According to a Sept. 30, 2011, article in The Wall Street Journal, the Securities and Exchange Commission is trying to make it easier for itself to hold firms and individuals accountable for alleged wrongdoing stemming from the financial crisis.
Some believe this is in response to the criticism the SEC has received from lawmakers and others who have complained that too few top executives have been sanctioned. For instance, Rep. Michael Capuano, a Massachusetts Democrat and senior member of the House Financial Services Subcommittee on Investigations, said in an interview, “It’s very good to hold a corporation responsible, but these corporations are run by people.”
Based on information gathered by the Journal during an interview of Kenneth Lench (the SEC’s structured and new products enforcement unit chief) and a recent enforcement action, the SEC appears to be filing more civil cases in which defendants are accused of negligence rather than fraud charges.
Negligence is the failure to exercise the care that a reasonably prudent person would exercise in like circumstances. The Association of Certified Fraud Examiners defines fraud as wrongful or criminal deception intended to result in financial or personal gain. A negligence claim eliminates the need to prove intent.
The Journal article characterized the SEC’s focus on negligence charges as a “major shift from the agency’s traditional enforcement strategy.” In the past, charges of negligence were typically accompanied by more serious allegations or were used by the SEC to persuade individuals to settle cases rather than fight in court over the harder-to-prove charges of intentional wrongdoing or recklessness.
In his interview with the Journal, Mr. Lench said, “Simply avoiding Ponzi scheme-style outright fraud is not enough to avoid enforcement action. Firms and executives have a duty of care. Failure to check properly that investors are being provided with fair and accurate information could, under some circumstances, be a breach of that duty, even if there’s no intent to defraud them.”
As further evidence of the SEC’s change in legal focus, the Journal also cites a recent enforcement action against an executive of GSC Capital Corp., which helped put together a collateralized debt obligation (CDO) that J.P. Morgan Securities LLC sold to its clients.
The CDO consisted primarily of credit default swaps referencing other CDO securities whose value was tied to the U.S. residential housing market. In its complaint, the SEC alleges that the executive helped draft misleading marketing materials for the CDO that failed to disclose that a hedge fund had helped choose some of the underlying securities for it and then bet nearly $600 million that they would lose value. At the time, this executive was also allegedly seeking employment with the hedge fund.
It remains to be seen how this “major shift” in strategy will impact the SEC’s pursuit of companies and individuals who allegedly helped fuel the financial crisis. Pursuing cases based on negligence eliminates the need to prove intent. A negligence claim only requires that the SEC show that someone acted “without reasonable care, even if there was no intent to harm investors.”
In contrast, winning a fraud case requires proof that the wrongdoing was intentional or reckless, which can often be difficult in financial-crisis-related cases because the alleged misconduct can usually be attributed to bad judgment, or poor risk-management policies and procedures.
It is unclear, however, whether this change in strategy will allay the concerns expressed by investors, lawmakers and judges who have asserted that too few top executives who contributed to the crisis have been sanctioned by the SEC.
Negligence charges may not necessarily satisfy the critics of the SEC because penalties for negligence typically are less harsh than those for intentional fraud. For instance, negligence charges ordinarily result in smaller fines and there is less risk of a ban from working in the securities or financial services industry. There is also less reputational damage for a defendant charged with negligence.
Already some have raised concerns about the allegedly weak settlements the SEC is reaching with firms for negligence-based claims. For example, Judge Jed S. Rakoff recently rejected the SEC’s $285 million proposed settlement in its Citigroup market crisis case over an allegedly faulty $1 billion CDO that was tied to the collapse of the housing market that Citigroup sold to investors in 2007. Previously, Judge Rakoff had issued an order raising a number of questions about the proposed settlement. Among other questions, Judge Rakoff asked:
- How can a securities fraud of this nature and magnitude be the result simply of negligence?
- Why is the penalty in this case to be paid in large part by Citigroup and its shareholders rather than by the “culpable individual offenders acting for the corporation?”
- If the SEC was for the most part unable to identify such alleged offenders, why was this?
Judge Rakoff previously forced the SEC to renegotiate a $33 million settlement with Bank of America, asserting that the fine was too small, and that the penalty was shouldered by shareholders instead of the individuals responsible. Although he ultimately accepted the revised $150 million settlement, Judge Rakoff denounced it as “inadequate” and “half-baked justice at best.”
Others believe the lower standard of proof will accelerate the resolution of financial-crisis-related cases and result in more successes for the SEC, increasing the likelihood that those who contributed to the financial crisis will pay a price. Therefore, even though penalties would be smaller, punishment would likely be more assured.
Not everyone is convinced that this change in strategy will be effective – or makes sense for an agency with limited resources. Some believe the SEC’s increased willingness to pursue enforcement actions against individuals based on negligence alone could actually backfire. For instance, there is the possibility that individual defendants will more likely fight actions all the way to trial instead of agreeing to a settlement like some companies.
The SEC has settled a number of cases based on negligence charges only but most of these matters have been with corporate entities rather than individuals. In instances where the SEC has settled cases with individuals based on negligence, it has usually done so to conserve resources or to avoid a fight in court over harder-to-prove charges of intentional wrongdoing or recklessness. Others believe the SEC’s pursuit of negligence cases is unwise because it would stretch the already limited resources of the agency.
There are also those who believe the SEC’s move toward punishing negligence may be bad news for chief executive officers (CEOs) and chief financial officers (CFOs) if the SEC begins to pursue charges based on mistakes in judgment.
Mistakes can happen. These critics do not believe such mistakes should be punishable by the SEC. In this regard, CEOs and CFOs of public companies who certify the accuracy of their company’s SEC filings may want to undertake a higher degree of diligence before certifying the filings.
For instance, CEOs and CFOs may want to ensure the internal audit function is focused on financial reporting matters, performing effectively and staffed adequately. Also, they may want to ensure internal audit has unrestricted access to all of the company’s operations and meets regularly with the audit committee to discuss their audit results.
CEOs and CFOs may also want to meet with the head of the internal audit department to inquire about the procedures applied to ascertain the accuracy and completeness of the SEC filings. In addition, they may want to consider meeting with the company’s external auditors to inquire about the audit results, their judgments about the quality of the company’s accounting principles – not just the acceptability – and ensure they have had frank and open discussions with the audit committee.
Finally, CEOs and CFOs may want to consider meeting with the audit committee to ensure they are taking into account all of that committee’s concerns.
The SEC’s shift in attention to negligence claims will put increased pressure on corporate board members, CEOs, CFOs, accountants and others who have financial reporting responsibilities to perform their duties with an increased sense of due professional care. Those with financial reporting responsibilities should consider “taking a hard look” at their company’s financial reporting policies and practices in place to identify areas of increased risk that may be susceptible to enhanced scrutiny by the SEC in their efforts to litigate perceived negligence.
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About the Authors
Anthony M. Lendez is a partner and Thomas J. Terranova is a director in the New York office of BDO Consulting, a division of BDO USA LLP.
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