Calculating SEC Civil Money Penalties: Do Hundreds Of Related Acts Constitute A Single Course Of Conduct Or Hundreds Of Separate Violations? by Jon Eisenberg, K&L Gates
In addition to going to court to seek sanctions, the Securities and Exchange Commission (SEC) may impose civil money penalties in its own administrative proceedings on any person who violates, or causes a violation of, the federal securities laws. Unlike federal district courts, administrative law judges do not have authority to base penalties on respondents’ pecuniary gains resulting from violations. Instead, under the various penalty statutes, maximum penalties in administrative proceedings are based on “each act or omission” violating, or causing a violation of, the federal securities laws.1 Currently, the maximum penalties for “each act or omission” are:
The potential impact of the “each act or omission” language is easily seen in the following hypothetical. A public company with 50,000 investors accidentally misstates its financial results. The Commission alleges that the misstatements were reckless. The misrepresentations or omissions are contained in its quarterly and annual reports distributed to its shareholders over a two-year period and affect four statements made in each such report.
Calculating SEC Civil Money Penalties: Do Hundreds of Related Acts Constitute a Single Course of Conduct or Hundreds of Separate Violations?
Depending on the methodology used to calculate “each act or omission,” the maximum potential liability could be any of the following:
There are many other realistic hypotheticals that could involve large multipliers. For example, for large broker-dealers a single coding error could, over time, easily lead to millions of inaccurate trade reports to an exchange. Or a failure to retain certain types of electronic communications could lead to millions of violations of record-keeping requirements if, for example, each unretained email were considered a separate act or omission. An overly literal reading of the “each act or omission” standard could result in an exposure far out of proportion to the gravity of the violations found.
We discuss below 28 cases, each decided between 2013 and 2016, to see how SEC administrative law judges have applied the “each act or omission” in practice. In more than a third of the cases reviewed, administrative law judges applied a “course-of-conduct” standard that combines related acts into a course of conduct and treats the course of conduct as a single act or omission for civil money penalty purposes. This greatly reduces the risk of disproportionate liability. Administrative law judges also employ other standards that reduce the number of violations, but not by as large a factor as the course-of-conduct standard. We also discuss that, in some cases, it is difficult to reconcile the different methodologies and that they often appear to be a means for backing into an amount based on other considerations—the administrative law judge’s perception of the fairness of the penalty in light of the totality of factors considered, such as the degree of culpability by the violator and the harm to investors. As we discuss below, these decisions might not survive appellate scrutiny under the standards set forth in Rapoport v. SEC, 682 F.3d 98 (D.C. Cir. 2012), but very few respondents appeal their sanctions all the way to the D.C. Circuit.
Rejection of the Enforcement Staff’s “Number of Investors” Standard When the Number of Investors Is Large But Not When the Number Is Small
A useful starting point is Chief Administrative Law Judge Brenda Murray’s August 17, 2015, opinion in In re Total Wealth Management, Inc., et al., Initial Dec. No. 860. In that case, Chief Judge Murray found violations of both the antifraud provisions and custody provisions of the securities laws. With regard to the anti-fraud violations, the enforcement staff urged that misrepresentations to each of 192 investors should count as separate violations. Chief Judge Murray called the staff’s approach “arbitrary,” and stated, “Equating the number of investors with the number of violations…. is overly simplistic and may lead to wildly disproportionate penalty amounts.” Instead, with respect to the misrepresentation claims, she found a total of five violations based on there being five distinct Forms ADV that contained the misrepresentations or omissions. With respect to the four years of custody violations, she found that each year constituted only one act or omission for civil money penalty purposes. She ordered a total civil money penalty of $780,000.
A good argument can be made that Total Wealth Management stands for applying a common-sense approach where the potential multiplier—whether it be the number of investors, the number of misleading communications, the number of reporting errors, the number of record-keeping errors—is very large. One potential concern for the Commission is that the Eighth Amendment prohibition against excessive fines could be triggered by a high multiplier. See United States v. Bajakajian, 524 U.S. 321 (1998) (forfeiture violates the Excessive Fines Clause if it is “grossly disproportional” to the gravity of the offense that it is designed to punish). Another, however, is simply that the amount of the penalty would be unfair, particularly considering that many of the cases also include other relief, such as disgorgement, suspensions and bars, and cease-and-desist orders.
On the other hand, there are decisions that have used a number-of-investors standard when the number of investors was much smaller than the 192 investors in Total Wealth Management. For example, in In re George N. Krinos, et al., Initial Dec. No. 929 (Dec. 21, 2015), Chief Judge Murray found that a number of false statements that she characterized as “legion” had been made to 19 individual investors over a two-year period. She treated each of the 19 individual investors as a separate “act or omission” for civil money penalty purposes, and she imposed a total civil money penalty of $1,155,000, which she stated was close to the amount of investor funds raised.
Similarly, in In re Gerasimowicz, Initial Dec. No. 496 (July 22, 2013), involving anti-fraud violations, Judge Carol Fox FoelakFoelak imposed a penalty of $1,950,000 based on “thirteen courses of action, one for each investor… harmed by Respondents’ fraudulent conduct.”
In In re Michael Bresner, et al., Initial Dec. No. 517 (Nov. 8, 2013), Judge Cameron Elliot found that respondents engaged in excessive trading in a number of customer accounts. For respondents who engaged in the trading, Judge Elliot imposed a single penalty for each customer whose account was traded excessively. The total penalties came to $435,000, of which $5,000 related to a failure-to-supervise charge.