Part I.
Criminal Proceedings

§ 6:1     In General

Willful violations of the substantive provisions of the principal secu­rities laws, including the registration and fraud provisions, are a criminal offense.[1] The Commission has broad subpoena powers which it delegates to members of its staff to investigate apparent violations of the federal securities laws.[2] The Commission’s inves­ti­gation may result from complaints made by disgruntled investors or, as is more often the case, as a result of the initiative of its staff. Surveillance is maintained of unusual price movements on all securities markets, and periodic inspections of broker-dealers are made on a routine basis. Upon conclusion of an investigation, the Com­mission may refer the matter to the Department of Justice with a recommen­dation that certain persons be indicted and prosecuted. If the Department of Justice concurs in the recommendation, the matter will be referred to a grand jury and, assuming indictment, prosecuted by the U.S. Attorney. In other instances, the Commis­sion may initiate an action in the appropriate U.S. district court to enjoin violations of the federal securities laws. See § 6:4. The Department of Justice may separately or in coordination with the SEC conduct investigations leading to criminal prosecutions that include securities fraud counts. Cooperative efforts of this nature often result in the creation of a Task Force. As discussed at § 6:72, in the aftermath of Enron President Bush created a Corporate Fraud Task Force, which includes the Department of Justice, the SEC, Treasury Department, postal inspectors and other federal agencies. It is clear that aiding and abetting one who the secondary actor knows (and perhaps recklessly disregards) is violating Rule 10b-5 constitutes a criminal violation.[3] The United States Criminal Code expressly provides that one who “aids, abets” a federal offense “is punishable as a principal.”[4] The Supreme Court in Central Bank expressed the view that criminal aiding and abetting requires proof of something more than “recklessness.”[5]

§ 6:2     SOA Enhanced Penalties for Securities Fraud and Related Crimes

Sarbanes-Oxley Act  impacts criminal penalties for securities fraud in a number of respects. Of most immediate significance to financial fraud are the following:

1.   Mail fraud and wire fraud penalties are increased from five years to 20 years.[6]

2.   Penalties for willful violations of any provision of the Exchange Act or rule or regulation adopted thereunder the violation of which is unlawful are increased from ten to 20 years and the fine that can be imposed is increased from $1 million to $5 million in the case of a natural person and from $2.5 million to $25 million for a person other than a natural person.[7]

3.   A provision is added that provides that anyone who attempts or conspires to commit an offense against the United States shall be subject to the same penalties set forth in the substantive offense that was the object of the conspiracy.[8]

4.   A new securities fraud crime is created. It is unlawful to knowingly execute or attempt to execute a “scheme or artifice to defraud any person in connection with any security of” a reporting company under the Exchange Act. It is also unlawful under this provision to knowingly execute or attempt to execute a “scheme or artifice” to obtain money or property by means of false pretenses or representations “in connection with the purchase or sale of any security” of a reporting company under the Exchange Act.[9] The penalty for violations of this provision is a fine or imprisonment of not more than 25 years, or both, exceeding the revised penalty for violating Rule 10b-5 or other provisions of the Exchange Act by five years.[10] Rule 10b-5 requires proof of scienter and only willful violations are punishable as a crime,[11] but query whether any less will be required to establish a knowing scheme or artifice to defraud under the new securities fraud. The new “scheme or artifice to defraud” crime is applicable to any such fraud “in connection with any security” of a reporting company, whereas violations of Section 10(b)(5) and Rule 10b-5 require that it be “in connection with the purchase or sale of any security,” but it remains to be seen how this might change the “in connection” requirement.[12]

5.   As discussed at § **, if a CEO or CFO of a reporting company furnishing the required written statement certifying periodic reports “knowingly” violates the certification provision, the penalty upon conviction is a fine not in excess of $1,000,000 and imprisonment of not more than ten years, or both. If the defendant “willfully” violates this provision, the penalty upon conviction is a fine not in excess of $5,000,000 and imprisonment of not more than 20 years, or both.[13]

6.   A little noticed provision of the Act in practice could have greater impact than any of the more publicized efforts to severely punish corporate crime. The Act includes a general provision that a violation of any provision of the Act or rule adopted thereunder by the Commission or the PCAOB shall be deemed a violation of the Exchange Act and subject to the same penalties imposed by that Act,[14] which as noted above have been increased from ten to 20 years. Section 32 of the Exchange Act, the criminal penalty provision, does provide that a criminal penalty can be imposed only for a willful violation of the Act and the rules adopted thereunder “the violation of which is made unlawful or the observance of which is required.” The penalties provided by Section 32 are also imposed for “willfully and knowingly” making a false or misleading statement of a “material fact” in any application, document, or report required to be filed under the Act.[15]

§ 6:3     SOA ― Instructing the Sentencing Commission on the Seriousness of Financial Fraud Introduction

The Act includes three to some degree overlapping provisions providing guidance to the United States Sentencing Commission in establishing sentencing guidelines relating to securities fraud. One provision directs the U.S. Sentencing Commission to review and amend the guidelines to implement the provisions of the Act.[16] In reviewing the guidelines, the Sentencing Commission is specifically instructed, among other things, to ensure that the guidelines reflect the serious nature of the offenses and penalties set forth in the Act; the growing incidence of serious fraud offenses; the need to modify the guidelines in order to deter, prevent, and punish such offenses.[17]

Separately the Sentencing Commission is asked to review the sentencing guidelines “applicable to securities and accounting fraud and related offenses,” and expeditiously consider adopting new or amended guidelines to enhance sentences “for officers or directors of publicly traded corporations who commit fraud and related offenses.”[18] In doing so, it is to take into account “the serious nature of securities, pension, and accounting fraud and the need for aggressive and appropriate law enforcement action to prevent such offenses.”[19] The Sentencing Commission is also to ensure that the guideline offense levels are sufficient when fraud victims adversely affected are “significantly greater than 50.”[20] Although the review guideline provisions are phrased as a “request,” the Sentencing Commission is to adopt the new or amended guidelines under this section as soon as possible and, in any event, within 180 days of enactment of the Act.[21] Still another provision of the Act instructs the Sentencing Commission to review and amend its guidelines to sufficiently take into account as a sentence-enhancing characteristic that the fraud offense “endangers the solvency or financial security of a substantial number of victims.”[22] The Sentencing Commission also is to take into account whether the guidelines “are sufficient to deter and punish organizational criminal misconduct.”[23] In addition to all of the above, there are provisions directing the Sentencing Commission to take into account whether, in the context of increased criminal penalties included in the Act for obstruction of justice involving destruction of evidence,[24] the guidelines are adequate.[25]

Part II.
Civil Proceedings

A.    Injunctions

§ 6:4     In General

The four principal acts enforced by the Commission all have provisions authorizing the Commission to initiate a proceeding to obtain an injunction and for the courts to issue an injunction to prevent violations or threatened violations of the Act. Section 21(d)(1) of the Exchange Act authorizes the Commission to initiate an action to enjoin any person engaged in or about to engage “in any acts or practices constituting a violation of any provision of this title.” Emphasis supplied. Section 21(e) of the Ex­change Act authorized a U.S. district court to issue “injunctions, and orders commanding (1) any person to comply with the provisions of this title.” Emphasis added. The Securities Act (Sections 20(b) and 22(a)), the Investment Company Act (Section 42(d)), and the Investment Advisers Act (Section 209(d)) all contain counterpart provisions authorizing the issuance of an injunction.

An injunction that merely enjoins one from further violations is not a very effective remedy. One in a sense is already under an order to not violate the law as a violation of the law has consequences. There is, of course, the pragmatic difference that one who is enjoined from violating the law, presumably, exercises more caution than the general citizen, although in the case of the recidivist securities violator this may not be the case. The principal differences are two-fold: First, one who is enjoined from further violations and is alleged to have committed a further violation can be tried for contempt. The likelihood that such proceeding will be initiated is not only greater than the likelihood of an indictment and criminal prosecution, but the defendant in the contempt proceeding is not entitled to a trial by jury. Second, there are a number of other provisions of the securities laws[26] that make the issuance of an injunction grounds for imposing remedial sanctions, such as barring one from the securities business or from acting as an officer or director of an investment company, provided the Commission determines that it is in the public interest to do so. It was recognition of the inadequacy of the injunction as an effective policing device that encouraged Congress to adopt the Securities Enforcement Remedies and Penny Stock Reform Act of 1990,[27] adding significantly to the Commission’s arsenal of weapons for dealing with penny stock and other forms of securities fraud. The Commission’s civil remedies under SERA are discussed below commencing at § 6:8 and those available in administrative proceedings commencing at § 6:20.

The Supreme Court has given added clout to a judgment ob­tained by the SEC in an injunctive action by holding that a private party plaintiff could use collateral estoppel affirmatively so as to preclude a defendant from relitigating issues of fact decided against him in the SEC action.[28] While the court suggested that the application of col­lateral estoppel is within the discretion of the trial court, it found that application of the doctrine in this context does not violate defendant’s right to a jury trial, and, since plaintiff could not have joined in the SEC action, it is not inappropriate for the court in its discretion to allow the plaintiff in the private action to assert the judgment in the SEC action as a bar to relitigating issues which have been fully and fairly litigated. One result of this hold­ing may be to encourage de­fendants in the SEC proceeding to con­sent to the entry of an injunc­tion so as to be in a position to avoid collateral estoppel in a private action as the issues have not been fully and fairly litigated.

§ 6:5     Scienter and Probability of Further Violations

The extent to which the SEC has to prove scienter in an injunc­tive action appears to depend on the specific section of the securi­ties laws being relied upon. In Aaron v. Securities and Exchange Com­mission,[29] the Court, having painted itself into a corner by this ap­proach (“we do not write on a clean slate,” to borrow its cliché), carried the dictionary approach to its logical extreme and holds that the plain meaning of the words of Section 10(b) compels it to con­clude that the Commission must establish “scienter” in an injunc­tive action based on violations of Rule 10b‑5. The Court at the same time holds that clauses (2) and (3) of Section 17(a) of the Se­curities Act, however, do not require “scienter,” thus driving a wedge be­tween those provisions, applicable to fraud in the offer or sale of secu­rities, and Rule 10b‑5, applicable to fraud in connection with the purchase or sale of any security.[30] The Court has also set the statu­tory interpretation process in a mold which will require the several other fraud provisions of the securities laws to be inter­preted on the basis of nuances of language separated from the ob­jectives of those laws, not the least of which is an interrelated and integrated regula­tory pattern.

Aaron involved the alleged failure of a managerial employee of a broker-dealer to supervise, and thus prevent, a fraudulent scheme by two registered representatives subject to his supervision. The facts, however, were not relevant to the Court’s decision since the Court in Aaron, as in Hochfelder, separates its discussion of the is­sues from the facts and considers “scienter” versus “negligence” in abstract terms. The Court resolves the issue left open in Hochfelder of whether Section 10(b) is to be read the same way in a proceed­ing in which the Commission seeks injunctive relief. The first clause of Section 17(a), the Court holds, like Section 10(b) and Rule 10b‑5, requires proof of scienter since it uses the terms “de­vice,” “scheme,” and “artifice,” all of which, to the Court, “connote knowing or inten­tional practices.”[31] The second clause of Section 17(a), however, merely makes untrue or misleading state­ments unlaw­ful, and “is de­void of any suggestion of a scienter re­quire­ment.”[32] The third clause, which refers to “transactions or practices which operates or would operate as a fraud or deceit” [emphasis added by the Court] upon the purchaser, “focuses upon the effect of particular conduct . . . rather than upon the culpability of the persons responsible.” Similar language of Section 206(2) of the Investment Adviser Act has been construed by the Court in SEC v. Capital Gains Research Bureau, Inc.[33] as not requiring scienter.

The practical implications of the Aaron decision are significant, although subject to different constructions. The Commission, after contending in argument that construing Rule 10b‑5 to require proof of scienter in injunctive actions would seriously interfere with its en­forcement efforts, through its staff publicly claimed after Aaron that its enforcement efforts will not be seriously affected since it will generally be able to rely on clauses 2 and 3 of Section 17(a) as a basis for its enforcement actions.[34] This will not be true, of course, with respect to fraud on sellers of securities since only Section 10(b) and Rule 10b‑5 are applicable to such fraud. As a re­sult, for exam­ple, an action to enjoin an insider who buys securities on the basis of undisclosed material facts will require the Com­mission to establish scienter, but it will not have to do so in an ac­tion in which an insider utilizes inside information as a basis for a decision to sell securities.

The dispute over a “scienter” requirement in an injunctive pro­ceeding may, as Chief Justice Burger suggests in a concurring opin­ion, “be much ado about nothing.”[35] The Chief Justice alludes to the fact that for a court to enjoin a defendant because of past violations, a “reasonable likelihood” that violations will be re­peated in the fu­ture must be shown. In Justice Burger’s view, “[t]o make such a showing, it will almost always be necessary for the Commission to demonstrate that the defendant’s past sins have been the result of more than negligence.”[36] The majority opinion does not go this far, but does refer to “scienter” or a “lack of it” as an important consid­eration in determining whether or not an in­junction should be is­sued.[37]

§ 6:6     Aiding and Abetting

The Court’s holding in Central Bank that no private action can be asserted for damages against one merely aiding and abetting a violation of Rule 10b-5[38] raised a serious issue as to whether the SEC could obtain injunctive relief against aiders and abettors of Rule 10b-5 violations. Justice Stevens in dissenting argued that the rationale of the majority of the Court “leaves little doubt that the Exchange Act does not even permit the Commission to pursue aiders and abettors in civil enforcement actions under § 10b and Rule 10b-5.”[39] Specifically, Justice Stevens referred to the statement in the majority opinion that “the text of the 1934 Act does not itself reach those who aid and abet a § 10(b) violation.”[40] The Court also said, perhaps more significantly, that “Congress has not enacted a general civil aiding and abetting statute — either for suits by the Government (when the Government sues for civil penalties or injunc­tive relief) or for suits by private parties.”[41]

The four principal securities laws all specifically authorize the issuance of an injunction to enjoin further violations of the Act. The Investment Advisers Act, however, differs in one significant respect from the others. In 1960, the Act was amended so as to encompass specifically any person who aided or abetted a violation of the Act.[42] The skimpy legislative history suggests that this provision was intended to “make it clear” that the Commission could enjoin aiders and abettors and acknowledged that the concept was borrowed from the general criminal aiding and abetting provision.[43] What to make of all of this? It suggests that in 1960 Congress did not believe that the injunctive provisions of the Investment Advisers Act (and, presumptively, of the other Acts as well) encompassed aiders and abettors and chose to amend only that Act in this respect. Congress, it can be argued on this basis, knew how to hold aiders and abettors responsible in an SEC-initiated injunctive proceeding, but did not do so with respect to the other Acts. On the other hand, the Court in Central Bank noted in another context that “the interpretation given by one Congress . . . to an earlier statute is of little assistance in discerning the meaning of the statute.”[44] The 1960 amendments to the Investment Advisers Act were primarily concerned with broadening the grounds on which persons could be denied registration as investment advisers and sanctions could be imposed under that Act, which was notoriously weak in this respect.[45] In Central Bank, the Court noted that in 1957, 1959, and 1960 bills had been introduced to make it unlawful to aid or abet a violation of the Exchange Act, which were not adopted. The Court, in rejecting the bank’s contention that Congress in failing to adopt such legislation interpreted Section 10(b) not to cover aiding and abetting, said that “failed legislative proposals are a particularly dangerous ground on which to rest an interpretation of a prior statute.”[46]

The Commission was sufficiently concerned about its authority that it announced its intention to seek legislation “providing that the Commission can seek injunctions and other relief against aiders and abettors.”[47] The Private Securities Litigation Reform Act “reinstates” the Commission’s authority to initiate an action to enjoin and/or seek judicially imposed civil penalties on “any person that knowingly provides substantial assistance to another person in violation of a provision of the Exchange Act.”[48] The PSLRA eliminates any question vis-à-vis Central Bank’s application to enforcement proceedings with respect to civil proceedings initiated by the Commission under the Exchange Act for an injunction or to impose civil penalties.[49] The PSLRA provides explicitly that the Commission may obtain an injunction or initiate an action to impose a penalty on “any person that knowingly provides substantial assistance to another person in violation of a provision of the Exchange Act.”[50] Presumably, the knowing substantial assistance subsumes knowing that the party being assisted is violating the Exchange Act. This provision, however, does not go as far as requested by the Commission, which sought such authority as to any person who recklessly aids and abets as well and also requested that it be extended to violations of the Securities Act and the Investment Company Act.[51]

§ 6:7     Statute of Limitations

A criminal proceeding under the securities acts must be initiated by an indictment or information within five years after the offense was committed.[52] In 1993, the Commission succeeded in convincing the Ninth Circuit in Rind[53] that a civil action for an injunction and disgorgement brought for violations of the fraud provisions of Section 17(a) of the Securities Act and Rule 10b-5 under the Exchange Act is not subject to any statute of limitations. In Rind, the SEC on August 15, 1990 initiated a proceeding to enjoin respondent and compel him to disgorge any unlawful gains resulting from his participation in the preparation of false and misleading financial statements included in the registration statement of ZZZZ Best. The complaint alleged violations of § 17(a) of the Securities Act, § 10(b) of the Exchange Act, and Rule 10b-5 adopted thereunder. The opinion does not set forth when the registration statement alluded to was prepared, but from other litigation it appears that ZZZZ Best filed a registration statement for a public offering on December 9, 1986.[54] If, as it appears, this is the registration referred to, the action was initiated more than three years, but less than four years after the alleged fraudulent activities on which it was based.

While the action was pending, Lampf[55] was decided by the Supreme Court. In Lampf, the Supreme Court held that a one year after discovery/three year statute of limitations was applicable to private actions alleging violations of Rule 10b-5. Rind argued that Lampf was applicable to an action initiated by the Commission and the latest date on which the Commission should have discovered the alleged violation was the date of ZZZZ Best filed for bankruptcy in July of 1987. Since more than three years had elapsed from that date to the date the action was initiated on August 15, 1990, the action was time-barred. The Commission argued that an injunctive action initiated pursuant it authority to initiate such actions under the Securities Acts is not subject to any statute of limitations.

The court first distinguished Lampf, holding it inapplicable. Lampf by its own language is limited to private actions. The interests being reconciled in a private action seeking money damages, differ from those in an action brought by the government to enforce the law, notwithstanding that disgorgement involves the payment of money as its purpose is deterrence rather than compensation. Having determined that Lampf does not govern, the court said, “we must ask whether any limitations period governs Commission enforcement actions.”[56] The court answered its own question, stating: “Congress created a number of private claims, each bound by an express statute of limitations. At the same time, and in the same acts, Congress granted the Commission broad power to enforce the substantive provisions of the securities laws but refrained from imposing an explicit time limit on Commission enforcement actions. Congress clearly devoted its time and attention to limitations issues. The fact that it did not enact an express statute of limitations for lawsuits instituted by the Commission, therefore, must be interpreted as deliberate.”[57] When the Commission brings an action to enforce the Acts by seeking to enjoin future violations and to compel the defendant to disgorge unlawful profits, “it vindicates public rights and furthers the public interest.”[58] To impose “a state or any other statute of limitations on Commission civil enforcement actions would also conflict with the underlying policies of the securities laws; this conclusion strongly negates any inference that Congress intended a limitations period to apply.”[59]

This does not preclude the courts from taking the length of time the Commission has taken to act in determining whether to grant relief. “We hasten to add,” the court said, “that our holding here will not open the door to the prosecution of stale claims. A court can and should consider the remoteness of the defendant’s past violations in deciding whether to grant the requested equitable relief. Although no fixed period of limitations governs Commission actions, a court may exercise its discretion to limit the Commission’s power to seek relief.”[60] The courts generally, however, are in agreement that no statute of limitations is applicable as to equitable relief sought by the Commission.[61] This makes classification important. A district court held that “[a]ccounting, disgorgement, and injunction constitute equitable relief” and as such are not subject to a statute of limitations.[62]

If the Commission seeks only an injunction and disgorgement, Rind may still be good law. The Commission, however, may in the same proceeding seek an officer director bar (see § 6:12) and/or civil penalties (see § 6:8), which may bring into play the Section 2642 statute of limitations. The Commission in administrative proceedings to impose remedial sanctions may have authority to enter a cease and desist order (see § 6:25), to order disgorgement (see § 6:28), to impose an officer/director bar (see § 6:29), and as to securities professionals to impose a money penalty (see § 6:21). The Section 2642 statute of limitations cuts across both the relief being sought by the Commission in a civil proceeding and the sanctions imposed in an administrative proceeding. For convenience in exposition we have discussed them together commencing at § 6:32.

B.    Civil Penalties

§ 6:8     Introduction

The Securities Enforcement and Remedies Act of 1990 (SERA)[63] authorizes the Commission to initiate a judicial proceed­ing to impose a civil penalty for any violation of the Exchange Act, the Securities Act, the Investment Company Act, the Investment Advisers Act, any rule or regulation adopted under any of the specific Acts, or for vio­lation of a cease and desist order entered by the Commission under any of the specified Acts.[64] The provisions relating to violations of the specified Acts are all subject to the proviso that they are not applicable to a violation subject to a penalty under Section 21A of the Exchange Act (the insider trading civil penalty provisions). Un­like the Commission’s authority to im­pose administrative fines which can be imposed only on specified securities professionals,[65] civil penalties can be judicially imposed on any securities violator. The Insider Trading Sanctions Act of 1984 (ITSA) authorized the Com­mission to seek the judicial im­position of civil penalties for in­sider trading violations, an author­ity broadened and strengthened by the In­sider Trading Act of 1988 (ITA).[66] The SERA civil penalty pro­visions do not affect the ITSA, which continues to operate on a sep­arate track with its own pecu­liar nuances.[67] The SERA civil penalty authorization was inspired by the fact that the experience with civil penalties in connection with “insider trading has been ex­tremely positive.”[68]

There are two different tracks for judicially imposing civil penal­ties — the ITSA civil penalty (hereinafter the insider civil penalty) and the SERA civil penalty of general application (hereinafter the general civil penalty); nonetheless, there should emerge a composite civil penalties jurisprudence with many simi­larities and some differ­ences. The ITA civil penalty is discussed at § . There are, nonetheless, advantages to a composite ap­proach in that, to the ex­tent the insider civil penalty and the general civil penalty have pro­visions in common, the legislative history relating to one should be relevant to the other, and, to the extent they differ, insights may be found as to why Congress chose to adopt a different approach. Fur­ther, the general civil penalty pro­visions are applicable only to the extent the insider trading civil penalty is not applicable; hence, to determine where the general civil penalty comes into play, one must first determine where the insider penalty provisions leave off. For these reasons, at the risk of some duplication, the two tracks are pre­sented below on a com­posite comparative basis.

SERA has added significant additional enforcement alternatives to the Commission’s arsenal, all of which are cumulative. The Commission, however, must be concerned with the possibility that civil penalties and administrative fines (see § 6:23) under appropriate circum­stances may constitute punishment for double jeopardy purposes.[69] The double jeopardy clause is applicable not only to a second prose­cution for the same offense after acquittal or a conviction, but to “multiple punishments for the same offense.”[70] The extent to which it may be applicable to a civil penalty has had a checkered history ..

§ 6:9     The Composite

The principal purpose of the ITSA is to create an additional rem­edy the Commission can seek with respect to insider trading viola­tions.[71] The SERA civil penalty provisions were enacted in recogni­tion of the fact that “many of the charges in the most prominent se­curities fraud cases of the 1980s have involved viola­tions other than insider trading,” such as manipulation in the penny stock markets and parking of securities in connection with take­overs.[72] Under both Acts such civil penalties can be imposed only at the instance of the Securities and Exchange Commission. Private parties cannot seek relief based on the provisions of either the in­sider or general civil penalty provisions. SERA and the ITSA pro­vide, in identical fash­ion, except as to the nature of the violations, whenever it appears to the Commission that “any person has vio­lated any provision, etc.,” that the Commission may bring an action “in a United States District Court to seek and the court shall have jurisdiction to impose, a civil penalty to be paid by the person who committed such violation.”[73] The Acts diverge at this point, as dis­cussed below,[74] as the insider civil penalty specifically imposes a civil penalty on controlling per­sons, and the general civil penalty is silent in this regard. The Commission under both Acts, however, retains all its other remedies, including ancillary relief in an action for an injunction.[75] The Com­mission typically in this context has sought disgorgement of profits, a remedy approved in SEC v. Materia,[76] as a means of compensating those adversely affected by the nondisclosure.[77] The House Report relating to SERA is explicit that the civil penalties “can be imposed in addition to orders of dis­gorgement directing a defendant to return the full amount of profits derived from a violation.”[78]

Since the Acts impose a civil penalty, it follows that (1) proof of the violation has to be by a preponderance of the evidence and (2) nonpayment of the penalty will not result in imprisonment.[79] The Supreme Court has held that the defendant is entitled to a jury trial in a proceeding to impose a civil penalty under the ITSA.[80] The penalty under both civil penalty provisions is payable to the Treas­ury of the United States.[81] If one fails to pay the penalty, the Attor­ney General is authorized under both civil penalty provisions to bring an action in the appropriate district court to recover the amount of the penalty.[82] The venue provisions under the insider and general civil trading provisions are the same,[83] treating the ac­tion as one to enforce a liability or a duty created by the Act and thus mak­ing the broad general venue provisions of Section 27 of the Act ap­plicable to such proceedings.[84]

The Commission is authorized under the ITSA civil penalty pro­visions to seek a penalty when any person violates any provi­sion of the Exchange Act or rules or regulations adopted thereun­der “by purchasing or selling a security while in possession of ma­terial non­public information” in a transaction effected through an exchange or a broker or dealer, and which (except as to standard­ized options) does not involve a public offering by an issuer.[85] SERA civil penalty provisions, similarly, do not create substantive liabilities, but are predicated on violations of the pertinent substan­tive law. Issues such as scienter, for example, are to be resolved under the relevant sub­stantive law that has developed in other types of proceedings. Con­ceivably, a different standard of scienter might be appropriate in a proceeding to impose a penalty. The case law relating to actions for damages vis-à-vis actions for an injunction suggests, however, that the degree of culpability required does not differ depending upon the nature of the civil action.[86]

The general civil penalty provisions impose liability for viola­tion of any provision of the Exchange Act, the rules or regulations adopted thereunder, a cease or desist order issued thereunder, other than a violation subject to the insider civil penalty.[87] This poses an interesting question as to whether an insider trading violation not subject to a civil penalty (e.g., one not involving a transaction in the organized securities markets) could be subject to the general civil penalty provision. Literally, the violation is not subject to the insider civil penalty provisions; therefore, the general civil penalty should be applicable. Arguably, however, Congress intended by omitting such violations from the insider civil penalty provisions to limit the reme­dies in this area to penalties other than civil penal­ties. Similarly, the Commission’s authority to enter cease and de­sists orders embraces any violation of the Exchange Act,[88] which would include a violation of the insider trading provisions. If the Commission orders one to cease and desist from a violation of the insider trading provisions, can the Commission seek a general civil penalty for a violation of that order? There is no insider civil pen­alty for violating a cease and desist order, but the violation of that order in the insider trading context is likely to involve a violation for which the insider civil penalty is available. This issue may be largely academic as the staff would probably seek the insider civil penalty provision, which, in most instances, is likely to be greater.

The Commission must initiate an action to recover the insider civil penalty within five years of the date of the appropriate pur­chase or sale.[89] SERA includes no period of limitation within which the Commission must initiate an action to recover the gen­eral civil penalty. But Chief Justice John Marshall in 1805 said that to impose no period of repose on a federal cause of action would be “utterly repugnant to the genius of our laws.”[90] This dictum has led courts to borrow a period of limitations if Congress failed to pro­vide one, which inevitably is the case as to implied private causes of action such as those that can be asserted under Rule 10b‑5. The resulting thicket as to whether an analogous state or federal period of limita­tions is appropriate was finally resolved by the Supreme Court, which elected to apply the express period of limitations of the Ex­change Act to implied claims arising under Rule 10b‑5.[91] Query, however, whether the borrowing doctrine is applicable to the impo­sition of civil penalties. It seems unlikely that Congress, which two years earlier imposed a specific limitation period on initiating an ac­tion for the insider trading civil penalty, intended to borrow an un­specified period of limitation for the general civil penalty, notwith­standing its presumed awareness of the borrowing doctrine.

The insider civil penalty provisions include a bounty provision authorizing the Commission to pay up to ten percent of the amount of the penalty to an informer or informers.[92] The general civil pen­alty provisions do not authorize the payment of a bounty. The gen­eral civil penalty provision includes a specific provision applicable to cease and desist orders that each violation of a cease and desist order constitutes a separate offense for which separate civil penal­ties can be imposed, except in the case of a continuing failure to comply, in which event each day of the failure to comply is deemed a sepa­rate offense.[93] The amount of the penalty that theo­retically could be imposed under this provision is staggering.

§ 6:10   The Penalty

Determining the amount of the civil penalty under the insider penalty provisions and the general civil penalty provisions differs significantly. The insider civil penalty as to a primary violator is “not to exceed three times the profit gained or loss avoided as a re­sult of such unlawful purchase or sale.”[94] The courts exercise dis­cretion as to the amount of the penalty (up to the maximum) based on the “facts and circumstances.”[95] “Profit gained,” and “loss avoided,” are defined as the difference between the sales price (or purchase price, as appropriate) and the value (measured by the trading price) of the security as determined a reasonable period of time after the withheld information is publicly disseminated.[96] De­termining the amount of the general civil penalty has more in com­mon with the determination of administrative fines[97] than with the insider civil penalty. As in the case of administrative fines, the pen­alties have a three-tier structure, as follows:[98]

(1)  First tier: An amount not to exceed $5,000 for a natural per­son or $50,000 for any other person.

(2)  Second tier: An amount not to exceed $50,000 for a natural person or $250,000 for any other person.

(3)  Third tier: An amount not to exceed $100,000 for a natural person or $500,000 for any other person, or the gross amount of the pecuniary gain to the defendant, if greater.

The basis for distinguishing among the tiers, with one differ­ence noted immediately below, is the same as that relating to ad­ministra­tive fines. The first tier is the residual tier; if the violation (act or omission, in the case of administrative fines) does not fall in the sec­ond or third tier it is a first tier violation. Second and third tier vio­lations must involve “fraud, deceit, manipulation, or delib­erate or reckless disregard of a regulatory requirement.” The third tier is dis­tinguished from the second tier in it must have resulted, directly or indirectly, in substantial losses or created a significant risk of sub­stantial losses to other persons. In the case of the admin­istrative monetary penalty, it also can be third tier because it re­sulted in sub­stantial pecuniary gain to the person who committed the act or omission. This may merely reflect the assumption that there can be no gain to one without a loss to someone else as evi­denced by the fact that the third tier judicial general civil penalty can be up to the amount of the defendant’s gross pecuniary gain if greater than the specified dollar amount of the penalty. The nu­ances in this respect are interesting. Substantial pecuniary gain of the respondent can be the basis for determining that the violation results in a third tier penalty in the case of an administrative fine, but does not otherwise affect the maximum amount of the penalty. In the case of the general civil penalty, pecuniary gain is not a basis for determining the appli­cable tier, but establishes, if greater, a higher maximum than the specified the third tier dollar penalty. In the case of the insider civil penalty, the maximum can be three times the amount of the defen­dant’s pecuniary gain.

§ 6:11   Civil Penalties and Controlling Persons

A principal difference between the insider civil penalty provi­sions and the general civil penalty provisions is the detailed man­ner in which the former deals with the liability of persons other than pri­mary violators and the complete absence of specific provi­sions relat­ing to secondary violators under the general civil liability provisions. There is a checkered history relating to secondary li­ability under the insider trading provisions that is described at § . The Insider Trading Act of 1988 specifically provides that civil penalties can be imposed on a person who directly or indi­rectly controls the person engaged in unlawful insider trading.[99] The concept of “controlling person” is based on Section 20(a) of the Exchange Act,[100] but the de­gree of culpability is specifically defined by the Insider Trading Act. The Commission must estab­lish that the controlling person “knew or recklessly disregarded the fact that such controlled person was likely to engage” in unlawful trading and “failed to take appropriate steps to prevent” such trad­ing.[101] The Committee Report speaks of an “objective standard” in­volving the disregard by the controlling per­son of a risk under cir­cumstances that “would constitute a gross de­viation from the stan­dard of care that a reasonable person would ex­ercise in such a situation.”[102] This does not require proof of aiding and abetting; such a “standard was specifically considered and re­jected by the Committee.”[103]

The civil penalty that can be imposed on a controlling person dif­fers in one respect from the liability of the primary violator in that the maximum is $1 million if that is greater than three times the amount of the profit gained or loss avoided as a result of the con­trolled person’s violation.[104] The concern of Congress over the re­sponsibility of controlling persons vis-à-vis insider trading viola­tions is evidenced by the fact that such liability can exceed that im­posed on the primary violator. The civil penalty that can be im­posed on a controlling person, however, can be based only on the standards of culpability described above, it cannot be solely by rea­son of employ­ing the controlled person who commits the viola­tion.[105] There can be no civil penalty imposed on one for aiding or abetting as such,[106] al­though the actions that give rise to culpability on the part of a con­trolling person might also involve aiding and abetting.

The SEC’s authority to impose money penalties on securities pro­fessionals in administrative proceedings also is clear.[107] This author­ity specifically extends to persons who willfully aid or abet as well as those who fail to reasonably supervise the primary viola­tor.[108] The authority to impose the general civil penalty under SERA is to “impose a civil penalty to be paid by the person who commit­ted such violation.”[109] Conspicuous by its absence is the second part of the counterpart provision of the insider civil penalty provisions im­posing liability on controlling persons as described above. One, on this basis, might conclude Congress intended that a penalty should not be imposed on secondary violators. Congress, perhaps, regarded insider trading as a more insidious violation than other violations of the securities laws as evidenced by the larger penal­ties that can be imposed.[110] One might question, however, that a Congress that was so tough on penny stocks generally[111] would re­gard controlling per­sons’ responsibilities as something of a lesser concern with respect to violations committed by others in connec­tion with a penny stock distribution. But, perhaps, Congress thought it sufficient that most such controlling persons are likely to be securities professionals subject to the administrative fining power of the Commission.[112] Secu­rities professionals for this pur­pose under the Penny Stock Re­form Act include not only broker-dealers and persons associated with broker dealers, but anyone who participates in a penny stock distribution.[113]

C.    Barring Securities Violators From Acting as an Officer or Director of a Public Company

§ 6:12   Introduction

SERA also authorized the Commission to initiate a judicial pro­ceeding to bar a person who violated Section 17(a)(1) of the Securi­ties Act[114] or Section 10(b) of the Exchange Act[115] and the rules adopted thereunder, respectively, the general antifraud provi­sions of the Securities Act and the Exchange Act, from acting as an officer or director of a reporting company (i.e., one with a class of securities registered under Section 12 of the Exchange Act or subject to the re­porting requirements of Section 15(d) of the Ex­change Act). Such an order can be obtained only in conjunction with a proceeding to obtain an injunction pursuant to the Securities Act or pursuant to the Exchange Act. In order to obtain such an order, the Commission in addition to proving ap­propriate violations of the Securities Acts had to also establish that the defendant’s “conduct demonstrated substantial unfitness to serve as an officer or director.” The Com­mission has similar and broader authority to bar persons from act­ing as an officer or director, in­vestment adviser, or underwriter to an investment company.[116] The Commission has previously ob­tained bars against securities violators acting as an officer or direc­tor of a public company as ancillary re­lief, but had no express statutory authority to do so.[117]

The PSLRA provision authorizing the Commission to obtain injunctive relief against one who aids or abets a violation of Rule 10b-5 (see § 6:6) strongly suggested that a bar order could not be entered against one who merely aids or abets a violation, since the provision expanding the Commission’s authority vis-à-vis aiding and abetting is applicable to actions brought by the Commission pursuant to Section 21(d)(1) (for an injunction) and to Section 21(d)(3) (to impose a penalty), whereas Section 21(d)(2) (to bar one from acting as an officer or director) is conspicuous by its absence from this provision.

Proposal #5 of President Bush’s ten-point plan to improve corporate accountability called for giving the SEC the power administratively to ban individuals from serving as officers or directors of publicly-held corporations if they engage in serious misconduct.[118]  SEC Chairman Harvey Pitt in testifying before Congress explained the need for such authority to the fact that “some courts have taken an inhospitable approach to the plain legislative language, thwarting our ability to prevent some officers and directors who inflict serious harm on investors from repeating that kind of conduct.”[119] Chairman Pitt as discussed at § 6:14, was referring to his reading of the Second Circuit’s opinion in Patel.

§ 6:13   Sarbanes-Oxley Lowers Standard for Officer/Director Bar

As discussed at § 6:29, Sarbanes-Oxley obliged President Bush and Chairman Pitt with a provision authorizing the SEC to impose an officer/director bar in an administrative proceeding. In addition, Congress attempted to clarify the “plain legislative language” of the civil remedy provided by SERA by amending the grounds for such bar from conduct that “demonstrates substantial unfitness to serve as an officer or director” to “demonstrates unfitness to serve as an officer or director.”[120] The Senate Report noted in this regard:[121] “Currently, it must be proved that an officer or director has both violated the securities laws, and has shown ‘substantial unfitness’ to serve before a bar can be imposed. The Commission has argued that the ‘substantial unfitness’ standard for imposing bars is inordinately high, causing courts to refrain from imposing bars even in cases of egregious misconduct. The proposed bill rectifies this deficiency by modifying the standard governing imposition of officer and director bars from ‘substantial unfitness’ to ‘unfitness.’”[122]

§ 6:14   Distinguishing between Unfitness and Substantial Unfitness

Sarbanes-Oxley purports to lower the standard from “substantial unfitness” to “unfitness”; tautology aside, there is no fine line between the two. Prior to the adoption of SERA, federal courts had imposed officer/director bars in proceedings initiated under the court’s inherent equitable powers. Courts in actions initiated after the adoption of SERA in 1990, but involving events that occurred before 1990, met the argument that SERA could not be applied retroactively by commingling the statutory officer and director bar with the inherent equitable power of courts, stating: “The Act merely codified the equitable authority to impose officer and director bar which the courts already possessed and exercised.”[123] As a result, cases in which an officer and director bar may be in issue may have been decided under the aegis of the statutory grant of power or the courts’ authority in equity, in some instances without distinguishing between the two.

At least one commentator suggested that the inclusion of the “substantial unfitness” standard in the statutes meant that a court should impose the officer and director bar under SERA only when a higher burden was met.[124] The six-factor test suggested by the law review article according to SEC Chairman Pitt was adopted by the Second Circuit in 1995 in Patel.[125] See S.E.C. v. Patel, 61 F.3d 137 (2d Cir. 1995).[126] The footnote supporting his written testimony at this point cited “SEC v. Patel, 63 F.3d 137, 141 (2d Cir. 1995) (in reversing the lifetime injunction against an officer of a company who was found to have violated the federal securities laws, the court discussed a non-exclusive six factor test for considering fitness to serve as officer or director: (1) the egregiousness of the violation; (2) whether the defendant was a recidivist; (3) the defendant's position when he engaged in the fraud; (4) the degree of scienter; (5) the defendant's economic gain from the violation; and (6) the likelihood that the defendant would repeat the misconduct).”[127]

Under the courts’ powers in equity, rather than “substantial unfitness,” the standard generally employed to decide whether an officer or director bar should be imposed was simply whether there is a reasonable likelihood that the misconduct would be repeated.[128] Although SEC Chairman Pitt characterized the six-factor text of Patel as “inhospitable,” in practice the two sources for the imposition of the officer and director bar has not proven so distinct. At least three different federal Circuits have heard cases where officer and director bars were asserted under the SERA but were ordered by the district court or sustained by the circuit court on the basis of the courts’ equitable powers.[129] See S.E.C. v. First Pacific Bancorp and Leonard Sands, 142 F.3d 1186, 1193 (9th Cir. 1998); S.E.C. v. Victor Posner and Steven Posner, 16 F.3d 520, 521 (2d Cir. 1994); S.E.C. v. Sprecher, 81 F.3d 1147, at *4 (D.C. Cir. 1996). In all three cases, the same evidence adduced to support the imposition of the officer and director bar under SERA was sufficient for the court in each case to fashion the bar as an equitable remedy. Similarly, the two standards themselves have sometimes been interchanged in the jurisprudence. For example, when a court has heard a case treating an officer and director bar under SERA, it has nonetheless looked to the “reasonable likelihood” of future violations standard from the precedent decided under the courts’ powers in equity.[130] See, e.g., S.E.C. v. Softpoint, Inc., 958 F. Supp. 846, 866-67 (S.D.N.Y. 1997); S.E.C. v. Leonard Sands, 902 F. Supp. 1149, 1158 (C.D. Cal. 1995). But perhaps most importantly, the specific factors looked to by a court when making a determination under either standard were very similar. In a case decided under the “reasonable likelihood” of recurrence standard,[131] Cf. S.E.C. v. Softpoint, Inc., 958 F. Supp. 846, 867 (S.D.N.Y. 1997).the specific factors looked to by a court included: (1) the degree of scienter involved; (2) the isolated or recurrent nature of the infraction; (3) the defendant’s recognition of the wrongful nature of his conduct; (4) the likelihood, because of the defendant’s occupation, that future violations might occur; and (5) the sincerity of the defendant’s assurances against future violations.[132] S.E.C. v. Leonard Sands, 902 F. Supp. 1149, 1158 (C.D. Cal. 1995). Under either set of factors, a court’s determination was essentially made with reference to the defendant’s culpability and likelihood that the investing public may be subjected to future misconduct.

In Patel, the Southern District of New York imposed a permanent and unconditional bar on Patel from ever serving as an officer or director of a public company in connection with his directorship and vice-presidency at Par Pharmaceuticals, Inc. Patel and others sold Par securities with the knowledge that the pending FDA application on which the stocks sales were predicated had been falsified. The scheme became the focus of a congressional subcommittee investigation into the generic drug business in 1988. Patel eventually pled guilty to charges of conspiracy to defraud the FDA and was sentenced to 27 months in prison. It was actually the District Court that employed the six factors suggested by the law review article[133] and that Chairman Pitt characterized as “inhospitable” in making the determination of whether a corporate executive “substantially unfit to serve.” It was Patel, the defendant in that proceeding (not the SEC), who was objecting to the use, or at least the application, of the six-factor test. The Second Circuit thought it not inappropriate to consider those factors, provided they were not exclusive, as “[a] district court should be afforded substantial discretion in deciding whether to impose a bar to employment in a public company.”[134]

The District Court found that Patel should be permanently barred from any officer or director position in a public company. What the Second Circuit took issue with was “the district court’s finding regarding the likelihood of future misconduct, which is always an important element in deciding whether the substantial unfitness found justifies the imposition of a lifetime ban.” The district court merely found that Patel “used his position as an officer and director to engage in misconduct.” Such finding, the Second Circuit said, “is merely a general statement of events and can in no way justify the prediction that future misconduct will occur.” To impose a bar involving a loss of livelihood and stigma, requires more. Cases applying a bar as an equitable remedy have required a finding defendant “had committed securities law violations with a ‘high degree of scienter’ and that their past securities law violations and lack of assurances against future violations demonstrated that such violations were likely to continue.”[135] Although past offenses (presumably, in addition to the acknowledged violation) are not a pre-requisite for the imposition of a permanent ban, in their absence, “a court should articulate the factual basis for a finding of the likelihood of recurrence.”[136]

The Second Circuit further supported its holding by reference to the sections of the Securities Acts that set forth the officer and director bar. In both sections, the statute states that a court may impose the ban “conditionally or unconditionally, and permanently or for such period of time as it shall determine,” 15 U.S.C. §§ 78u(d)(2), 77t(e). The court took the opportunity to construe the import of the passage: “[w]e take these provisions to suggest that, before imposing a permanent bar, the court should consider whether a conditional bar (e.g., a limited to a particular industry) and/or a bar limited in time (e.g., a bar of five years) might be sufficient, especially where there is no prior history of unfitness.”[137] When the officer and director bar came into issue subsequent to the Patel decision, a number of district courts within the Second Circuit and beyond reacted to the Circuit’s admonition by choosing to limit or condition the bars which they ordered.[138] Nonetheless, there are numerous cases decided after Patel which have imposed permanent and unconditional bars.[139] Interestingly, since Patel was decided, the SEC has acquiesced in connection with decrees entered pursuant to a settlement offer to a bar for a limited number of years.[140] Ironically, Chairman Pitt’s concern was that Patel and progeny imposed too severe a standard in determining substantial unfitness, but the real issue those cases raised was whether the bar should be permanent and conditional and was based on the language of the statute that has not been changed, suggesting under appropriate circumstances the bar should be conditional rather than permanent.

D.    Disgorgement

§ 6:15   Introduction

SERA interestingly gave the Commission authority in connection with administrative proceedings to enter cease and desist orders to also order an accounting and disgorgement (see § 6:28), but did not include similar authority to obtain disgorgement in a civil enforcement proceeding. This, perhaps, was in recognition of the fact the Commission in the civil enforcement actions based on alleged securities fraud it initiates pursuant to § 21 of the Exchange Act often sought and obtained disgorgement based on the equitable powers of a court to require the disgorgement of ill-gotten gains.[141] Courts have said that the purpose of disgorgement is to “force a defendant to give up the amount by which he was unjustly enriched.”[142] Although the SEC can and has used disgorgement as a method of returning ill-gotten gains to investors, the courts and the SEC are not required to do so.[143] Disgorgement has thus been traditionally used as a remedy that returns the violator to the position he or she would have been absent the violation, and only secondarily as a remedy that compensates the victims of fraud. Disgorgement has not been a highly efficient remedy for defrauded investors. See § 6:18.

The Commission in response to Enron announced that it was broadening the scope of disgorgement that it would seek in civil actions from officers who receive bonuses or profit from the resale of stock during a period the price of the stock is inflated by false financial information. The Commission’s efforts in this regard are discussed at § 6:16. The Sarbanes-Oxley Act attempts to address this objective in two respects. First, it provides that in any action brought by the Commission under any provision of the securities laws it may seek and the court may grant “any equitable relief” that is “appropriate or necessary for the benefit of investors.”[144] The Senate Committee report stated in this regard: “For a securities law violation, currently an individual may be ordered to disgorge funds that he or she received ‘as a result of the violation.’ Rather than limiting disgorgement to these gains, the bill will permit courts to impose any equitable relief necessary or appropriate to protect, and mitigate harm to, investors.”[145] Second, as discussed at § 6:17, the Act provides that under certain circumstances that if a company is required to restate its financial statement the chief executive officer and chief financial officer are to reimburse the issuer for any bonus, incentive-based, or equity-based compensation and the profit from any sale of securities during a relevant period.[146]

The Sarbanes-Oxley Act not only includes the reimbursement/ disgorgement provisions referred to above, but at the urging of the House Conferees,[147] allows the Commission at its discretion to add to the disgorgement fund the amount of any civil penalty assessed in the same proceeding.[148] The combined funds would then be available for the benefit of the victims of the violation that was the basis for ordering disgorgement and/or the payment of a civil penalty.[149] The Commission, with some fanfare, almost immediately made use of this provision. See § 6:79. The Conference Committee also added a provision allowing the Commission to accept gifts and bequests and to add the monies received and proceeds from the sale of any property received to the disgorgement fund for the benefit of the victims.[150]

The SEC can also seek disgorgement in an administrative proceeding in conjunction with a proceeding to enter a cease and desist order pursuant to § 21C(e) of the Exchange Act[151] and § 8A of the Securities Act,[152] as added by the Securities Enforcement Remedies and Penny Stock Reform Act of 1990.[153] See § 6:28.

§ 6:16   Disgorgement of Executive Equity Related Compensation

In the wake of the Enron scandal, President George Bush announced a ten-point plan to improve corporate responsibility in America and to hold corporate officers to higher standards of conduct.[154] One of the President’s proposals was to disallow CEOs and other officers of corporations to profit from erroneous financial statements.[155] See § 1:30. This inspired a new wave of SEC complaints seeking disgorgement of incentive-based executive compensation. The initial action seeking such relief was an action brought by the SEC against John P. Gallo, former president and chief operating officer of IGI, Inc. for violations of the antifraud, record keeping, periodic reporting, internal controls, and lying to auditors provisions of the federal securities laws.[156] The SEC complaint alleged that Gallo personally directed IGI’s former CFO to improperly account for destroyed and/or defective merchandise as inventory reserves, instead of writing them off as losses.[157] The complaint further alleged that Gallo directed the former VP of operations and former manager of international sales to record revenue from the sale of IGI products prior to shipment in order to fraudulently increase IGI’s revenues and to manipulate its earnings.[158] The SEC also accused Gallo of directing the CFO and other individuals to hold IGI’s books open after the quarter had ended and then backdate sales invoices and shipping documents.[159] As a result of Gallo’s fraudulent behavior, the SEC alleged that IGI materially overstated its assets, revenues, and net income for the years 1995, 1996, and 1997.[160] The SEC sought permanent injunctive relief, civil monetary penalties, a permanent bar against Gallo from acting as an officer or director of any public company, and disgorgement of any compensation or trading profits that Gallo earned based on misrepresentations of IGI’s financial results.[161]

An element of scienter also was present in the SEC’s complaint against Reza Mikailli and Gary Pado of Unify Corporation.[162] The SEC accused Mikailli and Pado of causing Unify to recognize revenue on transactions that they knew were subject to contingencies, such as rights of return or cancellation, or barter transactions.[163] These transactions are improper to recognize under generally accepted accounting principles until the contingencies disappear.[164] The complaint further alleged that Mikailli and Pado engaged in “roundtipping” ― a business practice that caused Unify to provide funds its customers needed to buy Unify products with no reasonable expectation that the customers would ever repay the funds.[165] As a result of these practices, the SEC alleged that Unify overstated its revenue over four fiscal quarters in amounts ranging from between 61 percent to 150 percent per quarter.[166] The SEC alleged that Mikailli and Pado profited from these transactions through sales commissions received on fraudulent transactions, bonuses, and the sale of stock.[167] The SEC sought to have all of these profits disgorged. Again, the SEC sought disgorgement of executive compensation that was the fruit of fraudulent actions.

The SEC also pursued incentive-based compensation derived from executive fraud in its complaint against Alan K. Anderson, former Chairman and CEO of Quintus Corporation, in federal district court.[168] In its complaint, the SEC accused Anderson of creating false contracts, emails, purchase orders, letters, “audit confirmations,” and of forging various signatures in order to cause Quintus to report sales revenue that did not exist.[169] For example, the complaint stated that Anderson proposed to Ticketmaster that they purchase $6 million in Quintus software licenses.[170] Ticketmaster only bought $1.5 million, but Anderson represented to the Quintus CFO that Ticketmaster would make a $6 million purchase and doctored a purchase order to reflect the $6 million.[171] Anderson is further alleged to have forged letters to make it look as if Sun Microsystems had accepted $2 million of Quintus product and AT&T has accepted $7 million in Quintus product, when in fact they had not.[172] According to the SEC, Anderson then actively misled Quintus accounting personnel and auditors to prevent discovery of his fraud.[173] The complaint alleged that Anderson’s fraud led to net revenue being overstated between 37.3 percent and 60.6 percent for three quarters and loss being understated by between 26.3 percent and 36.8 percent.[174] The SEC sought disgorgement as one of their remedies, including disgorgement of any bonuses Anderson received based on the company’s fraudulent financial performance.[175]

One of the most egregious cases of executive fraud and self-dealing involved the case of the Adelphia Communications and the family that founded and controlled Adelphia, the Rigas family. See § 6:75. The SEC’s complaint against the Rigas family and Adelphia alleged that from mid-1999 through the end of 2001, the Rigas family fraudulently excluded over $2 billion in Adelphia’s bank debt from its annual and quarterly financial statements by recording those liabilities on the books of unconsolidated affiliates.[176] The complaint further alleged that the Rigas family regularly misstated the number of Adelphia’s cable subscribers, the extent of cable upgrades, and its financial earnings in earnings reports, press releases, and SEC filings.[177] The SEC also alleged that the Rigas family used fraudulent misrepresentations and omissions of material fact to conceal rampant self-dealing by the Rigas family, including using Adelphia funds to pay for vacation properties and New York City apartments used personally by the Rigas family.[178] Lastly, the complaint stated that the Rigas family had over $772 million of Adelphia common stock and $563 million of Adelphia notes issued for the personal benefit of the Rigas family.[179] The SEC sought disgorgement of any and all compensation received by the Rigas family as a result of their violation of the securities laws, including any salary bonuses and advances.[180]

§ 6:17   SAO Provision Requiring Reimbursement of Equity Related Compensation in the Event of Restatements

Sarbanes-Oxley specifically provides, but in confusing language, that if a company is required to restate its financial statement because of any wrongful material noncompliance with a financial reporting requirement, the chief executive officer and chief financial officer are to reimburse the issuer for any bonus, incentive-based, or equity-based compensation and the profit from any sale of securities during a relevant period.[181] The provision refers to noncompliance “as a result of misconduct,” which we translate to mean “wrongful,” but it is not precisely clear what degree of culpability this requires or by whom. Literally, it would require the chief executive officer and the chief financial officer to reimburse the corporation if the misconduct in connection with the financial statements was by some other officer (e.g., the controller) or employee. This does not appear to be unreasonable in that the compensation was based on erroneous assumptions as to the financial performance of the company. The Senate Report supports this conclusion although it is ambiguous to some extent in this regard. The Senate Report refers to this provision as follows: “The bill requires that in the case of accounting restatements that result from material non-compliance with SEC financial reporting requirements, CEOs and CFOs must disgorge bonuses and other incentive-based compensation and profits on stock sales, if the non-compliance results from misconduct.”[182]

The period to which the reimbursement is applicable is the 12-month period following the first publication of the financial document in noncompliance with the relevant financial reporting requirement. Although not specific in this regard, a restatement covering a three-year period in each of which there was a wrongful material non-compliance (e.g., improper recognition of revenue) would trigger 12-month periods in relationship to each of the financial statements published during that three year period. Although this provision provides for reimbursement to the company, it does not indicate who can recover amounts due under this provision if the respective officers do not voluntarily reimburse the company. The provision also authorizes the Commission to exempt any person from this provision to the extent it deems it necessary or appropriate.[183] This provision on its face could apply retroactively to restatements of financial statements made after the enactment of the Act, but pertaining to financial periods prior to the adoption of the Act. The retroactivity issue, although it will go way over time, is a thicket;[184] particularly, since we do not know who can assert a claim under this provision.

What this adds, if anything, to the Commission’s authority to seek disgorgement of equity related compensation is not clear. Shortly after the adoptions of the SOA the Commission sought and obtained disgorgement by the officer defendants in a settled civil proceeding of profits they earned from the exercise of options and the sale of the company’s securities during the period the financial statements were fraudulent as evidence by subsequent restatements. The Commission sought disgorgement, not reimbursement to the company. The Commission at the same time requested the court to increase the disgorgement funds by the amount of the agreed to civil penalty as provided for by Sarbanes-Oxley. The fund the Commission announced “will be paid to the benefit of Homestore shareholders.”[185] The question remains, which shareholders? See § 6:79.

§ 6:18   How Effective is the Disgorgement Remedy

The Act as amended by the Conference Committee reflects a desire to find a way to make the victims of securities fraud at least partially whole through the ability of the Commission to make wrongdoers financially responsible for their misdeeds. To this end, it calls for the Commission to undertake a study covering a five-year period preceding the enactment of the Act of enforcement actions in which the Commission sought to obtain civil penalties or disgorgement. The study is to identify areas in which such proceedings or other methods might be “utilized to efficiently, effectively, and fairly provide restitution for injured investors.” The study is to include “methods to improve the collection rates for civil penalties and disgorgements.”[186] The SEC is to report to Congress within 180 days after the enactment date of the Act of the results of its study and the study is to be the basis of (1) “findings to revise its rules and regulations as necessary,” and (2) recommendations to Congress for legislative action.[187] The unstated premise for focusing on disgorgement as a remedy for defrauded investors may be to minimize the role of private actions.

A study of the SEC’s collection rate by the General Accounting Office found that the SEC recovered just $424 million, or 14 percent of the $3.1 billion in fines and ill-gotten gains the SEC ordered to be paid from 1995 to 2001.[188] The SEC, up until this point, according to the study, had just three full-time collectors, and so collection efforts have fallen mostly on the overworked attorneys who try the SEC cases.[189] The GAO study apparently fails to take into account that in civil actions in which the Commission seeks disgorgement, if the amount ordered is large enough, the Commission typically seeks and courts appoint a receiver to seek out cash and other assets of the defendant. The receiver after recovering assets reduces the assets to cash, establishes a procedure for investors to file claims, and at the end of the process distributes the amount collected after expenses to those whose claims are allowed by the receiver. The expenses incurred, including professional fees, in these proceedings can be substantial. The Commission maintains at its website a page titled “Investors Claims Funds.”[190] The site lists the names of defendants in civil actions brought by the Commission who have been ordered to disgorge their ill-gotten gains. Each name includes a link, generally to the website of the receiver who was appointed to collect the assets of the defendants and distribute the funds to claimants. The trials and tribulations of the receivers are demonstrated by following the link to the receiver’s website at which s/he meticulously details all the steps s/he has taken to enforce the disgorgement order. The link to the website for Heartland Finance Services, for example, is informative in this respect.[191] The complaint alleged a complex Ponzi scheme that had defrauded 330 investors of in excess of $29 million.[192] The receiver in his third report to the court[193] included an accounting showing approximately $1.7 million recovered; total expenses of $428,000 and $1,274,000 in “income” after expenses. A substantial part of the amount recovered was from investors who had been paid excess returns as part of the Ponzi scheme. Of the expenses, $360,000 was for professional services. The expenses apparently did not include approximately $123,000 in additional fees being concurrently applied for by the accountant, the receiver, and receiver’s counsel.

§ 6:19   Disgorgement Funds ― To Whom Do They Belong?

The well-intentioned effort to make funds available to benefit the defrauded investors in the fraud on the market context raises serious issues as to whom the funds should be distributed and what is the most efficient way of obtaining such funds. The issue is a relatively simple one in the context of the typical type of fraud in which the Commission has sought disgorgement in the past. If the fraud is the blatant type of fraud involving the sale of unregistered securities to gullible investors buying into promises of unreasonable returns and the defendant has used the funds entirely, or almost entirely, for their own personal purposes. All of the investors are victim of the fraud and it is primarily a matter of determining a scheme of pro-rating the available funds among all the defrauded investors. In some Ponzi type schemes, it becomes somewhat more complicated as some investors may actually have received “returns” taken out of funds contributed by subsequent investors. In the case of insider trading, the logical recipients are those that were contemporaneously in the market on the opposite of the transactions, which is also the remedy in the private action provided for by Section 20A of the Exchange Act.[194]

None of the foregoing cases, except the insider trading situation and then rarely, is likely to attract the interest of the securities fraud class action bar. A class action involving Enron, a fraud on the market type case, was filed almost concurrently with the breaking news of the fraud in October of 2001 and somewhat uncharacteristically has progressed rapidly.  In the typical fraud on the market case, the private right of action is governed by Rule 10-5 and limits recovery to persons who purchased (or sold, as appropriate) during the relevant period of time that the price of stock was fraudulently inflated (or in the rare case intentionally deflated). If the potential recovery is great enough the class action lawyers will be competing to have their plaintiffs named lead plaintiff. The shareholders of the corporation that held all or a substantial part of their stock during the class period, however, are shut-out because they were not purchasers, although except for the insiders they are also victims of the fraud and doubly so when the corporation as defendant has to pay all or part of the judgment (or settlement) in a class action. Still another possible claimant to disgorged funds may be unsecured creditors, particularly if the company is in bankruptcy or on the verge of bankruptcy.

The first of what may be several disgorgement actions directly related to Enron illustrates some of the competition that may be on the horizon. On August 21, 2002, the SEC brought a civil enforcement action against Michael J. Kopper, “a former high-ranking Enron official,” charging him with violations of Rule 10b-5 in connection with a series of transactions between Enron and so-called Special Purpose Entities (SPEs).[195] The Commission charged that, among other things, “Kopper and others exploited the fiction that these entities were independent of Enron to misappropriate millions of dollars representing undisclosed fees and other illegal profits.” Pursuant to an offer of settlement, in which Kopper neither admitted nor denied the charges, Kopper was enjoined from further violations of Rule 10b-5, permanently barred from acting as an officer or director of a public company, and subject to approval of the settlement by the court agreed to disgorge $12 million. The civil proceeding was brought in coordination with the Department of Justice Task Force, which filed criminal charges against Kopper to which he agreed to enter a plea of guilty and to “cooperate with the government’s continuing investigation.”[196]

Of the $12 million that Kopper agreed to disgorge, $4 million was in connection with the criminal proceeding and $8 million in the SEC civil proceeding. The unsecured creditors almost immediately filed a claim in the bankruptcy court for the entire $12 million. Somewhat later, they withdrew their claim as to the $4 million frozen by the court in the criminal proceeding, but continued to seek the remaining $8 million in the bankruptcy court. The SEC sought to move the case to the federal district court in Texas where the civil and criminal proceedings were brought. The Wall Street Journal reported “[d]ue to the complexity of Enron’s finances, it is likely many entities will assert claims against the same money the government expects to collect from Kopper for distribution among individual investors.”[197] Kopper is also a defendant in the private class action asserted against numerous former officers and directors of Enron, counsel, and investment bankers. Plaintiffs, among other remedies, are seeking disgorgement from a number of the defendants in the Enron related private action.

Sunbeam illustrates another possible scenario. On May 15, 2001, the SEC initiated civil and administrative proceedings against Sunbeam Corporation, Albert Dunlap, former Chairman and CEO, Russell Kirsh, former CFO, three other corporate officers, and the Arthur Andersen audit partner in charge of the Sunbeam audit. The complaint and order initiating proceedings alleged a number of improper accounting practices that resulted in false and misleading financial statements for year end 1996, 1997 year end and quarters, and the first quarter of 1998. The case against Sunbeam was settled with the issuance of an administrative cease and desist order and no additional penalty. On September 4, 2002, pursuant to an offer of settlement and without admitting or denying the charges Dunlap and Kirsh consented to the entry of an order in the civil action enjoining them from violating Rule 10b-5, barring them from serving as an officer and director and agreeing to the imposition of $500,000 and $200,000 civil penalties, respectively. The litigation release made a point of the fact as part of the settlement in the private action brought against them and Sunbeam that they both had out of their own pocket agreed to pay respectively $15 million and $250,000. The release also noted that neither Dunlap nor Kirsh had sold Sunbeam stock or received performance-based bonuses during the relevant period. The action against the four remaining defendants “remains pending.”[198] Nine months earlier, plaintiffs in the private action entered into a settlement with Arthur Andersen in an action initiated three years earlier in which Arthur Andersen agreed to pay $110 million, out of which the court allowed plaintiff’s counsel 25 percent of the amount recovered.[199] Subsequently Dunlap and Kirsch entered into the settlements referred to by the SEC. The shareholders who purchased during the class period recovered at least a portion of their losses. Sunbeam was already in bankruptcy at the time of the SEC settlement and two days later filed a reorganization plan under which the company would be owned entirely by its banks, except for a small equity stake granted to management and warrants to bondholders the value of which depended on the future stock price of the reorganized corporation. The shareholders under the plan received nothing.[200] In explaining the light penalties, received by Dunlap and Kirsh, Thomas Newkirk, the SEC’s associate enforcement director, said, “We got the relief we were seeking against both of them. We put the civil penalties in the context of the money they paid in the class-action suit out of their own pockets.”[201]

Part III.
Administrative Adjudication and Sanctions

A.    Administrative Enforcement Remedies

§ 6:20   Introduction

The Commission since the adoption of the Exchange Act has authority to impose remedial sanctions after notice and opportunity for a hearing on broker-dealers registered with the Commission and persons associated with registered broker-dealers. The Commission has similar but less extensive authority to impose remedial sanctions on registered investment advisers. Public Law 101‑429 combines “Securities Enforcement Reme­dies” (SERA) with “Pen­ny Stock Reform” (PSRA) to create the Secu­rities Enforcement Remedies and Penny Stock Reform Act of 1990.[202] The PSRA is the general subject matter of §§ 23:16-23:22, but one aspect of that Act is discussed herein since, like SERA, it enhances the enforcement capabilities of the SEC by extending the authority to impose remedial sanctions against securities violators who, al­though not directly associated with a broker-dealer, are participants in penny stock distributions.[203] See § 6:30. The Commission acquired additional authority under SERA in at least four areas: (1) to impose monetary penal­ties with or without disgorgement and other remedial sanctions in an adminis­trative proceeding involving securities professionals (see § 6:21);[204] (2) to enter cease and desist orders after notice and opportunity for hearing for any violation of the securi­ties laws against any person (see § 6:25);[205] (3) to seek in a civil action civil penalties with re­spect to a wide range of securities violations, not merely insider trading, against any federal securities violator; (see § 6:8)[206] and (4) to initiate a judicial proceeding to have a person barred from serving as an of­ficer or director of a pub­lic company because of violation of the antifraud provisions of the Securities Acts (see § 6:12).[207] SERA provides addi­tional weapons in the Com­mission’s battle against penny stock fraud and recidivists, but, unlike APSOP and the penny stock dis­closure rules,[208] those weapons are not predicated on the involve­ment of a penny stock and are of general application. In this Part III.A, we discuss those aspects of SERA that relate to administrative proceedings before the Commission and the extent to which Sarbanes-Oxley adds to the Commission’s authority to impose remedial sanctions in administrative proceedings.

The Commission has maintained its control over the competence and integrity of lawyers, accountants, and other professionals by using its power under Rule 2(e) to disqualify them from practicing before the Commission because of lack of requisite quali­fications, character, or integrity, for engaging in acts that vio­late the federal securities laws, or acts that constitute unethical or improper conduct.[209] Rule 2(e) has become Rule 102(e). Rule 102(e) was codified by the Sarbanes-Oxley Act..

§ 6:21   Securities Professionals, Remedial Sanctions and Administrative Fines

SERA authorized the SEC to impose an administrative fine (money penalty) against a securities professional (broker-dealers, persons associated with broker-dealers, investment advisers) who violates the securities laws. The authority to impose a money penalty in an ad­ministrative proceeding is limited to those areas in which the Com­mission otherwise has authority under three Acts — the Exchange Act ,[210] the Investment Company Act ,[211] and the Investment Advisers Act [212] — to impose remedial sanctions. The remedial sanction pro­ceed­­ings under the Exchange Act pertain to broker-dealers, as­soci­ated persons, municipal securities dealers, government securities deal­ers, clearing agencies, transfer agencies, and, under PSRA, per­sons participating in a penny stock offering.[213] Such proceedings un­der the Investment Company Act pertain to persons serving or acting in the capacity of an employee, officer, director, members of an ad­visory board, investment adviser to or depositor of, or princi­pal un­derwriter for a registered investment company.[214] The Com­mission similarly has authority to impose a money penalty in pro­ceedings pursuant to Section 203(e) or (f) of the Investment Advis­ers Act on an investment adviser or associated person of an in­vestment ad­viser.[215]

The scheme of administrative adjudication under the three Acts has much in common. The proceeding is initiated by an order of the Commission prompted by a staff investigation and recommen­da­tion.[216] The adjudication on the trial level is before an adminis­trative law judge who renders an initial decision. That decision is subject to review on the record, but is de novo insofar as findings of fact and conclusion of law are concerned by the Commission. The grounds for imposing remedial sanctions under all three pro­ceedings include the violation of any of the federal securities laws (Securities Act, Exchange Act, Investment Company Act, or In­vestment Advis­ers Act) or the Commodity Exchange Act, or the rules and regula­tions adopted under any of such Acts or, in the case of remedial sanction proceedings based on the Exchange Act, the rules of the Municipal Securities Rulemaking Board.[217] Remedial sanctions can also be imposed against one who has aided, abetted, counseled, commanded, induced, or procured such violation, and against a per­son who “failed reasonably to supervise with a view to preventing . . . another person who commits such a violation, if such other per­son is subject to his supervision.”[218]

In the proceedings under the Exchange Act and the Investment Advisers Act, the Commission has the authority to impose reme­dial sanctions that include censure, suspension for a period of 12 months, and revocation (or bar as appropriate). In the case of the In­vestment Company Act, the authority is to order respon­dent to dis­continue serving or acting in the named capacities to a registered in­vestment company. The authority to impose a money penalty is in addition to or in lieu of the other sanctions and viola­tions of the same statutes, and regulations are the principal basis for imposing a money penalty except that a violation of the Com­modity Exchange Act or rules adopted thereunder is not a basis for imposing a mone­tary penalty.[219] The Commission must also find that it is “in the pub­lic interest” to impose such remedial sanctions, including a money penalty.

The Commission has requested Congress to amend the securities laws to increase the amount of the administrative penalties (fines) and to further provide with respect to cease and desist proceedings under the Securities Acts that in addition to other sanctions it have authority to impose administrative fine. The Senate on April 9, 2003 passed S.476 (CARE Act of 2003) relating to tax and other aspects of charitable giving that included a last minute addition incorporating the requests of the Commission to amend the Securities Acts in this manner. Click HERE for the story.

§ 6:22   —Determining the Amount of the Administrative Fine

The money penalties (administrative fines) that can be imposed on securities professionals fall into one of three categories or tiers, depending upon the nature and, in some in­stances, the impact of the violation on others. The first tier mone­tary penalty for each act or omission is $5,000 for a natural person or $50,000 for any other person, and is a residual category for lesser violations.[220] The second tier penalty for each act or omission is $50,000 for a natural person or $250,000 for any other person. To impose the second tier penalty, the act or omission must involve fraud, deceit, manipulation, or deliberate or reckless disregard of a regulatory requirement.[221] The third tier penalty for each act or omission is $100,000 for a natural person or $500,000 for any other person. The conduct justifying a third tier penalty embraces the same kind of violation as the second tier, but, in addition, must re­sult, di­rectly or indirectly, in substantial losses, or a significant risk of substantial losses, to other persons or in substantial pecuniary gain to the respondent.[222] The Commission, in addition to a penalty, may order the respondent to furnish an accounting and to disgorge his profits and pay reasonable interest thereon.[223]

The Senate on August 9, 2003 approved an amendment that would increase the three tier penalties significantly. Click HERE.

§ 6:23   —Administrative Fines ― Determining the Public Interest

The authority to impose a money penalty in a remedial sanction proceeding is part of such proceeding and requires a finding that it is in the public interest to impose the money penalty. SERA sets forth specific criteria that are to be taken into account in determin­ing whether imposing a money penalty is in the public interest and that are not applicable to other remedial sanctions the Commission can impose.[224] Some of these criteria overlap with the determination that must be made as to the penalty tier.[225] The overlapping criteria in­clude (1) whether the violation involved fraud, deceit, etc., and (2) the harm resulting to other persons. The third criteria focuses on the respondent’s gain but in terms of “unjust enrichment” and the extent to which restitution has been made to persons injured. The remaining criteria are as follows:

(1)  The Commission is to take into account prior securities vi­o­la­tions broadly defined to include state laws, the rules of self-regulatory organizations and criminal violations in­volv­ing lar­ceny, theft, and other specified crimes.[226]

(2)  The need to deter such persons and other persons from com­mitting such violations.

(3)  Such other matters as justice may require.

The Commission, in its discretion, in determining whether an administrative penalty is in the public interest, also may take into account evidence presented by the respondent of its ability to pay; the impact such penalty will have on the respondent’s ability to con­tinue in business, and the collectability of a penalty, consider­ing other claims of the United States or third parties.[227]

§ 6:24   —Determining Willfulness

The Commission in order to impose a monetary penalty, as is true of other remedial sanctions, must find that respondent “willfully violated” or “willfully, aided, abetted” a violation of the federal se­curities laws or has “failed reasonably to supervise” an­other person who has committed such a violation.[228] The substantive violation may require a form of scienter and to that extent the willfulness issue, if it is an issue, may be redundant. The second and third tier penalty pre­requisites, stated in terms of fraud, etc., are a black type synopsis of scienter as applied to false or mislead­ing representations. Presum­ably, the willfulness issue is also re­dundant in such context. But the first tier penalty could be imposed for less culpable conduct, includ­ing negligent conduct, unless the requirement that the violation or the aiding and abetting be “willful” requires something more. The Com­mis­sion over the years, with considerable success, has read “will­ful­ness” out of the statutory proceedings involving remedial sanctions.[229] The view of the staff, and presumably the Commission, is that will­fulness does not require proof of scienter, but merely re­quires that the respon­dent consciously engaged in the acts that con­stitute the violation.[230]

The grounds for imposing the second tier penalty include “a de­liberate or reckless disregard of a regulatory requirement.”[231] This appears to require proof of the kind of “scienter” that tends to place emphasis on motive as distinguished from legally cognizable scien­ter. Congress, however, acted with deliberation in this regard as one of the objectives (although speaking of the counterpart civil penalty provision) of the legislation is to provide “financial disin­centive to violations that reflect an unwillingness to incur the cost of full compliance . . . as opposed to engaging in affirmative con­duct to de­fraud investors.” The House Report refers specifically to violations of broker-dealer bookkeeping provisions and the cus­tomer protection rules as illustrations.[232] It is clear that Congress, in contrast, intended that a first tier penalty can be imposed for con­duct involving some­thing less than “deliberate or reckless disre­gard of a regulatory re­quirement” or fraud or deceit.

§ 6:25   Cease and Desist Orders

SERA gives the Commission broad authority to administra­tively enter cease and desist orders restraining any violation or threatened violation of the principal securities laws (the Securities Act, Ex­change Act, Investment Company Act, and Investment Advisers Act) by any person.[233] The Commission heretofore had authority under Section 15(c)(4) of the Exchange Act to enter or­ders compelling compliance with certain aspects of the Exchange Act, but these pro­ceedings were so ineffective that they fell into disuse other than as a means of publicizing Commission views and concerns in such areas. Such proceedings were ineffective because (1) the Commission’s authority was limited to violations of Sec­tions 12, 13, 14, and 15 of the Exchange Act and the rules and regulations adopted thereunder,[234] and (2) there was (and is) no penalty for failing to comply with such order. The Commission has to go into a district court to obtain an order directing compliance with its order which can then be enforced and, if it is violated, through a contempt proceeding.

Under the cease and desist provisions, if the Commission finds “that any person is violating, has violated, or is about to violate any provision” of the Securities Act, the Exchange Act, the Investment Company Act, or the Investment Advisers Act, or any rule or regu­lation adopted under any of them, it may enter an order directing re­spondent “to cease and desist from committing or causing such vio­lation and any future violation” of same. The order may also di­rect the respondent to take specific steps “to effect compliance . . . within such time” as the Commission may order.[235] The Commis­sion must initiate such proceeding by giving respondent(s) notice fixing a hearing date not earlier than 30 days nor later than 60 days af­ter service of notice unless the Commission and respon­dent(s) agree to another date for the hearing.[236] After such hearing and prior to or in conjunction with the entry of such order, the Commission must publish its findings. The order may also be di­rected against any per­son who was, or is, or may become the cause of such violation “due to an act or omission the person knew or should have known would contribute to such violation.”[237]

§ 6:26   —Temporary Cease and Desist Order

The Commission has authority to enter a temporary cease and desist (TCDO) order, but, unlike a permanent cease and desist or­der, such order only can be entered against respondents acting as a bro­ker, dealer, investment adviser, investment company, municipal se­curities dealer or broker, government securities dealer, transfer agent, or as an associated person of any of the foregoing.[238] The TCDO procedure mimics in many respects the procedure for the en­try of a temporary restraining order in the federal courts. In order to enter a TCDO, the Commission must find that the violations al­leged are “likely to result in significant dissipation or conversion of assets, significant harm to investors, or substantial harm to the public inter­est.” The Commission may enter such order ex parte, however, only if “the Commission determines” that notice and hearing prior to entry would be “impracticable or contrary to the public interest.”[239] Pre­sumably, a hearing on a TCDO can be less than the full-blown evi­dentiary hearing necessary before a perma­nent cease and desist order can be entered. The House Committee Report viewed “a temporary cease and desist order entered on an ex parte basis as an extraordi­nary remedy and does not intend and does not expect this remedy to become a wholesale substitute for the range of Commission en­forcement procedure.” Violations of the penny stock cold call rule and the imminent fraudulent break­ing of an escrow in an all or none offering are given as illustrations of circumstances under which the entry of such order ex parte may be appropriate.[240]

For a discussion of procedures under the Commission’s Rules of Practice relating to the entry of temporary cease and desist orders and for judicial review of such orders, see § 6:59. The respondent may apply at any time to the Commission to set aside a TCDO. If the TCDO is entered ex parte, the respondent may, within ten days after service of the order on him, request a hearing and the Commission must “hold a hearing and render a decision on such application at the earliest possible time.”[241] Within ten days after respondent is served with a TCDO entered after a hearing, or within ten days after the Commission confirms after a hearing a TCDO previously entered ex parte, the respondent can apply to an appro­priate district court to set the TCDO aside. There is no stay, how­ever, pending such determination unless the court specifically orders such stay. In the case of a TCDO entered with­out hearing, the re­spondent cannot by-pass the step that requires it to apply to the Commission to hold a hearing.[242]

§ 6:27   —Enforcement of Cease and Desist Order

If a Commission cease and desist order is violated, the Commis­sion can initiate a proceeding in an appropriate United States dis­trict court to impose a civil penalty.[243] The basis for the remedy is the violation of the cease and desist order. The Commission does not have to prove the underlying violation that gave rise to the cease and desist order. The Commission has no authority to impose a money penalty for violation of such orders. It does have author­ity, however, to impose a money penalty on securities profession­als in connection with a proceeding to impose remedial sanctions based on past viola­tions of the securities laws.[244] Presumably, as to such professionals, the proceedings could be combined to impose civil penalties relating to past violations and to enter a cease and desist order proscribing future violations.

§ 6:28   —Disgorgement and Accounting

The Commission, in any proceeding to impose a cease and de­sist order, can enter an order requiring an accounting, disgorge­ment of any profit, and payment of reasonable interest.[245] Since a cease and desist proceeding can be initiated against any person as to any viola­tion of the federal securities laws, the Commission’s authority to re­quire all of the above is a far reaching one. Although the Commis­sion likes to insist that it is not a collection agency,[246] it now has a powerful weapon to force securities violators to make their victims whole. That Congress had something of this nature in mind is rein­forced by the fact that the Commission is specifically authorized to adopt rules “concerning payments to investors” to implement this provision.[247] For a discussion of procedures under the Commission’s Rules of Practice relating to the adoption of a plan of disgorgement, see § 6:60.

§ 6:29   —Officer and Director Bar

Proposal #5 of President Bush’s ten-point plan to improve corporate accountability called for giving the SEC the power administratively to ban individuals from serving as officers or directors of publicly-held corporations if they engage in serious misconduct.[248] See § 1:31. The Commission already had authority to initiate a civil action and seek to have the court enter an officer/director bar based on violations of the Securities Acts. SEC Chairman Harvey Pitt in testifying before Congress attributed the need for allowing the Commission to impose an officer/director bar due to the fact that “some courts have taken an inhospitable approach to the plain legislative language, thwarting our ability to prevent some officers and directors who inflict serious harm on investors from repeating that kind of conduct.”[249] Congress responded in the Sarbanes-Oxley by amending the language establishing the standard for imposing such bar in a civil action. See § 6:13. Congress also obliged President Bush and the SEC in Sarbanes-Oxley Act by authorizing the Commission to impose an officer/director bar in an administrative proceeding. Specifically, the provisions of the Exchange Act and Securities Act authorizing the Commission to enter cease and desist orders[250] is expanded by allowing it to impose such bars in the event of a violation of the anti-fraud provisions of the Exchange Act (§ 10(b) and Rule 10b-5) or the Securities Act (§ 17(a)(1)) by an officer or director of a public company if it finds the respondent’s conduct “demonstrates unfitness to serve as an officer or director” of a public company.[251] The case law that displeased Chairman Pitt and its possible continued relevance in determining “unfitness” as distinguished from “substantial unfitness” is discussed at § 6:14.

§ 6:30   APSOP — Matching Wits With Recidivists

The Penny Stock Reform Act of 1990 is designed primarily as a supplemental disclosure statute relating to market and other risks in­volved in purchasing penny stocks.  The Act, how­ever, also broadens the Commission’s power to control the activi­ties of persons, often recidivist securities violators, active behind the scenes in the distribution of penny stocks who were not regu­lated under the Commission’s historical authority to regulate bro­ker-dealers and as­sociated persons of broker-dealers. The Com­mission’s powers relating to persons participating in penny stock participations are re­ferred to herein, for the lack of a better term, as the “anti-penny stock operator provision” (APSOP).

The Commission has authority to sanction regulated broker-deal­ers and their associated persons in administrative proceedings based on violations of any of the securities laws and rules and regulations adopted thereunder, having been convicted within the past ten years of a number of specified crimes, including crimes involving the pur­chase or sale of any security, or being perma­nently or temporarily enjoined from acting, among other things, as an investment adviser, underwriter, broker, or dealer, or from en­gaging in any conduct or practice in connection with the purchase or sale of any security. The sanctions that can be imposed in such proceedings include “censure, place limitations on the activities, functions, or operations, suspend for a period not exceeding 12 months a broker-dealer [or associated person], or revoke the regis­tration of a broker-dealer” (bar from be­ing associated with a broker or dealer, in the case of an associated person).[252] See § 6:21. But these provi­sions, prior to the adoption of the Penny Stock Reform Act (PSRA) in 1990 did not reach unregu­lated persons (i.e., per­sons who are not broker-dealers or associated persons of a broker-dealer). An object of the PSRA is “to expand the barring authority to include a broad range of persons involved with the distribution of penny stock as promoters, consultants, agents or in any of a number of other guises.”[253]

The Penny Stock Reform Act attempts to give the Commission some additional tools to deal with such persons if they are involved in a penny stock offering. First, it gives the Commission authority to initiate a remedial sanction proceeding under the Exchange Act, on the same grounds noted above relating to regulated broker-deal­ers and associated persons,[254] against persons who are not broker-dealers or employed by a broker-dealer if those persons are partici­pating or at the time of the alleged misconduct were participating in a penny stock offering.[255] The grounds include violations of any of the securi­ties laws and rules and regulations adopted thereunder. This permits the Commission to examine such persons prior secu­rities activities without time limitations and to impose a bar or other remedial sanc­tions on the basis of alleged violations estab­lished in the remedial sanction proceeding. The Commission is authorized to bar such per­son after notice and opportunity for hearing from participating in an offering of penny stock. A person is “par­ticipat­ing in an offering of penny stock” for this purpose if acting as a “promoter, finder, con­sultant, agent,” or engaging “in activities with a broker, dealer, or is­suer for purposes of the issu­ance or trading in any penny stock, or inducing or attempting to in­duce the purchase or sale of any penny stock.”[256] This provision is broad enough to be applicable to activities relating to a penny stock offering self-underwritten by the issuer. In effect, a third class of persons, persons participating in a penny stock distribution, are added to the two (broker-dealers and associ­ated persons) that pre­viously could be subject to remedial sanctions under the Exchange Act for, among other things, prior or ongoing violations of the fed­eral securities laws.

There are two predicates to the Commission’s ability to exercise its authority under APSOP. First, the security involved must be a penny stock. Second, there must be an “offering” of a penny stock. Although not without its complexities, the statute and the Commis­sion’s rules  permit one to identify a penny stock for this purpose. The rules broadly define a penny stock in order to encompass all the arenas in which the penny stock recidi­vist is likely to be active and none of the exemp­tions from the definition are applicable to APSOP.[257] The term “offering,” how­ever, is not a defined term, although a “person par­ticipating in an offering of penny stock” is.[258] The activities that constitute partici­pation are described in terms of engaging in cer­tain activities “for purposes of the issuance or trading in any penny stock, or inducing or attempting to induce the purchase or sale of any penny stock.” It is clear, therefore, that “an offering” does not have the limited conno­tation of a public offering by an issuer, but embraces trading in as well as the distribution of a penny stock.

The Sarbanes-Oxley Act enables the Commission to seek similar relief in judicial enforcement proceedings for violations of the Securities Act or Exchange Act against persons participating in a penny stock offering.[259] This provision may be a candidate for the least needed provision, since the Commission has the authority to do this in an administrative proceeding. It does, however, permit the Commission to obtain such a bar in a judicial proceeding in which it is seeking other remedies not available in the administrative proceeding, e.g., a civil penalty, without the need of also initiating a separate administrative proceeding to impose the penny stock offering bar.

§ 6:31   Administrative Sanctions and Aiders and Abettors

The numerous provisions of the Securities Acts authorizing the Commission to impose sanctions, administrative fines, or seek civil penalties each pose the issue of the extent to which they reach secondary violators. Several, but not all, of these provisions were added to the Commission’s arsenal of enforcement remedies by the Securities Enforcement Remedies and Penny Stock Reform Act of 1990 (hereinafter “SERA”).[260] Fortunately, a number of these provisions expressly cover willfully aiding and abetting; others do not. It is convenient, therefore, to discuss the aiding and abetting provisions of these provisions and other administrative sanctions collectively, but apart from the substantive violations.

The Commission has broad authority to impose administratively after notice and hearing specified sanctions (including revocation or denial of broker-dealer registration) against any broker-dealer who “willfully violated or willfully aided and abetted” the violation by any person of any provision of the Securities Act, the Exchange Act, the Investment Advisers Act, the Investment Company Act, the Commodity Exchange Act, or the rules or regulations under any such Act, or any rule or regulation of the Municipal Securities Rulemaking Board.[261] The Exchange Act provision is one of the instances of which the Court in Central Bank took note that Congress has specifically provided for aider and abettor liability.[262] There can be no question that sanctions can be imposed under this provision of the Exchange Act, although some nice questions remain as to what constitutes “willfulness” generally and willful aiding and abetting.

The Commission is also authorized to impose sanctions on persons associated with a broker-dealer, including barring such persons from association with a broker-dealer, for violating or aiding and abetting the violation of the same laws and regulations applicable to broker-dealers.[263] Since the adoption of the Penny Stock Reform Act, the Commission has authority to impose identical sanctions on any person whether or not associated with a broker-dealer who, while participating in the distribution of a penny stock, violated or aided or abetted a violation of the same laws and regulations, specifically defining the violations by incorporating the provisions applicable to broker-dealers.[264] In addition, such persons may also be barred from participating in the distribution of a penny stock.[265] The authority of the Commission to proceed under these provisions against aiders and abettors is clear, again with a caveat as to what constitutes “willfulness.”

The Commission has similar authority to impose administratively remedial sanctions on investment advisers for willfully violating or aiding or abetting a violation of the same laundry list of securities and commodities laws and the rules and regulations thereunder (other than those of the Municipal Securities Rulemaking Board).[266] The Investment Company Act has a similar procedure to bar or limit one from serving in the capacity of employee, officer, director, member of the advisory board, investment adviser or depositor or principal underwriter for a registered investment company if such person “willfully” violated or aided or abetted a violation of the same laundry list of laws and rules and regulations.[267]

SERA supplements the foregoing provisions relating to remedial sanctions pertaining to broker-dealers, investment advisers etc. of an investment company by authorizing the SEC to impose an administrative fine (“money penalty”) against such securities professional who willfully violate or willfully aid or abet a violation of the securities laws. The authority to impose a money penalty in an administrative proceeding is limited to those areas in which the Commission otherwise has authority under three Acts — the Exchange Act,[268] the Investment Company Act,[269] and the In­vest­ment Advisers Act[270] — to impose remedial sanctions. The reme­dial sanction proceedings under the Exchange Act pertain to broker-dealers, associated persons, municipal securities deal­ers, government securities dealers, clearing agencies, transfer agencies, and, under PSRA, persons participating in a penny stock offering.[271] Such proceedings under the Investment Com­pany Act pertain to persons serving or acting in the capac­ity of an employee, officer, director, member of an advisory board, investment adviser to or depositor of, or principal un­derwriter for a registered investment company.[272] The Commission sim­ilarly has authority to impose a money penalty in proceedings pursuant to Section 203(e) or (f) of the Investment Advisers Act on an investment adviser or associ­ated person of an invest­ment adviser.[273] It is clear under all of the foregoing provisions that they encompass persons who willfully aided and abetted violations of the appropriate statutes or regulations.

Rule 102(e) relating to disqualification of professionals (primarily accountants and lawyers) includes a provision making aiding and abetting a violation of the securities laws a separate ground for disqualification. Sarbanes-Oxley Act codifies Rule 102(e) including the aiding and abetting language. The Public Company Oversight Board created by SOA to govern accountants and the powers of the Board to regulate, inspect, investigate, and discipline accountants is the subject of Chapter 21. The Commission retains its power to administratively disqualify accountants and is given a new directive to discipline attorneys practicing before the Commission. The regulation of accountants and attorneys that practice before the Commission is the subject of Chapter 39.

§ 6:32   Suspension of Trading

An important power of the Commission is its authority to summa­rily suspend trading for a period of ten days in both listed securities and securities traded in the over-the-counter market.[274] The Com­mission uses this authority liberally in situations in which the mar­ket appears to be dominated by unfounded rumors, or when it be­comes apparent that undisclosed material developments could af­fect the market and such information is evidently being utilized by insiders or others privy to the information. While such suspension orders can only be for a ten-day period, the Commission for many years followed the practice of rolling over such orders for succes­sive periods of ten days each in order to keep the suspension in ef­fect for a long period of time.

In SEC v. Sloan,[275] the Supreme Court held that the SEC could not continue the practice of rolling over summary trading suspen­sions in a security for successive ten-day periods, but must provide notice and an opportunity for hearing to suspend trading in securi­ties for extended periods of time. The Court read Section 12(k) of the Ex­change Act to mean what it says, that is, the Commission can sum­marily suspend trading in any security “for a period not exceeding ten days.” The Commission’s power is limited even though it makes a new determination every ten days that “the pub­lic interest and the protection of investors” require a suspension of trading. The Court left open the question of whether a second summary suspension could be entered based upon a different set of circumstances. The Court described the Commission’s right to sus­pend trading summa­rily as “an awesome power with a potentially devastating impact on the issuer.”[276] If the Commission wants to suspend trading in a secu­rity for a longer period of time, it must proceed under Section 12(j)[277] which authorizes the Commission to suspend for a period of 12 months or to revoke the registration of a security under the Exchange Act, but only after notice and de­termination on the record after an opportunity for a hearing that the issuer has violated a provision of the Exchange Act or a rule and regulation adopted thereunder. Such suspension or revocation pre­cludes a broker or dealer from trading in the security. This still leaves Section 12(k) as the only means of suspending trading in a security which is not registered under the Exchange Act. In the Court’s view, whatever unfortunate conse­quences might result can be ameliorated, if not avoided, by the Commission making its views known concerning the issuer at the end of the ten-day trading period, and by initiating other appropriate action, such as an in­junctive action, to restrain further violations of the federal securi­ties laws by the issuer.

The Commission’s Rules of Practice (see § 6:38) provide that any person adversely affected by a suspension of trading entered pursuant to Section 12(k) file a sworn petition with the Commission seeking an order terminating the suspension. The petition must set forth the reasons and facts justifying such termination.[278] The Commission’s procedures in considering such petition are discretionary, but in the event petitioner obstructs any examination being conducted by the staff the petition will be denied without more.[279] Since the objective of a suspension orders is to assure adequate information in the market place, the petitioner should take appropriate steps to make such information available and should emphasize the availability of information, if such is the case, in its petition.[280]

B.    SEC Enforcement Proceedings and the Statute of Limitations

§ 6:33   Introduction

The SEC over the years has been reluctant to acknowledge that any enforcement proceeding it initiated was subject to a statute of limitations, except in those instances in which there can be no question that there is an applicable statute of limitations such as criminal proceeding[281] or the civil penalty provisions of the Insiders Trading Act.[282] As discussed at § 6:7, the Ninth Circuit has held that there is no statute of limitations applicable to civil actions in which the SEC seeks an injunctions and disgorgement and has refused to “borrow” a statute of limitations to be applied by analogy.[283] Some commentators and courts have questioned this holding; particularly with respect to disgorgement. In the view of some, this holding is contrary to the long-standing tradition of borrowing a statute of limitations from an analogous area when there is no specific applicable statute of limitations.[284] Although the Supreme Court in Lampf reversed the several courts that over a period of years had borrowed state statutes of limitations and applied them to private actions based on Rule 10b-5, it actually held that they had borrowed the wrong statute of limitations and should have borrowed the more analogous limitation period applicable to actions brought under Section 9(e) of the Exchange Act. The issue of the statute of limitations in connection with SEC enforcement proceedings, whether civil or administrative actions, in the absence of an express statute of limitations not only raise the issue of whether a statute of limitations should be borrowed, but whether the catch-all 28 U.S.C.A. § 2642 statute of limitation is applicable.

§ 6:34   The Section 2642 Five-Year Statute of Limitations

In Johnson v. SEC, the Commission in an administrative proceeding had censured respondent an employee of a brokerage firm with supervisory responsibilities and imposed a six-month supervisory suspension for failure to adequately supervise someone subject to her supervision. The proceeding had been initiated more than five years after the alleged dereliction had taken place. Ms. Johnson argued that the proceeding was barred by a federal statute of general application to civil proceedings that provides as follows:[285] “Except as otherwise provided by Act of Congress, an action, suit or proceeding for the enforcement of any civil fine, penalty, or forfeiture, pecuniary or otherwise, shall not be entertained unless commenced within five years from the date when the claim first accrued.” The D.C. Circuit Court of Appeals had previously held that this provision was applicable to administrative proceedings as well as judicial proceedings.[286] The issue in Johnson was whether the sanctions imposed by the SEC constituted a “civil fine, penalty, or forfeiture, pecuniary or otherwise.” The Commission’s position was that § 2462 should not apply because the “proceeding before us does not seek to impose a civil penalty, but rather to determine the appropriate remedial action. The intent of Johnson’s suspension is to protect the public from future harm at her hands.”[287]

Looking at the dictionary definition of penalty and some case law that held that a sanction which only remedies the damages caused by the respondent does not constitute a penalty, the court defined a penalty as follows: “In sum, we conclude that a ‘penalty,’ as the term is used in § 2462, is a form of punishment imposed by the government for unlawful or proscribed conduct, which goes beyond remedying the damage caused to the harmed parties by the defendant’s action.”[288] The test is an objective one, but, nonetheless, “the degree and extent of the consequences to the subject of the sanction must be considered as a relevant factor in determining whether the sanction is a penalty.”[289] The punishment imposed “— censure and a six-month suspension — clearly resemble punishment in the ordinary sense of the word.”[290] It not only affected her ability to earn a living as a supervisor for six months, but it had collateral consequences as well. Those collateral consequences included, (1) it becomes a permanent part of her public file and (2) under legislation adopted by Congress the NASD must and has established a toll-free number allowing a caller to inquire and be informed as to all disciplinary actions taken against brokerage company employees. “These collateral consequences of the censure and suspension, while not the central determinant in whether a sanction reaches penalty status, do suggest its punishment-like qualities.”[291] The court also reminded the Commission of Chief Justice Marshall’s admonition in 1805: “In a country where not even treason can be prosecuted, after a lapse of three years, it could scarcely be supposed, that an individual would remain for ever liable to a pecuniary forfeiture.”[292]

Notwithstanding the Commission’s contention to the contrary, in imposing sanctions the Commission focused on her failure to supervise; not on her “current competence or the degree of risk she posed to the public.”[293] The latter suggests remedial action; the former punishment. The SEC argued “that a license suspension should not constitute punishment or a penalty where the government’s purpose is to protect the public.” In support of this position, the Commission pointed to a number of cases in which for purposes of the double jeopardy and ex post facto provisions of the Constitution courts had held that denying or suspending licenses is remedial and not punishment. The court said of these cases, whether or not the Commission’s construction is correct for purposes of the constitutional issues, “they do not control the question of whether license suspension is a penalty for purposes of § 2462.”[294] The test under § 2462, “is not whether Congress legislated the sanction as part of a regulatory scheme to protect the public, but rather whether the sanction is itself a form of punishment of the individual for unlawful or proscribed conduct, going beyond compensation of the wronged party.”[295] By way of footnote the court also explained that “[i]t is clearly possible for a sanction to be ‘remedial’ in the sense that its purpose is to protect the public, yet not be ‘remedial’ because it imposes a punishment going beyond the harm inflicted by the defendant.”[296]

§ 6:35   Section 2462 Bar and the SEC Post-Johnson

Since Johnson, the Commission in at least two proceedings has dismissed charges on the basis of Johnson without objection from the Division of Enforcement. In one proceeding, an administrative action had been initiated against an accountant under Rule 2(e) (now Rule 102(e) for improper professional conduct in connection with a 1986 audit.[297] The Administrative Law Judge prior to Johnson rendered an Initial Decision, denying respondent the privilege of appearing or practicing before the Commission for periods of one year and six months, respectively. Johnson was decided after the respondent filed a petition for review, but before the Commission acted on it. The proceeding had been initiated more than five years after the 1986 audit that was the basis for the charges. When the decision in Johnson became final because of the Commission’s failure to file a petition for certiorari by December 26, 1996, the expiration date for such filing, respondent renewed an earlier motion to dismiss, the Division of Enforcement raised no objection, and the Commission dismissed the proceeding. In Kulak,[298] prior to Johnson, the Administrative Law Judge found that Kulak, an employee of a registered broker-dealer had aided or abetted various violations of the Exchange Act and barred him from associating with a registered broker-dealer and also ordered him to cease and desist from committing future violations of the provisions he had violated. The violations occurred more than five years prior to initiation of the administrative proceeding. Johnson was decided while the matter was pending for review by the Commission. After Johnson, respondent moved for dismissal of the charges, the staff did not object, and the Commission dismissed the proceeding.

In Koch, respondent in January of 1995 was enjoined from engaging in further violations of the Securities Acts based on his activities in connection with the sale in April of 1990 of unregistered securities and his activities as a market maker. In September of 1995, the Commission initiated a proceeding to bar respondent from participating in penny stock distributions based on the issuance of the injunction. The Commission relied upon the provisions of the Penny Stock Reform Act permitting the issuance of such a bar against one who is temporarily or permanently enjoined from violating the federal securities laws upon a finding that such bar is in the public interest.[299] Respondent argued that Johnson precluded the bar order as it was based on conduct that occurred in April of 1990 and the proceeding was initiated more than five years after that date. Respondent also argued the April 1990 activities that were the basis of the injunction occurred before the Penny Sock Reform Act was adopted and to bar him from participating in a penny stock distribution would be to apply the Act retroactively. The Commission rejected both arguments on the basis that the sanction imposed in the proceeding issued in September of 1995 was not based on the violations of the Securities Acts that occurred in April of 1990, but the injunction issued in January of 1995. Under the relevant provisions, the injunction in itself is an appropriate basis for imposing the bar from participating in penny stock distributions. The sanction order, therefore, was not based on acts that occurred before the adoption of the Penny Stock Reform Act and the order was initiated timely under the five-year period of § 2642. The Commission had earlier in Sprecher adopted a similar approach with respect to a respondent who was convicted in January of 1992 for, among other things, conspiracy to sell unregistered securities. The sales upon which such conviction had taken place between June 1986 and September 1988. An administrative proceeding had been initiated in November 1993 under the Penny Stock Reform Act to bar respondent from participating in a penny stock distribution and to disgorge his unlawful profits in connection with such sales. The Commission on motion of respondent had previously dismissed the proceeding insofar as it sought disgorgement on the grounds that the acts relating to which disgorgement was sought had taken place prior to the Penny Stock Reform Act of 1990 and that the Act could only be applied prospectively. The Commission, however, refused to dismiss the order of the Administrative Law Judge barring respondent from participating in the distribution of penny stock. That order was based on the criminal conviction in January of 1992 and the proceeding to enter the bar was commenced well within five years from that date. Similarly, the Penny Stock Reform Act was not being applied retroactively as the criminal conviction in itself was a sufficient statutory basis to impose the bar; hence, the proceeding was not based on the sales that took place prior to the adoption of that Act.

The criminal proceeding in Sprecher had been initiated by indictment or information less than five years after the unlawful sale of securities or it would have been barred by the general five-year statute of limitations applicable to federal crimes.[300] The proceeding for an injunction in Koch had also been initiated less than five years after the April 1990 sales on which it was based as it was entered in January of 1995. In Rind,[301] the Ninth Circuit refused to impose any statute of limitations on the initiation of an action to enjoin one from committing further violations of the Securities Acts. The court, however, did not specifically consider and could not have considered whether the general civil action period of limitations of § 2642 was applicable as the proceeding had been initiated less than five years after the alleged violations of the Securities Acts. A district court has held that an action initiated by the Commission to enjoin violations of the Securities Acts is not a penalty for purposes of § 2462, since it merely forbids future violations of securities laws.[302] But what if the Commission more than five years after the specific violations of the Securities Acts initiates a proceeding to enjoin future violations by the associated person on the grounds that such persons caused the violations. If the court enters an injunction, can that injunction be used as the basis in an administrative proceeding before the Commission to bar the respondent from acting as an associated person of a broker-dealer? Could the approach adopted in Koch be applied so that the basis of the order is the injunction rather than the acts on which it is based, notwithstanding at the time the Commission initiated the action to enjoin the respondent it could not under Johnson have barred the respondent on the basis of those violations from acting as an associated person of a broker-dealer. In Johnson, the court attached some weight in determining whether the six-month suspension was a penalty to the collateral effect of the suspension.[303] The collateral effect of an injunction under these circumstances is much greater than the suspension order as it can be used as the basis to bar the respondent from engaging in the securities business. Although such collateral effect in itself may not be enough to turn the injunction into a penalty, when it is being or could be used indirectly to bar one from engaging in the securities business when s/he could not otherwise be barred, a court may well find that it is a penalty.

In Roche,[304] the Administrative Law Judge found that the respondent, a brokerage company employee, had made a number of misrepresentations from the period June 1989 to April 1990 and engaged in unauthorized trading. The ALJ also found that the respondent had churned the accounts of three of his customers. The Commission’s opinion does not specify the date on which the proceeding was initiated, but it was within five years of the transactions specifically referred to above as the only statute of limitations issued considered by the Commission was the finding as to churning (excessive trading in an account to generate commissions), as to which the Commission noted part of the period covered by the churning went back more than five years before the proceeding was filed. “Churning is a unified offense [and] a finding of churning, by the very nature of the offense, can only be based on a hindsight analysis of the entire history of a broker’s management of an account and of his pattern of trading that portfolio. Thus, the offense was not complete until the end of the review period, which here occurred within five years of the order instituting proceedings.”[305] This is dictum, however, as the Commission also concluded that “the sanctions are justified by the other violations that Roche committed.”[306]

The Division of Enforcement has been taking the position that it can reach conduct that occurred more than five years prior to initiation of the proceeding under the continuing violation doctrine. Under this doctrine, practices otherwise beyond the statutory period may be so closely related to those that are within the period there are deemed unitary for purposes of applying the statute. At least one court has applied the concept,[307] another found it unnecessary to do so, but noted “it is not at all certain that the continuing violation doctrine applies in securities fraud litigation.”[308]

The Commission in reviewing disciplinary sanctions imposed by the NASD has twice held that the Section 2462 five-year period of limitations is not applicable to a self-regulatory organization (SRO), taking the position that proceedings initiated by a SRO are not agency proceedings.[309] In Klein, the SEC advanced the following justification for its position: “We do not participate in the disciplinary proceeding before the SRO, and we do not control when the SRO begins or concludes its determination. Our sole responsibility in this context arises when an SRO imposes a final disciplinary sanction on a person who seeks review of the SRO’s determination from this Commission. Moreover, enforcement of the sanctions imposed will be the direct responsibility of the SRO, and any fine will be payable to the SRO, not the United States Treasury.”[310]

An administrative law judge in a proceeding to impose remedial sanctions based on violations of the Securities Act, some of which had occurred within five years of initiation of the proceeding and others of which had taken place more than five years before, based his findings as to the violations solely on those acts that occurred within five years, but took into account in determining the appropriate sanctions the acts that occurred more than five years previously as well.[311]

§ 6:36   Section 2462 and the Administrative Law Judges Post-Johnson

A number of Johnson issues have come up before Administrative Law Judges, several of which are relatively routine given the Johnson dicta and what the Commission held in Sprecher and Koch, including the following:

If the administrative proceeding is initiated within five years of an order enjoining the respondent from further violations of the securities laws, it can bar the respondent from being an associated person of a broker-dealer and from participation in a penny stock distribution.[312] .

In Coxon,[313] the Commission initiated a proceeding against a brokerage company employee on January 13, 1997. The respondent made a motion for summary disposition seeking an order baring the Commission from taking any action for illegal activities that occurred prior to January 13, 1992. The proceeding, according to the initiating order, was “to determine whether it is appropriate to enter cease and desist orders, and whether accountings, disgorgement, remedial sanctions and/or civil penalties against the Respondents are appropriate.” The ALJ denied the motion, stating: “While Johnson prohibits the imposition of a penalty for activities that are beyond the five-year statute of limitations, it clearly does not prohibit an accounting and disgorgement, and arguably does not prohibit cease and desist orders. ‘Where the effect of the SEC’s action is to restore the status quo ante, such as through a proceeding for restitution or disgorgement of ill-gotten profits, [28 U.S.C.] § 2462 will not apply.’ Johnson, 87 F.3d at 491.”[314] The ALJ, however, did say if the Division of Enforcement’s reply “is claiming that Johnson does not prohibit a suspension or bar based on activities that occurred five years before the Order because its objective is to protect the public from on-going misconduct, I disagree.”[315] The ALJ to make her point then quoted from Johnson that a penalty “is a form of punishment imposed by the government for unlawful or proscribed conduct, which goes beyond remedying the damage caused to the harmed parties by the defendant’s action.’ Johnson, 87 F.3d at 488.”[316] Presumably this would include an administrative fine (civil penalty) as well as a suspension or bar if it goes beyond the damage cause, although the ALJ omitted any reference to this aspect of the order initiating the proceeding. This may be explained by her further statement that summary disposition in advance of the proceeding “is appropriate [only] where it is clear that the maker of the motion is entitled to summary disposition as a matter of law.”[317]

In an interesting twist, an ALJ with respect to activities that occurred more than five years before the proceeding was initiated refused to order respondent to disgorge or cease and desist because the customers affected by the alleged violation were “satisfied and that a cease and desist order or disgorgement order would constitute [under such circumstances] penalties.”[318] This, however, was an alternative basis for her decision as she also found that the respondent’s activities did not constitute a violation of the federal securities laws. She, presumably, made alternative findings, because the Initial Decision is subject to review by the Commission if the Division of Enforcement chooses to seek such review. An ALJ has held that illegal activities that occurred more than five years before the proceeding was initiated can be taken into account in determining whether it is in the public interest to impose sanctions and the appropriate sanctions for violations that occurred within the statutory period.[319] The ALJ, however, refused to require the disgorgement of the amount sought by the Division when she concluded that the gains from the proven violations were a substantially lesser amount, which she ordered disgorged.[320]

The ALJs who have considered the issue have indicated that a cease and desist order can be entered with respect to conduct that occurred more than five years before the action initiated, comparing it to an injunction in this respect in that it does not impose punishment, but merely requires one to comply with the law.[321] In a proceeding brought under the cease and desist provisions of the Exchange Act,[322] the only sanctions that can be imposed are to cease and desist from violations of the securities laws and to disgorge illegal gains. “Sanctions of the type at issue in Johnson are not available in this proceeding. Accordingly, even if all of the alleged violations occurred more than five years prior to the institution of this proceeding,” Section 2642 is not applicable.[323]

§ 6:37   In the Matter of Warren G. Trepp — Some Other Issues

The proceeding in Warren G. Trepp[324] suggests that the Division of Enforcement will attempt to limit the scope of Johnson to the extent it is able to do so. Trepp was charged for violations of the securities laws in connection with alleged “parking” transactions that had occurred nine years earlier when he held forth at a trading desk next to Michael Milken at Drexel Burnham. The proceeding was initiated on September 28, 1995 and sought to compel Trepp to cease and desist from future violations of the securities laws and to bar him from acting as an associated person of a broker-dealer. Trepp had withdrawn from the securities business in 1992, but the Division apparently wanted to make sure that he was not tempted to return. The bar clearly constituted a penalty under Johnson. but the staff, nonetheless, argued that it was remedial and not subject to Section 2462. ALJ Carol Fox Foelak responded, “[i]f the five-year statute of limitations applies to a censure and suspension, a fortiori it applies to a bar.” The Division, more seriously but not convincingly, also argued that respondent concealed the fraud and the statute was tolled until January of 1992 when it first had notice of the fraud. Thus, the Division was attempting to assert the doctrine of equitable tolling and all of its uncertainties.[325] ALJ Foelak assumed that the doctrine was applicable, but concluded that “the Division did not meet its burden of proof in claiming that it exercised due diligence in discovering the cause of action at issue.”[326] The Commission’s staff had access to Drexel Burnham’s trading records since 1989. “The SEC expended substantial resources in an effort to uncover securities violations at Drexel, and parking was a noted feature in 1980s securities cases related to Drexel.”[327] The larger issue is whether equitable tolling is applicable at all; hopefully, the Commission will address it. In Johnson, the court specifically rejected the argument of the Commission that penalty should be narrowly construed because of the public policy aspects of SEC enforcement proceedings. In doing so, the Court said: “Whatever prejudice there may have been in ancient times against statutes of limitations, it is a cardinal principle of modern law and of this court, that they are to be treated as statutes of repose, and are not to be construed so as to defeat their obvious intent to secure the prompt enforcement of claims during the lives of the witnesses, and when their recollection may be presumed to be still unimpaired.”[328] The ancient prejudices referred to are those reflected by the doctrine of equitable tolling and a statute of repose is a statute not subject to the equitable tolling doctrine.

The ALJ rejected the respondents contention that the cease and desist order was a penalty, stating: “A prospective cease and desist order that the Respondent not violate the securities laws in the future is not a penalty. A respondent is not entitled to break the law.”[329] She, however, addressed the further issue raised by respondent of “whether the Commission must find a likelihood of future violation to issue a cease and desist order.” Although there is no specific authority with respect to the Commission’s authority in this regard, she noted that it has been held that other agencies with such authority are subject to this judicially imposed requirement. The cease and desist order “was described as an administrative remedy comparable to an injunction. H. Rep. 101-616, at 23-24 (1990). A likelihood of future violation is required for an injunction. SEC v. Steadman, 967 F.2d 636, 647-48 (D.C. Cir. 1992).”[330] The test under Steadman “is whether the defendant’s past conduct indicates . . . that there is a reasonable likelihood of further violation[s] in the future.”[331] Several pages later after reviewing the record in detail and concluding that respondent had participated in violations and that the violations were not merely technical violations, ALJ Foelak declined to enter a cease and desist order, stating: “On the other hand, the violations occurred nine years before this proceeding was instituted, there is no evidence to suggest recurrent violations during the interim, and the Respondent has not even been in the securities business since 1992. The Division argues that the Respondent could reenter the securities business in view of his age and experience, but even reentering the securities business is a ‘mere possibility’ rather than a ‘likelihood.’ On balance, it is concluded that there is not a reasonable likelihood of future violations, and a cease and desist order should not be issued.”[332]

The Commission, unlike private parties, has ample authority to investigate before initiating a proceeding and in the interest of efficient and timely enforcement of the law, if nothing else, should welcome the five-year limitation imposed by Johnson on initiating an action. A period of limitations, like an author’s deadline, imposes a badly needed discipline on the staff. One would think that an agency would be embarrassed to initiate a cease and desist proceeding nine years after the event. Although any agency has limited resources to accomplish its task, allowing matters to linger too long does not further the function of getting the job done. Nor does pursuing matters that occurred nine years earlier suggest an appropriate allocation of resources when violations are going on day to day that demand immediate attention. The usual reasons for a statute of repose, stale evidence and dim memories, as well as the unfairness to the prospective target, are apposite. In the case of a really bad actor and egregious behavior, there is unlikely to be a five-year interlude between violations or since the last violation. The attempt by the Division of Enforcement to argue its way out of Johnson may be explicable to some degree by the fact that in many of the cases in which the issue arose, the proceedings were initiated before Johnson, at a time when the Commission’s staff assumed it could proceed at its leisure.

Part IV.
Administrative Proceeding and SEC Rules of Practice

A.    Introduction

§ 6:38   Scope of the Rules of Practice

The Securities and Exchange Commission wears many hats, not the least of which is to adjudicate after a hearing on the record alleged violations of the securities laws. The Commission has authority under the Exchange Act,[333] to impose remedial sanctions on broker-dealers,[334] as­soci­ated persons,[335] municipal securities dealers,[336] government securities dealers,[337] and transfer agencies,[338] and to review disciplinary pro­ceedings initiated by a registered clearing agency.[339] The Commission has authority to sanction regulated broker-deal­ers and their associated persons in administrative proceedings based on violations of any of the securities laws and rules and regulations adopted thereunder, having been convicted within the past ten years of a number of specified crimes, including crimes involving the pur­chase or sale of any security, or being perma­nently or temporarily enjoined from acting, among other things, as an investment adviser, underwriter, broker, or dealer, or from en­gaging in any conduct or practice in connection with the purchase or sale of any security. The sanctions that can be imposed in such proceedings include “censure, place limitations on the activities, functions, or operations, suspend for a period not exceeding 12 months a broker-dealer [or associated person], or revoke the regis­tration of a broker-dealer” (bar from be­ing associated with a broker or dealer, in the case of an associated person).[340] The Commission has authority under the Investment Advisers Act[341] to impose remedial sanctions on investment advisers. Under the Investment Company Act, the Commission has authority to bar persons from serving or acting in the capacity of an employee, officer, director, members of an ad­visory board, investment adviser to or depositor of, or princi­pal un­derwriter for a registered investment company.[342] The Commission has authority in an administrative proceeding to stop-order a registration statement under the Securities Act.[343] Although the Commission does not have com­pa­rable stop-order authority with respect to registra­tion statements, reports filed under the Exchange Act, proxy or tender offer material, it does have authority to initiate an adminis­trative proceed­ing in which it may, after notice and opportunity for hearing, enter an order find­ing a failure to comply with the regis­tration and/or reporting, proxy, or tender offer re­quirements of the Exchange Act and order com­pliance.[344]

The Commission’s extensive areas of adjudication and remedies in such adjudication were significantly broadened by the Secu­rities Enforcement Remedies and Penny Stock Reform Act of 1990.[345] The Penny Stock Reform part of that dual Act extended the Commission’s authority to impose remedial sanctions against broker-dealers and associated persons[346] to securities violators who, although not directly associated with a broker-dealer, are participants in penny stock distributions.[347] See § 6:30. The grounds include violations of any of the securi­ties laws and rules and regulations adopted thereunder SERA authorized the SEC to impose an administrative fine (money penalty) against a securities professional who violates the securities laws. See § 6:21. The same provision specifically authorizes the Commission in any such proceeding to order the respondent(s) to furnish an accounting and to disgorge his profits and pay reasonable interest thereon.[348] See § 6:28. SERA also gives the Commission broad authority to administra­tively enter cease and desist orders restraining any violation or threatened violation of the principal securities laws (the Securities Act, Ex­change Act, Investment Company Act, and Investment Advisers Act) by any person.[349] See § 6:25.

The Commission under Rule 102(e) (formerly Rule 2(e)) brings proceedings to determine whether attorneys, accountants, and other professionals practicing before the Commission should be suspended or debarred. Such disciplinary proceedings are also subject to the procedural provisions of the Rules of Practice.[350]

The foregoing administrative proceedings in most instances are initiated by the Commission on the recommendation of its Division of Enforcement, which has the responsibility for “prosecuting” the matter. These proceedings, although labeled “adjudications,” are trials in every sense of the word. The “trial,” however, is not subject to the Federal Rules of Procedures, but is subject to the SEC’s Rules of Practice. The trial is typically presided over by an Administrative Law Judge (ALJ) appointed by the agency (the SEC) in accordance with the provisions of the Administrative Procedure Act[351] and related statute designed to preserve the independence of the ALJ and separate the judicial function within the agency from the prosecutorial function.[352] Decisions of the ALJ generally are subject to review by the Commission. See § 6:56.

The Commission also has the responsibility of reviewing a number of determinations made by self-regulatory organizations (national securities exchanges and the National Association of Securities Dealers, hereinafter collectively “SROs”), including proceedings in which the self-regulatory organization imposes disci­plinary sanctions on its members and/or persons associated with a member.[353] The trial-type hearing in such proceedings is before the SRO and is not subject to the APA. The person(s) subject to a final disciplinary sanction imposed by the SRO is entitled to a hearing before the Commission, but the “hearing may consist solely of consideration of the record before the self-regulatory organization and opportunity for the presentation of supporting reasons to affirm, modify, or set aside the sanction.”[354] If the proceeding before the SRO involved denial of membership or denial of association with a member of an SRO, or limitation on access to services provided by such SRO, the denial is also subject to review by the Commission and to a limited hearing as in the case of a disciplinary sanction.[355] See § 6:58.

The Administrative Procedure Act defines adjudication as the agency process for the issuance of an order that is a final disposition other than rulemaking, but including licensing.[356] The APA establishes certain minimum procedural safeguards applicable, with some limited exceptions, to “every case of adjudication required by statute to be determined on the record after an opportunity for a hearing.”[357] This Section is concerned primarily with the SEC’s Rules of Practice applicable to such adjudication, including the hearing, prehearing, initial decisions of the ALJ, and review by the Commission. The Rules of Practice applicable to such adjudications in some instances extend to other types of hearings and to that extent such proceedings are also covered. The Rules of Practice applicable to SEC review of disciplinary and related proceedings of SROs are also covered (see § 6:58) as are some special proceedings involving temporary orders issued by the Commission that are not subject to the APA. See § 6:59. This Section does not otherwise cover hearings not subject to the APA.[358] The Rules of Practice also cover some aspects of rulemaking[359] and no effort is made in this Section to cover such rules.

§ 6:39   Background

Administrative adjudication within the Commission is governed by its Rules of Practice.[360] In 1990 the Commission established a Task Force on Administrative Proceedings headed by then-Com­missioner Mary L. Shapiro. The Task Force issued its final report in March of 1993 and that report was the basis of the proposed new Rules of Practice that with some revisions based on comments received by the Commission were adopted on June 9, 1995.[361] The Rules of Practice as they appear in the Adopting Release include informative comments relating to several of the rules.

The Task Force was also responsible for assembling and publishing a formidable and informative collection of 397 previously unpublished rulings by the Commission and administrative law judges for the period 1964-1992 relating to issues arising in administrative adjudication before the Commission.[362] These rulings cover the minutiae of proceedings before administrative law judges relating to such matters as expert witnesses, Jencks Act statements, Brady material, work product and privilege issues, and the like. The rulings are an invaluable source of precedent relating to a variety of issues likely to arise in the course of an administrative hearing. The Commission at the same time adopted the practice of publishing additional rulings as Administrative Procedure Rulings Releases on a current basis. As of July 12, 1995 such rulings were up to number 478.[363]

The Rules are applicable only to a hearing initiated by an order of the Commission; they are not applicable to investigations conducted by the staff.[364] Investigations continue to be governed by a skimpy set of Rules Relating to Investigations[365] that have not been changed except for cross-references reflecting the new numbering system adopted by of the Rules of Practice. The Rules governing investigations would benefit from a similar re-examination.

§ 6:40   Wells Statements

An investigation by the Commission, whatever the source of the information that triggers it, is conducted under the auspices of its Division of Enforcement and usually commences as a preliminary investigation. If it appears at some point that the investigation is going someplace, it is likely that on request of the Division of Enforcement the Commission will enter a formal order converting it into a formal investigation.[366] Such an order is necessary in order for the staff to issue subpoenas for the production of documents and to compel testimony. Such proceedings are private unless (which rarely is the case) the Commission orders otherwise.[367] An investigation may extend over a lengthy period of time. At some point in the investigation, the Commission may, generally upon the recommendation of the Division of Enforcement, initiate an administrative proceeding for imposition of administrative sanctions; initiate a proceeding in the federal courts for an injunction or the imposition of civil penalties or other appropriate remedies, or refer the matter to the Department of Justice for criminal prosecution.[368] If the investigation is completed without recommendation for action, although discretionary, the staff generally will give the target notice that the investigation has been terminated without the recommendation of any action.[369] If the staff contemplates recommending some type of action, persons who will be affected adversely by the recommendation are generally given an opportunity to make a so-called “Wells” statement to the Commission.

A Wells statement is not part of the Rules of Practice, but rather is codified under “Informal and Other Procedures.”[370] The practice is an outgrowth of a 1972 recommendation of an advisory committee adopted in part by the Commission in 1973.[371] The Commission chose to keep it an informal and discretionary practice as it did not want to be precluded from taking immediate action when necessary.[372] Under the informal procedures, the staff may advise a party being investigated of the general nature of the investigation, how the indicated violations pertain to them, and the amount of time available prior to the submission of the recommendation to the Commission.[373] The affected party may submit a written statement setting forth its position. The statement should be sent to the appropriate Division Director, Regional or District Administrator with a copy to the staff members conducting the investigation. If the staff recommends commencement of an enforcement proceeding, the statement of the party affected by the recommendation is forwarded to the Commission in conjunction with the staff memorandum.[374] The Commission “authorizes proceedings after reviewing both a report on the investigation’s findings from the Division of Enforcement and any Wells statement that is submitted.”[375]

The 1973 Release noted that factual issues ordinarily can be resolved only through a consideration of the evidence and that the Commission avoids consideration of factual issues at this stage to avoid an appearance of prejudgment. “Consequently,” the Release advises, submissions by prospective defendants or respondents will normally prove most useful in connection with questions of policy, and on occasion, questions of law, bearing upon the question of whether a proceeding should be initiated, together with considerations relevant to a particular prospective defendant or respondent which might not otherwise be brought clearly to the Commission’s attention.”[376] Notwithstanding this advice, if there are obvious weaknesses in the staff’s case with respect to critical facts relating to the involvement of the party on behalf of whom the submission is made, those weaknesses should be pointed out.

In preparing a Wells statement care should be taken to avoid making statements that might be deemed an admission by the client or are subsequently established to be false. An Administrative Law Judge has used admissions in a Wells statement as a basis for specific findings.[377] An Administrative Law Judge in determining the severity of the sanction to be imposed took into account that the Wells statement denied certain conduct that was established in the proceeding, reflecting negatively on respondent’s character.[378] There has been at least one instance in which a respondent has attempted, unsuccessfully, to obtain copies of Wells statements made by other persons in the same matter.[379]

§ 6:41   Initiating the Proceeding

Proceedings are initiated by an order of the Commission. Although the entire structure of the Rules of Practice is built around this assumption, curiously, no Rule explicitly provides for the issuance of such order.[380] Rather, the objective is accomplished indirectly by defining “[a]n order instituting a proceeding” to mean “an order issued by the Commission commencing a proceeding or an order issued by the Commission to hold a hearing.”[381] A proceeding in turn is defined as “any agency process initiated by an order instituting proceedings etc.” The Comment to Rule 141(a) states: “The Commission commences proceedings to enforce the Federal securities laws by issuing an ‘order instituting proceedings.’”[382] A copy of the order instituting the proceeding must be served on each person named in the order as a party.[383] The order instituting the proceeding must[384]

(1)  State the nature of any hearing.

(2)  Set forth the legal authority and jurisdiction under which the hearing is to be held.

(3)  Contain a short and plain statement of the matters of fact and law to be considered and determined. If the order directs an answer, the order is to “set forth the factual and legal basis alleged therefor in such detail as will permit a specific response thereto.

(4)  State the nature of any relief or action sought.

The time and place of the proceeding must be fixed and in doing so the convenience and necessity of the parties, among other things, is to be taken into account.[385]

The hearing is to be presided over by the Commission unless, as is usually the case, the Commission designates a hearing officer.[386] If the proceeding is subject to the Administrative Procedure Act,[387] the Commission designates that the hearing shall be presided over by an Administrative Law Judge and the Chief Administrative Law Judge makes the selection of the ALJ to preside, subject to the requirements of the APA.[388] The APA requires that ALJs be assigned by rotation to the extent practicable and ALJs may not perform duties inconsistent with their responsibilities as judges.[389]

The order initiating the proceeding may require the filing of an answer.[390] If the order does require a party to file an answer, such answer must be filed within 20 days after service of the order on such party.[391] Even if not so required, every party may elect to file an answer.[392] The answer, if required, must specifically admit, deny, or state that the party does not have and is unable to obtain sufficient information to admit or deny each allegation in the order.[393] A party may file with an answer a motion for a more definite statement of specified matters of fact or law.[394] Such motion should state the respects in which and the reasons why each such matter of fact or law should be required to be made more definite.[395]

§ 6:42   Prehearing Conferences

The hearing officer, absent a proceeding in which the emergency nature clearly makes such conference inappropriate, must hold both an initial and final prehearing conference.[396] The initial prehearing conference ordinarily is to be held within 14 day of the service of an answer, or, if one is not required, within 14 days of service of the order instituting the proceeding. The final hearing conference is to be held as “close to the start of the hearing as reasonable under the circumstances.”[397] On his/her own motion or at the request of a party, the hearing officer may order any party, including the interested Division, to furnish such information as is deemed appropriate including the following:[398]

(1)  An outline or narrative summary of its case or defense.

(2)  The legal theories upon which it will rely.

(3)  Copies and list of documents that it intends to introduce at the hearing.

(4)  A list of witnesses including names, occupations, addresses and a brief summary of their expected testimony.

Each party who expects to call an expert witness must in addition to the information required above include a statement of the expert’s qualifications, a listing of other proceedings in which the expert has given expert testimony, and a list of publications authored or co-authored by the expert.[399]

Subjects to be considered at the prehearing conference (and action to be taken with respect thereto) include “any and all of the following”:[400]

(1)  simplification and clarification of the issues;

(2)  exchange of witness and exhibit lists and copies of exhibits;

(3)  stipulations, admissions of fact, and stipulations concerning the contents, authenticity, or admissibility into evidence of documents;

(4)  matters of which official notice may be taken;

(5)  the schedule for exchanging prehearing motions or briefs, if any;

(6)  the method of service for papers other than Commission orders;

(7)  summary disposition of any or all issues;

(8)  settlement of any or all issues;

(9)  determination of hearing dates;

(10) amendments to the order instituting proceedings or answers thereto;

(11) production of documents as set forth in Rule 230, and prehearing production of documents in response to subpoenas duces tecum as set forth in Rule 232;

(12) specification of procedures as set forth in Rule 202; and

(13) such other matters as may aid in the orderly and expeditious disposition of the proceeding.

B.    Discovery

§ 6:43   Introduction

The rules in the past, reflecting the general attitude of agencies responsible for law enforcement, seriously limited respondent’s prehearing discovery. The revised rules go a long way, but not all the way, toward making discovery comparable to that available under the Federal Rules of Civil Procedure. Ironically, at a time that Congress was significantly limiting discovery in private litigation arising under the Securities Acts,[401] the Commission is liberalizing discovery in administrative adjudications. The rules relating to prehearing conference (see § 6:42) make a significant contribution in this regard and as discussed below work in conjunction with the discovery provisions. The rules require the Division of Enforcement to open up a large part of its case file.[402]

§ 6:44   Documents Division of Enforcement to Make Available on Request for Inspection and Copying

The Division of Enforcement must make available for inspection and copying by any party the following documents obtained by the Division in connection with the investigation leading to the initiation of such proceeding:[403]

1.   Each subpoena and all written requests to persons outside of the Commission to provide documents or to be interviewed.

2.   The documents turned over in response to such subpoenas and requests.

3.   All transcripts and transcript exhibits.

4.   Any other documents obtained from persons not employed by the Commission.

5.   Any final examination or inspection reports prepared by the Division of Market Regulation or the Division of Investment Management.

The documents listed above must be made available if requested; it is not necessary for a party seeking to inspect and copy them to obtain an order directing they be made available. The discovery provisions are supplemented by the prehearing provisions that specifically authorize the hearing officer to take action relating to the “production of documents as set forth in Rule 230.”[404]

§ 6:45   Documents Obtainable by Subpoena

Beyond the significant information obtainable under Rule 230, any party may request issuance of subpoenas requiring the production of documentary or other tangible evidence “returnable at any designated time or place.”[405] This allows a party to subpoena and obtain documents from prospective witnesses prior to the hearing. Although a party may also request the issuance of subpoenas requiring attendance and testimony of witnesses, such attendance and testimony is limited to “at the designated time and place of hearing.”[406] The rule requires that the request for a subpoena must be made in writing and served on all of the parties. This permits each party to the proceeding to be aware of the subpoena requests of all the other parties. The issuance of the subpoena may be denied or limited if it is “unreasonable, oppressive, excessive in scope, or unduly burdensome,” taking into account “the general relevance and reasonable scope of the testimony or other evidence sought.”[407]

§ 6:46   Documents Obtainable on Motion

Rule 230 requires the Division of Enforcement to make available transcripts and documents obtained in the course of its investigation, but does not specifically refer to information obtained by the staff as the result of interviewing witnesses. To obtain this information, in an enforcement or disciplinary proceeding any party may move to require the Division of Enforcement to produce for inspection and copying “any statement or person called or to be called as a witness by the division that pertains, or is expected to pertain to his or her direct testimony and that would be required to be produced under the Jencks Act, 18 U.S.C. 3500.”[408] This provision goes beyond the Jencks Act, which is applicable to criminal proceedings, in that, among other things, it may require production of such statement prior to the prospective witness testifying, whereas the Jencks Act requires the production of such statement at the time the witness takes the stand. The fact that the Division can be required to make available a list of proposed witnesses in connection with a prehearing conference[409] should aid a party in moving for Jencks Act statements. Such statements can be useful not only to anticipate testimony, but for the purpose of impeaching the witness in the event the testimony is inconsistent with the prior information given to the staff as reflected by the notes.

The Jencks Act is applicable to statements of a (prospective) witness and fall into two general categories. First, “a written statement” made by the witness “and signed or otherwise adopted or approved by him.”[410] Second, a transcription of a prospective witness’s statement that is a substantially verbatim recital of an oral statement made by a witness and recorded contemporaneously.[411] There is often considerable controversy over whether notes taken by the staff in interviewing prospective witnesses are substantially verbatim and made concurrently with the taking of the “state­ment.”[412] The issue is typically raised when the staff refuses to turn over notes made by its investigator and trial attorneys on the ground that they were not substantially verbatim. In such circumstances, the administrative law judge has the responsibility of reviewing the notes in camera and making a determination whether they are a Jencks statement.[413] Although the notes may include some parts of the statement that are substantially verbatim, if the notes in their totality reflect only selected portions of the statement so as to possibly distort the statement, they are not Jencks Act statements.[414] A Jencks statement is not protected by the work product rule; hence, there may be an obligation to produce them throughout the hearing as staff attorneys continue to interview prospective witnesses.[415] As a result, the staff often attempts to prepare their notes so that they do not constitute a Jencks Act statement; in some instances this is done by deliberately not preparing them con­currently, or including only selected portions of what the prospective witness said, or making only cryptic references to what the witness said so that such notes are not a substantially verbatim rendition of the witnesses’ statement.

The Jencks Act does not “compel disclosure of a Government lawyer’s recordation of mental impressions, personal beliefs, trial strategy, legal conclusions, or anything else that could not fairly be said to be the witness’ own statement.”[416] The fact that such impressions, personal beliefs etc. are included as part of the notes, however, does not prevent the notes from being a Jencks Act statement if they otherwise include a substantially verbatim recording of the witnesses statement. Under such circumstances, the inappropriate part of the notes can be redacted before making them available to respondent’s counsel.[417] Notes of a staff member relating to the testimony expected to be given by a Commission employee (accountant, mining engineer, or other expert, for example) are also within the Jencks Act if the result of one staff member who is preparing and/or trying the case interviewing the staff member who is expected to testify.[418]

The Jencks Act is applicable only to statements of persons the staff expects to call as a witness. Statements of other persons interviewed do not as a general proposition have to be produced unless included in a transcript. The Commission and the staff under Brady,[419] however, have an obligation to turn over to respondent any exculpating material.[420] Respondents, therefore, should make a demand for all Brady material and the administrative law judge may on such request make a generic order directing requiring the staff to produce all Brady material in their possession. The administrative law judge, however, will not, if the staff insists it has no such material, then review all material available to the staff.[421] If the staff has doubts as to whether material needs to be turned over under Brady, it should turn the material over to the ALJ for in camera review.[422] Similarly, if respondent is able to point to specific material in the possession of the staff that he/she/it claims is likely to be exculpatory, the administrative law judge may request that it be produced for in camera examination.[423] The ALJ generally attempts to keep Brady demands under control so that they do not become a means of obtaining discovery of everything in the staff’s possession that does not have to be produced under the Rules.[424]

§ 6:47   Documents Division of Enforcement May Withhold

Rule 230(b) specifically provides that the Division of Enforcement may withhold the following documents:

1.   Documents that are privileged.

2.   Internal memoranda.

3.   Note or writing prepared by a Commission employee that is not to be submitted into evidence (other than final examination or inspection reports prepared by either the Division of Market Regulation or of Investment Management).

4.   Other attorney work product.

5.   A document that would disclose the identity of a confidential source.

The hearing officer is specifically given authority in Rule 230(c) to require the Division of Enforcement to submit for review a list of documents withheld pursuant to the foregoing and may require any document withheld to be submitted to him/her to determine whether it should be made available for inspection or copy­ing. Although the Rules appear to protect attorney work product including notes of the staff from discovery, Rule 230(b)(2) specifically provides that the authority to withhold documents on the grounds specified does not permit the withholding of documents that are exculpatory contrary to the Brady rule. Further, the author­ity to withhold documents is subject to a motion under Rule 231 for the production of Jencks Act statements. The authority to withhold notes and attorney work product under Rule 230(b) appears to be overridden by Rule 231 requiring on motion production of Jencks Act statements, since the Jencks Act requires the production of statements within its purview notwithstanding the fact that such notes and statements are part of the attorney work product. See § 6:46. The comment specifically states: “Rule 230 is not the exclusive means by which respondent may obtain access to or production of documents. Production of documents prepared by the staff may be required under the doctrine of Brady v. Maryland, or pursuant to Jencks Act requirements made applicable to the Commission pursuant to Rule 231, or may be sought by subpoena pursuant to Rule 232. . . .”[425]

The comments note that the above referred to reports of the Division of Market Regulation and Division of Investment Management are not attorney work product as they are not prepared by the Division of Enforcement and are within the documents that cannot be withheld. On the other hand, the comments specifically provide that the Division of Enforcement’s obligation to produce documents is limited to those obtained by that division. “Docu­ments located only in the files of other divisions or offices are beyond the scope of the Rule.”[426] Documents in the investigation file of the Division include a specific file number that provides objective criteria for identifying “the appropriate investigation file or files from which documents must be made available” to the extent provided by the Rules.[427] The comments make it clear that the Rules are not the only means of obtaining access to Commission files and specifically point out that the Freedom of Information Act may be available.[428] This may be particularly apropos as to files located in other divisions or offices of the Commission.

§ 6:48   Comparison to Federal Rules of Civil Procedure

The discovery procedures have some semblance of pre-trial discovery under the Federal Rules of Civil Procedure. Under Rule 26(a)(1), absent a local rule of court to the contrary, defendants are required to furnish plaintiffs with (1) the names, address, and telephone number of each individual “likely to have discoverable information relevant to disputed facts alleged with particularity in the pleadings,” and (2) are to furnish the plaintiffs with a copy or a description and the location of all documents in defendant’s possession or control relevant to the same disputed facts. The roles of the parties are somewhat reversed in that mandatory discovery (making documents available) is required of the Division of Enforcement which is bringing the action, whereas in a civil action it is required of the defendant. This reflects the fact that the Division of Enforcement has extensive relevant documents in its possession prior to the initiation of the hearing as a result of its investigation leading to the hearing. A major difference in the procedures is that the respondent’s right to further discovery under the Rules of Prac­tice in addition to what the Division of Enforcement is required to furnish and the documents that can be obtained by subpoena from third parties is very limited. The only prehearing depositions that a party can take require an order of the hearing officer based upon a finding that the prospective witness is likely to give material testimony and “will be unable to attend or testify at the hearing because of age, sickness, infirmity, imprisonment or other disability.”[429]

C.    Hearings and the Hearing Officer

§ 6:49   Authority of the Hearing Officer

The hearing officer, typically an Administrative Law Judge (ALJ),[430] has “the authority to do all things necessary and appropriate to discharge his or her duties.”[431] His/her authority specifically includes (but is not limited to) the following:[432]

·         Administer oaths and affirmations

·         Issue subpoenas

·         Rule on the admission of evidence

·         Hold prehearing and other conferences

·         Consider and rule upon all procedural and other motions

·         Prepare an initial decision

§ 6:50   The Hearing

All hearings except those in which a party is granted a confidential treatment protective order and ex parte applications for a temporary cease and desist order  are public unless otherwise ordered by the Commission.[433] Unless ordered otherwise, all hearings are recorded and a written transcript of the hearing is prepared.[434] Transcripts of public hearings are available for purchase.[435] The hear­ing officer may receive any relevant evidence, is to exclude irrelevant, immaterial, or unduly repetitious evidence,[436] and rules on objections to the admission of evidence, which objections must be made on the record.[437] If evidence is excluded, the party offering such evidence may make an offer of proof on the record.[438] All evidence is to be under oath or affirmation.[439] In any proceeding in which a hearing is required to be conducted on the record after opportunity for a hearing, a party is entitled to present its case or defense by oral or documentary evidence, to submit rebuttal evi­dence, and conduct cross examination; all subject to the discretion of the hearing officer as to scope and form.[440] In hearings not subject to the APA, respondent’s opportunity to put on testimony may be limited.[441]

In any proceeding, a person may be represented by an attorney admitted to practice before the U.S. Supreme Court or the highest court of any state.[442] An individual may represent himself in any proceeding.[443] A corporation trust or association may be represented by any bona fide officer; a partnership by any member, and a commission, political department or subdivision of a state may be represented by an officer or employee.[444] A person appearing in a representative capacity, on making an initial appearance by filing or otherwise, must file with the Commission and keep current a written notice setting forth name, business address, business telephone, and name of the proceeding.[445] An individual appearing on his/her own behalf must make a similar filing except it can be stated on the record in the proceeding.[446] A person appearing in a representative capacity can withdraw only on motion and an order of the Commission or the hearing officer permitting such withdrawal.[447]

Notwithstanding the public nature of the hearing,[448] Rule 322 provides a procedure pursuant to which “a party; any person who is the owner, subject or creator of a document subject to subpoena or which may be introduced as evidence; or any witness who testifies at a hearing” may seek a protective order “to limit from disclosure to other parties or to the public documents or testimony that contain confidential information.” Without revealing the confidential information, the motion should include a general summary of the document and a sealed copy should be submitted for in camera inspection. If the movant seeks to keep the document from being disclosed to other parties, a copy of the document should not be served on such parties.[449] Documents and testimony in a public hearing are presumed to be public. The motion will be granted “only upon a finding that the harm resulting from disclosure would outweigh the benefits of disclosure.”[450]

§ 6:51   Proposed Findings and Conclusions

On conclusion of a hearing in which an initial decision is to be rendered by an ALJ, each party is to have the opportunity to submit in writing proposed findings and conclusions with a brief in support thereof.[451] The party designated to file first ordinarily is to file within 30 days of the end of the hearing, unless the hearing officer for good cause shown sets forth a different time and the reasons therefor in his/her order scheduling the filing.[452] A reply brief may be filed by the party assigned to file first, or, if simultaneous filings are called for by each party, within the time frame prescribed by the hearing officer. No further briefs may be filed except with leave of the hearing officer.[453] All such filings, including reply briefs, are to be filed no longer than 90 days after the close of the hearing, unless the order scheduling such filings sets forth a different period and the reasons therefor.[454] The opportunity to file proposed findings and conclusions and briefs in support thereof also is applicable to proceedings not required under the APA to be on the record if the Commission’s order initiating the proceeding provides for an initial decision to be rendered by the hearing officer.[455]

§ 6:52   Motion for Summary Disposition

The Rules of Practice include counterparts to motions to dismiss and for summary judgment under the Federal Rules of Civil Procedure. Rule 11(e) under the prior Rules of Practice provided as follows: “[A]ll applications, motions and objections made during a proceeding prior to the filing of an initial decision therein . . . shall be made to or referred to and decided by the hearing officer, except that an application or motion which requires a ruling which would dispose of the proceeding in whole or in part shall be made to the hearing officer after the conclusion of the Division’s case or after the conclusion of the hearing.” This precluded a motion to dismiss or for summary judgment from being heard prior to the completion of the Division’s case. The new motion Rule[456] does not contain any limitation as to when such motions can be made and a new Rule 250 specifically provides for a motion for summary disposition. Under Rule 250, after respondent’s answer has been filed and after documents have been made available to respondent pursuant to Rule 230, any party or interested division may make a motion for summary disposition of any or all of the allegations of the order instituting the proceedings. If made prior to the completion of the case in chief, such a motion can be made only with leave of the hearing officer.[457] For purposes of the motion, the facts of the pleading of the party against whom made “shall be taken as true, except as modified by stipulations or admissions made by that party, by uncontested affidavits, or by facts officially noted pursuant to Rule 323.”[458] If it appears that a party for good cause shown cannot present by affidavit facts in opposition to the motion, the hearing officer is to deny or defer the motion. The motion can be granted only if there is no genuine issue as to a material fact and the party making the motion is entitled to a summary disposition as a matter of law.[459] The comment suggests that, although the Rule is applicable to all hearings subject to the Rules, it is less likely that it will be appropriate in an enforcement or disciplinary proceeding since such proceedings usually “involve genuine disagreement between the parties as to material facts.”[460] The hearing officer is also alerted not to allow such motions to be used as a dilatory tactic and may adopt a tight schedule within which such motions have to be made and disposed of. Further, the Rule does not “create a right to prehearing depositions or other discovery not otherwise provided for . . . in order to support or oppose the motion.”[461]

Ironically, one reason proffered by the Commission for not allowing prehearing depositions was that in civil actions “discovery, including depositions, is a crucial adjunct to motions to dismiss, summary judgment, and other procedural mechanisms designed to allow an assessment by the judge whether the allegations of the complaint are sufficient to warrant trial.”[462] The Commission’s role, the comment asserts, in initiating a proceeding is not comparable to that of a judge in determining whether the allegations “are sufficient to warrant trial.”[463] The Commission’s view of summary disposition is a limited one. If prehearing depositions were available, together with affidavits and the extensive information available from the staff’s investigation, the administrative law judge should have available a basis to summarily dispose of a matter and that could make the process more rather than less efficient. Although the present opportunity is a limited one, nonetheless there may be instances even involving disciplinary proceedings in which arguably there are no disputed issues of fact and summary disposition is appropriate. Counsel should take advantage of that opportunity. The ALJ has more time and more information on which to base such a decision than the Commission does in connection with its decision to initiate a proceeding.

D.    The Initial Decision and Commission Review

§ 6:53   Petition for Review

There is no specified time limitation on the rendering of an initial decision of the hearing officer. The Secretary to the Commission must promptly serve the initial decision upon the parties and publish notice of its filing in the SEC News Digest and publish the initial decision in the SEC Docket.[464] The initial decision becomes the decision of the Commission unless within the time limit specified in the initial decision an aggrieved party petitions the Commission to review the decision or unless the Commission on its own initiative orders a review of the decision.[465] The petition for review must set forth the specific findings and conclusions of the initial decision as to which exception is taken, with supporting reasons for each exception, which may be in summary form.[466] The opportunity to file a petition for review extends to all cases in which the hearing officer renders an initial decision, not merely those in which it would be required under the APA.[467] If the party filing the petition asserts an inability to pay any disgorgement, interest, or penalty imposed by the initial decision or sought by the Division of Enforcement, the opening brief must include a sworn financial disclosure setting forth specified financial information.[468] A party may seek leave to file a brief in opposition to the petition for review provided filed within five days of the filing of the petition,[469] but it is not likely that the petition for review will be denied as the Commission has “rarely found grounds for denial of a petition for review.”[470]

Notwithstanding the fact that such petitions are rarely denied, Rule 411(b)(1) sets forth certain categories in which review is mandatory and Rule 411(b)(2) sets forth factors the Commission considers in determining whether to grant the petition in categories as to which review is discretionary. The Commission may enter an order to review on its own initiative any initial decision within 21 days after the period established for filing the petition for review or any brief in opposition to such petition.[471] Although the Rule does not specifically so provide, a comment to the Rule indicates that “there is a 21-day period after the end of the period for the filing of a petition for review during which the Commission may determine whether to grant review.”[472] The Commission may summarily affirm an initial decision on the basis of the petition for review and response thereto if it finds that no further consideration by the Commission is warranted.[473] “Summary affirmance has very rarely been granted.”[474] The Commission, however, noted that “[s]ummary affirmance provides a potentially useful mechanism to resolve quickly certain cases,” and suggests that if its workload necessitates the use of such procedure it may be used to a greater extent in the future.[475]

§ 6:54   Briefs and Briefing Schedule

If the Commission grants the petition for review, the Commission will enter a briefing schedule order directing the parties to file opening briefs and specifying particular issues, if any, as to which briefing is to be limited. The opening briefs are to be filed within 40 days of the entry of the order; opposition briefs within 30 days after the due date of the opening briefs, and reply briefs within 14 days after the due date of the opposition brief, although the Commission may by order in each instance provide for different due dates. Briefs in addition to those provided in the briefing schedule can be filed only with leave of the Commission.[476] The briefing schedule order is generally entered within 21 days after the last day permitted for filing a petition for review (or a brief in opposition to such petition).[477] Except with leave of the Commission, opening and opposition brief are not to exceed 50 pages and reply briefs are not to exceed 25 pages. The table of contents, table of authorities, and addendum are not counted for purposes of determining the page limitation.[478] The brief should be based on the exceptions to the initial decision supported by citation by page to the relevant portions of the record.[479] The parties’ position should be supported by relevant citation of statutes, decisions and other authorities. Reply briefs should be confined to matters in opposition briefs of the other parties.[480]

§ 6:55   Oral Argument

The Commission on its own motion or the motion of any party may order oral argument.[481] A motion for oral argument on the affirmance of all or part of the initial decision will be granted absent exceptional circumstances. The Commission otherwise allows oral argument only if it determines that “the decision process would be significantly aided by oral argument.”[482] The request for oral argument must be made by separate motion accompanying the initial brief. The grant or denial of such motion is to be made promptly after the filing of the last brief called for by the briefing schedule.[483] Oral argument unless the Commission orders otherwise is limited to one half-hour per side.[484] The Commission may determine that persons with a common interest are a single side for this purpose, in which event the half-hour is allocated equally among them unless they agree otherwise. Motions for additional time for oral argument must be made reasonably in advance of the scheduled date for the argument. A Commissioner may participate in the decision without attending the oral argument if s/he has reviewed the transcript of the argument and the decision notes the fact of such review.[485]

§ 6:56   Commission’s Decision

The Commission must base its decision on a review of the record.[486] Under the APA, the agency on review of the ALJ’s initial decision has all the powers it would have in making the initial decision except it may limit the issues by notice or by rule.[487] The record includes the transcripts of testimony, exhibits introduced at the hearing, which together with other prescribed materials such as the order initiating the proceeding, stipulations, exhibit index, proposed findings and conclusions, will have been transmitted to the Secretary to the Commission by the hearing officer.[488] The record also includes the petition for review, all briefs, motions, submissions and other papers filed on review.[489] The record is transmitted to the Commission by the Secretary within 14 days after the last date set for filing briefs, unless the Commission directs a later date.[490] The Commission’s decision will be reflected in a final order which is served on the parties. Any party may file a motion for reconsideration within ten days after service of the order.[491] The motion should briefly and specifically state the matters alleged to be erroneous, the grounds therefor, and relief sought. Such motions are not to exceed 15 pages and no response to such motions is to be filed unless requested by the Commission.[492]

§ 6:57   Judicial Review and Stay Pending Review

The Commission’s decision in an administrative adjudication can be judicially reviewed under statutory provisions providing that a “person aggrieved by a final order of the Commission . . . may obtain review of the order in the United States Court of Appeals for the circuit in which he resides or has his principal place of business, or for the District of Columbia Circuit, by filing in such court, within sixty days after the entry of the order, a written petition requesting that the order be modified or set aside in whole or in part.”[493] The petition should be filed in accordance with Federal Rules of Appellate Procedure.[494] Ten copies of the petition filed under this provision must be submitted to the Secretary or the Office of the Secretary at the Commission’s principal office in Washington, D.C.[495] If petitions for judicial review filed in more than one court of appeals are received by the Commission within ten days after issuance of the final order, the Judicial Panel on Multidistrict Litigation randomly selects one of those courts as hav­ing jurisdiction over all cases challenging the order.[496] If no petition for review is received during such ten-day period and petitions are subsequently filed in more than one court of appeals, the appeal is heard by the court of appeals in which the first petition was filed.[497]

Any party who would be entitled to judicial review of an order of the Commission may move the Commission to stay the order at any time so long as the Commission continues to have jurisdiction to grant such a stay.[498] The court has jurisdiction concurrent with the Commission upon filing the petition, which jurisdiction becomes permanent after the record is filed with the court.[499] Thereafter the Commission does not have jurisdiction to grant a stay. The motion for a stay should set forth the reasons for the relief requested and the facts relied upon. If the facts are in dispute, the motion should be accompanied by affidavits or other sworn statements.[500] The Commission has said that it takes the following factors into account in determining whether to grant a stay:[501]

(1) whether there is a strong likelihood that a party will succeed on the merits in a proceeding challenging the particular Commission action (or, if the other factors strongly favor a stay, that there is a substantial case on the merits); (2) whether, without a stay, a party will suffer irreparable injury; (3) whether there will be substantial harm to any person if the stay were granted; and (4) whether the issuance of a stay would likely serve the public interest.

E.    Other Proceedings

§ 6:58   Commission Review of Disciplinary and Certain Other Decisions of SROs

The Commission also has the responsibility of reviewing de novo a number of determinations made by self-regulatory organizations (national securities exchanges and the National Association of Securities Dealers; hereinafter collectively SRO), including (1) proceedings in which the self-regulatory organization imposes disciplinary sanctions on its members and/or persons associated with a member, and (2) denial of membership or denial of association with a member of an SRO, or limitation on access to services provided by such SRO.[502] The proceeding before the SRO may be based on the violation of any provision of the Exchange Act or rules or regulations adopted thereunder, upon violations of the rules of the SRO, or upon violation of rules of the Municipal Securities Rulemaking Board.[503] Persons aggrieved by such actions of an SRO have the right under the statute to apply to the Commission for review of the SRO’s decision.[504] Rule 420 of the Rules of Practice provides an application for review procedure relating to any of the foregoing matters as to which there is a right to review SRO action by the Commission under the Exchange Act. The application for review must be made within 30 days after the SRO filed a notice of determination with the Commission and such notice was received by the person applying for review.[505] The application must be served by the applicant on the SRO; must identify the action complained of; set forth a brief summary statement of alleged errors and supporting reasons; state an address where applicant can be served, and be accompanied by a notice of appearance under Rule 102(d).[506] The self-regulatory agency is to certify and file with the Commission one copy of the record in the matter and three copies of an index to the record and is to serve upon each other party one copy of the index.[507] The Commission may, on its own initiative, within 40 days after the SRO filed with the Commission notice of its determination, order a review of any determination by an SRO that could be subject to an application for review.[508] The person(s) subject to a final disciplinary sanction imposed by the SRO is entitled to a hearing before the Commission, but the “hearing may consist solely of consideration of the record before the self-regulatory organization and opportunity for the presentation of supporting reasons to affirm, modify, or set aside the sanction.”[509] The issuance of a briefing scheduling order,[510] motions for oral argument,[511] issuance of a final order and petitions for reconsideration,[512] and judicial review of the Com­mis­sion’s decision[513] all follow the same procedures applicable to hear­ings in which a hearing officer has rendered an initial decision, except the review before the Commission is based on the record developed before the SRO and the briefs. The Commission may at any time before its final decision raise issues not raised by the parties and notice and opportunity to present supplemental briefs are allowed as to such issues if they “would significantly aid the decisional process.”[514] The Commission in reviewing the decision of the SRO must undertake an independent review of the facts and the law.[515]

There is no occasion to seek a stay of the initial decision of a hearing officer as it either becomes final vis-à-vis a party because of failure to file a petition for review or, if a petition for review is filed and granted, it does not become final as to that party.[516] In the case of an appeal of a decision of a self-regulatory organization, however, the decision is not automatically stayed pending review by the Commission. A party seeking a stay must file a motion with the Commission requesting the stay.[517] The stay may be entered summarily without notice or an opportunity for a hearing.[518] If the action has already taken place and the motion for the stay is filed within ten days of such action, or, if it will take effect within five days of the filing of the motion, the motion is to be considered on an expedited basis.[519]

§ 6:59   Temporary Cease and Desist Orders; Suspending Registration of Broker-Dealer

The Commission has authority to enter a temporary cease and desist order (TCDO) against certain securities professionals. See § 6:26. The Commission also has authority to suspend the registration of broker-dealers, municipal securities dealers, government securities broker-dealers, and transfer agents pending a hearing to determine whether the registration should be permanently revoked.[520] The Commission has combined the rules relating to temporary cease and desist orders and suspension of registration pending final determination in a discrete part of the Rules of Practice as the latter are modeled on the rules pertaining to temporary cease and desist orders. Because the procedures parallel each other, to the extent practicable they are discussed together, with suspension of registration in brackets.

The Division of Enforcement under the Rules of Practice initiates a proceeding for a temporary cease and desist order[521] [suspension of registration][522] by filing an application with the Commission setting forth the alleged violations and the relief sought. In the case of cease and desist orders, the application also is to include a specific statement whether respondent is to be required to take action to prevent dissipation or conversion of assets and whether the relief is sought ex parte. The application for a temporary cease and desist order[523] [suspension of registration][524] is to include a declaration of facts executed by a staff member or any other person with the appropriate knowledge; a memorandum of points and authorities; a proposed order imposing the relief sought; a proposed order instituting proceedings to determine whether a permanent cease and desist order [whether registration should be re­voked], and a proposed notice of hearing and order to show cause. In the case of an application for a cease and desist order, if ex parte relief is sought, the proposed notice of hearing is not included. There are special procedures described below applicable to a temporary cease-and-desist order issued by the Commission without prior notice and opportunity for hearing if such notice or hearing would be “impracticable or contrary to the public interest.”[525]

The hearings held in connection with a temporary cease and desist order or a suspension of registration are not formal “on the record” adjudications for purposes of the Administrative Procedure Act.[526] The hearing procedures are truncated and expedited. Notice of hearing and order to show cause in connection with a temporary cease and desist order[527] [suspension of registration][528] are initiated by the serving of notice of hearing which may, if normal service provisions are not practicable, be by any “means reasonably calculated to give actual notice,” including by telephone. The hearing is before the Commission, although the Commission may after commencement of the hearing assign a hearing officer to preside at the taking of testimony.[529] Parties or witnesses may participate by telephone or, at the Commission’s discretion, by “alternative means of remote access, including a video link.”[530] The testimony as determined by the Commission may be in the form of affidavits; ordinarily it is contemplated that the hearing “will proceed on the basis of affidavits and oral argument.”[531] If a hearing officer is appointed to preside at the hearing, such officer certifies the record of testimony or other evidence to the Commission, but makes no recommended or initial decision.[532] There is no argument, briefing or submissions to the hearing officer; to the extent allowed such argument and submissions is to the Commission and the decision to enter a temporary cease and desist order[533] [suspension of registration][534] is by the Commission.

Before entering a temporary cease and desist order, the Commission must determine that the alleged violations or threatened violations “is likely to result in significant dissipation or conversion of assets, significant harm to investors, or substantial harm to the public interest . . . prior to completion of proceedings on the permanent cease and desist order.[535] Before entering an order suspending the registration of broker-dealers pending a determination to revoke registration, the Commission must find such “suspension is necessary or appropriate in the public interest or for the protection of investors.”[536] A temporary cease and desist order[537] [sus­pen­sion of registration][538] is effective upon service on respondent. A respondent may any time thereafter make an application to the Commission setting forth specific facts in support thereof for an order to set aside the temporary cease and desist order[539] [sus­pen­sion of registration].[540]

The entry of a temporary cease and desist order [suspension of registration] necessarily results in the concurrent issuance of an order initiating a proceeding to determine whether to enter a permanent cease and desist order[541] [whether a permanent sanction should be imposed].[542] This proceeding results in a formal hearing on the record and proceeds in the same manner as other hearings of this nature provided for by the Rules of Practice.[543] If the hearing officer concludes that the cease and desist order [revocation of registration] shall be made permanent, the temporary cease and desist order[544] [suspension of registration][545] remains in effect until completion of the proceeding by the Commission to determine whether the cease and desist order shall be made permanent [whether a permanent sanction should be imposed]. If the initial decision of the hearing officer in such proceeding(s) is appealed to the Commission, however, the temporary cease and desist order[546] [suspension of registration][547] will terminate 180 days (or such longer time as consented to by the respondent) after the briefing schedule order entered by the Commission in connection with such appeal if the Commission has not entered its order prior to that date.

If the initial decision of the hearing officer goes against the Division of Enforcement and is to the effect that a permanent cease and desist order shall not be entered [registration shall not be revoked], the hearing officer has to make a separate determination and issue a separate order “setting aside, limiting or suspending” the temporary cease and desist order [suspension of registration] “in accordance with the initial decision.”[548] Such modification order, if entered, does not take effect until 14 days after service. Within one week of service of such order, any party may seek a stay or modification of the order from the Commission.[549] This process involves a balance of the hearing officer’s judgment that the temporary order is no longer necessary against the fact that the initial decision of the hearing officer may be reversed by the Commission.[550] The Commission’s decision as to such order is an interim procedural ruling that is not subject to judicial review.[551]

The Rules of Practice provide for expedited procedures for prep­aration of and review by the Commission of the initial decision of a hearing officer relating to whether a temporary cease and desist order [suspension of registration] should be made permanent.[552] The parties to the proceeding, to make such order(s) permanent, are to file proposed findings and conclusions and briefs in support thereof 30 days after the close of the hearing; the Commission’s Secretary is to serve the record on the hearing officer within three days after the date of the filing date of the last brief called for by the hearing officer and the initial decision of the hearing officer is to be filed with the Secretary at the earliest possible time, but in no event more than 30 days after service of the record. The hearing officer for good cause shown may extend such period by no more than an additional 30 days.

Any person who seeks review of such initial decision must file a petition for review within ten days after service of the initial decision.[553] If the Commission grants or orders review, unless otherwise ordered by the Commission, opening briefs are to be filed within 21 days of such order and opposition brief are to be filed within 14 days after opening briefs are filed.[554] Reply briefs are to be filed within seven days after opposition briefs. Oral argument, if granted, is to be held within 90 days of issuance of the briefing schedule order.[555]

The TCDO procedures differ in two important respects from the suspension of registration procedures. Under appropriate circumstances, a TCDO can be entered ex parte and the respondent can obtain judicial review of a TCDO without exhausting the procedures for determining whether the TCDO should be made permanent. A temporary cease and desist order can be entered ex parte only if “the Commission determines” that notice and hearing prior to entry would be “impracticable or contrary to the public interest.”[556] The temporary cease and desist order entered ex parte must specifically state why such was the case.[557] Within ten days after service of the order entered ex parte, respondent may apply to the Commission to have the order set aside, limited, or suspended and may request a hearing.[558] The hearing must begin within two days after the filing of the application unless extended with the consent of respondent or by the Commission for good cause shown. The Commission must render a decision within five days of the filing unless extended with consent of the respondent or by the Commission for a single period of five calendar days for good cause shown. If the Commission does not render its decision with ten days of the respondent’s application, unless a longer time is agreed to by respondent, the temporary order is suspended until a decision is rendered.[559] Within ten days after respondent is served with a TCDO entered after a hearing, or within ten days after the Commission confirms after a hearing a TCDO previously entered ex parte, the respondent may apply to a U.S. district court for the district in which respondent resides, or has its principal place of business, or the district court for the District of Columbia to have the order set aside, limited, or suspended.[560] There is no stay, how­ever, pending such determination unless the court specifically orders such stay. In the case of a TCDO entered ex parte without a hearing, the re­spondent cannot by-pass the step that requires it to apply to the Commission to hold a hearing in order to obtain judicial review.[561] Respondent alternatively may at any time after the entry of a TCDO apply to the Commission to have it set aside, limited, or suspended.[562]

§ 6:60   Proceedings to Approve Plan for Disgorgement

The Commission, in connection with a proceeding under SERA to impose a fine (mone­tary penalty) on securities professionals for violations of the securities laws and regulations adopted thereunder, may order the respondent to furnish an accounting and to disgorge his profits and pay reasonable interest thereon.[563] See § 6:22. The Com­mis­sion, in any proceeding to impose a cease and desist order, also can enter an order requiring an accounting, disgorgement of any profit, and payment of reasonable interest.[564] See § 6:28. Since a cease and desist proceeding can be initiated against any person as to any violation of the federal securities laws, the Commission’s authority to require all of the above is a far-reaching one. The revised Rules of Practice include rules specifically relating to the adoption of a plan for distributing monies received in such proceedings to defrauded investors.

The Rules of Practice provide for payment of prejudgment interest to run on the disgorgement amount for each violation from the first day of the month following the violation through the last day of the month preceding the month in which disgorgement is made. The interest rate is to be based on Section 6621(a)(2) of the Internal Revenue Code relating to underpayment of taxes and is to be compounded quarterly. Disgorgement ordered by a hearing officer must be paid on the first day after the order becomes final. Since a hearing officer’s order does not become final, even if no review is sought, for 21 days, payment would not be due for 22 days. See § 6:52. If review is sought, the order does not become final until the Commission denies the petition for review or enters an order affirming the initial decision. In that event, disgorgement must be paid no later than 21 days after service of the Commission’s order. The Commission, however, has no direct means of enforcing the order and must either bring a judicial action to enforce it or refer the matter to the Department of Justice for collection.

Rule 610 sets forth the procedure for submitting a plan of disgorgement and Rule 611 sets forth the contents of such plan. Under Rule 610, the Division of Enforcement ordinarily is to submit a proposed plan no later than 60 days after the funds have been turned over by respondent and any appeals have been waived, completed, or no longer available. The hearing officer may order any party to submit such plan in lieu of the Division of Enforcement and may alter the time period within which the Division of Enforcement is to submit such plan. The Division of Enforcement attempts when preparing a plan to consult with other parties and other persons who have notified the staff of an interest in the proposed plan. Rule 612 provides that notice of a proposed plan is to be published in the SEC News Digest and the SEC Docket and such other publications as may be determined by the Commission or the hearing officer. Such notice sets forth how a copy of the proposed plan can be obtained and advises that interested persons may submit their comments in writing to the Commission. The Commission or the hearing officer can approve the plan any time more than 30 days after the publication of the notice and if substantially modified may republish the modified plant for additional comment. The Commission or hearing officer may order a hearing on a proposed plan or may rule on it based only on written submissions, if any.

Under Rule 611, the plan for the administration of disgorgement is to include the following:

·         Specification of the account where funds are to be held and instruments in which such funds can be invested.

·         Categories of persons potentially eligible to receive proceeds from the fund.

·         Procedures for providing notice to potentially eligible persons.

·         Procedures for making and approving claims; handling disputed claims, and cut-off date for the making of claims.

·         Date for termination of the fund, including disposition of funds not otherwise distributed.

·         Procedures for administration of fund, selection, compensation and indemnification of fund administrator.

·         Power and duties of administrator to oversee the fund; process claims; prepare accountings; file tax returns, and, subject to Commission approval, make distributions to investors.

Rule 611(b) provides that a plan of disgorgement may provide for payment to a court registry or receiver in any pending case against a respondent or any other person based on a complaint against respondent based on substantially similar facts in any pending action in a federal or state court. This provision presumably is designed to permit a court in such a situation to make an overall determination of appropriate damages and establish procedures for sorting out and paying claims pursuant to a single plan that minimizes costs. The transfer of funds to a court in this manner may be subject to conditions on the use of the funds. The Commission “routinely” prohibits the use of any such funds to pay attorneys’ fees in the private litigation. Both the House and Senate versions of the securities litigation reform act preclude funds disgorged as the result of any action brought by the Commission in a federal court or in an administrative proceeding from being used to pay for attorneys’ fees or expenses incurred by private parties seeking distribution of the disgorged funds.[565] If the Commission or hearing officer determine that the costs of administration of the fund would not justify disgorgement of funds to injured investors, the plan may provide that the funds be paid directly to the U.S. Treasury.[566]

Part V.
SEC as Enforcer

A.    Pre-Enron

§ 6:61   Prevalence of Blatant Securities Fraud and the Need for Priorities

It is the responsibility of the Securities and Exchange Commission to investigate violations of the federal securities laws and to bring enforcement actions, or, if criminal prosecution is warranted, to refer the matter to the Department of Justice for prosecution.[567] This burden, particularly with respect to securities fraud, is a heavy one. The Commission as discussed in this Chapter has an ample arsenal of legal weapons with which to combat securities violations. The Commission, however, has a number of other responsibilities and limited resources with which to discharge them. Congress in recent years was almost paranoid in its concern that the Commission raises more money in registration fees than Congress is willing to provide to administer and enforce the law. Congress views such “excessive” fees as a tax on the capital raising process. See § 6:72. Yet, there is more securities fraud out there than an agency with limited resources reasonably can handle. There is a tremendous amount of blatant fraud, often involving the sale of unregistered securities and, in some instances, broker-dealers operating boiler shops at the edge of the law. If one accesses The SEC News Digest daily on the Commission’s web site, one will find under the heading “Enforcement Actions” a number of announcements of a variety of enforcement actions. The Commission, in some instances with the assistance of other federal agencies and often with the assistance of some of the states, fights the good fight in combating this much too rampant type of fraud. The Commission periodically issues press releases like the one issued on September 24, 1998 announcing “SEC Charges 41 People in 13 Actions Involving More Than $25 Million in Microcap Fraud.” The Director of the Division of Enforcement declares, “[o]ur actions against the scam artists charged in today’s actions, who issue and sell these phony investments, demonstrate that the Commission’s coordinated attack against microcap fraud is paying dividends.”[568] Although it may sound as if the good guys are winning the fight, they are not. Our society for some perverse reason, particularly during bull markets, produces an endless stream of “fraudsters” seeking to take advantage of the gullible. The telephone and the boiler shop have always been their main tool, but today they have another one ¾ the Internet. The Commission also devotes substantial resources to dealing with the seemingly irresistible temptation to some insiders and strategically placed outsiders to trade on the basis of inside information. The Commission also devotes substantial resources to policing and imposing remedial sanctions on broker-dealers.[569]

The blatant-type fraud takes its toll both in dollars and in victims, often the elderly and ill-informed. But the fact remains, accounting irregularities, whether of the fraudulent or negligent variety, involving “covered securities” take a far greater toll. “Consider the outbreak of accounting irregularity in business, especially three cases that cost shareholders a total of $34 billion.” This isn’t William Lerach of Milberg Weiss talking, although it could be, but Holman W. Jenkins Jr., who wrote the Business World column in the Wall Street Journal and who may abhor the thought of being linked in any fashion with Mr. Lerach.[570] Mr. Jenkins was referring to “accounting irregularities” at Oxford Health \, Cendant Corp., and Sunbeam Corporation. The SEC, as a federal agency charged with investigating violations of an Act and enforcing the Act, can investigate corporate behavior to satisfy the agency’s “official curiosity” that the law is being complied with.[571] The authority of the agency is akin to that of a grand jury and does not require probable cause as the basis for its investigation or for the issuance and enforcement of subpoenas to testify or produce documents. It is sufficient if “the investigation is authorized by Congress, is for a purpose Congress can order, and the documents sought are relevant to the inquiry.”[572] Testimony or documents are deemed relevant unless it is shown that they are plainly immaterial or irrelevant to the investigation.[573] So the Commission has the tools, but, perhaps, not all the personnel, it needs to do this job. Developing events compelled it to reevaluate its priorities even before the corporate scandals that led to the adoption of the Sarbanes-Oxley Act of 2002. See § 6:70.

Since the adoption of the Federal Rules of Civil Procedure in 1937, all parties in civil actions in federal courts, including private actions created by federal law, have the capability to discover not only information that is relevant, but information that may lead to relevant testimony.[574] There is one significant difference, however, between the Commission’s ability to investigate and discovery in a private action. The SEC can investigate without commencing a proceeding and invariably conducts extensive private investigations, formally or informally, before initiating a proceeding. A private litigant generally does not have the ability to obtain discovery before initiating a proceeding. Rule 27 does permit one to petition to take a deposition before initiating a proceeding for the purpose of preserving testimony, but is limited to situations in which the testimony might be lost if it could not be taken until after a proceeding is commenced. It does not permit “a person to fish for some ground for bringing suit.”[575] The Private Securities Litigation Reform Act (PSLRA) now limits the ability of plaintiffs in a private action arising under the Securities Acts to obtain discovery while a motion to dismiss is pending. This means, since such motions invariably are made, that there is no discovery until the adequacy of the complaint and pleading is tested.[576] This has not dissuaded class action lawyers from filing such actions and a large percentage of the actions filed involve some allegations of accounting fraud.

The Commission, with its arsenal of weapons and extensive authority to investigate, rarely files an action until its investigative process is complete, which may take several years. The Commission, to the extent subject to a statute of limitations at all, compared to private litigants, has a much longer period of time within which to initiate an action. See § 6:33. Securities fraud class action lawyers often, if not generally, tend to file class action complaints within a week(s) of a perceived basis for such an action, generally based on a sharp decline in the price of a widely traded security. The Commission, other than classic insider trading cases, prior to circa 1998 seldom brought civil actions against companies, the securities of which would be in the National Securities Markets Improvement Act (NSMIA) “covered security” category and that are widely traded.[577] The Commission’s enforcement actions against companies for the most part were directed against issuers not widely traded, if traded at all, and against broker-dealers. Former Commissioner J. Carter Beese, as a Commissioner and after leaving the Commission, made the point that many, if not most, of the class actions filed involving forward-looking statements are cases the Commission would not bring[578] — his point being that many of the private actions should not have been brought. Class action lawyers file actions primarily against companies in the covered security category. Class action lawyers would seldom file actions against the type of companies that for the most part were the subject of SEC enforcement actions. The Commission enforcement priorities, however, began to change to some degree in this area by 1998. See § 6:70. In the aftermath of the Enron/WorldCom and other financial fraud scandals, accounting fraud among Fortune 500 companies has become the Commission’s major enforcement priority. See § 6:72.

§ 6:62   Accounting Irregularities

The Stanford Class Action Clearinghouse reported[579] that of 432 class actions filed since the adoption of the PSLRA through August 27, 1998, 59 percent included allegations of accounting fraud and 55 percent include allegations of trading by insiders during the class period. The Commission also initiated a large number of enforcement actions involving insider trading and in some instances accounting irregularities. The two (Commission actions and private actions), however, seldom overlap. Of the 76 companies accused by the SEC of accounting irregularities in proceedings initiated in 1997,[580] only four overlapped[581] with private actions[582] filed since the initiation of the PSLRA. With rare exceptions, the transgressions in the SEC actions occurred several years prior to the proceeding. Undoubtedly, a few of these cases resulted in private actions filed before the adoption of the PSLRA. Relatively few of the proceedings initiated by the Commission in 1997 involved companies in the nationally-traded securities category. The SEC insider trading cases typically involved trading by insiders that takes place within a very short timeframe (often a matter of days) relative to the disclosure that results in a sharp rise or drop, as the case may be, in the price of the stock. The disclosure of the information in the class action situation invariably is of information (often accounting irregularities) that causes a sharp decline in price. Although class action lawyers may make a pretense of bringing a classic insider trading action, in most instances the insider trading alleged took place over an extended time period and is alleged to establish scienter rather to recover the insider’s profits (or loss avoided).[583] Many of accounting irregularities alleged by the SEC in enforcement actions (e.g., improper recording of revenues) do not differ from those frequently alleged in private actions. The defendants, however, with some notable exceptions, play in a different arena.[584]

Between January 1, 1998 and August 20, 1998 there were 63 Accounting and Auditing Enforcement Releases (AAER) — AAER 1005 to 1068. One related to a proceeding in which the Commission declined to enter a Rule 102(e) disqualification order as the matter was over eight years old, one related to an attorney seeking reinstatement, one related to an accountant seeking reinstatement, one involved a procedural issue. The remaining 59 Releases involved proceedings relating to 31 companies. Seven of the companies named in proceedings were also defendants in private actions. The other actions involving accounting irregularities brought against 24 other companies during the first seven months of 1998 for the most part did not involve widely traded securities and were brought several years after the events in question. Several involved consent proceedings in which accountants agreed to be disqualified from practicing before the Commission with respect to accounting irregularities that took place several years earlier. Nine of the 31 companies presently are or may have been at one time included in the nationally traded category.

The most prominent of the companies named was Sony Corporation. Sony Corporation was not charged by the Commission with violating the anti-fraud provisions, but rather was charged with violating the reporting requirements for inadequate disclosure in its Management’s Discussion and Analysis relating to a $2.7 billion dollar write-down of goodwill in 1994. Sony agreed to cease and desist and to engage an independent accountant to review its MD&A for the fiscal year ending March 31, 1999. Sony agreed to pay a penalty of $1 million. The penalty was characterized as “one of the largest fines we’ve ever imposed for a non-fraud violation,” by Paul Gerlach, associate director of the Division of Enforcement. According to the Wall Street Journal, “Sony already has paid $12.5 million to settle a shareholder class-action suit over other alleged financial-reporting irregularities.”[585]

§ 6:63   Centennial Technologies

Centennial Technologies, a New York Stock Exchange listed company, is a rare instance pre-1998 in which the SEC acted almost as quickly as the class action lawyers and represented SEC enforcement at its best. On February 11, 1997, the company announced that there may have been financial irregularities not reflected in financial statements for the prior fiscal year. On February 18, 1997, the company issued a press release that it expected to restate its financial statements for the fiscal year ending June 30, 1996 and for the first quarter of the current fiscal year ending September 30, 1996.[586] A class action was filed on February 11, 1997,[587] the same day the company first announced apparent accounting irregularities. On February 14, 1997, the Commission initiated an emergency action in the District Court of Massachusetts against Emanuel Pinez, the former chief executive officer.[588] The Commission alleged Pinez engaged in insider trading involving the sale of 5,400 call options at a time when he knew that the company’s board of directors was investigating a number of accounting irregularities orchestrated by him. The Commission sought and obtained a temporary restraining order and an asset freeze. It also requested civil monetary penalties, disgorgement, and preliminary and permanent injunctions. The Commission successfully froze $4.69 million in proceeds from the option transactions being held for him at Lehman Bros., prevailing against the claim of Lehman Bros. for the amount owed by Pinez on his margin account.[589] The Commission also succeeded in freezing just under $1 million being held by Pinez in an offshore account.[590] Pinez was indicted and apparently was incarcerated awaiting trial unable to make bail as the court declined to enjoin him so long as he was incarcerated as it thought it unlikely he could engage in illegal insider trading while in prison.[591] The Commission also initiated an action against another company and its president for aiding and abetting the fraudulent scheme. The company was a customer of Centennial and according to the allegations entered into sham transactions for the purchase of product from Centennial to permit Centennial to inflate its revenues. One such transaction in the amount of $1.25 million occurred in January of 1997, less than a month before Centennial announced apparent accounting irregularities. The defendants in this action on July 21, 1998 consented to the entry of an order enjoining them from further violations and the individual defendant consented to a disgorgement order under the terms of which he will pay approximately $3 million. One reason the Commission acted so promptly in this matter may be that it apparently learned that Pinez had engaged in option trading only a few days prior to the bad news announcement by the company. The private action apparently was settled and the settlement preliminarily approved on February 13, 1998.[592]

§ 6:64   California Micro

The most prominent of the cases involved California Micro Devices Corporation and “a stock collapse that cost shareholders more than $100 million,” according to the Commission’s Release.[593] It is informative to track the private actions and the SEC actions time-wise and otherwise. Judge Vaughn R. Walker, of the Northern District of California, prior to the adoption of the PSLRA used this case as a vehicle in a one-judge effort to reform securities fraud class actions. Judge Walker described how the private action commenced as follows:[594]

Three of the nation’s most experienced plaintiff law firms dealing in securities litigation filed the initial complaint in this action on August 5, 1994, following announcements in the late afternoon of the preceding day that defendant California Micro Devices Corporation (“CAMD”) had misreported its financial statements. Shortly thereafter, five other plaintiff law firms filed two additional putative class action complaints alleging basically the same facts. A second round of seven related lawsuits were filed in mid‑October 1994 after CAMD issued another set of press releases.

Judge Walker, after initiating a bidding proceeding to select counsel and expressing concern as to whether the plaintiffs represented by the law firms alluded to could properly supervise counsel, appointed the Colorado Public Employees Retirement Association (“ColPERA”) as class representative.[595] When a question arose as to whether ColPERA would be able to establish that it had been damaged, he allowed California State Teachers’ Retirement System (CalSTRS) to intervene and be named as an additional class representative.[596] It appeared from the outset that the case would be settled early because of the financial condition of the company. After refusing to approve an initial proposed settlement, Judge Walker on May 20, 1997 approved an improved settlement as fair, adequate, and reasonable. The settlement provided for payment of $6 million in cash by the company, $4 million by the accountant defendants, the issuance of 609,000 shares, and possibly up to $2 million from officer and director insurance policies.[597] The settlement provided for attorney fees based on a lodestar (time-billed) of $1.85 million estimated by the court to be approximately ten percent of the value of the settlement.

On December 15, 1995, the Commission filed a complaint naming the chief accounting officer of Cal Micro as defendant and the defendant consented to the entry of an order enjoining him from further violations of the securities laws.[598] Defendant was required to disgorge $86,000, plus prejudgment interest of $8,552, and pay a civil penalty of $86,000, part of which was excused because of demonstrated inability to pay. He was also barred from serving as an officer or director of any public company and separately he consented to a Rule 102(e) order disqualifying him from practice before the Commission as an accountant. On July 15, 1998, the chief executive officer and chief financial officer were convicted after a five-week jury trial presided over by Judge Walker.[599] During 1998, the Commission also brought and settled civil actions against three other officers of the company.[600]

§ 6:65   Sensormatic Electronics

On March 25, 1998, the Commission announced a number of actions that related to accounting irregularities occurring in 1993 and 1994 at Sensormatic Electronics Corp., a company listed on the New York Stock Exchange.[601] Those actions included cease-and-desist orders entered against the company, its director of management information service, and its controller. The controller also was disqualified from practicing before the Commission pursuant to Rule 102(e). All of these actions were by consent. The Commission at the same time announced it had filed a complaint seeking to enjoin and impose civil penalties on three officers of the company.

On July 10, 1995, two securities class action complaints were filed against Sensormatic, immediately following the company’s public announcement that its financial results for the fiscal year ending June 30, 1995 would not meet earning estimates. These actions apparently are still pending in the Southern District of Florida.[602] Milberg Weiss, along with other firms, represents plaintiffs. The accounting irregularities apparently were uncovered in August, 1995 by the company’s auditors who reported them to the audit committee, which in turn employed independent counsel to investigate.

§ 6:66   Media Vision Technologies, Inc.

On July 9, 1998 the Commission initiated a civil action naming four former officers of Media Vision Technologies, Inc., including the former chief executive and chief financial officers, based on alleged fraudulent overstatement of income for fiscal year 1993.[603] On July 17, 1997[604] and January 28, 1998[605] the Commission had announced filing of civil and criminal charges against two other officers of the company based on the same accounting irregularities. In both of those actions, the defendants consented to orders enjoining them from future violations, imposing penalties, and barring them from acting as an officer or director of a public company. Both defendants in these cases entered guilty pleas in the criminal actions, promising to cooperate with the authorities in the continuing investigation. The Commission’s July complaint alleged that the accounting fraud led to the market overvaluing the company’s stock, which reached a high of $46 a share in January of 1994, but was trading under $3 a share by May of 1994. The complaint sought a permanent injunction, civil penalties, disgorgement of profits from alleged insider trading, and the barring of two of the defendants from acting as an officer or director of a public company. One of the defendants had pled guilty to a criminal charge of lying to the SEC’s staff and the FBI in connection with the investigation.

On or about March 24, 1994, over three years before the Commission took its initial action, 18 class actions had been filed based essentially on the same accounting allegations. By September of 1995, a partial settlement had been reached in the consolidated cases; apparently, primarily with the outside directors.[606] The settlement created a fund of $1 million and the 50 some attorneys involved, including Milberg Weiss, applied for expense reimbursement out of the fund in the amount of $797,161.89 and requested that the balance be retained as a “war chest” to pursue other defendants. The court directed the magistrate to reduce the amount allowed in some respects, expressing concern about duplication, unnecessary experts, and high costs of travel and lodging. The case presumably has not been finally disposed of and the shareholders have received little recompense.

§ 6:67   Spectrum Information Technologies

Spectrum Information Technologies, Inc. stock traded on Nasdaq SmallCap. This case is not an illustration of SEC enforcement at its finest hour. The violations of the securities laws occurred in 1992 and 1993. During that period of time, the company used a scheme involving the issuance of stock options to employees to raise monies from the public in violation of the registration provisions of the Securities Act. The company also engaged in a number of transactions involving the licensing of technology that the Commission charged were sham transactions designed to inflate the company’s revenues and earnings. The Commission did not initiate an action in this matter until June 25, 1997 at which time the company consented to the entry of a cease-and-desist order.[607] On December 4, 1997,[608] the Commission filed a complaint naming two former officers of the company as defendants. The Commission seeks to enjoin the defendants from further violations, the imposition of a civil penalty, disgorgement of losses avoided by trading on the basis of inside information, and barring defendants from acting as an officer or director of the company. The Release announcing this action stated, the investigation is continuing. On May 22, 1998,[609] the Commission initiated an administrative proceeding certain to give rise to considerable controversy to determine whether a cease-and-desist order should be entered against two Arthur Andersen partners. The order is based on allegations that they gave advice and concurred in accounting treatment that allowed Spectrum to recognize “illusory revenues and profits” for the quarters ending June 30 and September 30, 1993. Interestingly, the Commission did not initiate a Rule 102(e) proceeding, perhaps in light of judicial decisions that the Commission has never enunciated appropriate stan­dards for determining the basis upon which accountants may be disqualified from practice before the Commission.  Arthur Andersen has stated that the accountants acted in a professional manner in giving the advice and that the company concealed information from them that led to the concurrence in the accounting practices in question.[610]

Interestingly, shareholders of Spectrum initiated a class action in May of 1993 in the Eastern District of New York before issuance of the financial statements in question.[611] This action was based on misrepresentations made by the company relating to the value of an agreement that Spectrum had entered into with AT&T. The statement in question was made on May 11, 1993. On May 20, 1993 a spokesperson for AT&T characterized the company’s statement as a “gross exaggeration,” and the class action was filed before the end of the month. The class period, presumably, was a relatively narrow one. A contingent settlement was reached under which defendants were to pay $10 million into the settlement fund. The settlement was contingent upon resolving issues being contested by two insurance carriers relating to the renewal provisions of D&O policies in favor of the company. The insurance carriers contended that the company had concealed information from them in connection with the renewal of the policies. The concealed information was that the Commission on May 21, 1993 had advised the company by letter that it had initiated an informal inquiry and requested that the company deliver to it a number of documents. The issue was decided against the insurance carriers and, presumably, the settlement was completed. It is apparent from the foregoing that the Commission was on the case at an early date, but did not act until over four years later.

§ 6:68   Woolworth

Woolworth is of the same vintage as Spectrum, although it involved a New York Stock Exchange security and undoubtedly was more widely traded. The accounting transgressions necessitated a restatement of the financial statements for fiscal 1993. The Commission took no action until June 29, 1998. On that date it initiated an administrative proceeding against the company, the former CFO of a subsidiary, and former assistant controller of the company at the relevant dates, all of whom consented to the entry of a cease-and-desist order.[612] On the same date, the SEC initiated and settled a civil action naming as defendants the company, its chief financial officer, and the chief financial officer of another subsidiary, all of whom were involved in the alleged accounting fraud.[613] The defendants were enjoined from further violations, and the CFO of the subsidiary agreed to pay a civil penalty of $25,000. The company CFO was not ordered to pay a civil penalty because of his demonstrated inability to pay one. The CFO, however, on July 8, 1998, consented to the entry of an order pursuant to Rule 102(e) under which he was barred from practicing as an accountant before the Commission for a period of five years.[614] Class actions were initiated based on the same accounting irregularities. The actions made some interesting law relating to discovery[615] and may still be pending.

§ 6:69   Tardy Action and Deterrence

The cases involving accounting fraud discussed above for the most part were brought against nationally traded companies, but with rare exception they were brought two, three or more years after the event. The Division of Enforcement has a long memory. Although it could take a long time in coming, the staff was likely to catch up with accountants involved in accounting fraud or questionable accounting practices. As a minimum, the accountants could expect that eventually a Rule 102(e) proceeding would be initiated to disqualify them from practice before the Commission. Such a proceeding was almost a certainty for the company’s financial and accounting officers if they were, as often was the case, accountants. The delay in bring proceedings against the company and the accountants in part reflected the fact that completing a securities fraud investigation in any category is a labor- [attorney/investigator] intensive effort, taking considerable time and resources. The failure to act within a reasonable time frame as in other areas of law enforcement, however, lessens the deterrent effect of the action. In the case of Woolworth, for example, the accounting transgressions that necessitated restating financial statements related to fiscal 1993, but the Commission did not initiate a proceeding until June 29, 1998. What the Commission did on June 29, 1998 was initiate an administrative proceeding against the company, the former CFO of a subsidiary, and former assistant controller of the company at the relevant dates, all of whom consented to the entry of a cease-and-desist order. On the same date, the SEC initiated and settled a civil action naming as defendants the company, its chief financial officer, and the chief financial officer of another subsidiary, all of whom were involved in the alleged accounting fraud. The CFO, on July 8, 1998 consented to the entry of an order pursuant to Rule 102(e) under which he was barred from practicing as an accountant before the Commission for a period of five years. See § 6:68. By that time many were undoubtedly asking, “Woolworth who”? Then Commissioner Roberts made the point dissenting in Checkosky I,involving accounting irregularities relating to fiscal 1992, 1983 and 1984. The Rule 2(e) proceeding to determine whether the accountants should be suspended from practice before the Commission was initiated in 1987 and the decision of the Commission affirming the findings of the Administrative Law Judge was rendered on August 26, 1992. Then Commissioner Roberts said of all this: “The majority reaches its conclusion after appellate review [by the SEC] of an administrative proceeding that began nearly five years ago and on the basis of conduct that occurred approximately ten years ago. In sum, the facts of this case are about the same age as petrified wood. It is difficult to understand what possible message could be delivered to the accounting community on the basis of facts this old.”[616]

§ 6:70   Change of Enforcement Priorities?

In February of 1998, the SEC Division of Enforcement chief accountant, Walter Scheutze, was reassuring the District of Columbia Bar Association that companies generally are doing a good job with their financial accounting. Referring to SEC statistics, he is reported as saying that over a five-year period only 0.7% of registrants violated the agency’s accounting rules.[617] Even 0.7% of a large number may be significant, but such statistics are inherently flawed if based on the assumption that there is a reliable method of detecting substantially all failures to comply with accounting rules. There is some indication that the Commission is aware that it may need to reconsider its enforcement priorities. One of the first tasks undertaken by Commissioner Laura S. Unger on assuming her duties as a Commissioner was to conduct a review of the Division of Enforcement. Although she prepared no formal report, the Commission released a summary of her recommendations.[618] Of particular interest, she recommended the Division “speed up investigations by shortening internal deadlines . . . and ensuring that cases are brought in a timely fashion.” She also recommended “better coordinating the Commission’s regulatory program with its enforcement program.”

In the long term, focusing on early detection and prevention of accounting fraud may be as important as timely enforcement. Richard Walker, who became Director of the Division of Enforcement in April 1998, indicated an awareness of the significance of accounting fraud, telling the Bureau of National Affairs “[a]ccounting cases are also another area that we need to pay particular attention and focus to.”[619] In the same interview, however, he stated “[f]raud in the microcap and municipal securities markets, as well as on the Internet, head the list of enforcement priorities.” These areas together with insider trading were the main focus of Commission’s enforcement efforts pre-1998. These areas are important, but such focus ignored that as to some of them the states and other regulators can play a larger role. The Commission was the only agency with the expertise to ferret out accounting fraud involving nationally traded securities; such fraud has a much greater impact on capital markets and investor confidence.

A series of headline-grabbing announcements by nationally-traded companies of the need to restate financial statements, and in some instances, acknowledgment of accounting fraud appears to have alerted the Commission to the problem. Chairman Levitt on September 28, 1998, delivered “a major address on the state of accounting.” In the address he “expressed concern that the quality of financial reporting in corporate America is eroding and he presented an action plan that calls on the entire financial community to remedy the problem.” Attributing it to a “zeal to satisfy consensus earnings estimates and project a smooth earnings path,” Chairman Levitt accused “[t]oo many corporate managers, auditors, and analysts” of participating in a game of creative accounting to meet the analysts’ expectations. Sounding like the allegations in class action complaints to support an inference of scienter, Chairman Levitt charged such miscreant activities are undertaken “in order to grow market capitalization and increase the value of stock options.” Auditors, of course, are supposed to keep this from happening; however, according to Chairman Levitt, “[a]uditors, who want to retain their clients, are under pressure not to stand in the way.”[620]

Chairman Levitt announced an action plan that, among other things, included the following:[621]

1.   SEC will formulate and augment new and existing accounting rules and interpretations covering revenue recognition, restructuring reserves, materiality, and disclosure.

2.   NYSE and NASD will sponsor a “blue ribbon” panel to improve audit committee performance.

3.   The AICPA’s Auditing Standards Board will give greater guidance heightening auditors’ scrutiny of problematic accounting practices during audits.

4.   The SEC Enforcement Division and Corporation Finance Division will vigorously identify and pursue accounting fraud.

5.   Corporate management and Wall Street need to undergo a wholesale cultural change, rewarding those who practice greater transparency and punishing those who don’t.

On the same day, the New York Stock Exchange, the NASD, and the SEC joined in an announcement that the blue ribbon panel for improving audit committee performance had been formed. The Committee announced that it would make an intensive study of audit committee performance and within 90 days would be submitting a number of concrete recommendations.[622] Coincidentally, during the same week, the SEC announced an amendment to Rule 102(e) establishing standards of professional responsibility for accountants. Under these standards, directed not only at intentional fraud but incompetent performance as well, upon a finding of failure to comply with those standards in conducting audits or otherwise it may keep an accountant from practicing before the Commission. 

Richard H. Walker, then Director of the Division of Enforcement, on June 14, 2000 announced “zero tolerance for fraudulent financial reporting.”[623] There is no doubt that the Division of Enforcement was energized and began placing considerable emphasis on fraudulent financial reporting. The Division’s enforcement mandate, however, is a broad one. So it is not surprising that on March 14, 2000 Mr. Walker announced “zero tolerance for insider trading.”[624] The breadth of the Commission’s enforcement activities was reflected in what it was doing on a daily basis. During the week of October 2, 2000, selected at random by the author, according to the SEC News Digest, the Commission announced 28 enforcement actions. Eight of them were proceedings against persons associated with registered broker-dealers (including in one instance Paine Webber) in which such persons were, among other things, barred from associating with any registered broker-dealer or investment adviser based upon a variety of securities violations. Three of the 28 actions related to investment advisers and one against a portfolio manager in which remedial sanctions were imposed and in some instances other action was taken. Two involved proceedings in which disciplinary action taken by NASDR against employees of broker-dealers was sustained. Two of the enforcement actions were against financial officers of companies who were disqualified from practice as accountants before the Commission because of involvement in the preparation of false financial statements. Three actions were brought against individuals for insider trading; including an action against a director for trading in advance of a bad news announcement and an action against an individual who received tips from an employee of a Wall Street investment banking firm. Three actions were brought against companies (and in some instances officers of the company) for failure to register securities under the Securities Act and for fraudulent representations in connection with such sales. One action sought to compel a company to file reports under the Exchange Act, the company being over three years delinquent in the filing of its report. Three actions in some manner involved the Internet, including an individual who put out a fake press release purporting to come from a public company and another involving a press release on a company’s web site that allegedly misrepresented its mining reserves. In one action, the Commission obtained a preliminary injunction against a dot.com company for false representations in a Form 8-K and an earlier press release. Two of the actions were taken against companies involving serious accounting irregularities. In at least three the matters, criminal actions were filed concurrently (or had been filed previously) by the Department of Justice.

Some of the major enforcement actions involving accounting irregularities taken by the Commission during 2000 included the following:

1.   On September 28, 2000, the Commission took its first action involving McKesson HBOC, a Fortune 100 company, charging three people, including the two top officers with participating in a long-running fraudulent scheme to inflate the company’s revenue and net income. Separately, the U.S. Attorney’s Office for the Northern District of California filed criminal charges against two of the officers.

2.   On October 5, 2000, the Commission entered a cease and desist order against Engineering Animation, Inc. (EAI) and an officer of the company for improper recognition of revenue during EAI’s second fiscal quarter ended June 30, 1999. The Commission concurrently filed an action seeking to impose a civil money penalty on the officer of the company.

3.   On June 14, 2000, the SEC brought civil and administrative fraud and other charges against seven former officials of CUC International Inc. (CUC) and Cendant Corporation for their involvement in a massive financial fraud that caused billions of dollars in losses for investors.

4.   On May 15, 2000, the SEC brought and settled civil and administrative charges against America Online, Inc. (AOL) for financial reporting violations in connection with its accounting for certain advertising costs., AOL agreed to pay a $3,500,000 civil penalty and consented to an administrative order prohibiting it from violating certain federal securities laws in the future.

On January 11, 2000 the SEC brought and settled an enforcement proceeding against Informix Corporation for fraudulently and otherwise improperly inflating revenues by $295 million and earnings by $244 million between 1994 and the first quarter of 1997.

B.    Post-Enron

§ 6:71   Cooperation for Leniency

There is no doubt that the Division of Enforcement during the Levitt tenure and under the direction of Richard Walker as Director of the Division of Enforcement was energized and placed a new-found emphasis on fraudulent financial reporting. During the year 2001, Chairman Levitt, Richard Walker, and Lynn Turner, Chief Accountant, all left the Commission. The three were the driving force behind the focus on accounting fraud. Chairman Harvey Pitt, in his first major speech as Chairman, appeared before the American Institute of Certified Public Accountants (AICPA) and referred to his predecessor’s SEC as a place that has not “always been a kinder and gentler place for accountants.”[625] He reminded them that for two decades he had represented the AICPA and that he had represented “each of the Big Five accounting firms.” A New York Times reporter highlighting the speech asked, “[c]an the new, friendlier Securities and Exchange Commission enforce the laws and assure investors that corporate financial reports are trustworthy?”[626] Chairman Pitt assured the AICPA that henceforth “the commission will make sound decisions, in a respectful, affirmative way, not in a demeaning, demanding or demonizing way.” He also cautioned that “practices that reflect venality and disservice to public investors, however, will not be tolerated.”

The day following Chairman Pitt’s speech to the AICPA the Commission issued a Report of Investigation explaining why the Commission did not take enforcement action against a company “it had investigated for financial irregularities.” The Report set forth a framework that the Commission would follow “for evaluating cooperation in determining whether and how to charge violations of the federal securities laws.” A press release announcing the new framework described it as follows:[627]

·         Self-policing prior to the discovery of the misconduct, including establishing effective compliance procedures and an appropriate tone at the top;

·         Self-reporting of misconduct when it is discovered, including conducting a thorough review of the nature, extent, origins and consequences of the misconduct, and promptly, completely, and effectively disclosing the misconduct to the public, to regulators, and to self-regulators;

·         Remediation, including dismissing or appropriately disciplining wrongdoers, modifying and improving internal controls and procedures to prevent recurrence of the misconduct, and appropriately compensating those adversely affected; and

·         Cooperation with law enforcement authorities, including providing the Commission staff with all information relevant to the underlying violations and the company’s remedial efforts.

The Commission’s press release does not mention the company’s name. The New York Times account of Chairman Pitt’s speech to the AICPA tied the Report of Investigation to the new friendlier SEC. The New York Times reporter commented,[628] “[t]he decision itself was reasonable, although one could wonder if top management did something wrong in failing to detect a fraud that went on for years. But the way the S.E.C. trumpeted it raised questions about whether the agency is turning into a friendly puppy rather than a guard dog. ‘Is this amnesty for financial fraud?’ Jane Adams, the accounting analyst at Credit Suisse First Boston and a former S.E.C. staff member, asked in a report to clients. She was not sure of the answer.”

One of the first to attempt to take advantage of this policy was Arthur Andersen, which reported the shredding of documents by its audit team at Enron. Arthur Andersen was rewarded with an indictment and prosecution for obstruction of justice.. The Arthur Andersen situation was atypical in this context, however, for a variety of reasons. First, the decision to prosecute is made by the Department of Justice, not the SEC although, presumably, the Commission was consulted. Second, Arthur Andersen was already subject to an injunction restraining it from committing violations of Rule 10b-5, among other things, in connection with its previous audits of Waste Management. See § 6:77. Third, the matter was too high profile to be ignored.

The Pitt Commission has not backed off from the self-report in return for a less hostile SEC. Chairman Pitt sees such policy as an aspect of achieving “real time” enforcement, describing it in a speech to the Department of Justice Corporate Fraud Conference in the following terms:[629]

In the civil context, we’ve also taken steps to create strong incentives for companies to behave cooperatively during our investigations so that our enforcement staff can move on an expedited basis. Similar to the DOJ’s guidance on prosecution of corporations, we have made it known that meaningful and complete cooperation will be favorably considered by the Commission.

For example, in the Homestore matter — jointly announced by DOJ and us just yesterday — we determined not to bring charges against the company itself, because of its swift and extraordinary cooperation, including by quickly reporting the potential problems to us, sharing results of its internal review, terminating the wrongdoers, and implementing remedial actions. Similarly, when companies drag their heels in responding to our subpoenas and other requests, that too will be reflected in our actions.

Creating strong incentives for companies to cooperate with our investigations — as we did with Xerox and Dynegy — is only one aspect of our “real-time” enforcement initiative. The objective of real-time enforcement is to protect investors by rapidly filing actions to halt misconduct, make public our suspicions of wrongdoing so that investors also may take steps to protect themselves, and freeze the assets of fraudsters so that, whenever possible, monies may be returned to harmed investors

Homestore is an example of “extraordinary cooperation,” whether attributable to the Commission’s cooperation policy or concerns among auditors and audit committees in the aftermath of Enron. The financial fraud involving the first three quarters of 2001 was brought to the attention of the audit committee before the year-end audit, the audit committee ordered an independent investigation and announced the need for a restatement of the first three quarter financial statements before year-end, at the same time reporting the results of its investigation to the SEC. The joint action referred to by the Chairman is discussed below at § 6:79.

§ 6:72   The Pitt/Bush Enforcement Record

Whether Chairman Pitt’s “kinder and gentler” SEC remarks were distorted or not, it soon became apparent in the aftermath of Enron that he was determined, among other things, to establish new records and new directions for SEC enforcement. Although the Commission’s Annual Report for fiscal 2002, which commenced on October 1, 2001 and ended September 30, 2002, is not available at this writing (October 23, 2002), Chairman Pitt understandably had attempted to get that record out. In a speech before the National Press Club on July 19, 2002 he summarized the Commission’s enforcement performance for the first ten months of fiscal 2002 on a comparative basis with fiscal years 2000 and 2001.[630] On October 22, 2002, he updated that record in a speech at a “Directors” Education Institute” at Duke University to include the entire fiscal 2002. Some of the highlights from that speech include the following:[631]

1.   We filed [in a record 163 actions for financial reporting and issuer disclosure violations, approximately 46% higher than we filed in fiscal year 2001 and 58% higher than in fiscal year 2000.

2.   Overall, we filed a record 598 enforcement actions, approximately 24% more than in fiscal year 2001, and 19% more than in fiscal year 2000

3.   We sought 126 permanent officers and directors. That is approximately 147% more than we sought in fiscal year 2001 and 232% more than in fiscal year 2000.

4.   The Commission filed 48 Temporary Restraining Orders, up approximately 55% from fiscal year 2001 and 45% from fiscal year 2000.

The speech as it appears on the Commission’s website includes a link to the following table reflecting the Commission’s enforcement record during fiscal 2002.[632]

Record of Enforcement FY 2000 ― 2002

	FY 2000	FY 2001	FY 2002
Total Enforcement actions filed	503	484	598
Financial fraud and issuer reporting actions filed	103	112	163
Officer and director bars sought (in all categories of cases)	38	51	126
Temporary Restraining Orders filed (in all categories of cases)	33	31	48
Asset Freezes (in all categories of cases)	56	43	63
Trading Suspensions	11	2	11
Subpoena enforcement proceedings	8	15	19
Disgorgement Ordered   (in millions)*	$463	$530	$1,328
Penalties Ordered (in millions)*	$43.7	$56.1	$116.4

* Includes amounts disbursed to the NASD as part of the Credit Suisse First Boston settlement.

In the speech to the National Press Club, Chairman Pitt noted that President Bush recently (July 12, 2002) ordered the formation of the Corporate Fraud Task Force, which includes the Department of Justice, the SEC, Treasury Department, postal inspectors and other federal agencies. Although only the Department of Justice can initiate a criminal prosecution for securities fraud, such cases are often investigated by or in conjunction with the SEC. Chairman Pitt noted that even before organization of the Task Force, “this year . . . approximately 75 prosecutions by 17 different U.S. Attorney’s Offices and the Department of Justice were filed with our assistance for securities related offenses or obstruction of justice in our investigations.” In his speech at Duke University, he claimed that “by the end of the fiscal year, these figures had grown to 259 and 30, respectively.”[633]

On September 26, 2002, Chairman Pitt noted that the Commission was “using asset freezes to protect investors’ funds at an extraordinary rate — we have obtained 57 so far this fiscal year — a third more than all of last fiscal year. We’ve also dramatically increased our use of TROs — up more than 50% from last year — and trading suspensions — imposing more than 5 times the number sought last year.”[634]

Although Chairman Pitt obviously is attempting to put the best possible face on the Commission’s performance, it indeed is a remarkable record. In significant part it is attributable to the Division of Enforcement and Stephen Cutler, appointed head of the Division by Pitt in October 2001. Chairman Pitt correctly in late September of 2002 characterized the SEC as “small by federal agency standards, with approximately 3,000 employees.” The Division of Enforcement as of September 2002 had a staff of less than 1,000 employees.[635] This compares with the approximately 2,000 FBI special agents reportedly “assigned to white-collar crime, nearly equaling the number assigned to terrorism.” This in part undoubtedly reflects resources devoted to the President’s Corporate Fraud Task Force.[636] The Wall Street Journal reported on September 27, 2002 that “[i]n the 10 weeks since [organization of the task force], more than 100 federal corporate-fraud cases have been opened. More than 150 defendants have been charged in civil or criminal cases, a number of them paraded before cameras in handcuffs. Some 46 cases have resulted in convictions or plea agreements.”[637] It is somewhat difficult to reconcile these figures with Chairman Pitt’s claim noted above that since organization of the task force through September 30, 2002 the prosecutions had increased from 75 to 259.

Without disparaging the results and the record of the Division of Enforcement, some of these statistics are designed to put this best possible political face on the administration’s effort to combat corporate crime. Cooperation among the SEC, Department of Justice, postal inspectors, and the formation of task forces among the agencies is not new but has been standard procedure in a number of areas for years. The Wall Street Journal reported on September 27, 2002,[638] “Attorney General John Ashcroft, flanked by top SEC and FBI officials, faced the television cameras” and hailed the task force for its role in bringing the action against Homestore. What he didn’t note, but the Journal did, the case was in the pipeline well before the organization of the task force. The politics also are apparent in the historical under funding of the SEC. Sarbanes-Oxley purported to remedy all of this by increasing the Commission’s budget for fiscal 2003 to $776 million, over $300 million more than contemplated under the Investor and Capital Markets Fee Relief Act designed by Congress to assure that the SEC did not impose registration fees in excess of what Congress deemed appropriate to meet its annual budget. Of this increased amount, $98 million was to go to not less than 200 additional qualified professional personnel for oversight of auditors and audit services, related investigative and disciplinary efforts. The only problem with all of this is the provisions of the Act have to be incorporated into the Commission’s fiscal 2003 appropriation as passed by Congress in order to be effective. As of October 21, 2002, 21 days into the 2003 fiscal year, the Commission’s 2003 budget had not been approved by Congress. President Bush was seeking to limit the Commission’s appropriation to $578 million, less than a $100 million increase and $200 million less than contemplated by Sarbanes-Oxley.[639] This increase has to cover pay parity and technological improvements, as well as additional staffing contemplated by Sarbanes-Oxley.

§ 6:73   —Enron Related Actions

Enron although first on the scandal scene has been among the last up to this point to result in criminal or other charges brought by the government. On August 21, 2002, the Commission announced coordinated actions by the SEC in a civil enforcement proceeding and the Department of Justice in a criminal action against Michael J. Kopper, “a former high-ranking Enron official.” In the criminal proceeding brought by the Department of Justice Task Force against Kopper, he agreed to enter a plea of guilty and to “cooperate with the government’s continuing investigation.”[640] On October 2, 2002, the SEC filed a civil action against Andrew S. Fastow, the former Enron chief financial officer, alleging numerous violations of the antifraud provisions and seeking a broad sweep of remedies.[641] On the same day, the Department of Justice arrested Fastow and filed a criminal complaint charging him with “with fraud, money laundering and conspiracy in,” as described by the Wall Street Journal, “a sweeping criminal complaint that clearly signals further charges are likely against other former executives of the collapsed energy giant.”[642]

§ 6:74   —WorldCom Real-Time Enforcement

The largest accounting scandal in history was acknowledged by WorldCom on June 25, 2002. See § 1:29. Ironically, the scandal at WorldCom was the largest but one of the simplest accounting scandals in history. In June 2002, WorldCom announced that it had improperly accounted for (capitalized) $3.8 billion of expenses in 2001 and the first quarter of 2002. Instead of reporting profits for these periods, the company should have reported losses. In August 2002, the company announced that it had discovered an additional $3.3 billion in improperly reported earnings before interest, taxes, depreciation and amortization (“EBITDA”) for 1999, 2000, 2001 and the first quarter of 2002. According to WorldCom, its pre-tax income for these periods was overstated by over $7.68 billion.[643] WorldCom announced “additional amounts of improperly reported EBITDA and pretax income may be discovered.” The effect of the scheme was exaggerated by WorldCom’s use of the EBITDA measure of earnings (earnings before interest taxes and amortization). By excluding amortization, WorldCom was able to totally exclude the costs. On the basis of this improper accounting WorldCom claimed it had made a profit in 2001 and the first quarter of 2002, when in fact it had suffered huge losses.

It would appear that WorldCom took steps to comply with the SEC’s new cooperation policy. Although the SEC had begun a formal investigation into WorldCom in March 2002, WorldCom discovered the improper accounting as a result of its own internal processes. Before disclosing the initial improper accounting of over $3.8 billion, WorldCom had:

·         volunteered to restate its financial statements;

·         asked its outside auditors to conduct a thorough review;

·         retained a former Director of the SEC’s Division of Enforcement and his law firm to conduct an independent investigation;

·         terminated its chief financial officer;

·         notified the SEC of the facts;

·         provided the SEC with the report of its internal auditor;

·         publicly announced the improper accounting within two weeks of the Board being notified of the findings.

The SEC did not reward WorldCom for its “cooperation.” The Commission in announcing its new policy regarding cooperation, warned “[t]here may be circumstances where conduct is so egregious and harm so great, that no amount of cooperation or other mitigating conduct can justify a decision not to bring any enforcement action at all.” WorldCom was such a case. WorldCom’s startling confession resulted in immediate and unprecedented reaction by the Commission that is discussed in detail at § 1:29, including the filing of a civil action and the indictment of the chief financial officer and the controller.

§ 6:75   —Adelphia Communications’ “Elaborate and Extensive” Corporate Fraud

Adelphia Communications involved allegations of abuse of off-balance sheet affiliates as well as self-dealing. In July 2002, the SEC filed a complaint against Adelphia, the sixth largest cable-television company in the U.S.[644]<