SEC’s Crenshaw throws down gauntlet: Large fines are good fines

Caroline Crenshaw, a Democrat, told the Council of Institutional Investors during a virtual conference Tuesday that “corporate penalties should be tied to the egregiousness of the actual misconduct—not just the benefit or impact on the shareholders.”

She then took that reasoning a step further.

“It is clear to me that the Commission has historically placed too much emphasis on 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,” she said. “This approach is fundamentally flawed. This approach, more concerningly, could allow companies to profit from fraud as it unnecessarily limits the Commission’s ability to craft appropriately tailored penalties that more effectively deter misconduct. If we are going to confront the novel issues today’s markets present and deter ever more complicated and hard-to-detect frauds, we must revisit our approach.”

At the moment, Crenshaw is part of a 2-2 Democratic/Republican split of the Commission. But she will be in the majority if Biden’s nominee for SEC chair, Gary Gensler, is confirmed as expected next week. This political calculation is important to consider, particularly since Gensler indicated a willingness in his Senate confirmation hearing to rework securities laws to promote Biden’s political priorities in areas as varied as climate change; environmental, social, and governance (ESG) issues; and boardroom diversity.

Crenshaw’s insistence the SEC ought not to consider the effect of large corporate fines on shareholders runs against the grain of more than a decade of conventional wisdom at the agency, embodied in this 2006 statement issued by unanimous vote of the then-commission.

The appropriateness of an SEC penalty, the 2006 statement suggested, should be based on whether the company received a direct material benefit from the misconduct targeted by the fine, as well as the degree to which the penalty will harm shareholders. The statement made the argument that in some cases, shareholders of the wayward corporation were as much damaged by a large fine as the victims of the crime at issue.

“The likelihood a corporate penalty will unfairly injure investors, the corporation, or third parties weighs against its use as a sanction,” the statement read.

Fines should act as a deterrent, the SEC said at the time, if the particular type of illegal activity is endemic in the market; if the violation of law deliberately harmed another party; if it is part of a corporate-wide practice; or if it is particularly hard to detect. If none of these factors are at play, the SEC might consider reducing the size of its fine against a corporation in order to protect shareholders.

The argument was that shareholders of a misbehaving company may have unwittingly benefitted from violations of securities laws and shouldn’t be punished for the actions of a few rogue corporate actors.

But Crenshaw argues measuring the benefits of a fraud to stockholders in this manner is too narrow.

“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?” she asked. “How do we adequately measure the impact fraud has on the market?”

She then argues a large fine might actually improve a corporation’s financial performance in the long run, particularly as it relates to strengthened compliance with securities law.

“If the penalties are sufficiently high to motivate the company to remediate problems, strengthen internal controls, clarify lines of responsibility, and prioritize individual accountability, those are all changes that likely lead to better future outcomes, and higher profits for shareholders,” she said.

Crenshaw is only one member of the SEC, but she is speaking from the soon-to-be majority side of the aisle. Under a Biden SEC, strong corporate compliance programs will be more important than ever. Done well, compliance can detect and root out wrongdoing before it rises to the SEC’s attention or can act as a firm’s best defense against punishment.

The tide has officially turned, corporate America. The SEC is returning to a previous position of measuring the agency’s success by the size and number of the fines it levies. Time to get your houses in order.