Public compensation for private harm: evidence from the SEC's fair fund distributions.

• Author: Velikonja, Urska
• Position: Introduction through III. Analysis of Fair Fund Distributions A. Amounts of Fair Fund Distributions 1. Some Fair Funds Undercompensate Investors, p. 331-363

INTRODUCTION I. BACKGROUND ON THE SEC'S COMPENSATION OF DEFRAUDED INVESTORS A. The Commission's Fair Fund Authority B. Problems with Investor Compensation C. The Paucity of Prior Research II. DATA, METHODOLOGY, AND OVERVIEW A. Data and Methodology B. General Characteristics of Fair Funds 1. When are fair funds created and what do they look like? 2. Fair fund distribution patterns have varied over time III. ANALYSIS OF FAIR FUND DISTRIBUTIONS A. Amounts of Fair Fund Distributions 1. Some fair funds undercompensate investors 2. Some fair funds fully compensate investors 3. Parallel litigation is relatively uncommon B. The Circularity of Fair Fund Distributions 1. Classification of securities violations 2. Defendants in enforcement actions 3. Availability of insurance and indemnification C. Contrary to Current Thinking, Fair Fund Distributions Are Not Duplicative IV. FURTHER IMPLICATIONS A. What the Results Tell Us About Fair Fund Distributions B. Fair Fund Distributions as Evidence of Administrative Flexibility C. What the Results Reveal About Public Compensation for Securities Fraud CONCLUSION INTRODUCTION

The success of the Securities and Exchange Commission (SEC) is conventionally measured by the number of enforcement actions it brings, the multimillion-dollar fines it secures, and the high-impact trials it wins. (1) But the SEC does not just punish wrongdoing. Over the last twelve years, the SEC has quietly become an important source of compensation for defrauded investors. (2) Since 2002, the SEC has deposited $14.46 billion (3) for defrauded investors into 243 distribution funds, usually called "fair funds" after the statute that authorizes them. (4) To put this figure into context, the aggregate amount distributed through fair funds over the past decade is substantially larger than the SEC's budget over the same period. (5)

The fair fund provision allows the SEC to distribute civil fines and disgorgements of ill-gotten profits collected from the defendants it prosecutes. Other federal agencies also direct distributions of funds they collect from defendants to victims; (6) the Commodity Futures Trading Commission (CFTC), (7) the Federal Trade Commission (FTC), (8) and the Department of Justice (DOJ), (9) among others, have the authority to distribute ill-gotten gains (but not civil fines) recovered from defendants to their victims. (10) But the SEC's distributions are of particular interest because they are the most extensive and sustained effort by a public agency to compensate the victims of misconduct. (11) Between 2004 and 2012, the SEC used fair funds to distribute more than 75% of all collected monetary penalties. (12) By contrast, the FTC distributed 7.3% of ordered monetary penalties in 2013, and 3.3% in 2012. (13)

Despite the SEC's enthusiasm for the fair funds provision, (14) the high aggregate dollar amount distributed, and the large number of funds, the SEC's compensation efforts have been neglected by scholars, policymakers, and the press. (15) At best, commentators have derided the SEC's contribution offhandedly as an insignificant supplement to private securities litigation and a socially wasteful transfer of funds from one set of innocent shareholders to another. (16) At worst, they have criticized the SEC for wasting resources on duplicative cases, (17) lacking a "coherent policy" regarding distributions, (18) burdening courts with "tortured restructuring and embarrassing consequences" of poorly drafted distribution plans, (19) and frustrating remedies available to creditors in bankruptcy. (20)

Until this study, there has been no inquiry into how the SEC has exercised its fair fund authority. Relying on an analysis of all fair funds created between 2002 and 2013, this Article provides the first comprehensive assessment of the SEC's compensation efforts, supplying the missing empirical foundation to inform the debate on administrative compensation programs like the SEC's fair funds. The study's findings suggest that a few controversial fair fund cases animate the scholarly and popular critiques, but these selected anecdotes are not representative of the whole. (21)

In addition to supporting the primary observation that the SEC distributes a surprisingly large amount of money to harmed investors through fair funds, of ten making defrauded investors whole, the study mostly disproves the conventional wisdom. (22) Specifically, the study refutes the widespread assumption that public and private enforcement of securities laws target and compensate investors for the same misconduct. (23) More often than not, the SEC compensates harmed investors for losses where a private lawsuit is either unavailable or impractical. Relatedly, the study finds that most fair fund distributions cannot be characterized as circular transfers of money from shareholders to themselves. (24) In contrast with private securities litigation, where such critiques may be justified, (25) the majority of fair funds compensate defrauded investors for what can best be described as customer fraud or anticompetitive behavior by financial intermediaries. For example, fair funds have compensated the victims of bid-rigging cartels, (26) undisclosed fees and false advertising, (27) collusive arrangements between investment funds and broker-dealers, (28) brokers' bribery to sell overpriced investments to municipalities, (29) embezzlement, (30) mutual fund market timing (31) and late trading, (32) pump-and-dump and other market manipulation schemes, (33) and blatant self-dealing. (34) The prosecution of these violations forces violators to disgorge illicit gains obtained through misconduct, while the subsequent distribution of monetary sanctions to defrauded investors reverses the wrongful transfer of wealth. Moreover, the study reports that individual and secondary defendants contribute to fair funds far more often and in larger amounts than they pay to settle private securities litigation. Unlike in private litigation, targeted individuals generally cannot shift the SEC's sanction to the firm through indemnification and directors and officers (D&O) insurance. Forcing individual defendants to pay out of pocket increases the deterrent effect of the SEC's enforcement action (compared to private litigation) and eliminates the concern that their payment is a circular transfer from shareholder victims to themselves. (35)

This Article makes an important contribution to two different literatures: the literature on private and public enforcement of securities laws, and the burgeoning theoretical literature on large-scale compensation efforts by public agents, including federal prosecutors, administrative agencies, and state attorneys general. (36) The securities enforcement literature largely concludes that compensation for securities violations is circular and thus futile. This Article challenges that consensus by showing that compensation for abuses by financial intermediaries is both possible and desirable. Private litigation for this sort of misconduct is rarely successful, and the SEC is often the only possible source of investor compensation. (37) Because the SEC punishes individual wrongdoers, who largely avoid liability in private lawsuits, its enforcement deters misconduct more effectively. Finally, the SEC has learned from its own mistakes and improved its settlement and distribution practices.

The large and generally critical body of literature on public compensation that has grown over the last few years has used the SEC's compensation effort as one of its primary examples. (38) The main critiques set out in the literature are procedural: public agencies fail to consult victims before they settle enforcement actions, (39) judges are too deferential when they review public agencies' compensation plans, (40) and agencies fail to police potential conflicts of interest between public agents and private victims. (41) This Article provides evidence that more traditional compensation schemes, in particular private litigation, fail to compensate victims for large classes of harms. The Article concludes that public compensation, in large part, complements private litigation by kicking in where private lawsuits do not compensate. Fundamentally, the Article urges caution before implementing policy changes based on anecdotal evidence.

Part I provides the background on the SEC's compensation approach and concludes with a brief summary of limited prior research. Part II describes the data used in this study, explains the methodology for collecting and analyzing the information, and provides an overview of fair fund distributions, including details about the size of fair funds, the measures of the central tendency, the types of securities violations, the ebb and flow of distributions over time, and the processes used to distribute fair funds. Part III discusses in depth the most serious critiques levied against fair funds specifically and against compensation for securities fraud more generally: small recoveries relative to investors' losses, the circularity of compensation for securities fraud, and duplicative enforcement. Parts II and III refute many of the conventional assumptions about fair fund distributions. The Article concludes in Part IV by offering some reflections on what this study reveals specifically about fair fund distributions and more generally about securities enforcement and public compensation schemes. Besides the already-stated observations that the SEC's distributions are neither small nor, for the most part, circular or duplicative, the Article concludes that the SEC is responsive to critiques and flexible about changing its approach when possible. Looking beyond the fair funds, the Article exposes the...