GOVERNANCE Beware the new cops on the block New York Attorney General Eliot Spitzer, is already notorious for his assaults on the investment banks, mutual funds and ratings agencies based in the US financial capital. But there is more in store for the international business community, because attorneys general in other states are now on the warpath, warn David Martin and Alan Vinegrad The SEC has long been regarded as the the NYAG civil and criminal jurisdiction taken aggressive steps to combat certain pre-eminent regulator for the national over fraudulent activity in securities. The trading practices in the mutual fund securities industry, but recent events have law defines security and the fraudulent industry. Mr Spitzer’s investigation called its position into question. Eliot sales thereof broadly – according to some, commenced this spring, and on Spitzer, the Attorney General of the State more broadly than any other statute.2 It September 3, 2003, he announced a of New York (NYAG), has opined that bestows upon the NYAG unusually broad settlement with Canary Capital Partners where power is not being exercised in investigative powers and permits the LLP, a New Jersey hedge fund alleged to Washington, state regulators have an NYAG to establish a violation of the Act’s have engaged in late trading and market opportunity to “flex [their] muscles.” And criminal provisions without proving timing. Late trading occurs when investors flex those muscles he has. The Wall Street criminal intent. The Act has been used who place their orders to buy and sell Journal has referred to Mr Spitzer as “a de sparingly in recent decades, though Mr mutual funds after the US market closes facto federal regulator of the securities Spitzer has referred to a ‘dusting off’ of get that day’s price instead of the price set markets.”1 In October, he was chosen as the Martin Act in recent years. for the next day.3 Market timing occurs ‘European Personality of the Year’ by the Mr Spitzer forced Wall Street to when investors rapidly buy and sell shares UK asset-management industry. While abandon decades-old conflicts between in mutual funds, attempting to take often playing the lead role, he has been analyst recommendations and investment advantage of share prices that are out of joined in his efforts to ferret out banking after he disclosed e-mail sync with the value of their underlying wrongdoing in the securities industry by messages from top analysts who portfolios. Though not illegal, in a regulators from a number of other states. disparaged the stocks that they praised number of cases regulators have State regulation of the securities publicly, in part to curry favour with expressed concerns that the practice has industry is not a new phenomenon. But companies and win banking business. Mr involved preferential treatment for some where the traditional role of state Spitzer’s investigation began in mid-2001, investors, particularly where fund policies regulators was in protecting the small and by the time it was finished, Wall provide that rapid trading either is not investor and addressing local misconduct, Street’s leading investment banks had permitted or is actively discouraged. increasingly active state regulators are paid a $1.4 billion settlement. It was this The SEC responded to the disclosure of now demanding a seat at the table of investigation that first raised questions the Canary settlement by commencing its national policymaking. Aggressive steps about the effectiveness of the SEC’s own review of mutual fund practices and by state regulators have been something enforcement group, with investors announcing plans to consider rules of an embarrassment for federal wondering where the feds had been. directed at trading practices. SEC regulators, the Securities and Exchange Mr Spitzer is not alone among state Chairman William Donaldson has Commission (SEC) in particular, which actors in his policing efforts. When acknowledged that “we were not there has by some accounts lost ground and telecommunications giant WorldCom first,” and has indicated that the SEC is been fighting to keep up. These are became embroiled in a massive reviewing how it handles tips and worrisome results. accounting fraud that allegedly hid costs conducts routine inspections of fund Although depression-era federal and inflated profits to the tune of $11 companies and brokerage firms.4 Mr securities laws notably broadened the billion, criminal charges against the head Spitzer’s response to the SEC’s action was scope of federal regulatory authority of of the company were filed in late August to accuse the SEC of having been “asleep the securities industry, these statutes were not by the US Attorney’s Office in at the switch.”5 And when a reporter in some ways no match for state-level Manhattan, which was engaged in an asked Mr Spitzer who regulates the regulatory statutes codified years before. extensive investigation, but by the mutual fund industry’s intermediaries, he In the 1920s, more than 40 states passed Attorney General of Oklahoma, Drew swiftly responded: “That’s easy. We do.” so-called Blue Sky laws in response to Edmondson. Only after pausing did the NYAG add, securities fraud scandals that were And Mr Spitzer has been at it again in “with the SEC, of course.”6 damaging investors nationwide. New recent months. Both the NYAG and the At a November 3, 2003, Senate hearing York’s Blue Sky Law – the Martin Act – is Massachusetts Secretary of the on the mutual fund industry, Senators widely viewed as the most expansive Commonwealth, William Galvin, who criticised the SEC for failing to act sooner. regulatory authority in the country, giving heads the state’s Securities Division, have For example, the SEC’s Boston office December 2003/January 2004 the European Lawyer 31 GOVERNANCE failed to pursue a tip about problems at General Edmondson charged five former against Putnam presents this inter-agency Putnam Investments, prompting the officers of WorldCom, four had already tension in stark relief. Massachusetts and informant to take the case to pleaded guilty in the federal case and New York regulators have been deeply Massachusetts securities regulators, who were awaiting sentencing. Mr critical of the deal, with Mr Spitzer have since filed an action against the Edmondson’s move may cause witnesses warning that the agreement should not company. The head of the SEC’s New be viewed as a template for settlements England regional office announced that with his office, and Mr Galvin of he would step down amid criticism that Massachusetts criticising the SEC for his office failed to properly investigate Active state regulators are setting the bar too low and “papering the accusations. increasingly demanding over wrongdoing [rather] than uncovering So what does this mean for businesses? it.”9 On the other hand, Stephen Cutler, It makes sense for regulation of national a seat at the table of the SEC’s Director of Enforcement, has markets and the major segments of the national policymaking countered that “[w]e don’t think an securities industry to be undertaken at enforcement issue X should be the forum the national level. To be sure, for a wish list people are considering for competition between different regulators the industry at large.”10 can lead to aggressive enforcement and In September, federal and state creative ideas for reform. However, the to hesitate to cooperate in investigations securities officials announced that they fact remains that dispersing regulatory for fear of how their statements will be have been discussing ways to find authority to the 50 states will increase the used in different enforcement contexts. common ground. It was expected that cost of doing business, as businesses are Some have suggested that the SEC’s protocols would be developed to dictate forced to comply with competing apparent failure to keep up with the states which regulator should take the lead in regulatory systems, undercutting the in discovering and pursuing misconduct certain cases, and when it is appropriate economies of scale of a national in the securities industry is the result of to notify other regulators of ongoing presence. As an example, at least 20 chronic understaffing and an inability to investigations in which they may share states have passed or are considering move swiftly. Recent budgetary an interest. We should hope that this their own versions of the Sarbanes-Oxley allotments should address this issue and comes to pass. law approved by Congress more than a enable the SEC to beef up its regulatory Whether state or federal, all year ago, creating the potential for efforts. While state regulators view government actors should be focused on contradictory policies and a tough road themselves as filling a void left by federal investor protection. Commenting on to navigate for national companies.7 The regulators, SEC defenders would argue recent turf wars between federal and state SEC has made it clear, however, that that in taking enforcement action, it is actors, former SEC Chairman Arthur while it wants to work more closely with wielding a mighty sword and must first Levitt stated: “What’s tragic is that there the states, it should remain the nation’s think about broader market impacts. is no philosophical difference between the standards-setter.8 Being in the business of securities two of them. These two organisations As far as regulators are concerned, the regulation on a permanent and full-time could do so much by working together.” involvement of federal and state actors in basis, federal regulators have seen the The regulatory environment is one of regulating the financial industry can lead impact that their actions can have on enormous responsibility and scope, but to coordination difficulties, particularly investor confidence and market stability.