SEC Issues Policy Statement on Corporate Penalties

With the dust still settling from the Enron, Worldcom, Tyco and other corporate scandals, the Securities and Exchange Commission (SEC) recently issued a new policy statement purportedly clarifying the criteria used in determining whether to impose civil penalties against a corporation in enforcement actions. The statement was viewed as a significant pronouncement by the SEC, and accordingly has been the topic of much discussion in securities circles, including a recent White Collar Roundtable hosted by Kamlet Shepherd, attended by, among others, the Acting Regional Director of the SEC, the U.S. Attorney for Colorado, the Colorado Attorney General, and the Colorado Securities Commissioner.

Brief History of Corporate Penalties

The imposition of significant corporate financial penalties, especially very large punitive penalties, is a fairly recent development in the SEC’s history. Federal laws enacted in 1990 gave the SEC general authority to seek monetary penalties in civil enforcement actions. Since the passage of Sarbanes-Oxley (SOX) in 2002, under the “Fair Funds” provision, penalties collected by the SEC may now be distributed to defrauded shareholders, rather than sent to the U.S. Treasury. But the SEC had not previously offered much guidance on its criteria for determining the appropriateness of a corporate penalty in a given enforcement action. While the recent policy statement was clearly intended to shed some light on the SEC’s practices, many important questions remain unanswered.

The SEC’s Focus on Further Harm to Injured Shareholders

According to the new statement, the two primary considerations in determining whether or not to impose a corporate penalty are:

• whether the corporation received a direct benefit as a result of the securities law violation, and
• the extent to which the fine will compensate or further harm the injured shareholders.

Under the first consideration, the strongest case for the imposition of a corporate penalty occurs when the corporate shareholders have received an improper benefit as a result of the wrongdoing. On the other hand, if the shareholders are the primary victims of the wrongdoing, this would present a weak case for a corporate penalty.

With the second consideration, the SEC recognized that there may be times when the imposition of a corporate penalty will result in innocent shareholders effectively paying the penalty. Thus, if the penalty could be used as a source to repay injured shareholders, this weighs in favor of a corporate penalty. Conversely, the case for a corporate penalty would be weakened if the penalty would unfairly harm shareholders, the corporation, or third parties. The SEC emphasized that where innocent shareholders are the primary victims, this weighs in favor of seeking monetary penalties from culpable individual offenders, in lieu of a corporate penalty.

The SEC indicated that it will consider seven additional factors in deciding whether to issue a corporate penalty:

• 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,
• the presence or lack of remedial steps by the corporation, and
• the extent of cooperation with the SEC and other law enforcement.

Unanswered Questions

While the SEC’s new policy statement is helpful in some respects, many questions remain unanswered. Missing, for example, is any guidance on determining the dollar amount of the penalty. As of April 2002, the largest pre-SOX penalty imposed by the SEC was $10 million against Xerox. In recent years, penalties have skyrocketed − up to a record $750 million levied against WorldCom. In these unprecedented times, further guidance and predictability is required.

Similar questions remain as to how much credit will be given for cooperation. In the first significant action under the new policy, the SEC apparently viewed its $100 million penalty against AIG as mitigated, in consideration of AIG’s substantial cooperation. Just 2 years earlier, by contrast, the SEC then regarded a $25 million penalty against Lucent as highly punitive, given Lucent’s clear lack of cooperation.

Also noticeably absent from the recent statement is to what extent a company’s cooperation, as measured by its waiver of attorney-client & work-product privileges, will be taken into account in the SEC’s penalty assessment. Presumably the SEC’s prior emphasis on this factor in the context of whether to bring an enforcement action, as articulated in the SEC’s October 2001 Seaboard Report, carries over into the SEC’s recent statement on penalty assessment.

The new corporate-penalties statement by the SEC helps shed some light on the SEC’s policy and criteria in assessing whether and in what circumstances a penalty should be imposed against a corporation. However, for those companies facing the possibility of an SEC enforcement action, many practical uncertainties remain. It remains to be seen whether and to what extent future enforcement actions will provide further guidance or predictability in this unsettled area, and we of course will continue to monitor all new developments.

This legal update is for informational purposes only as a service to clients and other friends, is not a complete summary of the rules relating to the subject matter discussed above, and is neither to be construed as legal advice nor intended as basis for decisions in specific situations. For more information about this subject matter or other recent developments, please contact the attorneys in our Securities & Corporate Finance practice group or any other attorney in our firm with whom you normally consult by calling (303) 825-4200.