SEC Issues Statement Concerning Financial Penalties Against Corporations

January 4, 2006

On January 4, 2006, the Securities and Exchange Commission issued a long-awaited and unanimous statement concerning corporate financial penalties. The Commission simultaneously announced the filing of two settled actions against corporate issuers, SEC v. McAffee and In the Matter of Applix. In the statement contrasting the actions, the Commission set out principles that will guide the imposition of civil penalties against corporations in future actions.

Drawing on statutory authority in the 1990 Securities Enforcement Remedies and Penny Stock Reform Act and the “Fair Funds” provision of Section 308 of the 2002 Sarbanes-Oxley Act, the Commission stated that it is a “fundamental principle” that corporate penalties are an “essential part of an aggressive and comprehensive” enforcement program. At the same time, the Commission noted that the cost of penalties might be borne by shareholders who may themselves have been defrauded. The statement emphasizes that penalties against individuals responsible for corporate misconduct are a “critical” part of its enforcement mission.

The statement sets forth two principal considerations in the Commission’s determination of whether to impose a financial penalty on a corporation:

· The presence or absence of a direct benefit to the corporation as a result of the violation. Where the corporation itself received a direct and material benefit from the offense or was otherwise unjustly enriched, the imposition of a penalty is supported. The strongest case for a penalty is presented if the shareholders of the corporation have received an improper benefit; the weakest case is one in which the current shareholders are the principal victims of the offense.

· The degree to which the penalty will recompense or further harm the injured shareholders. The opportunity to use the penalty as a meaningful source of compensation to injured shareholders through the Fair Funds provision presents a stronger case for imposing penalties. The likelihood that the penalty will unfairly injure investors, the corporation, or third parties weighs against imposing penalties.

The other factors that the Commission will consider in determining whether to impose a financial penalty on a corporation are:

· The need to deter the particular type of offense;

· The extent of the injury to innocent parties;

· Whether complicity in the violation is widespread throughout the corporation;

· The level of intent on the part of the perpetrators;

· The degree of difficulty in detecting the particular type of offense;

· The presence or lack of remedial steps by the corporation; and

· The extent of cooperation with the Commission and other law enforcement agencies.

In SEC v. McAfee, the settlement included a $50 million civil penalty against the company. At the press conference discussing the statement, Linda Chatman Thomsen, Director of Enforcement, noted that the unprecedented size of the penalty against McAfee reflected the nearly two-year duration of the fraud, the pervasiveness of the complicity of management in the fraud, and the use of the overvalued stock to make acquisitions. In her view, McAfee’s inflated financial results increased the price of stock used as the currency for acquisitions, resulting in a benefit to the company and its shareholders from the fraudulent conduct.

By comparison, Applix management engaged in only two discrete violations according to Thomsen. She added that the penalty that would be required to effectively deter Applix’s violations would make a financially weak company unstable and would be unlikely to result in compensation to the shareholders who had been wronged.

In our view, the impact of the statement is as follows:

· The statement is entirely consistent with current enforcement policy, and we do not expect immediate change. The $50 million civil penalty against McAffee in a disclosure case demonstrates that the Commission will continue to levy penalties at a level considered unthinkable as recently as three years ago. We do not expect the Commission to explain its choice of penalties except in very unusual circumstances.

· We expect the release to generate lively public debate. In particular, we expect a great deal of public comment on the Commission’s statement that “it is incumbent on management” to report securities law violations when they are discovered. In time, this debate – and the Commission’s response to it – may alter the Commission’s enforcement practices.

· The statement relies heavily on legislative history and other direct evidence of congressional intent. We expect this to be a hallmark of the Cox Commission in making public policy.

· The statement was issued by a unanimous Commission. We expect the Cox Commission to strive for consensus whenever possible.

The statement may be found on the SEC website at: http://www.sec.gov/news/press/2006-4.htm, and a webcast of the January 4, 2006 press conference is available at: http://www.sec.gov/news/otherwebcasts.shtml.

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Questions regarding these matters may be directed to your regular contacts at the firm or to any of our partners and counsel listed under Securities Enforcement in the Our Practice section of our web site.

CLEARY GOTTLIEB STEEN & HAMILTON LLP