Penalty Declined: SEC Often Takes Nothing

The Securities and Exchange Commission seemed to bring closure the largest corporate fraud scandal in history in July, when it announced final civil settlements with former WorldCom Chief Financial Officer Scott Sullivan and five other executives at the former telecommunications company.

At the time, Sullivan had agreed to be liable for $10 million in disgorgement and nearly $3.6 million in prejudgment interest. Observers were startled to learn, however, that as part of the deal the SEC agreed to waive the actual payment of those monies, and wouldn’t impose a civil penalty against Sullivan and two of the accountants based on their demonstrated inability to pay. Essentially, none of the three paid anything.

The following week, the SEC filed financial fraud charges against five former executives of Daisytek International, a distributor of computer and office supplies, which currently quotes its shares on the Pink Sheets.

Under terms of a settlement, Daisytek’s president agreed to pay disgorgement of $830,000, plus prejudgment interest of $148,600. In exchange, the SEC waived the amount and decided not to seek a civil penalty, based on the executive’s sworn financial statement—and again collected no actual money from the fines imposed.

So exactly how does the SEC determine fines and disgorgement penalties imposed on individuals nabbed in securities fraud cases? And how does it weigh a defendant’s ability to pay?

According to experts, no specific, detailed guidelines exist for imposing various monetary penalties, although “there is a far broader range than you would expect,” says Michael Koenig, a former federal prosecutor and now counsel at Dewey Ballantine, a law firm specializing in corporate fraud cases.

Peterson

“At the end of the day, it’s a negotiation,” says Lowell Peterson, a partner at the law firm of Meyer Suozzi English & Klein. (The firm did work on the WorldCom case, but Peterson was not part of that team.)

“Even though the SEC has some discretion in determining penalties in settlements, the concept that they can go to zero based on a poverty plea is rather strange.”

Penalties And More Penalties

In general, the SEC tries to return disgorged funds to aggrieved investors, according to Rick Sauer, a former SEC enforcement attorney and now partner at the law firm Vinson & Elkins. As a result of the Fair Funds provision of the Sarbanes-Oxley Act, civil penalties may be included in the funds available to compensate investors if a disgorgement award exists.

The SEC’s ability to impose punishment traces its origins back to the Securities Exchange Acts of 1933 and of 1940, but historically the Commission could not impose civil penalties, Sauer explains. That power was finally established with the Securities Law Enforcement Remedies Act of 1990.

Sauer

In the 1990s, Sauer says, the SEC largely explored how to use its penalty power with cautious steps and small fines. Only during the rash of massive corporate frauds in recent years has the Commission adopted a more muscular approach and started levying huge penalties: hundreds of millions of dollars for companies and millions for individuals.

Sauer divides the typical monetary remedies in financial fraud cases into three categories: disgorgement of ill-gotten gains; prejudgment interest on that amount (calculated from a statutorily determined rate of interest from the date of the violations to the date of the settlement); and civil penalties.

And within the category of civil penalties, Section 21(d)(3) of the Securities Act of 1934 establishes three “tiers” of fines that can be imposed on individuals:

At the first tier, the penalty cannot exceed the greater of $5,000 for an individual or $50,000 for a company;

At the second tier, the penalty cannot exceed the greater of $50,000 for an individual or $250,000 for a company;

At the third tier, the penalty cannot exceed the greater of $100,000 for a person or $500,000 for a company.

But the imposition of penalties can be impacted by myriad factors, from cooperation of those involved, to case law and precedent. In January 2006, the SEC published a list of factors that it would consider before imposing penalties on a corporation; many industry watchers claim some of those same factors may be considered by the Commission when considering disgorgement, including:

The need to deter the particular type of offense;

The extent of the injury to innocent parties;

Whether complicity in the violation is widespread throughout the corporation;

The level of intent on the part of the perpetrators; and

Extent of cooperation with Commission and other law enforcement (among others; see the SEC statement in the box above, right).

Derek Meisner, a former branch chief for the SEC and now attorney with the law firm Kirkpatrick & Lockhart Nicholson Graham, also stresses that the SEC is not obligated to follow the penalties provision in a settlement. “They can be used as guidelines for the appropriate penalty, but they are not dispositive,” he says.

As a result, Meisner and others say that many times the actual payments made are products of negotiations, regardless of public statements to the contrary. This is particularly true given the amount of interpretation that can go into determining the number of violations that have occurred from a particular course of conduct, Sauer adds.

Koenig

Koenig says results also can differ depending upon the SEC office that is bringing charges and the individual SEC lawyer handling the case, even though the final decision is subject to a higher level of approval. “Objectively, you would like to think that any office and any SEC person you deal with would get the same result,” he says. “That is not always the case.”

One major reason for such discrepancies is that many questions still remain when determining penalties. For example, an executive may have reaped $1 million from a fraud, which the SEC may request to be disgorged as ill-gotten gains. But some of the salary and bonus received by the executive may have stemmed from legitimate work—so some of his gains may not actually be illegitimate.

“One of the great mysteries is how the SEC determines restitution and disgorgement when an executive also did legitimate work as well,” Koenig says. “Disgorgement is subject to a certain subjective level of analysis.” As a result, attorneys say, much negotiation happens over each category of monetary penalty.

Ability To Pay

One well-established SEC practice is its judgment of a defendant’s ability to pay. Most attorneys are confident the SEC does a thorough analysis of the individual’s finances. “There are detailed financial disclosures that must be made,” Koenig says, and the defendant is subject to perjury during the disclosure process.

Meisner

Meisner says the exercise is very fact-specific. The SEC requests defendants to submit a sworn statement of financial condition, which detail their assets, liabilities and cash, and includes a credit check. “They will determine whether the individual has liquidity to pay the penalty sought,” he says. “If they don’t have the money [or the] … capacity to get money, then the staff will request to waive.”

Many times the SEC could obtain large judgments against poor defendants, Sauer says, but there is “little purpose in doing so since it will rarely be able to enforce the judgments.” Waiving the penalties in those situations brings closure to the administrative process—and, Sauer says, avoids building up large uncollected balances, which reflect poorly on the SEC when the media or government auditors come knocking.

In the case of Sullivan, Sauer points out that the SEC effectively stripped him of his assets through class action lawsuits. He also faces a jail term as a result of his plea in the Department of Justice action. ”There is little likelihood the Commission could ever extract any significant amount of money from him, even if it pursued him for the rest of his life, and it is simply being realistic in recognizing that through the waiver,” Sauer says.

So how was Sullivan’s wife reportedly able to keep more than $2 million? Attorneys theorize her husband deposited that sum in her account before he was charged. “If Sullivan transferred the money after he was indicted, you must believe the SEC did a thorough, rigorous analysis of his ability to pay,” Koenig says. “I’d be stunned if they took someone by their word.”

Related columns, coverage and resources—including information on the SEC's statement on financial penalties, released Jan. 4, 2006—can be found in the box above, right.