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The U.S. Securities and Exchange Commission is in the midst of major transition. Critical changes include President George W. Bush’s June 2 nomination of U.S. Rep. Chris Cox, R-Calif., to replace departing Chairman William Donaldson, the appointment of a new director of the Division of Enforcement, and filling a vacancy at the helm of the division, which oversees the mutual fund industry. All signs point to a more business-friendly SEC, moving away from the regulatory frenzy that followed the Sarbanes-Oxley Act of 2002. During the post-SOX frenzy, a divided SEC adopted a number of controversial reforms, such as hedge fund regulation, mutual fund governance and market system rules, with Donaldson as the swing vote; the SEC could revisit those changes under Cox. Of note, Cox’s resume includes authoring the safe harbor legislation known as the Private Securities Litigation Reform Act of 1995. The Cox regime will inherit a hard-charging Division of Enforcement. In one of his last official acts, Donaldson promoted Linda Chatman Thomsen to run the enforcement division. In her first two public appearances as enforcement director, Thomsen, a former federal prosecutor and the division’s deputy director since 2002, proclaimed that she intends to stay the course charted by her predecessor, Stephen M. Cutler. The securities defense bar is watching closely to ascertain how the new commission will approach enforcement — especially with regard to public companies. Since SOX’s passage, the SEC enforcement division has been exceptionally tough on public companies charged with financial fraud. Sanctions in this area have been unprecedented at any other time in the SEC’s 70-year history, especially in the areas of civil money penalties and corporate governance undertakings. Whereas in 2002 the largest penalty the SEC had ever handed out was $10 million, over the past several years it has obtained settlements of more than $100 million against a number of companies. Part of the controversy that cropped up during Donaldson’s tenure was the fact that he, a Bush appointee, sided with the two Democrats on the SEC, rather than the commission’s two Republicans. Cox may shift the balance of power back to the GOP commissioners, placing corporations in a far better bargaining position. BETTER CLIMATE? There are two words of caution to corporate executives who welcome a potential shift in policy. First, the two sitting Republican commissioners support penalties against individual wrongdoers to deter corporate misconduct; there’s no guarantee that they will be less stringent than their counterparts. Second, there are no assurances that the U.S. Department of Justice will follow the SEC’s lead, even if the SEC does go back to a more pro-business outlook. On June 15, a DOJ press release announced that the department was penalizing Bristol-Myers Squibb Co. $300 million for alleged financial fraud as part of a deferred prosecution agreement. That’s compared to $150 million paid to settle the SEC’s enforcement action against Bristol-Myers Squibb. The SEC’s Aug. 4, 2004, press release indicates the company neither admits nor denies the allegations in the SEC’s complaint. An SEC policy against corporate penalties could incentivize the DOJ to fill the void. Corporate undertakings — less visible, but also costly — are the SEC’s efforts to impose corporate governance reform in settlements. These types of undertakings have long been a part of the SEC’s enforcement arsenal. Recently, however, the SEC Division of Enforcement has taken this to the extreme as illustrated in settlements with Healthsouth Corp. on June 22 and Parmalat Finanziaria S.p.a. on July 28, 2004. Some of the corporate governance restructurings extracted by the SEC in recent settlements include: � Boards of directors: requiring changes to the composition of the board including the percentage, number and duties of independent directors; imposing term limits and experience and educational requirements on board members; requiring an independent chairperson; requiring specific notice to shareholders about why directors depart; and requiring specific director approval of material transactions. � Internal controls and accounting policies: adoption of a code of ethics; mandatory employee training; new procedures for credit, billing and revenue recognition; and establishment of an independent complaint center for employees. � Establishment of new positions: corporate inspector general, director of internal audit and corporate director of credit and collections. � Retention of corporate monitors: to review internal policies, procedures and controls over periods as long as three years, with unfettered access to corporate records and personnel, and to make reports of findings and recommendations to the board of directors. In his final speech, on March 18, before stepping down as enforcement director, Cutler stated: “We recognize that these sorts of forward-looking requirements can be very costly, but we believe they will go a long way to preventing a recurrence of the sort of misconduct we’ve seen.” It will be interesting to see if the SEC agrees. COSTLY INVESTIGATIVE TRENDS In an effort to find possible abuses, the SEC enforcement division conducts so-called “risk-based” investigations. These are investigations or inquiries where, at the outset, it is not clear that a securities violation has occurred, but rather involves an industry or business practice about which the enforcement staff has concerns. In these instances, the staff probes segments of a particular industry or business sector, seeking documents, meetings and explanations addressing the staff’s concerns. Typically, these probes do not require SEC approval, a complaint, or an indication of wrongdoing or harm to investors. Failure by a company to fully cooperate will evoke suspicion and trigger a formal investigation, and label the subject a noncooperator for purposes of potential enforcement action and settlement. Risk-based inquiries can be extremely costly and disruptive to a company, in terms of document search and review and legal and accounting services. Moreover, the probe, if made public, could substantially affect the company’s stock price to the detriment of innocent shareholders. Under Cox, the SEC could scale back the use of probes when no securities violation is apparent. In the upcoming months, the SEC will examine the financial impact on public companies of the regulatory reforms precipitated by SOX. This need was underscored by Chamber of Commerce of the United States of America v. SEC, a June 21 U.S. Court of Appeals for the D.C. Circuit ruling in which the court required the SEC to reconsider certain mutual fund reform, because the SEC had not adequately considered the costs to funds in complying with the rule. The court held that the SEC had an “obligation to do what it can to apprise itself — and hence the public and the Congress — of the economic consequences of a proposed regulation before it decides whether to adopt the measure.” SOX rulemaking will be tested. While less transparent, because the SEC’s enforcement considerations are nonpublic, the SEC under a new chairman may take a look at the cost-effectiveness of its enforcement practices. Corporate America should stay tuned. Spencer C. Barasch is a partner in and leader of the corporate governance and securities enforcement team at Andrews Kurth in Dallas.

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