House Committee on Financial Services: SEC Enforcement: Balancing Deterrence with Due Process
House Committee on Financial Services
Subcommittee on Capital Markets
SEC Enforcement: Balancing Deterrence with Due Process
Topline
- Republicans discussed concerns with the SEC Enforcement Division’s use of regulation by enforcement, focusing on the SEC’s use of administrative proceedings.
- Democrats emphasized the SEC’s role in regulating cryptocurrencies and digital assets as securities.
Witnesses
- Mr. Andrew Vollmer, Senior Affiliated Scholar at the Mercatus Center and former SEC Deputy General Counsel
- Mr. Nick Morgan, President and Founder, Investor Choice Advocates Network
- Professor Paul Eckert, Professor of the Practice of Law, College of William & Mary Law School
- Mr. John Reed Stark, President, John Reed Stark Consulting
Opening Statements
Subcommittee Chair Ann Wagner (R-Mo.)
In her opening statement, Wagner urged the SEC to strike the right balance between deterring and punishing securities fraud, preserving due process rights, and protecting those who rely on our markets to save for retirement. She discussed how the Enforcement Division’s current trend of regulation by enforcement harms market participants by implementing policy changes that are not subject to the Administrative Procedures Act (APA). Wagner said her goal is to protect the rights of all market participants, increase transparency, and enhance public trust. She noted that under Chair Gensler’s heavy-handed leadership, those goals are more important than ever.
Wagner warned that public trust in the SEC will decline when its employees are sanctioned and forced to resign for a gross abuse of power, as they were in the case against the crypto broker DEBT Box. She cited the SEC staff’s pursuit of shadow trading actions and off-channel communications sweeps that consider a company’s private WhatsApp messages as additional actions that are contributing to the deterioration of public trust in the SEC. Wagner concluded that public trust would continue to falter and decline if market participants cannot share truthful information related to their settlements if the SEC acts as both the prosecutor and the judge.
Subcommittee Ranking Member Brad Sherman (D-Calif.)
In his opening statement, Sherman noted the two lawyers in the DEBT Box case were fired, which he said would set an example to ensure that other SEC lawyers do not act similarly. He said the crypto industry says that Sam Bankman-Fried was a single snake in the garden, when in fact the crypto industry is a garden full of snakes. Sherman said the SEC has started to go after illegal crypto exchanges and emphasized the need to do so. He said he wanted Americans to invest in the stock of companies that create a product for consumers, rather than in the ephemeral effort to create a digital currency that will rival US currency. Sherman criticized the Crypto industry for fighting tooth and nail against any effort to apply even a patina of regulation and concluded that the SEC should be given clear jurisdiction over crypto since it’s the agency that’s proven its ability to regulate investment assets that are intangible.
Testimony
Andrew Vollmer, Senior Affiliated Scholar at the Mercatus Center and former SEC Deputy General Counsel
In his testimony, Vollmer noted the SEC and courts have total and unreviewable discretion to set penalty amounts. He explained that penalty amounts are often unpredictable, inconsistent, and disproportionate to a reasonable assessment of the severity of a violation. Vollmer said the federal courts are split over whether disgorgement may be ordered if distributing the proceeds to injured investors is not possible or cost-effective. He urged Congress to enact clarifying amendments to prevent the delay, uncertainty, and inconsistency that may occur if disgorgement is left to the courts. Vollmer encouraged Congress to act if the Supreme Court allows administrative proceedings (APs) in litigated cases to continue, noting the main problem with APs at the SEC is that the proceedings are biased against the defendant. He concluded that the best solution would be to eliminate APs and require the use of federal courts for all SEC enforcement actions.
Nick Morgan, President and Founder, Investor Choice Advocates Network
In his testimony, Morgan explained the beauty of regulation by enforcement from the SEC’s perspective is that even if a court says they do not have jurisdiction, the SEC can shop around until a judge finally agrees with them. He noted that courts, including the United States Supreme Court, have been critical of the SEC’s usual approach to disgorgement, in which the SEC does not allege or prove that any investors suffered from financial harm. Morgan criticized the SEC for addressing issues through piecemeal litigation on a case-by-case basis to seek favorable rulings in different jurisdictions, rather than creating a uniform policy regarding disgorgement in non-financial harm cases.
Professor Paul Eckert, Professor of the Practice of Law, College of William & Mary Law School
In his testimony, Eckert discussed how well-regulated securities markets are critical to our success as a nation, and noted the SEC has safeguarded markets for decades. He said delays in SEC violations remain a persistent challenge and urged the SEC to restore a two-year goal for the completion of investigations. Eckert explained that reforms to SEC disqualification waiver procedures would allow for a more principled and predictable process for enforcement actions. He recommended that process reforms include the restoration of the SEC’s policy of allowing a settling entity to request that the Commission consider an offer of settlement of the underlying enforcement action. Eckert said there should be a further presumption that no further qualification is necessary for enforcement actions in which the SEC is a party and has imposed sanctions that address misconduct. He recommended that the procedures already implemented by the SEC for waivers on Regulation D disqualification should be expanded to State AGs and other state and federal authorities to state their intentions in settlement papers. Eckert concluded that respondents in SEC administrative enforcement proceedings should have a federal removal right.
John Reed Stark, President, John Reed Stark Consulting
In his testimony, Stark questioned the digital asset industry’s claims that the SEC repeatedly violates the due process rights of legitimate crypto brokers by failing to provide fair notice of SEC rules to the crypto-verse. He explained that what the digital asset industry describes as SEC regulation by enforcement is simply enforcing the law. Stark said so-called digital asset investors are betting on the efforts of promoters of these assets, which triggers the Securities Act of 1933. He explained the SEC’s Enforcement Division has had no choice but to act and warned that these brokers will continue to act with no accountability if the SEC doesn’t get involved. Stark noted that digital assets often have no cash flow, yield, balance sheet, or history of operation. He questioned how any financial analyst, or every day investor could conduct a proper analysis in the face of such a large information vacuum. Stark concluded that SEC respondents should have a right of removal from SEC administrative courts.
Question & Answer
SEC Enforcement Concerns
Wagner cited SEC v. Jarkesy, and noted Morgan filed a brief with Elon Musk and Mark Cuban arguing that the SEC’s use of APs raises constitutional concerns. She asked Morgan to discuss those concerns. Morgan noted Jarkesy is currently pending before the Supreme Court. He explained the issue they focused on in the brief was whether the respondents in SEC cases are entitled to a jury, which he, Musk, and Cuban believe they are. Morgan said the bottom line is that respondents don’t get the benefit of a jury trial when penalties are assessed.
Wagner asked Morgan to explain why the SEC’s gag rule is problematic. Morgan explained the gag rule prevents the defendant from saying anything that contradicts the SEC’s allegations. He said markets are entitled to transparency and added that if there is information that shareholders should know about, then the SEC should insist on transparency.
Wagner asked how the SEC assessed penalties of over $9 million per case when the statutory limit is $11,000. Vollmer explained that excessive penalties are an issue because of statutory problems. He said there are no predictable and consistent rules, leaving courts free to set penalty amounts. Vollmer urged Congress to amend the language of the penalty statute.
Rep. Frank Lucas (R-Okla.) asked Morgan to discuss the risks of having an unpredictable enforcement arm of the SEC from the perspective of a small company looking to raise public funds. Morgan explained an unpredictable enforcement arm would create an incentive to disclose less information.
Rep. Pete Sessions (R-Texas) asked about the path towards potential balance to encourage fairness and trust at the SEC. Eckert said a right to remove would allow people to assert private rights in federal cases. Morgan explained that the length of time that it takes to conduct investigations is too long and emphasized the need to speed the process up. He noted that while there was a provision of the Dodd-Frank Act that required the SEC to issue a Wells Notice within a set period of time, that requirement has been ignored.
Rep. Bill Huizenga (R-Mich.) asked Morgan about his reaction to the sanctioning of SEC lawyers in the DEBT Box case. Morgan explained the problem with the DEBT Box case was that the SEC proceeded with an ex parte hearing where the defendant’s counsel was not present. Huizenga asked whether the SEC is abusing the Wells process. Vollmer said that after a defendant sends in their Wells Memorandum, the staff of the SEC can just ignore it. Eckert said one of the good things about the Dodd-Frank Act was that it implemented a 6-month limit, which forced engagement earlier.
Rep. Juan Vargas (D-Calif.) asked if the witnesses agreed that the SEC generally gets it right on enforcement cases. Morgan disagreed, and explained he has represented people who have settled with the SEC because the cost of being sued by the SEC is exorbitant. Stark said every case he was involved in during his time in the Office of Internet Enforcement was conducted fairly.
Rep. Dan Meuser (R-Pa.) asked how the Division of Enforcement should measure success. Vollmer said they need to achieve the goal of greater compliance through measures other than enforcement. He said the Division should be measuring the increase in compliance.
Meuser asked whether Eckert agreed with Commissioner Peirce’s remarks that there is fear of enforcement among companies. Eckert agreed. He explained agencies should develop the expertise to understand new markets and trading strategies so they can weigh in to guide activity that needs to be fostered and stop activity that needs to end.
Rep. Bryan Steil (R-Wisc.) asked Morgan to discuss the uncertainty of SEC forum shopping. Morgan explained that the SEC can forum shop either geographically or temporally. Steil asked whether administrative courts undermine the public’s trust in the SEC. Vollmer said people understand the differences in process between federal courts and administrative courts. He added that Congress should eliminate administrative courts altogether or provide an option to move from an SEC court to a federal court.
Steil asked whether it’s fair to say that the SEC brings overwhelming power to bear on some of these cases, where we see settlements and enforcement and legislation made through enforcement actions and we don’t have these court cases going all the way through court. Vollmer said that’s certainly true in the case of individuals, adding that the SEC has overwhelming power and pressure on larger institutions.
Rep. Zach Nunn (R-Iowa) asked if the SEC’s Enforcement Division has created a hostile environment for capital market formation in America. Morgan said yes, citing the number of people who would like to be involved in US capital markets but fear the negative consequences of the SEC’s regulation by enforcement policies. Nunn asked how this hostile environment has chilled innovation. Eckert explained new firms are listing on US exchanges because of the uncertainty. He said in the past, the SEC was more willing to do things like entertain no-action letters to give comfort to new entrants, but today they just sit back and wait.
Climate Disclosure Rule
Lucas asked Vollmer to discuss the harm to public markets if the SEC’s enforcement arm was called into question over the climate disclosure rule. Vollmer said the SEC’s rules have to apply to the enforcement agency and when that doesn’t happen, it generates and builds disregard for the law.
Vargas asked whether there should be a uniform policy for the SEC, and whether that would apply to the SEC’s proposed climate rule. Morgan said he supports rulemaking in that context as opposed to piecemeal litigation. He explained that unfortunately the final Climate Rule was very different from the proposed rule, and there wasn’t any opportunity to comment on it. Stark cited the materiality standard.
Meuser sarcastically asked why Congress shouldn’t allow the SEC to regulate healthy foods, cars, and hockey violence in the name of fiduciary duty, since the Commission is now allowed to regulate carbon emissions.
Crypto & Digital Assets Industry
Sherman cautioned that the crypto industry has vast amounts of money that it spends to try and influence Congress. He noted the crypto industry regards the US government as a criminal enterprise and the US dollar as illegitimate.
Sherman asked if there is a legitimate purpose for a crypto mixer. Stark said no. Sherman asked whether we are over-deterring beneficial actions in our capital markets. Stark said no and warned that investors would lose more money and there would be massive systemic risk if the SEC was not involved in crypto.
Waters asked Stark whether the SEC has clear authority to regulate cryptocurrencies as securities. Stark said yes, explaining that it’s precisely within the SEC’s boundaries. He described the Coinbase case as remarkable, noting that the judges explained that crypto assets are obviously securities.
Casten asked Stark how Congress can address Tether and mixers in stablecoin legislation. Stark noted that Tether claims to have some kind of audit, which is essentially a snapshot of their daily events. He said Congress should look at whether Tether is linked to any US securities.
Rep. Wiley Nickel (D-N.C.) asked what to do about Robinhood, other than to ask them to pack their bags and go overseas. Vollmer said Robinhood might be successful in talking SEC staff out of the case but noted it’s very unlikely. He explained that Congress needs to draft some authority to regulate digital currency.
Nickel asked Vollmer whether the SEC is providing regulatory clarity for the digital assets industry. Vollmer said no, explaining that while there are lots of assets that fall within the Howey Test, there are some crypto assets that do not. He urged Congress to decide if and how we want to regulate digital assets. Vollmer said we don’t need the SEC to preempt the field with its assertions of jurisdiction.
Rep. Stephen Lynch (D-Mass.) asked Stark to explain or amplify the thinking behind the SEC’s jurisdiction in policing tokenized securities. Stark said there has never been such an incredible use of various channels of communication to tell the world that these tokens are securities. Lynch asked whether people have called for certainty so they can avoid tokenized securities. Stark said the SEC has given everyone the clearest opportunity to understand.
Lynch asked whether the entire industry would tokenize securities to avoid new legislation if Congress and regulators accepted the argument that crypto securities are different and should have a different regime. Stark said yes, explaining that’s what the entire crypto industry has tried to do. He said that unless Congress wants to repeal the Securities Act of 1933 and the Securities Exchange Act of 1934, the SEC must act.
Artificial Intelligence & Automation
Lucas asked how the SEC and Congress should approach AI washing. Vollmer noted there were two cases at the SEC that were very straightforward investment advisor cases. He explained the two cases were not really about AI but were about what the defendants said about their use of AI. He urged the SEC not to stray from their boundaries and to ensure that companies are using complete and accurate disclosures about their use of AI.
Rep. David Scott (D-Ga.) asked Eckert to explain how fixed-income markets differ from equity markets when it comes to technology and automation. Eckert explained that bond markets tend to be decentralized and still over the counter. He discussed how the SEC and FINRA have been trying to equitize the debt market in terms of transaction reporting. Eckert noted there are always concerns with incremental increases in trade reporting, which is a big concern in the debt market.
Manual Trade Exceptions
Scott asked why it’s important for regulators to consider certain types of manual trade exceptions. Eckert said he was not familiar with that requirement. Scott asked whether a manual trade exception strikes the appropriate balance between shorter reporting time frames and avoiding disruptions to the marketplace.
Eckert noted there were technological issues with transactional reporting in the municipal bond reporting area because firms didn’t have systems that connected directly with FINRA or the MSRB’s trade reporting systems.
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