For its first forty years, the SEC enforcement remedies were limited to civil injunction actions filed in the federal courts, or suspensions and revocations in administrative proceedings. Basically, the injunction would require the defendant to "obey the law" in the future. If a defendant violated a civil injunction, that person or entity could be subject for prosecution for criminal contempt.

In 1971, the SEC for the first time persuaded a federal court to require that the defendant disgorge all proceeds of an improperly closed public offering and any ill-gotten gains on the proceeds as a result of the violation of the anti-fraud provisions of the Securities Exchange Act of 1934.  SEC v. Manor Nursing Centers, 340 F. Supp. 913 (S.D.N.Y. 1971), affirmed, in part reversed in part [deleting the ill-gotten gains on the proceeds of the public offering] 458 F.2d 1082 (2d Cir. 1972). 

Next, in 1984, the SEC gained the authority to levy statutory penalties for insider trading.  At that time, insider trading was viewed as the worst conduct in the marketplace.  
 
As a result of the savings and loan scandals, the SEC requested that Congress give it additional remedies so that it could do a better job in enforcing the federal securities laws. This resulted in the 1990 Remedies Act, which added two major new weapons to the SEC's enforcement arsenal. The first was monetary penalties in civil actions. The second was the right to permanently bar persons from being officers and directors of publicly held companies.
 
Unfortunately, after Worldcom, Enron and other financial scandals, monetary penalties are now the preferred vehicle for punishing perceived violators of the federal securities laws. Many defense attorneys believe that since every agency is now out for a scalp, companies and individuals might as well fight the charges. Other defense attorneys believe there are strong incentives that force companies and persons under investigation by the SEC to settle rather than fight:

• First, there is the adverse publicity, and the SEC has unlimited access to the media. Even if you win in court, the adverse publicity of a protracted litigation, and expenses and time of litigation, could so harm the business that it "pays" to settle before an enforcement action is filed.
• Second, the SEC staff has openly stated that if someone elects to contest their charges, the monetary penalties will be substantially more if the SEC prevails.
• Third, a prompt settlement could avoid a subsequent criminal investigation.

At a recent meeting of the SEC Historical Society, the head of the Division of Enforcement stated that all of the remedies have multiple purposes: (i) a punishment element; (ii) a protection mechanism; and (iii) a prevention element which includes deterrents. 

The SEC views punishment as being part preventive.  It is now perceived by many, including this writer, that regulators are in competition over who gets there first, and who gets the largest amount of money.  
 
In fact, the 1990 Remedies Act provides for three tiers to determine the amount of the penalty. The first tier calls for a penalty not to exceed $5,000, or the gross amount of pecuniary gain to such defendant as a result of the violation. The fight is over what is meant by "pecuniary gain." Defense counsel should take the position that pecuniary gain is the net profit realized from the alleged violation. However, the staff of the Division of Enforcement takes the position that the receipt of any money from the alleged violative conduct is pecuniary gain and that the offsetting expenses are irrelevant or only a partial credit.
 
The second tier states that the penalty shall not be the greater of $50,000 for a natural person or $250,000 for any other person, or the gross amount of the pecuniary gain to such defendant as a result of the violation, if the violation involved fraud, deceit, manipulation or deliberate or reckless disregard of a regulatory requirement.

The third tier states that notwithstanding the first two tiers, the amount of the penalty shall not exceed the greater of $100,000 for a natural person, or $500,000 for any other person, or the gross amount of the pecuniary gain ... if (i) the violation involved fraud, deceit, manipulation or deliberate or reckless disregard of a regulatory requirement and (ii) such violation directly or indirectly resulted in substantial losses or created a significant risk of substantial losses to other persons. 
 
In practice, the SEC enforcement staff disregards the tiers because they take the position that any receipts by a defendant arising from the alleged wrongful conduct resulted in substantial losses or created the risk of substantial loss are the starting point for any negotiations. With respect to an employee of a defendant, the SEC looks at the amount of compensation he or she received during the period of the violative conduct as the starting point. The assumption is that, as to the employee, neither the staff nor the employee can allocate what portion of the salary relates to the violative conduct and, thus, all of the salary and other compensation is the amount of pecuniary gain to the individual as a result of the violation. 
 
The target is left with a very difficult issue. Do you look at this as a business transaction and say that whatever it costs to resolve this makes sense, or do you argue that the SEC is misinterpreting the tier concept in the 1990 Remedies Act? Of course to do that, you are then paying substantial costs to litigate and, in theory, could be subject to much more publicity concerning the case and, if you lose, even higher penalties for the client. 
 
It is the general perception of defense attorneys that the SEC requests penalties in all cases. At the SEC Historical Society meeting, the head of the Division of Enforcement stated that in her review of hundreds of cases involving financial fraud and financial reporting, only about 20 involved penalties against companies. That does not match my experience. One of the rationales for the SEC's insistence on penalties is that under the fair funds provisions of the Sarbanes-Oxley Act, it has the option to permit the penalties to go back to the shareholders. This is one justification the SEC uses for asking for civil penalties, rather than disgorgement. When funds are disgorged they go to the U.S. Treasury. Now in its settlements the SEC often requires that the defendant consent to the assignment of the disgorgement amount to this fund.
 
The SEC takes the view that where an officer or director engaged in the fraudulent conduct involving a publicly held company, that person should not be put in the same position again. The more egregious the violation, the more likely the staff is to look for the individual involved, but, in practice the SEC views any officer or director of a public company that is directly, or sometimes only tangentially, involved in the alleged fraudulent conduct, as the type of conduct that routinely authorizes it to seek a permanent bar. From the individual officer or director's point of view, the only option open if they consent to such a bar is to try to find an equivalent position in a privately owned company. Not only are the pay levels substantially lower for equivalent non-public companies, but there is no longer the availability of meaningful stock based incentives. 

Under the new landscape, the vigorous defense of a client accused of the violation of the federal securities laws appears to be a declining trend. The government has unlimited funds, and makes it very clear that if you choose to litigate and lose, you run the risk of a far larger civil penalty, as well as possible referral to the Justice Department. In fact, refusing to cooperate is viewed by the SEC as a form of obstruction of justice. In short, vigorous defense of a client, even within the rules of proper defense, will be viewed by the SEC as a lack of cooperation, which ultimately penalizes the client for litigating. 
 
The irony is that, shortly after the adoption of the 1990 Remedies Act, the SEC was perceived to be very lackluster and weak in its enforcement actions. As a result, Elliot Spitzer, the New York Attorney General, and other state attorneys general, moved in to fill this vacuum. In response, the SEC has stepped up its enforcement activities, looking for new areas that have not been mined by the state attorneys general. In many instances the SEC asks for both monetary penalties and disgorgement as part of its settlement. When you combine a cease and desist order, injunction order, significant monetary penalties, disgorgement, along with the SEC's description of the alleged wrongful conduct, either in a complaint or, if it is settled as part of the order of proceedings in the administrative context, the publicity generated can have substantial adverse consequences on the company and individuals targeted by the SEC. Not only will it be bad for the business operations, but there is the possibility of follow-up class actions.
 
The arsenal of enforcement weapons now available, when combined with the current attitude of the SEC staff, discourage a defendant from litigating an enforcement action, even when there is good faith basis to resist the SEC's enforcement efforts. This is especially so in areas in which the SEC has not traditionally regulated. It is using its expanded arsenal of remedies as a way to force persons to settle issues which, if litigated, the SEC would stand a substantial likelihood of losing.
 
The new motto should be caveat SEC target, because if you decide to fight the SEC and do not prevail, you will be subject to much more severe monetary penalties, as well as a much higher level of adverse publicity. You also increase the risk of a referral to the Justice Department. If you elect to fight the SEC you must also be prepared to expend substantial legal fees and run the risk that the litigation will generate publicity over a longer period of time, than the public announcement of a settlement at the time the proceeding is instituted.

It often boils down to a business decision. What is the amount of the financial penalty, disgorgement, etc., requested by the SEC? What are my litigation expenses? What is the extent of the public relations and distraction to the employees of the company when the settlement is publicly announced? How much additional revenues can you generate by being able to focus on your business rather than litigating? How severely will the publicity of a "quick" settlement affect your business? Will the "quick" settlement still result in class actions? How much money will you make on the alleged violative course of conduct during the course of the litigation? Are you willing to abandon the line of business that is the subject matter of the SEC inquiry? What is the potential risk of a class action after a settlement where the SEC prevails and all appeals are exhausted?

Whether the SEC is legally correct or has a proper factual basis for its new theory or you want to fight as a matter of principle may no longer be the crucial issue.

CHARLES HECHT has been a principal of his own law firm specializing in securities law since 1971. He was previously on the staff of the Division of Corporate Finance of the Securities and Exchange Commission at its headquarters in Washington, DC. Contact him at 212.490.3232 or visit www.securitiescounselors.com

This article does not constitute legal advice.