Which should you fear more: a Formal Order of Investigation subpoena from the Securities and Exchange Commission, or a Martin Act subpoena from New York Attorney General Eliot Spitzer? Either would send shivers down the spine of any finance executive, but lately it’s the state subpoenas that have been making the most waves. Starting with Spitzer’s discovery of Merrill Lynch analyst Henry Blodget’s E-mails in April 2002, many of the major financial scandals of the past two years have been cracked open by state investigators—notably, but not exclusively, New York State’s pugnacious top cop. And since Merrill Lynch’s $100 million settlement with New York in May 2002, states have continued to move quickly—often faster than the SEC—to punish the companies involved.
The ensuing quarrels over jurisdiction, in turn, have provided great political theater—with the financial press gleefully reporting each salvo between state and federal regulators. On September 14, 2003, the SEC and the North American Securities Administrators Association (NASAA)—which represents state regulators—attempted to quell the ringside commentary by unveiling a joint effort to improve coordination and communication. And in his speech to NASAA that day, SEC chairman William Donaldson claimed the effort was for the greater good. “I wouldn’t be surprised if some investors, watching the reported tussle, have been wondering: ‘If state and federal regulators are fighting among themselves, who’s looking out for me?’” he said. “Everyone in this room is committed to rooting out fraud and corruption in our markets and otherwise protecting investors.”
Still, by many accounts, that joint commitment had been forestalled 11 days earlier, when Spitzer’s office announced its case against Canary Capital Partners, a hedge fund that was allegedly engaging in market-timing trades at multiple mutual funds. The enormous—and still unfolding—scandal further strained the fragile peace between state regulators and the SEC, and raised tensions elsewhere in Washington, D.C., notably Congress. And instead of updates from the joint task force on harmonization—which has not been heard from publicly since its formation—the turf wars have only escalated.
The result is an environment in which state and federal regulators compete for cases while their respective legislators look for ways to expand—or curtail—enforcement powers. Meanwhile their potential targets—public companies—must grapple with the fear of an exponential expansion of regulatory activity. So while Donaldson may believe that “business [people], and particularly legitimate business[people], have a right to expect that they are not going to be wantonly attacked from all angles by uncoordinated regulators,” as he told Congress on September 9, the reality is much more muddled, with few guarantees.
All Politics Is Local
“It’s important for executives to understand this is not a new story,” says former Massachusetts Attorney General Scott Harshbarger. “While it has ebbed and flowed over the last 25 years, there is often a healthy tension between state and federal regulation.” That tension even extends to city authorities. Witness the SEC’s involvement with New York City District Attorney Robert Morgenthau’s current prosecution of Tyco International executives.
But since Spitzer and SEC enforcement director Stephen Cutler jointly announced a settlement of $1.4 billion with multiple Wall Street firms in December 2002, the relationship has appeared anything but healthy. And the mutual-fund investigations have only increased the bad blood. “The SEC is in a very awkward position,” says former SEC chairman Arthur Levitt. “Credit for uncovering what turned out to be a very wide-reaching scandal will undoubtedly fall to a local regulator,” he says. “That hasn’t happened—ever.”
Moreover, Spitzer isn’t the only local regulator who has been giving the feds fits lately. In August, despite an ongoing federal investigation, Oklahoma Attorney General Drew Edmondson filed criminal charges against WorldCom former CEO Bernie Ebbers, former CFO Scott Sullivan, former controller David F. Myers, and three other former finance staffers. The basis for all 15 complaints against Mississippi-based WorldCom was that Oklahoma investors had been harmed by the company’s financial fraud—a charge that probably could be levied by every state in the nation.
Edmondson’s move drew sharp criticism from the SEC and federal prosecutors. Not only did he fail to inform them in advance, but the charges appeared to be piggybacked onto the federal case rather than based on independent investigation. (Indeed, Edmondson’s announcement was accompanied by an online questionnaire seeking Oklahoma investors who believed they had been harmed financially by WorldCom.) Since hauling Ebbers into a Tulsa courtroom, Oklahoma has dropped the charges (temporarily, according to Edmondson’s office) because they interfered with his availability as a witness in the federal case against Sullivan. “I have every intention of refiling these charges early next year,” said Edmondson in a statement.
But the episode fueled further words between Donaldson and Spitzer after the SEC chairman told Congress that he thought “there has been a politicization, if you will, of enforcement in some areas of the country. This is very dangerous.” Although apparently a reference to Edmondson, the comment initially drew a sharp reaction from Spitzer, who has all but announced that he will run for governor of New York in 2006. Spitzer and Donaldson promptly—and publicly—made up, but state regulators bristle at having their law-enforcement efforts dismissed as political grandstanding.
“Contrary to the popular view in the business community, it is the rare elected official that willingly takes on the leading industries in his community—represented by the best lawyers—to advance his own political agenda,” states Harshbarger, who is now a corporate-governance adviser with Boston law firm Murphy, Hesse, Toomey & Lehane LLP. In fact, he argues, the pressure not to act against the states’ critical industries is far greater (see “how much will it cost” at the end of this article). “To think that [Secretary of State William] Galvin [who is prosecuting Putnam Investments for mutual-fund abuses] is trying to nail the last remnant of economic power we have in Massachusetts, or that Eliot Spitzer is trying to bring down the world’s greatest financial market for his own political gain, is either naïve or hypocritical.” Besides, he adds, “neither Spitzer nor Galvin has drilled a dry hole yet.”
Former Colorado securities regulator Phil Feigin, now an attorney with Denver-based Rothgerber Johnson & Lyons LLP, agrees. “You can’t read the Canary or Invesco [which is being sued by the SEC, New York, and Colorado] complaints and say this is just some jingoistic hothead bringing spurious actions to build a name for himself,” he says. Instead, he adds, “we have seen good old-fashioned lying, cheating, and stealing from some of the biggest firms in the country, and the bottom line is that lying, cheating, and stealing are not the sole province of federal securities regulators.”
Blue Sky Below
Still, in most states, enforcement of securities laws rests primarily with specialized agencies with civil, not criminal, authority. These agencies then refer cases to the state attorney general’s office for criminal actions. Likewise, the SEC has only civil-enforcement authority, but works closely with the Department of Justice to initiate criminal cases.
States weren’t always so constrained. In the early 1930s, every state but Nevada had securities laws known as “blue-sky” laws (the name was a reference to the often outlandish scams the laws were intended to prevent). These laws—some of them quite powerful—were left in place after the passage of the securities acts of 1933 and 1934, but the states’ powers to regulate interstate securities were largely preempted by federal law, or simply neglected in deference to the new SEC. (The Supremacy Clause of the U.S. Constitution states that federal law “shall be the supreme law of the land,” while states retain any powers that are not specifically preempted.)
Although states registered and policed securities sold from within their borders throughout most of the 20th century, federal preemption continued to expand through additional national laws and court decisions. Recent events have shown, however, that blue-sky laws can still be potent tools. The most dreaded is New York’s 1921 Martin Act, which gives prosecutors broad civil and criminal authority in pursuing white-collar criminals. The act lay dormant for decades, until Spitzer revived it, with startling effectiveness. “The Martin Act is a fierce sword in the hand of a zealous prosecutor because it was written in a day when defendants’ rights were mere curiosities,” notes a Washington Legal Foundation paper.
New York’s attorney general has wielded the Martin Act so powerfully, in fact, that he has generated legislative envy in other states, notes Beth I. Z. Boland, who practices before the SEC as a partner at Boston-based Bingham McCutchen LLC. For some time, only New York, New Jersey, Maryland, Delaware, and South Carolina have allowed the attorney general’s office to prosecute both civil and criminal securities violations. But that is changing. One of Gray Davis’s final acts as governor of California was to sign into law a new criminal securities statute in the state. The law went into effect on January 1, and California Attorney General Bill Lockyer simultaneously announced an investigation into mutual-fund fees under the new law. Boland says Pennsylvania, Florida, Illinois, and, most recently, Massachusetts have also filed bills or signaled plans to expand securities enforcement. “I wouldn’t be surprised if more states ask for [such laws].”
In fact, there’s nothing in federal law to prevent states from doing so; enforcement has long been considered within their purview. The question that has really caused the fur to fly is whether states are using the threat of criminal prosecution to demand reforms that the SEC and some in Congress think are more appropriately set at the national level.
Just 10 days after the Merrill Lynch settlement with Spitzer regarding analyst conflicts of interest, Rep. Michael Oxley (R—Ohio), chairman of the House Committee on Financial Services, wrote to the New York Times warning that “[w]hat we are witnessing is nothing less than a regulatory coup that would usurp the proper role of the SEC and the [self-regulatory organizations]. This could result in a disastrous balkanization of oversight, meaning that every Wall Street firm would have to cut its private deal with every state attorney general or face the potential threat of fraud charges.”
Who Makes the Rules?
It is, of course, odd for Democrats like Galvin and Spitzer to be arguing for states’ rights while Republican appointees and representatives defend the preeminence of federal powers. Testifying about analyst conflicts in June 2002, Spitzer said he agreed with the need for national standards and has always opposed what he called “increased federalism—a belief that the federal government should scale back its involvement in our nation’s affairs.” However, he added, “Congress and the federal government cannot have it both ways. If Congress and the executive branch decide to curtail federal oversight of areas such as securities, they must recognize it is the responsibility of state securities regulators like me to step in to protect the investing public.”
This past summer, that debate erupted in a new battle over state preemption when Rep. Richard Baker (R—La.) introduced H.R. 2179, the proposed Securities Fraud Deterrence and Investor Restitution Act of 2003. Ostensibly intended to provide the SEC with greater enforcement powers, the bill contained an explosive provision that would prohibit states from making any laws or reaching any settlement whose requirements “differ from or are in addition to the requirements in those areas established by the [SEC] or by a national securities exchange or self-regulatory organization [SRO].”
The bill immediately drew coordinated protests from the attorneys general of Delaware, California, Maryland, New York, South Carolina, and New Jersey, as well as from NASAA, all arguing that it would severely hamper state enforcement of even minor frauds and sales abuses. Spitzer and Galvin, who had just launched joint investigations into the sales practices of Morgan Stanley brokerages, warned that the bill would prevent such enforcement efforts in the future. Testifying before Congress, Spitzer reacted with particular horror to the idea of states being preempted by SRO rulemaking, noting that SROs “have been failed regulatory institutions.”
The bill is now languishing, despite useful provisions that would help strengthen the SEC. “That’s an industry-sponsored bill there,” charges Ralph Lambiase, director of Connecticut securities and current president of NASAA, suggesting that industry pressure is behind congressional refusal to drop the state preemption provision.
Crime and Punishment
As the year drew to a close, the question of whether state law enforcement was being used to make national policy continued to rankle. Alliance Capital Management settled with both the SEC and the New York attorney general on December 18, but Spitzer’s settlement added a pledge by Alliance to lower its fees by 20 percent over five years. That prompted the SEC to take the highly unusual step of appending a special statement to its own Alliance settlement announcement to explain why it did not require fee discounts. “We determined, unanimously, that such relief would not serve our law-enforcement objectives in this case,” the commissioners wrote, adding: “We firmly believe that rules uniformly applicable to the entire industry are more desirable than a piecemeal approach that fragments the marketplace.”
Spitzer promptly retorted that “the SEC settlement with Alliance sells investors short because it does not provide any compensation to investors for that harm. A $250 million settlement—which is all the SEC negotiated for—is simply inadequate to address all of the harms uncovered in our investigation.” As CFO went to press, co-defendant Massachusetts Financial Services was in talks with Spitzer about a settlement that would lower its fees as well.
The federalism feud promises to continue this year—with repercussions for companies inside and outside the mutual-fund industry. “Because different competing agencies are trying to outdo each other, we have entered the age of real-time enforcement,” says Boland, who is also co-chair of the Boston Bar Association’s Corporate Governance Task Force. And the effects of real-time enforcement are already clear. Harshbarger says fear of state enforcement, for example, was the reason Putnam “rushed into the arms of the SEC and accepted a pretty draconian settlement.”
More-active state enforcement also makes it harder for corporations to know how to respond when they do run afoul of the law. The SEC and the Department of Justice have repeatedly made it clear that cooperation is a key factor in determining the severity of a punishment. Yet the unreserved Spitzer told New Yorker magazine that he went after Merrill Lynch because “they produced [their E-mails] quickly.”
Moreover, companies have long struggled to determine when an inquiry by the SEC must be disclosed to investors as a material event. But what if they get a subpoena from a state securities regulator? “That is an interesting question,” says Boland. These days, investors are likely to consider that to be material indeed. Likewise, several states have recently enacted mini-Sarbanes-Oxleys, which Boland says tend to focus on enforcement of accounting practices. “As a practical reality, these enforcement activities create a very, very expensive response system,” she notes. “One needs to have internal and external lawyers responding to a plethora of enforcement agencies.”
Still, not everyone is worried that rejuvenated state enforcement will be a potential burden for business. “I am not concerned that there will be a massive shift away from federal regulation to state regulation,” says Levitt. “Thus far the public has benefited.” Lambiase adds that the idea that business will be unduly burdened by state enforcement is “a crock. No state government is in the business of putting [companies] out of business,” he says. “But if a corporation wants to commit a crime in 50 damn jurisdictions and six other countries, they should answer to law enforcement in all those jurisdictions.”
Tim Reason is senior writer at CFO.
How Much Will It Cost?
Few things irritate state regulators more than the charge that their law-enforcement activities are political in nature. Yet the charge persists, in part because the office of attorney general or secretary of state is often a stepping-stone to higher state—if not national—office. Then-Manhattan District Attorney Rudolph Giuliani’s aggressive prosecution of Michael Milken helped him win the mayor’s office in New York City. And New York Attorney General Eliot Spitzer’s highly public battle with Wall Street is likely to make him a formidable candidate for governor in 2006.
But the introduction of partisan funding may further erode the perception of impartial enforcement. In 1999, the Republican Attorneys General Association was formed to raise funds at a national level for state races. Democrats followed suit in 2002 with the Democratic Attorneys General Association. Former Massachusetts Attorney General Scott Harshbarger, who also served as president of Common Cause, says this trend is deeply troubling.
Harshbarger says that only a few state law enforcers are actually making headlines aggressively pursuing corporate fraud, noting that the importance of local industries and the “immense power” of local executives is a powerful dissuasion. Campaign contributions up the ante, he says. “Soft money made a huge difference at the federal level. The power at the local level of these kinds of contributions is magnified.”
But Harshbarger is quick to add that business is not always at fault. “Most businesses were actually being solicited to give more [often] than they were offering to give,” he says. “That’s what really concerned me about Republican and Democratic attorneys general beginning to solicit from the very industries they were going to regulate. It really does raise the perception that in the end you pay to play.”
|May 21, 2002||New York Attorney General Eliot Spitzer announces settlement with Merrill Lynch over conflicts of interest in analyst research. Initially, the Securities and Exchange Commmission is not a party to the settlement.|
|December 20, 2002||In what appears to have been the high-water mark of state and federal cooperation, SEC enforcement director Stephen Cutler and Spitzer jointly announce a settlement with 10 top investment firms for analyst conflicts of interest.|
|July 14, 2003||Massachusetts Secretary of State William Galvin and Spitzer announce a probe into the sales of mutual funds at Morgan Stanley, warning that a bill pending in Congress might prohibit such investigations in the future.|
|August 27, 2003||Despite an ongoing federal investigation, Oklahoma Attorney General Drew Edmondson files criminal charges against WorldCom former CEO Bernie Ebbers, CFO Scott Sullivan, and four other former finance employees.|
|September 3, 2003||Spitzer announces settlement with Canary Capital Partners, touching off a broad mutual-fund market-timing investigation.|
|September 14, 2003||The SEC and the North American Securities Administrators Association announce plans to convene a 12-member working group to explore ways to improve cooperation between state and federal securities enforcement authorities.|
|October 28, 2003||Galvin files charges against Putnam for market-timing charges with the SEC.|
|November 13, 2003||Putnam settles market-timing charges with the SEC.|
|November 20, 2003||Edmondson dismisses case against Ebbers, pledging to refile after Ebbers testifies in a federal case against Sullivan.|
|December 2, 2003||Spitzer and the SEC bring coordinated charges against Denver-based Invesco. Colorado Attorney General Ken Salazar simultaneously files suit aginst Invesco for violations of the state’s Consumer Protection Act.|
|December 18, 2003||Alliance Capital Management settles with Spitzer and the SEC for $250 million. The settlement with Spitzer also requires a 20 percent reduction fees.|
|December 18, 2003||Salazar announces the investigation of Denver-based Janus Group for market-timing activities.|
Sources: SEC and state attorneys general press releases