Securities Law Advisory January 12, 2006
SEC Releases Guidance on Corporate Penalties On January 4, 2006, the Securities and Exchange Commission (the Commission) issued a Statement of the Securities and Exchange Commission Concerning Financial Penalties (the Statement), in which the Commission propounded principles that will guide its enforcement actions against corporate issuers. Using two recently settled actions as contrasting examples, the Commission emphasized that its criteria for charging and penalty decisions against corporations for violations of the securities fraud laws will turn on articulated factors, particularly assessments of the benefit to the corporation from the misconduct and of the impact of the Commission’s decisions on shareholders. The Statement represents an attempt by the Commission to bring “clarity, consistency, and predictability” to the enforcement process.1
Overview of the Commission’s Imposition of Penalties The Commission’s use of large corporate penalties against corporations is a recent development. The Commission’s authority to levy penalties is rooted in the Securities Enforcement Remedies and Penny Stock Reform Act of 1990.2 Congress, in enacting that legislation, contemplated the use of penalties against both corporate and individual wrongdoers.3 In recent years, the Commission has levied significant penalties against corporations, at times greater than $50 million. Examples of some of the more zealous penalties against corporate issuers include $500 million against WorldCom, Inc., $300 million against Time Warner Inc., $250 million against Qwest Communications International Inc., $120 million against Royal Dutch Petroleum Company, and $25 million against Lucent Technologies Inc. This practice has met with concern and criticism from the business community. The trend subjects corporations to significantly enhanced risks, but fails to provide any complementary guidance on avoiding or minimizing such corporate penalties. Securities experts have also vocalized concerns that this practice appears to be arbitrary and unpredictable and, in lieu of protecting shareholders, actually injures them twofold. In addition, there has been a public difference of opinion among the Commissioners on this issue.
1
Statement of the Securities and Exchange Commission Concerning Financial Penalties, No. 2006-4 (Jan. 4, 2006), available at http://www.sec.gov/news/press/2006-4.htm.
2
Securities Enforcement Remedies and Penny Stock Reform Act of 1990, Pub. L. No. 101-429, 104 Stat. 931 (1990).
3
S. Rep. No. 337, at 17 (1990).
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Thus, the Statement may be Chairman Christopher Cox’s manner of abating the disagreement within the Commission. The stated goal, however, is enhanced transparency. After closed-door deliberative sessions including the Commissioners, members of the Division of Enforcement, and members of the Office of General Counsel, the Commission has issued what it describes as “unanimous agreement” on “objective standards” to which corporations should conform their conduct in order to avoid charges and/or minimize penalties.4
The Guiding Principles In issuing these guiding principles, the Commission placed emphasis on the purposes driving its enforcement authority: the protection of investors and the deterrence of corporate fraud. To that end, the primary considerations for charging or imposing a penalty on a corporation for securities fraud will be: 1) the existence, or lack thereof, of a direct benefit to the corporation resulting from the wrongful conduct; and 2) the extent to which a penalty will benefit or further damage injured investors and shareholders. Because funds collected via penalties thus imposed can now be redistributed to compensate victims under the Fair Funds provision of the Sarbanes-Oxley Act of 2002,5 instead of amassing in the Treasury, the Commission’s apparent goal is to extract unjust benefits accruing to certain shareholders to redistribute the funds to injured shareholders. In addition to these two primary considerations, the Commission also delineated the following secondary, but important, factors: • the uniqueness of the offense and the corresponding need to deter that particular type of offense; • the severity of the injury to innocent parties as reflected by the extent of investor injuries and societal harm; • the pervasiveness of the infringing conduct within the corporation; • the culpability and fraudulent intent of the perpetrators; • the difficulty in detecting the particular type of offense; • the willingness of management to take remedial steps; and • the extent of the corporation’s cooperation with and assistance to the Commission leading up to and during an investigation. Although the Commission cautioned that each case is unique, it expressed the hope that its enforcement announcements going forward will reflect the evident balancing of these factors, instilling greater transparency in the process.
4
Press Conference, SEC News Conference to Announce Enforcement Actions and Commission Statement on Financial Penalties (Jan. 4, 2006) (hereinafter Press Conference), available at http://www.connectlive.com/events/secnews/.
5
15 U.S.C.A. § 7246.
2
Sample Enforcement Actions To illustrate the weighing of these factors, the Commission announced, in conjunction with the Statement, the filing of settled actions against McAfee Inc. (McAfee) and against Applix Inc. (Applix).6 The settlements levy a $50 million penalty against McAfee, but no penalty against Applix. Instead, Applix agreed to a Cease and Desist Order, and the Commission will pursue civil actions against three former officers. Although intended to be illustrative examples, these two actions pragmatically may elucidate little in more complex cases given their stark contrast. The Commission highlighted that the evidence showed that officers of McAfee engaged in fraud on the order of more than $600 million over the course of more than 18 months in an effort to meet revenue projections and earnings targets. The fraud resulted in a misstatement of 131% in net revenues. The misconduct was pervasive and was carried on at the company’s highest levels, including its financial officers and controller. McAfee and its stockholders further benefited from its fraudulent conduct in the form of acquisitions it made using stock at an inflated value. In addition, in the Commission’s view, McAfee today is a thriving company that can sustain the significant penalty, which can in turn be used to compensate injured shareholders. In contrast, the Commission perceived the weighing of the denoted factors differently with regard to Applix. There, the fraud consisted of improper revenue recognition in an effort to meet established revenue goals. The revenue at issue was less than $1.5 million dollars, constituting a misstatement of approximately 30 percent in the company’s reporting of net loss. The Commission distinguished these circumstances as ones in which the facts demonstrated that the company did not directly benefit from the fraud. In addition, the smaller size of the company suggested that a significant penalty would unduly harm the company’s current shareholders. Lastly, the conduct was reportedly limited and not widespread.
The Resulting State of Affairs As an initial matter, the Commission’s guiding principles are addressed to corporate issuers of securities. The Commission is not specifically bound to these principles in its enforcement actions against entities that are not corporate issuers – i.e., individuals, broker-dealers, investment advisers, securities exchanges, and/or accounting firms. The Commission has levied large penalties against such institutions in recent years as well, but does not intend its guidance to extend to such institutions as a matter of policy at this time. As to corporate issuers, the significance of the Commission’s Statement is its willingness to respond to the business community’s concerns by formalizing guiding principles for charges and penalties against corporations for fraudulent conduct. The substance of the guidance is, frankly, less momentous, since it falls mostly within parameters that the Commission has repeatedly highlighted in its public pronouncements.
6
See SEC Sues McAfee, Inc. for Accounting Fraud, Litigation Rel. No. 19520 (Jan. 4, 2006), available at http://www.sec. gov/litigation/litreleases/lr19520.htm; In the Matter of Applix, Inc., Rel. Nos. 33-8651, 34-53049, AAER-2359 (Jan. 4, 2006), available at http://www.sec.gov/litigation/admin/33-8651.pdf.
3
Stemming from its Seaboard Report of Investigation in 2001,7 the Commission has routinely espoused an aspiration to treat cooperation, prompt remedial measures, unintentional transgressions, and fleeting misconduct, among other factors, with comparative lenience. In addition, deterrence and protection of investors have always been the root of the Commission’s regulatory and enforcement measures. Lawyers practicing before the Commission have likewise adopted these factors as important indicators of the Commission’s reaction to a particular scenario. Indeed, the recent emphasis on these indicators likely persuaded the Commission that officializing them would not cause significant upheaval among businesses subject to the Commission’s regulations and lawyers practicing before it. Admittedly, however, the Statement does manifest the Commission’s increasing emphasis on weighing the relative benefit derived from the fraudulent conduct and the impact of the penalty on the corporation and the shareholders. The particular impact of these two factors, when mixed with other longstanding factors, remains to be seen. From an investigative or litigation perspective, we expect that the penalties demanded of companies subject to an investigation by the Commission will likely not change. In particular, the Statement is not likely to inform the practical but difficult question companies encounter early in an investigation before the facts are known, such as whether to cooperate. Thus, if approached by the Commission, companies should continue to exhibit careful and complete cooperation with the investigation. In addition, any fraudulent conduct should be swiftly brought under control and ceased, with suspensions imposed or resignations requested as necessary. Equally important is the immediate establishment, well in advance of any investigation or litigation, of internal control and compliance measures designed to thwart any fraudulent conduct and to discover it should it occur. The lack of specificity in the Commission’s guidance, and the polarity of the facts in the illustrative actions, instill skepticism that the Statement will change enforcement practices to any significant degree in the near future. Nonetheless, gradually, we expect the Commission’s explicit clarification will prove to be a meaningful tool in some regards. In particular, it speaks to the important role precedent should play in any regulatory system. Hence, we expect that the settlement negotiation process with the Commission will become one that will rely to a greater extent on the comparative egregiousness of a given entity’s violation, as compared to those of other corporate entities. This, in turn, will create tiers that investigated entities will be well advised to assess up front, at the initiation of an investigation. Although the Commission’s Statement may not alter the calculation companies will face, it may well underscore the importance of the assessment occurring immediately at the outset of the investigation.
7
See 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. 34-44969 (Oct. 23, 2001), available at http://www.sec. gov/litigation/investreport/34-44969.htm.
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