The SEC Shines First Light On A Penalty Policy

Wednesday, March 1, 2006 - 00:00

The post-Enron world of enforcement litigation by the Securities and
Exchange Commission has witnessed eye-popping penalties agreed to by public
companies settling civil charges of financial fraud. Among the notable examples
are a $750 million penalty in the SEC's settlement of its financial fraud
lawsuit against WorldCom Inc. in July 2003, and a penalty of $300 million in the
March 2005 settlement of similar fraud charges against America Online, Inc. In
the vast majority of settled enforcement actions, however, the Commission's
record on assessing penalties is uneven, creating uncertainty in two critical
respects, first, as to the circumstances likely to result in the SEC's
demand for a significant civil penalty and, second, how the Commission
determines the amount of a penalty.

In a rare public concession, the SEC acknowledged in a statement released on
January 4, 2006: "[r]ecent cases have not produced a clear public view of when
and how the Commission will use corporate penalties, and within the Commission
itself a variety of views have heretofore been expressed, but not reconciled."
The Commission also expressed the concern that "the costs of such penalties may
be passed on to [innocent] shareholders." In recognition of the need to
articulate a policy governing civil penalties, the SEC went on to provide
written guidance as to when penalties may be sought against a public issuer.
Unfortunately, however, the Commission elected to maintain its silence on how
penalties will be calculated.

In 1990, Congress provided financial bite to the SEC's traditional remedies
of injunctions against future securities law violations and disgorgements of
ill-gotten gains by giving the Commission the authority to seek civil penalties
in cases involving willful misconduct. Unlike the other two principal enforcers
of the federal securities laws, the U.S. Department of Justice (bound by
statutory sentencing guidelines and, in the area of business fraud, subject to
public prosecution policies) and the National Association of Securities Dealers
(published sanction guidelines), the SEC had largely remained silent and
admittedly internally conflicted on how and when it would use its statutory
authority to punish violators of the federal securities laws with monetary

The Criteria For Civil Penalties Against Issuers

According to the Commission's January 4, 2006 release, the decision to seek a
penalty against a public company will be based on a two-level analysis.

In furtherance of its stated concerns for shareholders, the SEC will first
determine the presence or absence of a direct benefit to the corporation as a
result of the violation, and the degree to which the penalty will recompense or
further harm the injured shareholders. This prong of the test makes economic
sense since the shareholders ultimately bear the burden of paying SEC penalties.

Then, the SEC will go on to consider seven additional factors:

  • The need to deter the particular type of offense;

  • The extent of the injury to innocent parties;

  • Whether complicity in the violation is widespread throughout the

  • The level of intent on the part of the perpetrators;

  • The degree of difficulty in detecting the particular type of

  • Presence or lack of remedial steps by the corporation;

  • Extent of cooperation with the Commission and other law
  • To illustrate application of these criteria, the Commission pointed to the
    filing of two settled actions on January 4, SEC v. McAfee, Inc. and In
    the Matter of Applix, Inc.
    , in which a $50 million penalty was required of
    McAfee, while no penalty was assessed against Applix. Applying the first-tier
    factors, the Commission found McAfee used price-inflated stock to acquire other
    companies to the benefit of its shareholders and therefore sought and received a
    $50 million penalty in its settlement. By contrast, the Commission found neither
    Applix nor its shareholders benefited from its fraudulent conduct and
    imposed no penalty at all.

    Had the Commission's analysis ended there, a much clearer picture would have
    emerged as to when a company would be subject to civil penalties. However, in a
    second statement released on January 4, the Commission announced that its
    decisions in McAfee and Applix also turned on the second-level
    factors but, unfortunately, stopped short of explaining how the disparate
    considerations ultimately affected its penalty decisions.

    The Commission charged both McAfee and Applix with financial fraud. McAfee
    was alleged to have inflated revenues and earnings for at least 10 consecutive
    financial quarters while Applix improperly recognized revenues for two
    transactions and understated losses as a result. The Commission also found that:
    (1) unlike Applix, McAfee could afford to pay a substantial penalty without
    undue harm to its shareholders; (2) the size of McAfee's penalty permitted
    economical distribution to injured shareholders though the Fair Funds mechanism
    of the Sarbanes-Oxley Act of 2002; and (3) McAfee's accounting fraud was
    pervasive and persisted over nearly three years, and resulted in grossly
    overstated revenues, three restatements of its financial results, and criminal
    charges against its chief financial officer and controller.

    Future Application Of The Commission's Penalty Criteria

    McAfee and Applix present factual extremes of the securities
    fraud spectrum. Can meaningful guidance be extracted from the results announced
    by the Commission in disparate cases?

    In its January 4 release, the Commission purported to "provide the maximum
    possible degree of clarity, consistency and predictability in explaining the way
    that its corporate penalty authority will be exercised." The penalty punch list
    is useful in gauging exposure to penalties insofar as it at last sheds some
    light on a process that, in a vacuum, has appeared at times to have had more in
    common with a star chamber than with the logical and predictable application of
    enforcement remedies now envisioned by the Commission. However, with so many
    factors to consider, and with the second-level factors having application in
    virtually every enforcement scenario, it appears the SEC remains free to fashion
    an argument for penalties in virtually every litigation.

    Accordingly, the Commission's desired "clarity, consistency and
    predictability" may not be substantially furthered by its January 4

    The Unanswered Question - Calculating A Penalty

    Equally disappointing was the Commission's failure to address how a
    penalty would be calculated. How did the Commission arrive at $50 million as a
    reasoned and just penalty in McAfee?

    Unfortunately, the statutes authorizing penalties provide few
    parameters on the amount of sanction the SEC can seek from an alleged violator.
    In the case of public issuers, for example, the SEC may seek $50,000 to $500,000
    or an amount equal to the amount of wrongful pecuniary gain for each
    violation of law. Was the McAfee penalty based somehow on the number of
    inaccurate SEC filings, the total of accounting errors in one, some or all of
    those filings, or on other considerations?

    Since the calculus of McAfee 's $50 million penalty remains a mystery,
    the question of "how much" continues to loom large for public companies facing
    enforcement proceedings involving the potential for a civil penalty.

    If positive guidance on the penalty calculus is to be gleaned from the
    January 4th release, it is the Commission's recognition that penalties should
    not injure shareholders. By logical extension, it would appear that the amount
    of a penalty should not be so large as to impair the subject's ability to
    function as a going concern - an outcome that could only hurt shareholders. This
    fact, above others, should be emphasized if the SEC Enforcement staff seems
    poised to recommend that the Commission seek civil penalties against a public

    However, as further enforcement remedies unfold, the application of the seven
    second-level factors to the Commission's sanctions ought to become more apparent
    to careful observers, and they can, for now, serve as a crude penalty-scoring
    template for defense counsel. In addition, the SEC is clearly sending a message
    to companies discovering securities law violations that earnest attention to the
    last two factors - remedial steps taken and cooperation with the Commission and
    other law enforcement - can help to reduce the financial costs of securities
    fraud. Those actions also cannot but help to begin restoration of some measure
    of shareholder and investor

    Debra M. Patalkis is a Partner in the Securities and
    Corporate Governance Litigation Practice Group of Drinker Biddle & Reath LLP
    and is resident in the firm's Washington, D.C. office. She previously served as
    Assistant Chief Litigation Counsel, Division of Enforcement, for the Securities
    and Exchange Commission. This article is not intended to constitute legal advice
    regarding any client's legal problems or specific questions and should not be
    relied upon as such. © 2006 Drinker Biddle & Reath LLP. All rights

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