This article was originally published in Bloomberg Law. It is reprinted here with permission. Copyright © 2021 The Bureau of National Affairs, Inc.
Commissioners on the U.S. Securities and Exchange Commission have long debated whether, or to what extent, to impose penalties against corporations in SEC enforcement actions.
The Commission tried to resolve the issue 15 years ago through a unanimous policy statement that specified factors it will consider in assessing corporate penalties. Since then, however, the commissioners have been unable to agree on how to appropriately weigh the factors-or whether certain factors even warrant consideration. As a result, the framework isn't evenly applied.
In a recent speech before the Council of Institutional Investors, Commissioner Caroline Crenshaw urged her colleagues on the Commission to reconsider its framework for assessing corporate penalties in SEC enforcement actions. Corporate penalties, she reasoned, should be tied to the egregiousness of the misconduct, "without fear or favor," to deter misconduct, incentivize compliance, inspire investor confidence, and level the playing field for market participants.
This is, indeed, an appropriate time to rethink principles that guide the Commission's imposition of corporate penalties. The SEC is in a transitional phase; new leadership, new caselaw, and new priorities will reorient the Commission's enforcement agenda. The corporate penalties framework should face a reckoning.
Over the years, there has been bipartisan support for reframing or replacing the corporate penalties policy. But reframing the penalty factors will require the Commission to reevaluate assumptions that have riven the commissioners' views on corporate penalties-including whether corporate shareholders are harmed by penalties assessed in SEC enforcement actions.
It is worthwhile for the Commission to grapple with this issue, and others, to deliver a new penalties framework that provides clarity, consistency, and predictability.
A Cop on the Beat
Crenshaw's call to reconsider the SEC's framework for assessing corporate penalties comes at an interesting time. The Commission and its Division of Enforcement are in a transitional phase, as the SEC's acting chair and the acting director of Enforcement will likely give way to permanent replacements in the coming weeks.
There has been widespread speculation about what will count among the SEC's enforcement priorities under new leadership; Regulation Best Interest, private equity, and digital assets are on many lists. Most commentators agree, though, that Gary Gensler, President Joe Biden's pick to head the Commission, will live up to his reputation as a tough enforcer-a reputation he earned while serving as chairman of the Commodity Futures Trading Commission after the financial crisis.
Indeed, Gensler acknowledged the critical role of enforcement in prepared remarks he delivered during his nomination hearing before the U.S. Senate Committee on Banking, Housing, and Urban Affairs: "[W]e have seen that when the SEC does its job-when there are clear rules of the road and a cop on the beat to enforce them-our economy grows and our nation prospers."
Assuming Gensler is confirmed, many expect upticks in both the number of enforcement actions brought by the SEC and the amount of monetary penalties the Enforcement staff seeks in those actions.
Expectations of higher penalties are driven by more than just Gensler's enforcement philosophy. The SEC is also learning to work around challenges created by decisions the U.S. Supreme Court handed down in recent years. Notably, in Kokesh v. SEC, the court held that a five-year statute of limitations applies when the SEC seeks disgorgement of ill-gotten gains in an enforcement action. 137 S. Ct. 1635 (2017). Later, in SEC v. Liu, the court held that "disgorgement" should be limited to the proceeds of the alleged misconduct and that "legitimate" expenses should be excluded from the SEC's claims for disgorgement. 140 S. Ct. 1936 (2020).
Together, Kokesh and Liu place significant limitations on the SEC's ability to obtain disgorgement. (It should be noted that, in January 2021, Congress responded to challenges created by Kokesh and Liu by inserting a provision in the National Defense Authorization Act that establishes a ten-year limitations period for SEC disgorgement claims. But this new statutory authority appears to be only a partial fix and it has not yet been tested.)
To adjust for these new limitations, former Enforcement Director Stephanie Avakian explained that "you should expect to see some changes in the balance between the penalties and disgorgement that we seek and recommend to the Commission. Penalties may be higher in some cases where the statutory scheme permits us to do so." As explained below, that comprises most cases against corporations. And the willingness to seek higher penalties when it is programmatically expedient is striking.
Thus, there are new factors that will impact how the Commission assesses corporate penalties in the coming years. And it appears Gensler and Crenshaw would agree that the SEC must establish clear rules of the road for assessing corporate penalties.
Rules of the Road
The statutory provisions that authorize the SEC to impose civil monetary penalties on corporations give the Commission considerable latitude to determine the amount of a penalty.
Mechanically applied, the statutory penalty-per-violation framework could result in massive corporate penalties. For example, imagine a public company with 50,000 investors. The SEC could plausibly seek more than $40 billion in civil monetary penalties in an enforcement action charging the company with knowingly misleading its investors. See, e.g., Jonathan N. Eisenberg, Calculating SEC Civil Money Penalties, Harvard Law School Forum on Corporate Governance (Jan. 24, 2016).
But neither the Enforcement staff nor the Commission itself seeks to impose penalties of that magnitude in financial disclosure cases-in fact, they rarely seek to impose on corporations the maximum monetary penalty allowed by law.
The SEC's prosecutorial restraint in actions against corporations is rooted in a longstanding, mostly partisan debate about whether, or to what extent, to impose civil monetary penalties against corporations in settled enforcement actions.
The Commission tried to resolve this debate through its 2006 Statement Concerning Financial Penalties (the Penalties Statement), which sets out factors the Commission will consider in assessing "the appropriateness of a penalty on the corporation in a particular case." The factors include whether the corporation benefited from the alleged violation, whether a penalty will harm shareholders, whether there is a need to deter the particular type of misconduct alleged, whether the corporation took remedial steps, and the extent to which cooperation credit is appropriate.
As former Commissioner Daniel Gallagher put it, the Penalties Statement "represented an attempt to impose a rational analytic framework on an area of the SEC's enforcement program that had been characterized for too long by disorder and contentiousness."
In practice, the Penalties Statements has fallen short of its goal to bring order to the Commission's use of corporate penalties. Indeed, "while civil penalties against public companies have become increasingly routine ... , how those penalties are calculated and on what basis, and how the penalties relate to the underlying misconduct remains largely opaque." David Rosenfeld, Civil Penalties Against Public Companies in SEC Enforcement Actions, 22 U. Pa. J. Bus. L. 179 (2019).
Contributing to the opacity is a sense that the commissioners cannot agree on whether or when to rely on the Penalties Statement. To highlight just a few examples, in 2009, Commissioner Luis Aguilar described the Penalties Statement as "a first step to formalize the analysis of corporate penalties" and called on the Commission to "revisit the 2006 factors promptly." In 2013, Chair Mary Jo White asserted that the Penalties Statement "was not then, and is not now, binding policy for the Commission or the staff."
Later in 2013, Commissioner Daniel Gallagher acknowledged (but dismissed as a red herring) "questions ... about whether the Penalties Statement is binding on the Commission." In 2014, Commissioner Michael Piwowar warned that the Commission is "fail[ing] to follow our own publicly-announced framework for monetary penalties" and hinted that the Commission should replace the Penalties Statement. And in fall 2020, Commissioner Elad Roisman described the Penalties Statement as "a useful starting place," but conceded that it "cannot be used to determine a particular outcome in every case."
Even assuming commissioners would agree that the Penalties Statement sets out a " non-exclusive list of factors that may guide a Commissioner's consideration of corporate penalties," the commissioners cannot agree on how to balance the factors-like weighing the benefit of sending a strong message of deterrence against the risk that a large corporate penalty could harm shareholders. Aguilar and Crenshaw tend to focus more on the nature of the misconduct and the need for deterrence, while Gallagher and Piwowar tend emphasize the risk of harm to "innocent shareholders."
From a practitioner's perspective, this has created a system where settlement terms are often negotiated and agreed with reference to the penalty-or range of penalties-assessed in past enforcement actions involving similar allegations of misconduct, and not explicitly factors in the Penalties Statement. In the end, approved settlement terms often reflect the Commission's view on whether the penalty-or a variation on a penalty-assessed in a past action still "feels right."
Meanwhile, the risk of shareholder harm has become a major bone of contention in the debate around factors the Commission should consider in assessing corporate penalties. Republican commissioners believe the risk of harm should be the foremost consideration; Democratic commissioners question whether corporate penalties harm investors at all.
Unless resolved, the question of shareholder harm will continue to be a stumbling block that impedes efforts to revisit or rewrite the rules of the road for corporate penalties. And until the issue is resolved, the Commission will continue to follow–or not follow–the Penalties Statement.
Risk of Shareholder Harm
Crenshaw recognizes the shareholder harm debate as an impediment to an effort to correct course on corporate penalties. Therefore, to inform any Commission action relating to corporate penalties, she has called for data or studies that would explicate the degree to which "SEC penalties actually harm investors." There appears to be a limited body of scholarly work in this area, and more research is required.
One way to measure shareholder harm is to look at how the market reacts to the announcement of an SEC enforcement action against a public company (i.e., to gauge whether there are typically stock drops after an Enforcement press release).
To that end, Crenshaw pointed to a study in the Journal of Financial Services Research, which found that the market is "able to discriminate [enforcement actions] based on their severity." Indeed, the market tends to show a "weak reaction" to enforcement actions imposing civil money penalties, and a positive reaction to actions that are "perceived as a corrective mechanism." Both findings would seem to undermine the notion that enforcement actions, as a rule, harm (current) shareholders. See John Pereira, Irma Malafronte, Ghulam Sorwar & Mohamed Nurullah, Enforcement Actions. Market Movement and Depositors' Reaction: Evidence from the US Banking System, 55 J. of Fin. Servs. Res. 143 (2019).
These conclusions are consistent with the market's reaction to several high-profile enforcement actions announced during the SEC's Fiscal Year 2020 and highlighted in the Enforcement Division's 2020 Annual Report.
Take, for example, the SEC's action against brand-management company lconix Brand Group Inc. in December 2019. The SEC charged the company with a fraudulent scheme to create fictitious revenue in order to beat analysts' projections. To settle the matter, lconix agreed to injunctive relief and to pay a $5.5 million penalty. The company's stock price ticked up immediately after the SEC announced the enforcement action and continued to trade above the pre-announcement price one week after the enforcement action was announced.
Also, in December 2019, the SEC charged Sweden-based Telefonaktiebolaget LM Ericsson with a wide-ranging foreign bribery scheme. To resolve alleged violations of the Foreign Corrupt Practice Act (FCPA), as well as charges in a parallel criminal matter, Ericsson agreed to pay more than $1 billion to the SEC and the U.S. Department of Justice and to install an independent compliance monitor. The market had a muted reaction to this arguably more severe enforcement action. Ericsson traded up, slightly, on the day of the announcement; and one week after the announcement the stock price had fallen approximately 1.8% from its pre-announcement share price.
The market had a similarly weak reaction after the SEC announced in June 2020 that Switzerland-based pharmaceutical company Novartis AG would pay $112 million to settle alleged violations of the books and records and internal accounting controls provisions of the FCPA. The company's stock priced ticked up the day the enforcement action was announced, but dipped slightly the following day. One week after the announcement, Novartis was trading down approximately 1.4%.
In September 2020, the SEC charged Germany-based automaker BMW AG and two of its U.S. subsidiaries for disclosing misleading information about BMW's retail sales volume in the U.S. To settle the charges, the companies agreed to pay a joint penalty of $18 million and to cease and desist from future disclosure violations. Again, the company's stock price ticked up on the day of the announcement; and one week later, the share price was trading up approximately 4.4%.
GRAPHIC: Market Reaction to Enforcement
Four enforcement actions provide a decidedly small sample set, but this cursory review and empirical studies in a similar vein make clear that the question of whether SEC penalties actually harm investors requires further study. It is unclear, for example, in what circumstances an enforcement action might move the market-and potentially harm shareholders. Does the size of the penalty matter? Does the (perceived) severity of the charges matter? Does the existence of parallel criminal proceedings matter? How often might one infer that the market reacted positively to the news? Do any such movements appear to have lasting effect (or at what point might one attribute price movement to other news/factors that changed to total mix of available information)?
Until the Commission answers questions like these, the investor harm issue will continue to be a roadblock to any efforts to overhaul the Commission's corporate penalties framework.
The commissioners must move beyond the truism that enforcement actions harm investors. Regardless of what the findings reveal, understanding whether or how SEC enforcement actions harm shareholders will help pave the way to a new policy.
Promoting Clarity, Consistency, and Predictability
In 2006, the Penalties Statement was issued to provide "clarity, consistency, and predictability." What is clear 15 years later is that the Commission should forge a new path. That much is not a partisan issue.
Commissioners on both sides of aisle have called for the Commission to reimagine its framework for assessing corporate penalties. For example, in 2013, Aguilar urged the Commission "to publish a new Penalty Statement that appropriately focuses on deterring misconduct;" he even proposed factors that should be included in a revised statement. Similarly, in 2014, Piwowar invited "a discussion about our analytical framework for corporate penalties," noting that "[i]f we decide to replace the 2006 penalty statement with a revised analytical framework ... , then my preference is to do it through an interpretative release by the Commission subject to the public notice-and-comment process."
In her March 2021 speech, Crenshaw joined the chorus encouraging the Commission to go in a new direction. "[A] decision made 15 years ago has taken us off course," she argued, "[and] changing tack now will yield better outcomes."
It is, indeed, time to consider replacing the Penalties Statement with a new framework. The staff, companies that may become subjects of SEC enforcement actions, defense counsel who represent those companies, the market, and the investing public would all benefit from a policy that delivers the clarity, consistency, and predictability the Commission sought to impart with its first Penalties Statement.
