Speech by SEC Staff:
24th Annual Ray Garrett Jr. Corporate & Securities Law Institute
by
Stephen M. Cutler
Director, Division of Enforcement
U.S. Securities and Exchange Commission
Chicago, Illinois
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.
Conclusion
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.
Endnotes
http://www.sec.gov/news/speech/spch042904smc.htm
