On Tuesday, SEC Commissioner Caroline Crenshaw spoke to the Council of Institutional Investors. Her presentation, Moving Forward Together—Enforcement for Everyone, concerned “the central role enforcement plays in fulfilling our mission, how investors and markets benefit, and how a decision made 15 years ago has taken us off course.” In her view, the SEC should revisit its approach to assessing financial penalties and should not be reluctant to impose appropriately tailored penalties that effectively deter misconduct, irrespective of the impact on the wrongdoer's shareholders. Is this a sign of things to come?
Crenshaw observes that, generally, SEC Commissioners of all stripes believe in a strong enforcement program but differ on the effect of corporate penalties in achieving the SEC's goals. Crenshaw believes that the SEC has overemphasized “factors beyond the actual misconduct when imposing corporate penalties—including whether the corporation's shareholders benefited from the misconduct, or whether they will be harmed by the assessment of a penalty.” Not only is this approach “fundamentally flawed,” but, more importantly, it allows companies to profit from their own fraud and handcuffs the SEC, inhibiting it from crafting “tailored penalties that more effectively deter misconduct” and that create financial incentives to follow the rules and invest in compliance. In Crenshaw's view, “enforcement best advances our agency's goals when it concentrates the costs of harm with the person or entity who committed the violation. For these reasons, ensuring that the violator pays the price is key to a successful enforcement regime and to promoting fair and efficient markets more broadly.”
But what should the “price” be? That has been a topic of some controversy. The critical “decision” that Crenshaw foreshadowed in the introduction occurred in 2006, when a unanimous SEC issued a statement on financial penalties suggesting that the SEC “should be careful not to impose penalties that unduly burden shareholders. Since then, when assessing penalties, the Commission has looked at whether a corporation's shareholders benefited from misconduct, or whether they will be harmed by the assessment of a penalty because the costs may be passed on to shareholders. This myopic approach is flawed and the reason why we need to make a change.”
SideBar
In discussing the appropriateness of a penalty on the corporation, the SEC's 2006 statement provided that the decision turned principally on two considerations:
“The presence or absence of a direct benefit to the corporation as a result of the violation. The fact that a corporation itself has received a direct and material benefit from the offense, for example through reduced expenses or increased revenues, weighs in support of the imposition of a corporate penalty. If the corporation is in any other way unjustly enriched, this similarly weighs in support of the imposition of a corporate penalty. Within this parameter, the strongest case for the imposition of a corporate penalty is one in which the shareholders of the corporation have received an improper benefit as a result of the violation; the weakest case is one in which the current shareholders of the corporation are the principal victims of the securities law violation.
“The degree to which the penalty will recompense or further harm the injured shareholders. Because the protection of innocent investors is a principal objective of the securities laws, the imposition of a penalty on the corporation itself carries with it the risk that shareholders who are innocent of the violation will nonetheless bear the burden of the penalty. In some cases, however, the penalty itself may be used as a source of funds to recompense the injury suffered by victims of the securities law violations. The presence of an opportunity to use the penalty as a meaningful source of compensation to injured shareholders is a factor in support of its imposition. The likelihood a corporate penalty will unfairly injure investors, the corporation, or third parties weighs against its use as a sanction.”
The SEC also cited as additional factors the need to deter the particular type of offense, the extent of injury to innocent parties, whether complicity in the violation was widespread throughout the corporation, the level of intent on the part of the perpetrators, the degree of difficulty in detecting the particular type of offense, the presence or lack of remedial steps by the corporation and the extent of cooperation with the SEC and other law enforcement.
The SEC's statement cited the legislative histories of both the 1990 Securities Enforcement Remedies and Penny Stock Reform Act, which gave the SEC authority generally to seek civil money penalties in enforcement cases, and the Fair Funds provisions of SOX, which allowed the SEC to add penalties paid by individuals and entities to disgorgement funds for the benefit of victims. According to the statement, the Report from the relevant Senate committee regarding the Reform Act “expressly noted both that the civil money penalty provisions would be applicable to corporate issuers, and that shareholders ultimately may bear the cost of penalties imposed on corporate issuers. According to the Report, such penalties should be assessed when the securities law violation that is the basis of the penalty has resulted in an improper benefit to the shareholders. It also cautioned that the Commission and courts should, in considering corporate issuer penalties, take into account whether the penalty would be paid by shareholders who had been the principal victims of the violation.”
Crenshaw then goes on to explain why. First, she argues, “corporate penalties should be tied to the egregiousness of the actual misconduct—not just the benefit or impact on the shareholders.” Focusing on the impact on the wrongdoer's shareholders is misplaced: it is “common sense and bedrock to our law enforcement regime that worse conduct comes with stiffer penalties.” And, she later contends, the issue of the impact on shareholders should be viewed more comprehensively; to the extent the SEC considers the impact of the penalty on shareholders at all, it shouldn't limit its consideration to the wrongdoer's shareholders alone, but should examine the impact more broadly to include all investors, which would help ensure fair markets. Enforcement for everyone.
Her second point relates to the issue of looking at the presence or absence of a shareholder or corporate benefit to determine whether to impose a penalty. This threshold matter arises out of “the view that it is unfair to impose a penalty if shareholders will be harmed by that penalty, unless the shareholders also benefited from the violation.” But, she maintains, it's not so easy to calculate these benefits:
“This is because the shareholder benefit stemming from a violation is not limited to the assets the company acquired as a result of its violation, nor is it just the inflated stock price shareholders enjoyed. Corporate benefits include economic and intangible benefits that the company obtained when the market was in the dark about the full extent of the violation. How do we identify and measure the benefits conferred by a good reputation, or determine the impact of dripping bad information out through multiple disclosures over time? How do we adequately measure the impact fraud has on the market? Does undisclosed fraud effectively reduce a company's capital costs? And what if there is a stock buyback during the period the share price is inflated? Does that harm shareholders because the company is spending money to repurchase its stock, or does it actually further benefit them by potentially raising earnings per share (EPS)? And one significant benefit we seem to have overlooked is the benefit all investors receive by encouraging companies to obey the law or face penalties. If we are going to consider the benefit to shareholders, we need to consider all of the benefits.”
And why should a corporation get off the hook, she asks, just because it's difficult to quantify the benefit it received from its misconduct? That could allow companies to actually profit from their fraud.
What's more, Crenshaw also questioned the underlying premise that SEC penalties even harm investors. Are there any studies in support? What's more, if penalties have their intended positive impact—e.g., creating incentives to “remediate problems, strengthen internal controls, clarify lines of responsibility, and prioritize individual accountability”—then shareholders could actually benefit. Imposing penalties only when shareholders benefited from the violation means that “we're doing no more than disgorging the proceeds of corporate wrongdoing,” not motivating corporate compliance or even encouraging shareholders to invest in companies that do not engage in misconduct. In addition, she contends, higher penalties can be effective in deterring violations that are particularly hard to detect. In Crenshaw's view, the current approach “is likely to jeopardize the integrity of our capital markets in the long-term. Simply put, a single-minded focus on having companies pay a calculated corporate benefit will not appropriately deter fraud or ensure fair and efficient markets. If our penalties were limited in such a way, the price of getting caught might not be high enough to deter misconduct.”
Her prescription? As a preliminary matter, the SEC needs to gather more data to help make better assessments. Moreover, in assessing penalties, the SEC needs to take into account other factors, such as the extent of self-reporting of the misconduct, cooperation and self-remediation. In particular, because it “promotes and protects investors' long-term interests,” cooperation can play a significant role in reducing penalties. But it has to be meaningful cooperation—proactive, not just responsive, behavior, such as “a commitment to proactively identifying and remediating wrongdoing, as well as holding accountable those individuals responsible for misconduct.”
In addition, for the reasons discussed above, she advocates that the SEC essentially jettison the historic elements of the analysis related to corporate benefit and shareholder harm, and focus instead on “penalties that are based on the actual misconduct and reflect the extent of cooperation with the Division of Enforcement staff.”
The SEC should also consider the extent of harm to victims, the number of harmed investors (if known) and the difficulty of detection of the violation (to create a deterrent). She suggests that establishing fair funds to distribute penalties to victims of misconduct (including shareholders who are victims) may help to “strike the right balance.” And finally, she contends, the “pervasiveness or complicity within the organization is another relevant consideration. Corporate culture comes from the top, and there is a strong need to incentivize companies to foster a culture of compliance—not misconduct. If companies believe they can profit from violations and are unlikely to be caught, they are more likely to break the rules.” By imposing penalties that take these factors into account, the SEC “will be most effective in deterring harmful misconduct—and we should remember that deterrence was a primary reason the Commission was given penalty authority in the first place.”
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