Engineering Change at the SEC
As seen in the Penn Law Journal
By Rick Schmitt
In January, the elite of the securities bar gathered for an annual conference at a resort near San Diego, eager to hear from Walter J. “Jay” Clayton III ENG’88, L’93, the new chairman of the Securities and Exchange Commission. Clayton was slated to deliver the gathering’s keynote address. What he really delivered was a shot across the bow.
His target: a recent burst of “initial coin offerings” in which investors had sunk billions of dollars. The offerings sought to capitalize on surging interest in digital currencies such as bitcoin. But, at least in some cases, they also skirted SEC rules requiring disclosure of material information to the public. Clayton feared a speculative bubble, and was concerned that lawyers for the issuers were giving bad advice or looking the other way.
“Market professionals, especially gatekeepers, need to act responsibly and hold themselves to high standards,” Clayton said. “To be blunt, from what I have seen recently, particularly in the initial coin offering space, they can do better.”
SEC staff was “on high alert” for conduct that “may be contrary to the spirit of our securities laws and the professional obligations of the U.S. securities bar,” Clayton warned.
“I’m constantly looking for where expectations are out of line with reality, because that leads to uncertainty, discord and inefficiency,” he says later in an interview in his office at SEC headquarters in Washington. “That is one of the key questions I ask myself. ‘Where are the risks?’”
Clayton has seen the downside of risky behavior before, as a lawyer who advised investment banks as they struggled to survive the mortgage meltdown. Now, he is applying those skills — along with a deep understanding of the intricacies of the capital markets, and an appetite for problem-solving — as the top cop on Wall Street.
At a time when unconventional leaders increasingly occupy positions of power in official Washington, Clayton is something of a throwback. He has acquitted himself as a serious, academically minded regulator, who has embraced his agency’s traditional mission and professional staff. And he has tackled a series of formidable challenges, while calling out what he sees as emerging threats to markets and the financial system.
“Jay has seen the damage that instability can do,” says Joe Frumkin, L’85, a partner at Sullivan & Cromwell, where Clayton worked for two decades. “One of many reasons I feel good about him being at the Commission is I think he will be in a position to try and take action to prevent that kind of situation from arising again.”
In the decade since the worst financial crisis since the Great Depression, regulators in Washington have been focused on writing and enforcing new rules in the hope of avoiding trouble in the future. Now, there is concern among congressional Republicans and the Trump Administration that those reforms have gone too far, and the focus has shifted to easing regulations to jumpstart growth and jobs.
Clayton has made it among his main goals to make it easier for companies to raise money from the public, including reversing a decline in offerings of stock by emerging growth companies, which he says has deprived public investors of a chance to participate in the often out-sized growth such companies show in their early years. As one inducement, the SEC has recently expanded a program in which firms can have registration statements privately reviewed by agency staff before they go public.
At the same time, he says it is the long-term interests of ordinary investors that serve as the key guidepost to his decision-making. “What can the Commission do to cultivate markets where Mr. and Ms. 401(k) are able to invest in a better future?” he observed in a speech in New York last year in his first public remarks as SEC chair. “I am confident this is the right lens for our analysis.”
Just a year into the job, he has won the respect of colleagues and others, even those with whom he has policy differences.
“Jay is curious and open-minded about what the right answer is. When we have a debate, I don’t always win, but I always feel like I am heard,” says Robert Jackson C’99, W’99, WG’00, a New York University law school professor who was appointed to one of two Democratic seats on the Commission by President Trump. “In Washington these days, that is very rare.”
Much of Clayton’s life’s story is more Main Street than Wall Street. Six weeks after he was born, his father shipped out to Vietnam as a second lieutenant, and his mother, then 20, moved the growing family to her childhood home in central Pennsylvania. Clayton’s grandfather, a child of coalminers, was a small-town lawyer and public servant, who took young Jay to township meetings, real estate closings and estate sales. Later, during college and graduate school, Clayton negotiated leases and designed inventory systems for a small warehousing and logistics business owned and operated by his parents. In high school and college, Clayton worked as a lifeguard in Ocean City, N.J. When people got out of hand at the crowded beaches downtown, it gave him some insight into how being respectful of people is almost always the best first step.
At Penn, he studied engineering, graduating summa cum laude with the Class of 1988, and receiving many senior awards as well as Penn’s Thouron scholarship for study in the United Kingdom. He earned bachelors and masters degrees in economics at the University of Cambridge, where he was a member of King’s College (home of John Maynard Keynes) and captained the University basketball team. He was admitted to the Wharton PhD program, and considered an academic life before committing to law. After graduating from the law school in 1993, he clerked for U.S district judge Marvin Katz C’51 in Philadelphia.
“To the extent I have gained practical insight into the intersection of law, capital markets and technology, Penn deserves the lion’s share of the credit,” Clayton says. “Penn gave me access, support, and the opportunity to both fail and succeed as a student and a practitioner. I think of points made years ago by my professors and fellow students often and with gratitude and respect.”
At Sullivan & Cromwell, over 20 years, he had postings in Washington, London and New York. He was elected partner after five years at the firm and became one of the youngest lawyers ever to serve on the firm’s management committee. His roster of clients included the likes of e-commerce giant Alibaba and wealthy investors and entrepreneurs such as hedge-fund billionaire Paul Tudor Jones and Reid Hoffman, the co-founder and executive chairman of LinkedIn.
In 2008, Clayton advised the board of Bear Stearns, the storied investment bank, in its government-aided sale to JPMorgan Chase, and helped Lehman Brothers in an ill-fated attempt to find a suitor before filing for bankruptcy protection. He also represented Goldman Sachs as it shored up its finances selling preferred stock to a firm controlled by investor Warren Buffet and negotiating a $10 billion investment from the U.S. Treasury.
Clients remember a lawyer who was always fully prepared, objective, and calm under pressure. Tom Russo, the former general counsel of Lehman, recalls spending a week with Clayton in Korea in high-stakes negotiations with a group of banks that was considering an investment in the financial services giant. The two sides spent hours at the bargaining table, while Clayton simultaneously distilled their words into legally enforceable writings. “He managed to put the gobbledygook of the negotiation of the negotiation into pristine legal documents,” Russo says. “It was like alchemy of sorts.”
Clayton also used his law degree to get back to the classroom, developing a reputation among students and young lawyers as a supportive teacher and mentor. For eight years, he and Frumkin taught the mergers and acquisitions course at the law school, and this spring he found time to lead the class in a discussion of shareholder activism. Ben Barocas, L’19 WG’19, says Clayton also shared a few tips on exam-taking, stressing the importance of “never forgetting who your client is” when analyzing and solving problems.
Clayton “always emphasized the question of why we regulate M&A to begin with and why that matters,” says Christina Gunzenhauser W’15, L’17, an associate at Latham & Watkins in Los Angeles. “It was apparent he cared about the course as an academic, rather than just as a practitioner.”
“Not every lawyer who is as successful as Jay has the EQ (emotional quotient) that matches the IQ,” adds Mark Greene, L’93, another classmate, who is now a partner at Cravath, Swaine & Moore and head of its corporate department. “That is one of the things that sets Jay apart, and makes him so desirable. We are fortunate as a country that that was recognized by the current administration.”
A registered Independent, Clayton reportedly came to the attention of then President-elect Trump when asked by a long-time client to offer suggestions to the Trump transition team. Clayton responded with detailed thoughts on making U.S.-equity markets more open and to promote growth by reducing regulatory burden. That led to his first-ever meeting with Trump just before Christmas at his Mar-a-Lago estate in Florida. Trump offered him the job the first week of the New Year. “He asked me to do a good job, and told me he would leave it to me to do a good job, which has been true,” Clayton says.
At his confirmation hearing last year before the Senate Banking Committee, Democrats questioned whether Clayton could be fair given his extensive ties to Wall Street. Clayton says he understands the concern, but feels strongly he can do the job without showing favoritism to one side or the other. Ultimately, some moderate Democrats joined their Republican colleagues to approve his nomination, by a 61–37 vote, and he was sworn in by Justice Anthony Kennedy May 4, 2017.
His is a daunting mission: the SEC oversees the more than $82 trillion in annual securities trading on U.S. markets, over 7,300 public companies and 26,000 registered entities, including investment advisors, broker-dealers, and exchanges. Besides the five-member Commission, which votes on things such as new rules and regulations and enforcement actions, there is a full-time staff of 4,500, including lawyers, economists, and analysts. By law, no more than three commissioners may belong to the same political party, with the President designating one of the commissioners as chairman.
Transitioning from private to public life has also had its own challenges. For one thing, his wife, a lawyer and former wealth management advisor, and three children are continuing to live in New York; Clayton commutes on weekends. For another, despite their prestige, high-level positions in Washington come with a sometimes challenging learning curve.
“There’s not a place you go to learn how to do one of these jobs, which is really kind of a problem,” Clayton says, adding that the most important consideration, by far, is picking good people around you. His staff includes Robert Stebbins, a Penn Law classmate and long-time Willkie Farr & Gallagher partner who is now SEC general counsel.
So far, he has proven to be a methodical and data-driven regulator, with a well-defined view of the agency’s mission and the need for considered rule-making. He sees the congressional mandate for the agency — protect investors, maintain fair, orderly and efficient markets, and facilitate capital formation — as “the first and last organizing principle.” He is sensitive to what he calls “knock-on effects” of regulation, and the need for regulators to do a better job at anticipating unintended consequences. Stebbins sees a lawyer who “thinks a lot like an economist or engineer.”
That thought process was on display at a public hearing in April where the Commission considered a staff proposal that would raise professional standards for stock brokers, who, unlike investment advisors, are not considered fiduciaries. Under Clayton, the agency had spent months soliciting comment from the public, and holding scores of meetings with investors and industry groups. Thousands of hours of staff time was spent evaluating such questions as the impact of changing standards on the cost of investment advice and on the type of products that brokers sell to the public.
The proposal, running more than 1,000 pages, would require brokers to provide investors with standardized disclosure documents highlighting the services they offer, the legal standards that govern their conduct, the fees customers will pay and certain conflicts of interests, among other provisions. Supporters say the proposal would, for the first time, prohibit brokers from putting their own interests ahead of their customers’.
The two Democratic commissioners were sharply critical, saying the proposal had too many loopholes and might not leave investors any better off. Currently, brokers are obligated to give advice that is “suitable” for their clients, based on their age, finances and appetite for risk. But that has also opened the door to conflicts of interest where brokers push investments that are good for them — in the form of lucrative commissions — but not necessarily for their customers. Jackson, for one, has been supportive of a new standard for brokers that is more in-line with the higher duties required of investment advisors.
Clayton responded that it was important to continue to give ordinary investors a choice when it comes to who they turn to for investment advice. Avoiding excessive costs to the industry and ensuring the agency would be able to effectively enforce any new rule were also key considerations. At the hearing, he elicited assurances from staff members that their proposal would likely accomplish all that. In the end, despite reservations, the Commission voted to send the proposal out for public comment, the next step in the approval process.
“Our capital markets — and the broad-based participation of retail investors in our capital markets — are the envy of the world,” he said. “That broad-based participation isn’t something that was turned on yesterday, and we certainly don’t want to turn it off tomorrow.”
Clayton has inherited many other challenges. Four months into his tenure, Equifax, one of the “big-three” U.S. credit bureaus, disclosed that it had experienced a data breach that exposed personally identifying information of more than 143 million Americans. The same month, the SEC discovered that it had experienced a data breach of its own, caused by a defect in custom software code in its EDGAR system, which handles 1.7 million public company electronic filings a year.
In response, among other things, Clayton ordered the creation of a new 30-person cybersecurity unit within the SEC’s enforcement division, and authorized the hiring of a “chief risk officer” to shore up the agency’s internal defenses and assess risks in the markets. In February, under his leadership, the Commission issued guidance to assist public companies in preparing disclosures about cyber risks and incidents. In April, sending another signal, the SEC extracted a $35 million penalty from Yahoo in a settlement of charges over a hacking incident that the firm had hidden from the public for two years. Together, the moves put cyber on the radar of public companies in a way that make clear what the SEC expects of them.
And then there has been the proliferation of high-flying coin offerings. Promoters of such deals are seeking to capitalize on a new kind of technology, known as blockchain, which derives its value from eliminating the middleman, such as a bank, in financial transactions. As part of the offerings, investors get tokens or other so-called cryptocurrency, which have no intrinsic value, but which, like bitcoin, are sold as payment alternatives to traditional currencies such as the dollar.
While the technology has enormous promise, it has also given rise to what Clayton and other regulators fear is a bubble reminiscent of the dot-com era. Investors poured nearly $4 billion into coin offerings in 2017, which were conducted without SEC registration. Some of the issuers have taken the position they do not have to abide by agency rules because they are not issuing securities.
Clayton has a different view. “I believe every ICO (initial coin offering) I’ve seen is a security,” he declared at a congressional hearing in February, a month after his saber rattling in front of the securities lawyers in San Diego. On his watch, the SEC has charged several ICO firms with defrauding investors, including the brains behind one start-up that promised debit card holders the ability to instantly convert digital assets into U.S. dollars. Through an unregistered ICO, the firm raised $32 million from the public, using fictional executives with impressive biographies and paid celebrities such as boxer Floyd Mayweather to market the venture on social media. Clayton says more such cases are likely.
“He has showed some real leadership,” Jennifer Zepralka, L’01, a former SEC senior special counsel who is now a partner in the Washington office of WilmerHale, says of Clayton. “He has really marshaled the forces of the SEC around that issue to get it under control.”
“Every day is interesting,” Clayton says. “It would be incorrect to say that every day is a barrel of laughs. There are lots of things that you have to deal with that you wouldn’t consider pleasant. But I can tell you that every single day I am glad I decided to do this.”
“I think the greatest gratification comes from realizing that what we are trying to do here makes a difference, and you can see it every day, because our capital markets do perform better than comparative capital markets and that benefits the country,” he says. “They’re not perfect. But they are a lot better, and that makes a big difference.”