June 10, 2004
"Wheel of Justice"--A Commentary by Prof. Jonathan Macey
(This essay originally appeared in the June 21, 2004, issue of Forbes magazine.)
Wheel of Justice
By Jonathan Macey, professor of law
How does the SEC arrive at its fines against corporate wrongdoers? Beats me.
In Finland a speeding fine is a function of the driver's income. Three years ago Internet entrepreneur Jaako Rytsola coughed up a reported $71,400 for doing 43 in a 25mph zone.
We don't do things that way in America. These days, however, U.S. securities regulators seem like fans of the Nordic approach, hitting the most profitable corporate defendants with the steepest fines. At least the Finns are consistent. They use a transparent algorithm to arrive at their fat speeding tickets.
By contrast, American regulators rely on an inconsistent jumble of factors, including politics, ability to pay and conduct. As the securities regulator for the state of Washington remarked in a rare moment of candor, "There's no art or science to how you fine someone. You put a number out for negotiation. We never want to cripple a firm. But we want to send a very strong message."
Look at the $1.4 billion message sent to Citigroup, Credit Suisse First Boston and eight others charged by the Securities & Exchange Commission with misleading clients by improperly mixing analysis with investment-banking activities. U.S. Bancorp Piper Jaffray of Minneapolis, a smaller company accused of the same misconduct, paid a far smaller fine of $32.5 million.
While it may seem just for bigger firms to pay stiffer penalties, even industry participants have no way of deciphering the elements that contributed to the different fines. All the firms engaged in the same conduct. Did the fines bear any relation to the amount of injury each firm caused? It's not clear.
Fines should be a function of both conduct and damage, and the calculation methodology should be consistent. It already works that way in antitrust and insider-trading enforcement, where statutory guidelines limit penalties to three times damages.
The SEC's power used to be constrained across the board. In the 1980s the agency had to obtain court approval for its actions and justify damage theories before a neutral tribunal. That changed in 1990 when Congress gave the SEC the authority to impose hefty penalties without the approval of a judge.
Sarbanes-Oxley made things worse by empowering the SEC to use both penalties and disgorged profits "for the benefit of the victim." But most of that money goes to amorphous "investor education funds" or "free, independent research" that investors never see. State attorneys general have gone a step further, putting fines and penalties directly into their states' coffers.
The SEC maintains that substantial penalties deter corporate criminals. But the more money the SEC collects from fines, the easier it is to justify larger budgets and more power. It is but one step removed from the infamous kangaroo courts of yore, whose judges pocketed a piece of the speeding fines they imposed.
Defendants in securities actions are also subject to prosecutorial piling on. In early April mutual fund Putnam Investments paid $100 million for what the SEC characterized as a self-dealing and market-timing scheme that cost investors $10 million. Two sets of prosecutors had to be satisfied, one in the state of Massachusetts and the other at the federal level. Just a couple of weeks later Janus Capital Group, a mutual fund family about the same size as Putnam, also paid a fine for market timing. Janus' scheme cost investors five times as much as Putnam's, but it got off with a $50 million penalty, equivalent only to the damage caused.
This problem should be easy to fix. First, the states and the feds should coordinate their efforts. Second, the SEC should continue to determine wrongdoing, but it should no longer set fines. That should be done by a neutral arbiter.
Third, penalties should be limited to a fixed multiple of damages. The 3x multiple in antitrust and insider cases is a good benchmark. If the SEC thinks a stiffer penalty is warranted, it should refer the case to the Justice Department for criminal prosecution.
Fourth, get rid of that Sarbanes-Oxley provision intended to aid victims. It's too difficult to implement properly. And if penalties are limited to a fixed multiple of damages, there won't be as much money to fight over.