By Linda Chatman Thomsen and Lanny Schwartz
The Securities and Exchange Commission has been increasing its scrutiny of individuals in the wake of the financial crisis, and its investigations can lead to enforcement actions against members of a firm. It is important for counsel and compliance staff to communicate to the business as a whole that a manager or other supervisor of the firm can be held individually liable — and that the individual need not have directly committed a violation of a rule, regulation or law.
In addition to direct liability, notable forms of indirect liability include aiding and abetting liability, control person liability and failure to supervise. The SEC has seized upon these theories of liability in its enforcement efforts.
- Aiding and abetting liability: Although there is no private right of action under the securities laws to hold a secondary actor liable for a violation, the SEC has the authority to bring an enforcement action under all of the securities laws against persons who knowingly or recklessly provide substantial assistance to primary violators of the securities laws. The SEC is also authorized to bring an action under the Advisers Act, but only for civil injunctions, not for civil monetary penalties.
- Control person liability: An individual can also be held joint and severally liable for the acts of persons under his or her control. Most courts have held that, to be held liable, there must be a showing of "culpable participation" by the controlling person in the conduct that causes the offense, a standard which some courts have held can be satisfied by a showing of "recklessness," and which a few courts have found can be satisfied simply by showing a primary violation and control. The SEC has continued to expand the use of control person liability in new types of cases.
- Failure to supervise: In SEC actions, and more frequently in disciplinary proceedings by self-regulatory organizations, an individual can be held liable for "failure to supervise" the activities of the firm or subordinates.
SEC federal civil proceeding remedies
In federal civil proceedings, the SEC must first establish by a preponderance of the evidence that the defendants violated the securities laws before the court will consider possible sanctions. The primary task of defense counsel is to argue that the SEC has not met its burden of proof or has not established a particular element of the alleged violation. If the action proceeds to the sentencing stage, the SEC can petition for a broad range of sanctions, including an injunction, disgorgement, monetary penalties, officer bars and undertakings.
The SEC frequently seeks injunctions in federal court to lay a basis for subsequent civil or criminal contempt charges if the defendants repeat their violations. The agency can pursue both temporary and permanent injunctions. To obtain a temporary injunction, the SEC must provide prima facie evidence that shows a violation of the law and a reasonable likelihood of its further violation. For a permanent injunction, the standard rises to a preponderance of the evidence that the wrong will be repeated.
Injunctions produce significant, additional collateral consequences for defendants. Filings to the SEC must disclose injunctions. Enjoined broker-dealers must update their registrations with SROs. Injunctions also may cause the loss of the benefits of the safe harbor provisions related to forward-looking statements provided in the Private Securities Litigation Reform Act of 1995, as well as other offering exemptions under the Securities Act and state laws.
Where appropriate, counsel should appeal to the discretionary authority of the court and seek to persuade the judge that injunctive relief would be superfluous and undesirable.
First, if there is an absence of injury to identifiable individuals or if the violation involved is technical in nature, your firm's in-house counsel may be in a position to argue that the injunction is not in the interest of the public. Second, in some cases, counsel may present a voluntary agreement by the defendants to stop the activity and to take steps to minimize further transgressions, such as employing independent agents to monitor expenditures and perform accounting audits, compensating victims, terminating culpable parties and enhancing board oversight. Counsel also can often use any delay in, or undue length of, the SEC's investigation to undercut claims of the necessity of immediate relief.
Because an injunction is remedial and protects against future violations, other ancillary relief mechanisms have developed to address infractions that already have occurred. These include disgorgement, officer bars and the rescission of transactions.
The SEC commonly seeks disgorgement to remedy unjust enrichment. A disgorgement order requires defendants to return to the government any gains they derived or losses they avoided because of the violation. The SEC need only make a reasonable approximation of the amounts causally connected to wrongdoing. The burden of proof then shifts to the defense to demonstrate that the calculation is not reasonable. The definition of illicit profit is somewhat malleable, and counsel should argue that the defendants earned a portion of the profits legitimately to reduce the total amount to be disgorged.
Disgorgement can be ordered against individuals who have not themselves violated the underlying securities laws. Accordingly, if the defendants transfer their ill-gotten gains to a third party, the third party will have to return them.
Federal courts can levy monetary penalties in a range of amounts against anyone who violates the securities laws. They may set the penalty up to a maximum of three times the pecuniary gain of the defendants, making it difficult to predict the likely consequences of an enforcement action. Factors that courts consider include:
- The egregiousness of the violation.
- The isolated or repeated nature of the violation.
- Whether the defendants attempted to conceal their wrongdoing.
- The financial worth of the defendants.
- Other available penalties.
- Whether the defendants are employed in the securities industry.
To defend against a monetary penalty, counsel should highlight any detrimental effects that a fine could have on the shareholders of the company. Courts are concerned with punishing violators, and their goal is not to cause harm to shareholders.
Officer or director bar
Federal courts also enjoy broad authority to ban defendants from acting as officers or directors of public companies. In the wake of Enron and other corporate accounting scandals, the SEC has aggressively pursued this sanction. The agency has sought temporary bars and permanent bars and has obtained them even for defendants who have not previously served as officers or directors. The Dodd-Frank Act allows the SEC to seek to bar officers and directors from acting in a wide range of regulated entities and not just the type of entity they were serving under at the time of the violation.
Counsel should attempt to limit the scope of any potential bar. Counsel should first address the time period of the bar: the majority of settlements with the SEC have resulted in five-year bars, although some have resulted in 10-year bars. Counsel also can seek to limit the bar to participation in specific activities. This will meet with a greater chance of success if the defendants have not acted as the principal perpetrators of the securities violation.
Undertakings are orders for defendants to undertake remedial steps to correct their misconduct, strengthen internal procedures to prevent future wrongdoing or cooperate in ongoing investigations. Typical undertakings include:
- An independent review of internal procedures.
- The establishment of new training programs.
- The replacement of individual members of the company board.
- The retention of a consultant to determine how best to distribute disgorgement payments to affected investors.
Counsel should proactively volunteer corrective actions to strengthen his or her position for negotiating more severe sanctions such as suspensions, bars or de-registrations. But counsel should try to avoid independent reviews to the extent possible since the defendants will be less likely to control the outcome of the review.
SEC administrative proceeding remedies
The typical sanctions imposed in an administrative proceeding include cease-and-desist orders, fines and additional sanctions against regulated entities. An administrative law judge (ALJ) may also impose officer bars and disgorgement.
A cease-and-desist order functions as the administrative counterpart to an injunction. It mandates defendants to stop violating a securities rule and prohibits any future violations of the same rule. The order provides a basis for bringing contempt of court charges if the defendants continue their illegal actions and may be the only penalty imposed on less culpable parties. The SEC can seek cease-and-desist orders against third parties whose negligence contributed to the violation of the law.
Cease-and-desist orders, however, are not an exact analog to injunctions: they are easier to obtain and harder to enforce. The SEC need only show some risk of future violation for a cease-and-desist order to issue, while an injunction requires it to establish a likelihood of future violation. If the defendants violate a cease-and-desist order, the SEC must first file an action in federal court seeking an order for the defendants to comply with the initial cease-and-desist order. The defendants must violate the second order before contempt charges can attach. The SEC can, by contrast, immediately enforce the violation of an injunction through civil or criminal contempt proceedings. As a result, injunctions are generally viewed as carrying more stigma than cease-and-desist orders.
Cease-and-desist orders may be temporary or permanent. The SEC can enter a temporary order ex parte against broker-dealers, investment advisers, investment companies, transfer agencies, registered public accounting firms and any associated individuals. A permanent order requires notice and a hearing.
The SEC can seek fines against securities professionals; others who aid, abet or counsel them; and those who fail reasonably to supervise them. Unlike in federal court, in an administrative proceeding the SEC must show that the monetary sanctions are in the interest of the public.
The public interest requirement does not provide a definite standard and offers a useful opportunity for counsel to present mitigating evidence. Potential arguments can include, where applicable, evidence that:
- The actions were not egregious.
- The actions were isolated.
- The actions were not made willfully.
- The defendants have recognized their wrongdoing and are unlikely to repeat the offense.
- Monetary sanctions will cause further harm to shareholders.
Securities firms and associated individuals may face additional sanctions for willful violations or willful aiding and abetting. The SEC can censure, limit operations, impose suspensions of less than a year or revoke the registrations of broker-dealers, investment advisers, municipal securities dealers, municipal advisors, government securities brokers or dealers and transfer agents. The SEC can also prohibit people from affiliating with a broker-dealer, investment company, investment adviser or principal underwriter to an investment company. The ALJ must determine that these sanctions operate in the public interest.
SRO proceeding remedies
The FINRA Sanctions Guidelines provide a range of remedies for SROs to impose. FINRA can censure its members, issue fines, suspend or cancel registrations and impose undertakings. Generally, the nature and magnitude of the violation, the disciplinary history of the defendants, the circumstances of the offense and existing precedents affect the severity of the sanction. Whenever possible, counsel should argue that these factors favor a lesser penalty, and also should highlight any cooperation on the part of the defendant.
Censure is the least serious sanction available to FINRA, but because reputation is of great importance within the securities industry, the sanction is nevertheless significant. The agency's disapproval becomes part of the defendants' disciplinary history.
The disgorgement sanction approximates the unjust enrichment the defendants received, and forces them to pay the amount that they were unjustly enriched as a fine. The money is forwarded to injured investors.
Monetary fines are assessed based on the gains to the defendants, the nature of their violation, their disciplinary history and whether they have taken remedial action. Previous restrictions capping the amount of SRO fines have recently been lifted. Failure to pay a fine leads to more severe sanctions, such as suspension from SRO membership. Members who continue to associate with other defaulting parties may also face suspension.
Suspension follows serious misconduct or a history of prior misconduct. It can take the form of a general bar or can preclude specific actions. Defendants may also be expelled or barred from SRO membership. This can be absolute or limited to particular activities.
Defendants can apply for reinstatement when the suspension concludes. The defendant's status with one SRO impacts his or her status with others. Concurrent suspensions are typical.
The agency may mandate additional remedial efforts. Examples include the appointment of an independent director to the board, the hiring of additional compliance personnel, the retention of an independent consultant to review policies and the employment of new management. New exams or other instructional courses are also common.
(Linda Chatman Thomsen and Lanny Schwartz are partners at Davis Polk. The views expressed are their own. Contributing authors include: Robert L.D. Colby, partner, Davis Polk's Financial Institutions Group; Annette L. Nazareth, partner, Davis Polk's Financial Institutions Group; Gerard Citera, counsel, Davis Polk's Financial Institutions Group; Zachary J. Zweihorn, associate, Davis Polk's Corporate Department Alex Crohn, associate, Davis Polk's Litigation Department; Catherine Reilly, associate, Davis Polk's Corporate Department. http://www.davispolk.com).
(This article was produced by the Compliance Complete service of Thomson Reuters Accelus. Compliance Complete (http://accelus.thomsonreuters.com/solutions/regulatory-intelligence/compliance-complete/) provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 230 regulators and exchanges).