Chapter 6 SEC Enforcement

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Hypothetical 6 – Background

NOTE: Chapter 6 is an extensive discussion of SEC enforcement. This Background is a bare bones summary.

There has to be a violation of a substantive provision of the securities laws for the Commission to initiate an enforcement proceeding of any type. We limit our consideration to substantive provisions of the Securities Acts, specific provisions thereof and specific types of violations. In the process we ignore a number of important areas, such as unlawful insider trading (a high SEC enforcement priority) because it requires an in depth understanding of the substantive aspects for which we do not have time. In terms of substantive violations we consider primarily actions involving a violations of Section 17(a) of the Securities Act, Rule 10b-5 its Exchange Act counterpart, and proceedings relating to broker-dealers.

Section 17(a) is the general anti-fraud provision of the Securities Act applicable only to offers and sales making it unlawful for any person in any offer or sale 1) to employ any device, scheme, or artifice to defraud, or (2) to obtain money or property by means of any untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or (3) to engage in any transaction, practice, or course of business which operates or would operate as a fraud or deceit upon the purchaser. See STAT. There is no express private action under Section 17(a) and, although at one time in doubt, it is reasonably certain that there is no implied private action under Section 17(a). Rule 10b-5 was modeled on Section 17(a) except its is applicable in connection with the purchase or sale of any security. Although Rule 10b-5 was adopted to form the basis for enforcement proceedings, as we have seen at § 1.04  implied private actions can be brought pursuant to Rule 10b-5. A good part of the law developed in private actions is not applicable to the SEC, including the requirement that plaintiff be a purchaser or seller, reliance, and causation all being read into the Rule for purposes of a private action. On the other hand, the holding in Hochfelder (see § 1.04[2]) that violation of 10b-5 requires proof of scienter is applicable to enforcement proceedings as it is based on the “any manipulative or deceptive device or contrivance” language that is part of Section 10(b) under which Rule 10b-5 was adopted, which the Supreme Court based its conclusion in Hochfelder. . In Aaron v. Securities and Exchange Com­mission,[1] 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 held 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 held clause (1) of Section 17(a) compelled the same conclusion, but that clauses (2) and (3) of Section 17(a) of the Se­curities Act, however, do not require proof of scienter to establish a violation of Rule 10b-5.

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, periodic inspections of broker-dealers are made on a routine basis, surveillance of the Internet, and the like. 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.[3] 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.[4] 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. 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. 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.

Willful violations of the substantive provisions of the principal secu­rities laws, including the registration and fraud provisions, are a criminal offense.[5] 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 mega cases, the Department of Justice with the assistance of the FBI, in cooperation with the SEC, and other law enforcement agencies may conduct its own investigation, leading to a grand jury indictment. In actions leading to a criminal indictment and more often in lesser situations, the Commission may initiate an action in the appropriate U.S. district court to enjoin violations of the federal securities laws. In these cases, the Commission must prove not only the violations but also the prob­ability of further vio­lations in order to obtain a restraining order.[6] The Commission also generally attempts to obtain a preliminary injunction based on affi­davits pending a trial on the merits. An in­junctive action is subject to the usual Federal Rules of Civil Proce­dure,[7] including Rule 9(b), and, in many instances, is ultimately resolved by a consent decree. The Commission often succeeds in obtaining ancillary relief, too, in connection with such proceedings and, in many instances, succeeds in requiring defendants to disgorge “profits” (ill-gotten gains) realized in transactions involving violations of the securities laws,[8] to rescind transactions,[9] to appoint independent counsel to conduct an investigation of any claim the cor­poration may have against its officers or directors,[10] and, in some in­stances, to replace the board.[11] Many investigations, of course, are completed with no action being taken.

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[12] 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 dual Securities Enforcement Remedies (SERA) and Penny Stock Reform Act (PSRA) of 1990,[13] adding significantly to the Commission’s arsenal of weapons for dealing with penny stock and other forms of securities fraud. The Commission is not subject to the pleading or other provisions of the Private Securities Litigation Reform Act that are applicable to private actions arising under the Securities Acts. The PSLRA does include a provision clarifying the Commission's authority to pursue aiders and abettors in civil enforcement actions. See § 6:6. The Commission in civil enforcement actions is subject to the Federal Rules of Civil Procedure, including Rule 9(b) relating pleading fraud with particularity. For discussion of Rule 9(b) generally, see § 3.01. For a case considering Rule 9(b) in the context of a motion to dismiss an SEC complaint, click HERE.

The Commission in addition to enforcing the Securities Acts by initiating civil proceedings, also has authority in a number of areas to initiate administrative proceedings in which, after notice and opportunity for a hearing, it may impose remedial sanctions. Prior to the adoption of SERA, the primary area in which it had such authority related to broker-dealers and persons associated with broker-dealers. To consider broker-dealer proceedings we simplify the substantive law to note (1) all broker-dealers with limited exceptions that we will ignore must be registered with the SEC and be members of the National Association of Securities dealers; (2) the Commission has authority to deny or revoke or impose remedial sanctions on a broker-dealer, among other things and oversimplified, who have willfully violated any provision of the Securities Acts, including but not limited to Rule 10b-5 of the Exchange Act and Section 17(a) of the ’33 Act; (3) the Commission has authority to bar from association with a broker-dealer or impose remedial sanctions on  any person who, among other things and oversimplified, who has willfully violated any provision of the Securities Acts, including but not limited to Rule 10b-5 and Section 17(a) of the ’33 Act; (4) the Commission can take the foregoing action against a broker-dealer only after notice and opportunity for hearing conforming with the Administrative Procedure Act and after finding that such remedy is in the public interest. Although not specifically provided for by statute, the Commission under Rule 102(e) (formerly Rule 2(e)) brings proceedings after notice and opportunity for hearing to determine whether attorneys, accountants, and other professionals practicing before the Commission should be disqualified from practicing before the Commission.

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.[14] The Penny Stock Reform part of that dual Act extended the Commission’s authority to impose remedial sanctions against broker-dealers and associated persons to securities violators who, although not directly associated with a broker-dealer, are participants in penny stock distributions.[16] 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 (broker-dealers, persons associated with broker-dealers, investment advisers etc.) who violates the securities laws. See § 6:23. The Commission requested and on April 9, 2003 the Senate approved a bill allowing the imposition of administrative fines in any proceeding in which the Commission can impose a cease and desist order (see §6:25) and increasing the amount of all administrative fines. Click HERE. SERA 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.[17] 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.[18] 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, but cannot impose a money penalty.[19] See §  §6:25. 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 the above is a far-reaching one. It is about to be enhanced with authority to impose administrative fines in such proceedings. Click HERE.

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[20] and related statute designed to preserve the independence of the ALJ and separate the judicial function within the agency from the prosecutorial function.[21] Decisions of the ALJ generally are subject to review by the Commission. See § 6.02[8].

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.[22] 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.”[23] 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.[24]

We have attached a TABLE showing for fiscal 2001 (from October 1, 2000 through September 30, 2001) and on a comparative basis with the four preceding fiscal years cases in various categories brought by the Commission; another TABLE with a breakdown of enforcement cases filed during fiscal  2001, and a third TABLE showing the status of investigations during 2001.  The first TABLE reflects the fact the Commission initiated 484 enforcement cases during the fiscal year -- 205 civil injunctive and related actions, 248 administrative actions, and 31 contempt actions. The second TABLE, among other things, reflects that of the enforcement action filed in fiscal 2001 in terms of the principal categories, 20% involved securities offerings (typically involving a large number of unregistered and blatantly fraudulent offerings); 13% broker-dealer cases; 21% financial reporting cases; 12% insider trading cases, and 8% market manipulation. As shown in the third We also learn from this table, that in the 484 enforcement enforcement actions a total of 1029 individuals or entities were named as defendants or respondents. The third. TABLE reflects that 570 investigations were opened during fiscal 2001(in which 324 Formal Orders were entered); 409 cases were closed during the year, leaving 2,401 investigations pending at year end or 161 more than were open at the beginning of the year.

Chairman Pitt after Enron placed increased emphasis on enforcement and timely enforcement and during fiscal 2002 (October 1, 2001 to September 30, 2002) the Commission's enforcement record outdid statistically any prior year. See § 6:72. Under Pitt a number of steps were taken to enhance enforcement. Very early in his tenure he encouraged wrongdoing companies to come forward and acknowledge their violations as part of settlement negotiations with the Commission. See 6:71. A number of high profile financial fraud actions were brought. See § 6:73-6:79. The Commission took the initiative under Pitt to expand the scope of disgorgement sought in enforcement actions to include bonus, other equity related compensation, and profit from the sale of securities that they realized as a result of financial frauds for which they were responsible. See § 6:16.

The Commission had a short laundry list that it requested be included in the legislation that emerged as SOX and a number of other provisions were added by Senators anxious to be seen engaged in the war on financial fraud. In the latter category are a number of provision increasing financial fraud crimes, sentences, and sentencing guidelines. See § 6:2 and 6:3. At the specific request of the Commission, SOX changed the standard for imposing an officer/director bar in an SEC enforcement action from substantial unfitness to fitness (see § 6:13) and extended the Commission's authority so that it can enter an officer/director bar in cease and desist proceedings involving fraud. See § 6:29. Sarbanes-Oxley also reiterates the Commission's authority in enforcement actions to seek the equitable remedy of disgorgement and permits the Commission to request the court to add any civil penalties assessed in an enforcement action to be added to the amounts disgorged and be used to for the benefit of the victims of the fraud. See § 6:15. Sarbanes-Oxley also includes a provision (Section 304) we discussed in the  context of private actions requiring the CEO and CFO under certain circumstances to reimburse the issuer in the event financial statements are restated. See §6:17. The Act also includes a provision allowing the Commission to obtain a temporary asset freeze before initiating an action. See § 6:80.

The Commission post-SOX has requested some additional legislation to enhance its enforcement efforts. See testimony of Stephen Cutler, Director of Enforcement. Click HERE. On the Commission's list is  legislation to enhance the Commission's ability to collect disgorgement amounts from defendants. The Commission also would like the provision allowing penalties to be added to disgorgement funds to be used for the benefit of the victims of the fraud to be able to use penalties assessed for this purpose in instances in which no disgorgement is ordered or appropriate. The Commission would also like to have the authority to impose administrative fines (penalties) in all cease and desist proceedings. The Senate on April 9, 2003 added a provision to an unrelated bill that gives the Commission this authority and increases the amount of such administrative fines generally. Click HERE.

In the Cross-Hairs—The New Face of Financial Fraud Enforcement

HealthSouth Corp. is (or was) the largest chain of rehabilitation hospitals and outpatient surgical centers when it was caught in the cross-hairs. On August 27, 2002, HealthSouth announced that changes in Medicare reimbursement for physical thereapy was causing it to reduce its forecast of EBITDA (earnings before interest, taxes, depreciation, and amortization) by $175 million. The stock dropped from $11.97 a share to $6.71 on the announcement, a loss of 44%.  The company claimed they did not become aware of the change until an August 15 meeting with Medicare officials. The initial focus of the government’s (SEC and DOJ) investigation was assumed to be on insider trading. HealthSouth engaged Fulbright and Jaworski to conduct an investigation and on conclusion of the investigation announced on October 30, 2002 that the investigation concluded that Mr. Scrushy, President of the company was not aware of the new Medicare policy when on May 14 he exercised options to buy stock and immediately sold the related shares for an indicated profit of $52 million. On July 31, he traded back shares to HealthSouth to repay a $25 million company loan. Fulbright and Jaworski after an intensive investigation concluded that Scrushy did not become aware of what Medicare characterized as a “clarification of existing policy” until August 6 at the earliest. On November 6, 2002 the company announced that third quarter net income dropped 32% from the comparable period of the prior year and the stock loss 81cents down to $4.07 or 17% of its value. On February 6, 2003, HealthSouth announced it had received a subpoena “from the U.S. Attorney's office for the Northern District of Alabama, seeking documents for an apparent investigation into trading in the company's stock.”

On March 19, 2003 the SEC and the DOJ unleashed the first salvo in what the Wall Street Journal subsequently referred to as a “Shock and Awe” strategy. The Commission filed a COMPLAINT naming HealthSouth and Scrushy alleging that since 1999, at the insistence of Scrushy, HealthSouth systematically overstated its earnings by at least $1.4 billion in order to meet or exceed Wall Street earnings expectations. The company immediately suspended Scrushy as President and William Owens as Chief Financial Officer. The Commission acknowledged the cooperation of the Department of Justice and on the same date (March 19, 2003) the Department of Justice announced that Weston L. Smith, former chief financial officer at HealthSouth Corp. agreed to plead guilty to conspiring with other executives to artificially inflate the health-care giant's profits and was cooperating with the government. The following day March 20, 2003, the Department of Justice announced that William Owens, current Chief Financial Officer, had agreed to plead guilty to fraud charges and was cooperating with the government. On April 1, 2003, Emery Harris, HealthSouth vice president of finance and assistant controller, pleaded guilty and agreed to cooperate. On April 9, 2003, DOJ announced that Michael D. Martin, who had been the CFO before Smith and Owens agreed to plead guilty to charges of conspiracy and falsification of books and records and was cooperating with the government. He was the ninth HealthSouth former officer or employee to agree to enter a guilty plea and cooperate with the government. On April 3, 2003, the Department of Justice had announced that HealthSouth's chief information officer and former assistant controller, Ken Livesay, pled guilty to federal fraud charges and made new allegations that raised the total of the health-care chain's overstated profit to nearly $2.5 billion since 1997. Documents filed with Mr. Livesay's plea agreement said that HealthSouth also overstated pretax income in 1997 by $440 million and in 1998 by $635 million. On the same date (April 3), guilty pleas were entered by group vice president Rebecca Kay Morgan; vice presidents Angela C. Ayers and Cathy C. Edwards; and assistant vice president Virginia B. Valentine. Prosecutors said these accounting executives, at the behest of senior company officials, helped inflate HealthSouth's profits since at least the mid-1990s by falsifying accounting entries for cash, inventory and assets, among other items.

On April 1, 2003 the Commission filed a complaint naming as defendant Emery Harris, Group Vice President, Accounting and Assistant Controller from March 2000 to March 2003, seeking among other things, money penalties and officer/director bar. On the same date the Commission filed a complaint naming Owens and Smith as defendants and seeking similar relief. On April 7, 2003 the Commission filed a Complaint naming as defendants Livesay, Ayers, Morgan, Edwards, and Valentine, all of whom as noted above had already agreed to enter guilty pleas. The Commission sought an injunction, disgorgement and penalties. The complaints in the above matters include interesting and detailed allegations of their participation in the financial fraud over a period of years. Since all of the above named defendants had agreed to enter a guilty plea, ordinarily, it would be expected that the civil actions would be filed and settled at the same time pursuant to agreement, but apparently this has not occurred. The Department of Justice subsequently added a former Treasurer as the 10th defendant to plead guilty. Click HERE.

On April 1, 2003, HealthSouth made its suspension of Scrushy permanent and also replaced its outside auditor Ernst & Young. The Commission on April 3, 2003, amended its complaint in its action against Scrushy to recover insider trading profits alleging that since 1991 he had sold over 13 million shares and realized over $170 million from such sales. The Commission in its action against Scrushy received an order from the court directing the company not to make an extraordinary payments to Scrushy, which according to the Wall Street Journal precluded the company from paying him over $15 million in severance pay. HealthSouth had already notified Srcushy that it regarded the severance agreement null and void. The Commission also asked for and received a temporary order freezing most of Scrushy’s assets. Scrushy attempted to have $70 million of his assets released from the freeze order, seeking $30 million for legal fees, $30 million for taxes, and $10 million for living expenses. In the course of the hearing, it became apparent that former CFO Owens who prior to the announcement of his agreement to plead guilty and a cooperate had at the request of the FBI wired himself and recorded an incriminating conversation with Scrushy that was used by the government in connection with the freeze proceeding. "Listen" HERE. The presiding judge unfroze his assets to permit him to pay taxes, but otherwise kept it in effect but continued the hearing on the other request. Scrushy as of April 11, 2003 had not been criminally charged. His counsel characterized the government’s tactics deplorable and insisted a great injustice was being done to his client. He alluded to the “collateral damage” being done by the false charges, citing the recent layoff of 165 employees at HealthSouth's headquarters.

Shifting gears to Gemstar, publisher of the TV Guide. Recall from Question 1 that the SEC has to get a court order to compel a person subpoenaed to comply with the subpoena. But NOTE what can happen if you do not show-up. We noted previously that Sarbanes-Oxley allows the Commission  during the course of an investigation involving possible violations of the federal securities laws before initiating an action to obtain a court order requiring a public company to place in an interest-bearing escrow account any “extraordinary payments (whether compensation or otherwise)” if it appears to the Commission that the company is likely to make such payment to the person(s) being investigated.  See § 6:80. Why would Gemstar do that without such an order. Click HERE.