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September|October 2003

Stock Phrase

When Wall Street analysts "neither admit nor deny" their bad behavior, are they fessing up or just dodging the bullet?

By Len Costa

STOCKS HAVE STARTED TO REBOUND, but these are still trying times on Wall Street. Last April, 10 of the largest securities firms settled "enforcement actions" with the Securities and Exchange Commission, New York State's attorney general, and other securities regulators. If a judge approves the settlement, heavyweights such as Merrill Lynch, Salomon Smith Barney (now known as Citigroup Global Markets), J.P. Morgan, Credit Suisse First Boston, and Morgan Stanley will pay a record $1.4 billion for a panoply of alleged sins. They include issuing biased research on particular stocks to attract investment banking fees and giving shares in hot IPOs to favored clients. The global settlement also encompasses SEC actions against two individual analysts: Henry Blodget, who covered Internet stocks for Merrill Lynch, and Jack Grubman, who analyzed telecom shares for Salomon Smith Barney. The pair agreed to pay a combined $19 million in fines and restitution to aggrieved investors. They will also be banned from working in the securities industry for life.

It might sound as if Wall Street is pleading guilty to the SEC's allegations by accepting these stiff penalties, but it isn't, thanks to a short but remarkably important phrase. SEC settlements nearly always stipulate that the defendant "neither admits nor denies" the allegations set forth in the SEC's findings. So despite what appears to be overwhelming evidence that the 10 firms violated the law, the public can only infer wrongdoing on their part. And courts can barely do that. Their implied guilt carries little legal weight. Why, then, does the locution exist?

The phrase was first coined in the 1970s, when the SEC had few resources and remedies in its arsenal. The commission could order individuals and companies to cease bad behavior. But it couldn't enforce those commands; it had to rely on courts to impose penalties requiring corporate culprits to return ill-gotten gains. The SEC adopted creative solutions like settlements (also known as consent decrees) to force corporate America to clean up its act. According to a recent article in Chief Legal Executive magazine, the settlements "encouraged both sides to agree to measures designed to prevent future violations."

At the time, the SEC's practice was to allow a defendant to settle without admitting to any allegations, said Stanley Sporkin, who became the second director of the Division of Enforcement in 1974 and was later appointed a federal judge. That approach, he said, left open the possibility that those who settled could publicly deny any wrongdoing, a prospect that dismayed the general counsel's office. As a result, the "neither admit nor deny" formulation was added to the code of federal regulations governing SEC investigations in November 1972. The amendment declared that the SEC would no longer permit a defendant to consent to an order imposing sanctions while at the same time denying the allegations listed in that order. It went on to state that "the Commission believes that a refusal to admit the allegations is equivalent to a denial, unless the defendant or respondent states that he neither admits nor denies the allegations" (emphasis added). Sporkin characterized the language as a compromise. "While not requiring them to admit," he recalled, "we would make sure [defendants] didn't deny."

TODAY THE "NEITHER ADMIT NOR DENY" CLAUSE continues to facilitate settlements, which suits the SEC. Its enforcement staff is not large enough to litigate all instances of fraud—it brought about 600 enforcement cases in 2002—and so it must pick its battles. And those battles are not easy to win. SEC investigators have to sift through reams of documents to prove that corporate wrongdoers deliberately or recklessly disregarded the law. As Joel Seligman, the dean of Washington University School of Law and an expert on securities regulation, put it, "Oftentimes, a settlement is the best the SEC is capable of rationally bargaining for."

And the SEC is always mindful that its actions don't just affect corporate wrongdoers. Litigation related to recent accounting and securities scandals can drag on for months or years (think Enron, for example), leaving the commission vulnerable to allegations that it is not acting quickly enough to restore investor confidence. By opting for settlements that include curbs on practices leading to abuse, the SEC can raise standards of conduct quickly and force systemic changes. To address conflicts of interest on Wall Street, for example, the recent consent decrees require a strict separation of research and investment banking, forbid compensating analysts based on the investment banking revenues they generate, and prohibit research analysts from taking part in efforts to solicit investment banking business.

Defendants, too, have big incentives to settle—as long as they aren't required to admit their guilt. That's because SEC actions almost always coincide with parallel lawsuits naming the same defendants. An admission of guilt in an SEC settlement can be used against a defendant in a civil lawsuit. But the "neither admit nor deny" language means allegations cannot automatically be used against a defendant in civil proceedings. "That's the technical reason you have the locution," said Joseph Grundfest, a Stanford law professor and former SEC commissioner.

In practice, though, the SEC knows that its settlements spur civil suits. Private litigants can use the information released as part of the settlements as a road map for their own cases. And while there's no legal standard establishing exactly how consent decrees should be weighed, judges are allowed to take the settlements into account in their rulings. So far, however, adjudicators seem to be giving Wall Street the benefit of the doubt. When a National Association of Securities Dealers arbitration panel ruled against Morgan Stanley in June, citing information released as part of the April settlement, the penalty was light. On a Florida investor's claim for damages of $3.3 million, the panel ordered the firm to pay only $100,000. And in July, a federal judge in Manhattan dismissed a class-action lawsuit against Merrill Lynch.

The "neither admit nor deny" language may seem like a godsend for targets of SEC investigations, but it makes defense attorneys nervous. After all, the commission's findings become public knowledge—in revealing detail—and can cause significant embarrassment and damage to a respondent's reputation. Furthermore, said Richard Morvillo, a securities and white-collar defense attorney with Crowell & Moring in Washington, D.C., defendants who consent to "neither admit nor deny" as part of an SEC settlement agreement may find that their rights are compromised if they are later called to testify in a class-action lawsuit or other SEC action. If as a witness the defendant offers testimony tantamount to a "denial" of the SEC's prior allegations, the commission has the right to reopen the consent agreement. Morvillo remembered a civil lawsuit in which a witness testified on cross-examination that he had agreed to "neither admit nor deny" the SEC's allegations because he lacked the resources to fight them. The SEC then grilled the witness, trying to get him to deny the allegations outright so the commission could reopen the case, until the judge intervened. Morvillo now counsels defendants to obtain settlement language to protect them from this kind of predicament. (The 10 banks that settled with the SEC in April must have received the same advice; their agreements preserve their right to testify truthfully and to characterize the agreement how they wish in subsequent actions.)

At least one firm interpreted that right rather broadly. Just days after the settlement, Morgan Stanley CEO Philip Purcell earned a written rebuke from the SEC for downplaying the significance of the commission's actions and for exhibiting "a troubling lack of contrition." A few days later, Bear Stearns was forced to delay an initial public offering it was underwriting, and to issue an apology to regulators, after it emerged that the firm had used an analyst to promote the new stock offering, a practice expressly forbidden by the global settlement.

Public relations snafus such as these have heightened political pressure for tougher sanctions. (Critics note that the $1.4 billion settlement is just a fraction of the security industry's pretax profit of $21 billion at market's peak in 2000.) Last June, SEC commissioner Harvey Goldschmid raised the possibility of requiring defendants in settlements to admit guilt while specifying that the admission wouldn't be binding in civil lawsuits. According to The Wall Street Journal, Goldschmid is concerned that defendants who do not admit guilt leave the impression that they didn't do anything wrong.

But Goldschmid may have underestimated "neither admit nor deny." These four words empower a relatively weak institution with few resources. And properly understood, they can humble even the most influential CEOs in America.

Len Costa is a writer in New York who has written about business and finance for Worth and Fortune.

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