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House Financial Services Subcommittee Hearing on Securities Law Enforcement

House Financial Services Subcommittee on Investor Protection, Entrepreneurship and Capital Markets

“Putting Investors First: Examining Proposals to Strengthen Enforcement Against Securities Law Violators”

Wednesday, June 19, 2019

 

Key Topics & Takeaways

  • Disgorgement: Crimmins said Kokesh prevents the use of disgorgement that can help to address the unfair practice of fraudsters keeping illegal gains. He said that disgorgement was a traditional equitable remedy prior to the Kokesh ruling. Thomas said the legal system should have overlap for state and federal authority, as well as for private and public investment to protect individuals. He added his belief that the SEC’s estimate of the 900 million dollars loss due to Kokesh is low due to the statute of limitations. Velikonja said she agrees with Thomas as tolling agreements used by the SEC to expand the scope of investigations show much of the disgorgement gains are outside the five-year limitation. She added that if disgorgement is a penalty, a court cannot impose the penalty without statutory authority, which ultimately harms the investors.
  • Statute of Limitations: Vollmer said that he does not see evidence that guides him to believe there is a need to alter the limitation period, but that there is some concern for the concealment of violations. Velikonja said the first step in enforcement is to establish the occurrence of the violation within the five-year period, then figure out the appropriate monetary penalty. She said there is concern at the SEC for the period being too small in scope, which could lead to less thorough investigations.
  • Bad Actors and Penalties: Velikonja said the use of the Foreign Corrupt Practices Act penalty process is quite lengthy, that detection is relatively small, and often outside the limitation period. She said that she is not sure whether deterrence works, especially for the use of the death penalty. However, Velikonja said sanctions combined with visible and active enforcement works, as it deters large firms. She added that the goal of SEC enforcement is not deterrence, but rather investor protection and public interest of capital formation and public competition. Velikonja continued that claw backs hold large firm executives and employees accountable.

Witnesses

Opening Statements

Chairwoman Carolyn B. Maloney (D-N.Y.)

Maloney said that investors need to know that bad actors will be punished and investor money will be returned in cases of wrongdoing. She said that the Kokesh vs. the Securities and Exchange Commission (SEC) ruling has damaged the SEC’s ability to return investors funds. Maloney stated the ruling limits claims of disgorgement to a five-year statute of limitation to investigate and prosecute, through a narrow technical interpretation. She said according to the SEC, investors have lost roughly 900 million dollars due to this ruling. Maloney said she supports legislation offered by Rep. Ben McAdams (D-Utah.) that would to correct this issue, as well as legislation offered by Rep. Vicente Gonzalez (D-Texas.) that would correct the ruling made under Gabelli vs the SEC, which determined the five-year window for investigations begins when the fraud occurred, rather than when it was detected. Maloney added her “strong” support for the Bad Actor Disqualification Act and the Stronger Enforcement of Civil Penalties Act, offered by Rep. Katie Porter (D-Calif.).

Ranking Member Bill Huizenga (R-Mich.)

Huizenga stated the SEC’s Division of Enforcement investigations of securities law violations are guided by five core principles: to focus on the mainstream investor, to focus on individual accountability, to keep pace with technological changes, to impose remedies that most efficiently further enforcement, and to consistently re-assess SEC resources. Huizenga said in fiscal year 2018 (FY18), the SEC brought forward 821 enforcement actions that led to the collection of nearly 3.9 billion dollars in penalties and disgorgement. He said that 794 million dollars was returned to investors, 280 securities trading companies were suspended, and 520 suspension and bars for companies were obtained. Huizenga said the SEC has always been fair and effective and the proposals being considered do very little to put investors first, adding that they create barriers to capital formation and investor opportunity. He said the U.S. initial public offering (IPO) market is steadily declining, while China now controls one-third of the IPO market, explaining this is due to the increasing costs of regulatory compliance and that lawmakers should be focused on allowing the free flow of capital, strengthen job creation, and increase economic growth for Americans.

Rep. Brad Sherman (D-Calif.), Subcommittee Member

Sherman explained that his legislation, the Holding Foreign Companies Accountable Act, would help correct the Public Company Accounting Oversight Board’s (PCAOB’s) ability for audit oversight.  He said last year the SEC and the PCAOB issued a joint statement that highlighted over 220 U.S. companies with a combined market capitalization of 1.8 trillion dollars that could not be effectively audited. Sherman said this puts Americans money at risk and he encourages U.S. Trade Representative Robert Lighthizer to work with China to resolve this issue. He also said that he wants the SEC to be willing to audit unregistered investments, such as cryptocurrency, as they are a form of investment with poor oversight.

Testimony

Jordan A. Thomas, Partner, Labaton Sucharow

In his testimony, Thomas stated he is increasingly becoming concerned that the status quo to protecting investors is not working, and without Congress intervening, financial watchdogs will be fighting a “losing battle.” He said that securities laws are extremely difficult to detect, investigate, and prosecute due to their scope, rapid growth, and complex markets, products and transactions. Thomas said that Congress can provide much needed relief with a few of the proposals, most critically to restore the SEC’s ability to obtain full disgorgement for ill gotten gains. Thomas said disgorgement has been a central component in SEC enforcement, and prior to the Kokesh ruling, common sense prevailed in penalizing wrong doers. However, he said that now fraudsters can hide their misconduct that prevents the SEC from prosecuting bad actors, which has cost investors approximately 900 million dollars through the disgorgement process. Thomas said another critical component is the SEC’s ability to obtain civil monetary penalties, which has been harmed by the Gabelli ruling. He recommended Congress expand the statute of limitations to a 10-year window to strengthen SEC penalties, increase maximum penalties, provide the size of penalties to be linked to victim losses, and establish penalties against repeat offenders. Thomas added his support to reform the PCAOB whistleblower intelligence program to make the board more effective and dynamic.

Urska Velikonja, Professor of Law, Georgetown University Law Center

In her testimony, Velikonja focused on considering an increase of market oversight and strengthening sanctions, and more urgently codifying existing relief for SEC enforcement, specifically for disgorgement and civil cases. She said the failure to adopt the considered proposals would hamper SEC enforcement. Velikonja said after civil penalties, disgorgement is the second most common form of relief in SEC enforcement, ordered 56 percent of the time, and with monetary penalties of 80 percent. She said from 2010 to 2018 she studied the effects of disgorgement and found that orders amounted to 145 billion dollars in penalties, compared to 9.8 billion in civil cases. Velikonja said that the average SEC case takes two years to complete, whereas 37 percent of cases include violation outside of the five-year limitations period and in 2018 that number was at 50 percent. Velikonja said because of the statute of limitations, Charles Kokesh was forced to pay far less than the 35 million that he stole, and that it was not necessarily due to SEC delay. She recommended that either the limitation period be increased or the SEC budget be increased.

Andrew N. Vollmer, Professor of Law, University of Virginia School of Law

In his testimony, Vollmer said that lawmakers should be attentive to helping entrepreneurs find much needed capital and reduce regulatory barriers to entry. He said the need to protect investors, the need for vigorous and fair enforcement of securities laws, and the denial of companies not subject to PCAOB audit inspection all deserve attention by Congress. However, Vollmer said the Holding Foreign Companies Accountable Act and the PCAOB Enforcement Transparency Act are both limited in their scope to address the issue of exchange trading and audit transparency. He said that due to the discrepancy in reporting exchange traded companies, companies would not be prevented from trading in U.S. markets. Vollmer said the other proposals being considered, such as Gonzalez’s legislation, would disrupt the enforcement system and make the process more arbitrary and less fair. Vollmer said longer statutes would cause further delay in the enforcement process which can prevent SEC staff from finishing an investigation or not sue.

Stephen Crimmins, Partner, Murphy & McGonigle PC

In his testimony, Crimmins said these bills are critical for SEC enforcement, during a period where the number of professionals and the budget for the SEC has decreased. Crimmins said that the Kokesh ruling has created a problem in defining disgorgement as a penalty, and Congress must “strongly” state that there is a need for a separate penalty specification for disgorgement for the SEC to continue the core use for remedy in enforcement. He also said that the statute of limitations must be addressed but that the legislative proposal should adopt a statute of limitations across the board for all SEC remedies rather than use the rule of construction. Crimmins said the statute must be appropriate and suggested using Sarbanes-Oxley as an example for creating defined periods after the discovery and before the violation of conduct. He recommended a timeline of three years to investigate the conduct and to allow penalties to be sought for a 10-year limit from the occurrence of the violation. Crimmins said that he is concerned about remedies used directly as restitution or as part of a penalty calculation.

Question & Answer

Disgorgement

Reps. David Scott (D-Ga.), Ben McAdams (D-Utah.) and Maloney asked how legislation to address the Kokesh ruling on disgorgement would benefit the SEC, return ill gotten gains to investors, and protect investors. Crimmins said Kokesh prevents the use of disgorgement that can help to address the unfair practice of fraudsters being able to keep illegal gains. He said that disgorgement was a traditional equitable remedy prior to the Kokesh ruling. Thomas said the legal system should have overlap for state and federal authority, as well as for private and public investment to protect individuals. He added his belief that the SEC’s estimate of the 900 million dollars loss due to Kokesh is low due to the statute of limitations. Velikonja said she agrees with Thomas as tolling agreements used by the SEC to expand the scope of investigations show much of the disgorgement gains are outside the five-year limitation. She added that if disgorgement is a penalty, a court cannot impose the penalty without statutory authority, which ultimately harms the investors.

Statute of Limitations

Reps. Vicente Gonzalez (D-Texas.) and Scott asked about how changing the statute of limitations period would affect the enforcement process. Vollmer said that he does not see evidence that guides him to believe the need to alter the limitation period. He said there is some concern for the concealment of violations. Velikonja said the first step in enforcement is to establish the occurrence of the violation within the five-year period, then figure out the appropriate monetary penalty. She said there is concern at the SEC for the period being too small in scope, which could lead to less thorough investigations.

Bad Actors and Penalties

Rep. Katie Porter (D-Calif.) asked about deterring bad actors through penalties, holding executives responsible, and the use of claw backs. Maloney also asked about the use of the Foreign Corrupt Practices Act penalty process to deter foreign bad actors. Velikonja said the use of the Foreign Corrupt Practices Act penalty process is quite lengthy, that detection is relatively small, and is often outside the limitation period. She said that she is not sure whether deterrence works, especially with the use of the death penalty. Velikonja said sanctions combined with visible and active enforcement works, as it deters large firms. She added that the goal of SEC enforcement is not deterrence, but rather investor protection and public interest of capital formation and public competition. Velikonja said claw backs hold large firm executives and employees accountable.

PCAOB Transparency

Reps. Huizenga and Sherman asked about the effects of the PCAOB Enforcement Transparency Act, and whether it would benefit investigations and the credibility of audit firms, as well as PCAOB and SEC coordination for the whistleblower program. Crimmins said the whistleblower program is a great idea and there is room for PCAOB and SEC overlap in this process to reduce costs. He said the legislation does create the concern for a negative public perception of audit firms under investigation. Thomas said that SEC investigations are confidential and focused to protect company reputations. Velikonja said this legislation addresses the process as an indictment and only after a long confidential internal process and review would the information become public.

Foreign Exchange Trading

Rep. Ann Wagner (R-Mo.) asked Vollmer about the effects of public companies using the exchange trades if the PCAOB Enforcement Transparency Act was enacted. Vollmer said the legislation would be quite disruptive, as current shareholders need a reasonable notice in advance to make investment decisions. He said trading would continue in U.S. over the counter markets and abroad, and the legislation would only be preventing exchange trading in the U.S. Vollmer suggested using an approach similar to the SEC 12-J proposals to remediate inadequate information of public trades, and also proposed a creative solution of the use of bonding insurance policies. Vollmer said Congress should encourage, not deter, companies from going public with more regulations and compliance.

For more information about this hearing, click here.