Risk & Compliance

Penalty Box

The SEC is handing out bigger and bigger fines for misdeeds. But is this the right approach?
Alix StuartFebruary 1, 2006

By SEC standards, it was an odd sort of press release.

On January 4, the Securities and Exchange Commission issued a statement regarding actions against McAfee Inc. and Applix Inc. The commission reported that the suits had been settled, and that in McAfee’s case, the company would pay a civil fine of $50 million, while Applix would pay nothing.

The discussion of the settling of the two actions took exactly two sentences. The SEC devoted another 2,000 words to describing how it determined the civil fines in the two cases. “We are issuing this statement describing with particularity the framework for our penalty determinations in these two cases,” the commission noted.

Actually, the statement had precious little to do with the two cases. Instead, it was the SEC’s roundabout way of addressing recent concerns about the size — and calculation — of settlement fines. The penalties have certainly gotten bigger. Four years ago, the $10 million penalty assessed against Xerox was a record. These days, $10 million barely qualifies as a slap on the wrist. WorldCom now holds the dubious distinction of receiving the largest-ever SEC fine ($750 million), with Adelphia a close second at $715 million. Bank of America was fined $10 million simply for dragging its heels in supplying documents to the SEC. All told, the SEC fined companies a combined $3.1 billion in its fiscal 2005, up from $313 million in 2003, the first year it started tracking such numbers.

That 10-fold increase begs the question of exactly what the SEC is trying to accomplish by imposing hefty fines on corporate entities that do not think, operate, or commit crimes by themselves. While the fines have always been intended to scare companies (and their executives) straight, a good deal of the increase is driven by the SEC’s new power to return fines to investors, thanks to the Fair Fund provision of the Sarbanes-Oxley Act. Says Lynn Turner, former SEC chief accountant and managing director of research for Glass, Lewis, & Co., a shareholder research firm: “When you see the magnitude of the fines in the WorldCom case, there’s no question they’re being driven in part by a desire for restitution.”

Fining a corporation to help compensate shareholders is fraught with difficulties, however. Figuring out what constitutes an appropriate fine has become a confused affair, both for the fined and — apparently — for those doing the fining. In its January 4 statement, the SEC acknowledged that recent cases have not produced a clear public view of when and how the commission levies penalties. The release also noted that “within the Commission itself a variety of views have heretofore been expressed, but not reconciled.”

What’s more, investors are hardly leaping at the money, with only about half claiming what was due to them in the first major settlement. That, combined with the administrative and ethical hassles associated with cutting checks to past investors, meant that only $302 million of the $1.6 billion in fines that the SEC collected last year went to investors.

Cash Back

To its credit, the SEC has done an admirable job of improving its record on collecting fines. Between 1995 and 2001, it collected only 14 percent of the $3 billion in fines levied during those six years, according to a 2002 Government Accountability Office report. After hiring some 20 full- and part-time staff and implementing a new software system, however, the agency was able to recover more than 70 percent in 2004 and 2005.

But getting that money back to investors is an inherently Byzantine process. The SEC must appoint a distribution agent, subject to court approval, whose first task is to come up with a fair plan for divvying up the fine among injured investors. That plan has to be published in major newspapers so that shareholders can dispute it, if they desire, and then be approved by a judge. Next, investors that held the shares during the time of the crime have to be identified, contacted, and given a deadline for submitting their claims. Once all the claims are in, the judge must make final approvals before checks can be cut — if any money is left over.

Given all the procedural elements, most of the money that has been collected in fines over the years — $1.9 billion — is still sitting at the U.S. Treasury Department, held in various government securities. Even one of the faster cases — the global research analysts’ settlement with 12 investment banks — took about 27 months from the final settlement date in October 2003 to the day the checks were sent out last month. And while the government may be able to expedite matters to some degree, the $433 million fund earmarked for investors in that case is a perfect example of how necessarily painstaking the distribution process is.

In trying to compensate shareholders of such companies as Adelphia and Inktomi, who might have been swayed by phony research reports, there was no easy formula. Distribution agent Francis McGovern, a professor at Duke University Law School, says his first challenge was deciding which losses would be eligible for the money, since not all could be attributed to faulty research. “There were analyst reports that affected people’s decisions about buying those stocks, but the importance of those reports dissipates over time,” says McGovern.

To be eligible for payment from the fund, the investor must have suffered a loss, either from the sale of the stock or from a reduction in the price of the stock if it was not sold. Thus, McGovern decided that the maximum restitution an investor could receive for an unrealized loss was the difference between the purchase price and the average value during the 90 days afterward — provided there was a net loss when the securities were finally sold.

Under those parameters, though, the $433 million was unlikely to cover all losses. McGovern was then faced with whether to give all the affected investors an equal percentage of their loss, or somehow rank them to give some more than others. He chose the latter, setting it up so that preference would be given to those who bought closer to the publication of the research report, and also to those who were ostensibly more dependent on the information (meaning individual investors will likely get more than institutional ones).

McGovern’s process was hastened by two factors. One, only two investors quibbled with his plan, and didn’t hold up the process significantly. Second, he had the names of investors and their contact information from the investment banks, so he didn’t need to track them down himself. “Our goal is to distribute all of the $433 million,” he says. “But we can’t tell right now” if that will be possible.

Indeed, despite doing all he could to reach injured investors — from sending them preprinted forms to sign to following up with those that did not initially respond — McGovern received responses from only 50 percent of eligible investors. In private suits, only about 30 percent of eligible financial institutions take the time to submit a claim for their money, estimates Duke Law School professor James Cox. He hypothesizes that the paperwork either gets lost, or is simply deemed too time-consuming to be worth the effort.

Such low recovery rates have some wondering if supersized fees are working. Some say fines miss their mark, punishing current shareholders more than the employees who perpetrated the crimes, since the fines come out of company coffers. “In at least some cases, there’s the perspective that these fines punish the victims twice,” says Joseph Grundfest, a professor at Stanford Law School and an SEC commissioner from 1985 to 1990. That’s particularly true, he says, if the fines are also supposed to be a deterrent. Once those responsible for the crimes have been replaced and punished, “most of the deterrent effect you would want to have is there,” and it would make sense “not to impose any penalty at all.”

Fair Funds Unfair?

Despite these obstacles to shareholder restitution, it may be too soon to say the system is broken. In contrast to private security settlements, SEC settlements do not include deductions for plaintiffs’ lawyers fees, which generally consume about one-third of any windfall in private cases. Plus, in the last two to three years, there has been a “big focus on the fact that a lot of money has been left on the table,” says Bruce Carton, securities class-action services vice president at Institutional Shareholder Services. This includes class-action lawsuits against 44 mutual-fund companies and investment advisers for their alleged failure to collect the recompense from private suits.

All of this has attracted the attention of members of the Council of Institutional Investors. Says CII managing director Alyssa Ellsworth: “We’re going to be looking into company payments to investors to see if Fair Funds is working, and if there are any recommendations we should be making to the SEC.”

It’s doubtful that the money could be better used elsewhere, however. Efforts to pool the money for a greater good, like investor education, have few supporters. In fact, funds from the global research analysts’ settlement earmarked for investor-education grants were bandied about within the SEC, then transferred to the National Association of Securities Dealers’s investor-education foundation, where they still sit untouched.

Further, levying a fine does not preclude the SEC from punishing individual executives, or requiring the company to reform itself and even pay for a court-appointed monitor in some cases. “People tend to rush and say we shouldn’t have these big fines, because they don’t benefit current shareholders,” says Turner. “But is it OK to rip off owners and not pay them anything?”

At least for now, a company that gets caught in the crosshairs of the SEC should brace itself for a substantial fine. “I don’t think anyone’s going to be made whole by them,” says Carton, “but anyone who had a meaningful number of shares in a company is glad to get the money back.”

Alix Nyberg Stuart is senior writer at CFO.

How the SEC Determines Fines


  • Presence or absence of a direct benefit to the corporation as a result of the violation
  • Degree to which the penalty will recompense or further harm the injured shareholders


  • Need to deter the particular type of offense
  • Extent of complicity in the violation throughout the corporation
  • Degree of difficulty in detecting the particular type of offense
  • Extend of cooperation with the SEC and other law enforcement

Source: SEC

Sticker Shock

Bargaining with the SEC is no bargain.

Negotiating fines with the Securities and Exchange Commission has become something of an art form, say lawyers who have been involved in recent cases. “You used to be able to go into the SEC and say, ‘What is this case worth to you?’ and they would give you a reasonable answer,” says Paul Huey-Burns, a partner at Dechert LLP in Washington, D.C. Since 2002, though, he says the SEC has become like a car dealership “where they say the sticker price is $40,000 and we can’t possibly take a penny less.”

The sticker price does usually come down — often by about 50 percent and sometimes more — but only after haggling over things like how much investors lost, how strong the evidence is, and how much a company has cooperated, say attorneys. And money is only one of many factors in the mix. For example, “the SEC threatens to bar CFOs from serving as officers or directors, or from practicing in front of the SEC in a huge number of cases, simply as a negotiating tactic,” says Steve Poss, partner at Goodwin Procter LLP and chair of its securities-litigation and SEC-enforcement practice.

SEC chairman Christopher Cox has acknowledged that the process of doling out fines is perhaps too ad hoc; hence the commission’s statement on penalties issued in early January. The statement stopped short of tying specific dollar figures to particular behaviors, however. And while the guidelines may make the negotiating process less convoluted — and, therefore, shorter — it is unlikely the haggling will end entirely. Says Huey-Burns: “It’s interesting that the SEC has decided to articulate these factors, but it doesn’t really change the world all that much.” — A.N.S.