'Improper Benefit' Key To SEC Policy

On January 4, Securities and Exchange Commission Chairman Christopher Cox announced the SEC's unanimously adopted policy on the use of the its enforcement powers to impose monetary penalties on public companies for securities law violations. According to the policy, when deciding whether to impose fines, the SEC will focus on whether a corporation's violation provided an improper benefit to the company and its shareholders. If so, the SEC will be inclined to seek fines to deter future conduct. Conversely, the SEC will be less likely to pursue fines in cases where they would result in further harm to shareholders already injured by a corporation's actions.

This article examines the new SEC policy regarding fines and its implications for corporations and shareholders.

The New Standards

Cox's announcement is in reaction to growing criticism leveled at the SEC that shareholders were being penalized twice as it increased the number and monetary value of penalties levied in recent years. Shareholders were often harmed by the securities law violation itself, through a loss to the corporation and/or a decrease in stock price. The subsequent imposition of hefty fines was perceived by many in the business community as a further cost to the already victimized shareholders.

The SEC's announcement expressed a desire to 'provide the maximum possible degree of clarity, consistency, and predictability' in the issuance of civil fines. The appropriateness of a penalty on a corporation turns principally on two major considerations: 1) 'the presence or absence of a direct benefit to the corporation as a result of the violation;' and 2) 'the degree to which the penalty will recompense or further harm the injured shareholders.' The SEC stated that the imposition of a fine is most heavily supported in situations where the corporation is unjustly enriched, such as through reduced expenses or increased revenues. Additionally, consistent with the goal of investor protection, the SEC will consider the likelihood that a penalty would unfairly injure innocent shareholders. However, to perhaps further confuse the situation, the SEC also raised the possibility of using penalties as a source of money to compensate injured shareholders.

In an apparent effort to reach a unanimous decision among the five SEC Commissioners (three Republicans and two Democrats), the policy announcement listed seven other factors that will be considered:

1. The SEC's perceived need to deter the particular type of offense. The likelihood that a financial penalty will deter other corporations similarly situated weighs in favor of the imposition of a penalty.

2. The extent of the injury to innocent parties, including such factors as the egregiousness of the harm done, the number of investors injured, and the harm to society if the corporation is not punished.

3. Whether complicity in the violation was widespread throughout the corporation. The more widespread the participation in the illegal activity, the more appropriate a fine becomes. Also, the SEC will consider whether the corporation has replaced those persons responsible for the violation.

4. Whether the conduct was inten-tional. The SEC will consider a fine a more appropriate deterrent device when the conduct giving rise to the securities violation was deliberate or intentional. Con-versely, the SEC may be less likely to impose a fine on conduct giving rise to an SEC violation that was accidental or unintentional.

5. The degree of difficulty in de-tecting the particular type of offense. Since offenses that are especially difficult to detect or police require a higher level of deterrence, the SEC will consider a monetary fine more appropriate is such situations.

6. Whether the corporation took any remedial steps. Because the SEC seeks to encourage public companies to remedy their violations on their own accord, exemplary remedial conduct weighs against the imposition of a corporate penalty. Accordingly, companies that are reluctant to change the conduct resulting in the SEC violation prior to an SEC enforcement decision are more likely to face a financial penalty as part of the enforcement decision.

7. The extent of 'true' cooperation. The extent of cooperation with the SEC and other law enforcement agencies, including the degree to which the corporation has self-reported an offense, is also considered.

Rather than clarifying the two major factors used in determining the appropriateness of a financial penalty in a particular case, the seven additional factors have the effect of watering down the primary factors' effectiveness and making the process of determining the likelihood of a fine more difficult. This effect is amplified by the SEC's reluctance to explain the weight that will be applied to each factor when deciding whether to impose a financial penalty.

Case Studies

On Dec. 30, 2005, the SEC hinted at the Commission's new policy in its filing of a civil fraud action against six former officers of Putnam Fiduciary Trust Company (Putnam). In its complaint seeking injunctive relief and civil monetary penalties against six former officers, the SEC alleged their misconduct arose out of Putnam's 1-day delay in investing a client's assets. The delay resulted in a near $4 million loss of market gains. Rather than informing the client of the investment delay, the SEC alleged that the six defendants improperly shifted '$3 million of the costs of the delay to shareholders of certain Putnam mutual funds through deception, illegal trade reversals, and accounting machinations.' Further, the six defendants, without disclosure, allowed the client's contribution plan to absorb nearly $1 million of the loss. The SEC also alleged that four of the officers engaged in conduct to cover up their earlier misconduct, delaying discovery for 3 years.

The SEC chose not to bring any enforcement proceedings against Putnam because of the corporation's extraordinary level of cooperation during the SEC's investigation. It noted Putnam's cooperation consisted of: 'prompt self-reporting, an independent internal investigation, sharing the results of that investigation with the government (including not asserting any applicable privileges and protections with respect to written materials furnished to the Commission staff); terminating and otherwise disciplining responsible wrongdoers; providing full restitution to its defrauded clients; paying for the attorneys' and consultants' fees of its defrauded clients; and implementing new controls designed to prevent the recurrence of fraudulent conduct.'

Two cases released January 4 along with the SEC's policy decision ' SEC v. McAfee, Inc. and In the Matter of Applix, Inc. ' further illustrate the application of the new standards.

In SEC v. McAfee, Inc., McAfee agreed to pay a $50 million fine for allegedly fraudulently inflating revenues by $622 million through the use of improper accounting practices that were knowingly concealed. The SEC chose to impose a fine on McAfee due to its use of several ploys to oversell products and thereby inflate revenues.

In contrast, the SEC decided not to seek civil monetary penalties in the case of In the Matter of Applix, Inc. In Applix, the SEC alleged that the company fraudulently inflated revenues and understated losses through the use of improper accounting techniques on two separate transactions. In the first transaction, Applix improperly recognized nearly $900,000 in revenue up front even though it should have been evenly distributed over the length of the contract. In its second transaction, Applix improperly recognized $341,000 as revenue even though the customer had yet to officially accept the product. No fine was imposed on Applix because there was no evidence that Applix sought to cover up their accounting errors and because Applix shareholders were not benefited to the same extent as McAfee's shareholders.

Conclusion

While it was the SEC's intent that the policy statement concerning financial penalties would 'provide a high degree of transparency to decisions in these and future cases, and be of assistance to the Commission's professional staff, to corporate issuers and their counsel, and to the public,' its outlined standards are still extremely subjective and provide for a great deal of individual interpretation. In fact, the inclusion of the seven additional factors undercuts the clear nature of the two primary guidelines and may have done nothing more than tell the market (again) that the SEC has wide latitude when deciding whether to impose a financial penalty. Nevertheless, the full list of factors does provide a set of specific standards to use when arguing against a financial penalty or that the amount of a proposed fine is inappropriate.

Finally, the factors also provide further details about how the company should react when it finds itself in an environment that suggests the federal securities laws have been violated. As the SEC's Enforcement Division chief Linda Thomsen recently noted, only the last two factors, cooperation and remedial action, remain in a corporation's control once a violation is discovered. While the extent and degree of cooperation required by the SEC remains decidedly unclear, it is apparent from the SEC's comments that given the exact same conduct, the company that cooperates may well end up in a better position, at least in the eyes of the SEC and its staff.

On January 4, Securities and Exchange Commission Chairman Christopher Cox announced the SEC's unanimously adopted policy on the use of the its enforcement powers to impose monetary penalties on public companies for securities law violations. According to the policy, when deciding whether to impose fines, the SEC will focus on whether a corporation's violation provided an improper benefit to the company and its shareholders. If so, the SEC will be inclined to seek fines to deter future conduct. Conversely, the SEC will be less likely to pursue fines in cases where they would result in further harm to shareholders already injured by a corporation's actions.

This article examines the new SEC policy regarding fines and its implications for corporations and shareholders.

The New Standards

Cox's announcement is in reaction to growing criticism leveled at the SEC that shareholders were being penalized twice as it increased the number and monetary value of penalties levied in recent years. Shareholders were often harmed by the securities law violation itself, through a loss to the corporation and/or a decrease in stock price. The subsequent imposition of hefty fines was perceived by many in the business community as a further cost to the already victimized shareholders.

The SEC's announcement expressed a desire to 'provide the maximum possible degree of clarity, consistency, and predictability' in the issuance of civil fines. The appropriateness of a penalty on a corporation turns principally on two major considerations: 1) 'the presence or absence of a direct benefit to the corporation as a result of the violation;' and 2) 'the degree to which the penalty will recompense or further harm the injured shareholders.' The SEC stated that the imposition of a fine is most heavily supported in situations where the corporation is unjustly enriched, such as through reduced expenses or increased revenues. Additionally, consistent with the goal of investor protection, the SEC will consider the likelihood that a penalty would unfairly injure innocent shareholders. However, to perhaps further confuse the situation, the SEC also raised the possibility of using penalties as a source of money to compensate injured shareholders.

In an apparent effort to reach a unanimous decision among the five SEC Commissioners (three Republicans and two Democrats), the policy announcement listed seven other factors that will be considered:

1. The SEC's perceived need to deter the particular type of offense. The likelihood that a financial penalty will deter other corporations similarly situated weighs in favor of the imposition of a penalty.

2. The extent of the injury to innocent parties, including such factors as the egregiousness of the harm done, the number of investors injured, and the harm to society if the corporation is not punished.

3. Whether complicity in the violation was widespread throughout the corporation. The more widespread the participation in the illegal activity, the more appropriate a fine becomes. Also, the SEC will consider whether the corporation has replaced those persons responsible for the violation.

4. Whether the conduct was inten-tional. The SEC will consider a fine a more appropriate deterrent device when the conduct giving rise to the securities violation was deliberate or intentional. Con-versely, the SEC may be less likely to impose a fine on conduct giving rise to an SEC violation that was accidental or unintentional.

5. The degree of difficulty in de-tecting the particular type of offense. Since offenses that are especially difficult to detect or police require a higher level of deterrence, the SEC will consider a monetary fine more appropriate is such situations.

6. Whether the corporation took any remedial steps. Because the SEC seeks to encourage public companies to remedy their violations on their own accord, exemplary remedial conduct weighs against the imposition of a corporate penalty. Accordingly, companies that are reluctant to change the conduct resulting in the SEC violation prior to an SEC enforcement decision are more likely to face a financial penalty as part of the enforcement decision.

7. The extent of 'true' cooperation. The extent of cooperation with the SEC and other law enforcement agencies, including the degree to which the corporation has self-reported an offense, is also considered.

Rather than clarifying the two major factors used in determining the appropriateness of a financial penalty in a particular case, the seven additional factors have the effect of watering down the primary factors' effectiveness and making the process of determining the likelihood of a fine more difficult. This effect is amplified by the SEC's reluctance to explain the weight that will be applied to each factor when deciding whether to impose a financial penalty.

Case Studies

On Dec. 30, 2005, the SEC hinted at the Commission's new policy in its filing of a civil fraud action against six former officers of Putnam Fiduciary Trust Company (Putnam). In its complaint seeking injunctive relief and civil monetary penalties against six former officers, the SEC alleged their misconduct arose out of Putnam's 1-day delay in investing a client's assets. The delay resulted in a near $4 million loss of market gains. Rather than informing the client of the investment delay, the SEC alleged that the six defendants improperly shifted '$3 million of the costs of the delay to shareholders of certain Putnam mutual funds through deception, illegal trade reversals, and accounting machinations.' Further, the six defendants, without disclosure, allowed the client's contribution plan to absorb nearly $1 million of the loss. The SEC also alleged that four of the officers engaged in conduct to cover up their earlier misconduct, delaying discovery for 3 years.

The SEC chose not to bring any enforcement proceedings against Putnam because of the corporation's extraordinary level of cooperation during the SEC's investigation. It noted Putnam's cooperation consisted of: 'prompt self-reporting, an independent internal investigation, sharing the results of that investigation with the government (including not asserting any applicable privileges and protections with respect to written materials furnished to the Commission staff); terminating and otherwise disciplining responsible wrongdoers; providing full restitution to its defrauded clients; paying for the attorneys' and consultants' fees of its defrauded clients; and implementing new controls designed to prevent the recurrence of fraudulent conduct.'

Two cases released January 4 along with the SEC's policy decision ' SEC v. McAfee, Inc. and In the Matter of Applix, Inc. ' further illustrate the application of the new standards.

In SEC v. McAfee, Inc., McAfee agreed to pay a $50 million fine for allegedly fraudulently inflating revenues by $622 million through the use of improper accounting practices that were knowingly concealed. The SEC chose to impose a fine on McAfee due to its use of several ploys to oversell products and thereby inflate revenues.

In contrast, the SEC decided not to seek civil monetary penalties in the case of In the Matter of Applix, Inc. In Applix, the SEC alleged that the company fraudulently inflated revenues and understated losses through the use of improper accounting techniques on two separate transactions. In the first transaction, Applix improperly recognized nearly $900,000 in revenue up front even though it should have been evenly distributed over the length of the contract. In its second transaction, Applix improperly recognized $341,000 as revenue even though the customer had yet to officially accept the product. No fine was imposed on Applix because there was no evidence that Applix sought to cover up their accounting errors and because Applix shareholders were not benefited to the same extent as McAfee's shareholders.

Conclusion

While it was the SEC's intent that the policy statement concerning financial penalties would 'provide a high degree of transparency to decisions in these and future cases, and be of assistance to the Commission's professional staff, to corporate issuers and their counsel, and to the public,' its outlined standards are still extremely subjective and provide for a great deal of individual interpretation. In fact, the inclusion of the seven additional factors undercuts the clear nature of the two primary guidelines and may have done nothing more than tell the market (again) that the SEC has wide latitude when deciding whether to impose a financial penalty. Nevertheless, the full list of factors does provide a set of specific standards to use when arguing against a financial penalty or that the amount of a proposed fine is inappropriate.

Finally, the factors also provide further details about how the company should react when it finds itself in an environment that suggests the federal securities laws have been violated. As the SEC's Enforcement Division chief Linda Thomsen recently noted, only the last two factors, cooperation and remedial action, remain in a corporation's control once a violation is discovered. While the extent and degree of cooperation required by the SEC remains decidedly unclear, it is apparent from the SEC's comments that given the exact same conduct, the company that cooperates may well end up in a better position, at least in the eyes of the SEC and its staff.