The Wall Street Journal: SEC Stakes Out Middle Ground On Fines Policy: Thursday 5 January 2006

The Securities and Exchange Commission, seeking to defuse a controversy about its use of big fines to punish corporate wrongdoing, publicly laid out a set of guidelines to help determine whether and how much to fine companies engaged in financial fraud.

The move is an attempt by Christopher Cox, who took over as SEC chairman five months ago, to address concerns by Republican commissioners and some in the business community that the practice of fining companies was a double hit on shareholders: once for being harmed by the fraud and again in the use of shareholder money to pay a fine. Others also had argued that the SEC was inconsistent in its use of corporate penalties.

Yesterday, Mr. Cox, with the full backing of the agency's four other commissioners, appeared to stake out a middle ground. He said the agency will take into account whether shareholders improperly benefited from a fraud and if a penalty would create further harm or could be used to repay shareholders.

The SEC also said it would consider whether the conduct was widespread in the corporation and whether the company cooperated when the fraud came to light. The guidelines don't apply to companies in regulated industries, such as broker-dealers or mutual-fund firms, or individuals.

"Our intention is that these principles will establish objective standards that will provide the maximum degree of investor protection," Mr. Cox said.

The agency used two enforcement cases announced yesterday to elucidate the principles. The SEC filed a case against McAfee Inc. in which the Santa Clara, Calif., software maker agreed to pay $50 million, without admitting or denying wrongdoing, to settle allegations it overstated revenue by $622 million from 1998 to 2000. During the period, McAfee, formerly called Network Associates Inc., used its inflated stock to acquire other companies, and the fraud was concealed, the SEC said.

In the second case, Applix Inc., a Westborough, Mass., software company, settled, without admitting or denying wrongdoing, charges of improper revenue recognition. Applix wasn't subject to a fine.

In explaining the difference, Linda Chatman Thomsen, the SEC's enforcement chief, said McAfee was subject to a penalty because it benefited from the conduct. Given the financial strength of the company, it was unlikely that a fine would hurt shareholders, she said.

Applix and its shareholders didn't appear to benefit from the fraud, which was more limited than McAfee's, she said. Applix is a smaller firm, and a fine could have a disproportionate effect on shareholders.

Peter Wallison, a resident fellow at the American Enterprise Institute for Public Policy Research who has been critical of the SEC's policy making in the past, said the agency has "set out principles that look as though they will be workable and give the market a sense of what to expect." Mr. Wallison, a former colleague of Mr. Cox's from their days in the Reagan White House, said the guidance affirms the view that "it makes no sense to fine a company when the fine simply hurts the shareholders."

But others argued that the guidelines were far from clear and would inevitably result in arguments about whether companies had benefited from the fraud.

Susan Hackett, general counsel of the Association of Corporate Counsel, which represents in-house corporate attorneys, said the SEC's guidelines don't seem to go much beyond what companies and attorneys already knew about the agency's expectations. "In looking at this, I'm still not given such a degree of additional guidance that I feel that I know a heck of a lot more than I did before," she said.

In particular, she said the guidance reaffirms the SEC's view that companies will be rewarded if they cooperate with the agency, but said it still doesn't give a clear explanation of what cooperation entails. "Part of the difficulty, especially for lawyers, is if cooperation means a company pleads guilty any time a company is accused and is supposed to roll over and play dead. Well, defense lawyers are paid to defend a corporation," she said. The guidance issued yesterday, she said, seems to still give SEC lawyers great latitude in determining what level of cooperation is sufficient to prevent a fine.

Ms. Hackett said corporate lawyers also want more clarity of what remedial steps are expected by the SEC. "If remedial steps means as soon as an allegation surfaces a company is supposed to disassociate itself and fire all the employees involved, that's a problem," she said. "A company puts itself between a rock and a hard place when it gets into making prejudgments."

Derek M. Meisner, a former branch chief in the enforcement division who is now in private practice, said, "The problem is that the criteria are not nearly as objective as I suspect many in the corporate world and defense bar were hoping for."

SEC commissioners acknowledged there likely would still be disagreements among them. Cynthia Glassman and Paul Atkins, two Republican commissioners, had clashed with the two Democratic commissioners and former Chairman William Donaldson, a Republican, in arguing against corporate penalties.

"It's a very good start that we had two cases in the context of this policy statement in that we had full consent," said Annette Nazareth, a Democratic commissioner. "I don't think it would be realistic to expect that every time people are presented with a set of facts that they would necessarily view them in the same light."

Known as a consensus builder when a congressman, Mr. Cox focused the commissioners on the Enforcement Remedies Act of 1990, which gave the SEC the authority to fine corporations, and the fair-funds provision of the 2002 Sarbanes-Oxley law.

Mr. Wallison said the guidance would at least stem some of the divisiveness at the SEC under Mr. Donaldson. "This reflects the fact that Chairman Cox has been able to bring the four other commissioners together on an agreed position on this question," he said. "That is the most significant thing about it, as far as I am concerned, because we're now getting beyond what had happened before where the commission was split on everything that Bill Donaldson wanted to do."

Write to Kara Scannell at kara.scannell@wsj.com