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
penalties.
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
corporation;
The level of intent on the part of the perpetrators;
The degree of difficulty in detecting the particular type of
offense;
Presence or lack of remedial steps by the corporation;
and
Extent of cooperation with the Commission and other law
enforcement.
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
pronouncement.
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
issuer.
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
confidence.
Published March 1, 2006.
