In the fallout of the 2007-2008 financial crisis, the Securities and Exchange Commission has been attacked for the size of penalties paid by the industry in settlements with the regulator. Recently, a judge in the Eastern District of New York, Frederic Block, decried the statutory limitation of SEC penalties,1 and Professor John Coffee advocated a substantial increase in the amount of SEC penalties.2 Historically, SEC penalties are relatively recent, and for much of the 1990s posed issues for the SEC, because the potentially criminal nature of the remedy (under a since overruled Supreme Court case) gave rise to a possible double-jeopardy defense in parallel criminal proceedings. Now, with SEC penalties higher than ever—despite the public clamor for even higher penalties—a decision by the Supreme Court last term, Southern Union v. United States,3 again raises the specter for the SEC that when the SEC seeks penalties in “civil” actions, defendants might deserve the constitutional protections afforded criminal defendants.
The SEC was first able to seek penalties in cases not involving insider trading in 1990, with the enactment of the Securities Enforcement Remedies and Penny Stock Reform Act or the Remedies Act. Before that, the only monetary sanction available to the SEC in a case not involving insider trading was the equitable remedy of “disgorgement,”4 i.e., recovery of a defendant’s unlawful gains. Since 1990, penalties against companies in SEC settled actions have soared, beginning with the $10 million payment by Xerox in 2002. The trend for massive penalties accelerated in the first decade of the 21st century, with a slew of broker-dealers paying more than $1 billion to settle cases alleging conflicts of interest in their research, and mutual funds and advisers paying tens, or even hundreds, of millions to settle market-timing cases.
Still, the maximum penalty amount per violation available to the SEC in federal court actions is a mere $725,000 per violation for corporate defendants, or, if higher, the amount of the defendant’s gain from the unlawful conduct. In administrative proceedings (before SEC administrative law judges), the ceiling per violation is the same flat penalty, without the extra wallop of the defendant’s gain. The far higher amounts in SEC settlements are presumably based on the premise that the companies committed multiple violations. However, the settled orders in these cases, available on the SEC website, shed no light on the basis for the over-sized penalties. And the findings in the orders instituting proceedings generally do not tie penalties to specific violations.
Despite the sky-high penalties in the research and market-timing cases, SEC Chairwoman Mary Schapiro has pressed for a statutory amendment to increase the maximum penalty for corporations above $725,000, explaining that “statutory limitations on our ability to pursue penalties” influence the SEC’s settlements. In a letter to Senator Jack Reed (D-R.I.) last November, Schapiro expressed the need for higher penalties for “the most serious securities law violations.” In addition to upping the maximum ceiling more than tenfold, to $10 million, she asked that the statutory maximum be tripled with respect to a defendant’s gain, and, in addition, that the SEC be authorized to obtain a penalty based on harm caused to investors. Such losses can be “enormous,” she pointed out, in the context of allegedly false financial statements.
Two circumstances may have impelled the SEC’s push for a dramatic escalation in penalties. First, the SEC has had to defend its enforcement record in financial crisis cases, including, most notably, its $285 million settlement with Citigroup. Second, the SEC’s enforcement program is now largely headed by former federal prosecutors, accustomed to the remedies available in criminal cases, which can include double the gain or loss from criminal acts. Enforcement Chief Rob Khuzami, formerly with the U.S. Attorney’s Office, has led the charge for higher penalties.
Senators Reed and Charles Grassley (R-Iowa) responded to the SEC’s request with a bipartisan bill, the “Stronger Enforcement of Civil Penalties Act of 2012 (“SEC Penalties Act”), which would crank up SEC penalties from “decimal dust”5 to real “firepower.” The bill, apparently prepared with text provided by SEC staff, would do exactly what Schapiro requested: the maximum penalty for corporations would rise to $10 million per violation; triple the gain to the defendant; or “the amount of losses incurred by victims as a result of the violation.” In addition, the bill would authorize the SEC to obtain such penalties not only in federal court actions, but also in administrative proceedings. Reed views his bill as a way to restore confidence in the financial system.6 But the draft legislation could have unintended consequences for the SEC, in light of the Southern Union decision last term.
‘Southern Union’ and ‘Apprendi’
Southern Union expanded the jury-trial guarantee of the Sixth Amendment to criminal cases seeking monetary penalties. The Supreme Court had previously held, in Apprendi v. New Jersey,7 that “[o]ther than the fact of a prior conviction, any fact that increases the penalty for a crime beyond the prescribed statutory maximum must be submitted to a jury and proved beyond a reasonable doubt.” In Apprendi, the criminal penalty at issue was imprisonment of an individual for a violent crime; in Southern Union, the penalty was a purely monetary fine imposed against a corporation, for violating an environmental statute.
Apprendi involved a New Jersey statute permitting judges to decide whether a hate-crime “enhancement” should increase the length of a defendant’s prison sentence. The statute provided that judges decide the appropriateness of the enhancement using a preponderance standard, rather than the standard used by juries to decide whether the defendant had broken the law (i.e., beyond a reasonable doubt). As a result of applying the enhancement, a 12-year sentence had been imposed, two years longer than the 10-year statutory maximum for the violation.
There was a split in the circuits as to whether Apprendi applied to the imposition of criminal fines. The Second Circuit, had applied Apprendi to criminal fines in United States v. Pfaff, 8 involving a $6 million fine imposed against an individual based on a judicial finding that the defendant had caused a pecuniary loss of more than $100 million. The majority in Southern Union agreed with the Second Circuit, and the Seventh Circuit, which also was applying Apprendi to fines.9
Southern Union involved a federal statute, the Resource Conservation and Recovery Act (RCRA). Violations of RCRA, like the securities laws, can give rise to both civil and criminal charges. “Knowing” violations of RCRA can be charged criminally, and are subject to a $50,000 per day cap. Violations of RCRA committed without specific intent are brought by the Environmental Protection Agency as administrative proceedings, and are subject to a $25,000 per day cap.
Southern Union was criminally indicted and charged with a continuing violation of RCRA that spanned two years, from “on or about September 19, 2002, to October 19, 2004.” The company was convicted by a jury on two counts of improper handling of hazardous waste. The trial judge then ordered the company to pay a $6 million fine and perform a $12 million “community service obligation.” Southern Union appealed, challenging a presentencing report that calculated the maximum fine under RCRA as $38.1 million, based on a series of violations lasting 762 days, with a $50,000 penalty imposed for each day that RCRA was violated. The Supreme Court tossed out the penalty, as violating the rule of Apprendi: The jury, not the judge, should have decided whether there was a violation on each day of the relevant period.
The court in Southern Union found a monetary penalty imposed against a corporation to be the equivalent of imprisoning an individual. Justice Sonia Sotomayor, writing for the majority, noted the general nature of fines: “penalties inflicted by the sovereign for the commission of offenses.” Next, she pointed out that “fines were by far the most common form of noncapital punishment in colonial America,” and that fines are “frequently imposed today, upon organizational defendants who cannot be imprisoned.” She explained that the amount of a fine is often calculated by reference to particular facts, which in the case of Southern Union was the duration of the statutory violation. Germane to the SEC is her observation that the particular facts relevant to the amount of a fine could be “under other statutes…the amount of the defendant’s gain or the victim’s loss.” In all these cases, she concluded broadly, “juries are required to find beyond a reasonable doubt facts that determine the fine’s maximum amount.”
Where Apprendi applies, it applies with full force. When a fine is pegged to the determination of specific facts, those facts must be (a) specifically alleged and (b) found by a jury, (c) using the standard of “beyond a reasonable doubt.” In Southern Union, the jury should have determined the duration of the violation and then decided whether the company had committed all of the acts constituting the offense “for each given day.” While it might be challenging for the government to aver and prove each fact, the Constitution requires it, Sotomayor drily observed.
Civil or Criminal?
SEC penalties have historically been viewed as civil, not criminal, unlike the RCRA penalties in Southern Union. However, whether penalties are civil or criminal does not depend on their labels.10 Courts ask first whether the legislature expressed a preference for one label or the other.11 In the case of SEC penalties, Congress has clearly expressed the preference that they be considered civil. With that label, the Sixth Amendment jury-trial guarantee would not apply.
This does not end the inquiry, however. Under old, but still valid, precedent, Congress’ intent that a penalty be civil can be overridden if the penalty is so punitive in form and effect as to render it criminal despite Congress’ intent. For example, the forfeiture of citizenship, while not labeled as criminal, is a punishment that cannot be imposed without due process of law.12 Similarly, a state tax on dangerous drugs, which gave rise to an obligation many times the amount of profit from a marijuana crop, was ruled invalid under the Constitution because it could be imposed without a trial.13
The SEC once worried that its penalties could be considered criminal, in the context of the Fifth Amendment prohibition against double jeopardy. A 1989 decision by the Supreme Court, United States v. Halper,14 held that a civil penalty could be considered criminal, for double-jeopardy purposes, if the penalty could not be fairly characterized as “remedial,” but rather had as its purpose deterrence or retribution. Halper, which involved multiple violations of the civil False Claims Act, led to so many novel claims of double jeopardy that the Supreme Court “disavowed” its method of analysis less than 10 years later, in Hudson v. United States.15
Hudson did not put an end to the question whether SEC penalties are always civil. Rather, Hudson merely corrected the “unworkable” test of Halper, which was itself limited to the context of the Fifth Amendment. In Hudson, the Supreme Court returned lower courts to an earlier method of analyzing civil penalties, applied in United States v. Ward,16 which involved the Fifth Amendment right against self-incrimination, and, like Southern Union, involved an environmental statute.
Ward had endorsed a seven-factor test for determining whether a penalty is civil or criminal. The list of Ward factors begins with two considerations found important in Southern Union: Does the sanction involve an affirmative disability or restraint, and has it historically been viewed as punishment? Sotomayor answered these questions affirmatively with respect to multimillion-dollar fines assessed against corporations. Two other Ward factors could tip the scale in favor of finding huge SEC fines to be criminal in nature: Does it come into play only upon a finding of scienter, and is the behavior to which it applies already a crime? Indeed, after Southern Union, it would be hard to argue that any of the Ward factors points to the civil nature of a huge fine assessed against a company for scienter-based violations of the securities laws.
Impact in Securities Cases
After Southern Union, the government has strong reasons to seek penalties in civil, rather than criminal actions. No court has ever found SEC penalties to be subject to the Sixth Amendment, and under existing precedent the only constitutional safeguard protecting companies against sky-high penalties is the little-used Excessive Fines Clause in the Eighth Amendment.
While juries are a remote prospect in government actions against corporations, the jury-trial guarantee announced in Southern Union might affect the dynamic between corporate defendants and the government. As Sotomayor recognized in Southern Union, the prospect of significant penalties, without Sixth Amendment protection, could increase the incidence of innocent defendants pleading guilty. That is, defendants might be likely to plead guilty to and pay fines for crimes they did not commit in the absence of a requirement that all facts supporting the penalty be specifically alleged and proven beyond a reasonable doubt to a jury.
The government would have even more incentive to seek penalties in SEC civil actions instead of criminal prosecutions were the SEC Penalties Act to become law. The bill would not only raise penalties, but also allow the government to try its cases and obtain these penalties within the executive branch. Review by the judiciary would occur only after a hearing by administrative law judge and appeal to the five SEC commissioners. Review by a circuit court would be for abuse of discretion only.
That said, Schapiro has recognized that authorization to base penalties on investor losses would come with a price, conceding that it “may require the Commission to expend significant additional resources and prove the amount of investor losses in particular cases—for example, to conduct event studies or to retain expert witnesses to evaluate and opine on such losses.” (It is worth wondering how the SEC would pay for high-priced damages experts.)
But even under the current statutory scheme, Southern Union might mean that when a penalty is based on multiple violations, the SEC should have to detail precisely each element on which a penalty is sought. Historically, the SEC has framed its allegations vaguely, describing a scenario, perhaps giving some examples, and then positing a period for the unlawful conduct or a round number of violations. Should the SEC be required, under the reasoning of Southern Union, to prepare its cases with a view to proving multiple violations in order to obtain significant penalties, targets of SEC investigations would be in a better position to negotiate settlements, and, perhaps even, defend themselves against the charges.
Dorothy Heyl is of counsel at Milbank, Tweed, Hadley & McCloy. Jonathan Y. Newman assisted in the preparation of this article while he was a summer associate at the firm.
1. SEC v. Cioffi, No. 08-CV-2457 (FB) (E.D.N.Y. June 18, 2012)
2. “Is the SEC’s Bark Worse Than Its Bite?” John C. Coffee, Jr. The National Law Journal, July 9, 2012, at 10.
3. 132 S.Ct. 2344 (June 21, 2012) (No. 11-94).
4. SEC v. Manor Nursing Centers, 458 F.2d 1082 (2d Cir. 1972).
5. “Senators Seek Bigger Firepower for U.S. Securities Regulator,” Reuters, July 23, 2012, quoting one the bill’s two sponsor, Senator Charles Grassley (“If a fine is just decimal dust for a Wall Street firm, that’s not a deterrent”).
6. “Bill would bolster SEC Penalties,” Corporate Crime Reporter, July 24, 2012.
7. 530 U.S. 466 (2000).
8. United States v. Pfaff, 09-1702-cr(L), 09-1707-cr(CON), 09-1790-cr(CON) (2d Cir. Aug. 27, 2010).
9. United States v. Lagrou Distribution Sys, 466 F.3d 585 (7th Cir. 2006).
10. Helvering v. Mitchell, 303 U.S. 391, 399 (1938).
11. United States v. Ward, 448 U.S. 242, 248 (1980).
12. Kennedy v. Mendoza-Martinez, 372 U.S. 144 (1963) (involving draft evaders).
13. Dept. of Revenue of Montana v. Kurth Ranch, 511 U.S. 767 (1994) (involving a tax of $181,000 on marijuana worth far less).
14. 490 U.S. 435 (1989).
15. 522 U.S. 93 (1997). The Second Circuit rejected a subsequent double jeopardy challenge to a disgorgement and civil penalty imposed in a civil proceeding after a securities fraud conviction. SEC v. Palmisano, 135 F.3d 860 (2d Cir. 1998).
16. 448 U.S. 242 (1980).