Speech by SEC Staff:
24th Annual Ray Garrett Jr. Corporate & Securities Law Institute
Stephen M. Cutler
Director, Division of Enforcement
U.S. Securities and Exchange Commission
April 29, 2004
As of late, it has become typical when the Commission announces the settlement of an enforcement action for observers - supporters and critics alike - to focus immediately, and sometimes exclusively, on the monetary penalty imposed. Where does it rank in the pantheon of SEC penalties? Is it too high? Is it too low? How was it determined?
These questions and concerns are most likely to be raised when the defendant or respondent is an entity -- whether a public company issuer, brokerage firm or investment advisor firm - for it is there that the penalties have been largest and the change in approach over the last several years the most dramatic. Consider a sampling of the settlements the Commission obtained last year. In July 2003, a federal court approved the largest civil penalty imposed in Commission history - a $2.25 billion penalty against WorldCom, to be satisfied, post-bankruptcy, by the company's payment of $500 million in cash, and common stock in the reorganized company valued at $250 million. Last December, the Commission imposed a $50 million penalty against Vivendi in settlement of financial fraud charges. Between March and December of 2003, the Commission brought four groundbreaking cases against financial services firms for aiding and abetting or causing Enron's accounting fraud. These four firms - Merrill Lynch, J.P. Morgan Chase, Citigroup, and CIBC - agreed to pay a total of $197.5 million in civil penalties, ranging from $37.5 million to $65 million each, in addition to making substantial disgorgement payments. Also during this period, the Commission reached a settlement in the global research analyst matter. That agreement included, among others, penalties of $150 million against Citigroup and $75 million against Credit Suisse First Boston. In the past, penalties this size were once-a-decade occurrences, if that. Now, they are commonplace. Indeed, all but three of the 12 penalties of $50 million or more obtained in Commission settlements since 1986 were obtained in the last twelve months.
Consider also the Commission's $10 million penalty against Xerox, which resulted from a long-running financial fraud that involved several company officers. In 2002, when the case was filed, it represented the largest civil penalty the Commission had ever imposed against an issuer in a financial fraud action. Today, many people view that penalty as antiquated. Indeed, only last month, the Commission obtained the same $10 million penalty against Banc of America Securities in an action that sprang entirely from the firm's uncooperative conduct during the staff's investigation.
A similar trend is evident in the relief the Commission seeks from individuals. Multi-million dollar penalties against individuals are becoming more frequent, as is our use of other remedies. The number of officer and director bars sought has more than quadrupled from fiscal year 2000 to fiscal year 2003. The Commission also has been more aggressive in seeking disgorgement of individual officers' compensation in financial fraud cases.
We're clearly in the midst of an evolution, if not a revolution, in thinking. In only a decade, we've gone from a regime in which monetary penalties were imposed only rarely to one in which large penalties seem to be part of virtually all significant settlements. Why? And, what are we trying to accomplish with these larger and larger penalties? On what does the staff base its recommendations concerning the size of the penalties to be imposed?
I'd like to use my time here today to explore some of these questions concerning civil penalties. As I do so, please keep in mind that the views I express are my own and do not necessarily represent the views of the Commission or its staff.
Brief History of Commission Penalty Authority
I'll need to start with some history, because I think the Commission's evolving approach to penalties is as much as anything a reflection of the changed statutory landscape. Perhaps it will come as a surprise to those who have only recently focused on what we do, but prior to 1984, the entirety of the Commission's civil penalty authority was found in one very narrow provision of the Exchange Act, which permitted the Commission to assess a penalty of $100 per day against issuers for failure to file certain statutorily required reports.1 Accordingly, until very recently, the Commission necessarily relied almost exclusively on forward-looking relief, such as federal court injunctions, orders of disgorgement, and remedial undertakings such as procedural reforms and independent monitors, to enforce compliance with the securities laws.
Congress began its drive to more retrospective relief by focusing on a particular type of violation that it believed existing sanctions did not adequately deter - insider trading. The Insider Trading Sanctions Act of 1984 (ITSA) authorized the Commission to seek in federal court civil money penalties of up to three times the profit gained or loss avoided by a person who commits illegal insider trading. While this was a narrow expansion of the Commission's penalty authority, the justifications Congress cited presaged the broader expansion that would follow. In particular, the ITSA legislative history reflected Congress's belief that civil penalties would increase deterrence of insider trading not only by making it financially painful for those who were caught2, but by drawing attention to the Commission's insider trading actions, and thereby communicating more widely the risks associated with such misconduct.3 If obtaining an injunction and disgorgement order were comparable to placing a classified ad stating that insider trading doesn't pay, imposing a significant penalty was like putting up a billboard. Congress believed that penalties would amplify the Commission's message and create greater deterrence.
Four short years and several major Wall Street scandals later, Congress again considered the adequacy of the Commission's remedies to combat insider trading.4 In the wake of highly publicized insider trading prosecutions involving employees of some of Wall Street's most prominent firms, Congress sought to enlist the firms themselves in the fight against insider trading. It did so by expanding the Commission's authority to obtain insider trading penalties to include penalties against "securities firms and other 'controlling persons' who knowingly or recklessly fail to take the appropriate measures to prevent insider trading violations by their employees." The intent of this provision was "to increase the economic incentives for [firms] to supervise vigorously their employees." Thus, Congress not only sought to employ civil penalties to deter individual misconduct, but also as a tool for motivating the firms - in this case, financial services firms -- to actively police their employees.
The most significant expansion of the Commission's penalty authority occurred in 1990, with the enactment of the Securities Enforcement Remedies and Penny Stock Reform Act (the Remedies Act). With the Remedies Act, Congress addressed misconduct outside the insider trading arena and for the first time, granted the SEC the power to seek penalties for any violation of any of the major securities statutes. Citing "the disturbing levels of financial fraud, stock manipulation and other illegal activity in the U.S. markets5," Congress intended that the new civil penalties would "deter unlawful conduct by increasing the financial consequences of securities law violations.6"
Despite Congress's endorsement of the deterrent effect of monetary penalties, it did not award this broad new authority without limitation. In the context of the new authority to impose penalties against regulated entities and persons in administrative proceedings, the Remedies Act required that the Commission find, based on factors such as the violator's degree of scienter, the harm to other persons, and the need for deterrence, that the imposition of a penalty was in the public interest. The Senate Committee also commented on use of penalties against two specific categories of entities -- public companies and mutual funds (investment companies).
"The civil money penalty provisions should be applicable to corporate issuers, and the legislation permits penalties against issuers," the Senate Committee stated.7 It cautioned, however, that because the costs of such penalties may be passed on to shareholders, this authority should be used "when the violation result[ed] in an improper benefit to shareholders.8" In situations where shareholders were "the principal victims of the violation," the Committee indicated that penalties against individuals are more appropriate. In making these determinations, the Committee explained that it is proper to "take into account" whether the penalties "will ultimately be paid by shareholders who were themselves victimized by the violations," and "the extent that the passage of time has resulted in shareholder turnover.9" Similarly, the Committee cautioned that the SEC should "not ordinarily seek penalties against registered investment companies," which could generally be expected to pass the costs on to shareholders.10
Congress set forth, unequivocally, its intention that the Commission use its broad penalty authority to deter securities law violations, but, appropriately, left to the Commission how best to achieve this goal. Not surprisingly, over time, the Commission has approached this challenge in different ways. For example, for many years, it was standard practice to require in insider trading cases that settling parties agree to disgorge all trading profits or losses avoided (plus interest) and pay an additional penalty equal to the amount disgorged (excluding interest). The certainty associated with this settlement package, which is known to the securities bar as "one plus one," was thought to enhance deterrence and streamline settlement negotiations. In recent years, however, the Commission has, on more than one occasion, departed from this model, and obtained insider trading settlements that included penalties equal to as much as two times the amount disgorged11 or as little as one half the amount disgorged.12 While opening the door to more wide ranging settlement negotiations, this approach may also enhance deterrence by raising the potential costs of insider trading. Also to enhance deterrence and accountability, the Commission recently has adopted a policy requiring settling parties to forgo any rights they may have to indemnification, reimbursement by insurers, or favorable tax treatment of penalties. I mention these situations simply to illustrate that perspectives on penalties may evolve and change, as the Commission grapples with how best to achieve investor protection with its enforcement program and penalty authority that is less than 15 years old.
In the current environment, which has been defined by some of the largest corporate frauds and Wall Street scandals in history, it is tempting to conclude that no penalty could ever be large enough to punish and deter such misconduct. And, of course, that approach would make our lives as enforcement lawyers quite simple - a rule of thumb that says always seek the largest possible penalty we can get is easy to apply. But, the fact is, even when faced with what, in the aggregate, may constitute the worst corporate misconduct in recent memory, we recognize that every wrongdoer, every scandal, is not equally bad. (Even during the hottest summer on record, some days are worse than others.) The trick is to reflect those distinctions fairly and consistently in the sanctions we seek. So how are we doing this in the enforcement program?
The Staff's Current Approach to Penalties
I think we start from the presumption that any serious violation of the federal securities laws should be penalized with a monetary sanction. Indeed, Congress's willingness to extend the Commission's penalty authority to reach all categories of violations suggests lawmakers agreed that no violation should be inherently exempt from a penalty. We recognize, however, that in particular cases, there may be factors present which justify departing from this penalty presumption. Unfortunately, the number and variety of factors that may be relevant in the broad range of cases we pursue precludes our developing - or my spelling out for you - a precise, formulaic approach to arrive at a penalty amount. Indeed, if you tried to do so, you would no doubt quickly conclude that the combinations of facts and factors are nearly infinite. Nevertheless, as the staff examines the equities in each case, there are certain core factors, which are always relevant to our analysis. Supplementing these core considerations are a number of other factors which, if relevant in a particular case, may also influence our penalty recommendation. I'll discuss first the core factors - those factors which are consistently part of our analysis.
Perhaps the most basic factor we consider is the type of violation committed. Specifically, whether it involved fraud, and if so, the degree of scienter, if any, that was present. In short, there is fraud, and then there is fraud. Conversely, while the absence of fraud is a factor that may mitigate the need for a penalty, I would caution against thinking of fraud as the bright line separating penalty cases from non-penalty cases. The Commission has frequently imposed penalties for violations of the non-fraud provisions of the securities laws. In other words, although it is always relevant, this factor may be swamped by the presence or absence of the other core factors.
The second core factor is the degree of harm resulting from the violations. Significant harm will very often lead to a significant penalty. In the case of public company violators, we are likely to look to the losses to investors from the misconduct as reflected in the company's change in market capitalization.
In cases involving regulated entities, the enforcement staff is likely to assess harm from a slightly different perspective. Because of the unique, gatekeeper role these entities play in the operation of our markets, instead of simply weighing investor losses, we may also assess the harm that their misconduct caused to public confidence and trust in the markets. Examples of violators that scored high in this regard include the Wall Street firms that were part of the global research analyst settlement and the investment advisory firms that recently have reached agreements with the Commission or its staff to settle actions involving late trading and/or market timing. In this category are Massachusetts Financial Services and Putnam, which have consented to orders to pay penalties of $50 million each, and Bank of America and FleetBoston, which have agreed in principle to pay penalties of $125 million and $70 million, respectively.
The third core factor, which will often prove decisive in our analysis, is the extent of a violator's cooperation, as measured by the standards set forth in the Commission's 21(a) Report.13 If, for example, an entity -- whether public company, accounting firm, or regulated entity -- or its counsel is recalcitrant during an investigation, misleads the staff, or fails unreasonably to comply with Commission processes, the staff is very likely to seek a penalty in settlement. The penalty is likely to be particularly substantial if the violator's underlying conduct has also resulted in significant investor harm.
As you would expect, the provision of extraordinary cooperation, on the other hand, including self reporting a violation, being forthcoming during the investigation, and implementing appropriate remedial measures (including, in the case of an entity, appropriate disciplinary action against culpable individuals), can contribute significantly to a conclusion by the staff that a penalty recommendation should be more moderate in size or reduced to zero. For example, in two recent actions involving Reliant Resources and Conseco, Inc., the Commission declined to impose civil penalties on either public-company respondent. The Commission's order against Reliant notes that the company voluntarily undertook an internal inquiry to determine whether it had engaged in illegal round trip trades, and that when the internal inquiry revealed that it had, the company promptly reported the facts to the Commission and publicly disclosed those facts in a press release.14 The Commission's order against Conseco stated that in accepting a settlement, which did not include charges of fraud or a penalty, "the Commission considered certain remedial acts promptly undertaken by Conseco, and Conseco's cooperation with the Commission's staff.15"
Supplementing the three core considerations -- the type of violation, the degree of harm, and the extent of cooperation -- are several other factors, which may, if present, incrementally influence the staff's penalty recommendation. For example, if the wrongdoer is a recidivist, that will weigh in favor of a (larger) penalty. If the staff is recommending charges against a sophisticated party who violated a clear legal standard and should have known better than to commit a violation -- an officer, director, lawyer, or regulated person, for instance -- the staff is more likely to seek a (higher) penalty. A person or entity that was enriched by its own wrongdoing, too, may be subject to a stiffer penalty. Larger penalties are necessary in such cases to deter misconduct that otherwise would be perceived as particularly lucrative. We will also consider the duration of the misconduct and the seniority of the employees involved in it when determining an appropriate penalty against an entity.
It is also important that a penalty be of sufficient size for the wrongdoer to feel some sting. While we don't take the approach they use in Finland -- where traffic fines are mathematically proportionate to the offender's income, sometimes resulting in speeding tickets upward of $100,00016 -- we may take into account, in a macro sense, the size of an entity or the net worth of an individual in determining the appropriate amount of a penalty recommendation. Finally, in assessing all of the various factors, the staff also seeks to fairly reflect in the penalty amounts the relative culpability of violators involved in the same or a similar scheme.
It may be worth pausing for a moment to discuss why we believe it is appropriate in any case to seek penalties against entities, which act, whether or not in compliance with the securities laws, through their individual employees and agents. I begin from the proposition that nothing in the securities laws themselves suggests that Congress believed entities should be immune from civil penalties. In fact, there is strong evidence of just the opposite. As I noted earlier, the Remedies Act legislative history indicates explicitly that penalties may be used against corporate issuers. Similarly, the 1988 insider trading legislation provided penalty authority against so-called "control persons," which frequently are securities firms or other entities, rather than natural persons. Thus, it seems clear that penalties against entities should be used for the same reason they are used in part against individuals - to deter misconduct.17
Let me emphasize at this point that the Commission's more frequent use of penalties against entities has not lessened the commitment to imposing significant penalties against individual wrongdoers. These efforts are complementary rather than mutually exclusive. One is not a substitute for the other.
Perhaps as much as penalties against individuals, penalties against entities can help maximize deterrence of securities violations. When the Commission obtains a penalty against an entity, it provides a powerful incentive for companies in the same or similar industries to take steps to prevent and address comparable misconduct within their own walls. Thus, a single enforcement action has the potential to effect change on an enormous scale, causing the development or enhancement of internal controls, supervisory procedures, and compliance functions at hundreds of other companies.
Moreover, entities have the ability to influence strongly the compliance orientation of their own employees. For instance, in a classic good news-bad news situation, a recent survey found that 83% of companies surveyed have developed formal codes of ethics or conduct.18 The bad news is that only 75% of companies that have a code actually check for compliance with it.19 Imposing a significant penalty may be the best way for the Commission to cause companies to change their cultures and to make it in their financial interest to take a proactive role in preventing individual misconduct.
So what about Congress's concern that penalties not be borne by shareholders who have already been victimized? Another change to the legislative landscape has profoundly changed the calculus. Under Section 308 of the Sarbanes-Oxley Act, the Commission can place certain civil penalties, which previously would have been paid to the U.S. Treasury, into a Fair Fund to be used to recompense harmed investors. Thus, when a Fair Fund is created, the victims of the fraud are not further victimized by the imposition of the penalty.
One thing that the introduction of the Fair Fund has not changed, however, is the purpose of civil penalties, which remains distinct from the purpose of disgorgement. Despite the fact that penalties, like disgorgement, can now be used to compensate harmed investors, they are still fundamentally a punitive measure intended to enhance deterrence of securities laws violations. That harmed investors can benefit directly from these efforts is icing on the cake, so to speak.
Civil penalties against entities in the tens of millions of dollars are no longer rare; indeed, they seem to be expected by many. In part, this trend may be the result of the significant corporate accounting scandals and widespread misconduct by regulated entities we have witnessed over the last few years. But it is difficult to know whether the larger penalties reflect a desire to hold accountable those responsible for the extreme misconduct and significant harm that have defined the recent scandals, or whether they are instead an effort to step up deterrence to prevent such large frauds from recurring in the future. Indeed, there may be a concern among some that were the Commission to continue its historic reliance on prophylactic relief supplemented by modest civil penalties, it could not effectively deter future scandals. I believe the ratcheting up of penalties is driven by both goals - increased accountability and enhanced deterrence.
This apparent trend raises the question whether there is any limit. Could we reach a point at which the SEC extracts large penalties so routinely that they barely garner notice? Fortunately, I'm not paid to predict the future. One can imagine, however, that if penalties were to become uniformly high, they could, ironically, become less powerful as a deterrent. If monetary penalties ceased to distinguish the bad from the worse, no longer carried with them the specter of reputational damage, lost their ability to impose a "publicity penalty"20 - then the Commission would be deprived of an important investor protection tool.
I do not believe we currently are in danger of falling into that trap. There is value in exercising judiciously our authority to impose or seek penalties, a value that is magnified by the current public thirst for ever-larger penalties. The Commission takes care not to extract larger penalties just because potential defendants or respondents might be willing to pay them in an effort to mitigate market reaction or competitive pressures. Working within the broad framework I've outlined today, we go to great pains to arrive at penalties that reflect appropriate consideration of the particular facts of each case, while still advancing the larger programmatic goals of fairness, consistency, accountability, efficiency, and deterrence.
The regular imposition of large civil money penalties in SEC enforcement actions is a relatively recent phenomenon. In making penalty recommendations to the Commission, in every case we weigh the extent of the harm, the degree of cooperation, and the presence or absence of fraud and scienter. In cases with facts that make additional factors relevant -- such as the role or violation history of the wrongdoer, the duration of the fraud, the relative culpability of other parties, and whether and how much the wrongdoer was enriched -- we will assess those as well. In so doing, we will continue to strive to achieve the benefits Congress envisioned when it authorized the Commission to seek and impose penalties.