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

Author:Velikonja, Urska
Position:III. Analysis of Fair Fund Distributions A. Amounts of Fair Fund Distributions 2. Some Fair Funds Fully Compensate Investors through Conclusion, with footnotes, p. 363-395
  1. Some fair funds fully compensate investors

    But the SEC does not only sanction issuer reporting and disclosure violations; it prosecutes a great variety of securities misconduct. Many of these violations have elements of theft, embezzlement, and customer fraud. Their prosecution and subsequent distribution of collected monetary sanctions to defrauded investors reverses real wealth transfers. There is evidence suggesting that the SEC's compensation through fair fund distributions for some categories of securities violations is significant.

    This conclusion is based on three findings in the study. First, eligible participants who filed claims with the fund administrator were fully compensated for their losses in several fair fund distributions. (169) This does not imply that the SEC forced the wrongdoer to pay monetary sanctions equal to the social cost of its misconduct. It is likely that some (or perhaps many) of the victims did not file claims and/or that they filed claims but not all of their losses were eligible for compensation, a common result in large-scale compensation schemes, including class action litigation. (170) But the finding suggests that some investors are made whole through fair fund distributions.

    Second, the study identified eighteen cases in which the order imposing sanctions directed the defendant to pay defrauded investors specified amounts of money. Penalties in most such cases were set at the level that would appear to fully compensate investors identified in the order or consent decree. (171) Again, the orders likely did not include all of the victims.

    Finally, evidence from settled parallel securities class actions suggests that the SEC came very close to fully compensating defrauded investors in two dozen market-timing and late-trading cases as well as in seven cases against New York Stock Exchange (NYSE) specialist firms for improper trading practices. (172) The SEC settled its enforcement actions and distributed the monies in the fair funds years before the class actions were settled. The SEC's settlements were larger than class action settlements by an order of magnitude because the class action courts took into account monies that investors had already received as compensation. (173) At least in these cases, the SEC's fair fund distributions crowded out parallel private litigation.

    In response to fair fund distributions in market-timing cases, some management groups have complained that fair funds overcompensate investors. (174) Their complaint appears to be unfounded. Both the courts and the SEC take into account parallel compensation proceedings when distributing funds to investors. And both have refused to distribute to investors more than the amount necessary to compensate the full extent of their losses. (175)

    However, large fair fund distributions (relative to investors' likely losses) that predate class action settlements have the potential to dilute the SEC enforcement action's deterrence. (176) According to the policy expressed in its settlements, the SEC allows defendants to offset damages paid in a class action against the disgorgement amount in the enforcement action, but it denies credit against the civil fine part of the sanction. The purpose of the prohibition is to "preserve the deterrent effect of the civil penalty." (177) But most parallel class actions settle years after the SEC has settled its enforcement action, and often after the SEC has distributed the fair fund to investors. (178) Despite the prohibition against offsetting the civil fine, defrauded investors cannot receive in a subsequent class action settlement damages that would exceed their uncompensated losses. (179) Where investors have been fully compensated from the fair fund, it is possible that a court would dismiss the parallel lawsuit. (180) Recent SEC settlements require defendants to pay the SEC any amount by which awarded damages in a class action were reduced because of a distribution of the civil penalty, which would appear to include class actions that were dismissed because investors have been fully compensated. (181)

    The only situation where one could argue that fair fund distributions overcompensate investors is where the sanctioned firm is bankrupt and investors receive more than they should under bankruptcy law. Consistent with the principle of absolute priority, [section] 510(b) of the Bankruptcy Code subordinates shareholders' damages claims for securities fraud to claims of the bankrupt company's creditors. (182) Because bankrupt firms are by definition insolvent, the Bank-Bankruptcy Code effectively precludes equity holders with securities fraud claims from recovering anything from the bankrupt estate. (183) As a result, securities class actions against bankrupt companies are ordinarily dismissed. (184)

    The SEC may pursue an enforcement action against a bankrupt firm (as well as against its officers, (185) auditors, (186) and other aiders and abettors (187)), but the automatic stay in bankruptcy stops it from collecting any money judgment from the firm. (188) The SEC's claim for civil fines and disgorgement is treated as an unsecured creditor claim and is distributed pro rata, along with other unsecured creditors. (189) However, [section] 510(b) does not preclude the SEC from distributing civil fines and disgorgements to defrauded shareholders through a fair fund. When the SEC distributes monetary sanctions it collects from the bankrupt company to defrauded shareholders, the ultimate result is that unsecured creditors' recoveries are smaller as a result of the monetary penalties paid in the SEC's enforcement action, while shareholders' recoveries are greater because of the fair fund distribution. (190)

    The abstraction described above became reality for WorldCom, which filed for bankruptcy protection soon after it revealed a massive accounting fraud. (191) The SEC collected $750 million from the bankruptcy estate as a civil fine and distributed it to defrauded shareholders, who would otherwise have received nothing. (192) This outcome gave rise to considerable scholarly and popular criticism. (193)

    Yet WorldCom is the exception, not the rule, for fair fund distributions. Thirty-one companies that were primary defendants in the fair fund sample filed for bankruptcy within two years of the SEC's enforcement action. (194) Of those, sixteen were issuer reporting and disclosure cases, in which priority conflicts between creditors and shareholders are particularly likely. (195) In enforcement actions against those sixteen, however, the SEC imposed a financial penalty against only two companies: Nortel Networks and WorldCom. Nortel paid $35 million while WorldCom settled for $750 million, and these civil fines were distributed to defrauded shareholders. But Nortel paid the civil fine fourteen months before filing for bankruptcy, and the fine did not directly reduce creditors' recoveries in bankruptcy. (196) In all other cases the SEC either did not pursue the bankrupt debtor at all or did not order the company to pay monetary sanctions. (197)

    Instead, the SEC prosecuted individuals and third-party defendants (auditors and investment banks), who paid $280 million and $492 million, respectively, and the SEC distributed that $772 million to harmed investors through fair funds. The SEC's settlements with executives and third parties were not part of the bankruptcy estate and could not deplete the monies earmarked for unsecured creditors. The same defendants that settled with the SEC often ended up settling with the bankruptcy trustee and paying additional damages to compensate creditors. (198)

    As a result of the SEC's selective enforcement, only bankrupt WorldCom paid $750 million to the SEC for distribution to defrauded shareholders from its bankruptcy estate. The WorldCom fair fund cast a dark shadow over the SEC's distribution efforts, but WorldCom is the exception, not the rule. There is no empirical support for the allegation that the SEC's fair fund distributions systematically overcompensate defrauded shareholders.

  2. Parallel litigation is relatively uncommon

    There are several reasons to believe that the SEC's fair fund distributions would often be accompanied by parallel securities litigation. SEC enforcement suggests that misconduct was serious. Moreover, the SEC can only distribute collected monetary penalties in cases in which the size of the fund is large relative to the number of victims. Large potential recoveries draw litigation where legal fees are assessed at a set percentage of the aggregate recovery. As a result, one would expect that events that gave rise to an SEC fair fund distribution would usually trigger securities litigation.

    The data collected in this study reveal that parallel private litigation is less common than one might expect (199): parallel securities class actions were filed in 64.7% of cases in which the SEC established a fair fund (154 of 238 with available information) (200) and settled for nonzero monetary damages in only 46.8% of cases (108 of 231). (201) In more than half of the fair fund distributions-53.2%--defrauded investors received no compensation from private litigation, the traditional source of compensation.

    Fair fund cases without filed parallel private lawsuits are on average smaller than cases with parallel litigation: eighty-four such fair funds distributed $1.08 billion (7.5% of the aggregate fair fund amount), with a mean fund of $12.8 million and a median of $1.7 million (compared with a $59.5 million mean and a $16.5 million median for all fair funds). This group includes three categories of cases. The first and largest category comprises cases involving smaller frauds, predominantly against individual defendants, including insider trading, certain broker-dealer and investment advisor violations (e.g., failure to supervise a rogue employee), and other market manipulations. (202) What these cases have in common is...

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