The U.S. Securities and Exchange Commission (SEC) has not been shy about promoting its use of monetary punishments under new Chair Mary Jo White.1 In September 2013, White asserted that “we must make aggressive use of our existing penalty authority, recognizing that meaningful monetary penalties—whether against companies or individuals—play a very important role in a strong enforcement program.”2 Co-Director of Enforcement Andrew Ceresney was even more blunt in an address several days later: “Monetary penalties speak very loudly and in a language any potential defendant understands . . . . Enforcement needs to be aggressive in our use of penalties.”3

Although the rhetoric is new, the SEC’s growing reliance on monetary penalties preceded White’s appointment.4 The amount of penalties that the SEC has assessed against securities law violators in judicial and administrative proceedings since 1990 has increased at a calculated annual growth rate of 22%, compared to only a 4% increase in total cases filed annually.5 Since 2000, the growth has been even more striking: penalties have grown 30% year-over-year, compared to 3% growth in cases filed. The maximum fee assessed has also skyrocketed: Xerox’s 2002 $10 million civil penalty was then “the largest ever levied in a Commission action against a public company for financial fraud.”6 By 2006, one commentator noted that “[t]oday, a $10 million SEC penalty would probably be considered a ‘victory’ for most entities settling SEC fraud charges.”7 From 2000-2013, the mean payment by corporate defendants in SEC issuer reporting and disclosure cases was $57.9 million.8 Although that figure includes several outliers, the median payment was still $9 million.9

Despite the increase in the sums assessed, most of the money collected goes where it always has: to the U.S. Treasury General Fund. Compensating harmed investors was not historically an agency priority,10 but the Sarbanes-Oxley Act of 2002 (SOX) fundamentally shifted the SEC’s approach to distributing funds collected—at least nominally. Section 308 authorized the SEC to use penalty funds, in addition to disgorgements, to compensate harmed investors via Federal Account for Investor Restitution (Fair) Funds. The agency’s response has been seemingly enthusiastic, with multiple proclamations about its efforts on behalf of shareholders.11 However, based on an analysis of SEC data, this enthusiastic rhetoric does not reflect reality. Efforts to distribute funds to harmed investors have tapered off over time, such that the vast majority of sums collected are still deposited in Treasury’s General Fund. This ensures that the SEC contributes more revenue to the government than any other independent agency.12

Figure 1.

growth in sec monetary punishments compared to enforcement actions13

The dramatic increase in monetary sanctions with minimal changes in the location to which the money goes raises certain questions: Does the new strategy improve the SEC’s efforts to police the securities markets and protect investors? What are the strategy’s larger implications for corporations and their shareholders? I address these issues and argue that the net consequence of the SEC’s new approach is negative. My focus is on corporate violators, both because they have incurred the steepest fines and because they implicate the unique concerns that arise when third parties (that is, shareholders) foot the bill. This Comment is organized as follows: Part I explains where the sums that the SEC collects go. Part II examines the effectiveness of fines on corporations and the implications for deterrence when shareholders pay for management misdeeds. Part III highlights additional concerns stemming from the SEC’s self-interest in setting its enforcement agenda, while Part IV argues that this dynamic is particularly troubling in light of the SEC’s near-total discretion, absent effective judicial scrutiny. Part V concludes.

I. where does the money go?

The SEC has loudly championed its ability to collect billions of dollars from securities law violators every year, but it has not been as clear in identifying where all of this money goes. The answer to that question, which I addressed by sifting through SEC Annual Reports and the Office of Inspector General (OIG) Semi-Annual Reports, is threefold: (1) Fair Funds; (2) the new Investor Protection Fund; and (3) the Treasury General Fund. But how much is distributed to each, and who decides, are more complicated questions.

Fair Funds are relatively new; § 308 of SOX14 granted the agency authority to compensate harmed investors with Fair Funds composed of both penalty funds and disgorgements. Before 2002, the vast majority of funds collected by the SEC were directed to the General Fund.15 Although disgorgements were available to compensate harmed investors, the SEC made limited use of the remedy. Only after SOX was passed did investor compensation become an explicit goal of the agency.16 SOX gave the SEC total discretion to direct that funds be distributed to harmed investors; neither corporations nor their shareholders can object to the creation of such a fund.17 Although the text of § 308 does not explicitly encourage the SEC to elevate investor compensation as an agency priority, and the available legislative history focuses on the use of disgorgements as a tool to penalize wrongdoers rather than to benefit their victims, the SEC nonetheless interpreted the provision as requiring a shift in agency policy. In its 2003 Annual Report, the agency listed “[w]herever practical, continue to seek to return recovered funds to defrauded investors” as one of its “main objectives” going into 2004.18 Moreover, the agency’s 2006 Statement Concerning Financial Penalties—intended to clarify the SEC’s decision-making process in seeking monetary penalties—explicitly included “[t]he degree to which the penalty will recompense or further harm the injured shareholders” as one of its two principal considerations in assessing a financial penalty against a corporation.19 Deterring future misconduct, historically the SEC’s foremost priority, was demoted to an “additional” concern.

Despite the SEC’s vocal support, the creation of new Fair Funds has dropped dramatically over time. In 2004, more than twenty funds were created from corporate violators; only one such fund was created in 2010.20 The total amount in such funds has also decreased: the average fund created in 2005-2006 contained more than $90 million at inception, versus $24 million for funds created between 2007 and 2013.21 Distribution takes a long time: 67 of the 93 funds created from corporate violators since 2003 are still extant.22 Each step of the fund distribution process takes time; for example, the average delay between the initial order creating the fund and the proposed distribution plan is over two years (816 days). For those funds that have terminated, the average time between initial order and termination was over five years.23

One potential reason for the SEC’s disinclination to create new funds is the administrative burden of distribution. Because the SEC historically has focused on enforcement, fund distribution is not a core competency.24 As a result, the publicity surrounding Fair Funds has often been less than positive. Critics have focused on the SEC’s lack of coherence in its distribution policy, beyond “reacting to pressure to negotiate large funds.”25 The agency has also struggled in its efforts to actually distribute collected funds. Two cases in particular highlight the agency’s disorganization. In one, an enforcement against seven specialists, an approximately $250 million fund was created for investor compensation. Although seven years passed between the initial order creating the fund (March 30, 2004) and the date of termination (May 26, 2011), the administrator “encountered a number of obstacles in its efforts to identify injured investors,” such that $160 million remained at the end.26 There was vigorous opposition on the part of one Commissioner, who argued in dissent that closing the fund with so much money remaining was premature.27 Similarly, a 2003 case against ten investment banks and two individual analysts resulted in a $1.4 billion “Global Research Analyst Settlement,”28 which went from “much-heralded” to “embarrassing,” in the words of Judge Pauley who presided over the case.32

Figure 2.

number of fair funds created and current status (terminated or extant)29

FIGURE 3.

total dollars awarded to fair funds (total and mean) by year30

Figure 4.

time delays in fair fund distributions31

Of course, the April 2003 headlines regarding the “Global Research Analyst Settlement” had faded by September, and the SEC as well as these Defendants were indifferent to the mechanics of restitution. . . . In the final analysis, this Court does not question the SEC’s interest in bringing to an end improper conduct. Nor does it question the SEC’s interest in recompensing investor victims and deterring future violations. However, whether the SEC has the institutional resolve and commits adequate resources to reach these goals is an open question.33

By the time that fund was closed in 2009, almost $80 million of the originally earmarked $432.5 million was remitted to the U.S. Treasury rather than to the investors for whom it was intended.34 These administrative hassles, compounded by the resulting bad publicity, may have dampened the agency’s enthusiasm for creating new funds.

The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) also created a new destination for collections: the Investor Protection Fund.35Under Dodd-Frank, monetary sanctions not otherwise earmarked to disgorgements or Fair Funds (or remaining in Fair Funds upon termination) can be used for two purposes: to pay whistleblower awards36 or to fund the SEC Office of the Inspector General’s Employee Suggestion Program.37

The whistleblower program is designed to incentivize individuals with “specific, credible, and timely information” to proactively contact the SEC.38 Would-be informers have responded exactly as Congress intended; the number of whistleblowers grew from 3,001 in FY2012 to 3,238 in FY2013.39 However, very few whistleblowers received compensation: in 2011-2012, only one whistleblower received an award, for less than $50,000.40 In 2013, the agency distributed $14,831,965.64, but more than $14 million went to one whistleblower; four others split the remainder.41 Nearly $440 million remains of the initial disbursement of about $450 million to the fund.42 Consequently, no additional amounts have been deposited since its inception: if the balance exceeds $300 million, new collections cannot be added.43

The SEC also uses Investor Protection Funds for its Employee Suggestion Program. Before Dodd-Frank, SEC employees were not without recourse to address their complaints; the Office of Human Resources (OHR) had a similar program that it discontinued in 2011.44 Much as with Fair Funds, use of the new program has tapered off, from 48 suggestions and allegations lodged in FY2011 (including holdovers from the previous program) to 27 in FY2013. The vast majority of suggestions do not involve serious concerns, and few lead to agency action.45 For example, the Program received an allegation that many employees received their second choice of new laptop computers, and a suggestion that the SEC limit distribution of paper copies of the Code of Federal Regulations to save $21,000 per year.46 Receiving and investigating these allegations and suggestions has cost the Investor Protection Fund $233,556.65 over the past three years; in two of those years, the allocation exceeded the sum paid to whistleblowers.47

Figure 5.

investor protection fund budget and activities48

If the SEC is not creating new Fair Funds or adding money to its Investor Protection Fund, then where is the SEC putting the sums it collects? Where it always has: the U.S. Treasury General Fund. Despite the SEC’s rhetoric about compensating harmed investors, funds earmarked for its two investor compensation programs have declined dramatically as a percentage of the SEC’s total assets, from approximately 28% in 2005 to 13% in 2013.49

FIGURE 6.

percentage of sec assets allocated to fund balance with treasury vs. investments (disgorgement and penalties fund and investor protection fund)50

Although disgorgements and penalties cannot be used directly for SEC expenses, it is a point of pride within the agency that it is a net contributor to the Federal Government’s budget and any appropriations from Congress are “fully offset.”51 To be sure, the SEC would be a net contributor even without violator fines: securities transactions fees alone fully offset the SEC’s total FY2013 budget request.52 Up to $50 million in additional registrant filing fees are deposited in the SEC’s Reserve Fund, created under 15 U.S.C. § 78d(i) to be used “as the Commission determines is necessary”; the remainder of those fees also go to the General Fund.53 Even if these additional funds are not factored into actual SEC expenses, though, they are considered to be part of the SEC’s total budget, which has steadily increased as a result.

There are only six other entities that are expected to provide any net contributions to the Treasury General Fund in 2014, and none provide sums remotely close to the SEC’s expected $737 million contribution.54 Potentially as a result of its generosity to the rest of the government, the SEC has enjoyed rapid expansion in the past five years. According to one analysis, the SEC’s budget grew by 46% from FY2008-FY2013, compared to 24% for the Federal Government as a whole, and 14% GDP growth.55 This disproportionate growth does not look like it will soon slow: the SEC’s 2014 budget represents a nearly 30% increase over 2013 ($1.608 billion vs. $1.254 billion).56 By comparison, the total outlay for all “discretionary” programs shrunk by 2% between 2013 and 2014.57

II. do fines do any good?

Given the magnitude of monetary penalties, it is surprising that there is little evidence of their effectiveness in deterring securities law violations. Indeed, for public companies, evidence suggests that the opposite may be true. There is ample evidence that individuals can be deterred by the threat of financial penalties when they pay the cost themselves.58 However, if their employer (or its shareholders) pays, the deterrent effect is undermined. Corporate fines for securities law violations present a classic example of the agency problem: managers who violate securities laws may gain from misconduct, especially in the short-term, while long-term losses from fines are spread across shareholders.59 As former SEC Commissioner Cynthia Glassman once noted in voting against the imposition of a fine on a corporation, “When the boards and management are agreeing to these penalties, they’re agreeing to pay with other peoples’ money.”60

Depending on how punishments are structured, even a massive fine may not directly affect executive compensation; instead, the sum is effectively split among shareholders. To borrow a phrase from an eminent securities law professor, this system is “akin to punishing the victims of burglary for their failure to take greater precautions.”61 Although executives may be deterred by other means—including the possibility of being fired by the corporation for the original misconduct or of being assessed a fine individually by the SEC—they are not personally liable for fines assessed against the corporation.

Although the circularity problem is particularly troubling when shareholders do not share in any of the initial benefits of misconduct (for example, accounting fraud), the concern is not limited to these violations. Circularity is exacerbated by a temporal disconnect: if the company has sufficient liquidity, then shareholders enriched by the initial misconduct have likely already sold their stock. Remaining shareholders are then doubly penalized: by the penalty itself and the “reputational penalties” that companies suffer after SEC actions, which can be higher than the fines themselves.62 Enforcement actions also can divert management’s attention, leading to further lost revenue. This timing issue has distributive consequences; it benefits investors who sell rapidly (for example, hedge funds) and penalizes those who hold for longer periods (for example, retail investors).63 This is not to suggest that corporate fines are never appropriate. For example, requiring a corporation to disgorge the profits gained from a price-fixing scheme appropriately requires the beneficiary of the violation to pay, and this may deter similar future misconduct. However, these considerations suggest the importance of paying careful attention to the particular factors involved before any fine is assessed.

Indeed, Congress explicitly urged such caution in fining public corporations when it initially granted the SEC the authority to seek civil monetary penalties. The legislative history of the 1990 Securities Enforcement and Penny Stock Reform Act includes the following passage:

[B]ecause the costs of such penalties may be passed on to shareholders, the Committee intends that a penalty be sought when the violation results in an improper benefit to shareholders. [When] shareholders are the principal victims of the violations, the Committee expects that the SEC, when appropriate, will seek penalties from the individual offenders acting for a corporate issuer.64

Deterring future misconduct is not merely a positive side effect of enforcement; according to Congress, it is one of the primary reasons we have the securities law regime we do.

The legislative history of the Reform Act makes clear that broadening monetary penalties was “intended to permit the Commission to achieve the appropriate level of deterrence.”65 To quote Judge Rakoff, “Where management deceives its own shareholders, a fine most directly serves its deterrent purposes if it is assessed against the persons responsible for the deception.”66 If these penalties do not produce the desired deterrent effect because they are assessed against the corporation, rather than the individuals engaged in misconduct, then it is hard to argue that they are worth the costs.67

III. whom does the sec target?

Inability to deter misconduct is one problem with corporate monetary penalties, but it is not the only one. At least two additional, related issues prompt consideration: the way in which the SEC prioritizes enforcement, and the lack of meaningful checks on the agency. This Part addresses the former; the following Part discusses the latter.

The SEC has considerable latitude to prioritize its enforcement agenda. This raises the possibility that the SEC will select targets not because they are the worst violators, but for improper reasons such as agency or individual self-aggrandizement. For example, empirical evidence suggests that the SEC targets “deep pockets” for whom large-dollar fines will not induce insolvency, as well as violators whose cases will engender positive press. One study found a marked increase in enforcement actions targeted at larger companies starting in 2002.68 After 2002, the mean market capitalization of companies facing SEC action was over six times greater than that of companies facing private litigation alone; pre-2002, the reverse was true.69 Comparing private and public enforcement provides strong evidence that the SEC is not just pursuing more egregious violations in prioritizing larger companies; private litigants have even more incentive to target “deep pockets.”70 Another study, focusing on the options backdating scandal, supports a publicity-seeking theory: it found that the SEC increased related investigations—and decreased investigations of other crimes—as the level of media scrutiny of option backdating increased.71 More troubling, the quality of investigations declined over the period, suggesting the SEC was scraping the barrel to accommodate public outrage, rather than investigating substantive violations.72

Although focusing on a “hot” issue may bring in fewer dollars,73 both the “deep-pockets” theory and the “publicity-seeking” theory can be explained by the incentives faced by the agency and its officials. Niskanen’s model of the budget-maximizing bureaucrat is helpful in understanding how these incentives operate.74 Niskanen posits that bureaucrats attempt to maximize their agencies’ discretionary budgets in order to maximize their own utility, and that they are largely successful in these attempts.75 A bureaucrat’s utility is determined by, inter alia, “salary, perquisites . . . , public reputation, power, . . . [and] output.”76 The “revolving door” of modern political careers adds an important gloss; even if salaries are standardized across federal agencies, officials within more powerful agencies with more complex regulatory regimes can demand higher wages upon entering the private sector.77

IV. are there any meaningful checks on sec enforcement?

The force of the incentives that the SEC faces in prioritizing its agenda is particularly troubling given the lack of meaningful checks on SEC enforcement power. Although all administrative agencies are theoretically “checked” by judicial review, in practice the judiciary does not provide much of a constraint on SEC enforcement actions. Like all administrative agencies, the SEC enjoys considerable deference in judicial review.78 Because of the SEC’s particular focus, it might receive even greater latitude: “[F]or the field of technical and economic regulations, agency expertise leaves the Justices less equipped to understand the issues than specialized agencies.”79 As a result, the SEC has a high win rate at trial: 80% since 2011, according to Chair White.80

Moreover, the SEC can avail itself of administrative proceedings that effectively bypass the judiciary. Administrative proceedings are overseen by administrative law judges—employees of the SEC—rather than Article III judges. There is no jury, and no right to discovery.81 Consequently, the timeline for administrative cases is condensed compared to trial: administrative hearings must be completed within 270 days of the SEC’s complaint. SEC reliance on these adjudications has grown rapidly; whereas civil cases outnumbered administrative proceedings as recently as 2005, there were nearly twice as many administrative proceedings as civil actions in 2012.82 Commentators expect this trend to continue, particularly because Dodd-Frank broadened the reach of these proceedings by enabling the SEC to impose financial penalties on any offender, rather than only those it directly regulated (for example, broker-dealers and investment advisors), as before.83

Figure 7.

enforcement actions initiated: percentage of cases brought as civil actions vs. administrative proceedings84

In reality, few public companies go through either judicial or administrative proceedings because most opt to settle instead. Litigation is particularly risky for a public company: even if it ultimately prevails, the uncertainty of pending litigation can be disastrous. The paradigm example of this phenomenon is Arthur Andersen. The Supreme Court ultimately overturned Andersen’s guilty verdict, but it was “little more than a Pyrrhic victory”: “Andersen . . . lost its clients after being indicted on obstruction of justice charges and has no chance of returning as a viable enterprise.”85 Moreover, “the pendency of an investigation places a cloud over the corporation that may inhibit its access to capital markets, chill relationships with vendors and customers, and distract and demoralize management.”86 Depending on the structure of the settlement, companies can also avoid an onslaught of follow-on private suits.87

Settlement is also preferable from the SEC’s perspective, given the costs of litigation. Since “settled injunctive actions rarely receive any detailed judicial scrutiny,”88 these actions ensure a quick “victory” that can be publicly touted.89 Indeed, many critics have lamented the rise in “sue-and-settle” cases, in which the SEC charges a corporation, settles for large sums, but does not require anyone to admit responsibility.90 The SEC recently restricted neither-admit-nor-deny settlements, but it is too soon to gauge the impact of this move.91

Even before the settlement or litigation phase of an enforcement action, the SEC’s policy of penalizing non-cooperation further skews the outcome in the SEC’s favor. It is surely sound public policy to encourage defendants to cooperate with investigations—some analysis even suggests that optimal enforcement requires some degree of self-reporting and compliance92—but the SEC has been accused of exerting undue pressure on defendants to divest themselves of appropriate legal protections, including the attorney-client privilege.93 One study found that cooperation increased over time, particularly after the 1990 Remedies Act, and even more so after 2000.94 Between 1978 and 1989, only 3.1% of enforcement actions cite company cooperation, compared to 63.4% in 2010.95 Furthermore, researchers found that larger firms are more likely to cooperate than smaller firms; the average market capitalization of cooperators is $13.1 billion compared to $4.0 billion for non-cooperators.96 In addition to the deep pockets hypothesis discussed above and the likelihood that large public companies will settle rather than litigate, the increased likelihood of cooperation on the part of large public companies provides yet another reason for the SEC to target them. The SEC can investigate with the company’s help and then garner headlines by assessing hefty monetary penalties that firms see as merely a “cost of doing business,”97 all with only minimal checks to ensure that the agency is penalizing the appropriate actors or targeting the most egregious violations.

Conclusion

By every available metric—litigated cases won, billions of dollars assessed, number of headlines generated—the SEC’s enforcement division has been remarkably successful in the past few years. Whether these efforts have been effective in protecting investors, maintaining fair, orderly and efficient markets, and facilitating capital formation is not as clear. The SEC’s use of monetary sanctions has grown rapidly, without much critical consideration given to the effects of the new focus on the alleged violators themselves or the market as a whole.

There are multiple reasons to be concerned. Particularly for public corporations, the source of the largest sums garnered and circularity and temporal problems may prevent optimal deterrence. The absence of deterrence is particularly concerning given that the SEC’s budget grows in tandem with the growth in monetary penalties. The SEC’s near-total discretion over its enforcement strategy raises an additional issue: if the SEC targets those with the deepest pockets or those most likely to garner publicity, then other equally or more culpable violators might be able to operate with impunity. Insofar as those violators will not otherwise be sanctioned by private investors, the SEC’s approach is suboptimal. Yet without any checks, including judicial review, it is difficult to discern whether the SEC’s approach is the right one in any individual case, let alone systematically.

The SEC has not always sought monetary penalties from securities law violators, as a punishment in itself or on behalf of harmed investors. Indeed, the SEC’s initial remedies for violations of the 1933 and 1934 Acts were limited to injunctions and disgorgement of profits, although the latter was not widely used until the 1970s.98 The SEC was not authorized to seek civil monetary sanctions until 1984, and then only for insider trading violations.99 Indeed, both Congress and the SEC itself historically warned against the imposition of fines against public corporations. The legislative history of the Securities Enforcement Remedies and Penny Stock Reform Act of 1990,100 which initially granted the SEC authority to seek civil monetary penalties in enforcement cases, indicates that Congress was particularly concerned about inadvertently penalizing shareholders:

[B]ecause the costs of such penalties may be passed on to shareholders, the [Senate] Committee [on Banking, Housing, and Urban Affairs] intends that a penalty be sought when the violation results in an improper benefit to shareholders. In cases in which shareholders are the principal victims of the violations, the Committee expects that the SEC, when appropriate, will seek penalties from the individual offenders acting for a corporate issuer.101

Similarly, in a 2006 statement,102 the SEC differentiated between cases where penalties assessed against corporate violators would be appropriate and where they would not be:

[T]he strongest case for the imposition of a corporate penalty is one in which the shareholders of the corporation have received an improper benefit as a result of the violation; the weakest case is one in which the current shareholders of the corporation are the principal victims of the securities law violation.103

This historical background suggests that there are viable alternatives to the current strategy. The SEC need not always impose monetary sanctions against corporations, and when it does so, it can tie the amount to the gains generated by wrongdoing. The SEC can also refocus its monetary penalties on individuals within corporations, potentially strengthening the deterrent effect of these penalties. Long before the SEC had the authority to pursue monetary sanctions, it availed itself of other regulatory tools, including censures, deregistrations, and cease-and-desist orders. All of these tools are still available—and are still used by the SEC—but they do not raise the concerns regarding self-interest or agency aggrandizement articulated above. Given the clear costs of centering its enforcement program around large-dollar sanctions and absent clear benefits of that strategy over alternatives, the SEC would be best served by refocusing its enforcement agenda accordingly.

Because the SEC’s current incentives likely preclude the agency itself from desiring such a change, other actors may need to intervene. Congress could clarify the goals toward which the enforcement program should be oriented. The courts could likewise meaningfully assess SEC actions and settlements, rather than “rubber-stamping” the cases that the agency brings. The result might just be a more robust and fair market that protects investors and deters potential violators better than the current system.

SONIA A. STEINWAY*