Speech by SEC Commissioner:
Remarks before the ABA National Institute on Securities Fraud
Commissioner Annette L. Nazareth
U.S. Securities and Exchange Commission
September 28, 2006
Thank you so much for inviting me to speak today at the ABA's inaugural National Institute on Securities Fraud. Since becoming a Commissioner last year, I have had the opportunity to immerse myself in a number of areas that are central to the SEC's mission of investor protection, one of which is the enforcement of our federal securities laws. Indeed, it is fair to say that I have reviewed more enforcement actions in the past year than I ever expected to focus on in my lifetime. And unfortunately, I have concluded that securities fraud will be with us for many years to come, so hopefully this will be only the first of many thoughtful conferences on this topic. Before I begin, however, I must remind you that my remarks represent my own views, and not necessarily those of the Commission, my fellow Commissioners, or the staff.1
Today I would like to discuss monetary penalties against corporations and issuers in SEC enforcement actions. In particular, I will highlight the provisions of the Commission's penalties statement, and then discuss how we arrived at these provisions and how the statement has actually been applied in practice over the past nine months.
As you know, in recent years, we have seen an increasing number of complex financial fraud cases. Settlements with the SEC in some of these cases have involved large monetary penalties, both against individuals and against corporations. In the vast majority of enforcement cases that we consider, the Commissioners unanimously agree on the course of action to take and the penalties to impose. The Commissioners have traditionally all agreed that monetary penalties are appropriate against the responsible individuals. That having been said, in the past, certain cases involving penalties against public corporations resulted in certain Commission votes in which the Commissioners were split about whether to seek a monetary penalty. Thus, last year Chairman Cox initiated a series of discussions among the Commissioners to build a consensus about the circumstances under which seeking monetary penalties against corporate issuers may be appropriate. The goal was to add clarity, consistency, and predictability to this process.
On January 4, 2006, a unanimous Commission statement about financial penalties against corporations was announced.2 This statement of principles was the product of over 40 hours of meetings among the Commissioners as well as the SEC's General Counsel and the Director of the Division of Enforcement. The Commission articulated a series of factors that would guide our decisions about whether it is appropriate to seek a monetary penalty against a corporate wrongdoer in each individual case.
Let me emphasize that, from the outset, we were, and are, united in our desire to protect investors and in our belief that civil monetary penalties are an important tool for deterrence of wrongdoing. We started our discussions by identifying the principles on which we agreed. To do this, we closely examined the sources of our authority to impose monetary penalties-particularly, the law and its legislative history.
We recognized that monetary penalties are a relatively new tool in the SEC's enforcement arsenal. In 1990, Congress passed the Remedies Act, which for the first time allowed the SEC to seek civil monetary penalties against both individuals and entities for a wide range of federal securities law violations.3 The Remedies Act also added or strengthened other enforcement remedies, including cease-and-desist orders and officer and director bars. The law's purpose was to provide the SEC with stronger and more varied tools to protect investors and maintain the integrity of the securities markets.
The SEC had urged the adoption of the Remedies Act. Former Chairman David Ruder submitted a legislative proposal to Congress in January 1989.4 The SEC's memorandum in support of the legislation specifically proposed civil penalty provisions that would permit, but not mandate, penalties against issuers. The Commission noted that in deciding whether to assess penalties, it could "properly take into account its concern that civil penalties assessed against corporate issuers will ultimately be paid by shareholders who were themselves victimized by the violations."5 The Commission specifically noted that penalties against issuers "should be imposed or sought only where the violation resulted in an improper benefit to shareholders," and it noted that it "would consider this factor and also the extent to which the passage of time has resulted in shareholder turnover."6 Thus, examining the contemporaneous documents demonstrated to us that even in 1989 when it proposed broad monetary penalty authority, the Commission was concerned that in exercising that authority it not penalize the victims of a fraud.
The SEC also provided testimony before Congress on this bill. Chairman Richard Breeden testified before the Subcommittee on Securities of the Senate Committee on Banking, Housing and Urban Affairs on February 1, 1990. He cited two primary reasons to authorize civil monetary penalty authority: increased deterrence and increased flexibility to tailor a remedy to the violation.7 When Chairman Breeden was asked under what circumstances it was appropriate to fine a company as opposed to the individuals, he responded that traditionally the Commission proceeds against both the company and the individual. Specifically, he observed that "where an entire organization has engaged in a pattern of conduct that must have required the participation of a large number of individuals," it is not always practical to proceed against every individual.8
Following the Remedies Act, the Commission has used monetary penalties as one of its tools to deter future violations and help maintain investor confidence. Large civil monetary penalties against corporations were used only rarely throughout the 1990s. However, there has been a fundamental shift in recent years due to the types and magnitudes of frauds that have been uncovered. During this time period, the financial scandals have led to a corresponding increase in the number of cases in which the SEC has sought large financial penalties against corporations for their wrongdoing. These penalties reflected a rash of large-scale corporate wrongdoing that received nationwide focus and contributed to the passage of the Sarbanes-Oxley Act in 2002.
For purposes of the Commission's recent discussions on penalties, the Remedies Act continues to provide the appropriate framework for addressing these frauds. However, Section 308 of the Sarbanes-Oxley Act, the "Fair Funds" provision, has given the SEC an important additional tool with which to tailor our remedies. Prior to Fair Funds, any penalty money that the SEC collected went to the U.S. Treasury. Fair Funds allows the SEC for the first time to add monetary penalty amounts to any disgorgement that will be distributed to harmed investors. The availability of a Fair Fund distribution was a critical consideration in our recent discussions about the appropriateness of monetary penalties against corporations. In my view, the Fair Funds provision has the potential to substantially mitigate the concerns raised in the legislative history of the Remedies Act, and shared to this day by the Commissioners, about avoiding duplicative harm to victims of fraud. We now have the means to return monies to investors in corporate fraud cases.
All of this legislative history provided an important platform for the Commissioners to help us focus on the areas on which we could agree. Not surprisingly, we all agree that monetary penalties serve an important deterrence function and that they allow us to tailor a remedy more closely to the facts of each case. Thus, we made a strong statement that penalties are an essential part of an aggressive and comprehensive enforcement program.9 Our challenge was to provide added guidance and transparency about the factors that we consider in determining whether it is appropriate to impose a monetary penalty on a corporation and the size of any such penalty. After extensive discussions, we arrived at two principal considerations and seven additional considerations.
One principal factor is the presence or absence of a direct benefit to the corporation. The fact that a corporation itself has received a direct or material benefit from its wrongdoing weighs in support of the imposition of a penalty. A benefit can come in a variety of forms, including increased revenues or reduced expenses. The benefit need not be solely monetary or be capable of precise measurement. One example might be a company's use of its inflated stock price to make acquisitions. In light of the guidance provided by our statement of principles, in recent cases, our staff has performed a more rigorous economic analysis than in the past. The Office of Economic Analysis has become more involved in analyzing and providing guidance to the Commission on this aspect of our cases. They often help to identify and quantify the benefit received by the corporation.
The second, and equally important, principal factor, is the degree to which the penalty will recompense or further harm the injured shareholders. Imposition of penalties on a corporation may impose additional harm on shareholders. That having been said, in some cases, the penalty may be used to recompense shareholders through a Fair Fund. This ability to recover monies for injured shareholders weighs in favor of a penalty.
Over $8.5 billion in Fair Fund money has been ordered, and approximately $770 million in Fair Funds has been distributed to harmed investors since the Sarbanes Oxley Act gave the Commission Fair Funds authority. In July of this year, distributions began to be made to compensate the victims of unlawful proprietary trading by seven New York Stock Exchange specialist firms. Additionally, distribution has begun in the Global Analysts Settlement. As of August 31 of this year, the Commission held approximately $3.6 billion in funds for distribution to harmed investors. The Courts or other escrow accounts held an additional $4 billion. Most of the amount held by the Commission-approximately $3.3 billion-relates to recent mutual fund scandals. We have published three of those distribution plans for comment, with several additional plans to be published shortly. After working through some issues on the first three published plans, we hope to start those distributions in the near future. Additionally, the claims period for the $750 million Fair Fund in the WorldCom case has now ended, and we expect that distribution will begin this fall. Fair Funds distribution does have associated administrative costs, so even with a Fair Fund, not every dollar of recovery benefits investors. We sometimes are able to structure settlements such that the company pays the administrative costs, leaving more funds available for the investors. At times, when there has been a distribution mechanism already in place through a related private class action, we have piggybacked off that mechanism at no expense to the fund and without contributing to attorney's contingency fees. In other cases, particularly those with smaller numbers of victims, our staff is able to develop a distribution plan and act as plan administrator, thereby avoiding spending Fund resources on the administrative process. As we gain experience with the Fair Funds distribution process, I am hopeful that we will be able to more quickly identify the injured parties and provide distributions to them in a more expeditious and cost-effective manner.
In addition to these two primary considerations, we have seven other enumerated factors that I will not detail today that guide our penalties decisions. Although these are not the primary factors, there may be cases in which they are the determinative factors in analyzing whether a penalty is appropriate. In fact, there may be some cases in which although the overall penalty analysis might point in favor of a penalty, the Commission decides not to seek one. In a case in which imposing a penalty could threaten the company's viability as a going concern, causing extensive injury to innocent parties, that factor might be dispositive. For example, the Commission recently accepted a settlement in its civil action against Biopure Corporation. In that case, Biopure consented to be enjoined from violating the antifraud provisions of the federal securities laws and agreed to retain an independent consultant, but was not assessed a monetary penalty.10
One issue that has arisen is how these principles apply to penalties against entities that the Commission regulates. Often in the regulated entity context, the "benefit" is the evasion of our rules, so this prong is generally clear cut. In such circumstances, a full-blown penalty analysis is not undertaken-the Commission has generally agreed that a penalty is appropriate. However, if the violation were at the holding company level, rather than a violation committed directly by the regulated entity, and the violation more closely resembled a fraud at other public companies, then the full penalty analysis would be appropriate.
When we were crafting the statement of principles, I was particularly mindful of the overall regulatory climate in which we operate. Since 2000, there have been an increasing number of fraud cases brought both criminally and civilly by other enforcement entities, including the U.S. Department of Justice and state attorneys general. I understand that some of the sessions at this conference will address issues that arise in parallel proceedings, which have received much focus lately. As you know, the SEC's actions do not occur in a vacuum but often are one piece of a larger set of government efforts to address wrongdoing. Sometimes our settlements are part of a global resolution, which can involve both federal and state actions, such as our recent settlement with AIG, in which the company's payments in the Commission's civil action of $700 million in disgorgement and $100 million in civil penalties were part of a larger resolution involving total payments in excess of $1.6 billion. If we do not thoughtfully address these penalty issues, others may fill the void. Thus, in our penalty discussions, I was aware of and considered the reality that our actions may impact the independent actions taken by other authorities.
One of the secondary factors that we consider in evaluating corporate penalties is the extent of cooperation by the issuer with the Commission and other law enforcement. Our penalty statement addresses whether a corporation has reported an offense and has remediated the offense. Recently, there has been much attention paid to a cooperation provision in the Department of Justice's "Principles of Federal Prosecution of Business Organizations," also known as the "Thompson Memo."11 The section of the Thompson Memo concerning cooperation discusses, among other things, the corporation's willingness to waive attorney-client and work product protections. Our penalties statement does not include such language. In crafting our penalties statement, the Commission considered the guidance provided to federal prosecutors in the Thompson Memo and we discussed issues such as the waiver of attorney-client privilege. While we too consider the degree of cooperation to be an important factor, we did not include similar language about legal privileges in our penalties guidance. Cooperation can take many forms, and I personally view cooperation solely as a positive-something that should weigh against a penalty. This factor, in my mind, cannot be transformed into a negative element-in other words, if cooperation or a waiver is not provided, it should not enhance a penalty unless the conduct goes beyond a lack of cooperation by actually obstructing the investigation.
In the nine months since we issued our guidance, the Commissioners have applied these factors in a number of cases-some in which a corporate penalty was imposed and others in which it was not. For example, the Commission recently imposed a $12 million penalty on Raytheon Company, charging that the company had masked declining financial results and a deteriorating business through the use of false and misleading disclosures in its periodic reports.12 In another recent case, the Commission imposed a $25 million penalty on Doral Financial Corporation, charging that the company overstated its income by 100% on a pre-tax cumulative basis from 2000 to 2004, facilitating the placement of over $1 billion of debt and equity.13 On the other hand, the Commission did not impose penalties on corporations involved in other financial frauds. For example, the Commission did not impose a penalty against TV Azteca in a recent settlement, and instead enjoined the company and imposed penalties of $8.5 million on two officers for their role in failing to disclose a related party transaction.14 Likewise, in a case against Virbac Corporation, the Commission imposed penalties on officers of the company for their role in an improper revenue recognition scheme, but declined to impose a penalty on the corporation.15 The Commission's decisions applied the penalty factors to the particular facts and circumstances of each case.
The principles we crafted have guided our discussions about the appropriate course of action to take, but of course each case is considered based on its own facts. Ultimately, each Commissioner must make an admittedly subjective determination about how these factors apply to the facts of a specific case. Although each Commissioner brings his or her own experience and perspective to bear on these issues, I expect that these principles will continue to unite us and to guide our decisions.
In conclusion, I hope that the Commission's statement and the cases that we have brought since the statement have helped reaffirm that monetary penalties against issuers remain an important remedy that we continue to use. Investors can rest assured that the SEC continues to protect their interests through vigorous enforcement of the federal securities laws.