Compensatory penalties, hedge-fund insider cases mark SEC enforcement trends

March 14, 2012

By Nick Paraskeva

NEW YORK, March 14 (Thomson Reuters Accelus) – The U.S. Securities and Exchange Commission wants more power to fine firms and individuals for fraud and market abuses, in the face of tougher public scrutiny and judicial opposition to recent settlements. While the agency has been imposing stiffer penalties, the amount remains constrained by the agency’s current authority, said George Canellos SEC New York Regional Office Director.

Canellos was speaking as part of a panel last week on trends in financial enforcement and securities litigation after Dodd-Frank. The panel was organized by NYU Stern Business School and NERA Economic Consulting.“The most important new powers would be an ability to make victims whole,” Canellos told Thomson Reuters on the sidelines of the conference. One way to do that would be by assessing compensatory damages, he said.

“In the last 20 years, there has been a sea change in the objectives pursued by the SEC, Canellos told the conference. “In 1990, the SEC had authority to seek injunctive relief (such as against additional violations) and that was pretty much it.” The courts also allowed, as an incidental authority, for the SEC to seek disgorgement of ill-gotten gains. But there was no authority to seek compensatory damages, or to seek a penalty.

This changed in 1990 with the Remedies Act, Canellos said. The act allowed the SEC to seek limited penalties, based either on the number of violations or the monetary gain to the defendant. Any penalties could only be paid to the U.S. Treasury, so authority to provide compensation to victims remained curbed.

The Sarbanes Oxley Act of 2002 led to a dramatic change in SEC enforcement. Section 308 provides for a judicially administered “fair fund,” so when the SEC obtains disgorgement or a penalty it now has discretion to award the penalty to victims. The act didn’t change the underlying purpose of a penalty, which is to punish the offender.


In the modern era, there has been pressure to change the purpose of a penalty from punishment to compensation. A $150 million SEC settlement with the Bank of America was approved by U.S. Judge Jed Rakoff, but he nonetheless criticized the deal as weak compensatory justice for the harmed shareholders. The SEC had charged the firm with failing to properly disclose employee bonuses and financial losses at Merrill Lynch before shareholders approved the merger.

A $285 million SEC settlement with Citigroup over marketing of collateralized debt obligations used the SEC’s maximum authority to obtain ill-gotten gains and a related penalty. But Rakoff rejected it, saying it the settlement failed to recoup the full extent of shareholder losses and to make Citigroup acknowledge responsibility. The SEC is appealing the rejection in the U.S. Court of Appeals.

SEC Chairman Mary Schapiro recently asked for legislation to increase enforcement powers, which U.S. President Barack Obama has indicated that he supports, Canellos said. The changes would de-link a penalty so it is not tied to the gains of defendants, but to the loss of victims. It would also allow a penalty of up to three times the amount of the victims’ losses, and allow greater penalties for those defendants that have committed repeat violations.


The focus of criminal enforcement has been insider trading, with 60 recent cases and up to 120 arrests to come, said Jonathan Streeter, who joined Dechert law firm last month after serving as deputy chief of the criminal division at the U.S. Attorney’s Office in the Southern District of New York. Since 2009, hedge funds have increasingly become the focus of insider-trading cases. Previously insider trading cases had usually involved a single trader, or a non-professional who had chanced on the information.

An additional, and related, change in insider cases has been the use of wiretaps in investigations. It had not been possible for the government to pursue hedge funds without wiretaps, Streeter said. The crime is nearly always communicated over the phone, and because hedge funds trade so heavily they would be able to claim that a position which was otherwise suspicious was made in the ordinary course of their ongoing trading. Wiretaps provide the clear link between the insider and the trade, said Streeter, or they create a record that demonstrates a cover-up attempt.


The SEC has wider powers under Dodd-Frank, but many of these have not yet been applied, said James Overdahl of NERA Economic Consulting. Recent enforcement trends show 682 SEC settlements in 2011, a similar level to those in recent years since 2006. However, the proportion of actions against financial firms has gone up significantly, to 41 percent of all cases, which reached a post-Sarbanes Oxley high.

Major areas include insider trading cases, and the Foreign Corrupt Practices Act. The SEC Office of Litigation Support has significantly ramped up hiring of economists and others with quantitative skills.

Recent trends in securities-class actions litigations were also discussed by John Montgomery of NERA Economic Consulting. A new trend has been lawsuits against Chinese companies, with 9 cases in 2010, going up to 28 cases in 2011. Cases against accounting co-defendants are now a smaller proportion, making up only 4.5% of all federal filings. Two thirds of all cases get settled, Montgomery noted, and most of the others get dismissed, with very few going to trial.


Cases against Chinese issuers were often brought against those that went public in the United States via a reverse merger, said Michele Rose, a partner at Latham and Watkins. This involves taking over a shell company, which is a quicker way of going public. The types of cases seen include allegations of accounting fraud, and undisclosed related third-party transactions. Many of these cases grew out of scrutiny by research analysts and short sellers, the common themes being that financial statements in the U.S. differ from reports filed in China.

These issuers also attracted the attention of the SEC, which issued a bulletin warning investors of the risk. Matters for the defense bar include cultural issues, translation of documents, and the length and cost of the cases. Issuers are often reluctant to provide disclosure of their documents, and there are strict privacy laws in China when an employee’s personal and business documents are on the same personal computer.

(This article was produced by the Compliance Complete service of Thomson Reuters Accelus.  Compliance Complete ( ions/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.)

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