Sarbanes– Oxley Enhancements to the SEC’s Enforcement Authority
by William R. Baker III and Christopher E. Campbell

Much has been written about the dramatic effect of the Sarbanes-Oxley Act of 2002 on issues such as auditor independence, corporate disclosure, and corporate governance. Less attention has been focused on the ways that Sarbanes-Oxley changes, and enhances, the authority given to the SEC’s Division of Enforcement. Some changes are obvious, like new remedies; some are less obvious, although at least as important. And additional changes may be coming.

Increasing the Cost of an SEC Enforcement Action

Last year, the Division obtained orders in judicial and administrative proceedings requiring defendants or respondents to pay disgorgements and penalties totaling over $1.4 billion. As impressive as that number is, it will be substantially larger in future years; Sarbanes- Oxley contains an important provision that should encourage the Commission to seek even larger penalties. In five significant 2003 cases alone, the SEC obtained disgorgement and penalties totaling over $1.6 billion. At the same time, Sarbanes-Oxley gave the SEC additional authority to ensure that money is not dissipated before the SEC can file an action and obtain an asset freeze or an order imposing disgorgement or penalties.

The Fair Funds provision

Described by former SEC Chairman Harvey Pitt as one of the most important new tools received by the Commission,¹ Section 308(a) of Sarbanes-Oxley, known as the Fair Funds provision, provides that where a disgorgement fund has been created as a result of an SEC enforcement action against any person, civil penalties² paid in the action may be placed in the disgorgement fund for the benefit of victims of the violation. Otherwise, penalties are paid to the U.S. Treasury.³

The use of penalties for compensatory purposes is a substantial departure from the original rationale for providing the Commission with the ability to obtain civil penalties, which was to deter future violations.⁴ Section 308(a) gives the Commission a powerful incentive to seek larger penalties, particularly against those entities that have been viewed as “deep pockets” in private securities litigation—public companies, and the professional firms that advise them. Since receiving Fair Funds authority, the Division of Enforcement has sought federal court approval of payment of civil penalties into disgorgement funds in a number of high-profile enforcement actions.

The Securities Law Enforcement Remedies Act of 1990 first gave the Commission the authority to obtain civil money penalties for violations of the federal securities laws other than for insider trading. Since then, the conventional wisdom has been that penalties in enforcement actions against public companies not otherwise regulated by the SEC (e.g. brokerdealers) should be (and they were) rare.⁵ A justification frequently offered for the limited use of penalties against corporations was that penalties served only to harm shareholders, and ultimately went to the Treasury. However, in several recent cases, public companies paid substantial civil penalties when the Commission felt those companies fell short in cooperating with the SEC during an investigation.⁶ In the last several years, the SEC also has departed from past practice by insisting on penalties or other non-disgorgement payments to settle cases against auditing firms.⁷

With its new ability to take money paid as a penalty and return it to fraud victims, we can expect the Commission to be more willing to seek penalties in types of cases where it was previously reluctant to do so. For example, in three cases involving Enron Corporation counter-parties, the SEC has obtained penalties and disgorgement totaling $316 million—a figure that far exceeds the fees those counterparties received from their Enron-related businesses. In the SEC’s March 2003 action against Merrill Lynch, the Commission charged Merrill Lynch and four of its executives with aiding and abetting the Enron accounting fraud.⁸ As part of its settlement of the charges, Merrill Lynch agreed to pay a total of $80 million in disgorgement and penalties. According to the SEC’s litigation release, all of that money will be paid into a court account pursuant to the Fair Funds provision for ultimate distribution to victims of the Enron fraud.

More recently, in two other matters arising out of the Commission’s Enron investigation, J.P. Morgan Chase⁹ and Citigroup¹⁰ have agreed to pay a total of $236 million in disgorgement and penalties to settle allegations that the firms separately assisted Enron’s manipulation of its financial statements. The SEC charged that each company helped Enron mislead investors by mischaracterizing loan proceeds as cash from operations. Again, the Commission intends to direct the $236 million to Enron fraud victims pursuant to the Fair Funds provision.¹¹ Furthermore, in amending its complaint against former Enron executives, the SEC is seeking an order providing that any civil penalties will be added to other monies received, which will then be distributed to the fraud victims.¹²

[W]e can expect the Commission to be more willing to seek penalties in types of cases where it was previously reluctant to do so.

The settlement of the SEC’s case against WorldCom is another example of this trend. In June 2002, the Commission filed a civil action against WorldCom for massive accounting fraud, alleging that WorldCom improperly shifted the cost of leased telephone lines to its capital accounts, causing earnings to be overstated by as much as $17 billion.¹³ Shortly thereafter, WorldCom filed for bankruptcy protection. As part of a negotiated settlement with the SEC, WorldCom agreed to a penalty of $2.25 billion, which is more than 40 percent of WorldCom’s estimated liquidation value and is more than 15 percent of its estimated reorganization value. Based on the anticipated bankruptcy discount, the actual penalty paid will be $750 million— $500 million in cash and the other $250 million in the form of new company common stock.¹⁴ The Commission has promised that all of “the funds paid and the common stock transferred by WorldCom to satisfy the SEC’s judgment will be distributed to victims of WorldCom’s fraud,” pursuant to the Fair Funds provision.¹⁵ The Bankruptcy Court overseeing WorldCom’s reorganization recently approved the settlement, finding it “fair and equitable and in the best interests of the Debtors’ estates.”¹⁶

Actions against gatekeepers

As the SEC casts a broader net in order to compensate defrauded investors, auditing firms could be next. In a speech late last year to the American Institute of Certified Public Accountants, Stephen M. Cutler, the Director of the Division of Enforcement, used tough language to suggest that one cause of the current crisis in financial reporting and corporate governance “was the laxity of the so-called gatekeepers—the accountants, lawyers, research analysts, board members, and others controlling access to our capital markets.”¹⁷ One response, Cutler suggested, is to pursue directly the firms responsible. Consistent with the approach advocated by Cutler, earlier this year the Commission charged KPMG and four of its partners with fraud in connection with audits for Xerox.¹⁸ The Commission’s complaint charges KPMG with direct violations of the antifraud provisions of the federal securities laws and Section 10A of the Exchange Act, and with aiding and abetting Xerox’s violations of the reporting provisions of the Exchange Act. The Commission is seeking injunctions, disgorgement of all fees paid to the defendants, and civil penalties. That case is still pending, and it may be some time before we know whether the SEC will prevail and, if so, whether any penalty ordered will go into a disgorgement fund.¹⁹

Asset freezes

Before the current era of real time enforcement, a common complaint was that SEC enforcement proceedings (investigations and litigation) took so much time that assets fraudulently obtained were often dissipated before judgment was rendered. Section 1103 of Sarbanes-Oxley allows the Commission, while investigating possible securities law violations, to request a federal court to impose a 45-day freeze on extraordinary payments to corporate executives or employees. If the court grants the Commission’s request, the company must place these extraordinary payments into an escrow account. The order may be extended for an additional 45 days upon a showing of good cause. And, if a company or an executive is then charged with a violation of federal securities laws, the Commission may obtain a freeze for the duration of the action (or extend a freeze already in place). Notice and opportunity for a hearing on the Commission’s freeze request is not required if the court finds that such a hearing would be impracticable or contrary to the public interest.²⁰

The Commission’s use of this new power has met with mixed success. In its March 2003 civil fraud action against HealthSouth and HealthSouth’s CEO, Richard Scrushy,²¹ the SEC alleged that HealthSouth, at Scrushy’s direction, overstated its earnings since 1999 by at least $1.4 billion. When the case was filed, pursuant to a stipulation by the company, HealthSouth was ordered to place in escrow, under the court’s supervision, all extraordinary payments (whether compensation or otherwise) to its directors, officers, partners, controlling persons, or employees. At the same time, the SEC obtained a broader freeze against Scrushy of all personal assets. One month later, that freeze was dissolved following an 11-day hearing.²²

In another matter, in May 2003 the Commission requested a U.S. District Court in Los Angeles to freeze a $38 million severance package to two former Gemstar-TV Guide International executives. The Commission requested the freeze after its preliminary investigation into Gemstar’s accounting practices revealed that Henry C. Yuen, founder and former CEO of Gemstar, and Elsie Ma Leung, the former CFO of Gemstar, “may have culpability for violations of the federal securities laws.”²³ Six weeks later, the Commission filed charges against Yuen and Leung, charging them with fraudulently inflating Gemstar’s revenues.²⁴ The Commission’s action seeks antifraud injunctions, civil money penalties, disgorgement, and permanent bars for both Yuen and Leung from service as an officer or director of a public company. The Commission also seeks continuation of the order requiring Gemstar to place into escrow the $38 million severance package.

Expanded Authority to Obtain Officer- Director Bars

Linda Chatman Thomsen, Deputy Director of the Division, recently remarked that an increase in officer-director bars sought “is probably the biggest trend. The Commission has indicated a keen interest in keeping people who have abused their trust from being in a position to do so again.”²⁵ In fact, in 2002 the Commission sought orders barring 126 defendants from serving as officers or directors of public companies. ²⁶

The SEC has not had unlimited success in obtaining the bars sought. Federal courts were authorized to impose a bar on an individual who violated the antifraud provisions of the federal securities laws upon a finding that the person was “substantially unfit” to serve as an officer or director. However, judges are not always willing to impose permanent bars for first time offenders. On occasion, conditional bars—limited by either scope or time—were found to be sufficient. ²⁷

Sarbanes-Oxley expands the SEC’s ability to obtain officer and director bars. Specifically, Section 305 of Sarbanes-Oxley reduced the standard for the Commission to obtain an officer or director bar in an injunctive action from “substantial unfitness” to “unfitness.” Furthermore, Section 1105 of Sarbanes-Oxley allows the Commission to obtain such a bar in an administrative proceeding pursuant to a ceaseand- desist order without first instituting an enforcement action in federal court.

Other Provisions of the Sarbanes-Oxley Act Affecting SEC Enforcement

There are several other provisions of Sarbanes-Oxley designed to enhance the Commission’s enforcement powers.

Penny stock bars. Before promulgation of Sarbanes-Oxley, a “penny stock”²⁸ bar could be imposed only in an administrative proceeding. Section 603 of Sarbanes-Oxley now authorizes federal courts to impose a penny stock bar, conditionally or unconditionally, permanently or temporarily, to prohibit a person from participating in penny stock offerings. The Commission has already taken advantage of this new authority. ²⁹

Equitable relief. If there was any doubt about the Commission’s authority to seek broad equitable relief in an enforcement action filed in federal court, Section 305(b) of Sarbanes-Oxley puts that doubt to rest. Section 305(b) amends Section 21(d) of the Exchange Act to provide that in any action in federal district court, “the Commission may seek, and any Federal court may grant, any equitable relief that may be appropriate or necessary for the benefit of investors.”

Foreign audit firm work papers. Under Section 106 of Sarbanes-Oxley, if a foreign audit firm issues an opinion or otherwise performs material audit services upon which a registered public accounting firm relies in issuing its audit report, the foreign audit firm will be deemed to have consented to produce its audit work papers upon Commission request and to be subject to the jurisdiction of United States courts for purposes of enforcing the production of such audit work papers.

Industry-wide bars. Finally, Section 604 of Sarbanes-Oxley gives the Commission the authority to bar persons from the securities industry who have been suspended or barred by a state securities, banking, or insurance regulator because of fraudulent, manipulative, or deceptive conduct.

More to Come?

Not satisfied with the authority provided by Sarbanes-Oxley, the Commission is seeking further enhancement of its ability to obtain penalties and to use those penalties to compensate the victims of fraud. Section 308(a) allows a penalty to be added to disgorgement funds only when the penalty is collected from a defendant who has also been ordered to pay disgorgement. The Commission has requested that Congress amend this provision to allow it to place all penalty funds into the Fair Fund regardless of whether the defendant is also paying disgorgement.³⁰ At the same time, the Commission also has asked Congress to provide it with authority to impose penalties in administrative cease and desist proceedings against any respondent. Today, the Commission may impose civil penalties in its administrative proceedings only against broker-dealers, investment advisers, and persons associated with them.

The SEC may soon receive even more enhancements to its enforcement authority. In a series of reports required by the Sarbanes-Oxley Act, which were sent to Congress in January, the SEC asked for a range of legislative changes.31 In addition to the amendments with respect to penalties discussed above, the Commission asked for legislation to:

• allow companies to produce internal reports and other documents pertaining to investigations without waiving any privilege;³²
• amend the federal criminal code to provide Commission staff with access to grand jury materials;³³
• provide for nationwide service of process for testimony in Commission litigation;³⁴ and
• amend the Right to Financial Privacy Act to permit the SEC to subpoena an individual’s financial records during an investigation without notice and an opportunity to object.

Congress responded. In April of this year, the Senate passed the CARE Act of 2003,³⁵ which deals principally with unrelated issues, but which incorporated many of the SEC’s requests. The CARE Act would provide the Commission with new administrative authority to impose civil monetary fines against anyone who violates federal securities laws. The CARE Act also would provide the SEC with larger penalties—up to $2 million per violation in administrative proceedings. Furthermore, the CARE Act would grant the SEC new authority to subpoena financial records without prior notification to the subject of the request—similar to the authority now granted to the Federal Reserve and other federal banking agencies.

[T]he Commission is seeking further enhancement of its ability to obtain penalties and to use those penalties to compensate the victims of fraud.

Following the lead of the Senate, Representatives Richard H. Baker (R-LA) and Michael G. Oxley (R-OH) introduced the Securities Fraud Deterrence and Investor Restitution Act (HR 2179) in May 2003. In addition to including all of the SEC’s requested legislation, the Securities Fraud Act would:

• allow the Commission to seek monetary penalties against any individual or entity in administrative cease and desist proceedings;
• permit the SEC to hire private counsel to aid in collection of disgorgement and penalties in order to counter the SEC’s low collection rate;
• clarify restitution laws to allow any civil penalty obtained in a Commission action to be used for victim compensation and provide for remittance to the SEC of any civil penalty or disgorgement that results from a state or other local jurisdiction’s regulatory requirement; and
• exempt SEC judgments from state homestead laws that shield assets from collection.

The most controversial provision of the Securities Fraud Act, the so-called “anti-Spitzer” amendment, would amend Section 308 of Sarbanes-Oxley to preclude individual states from bringing their own enforcement actions.³⁶

Conclusion

The Sarbanes-Oxley Act, described widely as the most significant change in the federal regulation of securities since the creation of the SEC, provides the Commission with considerable new enforcement authority and the money to hire additional staff to use that authority, and thus changes the enforcement landscape in important ways. Whether or not the SEC receives the additional power it has requested, the costs have risen dramatically for those who are found to have violated the federal securities laws. Only time will determine whether the SEC’s vigorous use of its new authority will help to satisfy the most important goal of Sarbanes-Oxley— restoring investor confidence.

William R. Baker III (william.baker@lw.com) is a partner in the Washington Office of Latham & Watkins LLP. Mr. Baker was Associate Director of the Division of Enforcement at the SEC for almost five years ending November 2002. Christopher E. Campbell (christopher.campbell@lw.com) is an associate in Latham’s Orange County Office.