent year for which data is available. In some unpredictable, but probably substantial, percentage of these cases, defense counsel could have raised a colorable Section 15(h)(1) defense if the proposed language had then been in force. Thus, significant costs are imposed on state regulators, even if it were the case that no outcome changes in any case.
In this light, what kind of legislative reform would make sense if one perceives that there is a threat to the national market system from aggressive enforcement of novel legal theories by state regulators? The simplest and most logical answer would be to give the SEC standing, but not private parties, to enjoin and/or invalidate any "law, rule regulation, agreement, or other action by any state or political judgment thereof" if such law, rule, regulation, agreement or other action "threatened in the Commission's reasonable judgment to unduly burden, hamper or impede the national market system," as such term is defined in Section 11A of the Securities Exchange Act of 1934. Procedurally, the SEC would be given jurisdiction to sue in federal court to challenge the state law, rule, regulation, agreement or other action, and it would be authorized to remove cases pending in state court to federal court for the limited purpose of such a determination. To avoid unnecessary uncertainty, the SEC's power to obtain a judgment obtained in state court could be limited to some reasonable period of time (say, 90 days) after the prevailing party served a copy of the judgment and the pleadings on it. The same legislation might also give the Department of Justice authority to seek a stay in federal court of a state court proceeding that in its judgment threatened to disrupt an actually pending federal investigation or prosecution.
What really differentiates this approach from the proposed language in Section 15(h)(1)? First, it spares state regulators from having to defend in numerous cases against frivolous claims that a law, rule, regulation, agreement, or other action embodied a new "disclosure or conflict of interest regulation" that was in excess of the SEC's requirement. Second, it would require that any such rule or regulation be reasonably found by the SEC to "unduly burden, hamper or impede" the national market system. Not everything that is new or in excess of the SEC's rules "unduly" burdens or interferes with the national market system. Finally, by giving the SEC exclusive standing to raise this claim, this proposal makes the SEC politically accountable. It cannot feign neutrality and hide behind the actions of others. If it wishes to block aggressive enforcement or a novel extension of the law, it must bear the political heat and be prepared for the reply from the state regulator that it has done too little and is only defensively guarding its turf.
To sum up, nothing yet has truly suggested that state regulators are about to overburden the national market system. But to the extent that this danger could arise because of the new activism of state regulators, the better answer is not to preempt all new initiatives by the states, but to give the SEC authority to determine that a particular initiative or action went too far and unduly burdened a national market system that ideally should be uniform. While the Baker bill may be doomed for the present, this is an issue that will not disappear, but that will regularly re-appear as federal and state regulators continue to compete for fame and political advantage.
* Professor Coffee is the Adolf A. Berle Professor of Law at Columbia University School of Law, and Director of its Center on Corporate Governance.
- See Riva D. Atlas, "S.E.C. Chief Plays Down Clash With State Attorneys General," New York Times, September 15, 2003, at C-2.
- See Letter, dated July 21, 2003, from Christine A. Bruen, NASAA President, to Congressman Paul E. Kanjorski, Ranking Member of the House Subcommittee on Capital Markets.
- Id. at 3.
- NYSE Rule 405 (the NYSE's "Know Your Customer Rule") applies more broadly than does NASD Rule 2310, which only becomes applicable when the broker makes an actual recommendation to the customer. For an overview of the differences, see Louis Lowenfels & Alan Bromberg, Suitability in Securities Transactions, 54 Bus. Law. 1557 (1999).
- See Letter, dated July 24, 2003, from the Attorneys General of California, Maryland, New York, Delaware and South Carolina to Congressman Kanjorski at p. 2.