Does the SEC Need Authority to Impose Larger Fines?

Does the SEC need authority to impose larger civil penalties? SEC Chairman Mary Schapiro recently told Congress the agency needs additional authority to impose large fines. The story broke in the press the day Judge Rakoff issued his order rejecting the SEC's settlement with Citigroup Global Markets, giving the Commission some relief from the negative publicity generated by that ruling. The two issues, of course, have nothing to do with each other, although many journalists juxtaposed the stories.

The SEC's authority to impose fines, and particularly corporate civil penalties, has long been controversial. Those who favor corporate penalties argue that they are critical to deter future violations. While proponents concede that ultimately those penalties are imposed on shareholders, they cite the SEC's guidelines for imposing corporate penalties which consider this issue and the fact that the money can be returned to shareholders through a Fair Fund.

Those opposed to corporate civil penalties contend that they have little if any deterrent effect. Rather, for most corporations they simply become a cost of doing business since few business organizations are willing to take a case brought by a regulator like the SEC to trial. In the end it is simply the shareholders who suffer regardless of whether there is a Fair Fund since that mechanism is imperfect at best in restoring the lost wealth to the shareholders, according to this argument. What the SEC should focus on, according to many who oppose corporate fines, is procedures to prevent a reoccurrence of the wrongful conduct in the future as it did prior to the Remedies Act when its enforcement program was considered among the best in government.

There is no easy way to resolve this debate. An analysis of the Commission's recent high profile market crisis cases however points to the answer.

  • SEC v. Goldman Sachs & Co., Case No. 3229 (S.D.N.Y.) is perhaps the Commission's most high profile market crisis case. The action centered on the sale of interests in a synthetic CDO tied to the sub-prime market without disclosing the role of a firm client who influenced the collateral selection and short it. The Commission settled with the firm for a record setting $550 million fine, an injunction prohibiting future violations of Securities Act Section 17(a), an admission by the bank regarding its inadequate disclosures and the institution of procedures to prevent a reoccurrence.
  • SEC v. Bank of America Corp. Case No. 09 cv 6829 (S.D.N.Y.) was an action against the bank arising out of its acquisition of Merrill Lynch & Co. The complaint centered on a claim that the firm's proxy materials used to solicit approval of the acquisition were false and misleading regarding the payment of huge bonuses for Merrill executives. The initial settlement rejected by the Court proposed a $33 million corporate fine, an injunction prohibiting future violations of Exchange Act Section 14(a) and certain procedures. The Court issued a scathing opinion charging that the SEC conducted a sham investigation and that the fine and proposed procedures were inadequate. Eventually the Court approved a settlement which included a $150 million fine and strengthened procedures.
  • SEC v. Citigroup, Inc., Civil Action No. 1:10-CV-01277 (D.D.C. Filed July 29, 2010) was an action alleging violations of Securities Act Section 17(a)(2) and Exchange Act Section 13(a) for failing to disclose and misrepresenting the bank's exposure to the sub-prime real estate market which was in fact $56 billion and not the $13 billion as disclosed. The bank settled by consenting to an injunction based on the sections cited in the complaint, paying a $75 million fine and instituting certain remedial procedures. The Court reluctantly approved the settlement noting that the fine was not a deterrent and requiring the SEC to certify that the proposed procedures were in fact implemented.
  • SEC v. Citigroup Global Markets Inc., Case No. 11 Civ. 7387 (S.D.N.Y.) is the Commission's most recent market crisis case. The action, like Goldman Sachs, centered on the sale of shares in a largely synthetic CDO tied to the sub-prime market. The bank failed to disclose its role in selecting the collateral or that it was shorting only the collateral it selected. The proposed settlement called for an injunction based on Securities Act Sections 17(a)(2) & (3), the payment of disgorgement and prejudgment interest and a civil penalty of $95 million dollars and certain procedures. The Court rejected the settlement, concluding that the deal was good for the bank since the fine was little more than a cost of doing business while the SEC and the public got little more than a headline. This is particularly true in view of the egregious conduct alleged in the complaint. The court also found the proposed procedures in adequate.

An analysis of these cases does not suggest that the SEC needs additional authority to impose corporate fines. Goldman Sachs paid a record fine. In each of the others the Court questions the amount of the fine and, in two virtually forced the Commission to increase the amount. Indeed, in Bank of America, Citigroup and Citigroup Global Markets the Commission defended the fine initially proposed as appropriate without even suggesting that it was constrained by statutory limitations.

What is perhaps more telling, however, is the fact that procedures to prevent a reoccurrence of the wrongful conduct in the future seem to be largely an afterthought. In Bank of America, Citigroup and Citigroup Global Markets the Court questioned the adequacy of the procedures. In Bank of America Judge Rakoff required the SEC to strengthen the procedures before he would approve the settlement. In Citigroup Judge Huvelle was so skeptical of the proposed procedures that she required the Commission to certify their implementation. Citigroup Global Markets has yet to be resolved.

While these cases represent just a small sample of those in the enforcement program, it is noteworthy that each is a major case. Each is an important market crisis case. Each is against a major Wall Street player. In each the SEC had more than adequate authority to impose fines involving a range of wrongful conduct. And, in each the procedures to prevent a reoccurrence in the future, while present, did not appear to be a critical component of the settlement as initially crafted by the agency. Yet preventing a reoccurrence of the wrongful conduct is a critical part of the Commission's statutory mandate. If the SEC is going to fulfill that mandate perhaps it is time to learn the lessons from these cases and focus not on dollar penalties which are popular and generate headlines as Judge Rakoff wrote in rejecting the settlement in Citigroup Capital Markets, but on reforming the procedures and perhaps the culture of organizations which permits and perhaps rewards conduct such as that charged in these cases.

For more cutting edge commentary on developing securities issues, visit SEC Actions, a blog by Thomas Gorman.

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