Afederal appeals court has rebuked the Securities and Exchange Commission for imposing severe civil penalties under the Sarbanes-Oxley Act on a company’s directors for engaging in market manipulation and making false statements.
The court said that the Commission failed to show that the directors’ conduct “created a significant risk of substantial loss to other persons,” or resulted in personal gain for the directors—a prerequisite under SOX to imposing so-called third-tier sanctions, the harshest available under the statute.
Sentelle
“[T]he SEC gives no explanation of how [the directors’] conduct either resulted in or created a significant risk of substantial loss to others,” wrote Judge David Sentelle of the D.C. Circuit Court of Appeals. “Neither does it give support for a finding of pecuniary gain. In sum, the SEC’s analysis was not just superficial; it was nonexistent.”
The SEC declined a request for comment on the ruling in the case—The Rockies Fund, Inc. v. Securities and Exchange Commission. The matter is now back before the Commission for further proceedings.
Warning To SEC
Nicolas Morgan, of counsel with the law firm DLA Piper Rudnick Gray Cary in Los Angeles, says the D.C. Circuit’s ruling constitutes a strong message to the SEC.
Morgan
“This is the first appellate court ruling that dealt with what kind of showing the SEC has to make under Sarbanes-Oxley to get the harshest penalties,” notes Morgan, a former SEC staff attorney. “The decision makes clear that the SEC has to make the same showing to obtain third-tier penalties whether it is in federal court or an administrative proceeding.”
Here, the court said it didn’t find any discussion by the SEC that there was a substantial risk of loss to others, notes Morgan. He isn't even sure why the SEC thought it had met its burden. According to Morgan, the Commission “didn’t even attempt to demonstrate how [the directors’] conduct could cause a substantial risk of harm.”
The message to the SEC is that it’s “not going to have an easier time obtaining third-tier penalties in civil administrative proceedings,” says Morgan. He also notes noting that officers and directors can take heart that the SEC is not going to have an unfair advantage when seeking sanctions in administrative actions.
Paccione
Anthony Paccione, a partner with Katten Muchin Rosenman in New York, tells Compliance Week that it’s unusual for the D.C. Circuit—the SEC’s “home court”—to overturn a Commission finding “on the basis that it’s arbitrary and capricious.”
Paccione adds that the decision is a warning to the SEC to support its findings with specific evidence. He adds that the courts having been willing to remind the SEC that there is some limit to its power, and the Commission should heed the warnings that they’re giving them. “When the SEC is pushing the prosecutorial envelope, [the courts] will be careful.”
PENALTIES
The excerpt below is from Title 15 Of The U.S. Code; Chapter 2D, Subchapter I, § 80a–9: Ineligibility Of Certain Affiliated Persons And Underwriters; "Money Penalties In Administrative Proceedings:
1. Authority of Commission
In any proceeding instituted pursuant to subsection (b) of this section against any person, the Commission may impose a civil penalty if it finds, on the record after notice and opportunity for hearing, that such person—
has willfully violated any provision of the Securities Act of 1933 [15 U.S.C. 77a et seq.], the Securities Exchange Act of 1934 [15 U.S.C. 78a et seq.], subchapter II of this chapter, or this subchapter, or the rules or regulations thereunder;
has willfully aided, abetted, counseled, commanded, induced, or procured such a violation by any other person; or
has willfully made or caused to be made in any registration statement, application, or report required to be filed with the Commission under this subchapter, any statement which was, at the time and in the light of the circumstances under which it was made, false or misleading with respect to any material fact, or has omitted to state in any such registration statement, application, or report any material fact which was required to be stated therein;
and that such penalty is in the public interest.
2. Maximum amount of penalty
First Tier
The maximum amount of penalty for each act or omission described in paragraph (1) shall be $5,000 for a natural person or $50,000 for any other person.
Second Tier
Notwithstanding subparagraph (A), the maximum amount of penalty for each such act or omission shall be $50,000 for a natural person or $250,000 for any other person if the act or omission described in paragraph (1) involved fraud, deceit, manipulation, or deliberate or reckless disregard of a regulatory requirement.
Third Tier
Notwithstanding subparagraphs (A) and (B), the maximum amount of penalty for each such act or omission shall be $100,000 for a natural person or $500,000 for any other person if—
the act or omission described in paragraph (1) involved fraud, deceit, manipulation, or deliberate or reckless disregard of a regulatory requirement; and
such act or omission directly or indirectly resulted in substantial losses or created a significant risk of substantial losses to other persons or resulted in substantial pecuniary gain to the person who committed the act or omission.
3. Determination of public interest
In considering under this section whether a penalty is in the public interest, the Commission may consider—
whether the act or omission for which such penalty is assessed involved fraud, deceit, manipulation, or deliberate or reckless disregard of a regulatory requirement;
the harm to other persons resulting either directly or indirectly from such act or omission;
the extent to which any person was unjustly enriched, taking into account any restitution made to persons injured by such behavior;
whether such person previously has been found by the Commission, another appropriate regulatory agency, or a self-regulatory organization to have violated the Federal securities laws, State securities laws, or the rules of a self-regulatory organization, has been enjoined by a court of competent jurisdiction from violations of such laws or rules, or has been convicted by a court of competent jurisdiction of violations of such laws or of any felony or misdemeanor described in section80b–3(e)(2) of this title;
the need to deter such person and other persons from committing such acts or omissions; and
such other matters as justice may require...
Source
Title 15 Of The U.S. Code; Chapter 2D, Subchapter I, § 80a–9: "Ineligibility Of Certain Affiliated Persons And Underwriters"
Although Paccione says that directors and officers shouldn’t take too much comfort from this single decision. “If you’re a director or officer you still need to be careful in this post-Enron environment,” he says. Still, the striking language and the sternness the court used in overturning the SEC’s decision “suggests that the pendulum may be shifting slightly in favor of companies.”
Third-Tier Sanctions
The case involved The Rockies Fund, a business development company that invested in a number of startups. In 1994, Rockies Fund purchased shares in a company called Premier Concepts, as part of a private placement, and The Rockies Fund later participated in Premier’s initial public offering.
Rockies’ directors also purchased shares in Premier, and one of the directors later engaged in wash sales and matched orders of Premier’s stock—techniques in which there is no actual change in beneficial ownership despite the appearance of trading activity. Rockies also apparently mischaracterized and overvalued its Premier holdings in SEC filings.
After the SEC instituted administrative proceedings against Rockies Fund and its directors for antifraud violations, an administrative law judge ruled that the company and its directors violated Section 10(b) of the Securities Exchange Act of 1934, as well as Rule 10b-5, and imposed civil penalties ranging from $160,000 to $500,000 against the directors for their conduct. The SEC agreed with the ALJ’s ruling and upheld the penalties.
On appeal, the D.C. Circuit said the Commission erred when it found that the wash sales and matched orders were enough on their own to constitute securities fraud. The court, however, agreed that the company made misstatements in its SEC filings that violated antifraud provisions. But the court criticized the SEC’s imposition of civil penalties.
Under federal law, the SEC is authorized to sue in federal court to seek civil penalties for securities violations. The amount of the penalty that can be imposed depends on the severity of the conduct.
So-called first-tier sanctions, the lowest penalties, are available for any violation of the federal securities laws. The next level, second tier penalties, may be imposed if the violation “involved fraud, deceit, manipulation, or deliberate or reckless disregard of a regulatory requirement.” Third-tier penalties, the harshest available, can only be imposed if there is fraud, deceit, manipulation or deliberate or reckless disregard of a regulatory requirement and the conduct and “directly or indirectly resulted in substantial losses or created a significant risk of substantial losses to other persons or resulted in substantial pecuniary gain to the person [who engaged in the misconduct].”
The SEC’s decision to impose third-tier penalties in the Rockies Fund case was made despite the Commission’s failure to provide any explanation about how the directors’ conduct resulted in a significant risk of substantial loss to others or in pecuniary gain for the directors, the court noted.
In sending the matter back to the Commission for further proceedings, the court chastised the SEC was for “arbitrarily and capriciously [imposing] third-tier sanctions” against the Rockies Fund directors.
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