Editors Note: Amalie L. Tuffin is a member of the Research Triangle Park law firm of Daniels Daniels & Verdonik, P.A.
_________________________________________________________________________________________The Securities and Exchange Commission (SEC) has the power to impose significant monetary penalties for violations of federal securities laws.
The SEC can impose these penalties not only upon individuals, but also on corporations that violate these laws. The SEC’s imposition of civil penalties against corporations has increased dramatically since the enactment of the Sarbanes-Oxley Act of 2002 (SOX), prompted by the corporate scandals involving Enron, Worldcom and others. Prior to 2002, the largest fine the SEC had ever imposed on a corporation was $10 million. That has changed markedly – for example, the SEC imposed a gargantuan fine of $750 million on Worldcom, and a similarly massive one of $715 million on Adelphia Communications.
Lesser, but still mammoth fines include one of $300 million imposed on AOL Time Warner and another of $150 million imposed on Bristol-Myers Squibb. In 2005 alone, the SEC imposed penalties of $10 million or more on 15 companies. The SEC has already started 2006 out by imposing a $50 million penalty on one company.
Exercise of This Power Has Not Been Without Controversy
The SEC power to impose corporate level penalties has generated controversy. After all, the SEC’s primary mission is to protect investors (i.e., corporate shareholders), but who really takes the loss when a corporation pays a significant civil penalty? It’s shareholders, of course. Further, in many cases it is the corporation’s shareholders who, in the end, were the ones hurt the most by the conduct the penalties are punishing; just look what happened to holders of Enron and Worldcom stock when those schemes came to light.
At the same time, the power to impose corporate level penalties is an important tool for deterring corporate securities law violations. This dichotomy has led to tension within the five member panel of commissioners both about when to impose corporate-level penalties and how large those penalties should be. A number of these decisions have been made on a 3 to 2 basis, showing a deep divide among the commissioners.
New Guidelines Govern Imposition of Corporate Level Penalties
Hoping to defray this controversy, on Jan. 4 the SEC announced new guidelines it will use when determining whether to impose corporate level penalties for violations of federal securities laws. The five commissioners unanimously adopted the guidelines, which attempt to take into account the tension between the harm penalties might create for shareholders and the deterrent effect of the penalties on those who might be tempted to violate securities laws.
The announcement adopting the guidelines also expressly noted the fact that, under SOX, the SEC has the power to disburse civil penalties to corporate shareholders (i.e., those who were shareholders when the fraud took place and who were harmed by it) and other victims of corporate fraud rather than the government retaining the penalties.
The new guidelines expressly take into account specified factors for determining when a corporate level penalty is appropriate. One of the two principal factors in making the penalty determination is whether the securities law violation resulted in an improper benefit to shareholders, which could occur when, for example, inflated revenue numbers increase stock prices and shareholders sell at the inflated price. If so, the SEC believes that imposing corporate level penalties is appropriate. On the other hand, if the securities law violation primarily harmed the shareholders, then the imposition of corporate level penalties is less appropriate, and the SEC has indicated that it will focus on targeting individuals in such cases.
The other principal factor to which the SEC will look is whether the corporation itself directly benefited from the wrongful conduct, such as through decreased expenses or increased revenue. The more the corporation itself benefited from the violation, the more likely it is that a civil penalty will be imposed, especially if the shareholders also benefited from the wrongful conduct.
In addition to these two principal factors, the SEC also noted a number of other factors that will be taken into account in determining whether imposing a corporate level penalty is appropriate. How much of a deterrent effect will the penalty have in the particular case, i.e., is the conduct being punished common and easily replicable by others, or is it unique to the corporation in question? How badly were innocent parties injured? How widespread was the violation? Did many individuals in the corporation participate, or did just a few know that something was improper? Was the conduct the result intentional fraud or were securities laws violated unintentionally? Did the corporation take prompt and appropriate steps to remedy the securities law violations once they came to light? Did the corporation cooperate with the SEC and other law enforcement officials investigating the violations?
SEC Decisions Suggest How The Guidelines Will be Applied
When it announced the new guidelines, the SEC also issued its decisions in two enforcement cases as examples of the application of the new guidelines. Both decisions were made on a unanimous basis.
The first decision involved McAfee Inc. (formerly known as Network Associates Inc.). The SEC alleged that from 1998 through 2000 McAfee improperly inflated its revenue by $622 million by channel stuffing and similar techniques. McAfee then allegedly used its stock, which was overvalued because of these overstatements, to acquire other companies, and McAfee officers actively worked to conceal the fraud from the SEC and others, with two of its former officers awaiting trial on criminal securities fraud charges. The SEC imposed a fine of $50 million on McAfee, noting that the company benefited from the conduct and had sufficient financial strength to bear the penalty without unduly hurting its shareholders.
The second decision involved Applix Inc., a much smaller company than McAfee, which was charged with improper revenue recognition. In that case, the SEC chose not to impose a corporate level fine, noting that Applix and its shareholders did not materially benefit from the fraud, which was much more limited than that at McAfee, that Applix’s board of directors acted swiftly to address the violations when they came to its attention and that, given the size and financial condition of the company, a fine would have a marked negative effect on its shareholders.
It will take some time and experience with the guidelines to see if they either brought some level of predictability to determining when a corporation is at risk for paying civil penalties in a securities fraud case, or have truly helped mend the rift within the SEC over when and how to impose such penalties.
Daniels Daniels & Verdonik, P.A. has been serving the legal needs of entrepreneurial and high technology clients for more than 20 years. Amalie L. Tuffin concentrates her practice in the representation of entrepreneurial and technology-based businesses, focusing on corporate, taxation and securities matters. Questions or comments can be sent to firstname.lastname@example.org