Implementing the Global Research Analyst Settlement: Judge Pauley and the SEC

Nine years ago, the SEC announced, with great fanfare, the Global Research Analyst Settlement with ten leading investment banks. The resulting consent judgments had laudable purposes: to compensate aggrieved investors, untangle investment banking and research, and establish an investor education fund.  Judge William H. Pauley III is the judge with oversight responsibility over the consent judgment, and he has over the years expressed his frustration over the SEC’s lack of diligence in implementing the Settlement.  In a recent memorandum and order, SEC v. Bear Stearns (S.D.N.Y. July 25, 2012), he reviews the settlement’s troubled history and reminds us of the importance of judicial supervision. (Download SECvBearStearns)

Three years ago, the judge reluctantly transferred more than $79 million of disgorgement funds to Treasury because the parties were not able to identify harmed investors that were the intended beneficiaries of the fund.

More than two years ago, the judge refused to approve the parties' request to permit "research personnel and investment banking personnel to communicate with each other ... regarding market or industry trends, conditions, or developments." The court concluded that the parties' proposal ''would deconstruct the firewall between research analysts and investment bankers[,] ... be inconsistent with the Final Judgments[,] and contrary to the public interest."

In the July 25, 2012 memorandum and order, the court addresses once again the Settlement’s commitment to establish a $55 million foundation for investor education, intended “to finance efficient, cost-effective programs designed to educate the investing public.” The judge has devoted considerable attention to the investor education aspect of the consent judgment, and, as the court notes, “resolution of this aspect of the parties' consent decrees remains elusive.”  Originally the SEC planned for the creation of a grant-making investor education entity.  When that plan fizzled because of “agency torpor,” the consent judgment was modified in 2005 to transfer those funds to the NASD Investor Education Foundation (now the FINRA Foundation).  In 2009 the court criticized the Foundation's ratio of administrative expenses to grant disbursements over the prior three year period. During that period, the Foundation paid $800,000 in administrative expenses while disbursing only $6.5 million to grantees, and paid administrative expenses of more than $21,800 per grant, with an average grant totaling $200,000.  The court sought to prod the SEC into action and posed two rhetorical questions: "Is this the efficient and cost-effective program the SEC had in mind when it urged this Court to adopt it? When will the SEC exercise its responsibility to ensure that these substantial sums are expended to educate the investing public?"

In its recent opinion the court acknowledges that “over the last three years, a majority of the corpus has been disbursed,” but continues to have concerns about “whether the Foundation's management of the funds measures up to the SEC's promise of a cost-efficient and expeditious disbursement….  The Foundation's operational expenses, opaque project expenditures, internal audits, and the SEC's lack of oversight all contribute to this Court's skepticism.”  The court directs both the SEC and the Foundation to comply with the court's September 2, 2005 Order requiring "an accounting of receipts and expenses in reasonable detail."

The court’s concerns related to the following areas:

1.  Operational expenses.  The Foundation’s 2011 audit showed expenditures of $16 million, of which $4.2 million were for “operational expenses” (of which $3.6 million were services provided by FINRA to the Foundation for free).  The court observes that “Had the Foundation been responsible for its own costs in these areas, it would have distributed roughly seventy-three cents of each dollar directly on its mission programs. Neither the Foundation nor the SEC provides any guideposts to evaluate the efficacy of these expenditures.”

2.  Opaque Project Expenditures.  The court observes that generally “the amount of money the Foundation spends on a project often seems disproportionately high compared to the nature and scope of the activities undertaken” and provides some specific examples.  For example, $683,000 (of which $500,000 came from the investor education fund) was spent on the “Investor Protection Campaign” in 2011 that consisted of “a press release, an e-newsletter, five one-to-two-hour events presenting existing programming, various ad campaigns, distributing copies of its DVDs, a strategy session, and possibly sixty-three partner events.”  The court has similar concerns about the $775,000 (of which $542,000 came from the investor education funds) spend on the Investor Protection Campaign in 2010.  In particular, the court questions “how Alabama, Colorado, Florida, Maine, North Carolina, Vermont, Washington, and West Virginia evolved to be the "eight primary states" in the campaign.

With respect to a third initiative, the Foundation's "Smart [email protected] library" program, the court observes that of the seventeen new grants, “many of these libraries do not appear to be in major population areas or places evidencing the greatest need for investor education, and the grants they received could be significant additions to their budgets. Moreover, a random review by this Court of several participating libraries' online event calendars reveals little evidence of any investor education initiatives. And to the extent that some libraries appear to be scheduling investor education events, the disparities in apparent progress among various libraries suggest that the Foundation's and the SEC's oversight of these grants is far from uniform.”

3.  Internal audits.  The court details some troubling inadequacies in the Foundation's reporting structure.

Finally, the court makes clear its displeasure with the SEC’s continual lack of oversight over the Foundation’s activities:

The SEC has let fall to this Court the task of raising questions about the Foundation's reports, its disbursements, and the results of its funded grants and projects. The SEC appears to place its imprimatur reflexively on each and every quarterly report, no matter the content. This Court once again directs the agency to perform its duty (emphasis added).

ADDENDUM:  After publication of the above post, George Smaragdis, spokesman for FINRA, sent me the following statement:

We strongly disagree with many of the Court’s statements and will provide the Court with the additional detailed information it requests.  We are confident that the Investor Education funds from the Global Research Analyst Settlement are being used for maximum public good.  We are proud of the FINRA Foundation’s work and look forward to addressing the Court’s concerns.