The Illusory Nature of the SEC’s New Corporate Penalty Standards

    In the post-Enron era, civil penalties imposed against public companies by the Commission seemed arbitrary and consistent.  In January 2006, commentators applauded the SEC for issuing its Statement Concerning Financial Penalties (“Statement”).  Chairman Cox intended this document to provide guidance and transparency regarding the factors the Commission would consider in deciding whether to impose a civil penalty against a public company, and if so, the amount of such a penalty.  However,  the “major factors” set forth in the Statement - the benefit to shareholders resulting from the misconduct,  and the degree to which the penalty will unfairly harm injured shareholders – have posed conceptual problems.  As discussed below, an intellectually honest application of these factors would preclude all corporate penalties, since the first is rarely, if ever, satisfied, and the second always is present.  This article suggests that the Commission has chosen to interpret these two factors in a manner that renders them illusory and meaningless, and is instead giving great weight to the size of the company being sued, as well as remediation and cooperation, factors that are characterized by the Statement as “minor.”

   

A.        Penalized Shareholders Have Rarely Realized an Improper Benefit

            

            The Statement indicated that, regarding the first factor, “the strongest case for the imposition of a corporate penalty is one in which shareholders of the corporation have received an improper benefit as a result of the violation.”  Assuming the Commission is referring to current shareholders, this statement raises the question whether such shareholders are likely to have benefited from a fraud that has been disclosed and is now the subject of an SEC enforcement action.  Clearly, the answer is no.  Typically, a disclosed fraud causes a publicly traded company’s stock price to decline.  Current shareholders either bought stock before the disclosure, presumably incurring unrealized losses, or bought stock after the disclosure, therefore realizing neither gains or losses due to the disclosure.  In contrast, investors fortunate enough to have sold their stock at an artificially high price prior to disclosure of the fraud may be said to have realized an “improper benefit” from the fraud.  But these investors would no longer be current shareholders being asked to fund a corporate penalty payment.   Therefore, from a profit/loss perspective, it is difficult to conceive of a scenario in which current shareholders incurred an improper benefit.   

            Besides not requiring a benefit to current shareholders, the Commission has indicated that nearly anything will suffice as a benefit to the companies themselves. The Statement indicates that “reduced expenses or increased revenues,” a reference to the effect of the financial misstatements, can be a “direct and material benefit.” But nearly all financial fraud cases involve material net income increases or debt reductions; after all, materiality is an element of fraud.   The Commission appears to be saying that it believes penalties are appropriate whenever the fraudulent accounting was material.  If so, this factor is illusory and in no way provides guidance as to when penalties should be imposed.    Further, in announcing the agreement of AIG, Inc. to pay a $100 million penalty, the Commission focused on the company’s bad motives, namely that the misstatements were “designed to inflate falsely AIG’s loss reserves by $500 million in order to quell analyst criticism that AIG’s reserves had been declining.”[1]  Without elaboration, Commissioner Atkins, a frequent critic of corporate penalties, lauded this case as involving “a company and its shareholders” that “have broken the law and accrued a benefit from it.”[2]  Scienter, a critical element of fraud, usually is proven circumstantially, often by showing evidence of motive.  If a motive to commit fraud can be an improper benefit, this factor again lacks meaning. 

            At first blush, the example of an improper benefit given in Linda Thomsen’s speech made the same day as the Statement is more substantive.  She states that McAfee benefited through “acquisitions made with its inflated stock.” [3] If penalties are appropriate only where there is evidence of specific corporate actions dependent on a company’s manipulated stock price, this could be a meaningful check on the Commission’s discretion.   However, the Commission’s 17 enforcement actions filed after the McAfee case have not mentioned such actions, and there is no reason to believe they will be required in future penalty cases.

            B.        Penalties Always Harm Shareholders

            The second major factor,  the degree to which the penalty will recompense or further harm the injured shareholders, is equally problematic. The Statement notes that “the imposition of a penalty on the corporation itself carries with it the risk that shareholders who are innocent of the violation will nonetheless bear the burden of the penalty.”  This statement is curious for two reasons.  First, shareholders who are members of the public would be expected to be innocent of any corporate wrongdoing.   Second, it is a certainty, rather than a mere “risk,” that current shareholders will indirectly fund any corporate penalty. The harm to shareholders resulting from penalties is unavoidable, merely varying by degree.  Thomsen’s speech implicitly recognized this point when she stated that the penalty imposed on McAfee would not result in an “undue” hardship to its shareholders. 

            The Statement further indicates that “[t]he presence of an opportunity to use the penalty as a meaningful source of compensation to injured shareholders is a factor in support of its imposition.”  This is an obvious reference to the Commission’s ability under Section 308 of the Sarbanes-Oxley Act to return penalty amounts to shareholders through a Fair Fund mechanism.  The “opportunity” to return penalties to investors is a near-certainty, since the Act does not restrict the circumstances under which the Commission can seek to include penalties in a Fair Fund.            Further, returning penalties to injured shareholders through a fair fund is illogical if, as would be expected, the current shareholders are the ones who were injured.  As stated by  former Commission Glassman, “Fair Funds . . . lead to the anomalous result that we have shareholders paying corporate penalties that end up being returned to them through a Fair Fund - minus distribution expenses.”[4]  It thus appears that, like the first major factor, the second major factor in the Statement is illusory as applied by the Commission, since the harm to shareholders is inevitable, and Fair Funds do not truly recompense them.

            Seemingly confounded by the ambiguity of the two major factors in the Statement, and its virtually limitless interpretation of them, the Commission has placed great weight on the financial resources of the company being punished.   This factor was not mentioned in the Statement, but Thomsen referred to McAfee in her speech as a “financially strong” company. To the extent financial strength is viewed as relating to shareholder harm, the Policy Statement could operate to the disadvantage of  large companies, which would be more likely to be financially strong than small companies.  As seemed to be the case before the Statement, the Commission may be reduced to imposing penalties largely on the basis of a simplistic “size matters” approach.

            C.        The Continuing Relevance of Seaboard

            The theoretical difficulties posed by the two major factors, and their broad interpretation by the Commission, have led the Commission to  place great weight on the cooperation and remediation factors first articulated in the Seaboard Report, [5] which are described by the Statement as “minor” in nature.  In marked contrast to the lack of explicit discussion of the two “major factors” set forth in the Statement, public statements relating to six of the 17 post-McAfee enforcement actions contain references to cooperation, remediation, or obstruction.   The ability of defense counsel to influence the nature of his corporate client’s response to wrongful behavior provides the best opportunity to influence the Commission’s decisionmaking regarding penalties.

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[1] “AIG to Pay $800 Million to Settle Securities Fraud Charges by SEC,” Feb. 9, 2006, available at http://www.sec.gov/news/press/2006-19.htm

[2]  “Remarks of Commissioner Paul S. Atkins Before the SEC Speaks Conference,” SEC Speaks Conference (March 6, 2006), available at http://www.sec.gov/news/speech/spch030306psa.htm

[3] “Statement regarding McAfee, Inc. and Applix, Inc.,” Linda C. Thomsen, Jan. 10, 2006, available at http://www.sec.gov/news/speech/spch010406lct.htm

[4] “SEC in Transition: What We've Done and What's Ahead,” Cynthia Glassman, June 15, 2005, available at http://www.sec.gov/news/speech/spch061505cag.htm

[5] Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934 and Commission Statement on the Relationship of Cooperation to Agency Enforcement Decisions, Rel. No. 44969 (Oct. 23, 2001), available at http://www.sec.gov/litigation/investreport/34-44969.htm