SEC Clarifies Its Stance on Penalizing Corporations, But Uncertainty Remains

        In response to accounting frauds by corporate giants, the U.S. Securities & Exchange Commission (“Commission”) imposed civil penalties as a way to deter similar conduct and demonstrate its commitment to restoring investor confidence.  In 2003 and 2004, federal courts approved a $2.25 billion penalty against WorldCom, a $250 million penalty against Qwest Communications, and a $50 million penalty against Vivendi to settle financial fraud charges against these companies, to name just a few.  In 2004, former Division of Enforcement Director Stephen M. Cutler noted that the $10 million penalty imposed against Xerox in 2002 appeared “antiquated” in light of then-current trends.[1]

But the Commission itself was bitterly divided, on a 3-2 basis, about the propriety of requiring corporations to pay large civil penalties.  Chairman Donaldson joined Commissioners Goldschmidt and Campos in supporting the imposition of such penalties over the objections of Commissioners Glassman and Atkins.  Commissioner Glassman was on record as stating that she could not “justify imposing penalties indirectly on shareholders whose investments have already lost value as a result of the fraud.”[2]  Similarly, Commissioner Atkins argued that that corporate penalties amounted to fines against shareholders, which were “often not appropriate.”[3]  The departure of Chairman Donaldson and Commissioner Goldschmidt appeared to signal the end of the existing penalties regime. In September 2005, newly-appointed Chairman Cox told the Wall Street Journal that he hoped the Commission could adopt a framework making penalties more predictable. [4]

On January 4, 2006, the SEC issued a Statement Concerning Corporate Penalties (“Statement”) describing the framework for its penalty determinations regarding recent settlements in two cases in which public companies allegedly engaged in accounting fraud, SEC v.  McAfee, Inc. [5] and In re Applix, Inc. [6]  The Statement is potentially important because it gives guidance to executives and defense attorneys about the circumstances under which the Commission will seek large penalties against corporations.  In McAfee, the company agreed to pay a $50 million penalty, and in Applix, the company was not required to pay any penalty.  The Statement indicated that whether the SEC would impose a penalty on corporations would depend primarily on two major factors: whether the corporation benefited from the violation, and whether the penalty would compensate, or further harm, the injured shareholders. The Statement also mentioned seven secondary factors that the SEC would consider: the need for deterrence, the extent of injury to innocent parties, the pervasiveness of violative conduct, the level of intent on the part of the perpetrators, the degree of difficulty in detecting the offense, the existence of remedial steps by the corporation, and the extent of cooperation.[7]   

          It is unclear whether the Statement signals a significant retreat from the SEC’s previous willingness to impose civil penalties against companies that commit fraud.  Regarding the first factor, the Statement indicates that where a corporation has “received a direct and material benefit from the offense, for example through reduced expenses or increased revenues,” this would weigh in support of the imposition of a penalty.  On its face, this language is extremely broad, since companies engaged in accounting fraud often improperly defer expenses or recognize revenues.  Thus, the SEC’s own example seems to leave open the possibility that if a company’s net income is materially overstated, the agency will conclude that it received an improper benefit.   However, in the context of the two settlements at issue, Linda Chatman Thomsen, the Director of the Division of Enforcement, stated that a large penalty was justified in McAfee because, among other things, the issuer improperly benefited from the fraud by acquiring other companies using its artificially inflated stock, and, conversely in Applix,  the issuer, which improperly reported inflated revenue and net income figures, nonetheless did not realized any “direct benefits” through the fraud.[8]  Ms. Thomsen’s comments suggest that the SEC may limit its definition of an “improper benefit” to relatively narrow and extraordinary circumstances.

          At first blush, the second major factor described in the Statement, the desire to avoid imposing penalty costs against “shareholders who are innocent of the violation,” constitutes a significant new obstacle to imposing civil penalties.  This language appears to be a nod to Commissioner Glassman’s previously expressed concern about having shareholders indirectly pay corporate penalties “that end up being returned to them through a Fair Fund - minus distribution expenses.”[9]  The concern is that victimized investors who bought stock prior to disclosure of the fraud may continue to hold their shares when the company pays penalties to the SEC.  Under such a scenario, the shareholders could be viewed as paying penalties to themselves, an illogical and undesirable result.   Thus, adherence to the second factor seemingly would require analyzing shareholder turnover, i.e., the extent to which investors sold their stock after disclosure of the fraud, but prior to payment of the penalty.  Engaging in this type of analysis would open the door to a technical, fact-specific debate about the degree of shareholder turnover in a particular situation.[10] 

          Perhaps recognizing the difficulties that would attend such analysis, the Commission staff’s public statements about the McAfee and Applix cases entirely avoided addressing the issue of shareholder turnover.  While stating, without further explanation, that penalty monies collected from McAfee could be “effectively distributed” to injured shareholders, Ms. Thomsen did not state whether the injured shareholders continued to hold their shares, and would therefore in effect fund their own compensation.  Rather, Ms. Thompson observed that the company was “financially strong,” and stated that the penalty it has agreed to pay was unlikely to cause current shareholders “undue hardship.”  In contrast, she stated that Applix was “a relatively small company,”and expressed concerns that a significant penalty would “have a disproportionate effect on its financial situation with hardship flowing to its shareholders.”[11]  These comments suggest that the Commission may interpret the second factor as merely requiring a finding that the penalized company is financially strong -- a much easier hurdle than that suggested by Commissioner Glassman.  Based on these two cases, the Commission has signaled a willingness to indirectly punish shareholders victims, as long as the harm is mitigated by the financial strength of the penalized company.   Since evidence suggests that the Commission gave strong consideration to the financial strength of corporate wrongdoers even before issuing the Statement, the second factor therefore may not represent a significant departure from past policy.[12]

          The Statement leaves substantial uncertainty in its wake.  It  gives no guidance regarding the relative weight to be given to the factors, or the amount of any financial penalty likely to be sought.   Many of the secondary factors are themselves vague and subject to argument.  For instance, what does it mean to cooperate?  To be deemed a cooperator, does a company always have to terminate employees who engaged in allegedly improper conduct?  Answers to these and other questions will come only with the passage of time, as read through the “tea leaves” of future SEC enforcement actions.

         

         

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[1] See Stephen M. Cutler Remarks at Ray Garrett Jr. Corporate & Securities Law Institute (Apr. 29, 2004), http://www.sec.gov/news/speech/spch042904smc.htm.

[2] See Cynthia A. Glassman, “SEC in Transition: What We’ve Done and What’s Ahead” (June 15, 2005) (“Glassman Speech”), http://www.sec.gov/news/speech/spch061505cag.htm.

[3] See Commissioner Paul S. Atkins, Remarks before the Atlanta chapter of the National Association of Corporate Directors (Feb.23, 2005), available at http://www.sec.gov/news/speech/spch022305psa.htm.

[4] Tim Reason, Fine Time at the SEC, CFO Magazine (Dec. 1, 2005), available at http://www.cfo.com/article.cfm/5268469/c_5246221

[5] See SEC v. McAfee, Inc., Civ. No. 06-009 (N.D. Cal. 2006), available at http://www.sec.gov/litigation/litreleases/lr19520.htm.

[6] See In re Applix, Inc., File No., 3-12138 (Jan. 4, 2006), available at http://www.sec.gov/litigation/admin/33-8651.pdf.

[7] See Statement of the Securities and Exchange Commission Concerning Financial Penalties, http://www.sec.gov/news/press/2006-4.htm.

[8] See Linda Chatman Thomsen, Statement Regarding McAfee, Inc. and Applix, Inc., (Jan. 4, 2006) (“Thomsen Speech”),  http://www.sec.gov/news/speech/spch010406lct.htm.

[9] See Glassman Speech.

[10] See Commissioner Annette L. Nazareth, Remarks before ALI-AQBA Broker-Dealer Regulation Conference (Jan. 12, 2006) (noting that the “extent to which the passage of time has resulted in shareholder turnover" was a factor relevant to the determination of a penalty), http://www.sec.gov/news/speech/spch011206aln.htm.

[11] See Thomsen Speech.

[12] For instance, in SEC v. Johnson, No. 04-RB-0626 (D. Colo. Sept. 10, 2004), the Commission charged a microcap issuer with accounting fraud, and later accepted its  offer to consent to an injunction, without imposition of a penalty.  See Litigation Release No. 18879 (Sept. 10, 2004), available at http://www.sec.gov/litigation/litreleases/lr18879.htm.  Apparently due to its lack of financial resources, the issuer had filed a Form 15 terminating the registration of its common stock resources, prior to the filing of the Commission’s complaint. See http://www.sec.gov/litigation/complaints/comp18652.htm.