In recent years the SEC has dramatically increased the size of civil penalties it seeks from companies accused of violating the federal securities laws. Critics questioned the SEC's lack of standards for determining such penalties and argued that the SEC's approach simply heaped additional punishment on the very same shareholders who were victimized by the company's violations. In an apparent attempt to address those criticisms, the SEC recently released a unanimous Statement setting out guidelines for imposing civil penalties on corporations that violate the federal securities laws. The SEC's guidance will interest any public company facing an SEC investigation.

This Update summarizes key issues addressed by the Statement.

The SEC's Statement

Two Principal Factors. The Statement provides that the SEC's determination of the appropriate civil penalty against a corporation (as opposed to an individual) will turn on two principal factors:

• The Presence or Absence of a Direct Benefit to the Corporation as a Result of the Violation.

If the corporation received a direct and material benefit from the offense, or was in any other way unjustly enriched, that weighs in support of imposing a penalty. The strongest case for a penalty is where shareholders have received an improper benefit; the weakest case is where the current shareholders are the principal victims of the securities law violation.

• The Degree to Which the Penalty Will Recompense or Further Harm the Injured Shareholders. There is a risk in some cases that innocent shareholders might bear the burden of penalties against a corporation. In other cases, the penalties might be used to recompense injured shareholders. The likelihood that the penalty will unfairly injure investors, the corporation or third parties weighs against imposing penalties. The presence of an opportunity to use the penalty as a meaningful source of compensation to injured shareholders weighs in favor of imposing penalties.

Other Factors.

In addition to identifying the two primary considerations upon which corporate penalties will turn, the Statement lists seven additional factors that the SEC will consider in determining whether to impose a financial penalty:

• need to deter the particular type of offense;
• extent of the injury to innocent parties;
• extent of complicity in the violation throughout the corporation;
• level of intent on the part of the perpetrators;
• degree of difficulty in detecting the particular type of offense;
• presence or lack of remedial steps by the corporation; and
• extent of cooperation with the SEC and other law enforcement agencies.

Two Cases Against Corporations Illustrate the Guidelines

In an attempt to illustrate the principles addressed in the Statement, the SEC simultaneously announced the settlement of two cases against corporations. In one case, McAfee, Inc. agreed to pay civil penalties of $50 million. In the other, Applix, Inc. paid no penalties. The Director of the SEC's Enforcement Division explained that McAfee's shareholders benefited from its fraud through acquisitions made with inflated stock. The shareholders in Applix did not directly benefit from its improper conduct.

In addition, the fraud at McAfee was pervasive and lasted for two years, whereas a small number of individuals were responsible for the fraud at Applix, which was limited to two discrete occasions. Moreover, McAfee is large and financially strong so that a penalty would not cause financial hardship to its investors. Applix is small and financially weak. The penalty required to effectively deter Applix's violations could greatly injure its shareholders and would not likely provide compensation to injured investors. The SEC is pursuing charges against three individuals responsible for the alleged fraud at Applix.

Impact of the Statement

Statement Reaffirms SEC's Commitment to Civil Penalties.

In announcing these principles, the SEC reaffirmed its commitment to the use of civil penalties, stating that "corporate penalties are an essential part of an aggressive and comprehensive program to enforce the federal securities laws." The SEC is likely to continue to levy penalties against companies at levels unprecedented before 2002. The Statement likewise suggests no change in the use of penalties in cases against individuals.

Effect of Cooperation with the SEC Unclear.

In a release known as the "Seaboard Report," the SEC previously set out factors that it will consider in determining how much credit (if any) to give a company for self-policing, self-reporting, remediation and cooperation with the SEC's investigation. The new Statement does not mention the Seaboard Report, but it does identify remediation and cooperation as factors it may consider in determining an appropriate civil penalty, and it emphasizes that management's response to alleged wrongdoing will continue to play a significant role in determining the propriety of a corporate penalty. Presumably the SEC will continue to apply the Seaboard Report factors in assessing a corporation's conduct after discovering a violation. However, the Statement raises some questions: for example, whether cooperation provides a mitigating factor or is a minimum requirement to avoid a higher penalty. Potentially troublesome is the SEC's assertion in the Statement that "it is incumbent upon management" to report securities law violations to the SEC.

Conclusion

The SEC's announcement of express criteria for determining whether to impose a financial penalty on a corporation will focus discussions between corporate defense counsel and the SEC enforcement lawyers. The Statement is a step — albeit a small one — towards increasing the transparency and predictability of SEC decisions concerning the assessment of corporate penalties.

Additional Information

You can find the full text of the SEC's Statement at http://www.sec.gov/news/press/2006-4.htm. You can find the full text of a speech by SEC Chairman Cox at http://www.sec.gov/news/speech/spch010406cc.htm. You can find the full text of a speech by Linda Chatman Thomsen, Director of the SEC's Division of Enforcement, at http://www.sec.gov/news/speech/spch010406lct.htm. You can find the SEC's press release announcing the McAfee settlement at http://www.sec.gov/news/press/2006-3.htm and the full text of the SEC's litigation release on the McAfee settlement at http://www.sec.gov/litigation/litreleases/lr19520.htm. You can find the SEC's administrative proceeding release regarding the Applix settlement at http://www.sec.gov/litigation/admin/33-8651.pdf. You can find discussion of other recent laws, regulations and rule proposals of interest to public companies on our website.