Does the SEC’s practice of extracting a civil fine from a corporate defendant only to return the money to shareholders make economic sense?

Emory School of Law Assistant Professor Urska Velikonja attempts to answer this question in an article titled “Public Compensation for Private Harm:  Evidence from the SEC’s Fair Fund Distribution.”

The Sarbanes-Oxley Act of 2002 expanded the SEC’s ability to compensate investors by allowing the agency to distribute collected civil fines through a program known as the “Fair Fund.”  See 15 U.S.C. 7246.  This authority is in addition to its prior authority to distribute funds collected through disgorgement; however, Emory Prof. Velikonja’s study only deals with fines collected through the Fair Funds program.

The study attempts to answer the question of whether its makes economic sense for the SEC to extract fines from corporations only to redistribute the funds to shareholders – – the criticism being a perceived inefficiency due to the circularity of the Fair Fund distributions, especially when one accounts for transaction costs.

The study’s results are quite interesting.

Prof. Velikonja does find some validity to the criticism in one subset of cases she describes as “issuer reporting and disclosure” which might also be thought of as financial statement manipulation done through an accounting fraud – – think WorldCom and AIG.  In these cases, a corporate defendant pays a fine to the SEC which then redirects the funds to shareholders through the Fair Fund program.

In addition to a circularity argument, one could argue the SEC’s actions are duplicative of private plaintiffs’ efforts.  The study showed the SEC’s results in these cases pales in comparison to the large judgments being obtained through private parallel litigation often in the form of class actions lawsuits.

In contrast to the “issuer reporting and disclosure” subset which accounted for about one-third of the cases studied, Prof Velikonja found that in the remaining two-thirds of the cases the Fair Fund program more efficiently compensated investors for consumer fraud or anticompetitive behavior by security market intermediaries.  These cases were SEC enforcement actions studied under the categories of broker dealers, insider trading, investment advisors, market manipulation, municipal securities, and security offerings.  This subset of SEC actions was viewed to be more efficient for two primary reasons.  The circularity criticism is lessoned because many of the defendants in these cases were individuals, accounting firms, and investment banks.  Further, the dollar losses were often smaller, and accordingly, private litigation often did not occur because of the lower potential returns.

In summary, the article concludes the SEC’s Fair Funds program is not an inefficient transfer of funds from harmed shareholders to themselves.  That argument may only apply to a relative few large accounting scandals.  Rather, the Fair Funds program compensates harmed investors in cases involving consumer fraud and bad conduct by market professionals for which there is no real potential for relief through private litigation.