Capital markets can’t work efficiently unless investors trust the process. They’ll put their hard-earned money under the mattress instead.
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With that in mind, investor trust in financial markets rises and falls in direct proportion to the levels of transparency and accountability found in those markets.
Consequently, it’s not surprising that both attributes are held up as key to the core mission of the Securities and Exchange Commission, the regulatory agency that oversees U.S. securities markets.
However, a spate of recent insider trading cases and several well-publicized instances in which major investment banks have been accused of defrauding their clients for their own gain have raised concerns for transparency and accountability in U.S. securities markets.
Investor trust has been sorely tested by all of this.
A mission statement found on the SEC’s website elaborates at length on the powerful relationship between transparency, accountability and healthy markets. The statement includes the following sentence: “Only through the steady flow of timely, comprehensive, and accurate information can people make sound investment decisions.”
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How, then, to reconcile that core mission with the SEC’s long-standing policy of allowing financial institutions to settle enforcement actions without admitting or denying guilt?
Common sense suggests that no good purpose can be served if a company accused of financial wrongdoings can sweep those allegations away by paying a fine and “neither admitting nor denying” guilt.
If guilt is neither admitted nor denied then for all intents and purposes nothing really happened. There was no wrongdoing to acknowledge and business continues as usual.
So much for transparency and accountability.
U.S. District Judge Jed Rakoff took direct aim at that regulatory paradox in a ruling last November that threw out a $285 million settlement between the SEC and Citigroup (C) over allegations the bank defrauded investors in a $1 billion deal tied to mortgage backed securities that eventually blew up.
Rakoff articulately made his point from the perspective of a judge trying to determine whether the $285 million settlement was fair. How could he know whether it was fair, he asked, if the settlement allowed Citigroup to remain silent on the SEC’s allegations.
The judge’s ruling can essentially be boiled down to this: if Citigroup agreed to pay $285 million to settle the SEC’s allegations, then presumably something happened to warrant such a fine. But if we don’t know what happened, how do we know whether the punishment fits the crime?
Rakoff wrote, “… most obviously, the proposed Consent Judgment does not serve the public interest, because it asks the Court to employ its power and assert its authority when it does not know the facts.”
The judge’s opinion taps into a related criticism of SEC settlements with big investment banks: that the multi-million dollar fines are eye-catching but amount to little more than spare change to the banks that agree to pay them.
In any case, the same reasoning used by the judge can also apply to investors. If Citigroup neither admitted nor denied doing anything wrong, how can investors who lost money in the alleged fraud know whether they were cheated or not? And if they don’t know whether they were cheated how can they go about fighting to be reimbursed for their losses?
“There are real dollar and sense reasons why this issue is so important.”
Rakoff’s was (and is) potentially a landmark ruling, one that put corporations and government regulatory bodies on notice that settlements of convenience reached for quick headlines and to expediently make charges go away might be on their way out.
The SEC is appealing Rakoff’s decision and has strongly defended itself and the four-decade-old ‘neither admit nor deny’ policy. In a nutshell, the agency has argued that the policy is a necessary tool in obtaining financial settlements with rogue companies. Without the wording, deep-pocketed companies would fight SEC enforcement actions in perpetuity and the SEC, with its limited funds, would be all but helpless to match the accused dollar for dollar.
The SEC seemed to relent a bit earlier this month, announcing a change to the policy that would block defendant companies from using the ‘neither admitted nor denied guilt’ working when the company in question has already been convicted of or admitted to related criminal charges.
Critics say the shift is virtually meaningless because it applies to so few companies facing SEC enforcement actions.
Andrew Stoltmann, a Chicago-based securities lawyer, said the new policy would apply only to the “most egregious criminal cases possible” and that he has trouble seeing how it helps restore investors’ badly shaken faith in U.S. markets.
Its impact will be “marginal, at best,” Stoltmann said.
SEC Enforcement Director Robert Khuzami has denied that the new policy came in response to Rakoff’s ruling.
Khuzami, who acknowledged that the new policy would apply to a minority of the SEC’s cases, said the change had been in the works well ahead of Rakoff’s ruling. “It … seemed unnecessary for there to be a 'neither admit' provision in those cases where a defendant had been criminally convicted of conduct that formed the basis of a parallel civil enforcement proceeding,” he said.
Stoltmann doubts that. “This is typical of the SEC. They basically got their arm twisted so hard and they were embarrassed so badly by Judge Rakoff that they had to do something.”
“If they really wanted to help investors they’d implement (the new policy) for virtually all of its cases,” he added.
In other words, very few companies that agree to settle SEC allegations of wrongdoing should be able to hide behind the "neither admitted nor denied guilt" phrase.
The benefits to investors by removing the phrase altogether from SEC settlements are tangible.For instance, it would make it much easier for investors involved in civil litigations against big investment banks to recoup their losses if those banks were forced to acknowledge liability in cases brought by the SEC.
“If companies have to admit to liability, that will make the loss recovery process infinitely easier,” said Stoltmann. “There are real dollar and sense reasons why this issue is so important.”