Corporate Governance

From the Pages of The Pomerantz Monitor: Should SEC "Fair Funds" Supplant Private Securities Fraud Litigation?

By Carolyn Moskowitz

As Pomerantz Partner Marc I. Gross advised readers in the July issue of The Pomerantz Monitor, the SEC has set up an $800 million fund to be paid to investors in American International Group ("AIG") securities during a four year period. This fund will distribute to injured investors $700 million in "disgorgement" and $100 million in civil penalties that AIG paid to the SEC, in settlement of the SEC's securities fraud claims.

The AIG fund is one of several "Fair Funds" that the SEC has created under Section 308 of the Sarbanes Oxley Act ("SOX"). SOX, enacted in 2002, gave the SEC for the first time the authority to distribute to injured investors any "disgorgements" and penalties recovered by the agency. Fair Funds have also been created in proceedings against Fannie Mae ($350 million), Tyco ($50 million), and from mutual fund companies and third party institutions that engaged in "market timing" of those funds' shares (over $1 billion). Such a compensatory role is a departure from the historic mission of the SEC. Prior to adoption of SOX, the SEC had principally focused on deterring future violations, looking to the securities class action bar, the "private attorneys general," to recover compensation for injured investors.

But now, in the wake of the advent of Fair Funds, business leaders have started arguing that private securities litigation is no longer necessary to achieve compensation for injured investors.

This argument has had some effect. For example, in its StoneRidge decision, the Supreme Court cited the Fair Funds provision as a justification, from a policy basis, not to "expand" the liability of "secondary actors" to private plaintiffs. In addition, SEC Commissioner Atkins and others have pointed out that compensation through an agency action is less costly to investors, because there is no cost for attorneys' fees when the agency acts.   

A pushback against these arguments has already begun. For example, a recent article by Professor Barbara Black of the University of Cincinnati College of Law concludes that "a focus on compensating investors presents the danger that the SEC may give undue emphasis to the possibility of obtaining a large settlement in its selection of enforcement actions." She argues that "effective enforcement policy is not necessarily compatible with a dominant emphasis on recovering and returning funds to investors," and concludes that "the securities fraud class action has its flaws and has, on occasion, been misused. It remains, however, the most effective mechanism for shareholder compensation."

As suggested by Ms. Black's article, as well as another article by Dr. Elaine Buckberg and Dr. Frederick  Dunbar of NERA Economic Consulting, there are several reasons why SEC Fair Funds fall short of a being an exclusive remedy for defrauded investors.
Most importantly, the SEC is not authorized to seek compensatory damages for investors but, rather, is limited to requiring "disgorgement" of improper benefits received by the wrongdoers, and to imposing "penalties" on them. In matters such as backdated options or misleading stock offerings, the computation of benefits received by defendants is straightforward. However, most cases involve earnings manipulations which could be unrelated to any quantifiable benefit to the corporation. Penalties are not scaled to the harm inflicted on investors either.

As Buckberg and Dunbar note, "disgorgement is primarily concerned with recouping ill-gotten gains from the defendant as a disincentive to committing fraud, it is not a compensatory remedy for fraud victims. In order to be equitable, disgorgement should be calculated as the defendants' gain, which may not equal the loss suffered by fraud victims." 

For example, in Worldcom the SEC recovered $750 million in disgorgement, while private plaintiffs recovered over $7 billion as damages for investors, most of which came from investment banks and others whose gains from the fraud would have been relatively minimal.  In that case, the Court estimated that Worldcom had benefited from the fraud by $10-17 billion, whereas investors had lost over $200 billion. Similarly, in Charter Communications, the Pomerantz firm recovered $146.25 million for investors from the Company, its officers and outside accountants, while the SEC settled with the Company for non-compensatory injunctive relief; and in Elan plc, Pomerantz recovered $75 million for investors, 5 times the $15 million penalty the Company paid to the SEC. This disparity between class action and SEC recoveries is borne out by a statistical analysis performed by Professor John Coffee, and is undoubtedly due to the fact the private attorneys are incentivized by the percentage fee awards. 

If recovery were to be limited to the return of ill-gotten gains, plus a penalty, the deterrence effect of securities fraud actions would be drastically reduced. Even if, under the Fair Funds provision, disgorgement could include not only the profits from backdated options or insider sales, but also bonuses and other benefits received from fraudulently achieving certain performance related goals, at the end of the day even if they get caught the wrongdoers will lose nothing but their ill-gotten gains. There is going to be more fraud if the calculation is going to be "heads I win, tails we?re even." Deterrence needs to include more downside risk than that.

Finally, the effectiveness of the SEC in recovering compensation for investors is inherently limited by the funding and priorities of that agency, which are often dictated by politics. If it ever succeeds in curtailing private actions under the securities laws, there will be nothing to stop big business from trying to get Congress to hamstring the SEC or slash its budget.

Full post as published by PomTalk on July 15, 2008 (boomark / email).