TCS Daily


Fines and the Fraudsters

By Stephen Bainbridge - January 9, 2006 12:00 AM

The Securities and Exchange Commission (SEC) recently announced a new policy for deciding when it will impose monetary fines on corporations that violate the securities fraud rules. Under it, two principal considerations will go into the decision:

  • "The presence or absence of a direct benefit to the corporation as a result of the violation."
  • "The degree to which the penalty will recompense or further harm the injured shareholders."

In addition, however, the Commission also will consider seven other factors:

  • "The need to deter the particular type of offense."
  • "The extent of the injury to innocent parties."
  • "Whether complicity in the violation is widespread throughout the corporation."
  • "The level of intent on the part of the perpetrators."
  • "The degree of difficulty in detecting the particular type of offense."
  • "Presence or lack of remedial steps by the corporation."
  • "Extent of cooperation with Commission and other law enforcement."

The new policy is an important conceptual advance, but needs significant refinement in order to become practicable.

The question of how -- or, indeed, whether -- to punish corporations has been a surprisingly intractable one. The central problem classically was put by Edward, First Baron Thurlow, who asked: "Did you ever expect a corporation to have a conscience, when it has no soul to be damned, and nobody to be kicked?" His point is that the corporation is not a moral actor -- it's a legal fiction for the set of contracts between various stakeholders, such as employees, creditors, shareholders, and so on.

When we purport to punish the corporate entity by fining it, the fine comes out of the corporation's treasury, which reduces the value of the residual claim on the corporation's assets and earnings. As a result, it is the shareholders effectively pay the fine, not the fictional entity.

As a result -- when we fine a corporation -- neither retributive justice nor deterrence is well-served.

As a rationale for punishment, retribution requires that punishment be directed at those who actually commit wrongdoing. In this context, it typically would be the corporation's directors, officers, or controlling shareholders (if any) who committed fraud, not the corporation's passive investors.

As far as deterrence is concerned, the problem with fining publicly held corporations is that shareholders typically don't control them. Corporation law assigns the responsibility for making corporate policy to the board of directors and the firm's managers. Holding the shareholders liable for corporate fraud is far less likely to deter management misconduct than would the prospect that the managers who made the decisions would be held personally liable. Again, the purposes of punishment would be better served by fining or imprisoning the people who committed the fraud rather than fining the corporate entity.

In terms of the goals of punishment, corporate fines thus are appropriate only where they serve to compensate those injured by corporate wrongdoing. After all, the corporation likely will have far deeper pockets and thus far greater ability to compensate victims than either managers or shareholders.

In some cases, shareholders may well have benefited from the fraudulent conduct of the corporation's directors or managers, such as where the corporation used fraudulently overvalued stock as the consideration to acquire assets in an acquisition. In most cases, however, corporate fraud affects mainly its existing or prospective investors. In such cases, fining the corporation amounts to a double whammy for the investors. They'll have lost out to the fraudsters and then again when the corporation's bottom line is adversely affected by the fine.

The SEC thus appropriately recognized that:

"... the strongest case for the imposition of a corporate penalty is one in which the shareholders of the corporation have received an improper benefit as a result of the violation; the weakest case is one in which the current shareholders of the corporation are the principal victims of the securities law violation."

Even where a fine of the corporation would create a fund for compensating injured investors, the SEC's track record on that score has been quite poor. Relatively modest amounts of corporate fines have been refunded to injured investors. In most cases, the fines went into the federal treasury or were chewed up by administrative expenses. The SEC's policy announcement seems to implicitly acknowledge the need for the Commission to do better on this front.

Conceptually, the new SEC policy announcement thus appropriately recognizes that compensation is the principal justification for punishing corporations and, furthermore, that the policy of compensation applies only when the corporate fraud principally injured third parties rather than shareholders.

Yet, in practice, the SEC policy will require refinement. First, several of the SEC's additional factors assume that fining the corporation is an appropriate deterrent mechanism. Except where the fraud was committed by a controlling shareholder, however, imposing a fine to be paid from corporate assets has little impact on those who committed the offense while punishing the innocent. A policy of effective deterrence would focus on penalizing the officers or directors who committed the fraud rather the fictional legal entity.

Second, the SEC's inclusion of multiple subsidiary factors unrelated to the central policy goals of punishment leaves the policy vague and ambiguous, with considerable room for capricious exercises of prosecutorial discretion. The rule of law requires that law restrict both its subjects and its enforcers. A clearer policy narrowly emphasizing the critical issue of compensation would focus the SEC's enforcement efforts, and thus be fairer to the investors the SEC is supposed to protect.

Steve Bainbridge is a professor of law at UCLA. His blog ProfessorBainbridge.com is a popular law and politics blog
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