SEC on Financial Penalites

The Securities and Exchange Commission has issued a statement on financial penalties for corporations.  Release  Critics of financial penalties on corporations, a relatively recent SEC practice, claim that shareholders suffer twice -- once when managers fraudulent practices are revealed and again when the firm is assessed a fine that is a charge on the firm's equity.   The SEC states that it will seek penalties only "when the violation results in an improper benefit to shareholders."  If shareholders are the primary victims, the SEC "will seek penalties from the individual offenders."  The SEC also expects "shareholder turnover" be a factor in the decision.  Illustrating the distinction the SEC announced a $50 million penalty against McAfee Inc.  The company had used fraudulent disclosures to make acquisitions using overpriced shares.  In a second case, the commission refused to assess a corporate fine against Applix Inc..  Applix shareholders had not benefited from the accounting fraud. 

The cases of "improper benefit to shareholders should be rare.  In the garden variety disclosure fraud case, managers lie to keep stock prices high so they can cash in compensation options and/or sell their stock.  Shareholders in general do not profit in such cases;  only managers do (and those shareholders who are lucky enough to sell before the fraud is revealed).  Those shareholders that hold stock (choose not to sell because of artificial expectations) or those that purchase when prices are artificially high are big losers. Whether or not they are victims depends on one's view of whether they should be held responsible for choosing the firm's managers.  On the other hand, when managers take overpriced stock and exchange it for valuable, permanent assets (either directly, as in McAfee, or indirectly) shareholders do, as a whole, benefit.    

The controversial part of the release is an assessment of shareholder benefit after the SEC begins to investigate the fraud.  The release seems to imply that shareholders who are victims of their manager's fraud may turn into fraud "beneficiaries" if the firm does not cooperate with the investigation.  This makes little sense; the managers are the one's not cooperating, not the shareholders.  Shareholders should not be held responsible for their manager's refusal to cooperate.  The cooperation mitigation principle should only kick in the those cases in which the firm exhibits a permanent benefit from the fraud (the McAffee type case).   This need to be cleared up.