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Securities Litigation Alert

SEC Announces Factors Influencing Assessment of Monetary Penalties Against Corporations

By Deborah Meshulam, David Priebe, and Nicolas Morgan

On January 4, the Securities and Exchange Commission (SEC), acting unanimously, issued an important statement discussing the factors it will consider in determining whether to impose civil monetary penalties on corporations alleged to have violated the securities laws. 

The statement clarifies a topic which previously divided the commissioners.  In order to minimize the likelihood of a penalty, corporations should carefully consider the guidelines outlined by the SEC and be prepared in the event they discover possible securities law violations or find themselves in an SEC investigation.  Corporations should also recognize that the new policy does not provide complete guidance because it does not outline the SEC’s position as to the amount of civil penalties it believes are appropriate in any given case.

At the same time the SEC announced its policy, it announced two settlements that demonstrate the application of the policy.  In one settlement, the corporation was assessed a $50 million fine1; in the second, the corporation paid no penalty.2  These settlements provide a first look at how the SEC will apply its standards going forward.  

The Policy Statement

After reviewing its legal authority to impose civil penalties, the SEC affirmed3 that the principal considerations it would apply in determining whether to seek civil monetary penalties against a corporation are:  

1.  The presence or absence of a direct and material benefit to the corporation itself as a result of the violation.  Violations that benefit the corporation through reduced expenses, increased revenues, or other forms of unjust enrichment are more likely to lead to a penalty.  The weakest case for monetary penalties exists when the current shareholders are the principal victims of the violation. 

2.  The degree to which the penalty will recompense or further harm the injured shareholders.  The ability to use the penalty as a meaningful source of compensation to injured shareholders favors imposition of a penalty, while the likelihood that a penalty will unfairly injure investors, the corporation, or third parties weighs against its use.

Additional Factors the SEC Will Consider

The SEC also set forth seven additional factors it would consider:

The need to deter the particular type of offense.  Violations that are common are more likely to lead to a penalty on the corporation to deter others; unique violations suggest a need to penalize responsible individuals.

The extent of the injury to innocent parties.  Violations that are egregious and cause more harm to investors and society are more likely to lead to a penalty.

Whether complicity in the violation is widespread throughout the corporation.  The more pervasive the participation in the violation, the greater the likelihood of a penalty, particularly if the participants remain employed by the corporation.

The level of intent on the part of the perpetrators.  The more intentional the violation, the greater the likelihood of a penalty.

The degree of difficulty in detecting the particular type of offense.  Violations that are difficult to detect and hence difficult to deter without strong measures are more likely to lead to a penalty.

Presence or lack of remedial steps by the corporation.  The sooner management acts to prevent future violations, the more favorably the corporation will be viewed by the SEC.

The extent of cooperation with the SEC and other law enforcement.  If management reports violations as soon as they are discovered to the SEC and other law enforcement authorities, its prompt action will weigh in favor of the corporation in the penalty calculus.

The SEC did not state that these were merely some of the factors that would be considered.  It also did not say whether it would consider some or all of these factors on a case-by-case basis.  Corporations should, therefore, consider all of the listed factors in every case.

How SEC Applied the Policy

In its settlement with McAfee, Inc., the SEC assessed a $50 million penalty.  The SEC’s allegations suggest that pervasive and egregious accounting fraud had benefited the company at the expense of investors.  The SEC alleged that the corporation overstated revenues over a four-year period (including $562 million in one year alone) through a “variety of ploys,” including massive undisclosed payments to distributors and the use of an undisclosed subsidiary to repurchase excess inventory.  The SEC alleged that the corporation then actively concealed the fraud from investors by manipulating reserve accounts and making improper accounting entries.  The SEC also alleged that the corporation had raised nearly $350 million in offerings conducted via registration statements that included the false financials and had made several acquisitions using stock whose price had been inflated by the false statements.  Even after the corporation changed management and ended the improper practices, it nevertheless continued to experience material weaknesses in accounting controls, leading to an additional restatement.  In addition, while not mentioned in the SEC’s announcement of the settlement, the type of violations that allegedly occurred were common and appear to have been committed with a high level of intent.

In contrast, the SEC did not impose a penalty on Applix, Inc., whose alleged violations were isolated and apparently did not benefit the corporation.  The corporation at issue allegedly overstated revenues and income in two quarters as a result of improper revenue recognition on two transactions.  There is no allegation in the SEC’s cease-and-desist order that the corporation conducted any public offerings using its inflated financial statements.  Management reported the issues to its audit committee (although it did not report its own knowledge of the improprieties), which promptly conducted an internal investigation.  As a result of the investigation, the corporation obtained the resignation of the CEO, put the CFO under direct supervision of the audit committee, and eventually obtained the CFO’s resignation as well. 

Corporation’s Behavior Determines SEC’s Actions

These settlements demonstrate that while the SEC will take into account the response of a corporation when it discovers a potential violation, it remains serious about imposing significant monetary penalties against corporations that use systematic and surreptitious securities law violations to raise money or gain other assets.  When a corporation has not cooperated or remedied the problems that led to the violations, the SEC will seek penalties.  Corporations must create structures and policies to ensure that potential violations are reported to the board of directors or a compliance committee (such as the audit committee) and are promptly investigated, to determine rapidly whether a problem actually exists and should be disclosed to the SEC. 

In the final analysis, however, even if violations are reported and remedied, the SEC is likely to seek monetary penalties if the nature and effect of the violations warrants them.  Corporations should also note that securities law violations can lead to serious consequences even if the SEC does not assess monetary penalties.  The SEC has remedial and penalty powers beyond monetary sanctions.  For example, even the corporation that did not pay a civil penalty consented to hire an independent consultant to review and make recommendations for the improvement of its revenue recognition policies and agreed to adopt any recommendations made by that consultant.  In addition, by consenting to findings that it violated the antifraud provisions of the securities laws, the company cannot issue projections or other forward-looking statements with the protection of the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995.4 

Apart from additional SEC sanctions, settlement of SEC charges such as those at issue in the settlements summarized above often lead to private class action lawsuits, with their attendant management distraction and legal fees. 


1  Securities & Exchange Comm’n v. McAfee, Inc., No. 06-009 (PJH) (N.D. Cal.) (Jan. 4, 2006).

2  In the Matter of Applix, Inc., Administrative Proceeding No. 3-12138 (Jan. 4, 2006)..

3  Many of the factors described by the SEC as pertinent to the issue of whether to impose civil penalties against a corporation reiterate criteria the SEC had previously described as pertinent to whether it would bring an enforcement action against a corporation in the first instance.  See Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934, Exchange Act Release No. 44969 (Oct. 23, 2001).

4  See 15 U.S.C. § 77z-2(b)(1)(A)(ii); id. § 78u-5(b)(1)(A)(ii).




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