Risk & Compliance

To Err Is Human . . . and Punishable by the SEC

The securities regulator stretches itself thinner by adding negligence cases to its docket.
Russell G. RyanNovember 1, 2011

If you ran a chronically underfunded department that was part of an organization in urgent need of across-the-board belt-tightening, would you go out of your way to take on new responsibilities with your limited resources?

I doubt it.

But according to recent media reports, the Securities and Exchange Commission has decided to do something similar in the midst of the overall federal budget debate. Even as the SEC pleads for more resources from Congress to keep up with existing responsibilities and the mind-boggling array of new regulatory burdens dumped upon it by last year’s Dodd-Frank financial reform act, the agency reportedly intends to expand its enforcement reach. The regulator will apparently pursue not only its signature cases against deliberate and reckless fraudsters, but also cases against people who make merely negligent mistakes. Apparently, as the SEC has progressed with its investigations relating to the financial meltdown, it has found many examples of negligence and bad judgment, but fewer instances of deliberate fraud than most people assume. 

Two weeks ago, the SEC put its intentions into action. In a blockbuster $285 million settlement with Citigroup over the marketing of a collateralized debt obligation (CDO) to several hedge funds and other sophisticated investors, the agency did not charge the bank with committing deliberate fraud. Instead, it alleged only that the bank had “negligently misrepresented key deal terms” to the investors.

This move toward punishing negligence is especially bad news for CFOs and others in corporate accounting departments. In any large organization (including the SEC itself), mistakes inevitably happen from time to time. To quote the irrefutable wisdom of 18th-century English poet Alexander Pope: “To err is human.”

At public companies, however, mistakes can easily lead to material errors in financial statements. And those errors — even if unintentional — often technically violate federal securities laws. Moreover, everyone responsible for those errors is, at least in theory, at risk of SEC enforcement action.

Fortunately, the SEC has long exercised sound prosecutorial discretion by not charging people who were guilty of only negligent mistakes. Instead, the agency has historically prioritized its limited resources by mostly going after people it believes committed deliberate fraud.

It’s true that the SEC has settled many cases over the years with only negligence charges. But most of those settlements have been with corporate entities rather than with flesh-and-blood human beings. And even the negligence-based settlements against individuals usually resulted from extensive negotiations in cases where the SEC staff genuinely suspected intentional or reckless misconduct but wanted to either conserve resources or avoid the anticipated difficulty of proving intent in court. Contested SEC cases, by contrast, have rarely involved only negligence charges.

Now, however, the SEC appears willing to pursue cases even when the agency knows the defendant did not act with what the law calls scienter — that is, an intent to defraud, knowledge of wrongdoing, or at least reckless disregard of the law. While the SEC deserves a lot of credit for not pressing fraud charges in cases where proof of intent is lacking, the agency’s pursuit of negligence cases is unfortunate for several reasons.

First, as a matter of public policy, we should all be concerned when the full force of federal law enforcement is set upon people merely for making mistakes. It’s bad enough that mistakes can lead to costly private civil lawsuits that end quietly, with the amends isolated to those who were adversely affected. It’s quite another thing to have enforcement authorities — motivated by a different set of priorities, incentives, and political pressures — picking and choosing whose mistakes will be singled out for public scorn and career-ending charges.

On a more practical level, however, why would the SEC gratuitously stretch itself thinner by taking on marginal cases when the regulator has acknowledged it already lacks sufficient resources to catch anywhere close to all the crooks who engage in deliberate securities fraud? After all, for every case of negligent conduct the agency decides to pursue, it necessarily diverts limited resources away from more serious cases of deliberate fraud.

About a year ago, under a mandate imposed by Dodd-Frank, the SEC retained the Boston Consulting Group to study the agency’s operations and analyze opportunities for reform. Among the key recommendations of the study was that the SEC should “reprioritize” its activities.

“The SEC should engage in a rigorous assessment of its highest-priority needs in regulatory policy and operations, and reallocate resources accordingly,” the study sensibly recommended. “The agency’s various divisions and offices have identified several high-priority regulatory activities they deem necessary to initiate or expand. Given that at least some of these activities are of greater priority than current activities . . . this will enable the agency to reallocate its resources in a more effective manner.”

It’s not easy to square these recommendations with a reallocation of the agency’s limited enforcement resources to cases involving mere negligence.

Russell G. Ryan, a former assistant director of the SEC’s Division of Enforcement, is a partner in the Washington, D.C., office of the law firm King & Spalding LLP.