Does the SEC inflate its numbers?
Bethany McLean is a contributing editor at Vanity Fair and bestselling author. Her recent book is "Shaky Ground: The Strange Saga of the U.S. Mortgage Giants," published by Columbia Global Reports.
Yay, SEC! (Or maybe not.)
A recent headline in the Wall Street Journal, “SEC Takes Tougher Stance,” suggests that kudos are in order for the watchdog agency. And, in fact, the Securities and Exchange Commission just announced that for the year ended in September, it filed 807 enforcement actions, and obtained orders totaling approximately $4.2 billion in disgorgement and penalties, up from 755 enforcement actions and $4.17 billion last year. Each and every year (with the exception of a few down years back when Christopher Cox was the chairman) the numbers show nice, steady growth. Which is great! It’s the SEC’s job to keep us safe from fraudsters and big bank shenanigans. As SEC Chair Mary Jo White said, "Vigorous and comprehensive enforcement protects investors and reassures them that our financial markets operate with integrity and transparency.”
Unfortunately, if the SEC were one of the publicly traded companies it polices, the short sellers would be flocking, because the numbers are not what they're cracked up to be.
In September, Urska Velikonja, an associate professor of law at Emmory, reviewed 15 years of enforcement actions and published the draft of a paper in which she wrote that the SEC’s “widely circulated statistics are invalid because they do not measure what they purport to measure, and unreliable because they can be manipulated all too easily.”
Cracks one lawyer, “The SEC inflates its reported numbers to make its performance look better. We should have a government agency in charge of preventing that kind of thing.”
It should be noted upfront that the SEC is making an attempt to clarify its disclosures—which, as these things sometimes go, also helps to shed light on the problem. (It may not be a coincidence that this came after the draft of Velikonja’s paper was published.) When the SEC published 2015’s numbers, there was a line noting that a record 507 enforcement actions were “independent.” What does that mean? That total figure of 807 contains what Velikonja calls both “primary” enforcement actions—lawsuits in district courts or administrative actions that, say, allege a defendant violated securities laws—and what she calls “derivative” actions or “follow-on” proceedings, which might seek to suspend someone’s registration as an investment adviser.
Both actions are worthwhile. But they are brought against the same offender, based on the same set of facts. Should they be counted as two separate actions? Velikonja calculates that these “follow-on” cases have boosted the SEC’s overall number of enforcement actions by between 23% and 34% from 2002 to the present.
Another way to see this is by zeroing in on everyone’s favorite whipping boy—broker dealers. (JP Morgan was the subject of the Wall Street Journal headline about the SEC’s “tougher stance.”) You might think that the SEC’s enforcement of broker-dealers’ sins would be intense after the financial crisis and the Bernie Madoff scandal. And indeed, from fiscal 2010 to 2014, the SEC brought an average of 121 enforcement actions a year against broker-dealers, which seems like a big increase from the average 89 a year that the agency brought between 2000 and 2009. But, says Velikonja, in reality, much of the increase is due to follow-on cases; primary enforcement actions against broker-dealers actually declined between 2010 and 2014. “Inflated statistics thus suggest that the SEC is a much more serious enforcer in the financial industry than it really is,” she writes. That is not encouraging. (The SEC has pointed out that the penalties it has ordered have increased dramatically, which is true, although this number is fraught too – a topic for another time.)
The figures have also been arguably inflated by so-called “strict liability” cases, meaning cases that don’t depend on any actual negligence or intent to harm. An example would be the SEC revoking the registration of companies that are delinquent in filing their financial reports. Many of these small-time scofflaw firms don’t even bother responding to the notice—but the SEC gets to notch another action, or “stat,” as it’s called. This is worth doing. But it’s not nabbing the next Madoff. And it has had a big impact on the stats. Velikonja says the share of delinquent filing cases has increased from 2% of the total number of enforcement actions back in fiscal 2003 to 20% in fiscal 2013. (The percentage declined in 2014.)
Velikonja says she was “very pleased” in this year’s release to see that the SEC broke out the number of independent actions. The SEC says that both “follow-on” actions and delinquent filings have been stripped out of that number. In a statement, the SEC’s Division of Enforcement Director Andrew Ceresney says: "We disagree with a number of the article's observations. We have consistently and transparently reported our enforcement action numbers for years, including this year when we reported a record number of standalone cases after backing out delinquent filings and follow-on administrative proceedings. But as we have emphasized, first and foremost is the quality of our cases, which span the securities industry, include first-of-their-kind actions, aggressive use of industry and other types of bars, and demonstrate successful pursuit of wrongdoers.”
OK, and thus we certainly hope. And yet it’s still hard to tell how meaningful the “record” 507 independent actions is. For one thing, over the years, Velikonja says the SEC hasn’t been consistent as to whether defendants are sued together or separately, or whether one investigation equals one enforcement action—or 20. Sometimes, the SEC will file separate actions because some defendants settle, and some don’t. In 2014, the SEC investigated a man named John Briner, who set up 20 mining companies, which filed registration statements offering stock to public investors. Based on that one investigation, the SEC reported 20 enforcement actions. (Velikonja points out that some of this seems to be mandated by various statutes.)
And now, there’s an initiative announced by the SEC in the spring of 2014 to have issuers and underwriters of municipal securities self-report for not providing continuing disclosure of the issuer’s financial condition. Many of the major underwriters, including Citigroup (C) and Goldman Sachs (GS), were charged in June; Velikonja calculates that such actions for “self-reported securities violations” accounted for 58 of the total 507 “independent enforcement actions,” or just over 10%. (And 22 of them were filed on the last day of the SEC’s fiscal year! Corporate America, are you taking notes?)
The SEC can also continue to notch stats by going after issuers, which could give a nice boost to numbers in the coming years. This is worth doing, but you can see how few people care by the fact that no investors have filed lawsuits over the disclosure failures.
None of this is a secret. In fact, it was an inside joke (and a cause for some concern) at the SEC enforcement division that the numbers were “fluffy,” says a former lawyer. And the data is there for those who want to parse it, as Velikonja did, to get at a more accurate count. Although the details of the 2015 numbers won’t be out until 2016, she also believes from the preliminary look that 2014’s numbers were “significantly more distorted than 2015 numbers.” (Meaning, as I said, that the SEC seems to be trying for clarity, just as it wants companies to do.)
But it’s still a problem. The SEC has been in the crosshairs for years due to perceived failures, and Velikonja says that it has relied on these statistics to convince Congressional overlords to increase the budget. In a way, what the SEC is doing is akin to a company in a cyclical business trying to show Wall Street analysts and investors ever-increasing earnings. As Velikonja points out, both accounting fraud and Ponzi schemes are highly cyclical: They are much more common during investment booms. (In speeches, enforcement chief Ceresney has said that it is “breadth and impact” that matter, and that “numbers only tell a small part of the story.” But then why highlight the numbers?)
All of this speaks to a larger question about the SEC’s strategy. Under current chair Mary Jo White, the SEC has announced a plan to do “broken windows” policing: Get ‘em for the small stuff, and the big stuff won’t happen. White has stressed that this will not come at the expense of a “vigorous pursuit of the bigger violations,” so we all certainly hope. But the validity of that thinking is controversial when it’s applied to policing the mean streets—and unproven when applied to the wily wolves of Wall Street. The SEC insists that it uses its resources efficiently, but those resources are not limitless. If enforcement lawyers are spending time on delinquent filers and other “broken windows” offenses, do you think it increases or decreases the chances that they find something serious? We will find out!