Our recent discussion of Judge Scheindlin’s rejection of overreaching SEC remedial demands in SEC v. Wyly (which you can read here) leads into a more extensive discussion of excessive remedies sought by the SEC in its enforcement prosecutions. In Wyly, the SEC sought as “disgorgement” all profits the Wyly brothers realized from the sale of their stock holdings even though the value of that stock, which was earned as stock options granted to the Wylys as officers and directors of public companies, was totally unrelated to the securities violations found by a jury. Judge Scheindlin appropriately rejected the outlandish demand by the SEC that the Wylys should pay $500 million in “disgorgement” for these violations. As we discuss further below, two other recent cases suggest federal courts may trending towards recognition of the excesses of SEC remedial requests in relation to the actual misconduct involved.
It is now standard SEC practice to seek “remedies” in its enforcement actions that go far beyond reasonable remedial responses to the violations alleged. Over the last decade or so, the SEC has succumbed to a “remedy creep” that leaves the enforcement division exercising very little thoughtful discretion about the right remedy to seek under the facts and circumstances of each case. Instead, SEC enforcement actions now routinely ask for ruinous penalties and so-called “disgorgements,” and then go beyond those remedies to seek debilitating court orders barring defendants from pursuing their livelihoods as public company officers, or as accounting or legal professionals. The end result is that the SEC numbingly insists that nearly all enforcement defendants accused of “fraud” – itself a near limitless concept in the minds of SEC bureaucrats – and even some non-fraud violators, must face ruin to themselves and their families, currently and indefinitely into the future.
It was not always so. The SEC’s enforcement lawyers have always sought court injunctions against future unlawful behavior. In more recent years these were accompanied by penalties and requests for disgorgement that were limited by genuine, if debatable, efforts to calculate a remedy based on benefits derived from the alleged misconduct. That is no longer true. The SEC’s enforcement lawyers, aided and abetted by Commissioners who see political or public relations exposure only for remedies portrayed as too light, now rabidly seek more and more to “remedy” alleged violations.
For those of us who have been around long enough, we have seen the SEC enforcement lawyers morph from genuine representatives of the public interest into prosecutorial zealots for whom no punishment in the form of “remedy” seems enough. For years, it was the securities plaintiffs’ bar that would develop sketchy theories and theories of loss, driven by profit motive. Now, in a bizarre twist of history, SEC enforcement lawyers tend to channel how private plaintiffs’ lawyers used to act, and the private securities bar has tended to become much more rational and principled in its approach to cases (largely because that is more appealing to the federal judges they typically appear before).
I am not alone in having commented in recent years that SEC lawyers now act more like rabid plaintiffs’ lawyers than protectors of the public interest. Why has that happened?
- First, as noted above, this occurs in part because the hydraulic pressures all push in that direction. Few public servants get kudos for resisting overreaching remedies or excessively zealous prosecutorial theories. Much more often, critics – from the Congress, the press, the “public interest” bloggers, or the like – attack the SEC for failing to prosecute this or that person or company, or for failing to impose harsher or more debilitating penalties or relief.
- Second, following the lead of Elliot Spitzer as the once-attorney general of New York, state attorneys general have realized that they can pander to these elements by commencing state investigations into putative federal securities compliance issues and generate press that helps springboard future political advancement. This trend dates back to the early 2000s, when Spitzer realized he had free reign to inquire into various forms of securities-related matters under the rubric of state law violations. Instead of fighting for its position as the national securities regulatory agency that should rule the roost over these complex issues, the SEC decided instead to show it can be an even more zealous prosecutor than Spitzer et al. It now measures its success not by how the public interest is affected but by how many billions of dollars in penalties it can announce in a press release.
- Third, the size of the SEC’s enforcement division has increased enormously over the years. The need for so many lawyers leaves the SEC with a group of investigators and prosecutors of decidedly mixed quality. Even worse, the less able lawyers are often the ones that hang around the longest because their limited abilities simply don’t appeal to private law firms or provide other forms of job mobility. The leaders of the enforcement division often are very good lawyers, but pretty poor managers. Some of them worry more about what the press releases look like than how to exercise control over a huge group of relatively young lawyers. As a result, controls over poor decision-making and questionable tactics by lower-level enforcement lawyers are plainly inadequate and are causing real reputational harm to a once-proud and highly-regarded law enforcement organization.
- Fourth, the line staff in the enforcement division are lawyers with almost no real-world business experience. Many of them have a strong tendency to assume the worst — that if something was done incorrectly the mistake must have been intentional. They have little understanding of how public company employees and officers function. They also fail to realize that in a complex organization like most public companies, responsibilities are divided and delegated, and employees assume (properly, under state corporation law) that their colleagues are doing their jobs right. Even where the evidence points to mistake or things “slipping through the cracks,” they press for conspiracy theories of wrongdoing. Some of them even work to distort the investigatory record to support such a theory. The more senior enforcement lawyers are largely dependent on the more junior ones to develop the evidentiary record and present it fairly when a charging decision is being made. Unfortunately, that often does not occur, and the senior officials proceed without a fair sense of the facts. Those senior enforcement officials also believe that from an organizational standpoint, they must support the lower-level staff or lose their loyalty. The end result is that in many cases, the enforcement decisions are driven by analyses by people who simply have no understanding of real-life business environments.
- Fifth, the SEC’s line enforcement lawyers are not blind to the fact that the Commissioners and high-level enforcement officials crave big-headline prosecutions and eye-popping remedies, and they naturally try to make that happen. SEC enforcement lawyers receive woefully little training and guidance about what it really means to try to serve the “public interest” in the complex process of regulating and policing the Nation’s capital markets.
All of this leads us to a number of recent cases in which federal judges express consternation over the SEC’s remedial requests in enforcement actions. As noted, in SEC v. Wyly (SEC v Wyly Disgorgement Opinion), Judge Scheindlin was astounded that the SEC would seek a half-billion dollars in purported “disgorgement” based on a theory of unjust enrichment that didn’t pass the “ha-ha” test.
In SEC v. Nocella, Civil Action No. H-12-1051 (S.D. Tex. Aug. 11, 2014) (available here: SEC v. Nocella), Judge Lynn Hughes rejected the SEC’s effort to bar the CEO and CFO of a bank from serving as officers or directors of any public company because they were part of an alleged fraudulent accounting scheme because the bank failed to classify certain mortgage loans as non-performing in the midst of the 2007-2008 housing crisis. Because the defendants were first-time offenders, the violations were egregious, they relied on other bank employees, there was no evidence of intent to defraud shareholders, their financial gain was minimal, and neither was in a position to repeat the misconduct, the court found it “abusive to seek a permanent bar against two executives who were working for a troubled company in a troubled time without adequate evidence that they were responsible for the improper accounting.” Id., slip op. at 4.
In SEC v. Benger, No. 09 C 676 (N.D. Ill. Aug. 13, 2014) (available here: SEC v. Benger, Magistrate Judge Jeffrey Cole rejected the imposition of an order against an attorney permanently barring him from any form of involvement in penny stock offerings, even including providing no more than legal advice to clients about penny stocks. The SEC failed in efforts “to make out a fraud claim” against the defendant (id., slip op. at 6), and accepted a settlement for violating broker dealer registration requirements (section 17(a)(1) of the Securities Act of 1933), which was not an “egregious” violation. The SEC “was unable to cite a case in which a failure to register as a broker-dealer was punished with such a sanction.” Id., slip op. at 6. Noting that a lifetime bar “is an extraordinary remedy, usually reserved for those defendants who intentionally engaged in prior securities violations under circumstances suggesting the likelihood of future violations “ (id., slip op. at 3), the magistrate denied the SEC’s broad bar request. As it does in many cases, the SEC cherry-picked portions of “a handful of emails” and proclaimed them evidence warranting a bar order. On examining them, however, the magistrate saw little of major concern, and in fact viewed them as indicative of real efforts by the defendant to avoid improper sales practices by others. The SEC’s main theory was that these emails put the defendant on notice of misconduct by others and he failed to extricate himself from the venture. But the court found that far from sufficient to justify a remedy that could seriously impair the defendant from pursuing his professional livelihood.
These recent examples build on a growing body of cases questioning the SEC’s choice of suggested remedies in its enforcement actions. See, e.g., SEC v. Fisher, No. 07 C 4483 (N.D. Ill. Aug. 28, 2012) (denying remedies of injunction or officer/director bar: “Here, the Commission has staked its claim for these two equitable remedies on the alleged scope of the fraud and Defendants’ level of scienter. But even assuming the Commission’s most sweeping allegations about the fraud, including an assumption that the entire scheme was wholly deliberate, no reasonable jurist could order an injunction and director and officer bar in this case. This is because there is no evidence to support a significant number of the relevant factors. For instance, regarding the current occupations of Defendants, Behrens is now employed by a privately held company rather than a publicly held one. The Commission offers only rank speculation that he could at some point return to a public company that would issue the kind of financial statements that form the heart of the alleged wrongdoing here. Further, the Commission has put forth no evidence that Behrens has ever done anything comparable before or since the Nicor fraud.”); SEC v. Schroeder, No. C 07-03798 (N.D. Cal. Nov. 17, 2010) (in case for fraudulently backdated option grants in which the parties entered into a consent settlement and penalty but disputed the motion for a bar order, the court finds the evidence insufficient to support the requested bar order); SEC v. Shanahan, No. 07-cv-2879 (D. Minn. Jan. 13, 2010) (“even if the SEC succeeded in showing Defendants violated the Exchange Act or SEC Rules, the SEC is not entitled to a permanent injunction or an officer/director bar” because degree of scienter, lack of evidence of additional misconduct, lack of egregiousness of violation, and lack of evidence of personal profit do not satisfy standards for either form of relief); SEC v. Stanard, No. 06-cv-7736 (S.D.N.Y. Jan. 27, 2009) (defendant found liable for accounting fraud but request for officer/director bar denied); SEC v. Johnson, 595 F. Supp.2d 40 (D.D.C. 2009) (after criminal conviction for scheme to overstate company financial results, court found officer/director bar “far too Draconian” because the violation was an isolated incident in defendant’s career and he now worked for a non-public company); SEC v. Conaway, 697 F. Supp. 2d 733 (E.D. Mich. 2005) (after jury found Kmart CFO liable for fraud, court ordered over $10 million in disgorgement and penalties, but denied SEC’s request for officer and director bar); cf. SEC v. Bartek, 484 Fed.Appx. 949 (5th Cir. 2012) (finding officer and director bar a punitive remedy).
The SEC’s failure to distinguish between enforcement actions warranting a “nuclear option” and those for which more measured remedies are appropriate is steadily endangering its credibility in the courts. The knee-jerk reaction to seek maximum relief at all times is unsupported by the law, wrong as a matter of public policy, not in furtherance of the public interest, and squanders the inherent advantage SEC litigators have before federal judges, who have long been inclined to grant the SEC the benefit of the doubt in close cases. Enlightened leadership among the Commissioners and in the Division of Enforcement should see this and do a better job of getting it right.
August 20, 2014
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