If you or your company has ever been involved in a long SEC enforcement investigation, you’ve probably gone through the five stages of grief?denial that you did anything wrong, anger that the enforcement lawyers are pursuing you, hope that things won’t turn out too badly, depression that it appears they will, and finally acceptance that it’s best to resolve the matter and move on even though you think the outcome is unfair.
One of the stumbling blocks in the final stage is grappling with the amount of the money penalty, i.e., the fine on top of any other remedies, such as bars, suspensions, and disgorgement of ill-gotten gains. Between 2004 and 2013, the SEC obtained orders in judicial and administrative proceedings requiring defendants and respondents to pay $8.9 billion in money penalties. In financial crisis cases alone, the SEC obtained money penalties of $1.64 billion?far more than it obtained in disgorgement. On at least a dozen separate occasions over the past few years, banks and other financial institutions have settled SEC actions with fines ranging from $50 million to over $500 million, and have paid even more in actions brought by the Department of Justice and state attorneys general. Individuals are being hit with fines as well -- as much as $22.5 million in an SEC financial crisis case and $93 million in an SEC insider trading case. Other than negotiations about the wording of settlement documents, agreeing to the amount of the money penalty is often the last barrier to resolution. And it’s one of the most frustrating because the amounts proposed may appear untethered to any principle or precedent..
In an effort to provide more clarity on SEC money penalties, we look at four sources that should inform the negotiations about those penalties: first, the explosive growth in the SEC’s authority to impose civil money penalties; second, the relevant statutory language since the SEC’s authority to impose civil money penalties ccomes from and is limited by Congress; third, two recent D.C. Circuit decisions making clear that there are meaningful limits on the Commission’s discretion in assessing money penalties; and fourth, the outcome in recent cases before SEC administrative law judges in which the amount of the penalties was contested.
I. A Brief History of the SEC’s Penalty Authority-- From Tiny Acorn to Mighty Oak
It might surprise some readers to learn that for the first 50 years of its existence, the SEC had no authority to obtain money penalties. The SEC could go to court to seek an injunction to stop ongoing violations or prevent future ones, it could seek a court order directing a defendant to hand over ill-gotten gains resulting from violations, and it could bar securities firms and professionals from the securities industry. But the SEC was not in the money penalty business. The same Congress that created the SEC granted prosecutors in criminal cases, not the SEC, authority to seek money penalties. Criminal cases are generally reserved for the most serious violations, and defendants in criminal cases have a variety of safeguards, including a right to a jury trial.
But all good things come to an end. In 1984?the same year that Fantasy Island, Three’s Company, Happy Days, Captain Kangaroo, and the Dean Martin Celebrity Roast went off the air?a new, tougher era also began at the SEC. Congress started slowly and cautiously. In the Insider Trading Sanctions Act of 1984, it granted the SEC authority to seek money penalties, but only for insider trading violations and only by going to court. It set the maximum penalty at three times the profit gained or loss avoided resulting from the insider trading violation.
Four years later, Congress passed the Insider Trading and Securities Fraud Enforcement Act of 1988. It gave the Commission authority to seek penalties against controlling persons of persons who traded on inside information. Again, however, Congress limited the penalty authority to insider trading violations, and required the Commission to go to court to prove its right to a penalty.
Two years later the tiny penalty acorn exploded into a mighty oak. As part of the Securities Enforcement Remedies and Penny Stock Reform Act of 1990, Congress authorized the Commission to go to court to seek civil money penalties against any person who violated any of the four principal securities statutes. In court cases, the Commission could obtain a maximum penalty equal to the amount the defendant made from the violation. Thus, for example, if the Commission proved that a defendant made $10 million from a securities violation, for the first time it could potentially obtain a $10 million penalty on top of the $10 million in disgorgement. Alternatively, it could obtain different tiers of fines in the amounts discussed below for “each violation” of the securities laws.
The Act also gave the Commission authority to impose money penalties in its own administrative proceedings against regulated persons and companies. Those penalties apply to “each act or omission” violating the securities laws. Depending on nature of the violation, they now range from a maximum of $7,500 to $160,000 for individuals and from $80,000 to $775,000 for companies for “each act or omission” violating the securities laws.
Finally, in 2010 Congress wrote into Section 929P of the 2,200-page Dodd-Frank Wall Street Reform and Consumer Protection Act yet further penalty authority for the SEC. For the first time, the Commission can impose money penalties in its own administrative proceedings against any person the Commission claims violated the securities laws, regardless of whether that person or firm is in the securities business. The Commission can impose the penalty by finding that the violation was “willful” (which in SEC parlance requires no culpability at all) and that the penalty is in the “public interest,” which is short-hand for a laundry list of factors covering everything from culpability to “such other matters as justice may require.”
In short, the change in the Commission’s penalty authority has been breathtaking. An agency that for 50 years could not even go to court to seek a money penalty, and later could seek penalties only for insider trading violations and only by going to court, can now bring its own administrative proceedings to assess money penalties against anyone for any alleged securities violation. Commission administrative proceedings, unlike court cases, have significant disadvantages for respondents?for example, there is no right to a jury trial, very limited discovery rights (compared to massive investigative powers for the Division of Enforcement), an absence of motions practice, shorter deadlines, a less strict application of the rules of evidence, and an initial appeal to the very Commission that authorized the case. Even New York Times columnist Gretchen Morgenson, who almost never writes a column sympathetic to defendants, wrote in an October 5, 2013 column that authorizing the Commission to seek money penalties in proceedings before SEC administrative law judges raised a serious issue of fairness and “home-court edge” for the Commission.
II. Statutory Language and the Multiplicity Issue
In SEC administrative proceedings, there are three tiers of maximum penalties. For any violation of the four principal securities statutes, the statute authorizes the SEC to impose a first-tier money penalty of no more than $7,500 for an individual and $80,000 for a company for “each act or omission” violating the securities laws. For violations involving at least reckless misconduct, the statute authorizes the SEC to impose a second-tier money penalty of no more than $80,000 for an individual and $400,000 for a company for each such act or omission. For violations involving at least reckless misconduct that also create a significant risk of substantial losses to other persons or result in a substantial pecuniary gain to the alleged wrongdoer, the statute authorizes the Commission to impose a third-tier money penalty of no more than $160,000 for an individual and $775,000 for a company for each such act or omission. The tiers are the same in SEC court cases, except that in a court case the SEC has the option of seeking, instead, a penalty equal to the defendant’s gain from the violation (which is why the fine in many court cases is the same as the amount of disgorgement).
The principal challenge is figuring out what “each act or omission” or “each violation” means in the context of violations that may involve hundreds or even thousands of arguable acts and omissions. The act or omission has to involve a violation of the securities laws, but that tells us very little. For example, has a company that sends an allegedly misleading prospectus to 100,000 investors engaged in a single violative “act or omission” or “violation” or, instead, 100,000 violative acts or omissions. Theoretically, that could be the difference between a maximum $775,000 fine and a $77.5 billion fine. This is why it’s critical to look beyond the statutory language to court cases and administrative law judge precedents to understand the limits on the SEC’s money penalty authority.
III. The Requirement of Sanction Consistency
The D.C. Circuit has jurisdiction to hear petitions to review SEC disciplinary actions, and has a history of reviewing SEC decisions carefully and often skeptically. Its decision in Rapoport v. SEC, 682 F.3d 98 (D.C. Cir. 2012), is important to understanding the limits on the Commission’s discretion in assessing money penalties and should inform settlement negotiations even when a case is not litigated to conclusion.
In 2008, the SEC filed an administrative proceeding against Dan Rapoport, a resident of Russia, in which it claimed that Rapoport violated the registration provisions of the Securities Exchange Act by effecting transactions in securities without being registered as a broker or being associated with a registered broker-dealer. Mr. Rapoport didn’t respond, but after the administrative law judge imposed a $315,000 penalty against him, Mr. Rapoport thought again. He first asked the Commission to set aside the default judgment and, when that failed, he successfully petitioned the D.C. Circuit to vacate the judgment.
Of particular significance, the court faulted the administrative law judge’s explanation of the penalty calculation. The administrative law judge had acknowledged that he had to decide “whether to treat the entire course of conduct as a single act or as a series of acts, as to which multiple penalties will be appropriate.” He then imposed a second-tier penalty and multiplied it by five?once for each year that the alleged misconduct occurred. In reversing, the D.C. Circuit stated, “These calculations do not follow the formula set by the statute. To impose second-tier penalties, the Commission must determine how many violations occurred and how many violations are attributable to each person, as the statute instructs.” Lest there be any doubt about what it thought of the administrative law judge’s decision, it went on to state that the analysis “was not just superficial; it was non-existent.”
As we discuss below, administrative law judge decisions since Rapoport have addressed the bases for their determination of the number of separate violative acts/ omissions. In fact, they now often cite Rapoport. This is creating a body of precedent that will be instructive in other cases. Elsewhere in its Rapoport opinion, the D.C. Circuit stated that “agencies must apply their rules consistently” and “may not depart from their precedent without explaining why” and it criticized the Commission for “not provid[ing] a consistent interpretation of the Rule [related to default judgments] nor justif[ying] the apparent inconsistency of its application.” There is every reason to believe that the court would apply those same considerations to penalty calculations.
The D.C. Circuit’s recent decision in Collins v. SEC, No. 12-1241 (D.C. Cir. Nov. 26, 2013), is also instructive. There, the court upheld the Commission’s imposition of a $310,000 civil penalty against attacks that it was arbitrary and capricious and violated the Excessive Fines Clause of the Eighth Amendment. But while upholding the penalty in that case, the court compared the penalty to penalties in other SEC cases and made clear that a lack of consistency could result in reversal in future cases: “Review for whether an agency’s sanction is ‘arbitrary or capricious’ requires consideration of whether the sanction is out of line with the agency’s decisions in other cases.”
IV. Recent Administrative Law Judge Decisions on Money Penalties
SEC administrative law judge decisions in litigated cases involving money penalties are an especially important source of precedent for determining the number of violative acts and omissions and the amount of penalties. It is one thing to allow inconsistent results in penalty determinations among a large number of district courts and juries throughout the country; it would be quite another to allow inconsistent results among just three administrative law judges within a single agency. The result is that precedents set by SEC administrative law judges are potentially important limitations on the ability of the Division to make inconsistent arguments in future cases. A review of three recent examples?one from each SEC Administrative Law Judge?shows how informative they can be.
In a December 6, 2013 decision, Administrative Law Judge Cameron Elliot found that a nationally syndicated radio show host and author of three books had, over a period of years, conducted seminars for roughly 50,000 people in which he presented back-test data that were misleading in multiple respects. In the Matter of Raymond J. Lucia Companies, Inc. and Raymond J. Lucia, Sr., Initial Decision Release No. 540 (Dec. 6, 2013). In determining the penalty, Judge Elliott did not multiply the third-tier maximum by 50,000 attendees or by the dozens of seminars at which the allegedly misleading information was presented or by the number of misrepresentations or omissions. Instead, Judge Elliott imposed a penalty of $250,000 against the company and $50,000 against the individual?which was approximately one third of what could have been assessed for a one violative act/omission third-tier penalty. In assessing the penalty, Judge Elliott stated that although the respondents “technically violated the statute hundreds of times,” imposing penalties on that basis “would plainly be disproportionate and unreasonable.” Indeed, the Division of Enforcement itself sought only a one-time, tier-three penalty, and Judge Elliott reduced that by nearly two thirds.
In an August 2, 2013 decision, Administrative Law Judge Carol Fox Foelak found that over a multi-year period three individuals violated antifraud provisions while employed at a broker-dealer owned by “convicted Ponzi-schemer R. Allen Stanford.” In the Matter of Daniel Bogar, et al., Initial Decision No. 502 (Aug. 2, 2013). In deciding on an appropriate penalty, Judge Foelak did not add up the number of misrepresentations or omissions, or the number of misleading documents, or the number of investors who received the allegedly misleading communications. Instead, Judge Foelak assessed a two violative act/omission penalty ($260,000 for each respondent) based on there being “two courses of action”?a primary violation and a secondary violation.
Finally, in a June 7, 2013 decision, Chief Administrative Law Judge Brenda Murray found that between October 2008 and March 2010, a clearing firm violated Reg SHO (related to short sales) 1200 times; that its client committed fraud in connection with 390 separate trades; and that the CFO of the clearing firm aided and abetted the violations. In re optionsXpress, Inc., et al., Initial Decision No. 490 (Jun. 7, 2013). Applying the third-tier maximum penalty to each trade would have resulted in an $870 million penalty against the company. Chief Judge Murray stated that a “literal application of the each act or omission language would have an absurd result,” and imposed a penalty of $2 million, which she pointed out amounted to $1,667 for each of the 1,200 Reg SHO violations exclusive of the aiding and abetting violations. She imposed the same penalty of $2 million on the customer, which she stated amounted to $5,128 for each of the 390 violations. And she imposed a $75,000 fine on the CFO, which is what the Division recommended. She stated that the result was “[w]ith deference to Rapoport and to a reasonable outcome….”
In each of these cases, which are offered only by way of illustration, the risk of multiplicity was significant if the statute had been read too literally. The risk did not materialize. The administrative law judges dealt with the problem by concluding there were only one or two units of violation for purposes of the civil money penalty statute or by reducing the fine for each act/omission from a maximum of $750,000 to $1,667?a reduction of 99.8%.
In addition to analyzing the number of units of violation, the administrative law judges invariably analyze the factors courts have held are relevant to the “public interest” determination: the egregiousness of the actions, the isolated or recurrent nature of the infraction, the degree of scienter involved, the sincerity of the respondent’s assurances against future violations, the respondents recognition of the wrongful nature of his or her conduct, the likelihood that the respondent’s occupation will present opportunities for future violations, whether the conduct created substantial losses or the risk of substantial losses to other persons, lack of cooperation or honesty with authorities, and whether the penalty should be reduced due to respondents’ demonstrated current and future financial condition. Even when they found such factors justified a “severe” money penalty, they assessed amounts that came to no more than a few “units of violation.” The “public interest” requirement provides a second-level limitation on the size of the fine that can be imposed in an administrative proceeding.
V. Flip Flopping on Public Company Penalties
Imposing penalties on public companies has long been controversial because those costs are often borne by innocent shareholders already harmed by the company’s misconduct. Unfortunately for public companies, the SEC’s earlier concern about punishing innocent shareholders no longer appears to resonate with a majority of the Commissioners.
Thus, 1) the Cox Commission’s January 4, 2006 “Statement Concerning Financial Penalties,” which emphasized the importance of considering harm to shareholders before imposing penalties on public companies, and its Penalty Pilot program, which required the Division of Enforcement to seek special approval from the Commission before seeking to negotiate monetary fines for public companies, was followed by 2) Chairman Mary Schapiro’s February 6, 2009 speech in which she announced the termination of the pilot program in order “to ensure that justice is swiftly served to those public companies who commit serious acts of securities fraud,” and by some of the largest fines ever imposed by the SEC on public companies, which in turn was followed by 3) Chairman Mary Jo White’s September 26, 2013 speech in which she stated that the 2006 Release on Corporate Penalties was “not binding” on the Commission and that she would support legislation to allow the SEC to impose even larger fines.
All of this leaves us with five important lessons:
The statutory language has both helpful and unhelpful parts for a defendant. A $775,000 cap on penalties for a corporation’s reckless or knowing violation of the securities laws (or, if higher and in a court case, a penalty no more than defendant’s ill-gotten gains) is a helpful limitation. On the other hand, the language in the statute making the penalty applicable to each violative “act or omission” is unhelpful.
The relevant precedent in litigated administrative law judge decisions shows that administrative law judges do not take a literal approach in applying the “each act or omission” language and that the Division of Enforcement itself ordinarily does not take a literal approach. Even when the administrative law judges found tier-three misconduct meriting a severe penalty, they generally found a very small number of actionable acts and omissions for penalty purposes or achieved the same result by drastically reducing the amount of the fine per act/omission. The “public interest” standard, which must be satisfied to impose any penalty in an administrative proceeding, provides a second-level check against the imposition of fines disproportionate to the violation.
In determining whether a penalty is arbitrary and capricious, the D.C. Circuit will look carefully at whether the penalty is consistent with penalties in similar cases and, if not, whether there is a strong articulated rationale for the departure. Especially after the D.C. Circuit’s decision in Rapoport, the burden falls on the Commission to explain how many separate violative “acts or omissions” it is claiming for money penalty purposes. Administrative law judges are routinely deciding these issues in litigated cases.
Given the courts’ focus on consistency, counsel are well advised to familiarize themselves with the way SEC administrative law judges analyze the penalty issue in contested cases. For example, even if an overly literal approach to the statute might support an interpretation suggesting many separate “acts or omissions” in a particular case, if administrative law judges found that analogous securities violations involved only one or two such “acts or omissions” for money penalty purposes, the analysis in those cases should control.
Whatever sympathy the Commission once had for the argument that severe penalties should not be imposed on public companies because those penalties harm innocent shareholders, that argument no longer appears to resonate with a majority of the current Commission.
Does any of this mean that money penalties can be calculated based on a mechanical formula? No, but it shows how important advocacy is on the issue of penalty amounts. As the above analysis shows, the Commission has an obligation to be consistent, precedent in contested cases is critical, the body of precedent that already exists in these cases is helpful, there is an opportunity for meaningful negotiations based on these precedents and, if settlement negotiations fail, there is an opportunity for meaningful appellate review of sanctions in the D.C. Circuit.
 On January 27, 2014, the Committee on Capital Markets Regulation reported that total financial penalties paid by financial institutions in the United States rose from $123 million in 2009 to $31.3 billion in 2012 and $43.4 billion in 2013.
 Apart from these penalties, the SEC may obtain a fine of up to three times the profit gained or loss avoided for insider trading violations, and there are separate provisions that govern the potential fines against “controlling persons” of the insider trader. There are also separate provisions governing fines for violations of the Foreign Corrupt Practices Act and the failure to file certain information with the Commission.