New SEC framework for imposition of financial penalties on corporations

By: Cydney Posner

Over the past several years, there has been significant conflict among the SEC commissioners with respect to the imposition on companies, as opposed to individual malefactors, of significant monetary penalties. Commissioners Glassman and Atkins have argued strenuously that the imposition of monetary penalties has the ultimate effect of compounding the harm to the corporation's shareholders, many of whom were already harmed by the illegal conduct. The other Commissioners have argued instead that the SEC's mission to protect investors requires that wrongdoers be punished and further misconduct be deterred by the imposition of financial penalties on corporations. The SEC has just announced that the commissioners have unanimously agreed to a framework of guiding principles to be applied in determining the propriety of the imposition of financial penalties against corporations. In announcing the resolution of the conflict, Chairman Cox acknowledged "particular satisfaction... that, through careful deliberation, our various views were forged into a single general framework," signaling perhaps his desire and ability to build consensus among the sometimes hostile contingents on the Commission.  The statement of SEC Enforcement chief, Linda Chatman Thomsen, is at http://www.sec.gov/news/speech/spch010406lct.htm.

As announced, the SEC's framework turns principally on two considerations:

The presence or absence of a direct benefit to the corporation as a result of the violation. Where the corporation itself has received a direct and material benefit from the offense, particularly where the shareholders have received an improper benefit as a result of the violation, a corporate penalty is most likely to be imposed. In contrast, a corporate penalty is least likely to be imposed where the current shareholders of the corporation are the principal victims of the securities law violation.

The degree to which the penalty will recompense or further harm the injured shareholders. The presence of an opportunity to use the penalty as a meaningful source of compensation to injured shareholders, such as through the fair funds provision of SOX 308, is a factor in support of its imposition. The likelihood a corporate penalty will unfairly injure investors, the corporation or third parties militates against its use as a sanction.

In addition to these two principal considerations, the framework takes into account several additional factors:

The need to deter the particular type of offense, that is, whether the corporate penalty will serve as a strong deterrent to others similarly situated or whether unique circumstances make the offense unlikely to be repeated in other contexts.

The extent of the injury to innocent parties, including the egregiousness of the harm done, the number of investors injured and the extent of societal harm if the injury to innocent parties goes unpunished.

Whether complicity in the violation is widespread throughout the corporation, that is, the extent to which the conduct was pervasive or isolated, including whether the corporation has replaced those persons responsible for the violation.

The level of intent on the part of the perpetrators, taking into account the level of culpability and fraudulent intent of the perpetrators.

The degree of difficulty in detecting the particular type of offense, with offenses that are particularly difficult to detect calling for an especially high level of deterrence, which would militate in favor of the imposition of a corporate penalty.

Presence or lack of remedial steps by the corporation, with an aim to prevent future harm and to encourage the management of corporations accused of securities law violations "to do everything within their power to take remedial steps, from the first moment that the violation is brought to their attention."

Extent of cooperation with SEC and other law enforcement, including the degree to which a corporation has self-reported an offense or otherwise cooperated with the investigation and remediation of the offense.

In connection with the announcement of the framework, and in illustration of its application, the SEC also announced the settlement of charges against two companies, McAfee, Inc. (first and second McAfee reference)and Applix, Inc. The McAfee settlement includes a $50 million corporate penalty. The SEC charged that McAfee had engaged in extensive channel-stuffing and other fraudulent conduct that was egregious and pervasive, leading to an aggregate overstatement of revenues of $622 million. (The overstatement in 1998 alone was 131%.) The fraud, in which both the CFO and controller were alleged to be complicit, continued for over a year and a half, was alleged to have been implemented and concealed through the use of various artifices and accounting ploys, including secret payments and discounts to distributors, the creation of a subsidiary to repurchase oversold McAfee product from its distributors, false accounting entries and manipulation of reserves. During this period, McAfee "used its overvalued stock to acquire other companies, capitalizing on the artificial value it had created through its fraud." In contrast, Applix was alleged to have engaged in a fraudulent scheme to improperly recognize revenue on two transactions aggregating less than $2 million, resulting in understatements of net loss of 8.3% in one year and 33.6% in one quarter. Applix was not required to pay a financial penalty, but instead agreed, among other things, to engage and implement the recommendations of a financial consultant, to produce all documents and other information requested by SEC staff and to use its best efforts to cause its employees to be interviewed and testify.

In applying the announced framework, Thomsen argued that McAfee benefited from its conduct, especially through acquisitions made with its inflated stock, while there did not appear to be direct benefits to Applix or its shareholders by virtue of its fraud. In addition, because of McAfee's financial strength, the penalty was unlikely to cause its shareholders undue hardship, while Applix, as a relatively small company, would suffer a hardship from a large financial penalty, and that hardship would flow to its shareholders. The large penalty imposed on McAfee could be effectively distributed to shareholders that were injured by the fraud, while the SEC believed it would be difficult to impose a penalty on Applix that would be large enough to make distribution to victims practical without causing undue harm to the company and its current shareholders. Moreover, the conduct at McAfee was pervasive and occurred over a significant time period, while the conduct at Applix, "while certainly fraudulent, was more limited."

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