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Should the SEC Have Power to Impose Higher Penalties?

Bruce Carton | October 10, 2012

Last November, U.S. District Judge Jed Rakoff rejected the proposed $285 million settlement between the Securities and Exchange Commission and Citigroup related to allegations of improper tactics by Citigroup on the sale of mortgage-backed securities. There were many parts of the proposed settlement that failed to meet Judge Rakoff's approval, including the fact that the SEC settled the case without requiring Citigroup to admit or deny liability. Another factor, however, was the fact that Judge Rakoff deemed the penalty portion of the settlement—$95 million—to be mere “pocket change” to Citigroup.

Judge Rakoff pointed out that Citigroup had made $160 million in profits off of the questionable transactions and that investors in these securities lost almost $700 million. He found that under the circumstances, a $95 million penalty was simply a “mild and modest cost of doing business” for Citigroup.

Given the high-profile scrutiny Judge Rakoff gave to the SEC-Citigroup settlement, the SEC probably would have been pleased if it could have imposed a significantly greater penalty against Citigroup. The agency was limited, however, due to restraints in the law governing the penalties the SEC may levy against defendants. In an unusual “public statement” posted on the SEC's Website the same day Judge Rakoff rejected the settlement, Enforcement Director Robert Khuzami explained:

Although the court questions the amount of relief obtained, it overlooks the fact that securities law generally limits the disgorgement amount the SEC can recover to Citigroup's ill-gotten gains, plus a penalty in an amount up to a defendant's gain. It was for this reason that we sought to recover close to $300 million—all of which we intended to deliver to harmed investors. The SEC does not currently have statutory authority to recover investor losses.

Khuzami did not address why the proposed $95 million penalty did not at least match Citigroup's alleged ill-gotten gain of $160 million.

That same day, SEC Chair Mary Schapiro went a step further, and tried to use the lemons of the Citigroup case to make lemonade. Schapiro sent a letter to Senator Jack Reed (D., R.I.) and Senator Mike Crapo (R., Idaho), the ranking members of the Senate banking subcommittee on securities, asking for a change in the SEC's authority to obtain penalties. Under current law, the SEC may penalize individuals a maximum of $150,000 per offense, and institutions a maximum of $725,000 per offense. Alternatively, as alluded to by Khuzami, the SEC is authorized to assess penalties capped at the “gross amount of ill-gotten gain” to the defendant in a federal court case.

Schapiro stated that these restraints left the agency with inadequate penalty authority because the gross amount of the pecuniary gain to a defendant may be small in relation to the seriousness of the violation and the resulting harm to investors. This was particularly true, she argued, in frauds involving misrepresentation of a public company's financial condition. Such cases often result in a relatively small financial gain to the company itself or its executives, but enormous losses to innocent investors. Echoing one of Judge Rakoff's criticisms, Schapiro argued that in such cases the maximum penalty available to the Commission “may not adequately reflect the seriousness of the violation or the impact on victims of the fraud.”

Given the high-profile scrutiny Judge Rakoff gave to the SEC-Citigroup settlement, the SEC probably would have been pleased if it could have imposed a significantly greater penalty against Citigroup.

Senator Reed responded this July by announcing that he and Senator Charles Grassley had introduced bipartisan legislation called “The Stronger Enforcement of Civil Penalties Act of 2012,” (also known as the SEC Penalties Act) which was designed to expand the SEC's authority as Schapiro had requested. Drawing on specific suggestions made by Schapiro and the SEC staff, the bill provides for increased statutory limits on civil monetary penalties. In the most serious cases, where “fraud, deceit, manipulation, or deliberate or reckless disregard of a regulatory requirement that resulted in substantial losses to victims or substantial pecuniary gain to the violator” is alleged, penalties for each violation are authorized up to the greater of (a) $1 million for individuals or $10 million for entities, (b) three times the gross pecuniary gain, or (c) the losses incurred by victims as a result of the violation.

In addition, the bill comes down hard on repeat securities law violators, and provides that the maximum penalty for these offenders can also be tripled. Sen. Grassley stated his belief that the greater fines allowed under the bill, particularly for recidivists, would get the attention of business. “If a fine is just decimal dust for a Wall Street firm, that's not a deterrent. It's just the cost of doing business.  A penalty should mean something …,” he said

On the day it was introduced, the SEC Penalties Act was referred to the Senate Committee on Banking, Housing, and Urban Affairs, where it remains to date. As a bipartisan bill with the support of the SEC and presumably the president, many commentators believe that the bill is likely to become law without significant opposition. If this is true, what are the likely implications of the SEC Penalties Act and are they desirable?

Proponents of the bill such as Chairman Schapiro believe that increased penalties will enhance the effectiveness of the SEC's enforcement program by deterring individual and corporate violators. Beyond deterrence, the enhanced penalties may allow the SEC to better structure its settlements to meet the severity of the alleged violation, and improve the SEC's bargaining power in settlement negotiations.

In a case such as Citigroup, for example, the SEC would not have been limited to a maximum penalty of $160 million in its settlement. Instead, it could have sought a penalty equal to three times Citigroup's gain of $160 million ($480 million) or equal to the losses incurred by victims ($700 million). Another likely result of the bill's provision for penalties in administrative actions is that the SEC will seek penalties in a greater number of its matters, perhaps emboldening it to become more aggressive in its enforcement efforts.

Not everyone agrees that the bill and its increased penalties are the solution to securities fraud, however. Some lobbyists believe that despite the bipartisan nature of the bill, it may still face a challenge from House Republicans who have demonstrated that they are philosophically opposed to giving the SEC any more resources or power without first seeing structural changes that they have been seeking at the agency for some time now.

Others such as Russell Ryan, a former SEC enforcement official who is now a partner at the law firm of King & Spalding, take issue with the bill itself. Ryan notes that if the SEC Penalties Act does become law, it will mark the sixth time Congress has raised SEC penalties in the past 30 years—this despite “scant evidence that increasing penalties again would improve deterrence or financial compliance.” On the flip side, he argues, there are real concerns with further increases to SEC penalties that are being ignored in the rush to be tough on fraud.

First, Ryan says, each enhancement to SEC penalties further blurs the line between the SEC's role of civil regulatory enforcement and criminal punishment. Unlike the Department of Justice, the SEC is an independent agency run by unelected officers who are not removable at will by the president. In addition, he says, SEC enforcement actions do not carry with them many of the due-process safeguards that exist in criminal cases. For example, in SEC cases the burden of proof is a “preponderance of the evidence” rather than the much tougher “beyond a reasonable doubt” standard used in criminal cases; the SEC can use a defendant's silence as evidence of his or her culpability; and there is no Sixth Amendment right to counsel for those who cannot afford a lawyer.

The due process concerns are exacerbated even further by a provision in the SEC Penalties Act that also extends the new, higher penalties to SEC administrative proceedings. Unlike federal court cases, administrative proceedings are conducted and decided by SEC employees, rather than independent judges or juries. In short, Ryan argues, “draconian SEC penalties constitute punishment that warrants the full panoply of due-process rights before they are imposed.”

As we head toward November elections, it remains unclear whether the SEC Penalties Act will make it to a vote this year. If the bill is not signed into law during the current session of Congress which ends in December 2012, its sponsors will need to reintroduce it in the next session, which begins in January 2013. Neither Senator Reed nor Senator Grassley is up for reelection, so they will presumably be on hand to reintroduce the bill, if necessary. The results of the November election could immediately lead to changes in some or all of the remaining key parties involved, however, including the president, members of Congress, and the chairman of the SEC.