The Watchdog Losing Its Bite: The Commission and Corporate Penalties

With the collapse of Bear Stearns and the continued unraveling of the subprime scandal, attention has shifted to the role of the Commission.  In the weeks before Bear Stearns collapsed, Chairman Cox issued public statements indicating that the investment banking firm was adequately capitalized, something that proved entirely inaccurate.  It wasn't the first time that the Commission had gotten involved in the corporate disclosure business with less than stellar results.

Perhaps as a result, the Commission has been under greater scrutiny, with the Chairman using data to defend the agency.  In a letter to Senator Dodd on the subject, Cox defended the agency's record, pointing to the $600 million collected from UnitedHealth as part of the agency's tough policy on corporate scofflaws.  As he noted in the letter:  "`The former CEO of UnitedHealth paid more than $600 million to settle charges related to options backdating. That is a record that eclipses even what Michael Milken paid in the most notorious financial fraud case of all time.'' 

As we have discussed here, that's not entirely an accurate description of what happened.  What did happen?  As we have discussed, $600 million was "satisfied" through a settlement in private litigation.  The only real addition by the Commission was a fairly insignificant $7 million penalty (even the $12 million in disgorgement and interest was credited against the private settlement).  Jonathan Weil at Bloomberg described:  "It didn't really happen that way, though. Assuming all goes according to plan, the SEC will never touch most of those dollars. If this isn't quite a Hillary Clinton sniper-fire moment, it's close."

The inquiry from Dodd arose out of the declining amount of penalties assessed by the Commission.  The amount collected in 2007 was $1.6 billion, almost 50% less than the prior year.  Using raw dollar amounts is not an appropriate way to assess the Commission's toughness, particularly as the Enron era scandals work through the system, reducing the number of cases involving mega penalties. 

This Commission has slowly been tightening the noose around the staff's ability to assess penalties against public companies.  In 2006, the Commission announced a set of standards that would go into the consideration of penalties, standards that provided plenty of room to argue that a penalty should not be assessed.  At a minimum, they reduced staff discretion in assessing penalties. 

While the factors seem reasonable if applied in a neutral fashion, the Commission has at least one member, Commissioner Atkins, who is an implacable foe of penalties.  As he noted in a speech:

• The SEC's own enforcement program, if not carried out with proper discipline, can have some of the same deleterious effects as meritless private securities actions. For example, hefty corporate penalties for financial frauds in which the shareholders were themselves the victims of deceit by their employees in management may appear to be of no consequence to the large companies on which we impose them. The cost of such penalties, however, like any other corporate expense, is borne by the company's shareholders. A large percentage of these shareholders are likely to have been victims of the financial fraud for which the company paid the penalty. The SEC should exercise more discipline in imposing corporate penalties to avoid further victimizing shareholders.

His views suggest that the policies were not designed to promote fairness but were designed to lower the number and amount of penalties. 

Things got worse in 2007.  The Commission imposed on the staff an obligation to pre-clear any penalties before commencing negotiations with the offending issuer.  As the Chairman noted in testimony:  "To that end, the staff are beginning to present their recommendations for penalties to the Commission before negotiating penalties with the issuer."   The problems with the approach?  The New York Times noted that "[s]ome staff members complain that this makes them feel as if they must get permission to do their jobs.

But the problem is far more invidious.  Pre-approval essentially allows the Commission to kill a penalty before any negotiations ever occur.  That minimizes the risk that the issue would surface publicly, something more likely if a penalty is successfully negotiated but the Commission rejects the amount.  In other words, some penalties won't even be considered out of fear that it will be rejected.  In other cases, penalties will not be assessed because the Commission declines to provide the requisite authority.

Pre-clearance does not help.  It adds a layer of bureaucracy and makes the settlement process more complex.  What it does do is give the Commission a chance to reject penalties in a non-transparent manner.  It is this attribute of the enforcement process that ought to be examined by those worried that the Commission has become a toothless watchdog.

Comments

[Herrick Lidstone]

One wonders if the 2006 SEC announcement and subsequent restrictions on the staff's ability to assess penalties against corporations is intended to lead the staff to the conclusion that they should focus on the individuals involved in corporate malfeasance.

Corporations are still "legal fictions" and only operate through individuals. Admittedly, individuals may be harder to catch and prove wrongdoing against. That should be where the staff's focus is.