This article isn't about options, but SEC actions and the part about ‘fair funds’ concept seems to be central. The SEC is going to be very careful not to wipe out over 100 companies thru their investigations and actions. Hurting lots of stockholders is the last thing they want to do. In this case the stockholders were victims.
whatpc.co.uk
A fine line for SEC penalties
The SEC bares its teeth as two US companies are taken to task for inflating revenues. But only one was fined
Andrew Sawers, Financial Director 27 Jun 2006
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The Securities and Exchange Commission recently took action against two US-listed companies involved in unrelated breaches of SEC rules, choosing to levy a “civil money penalty” against the software group McAfee Inc, but declining to do so in its action against the smaller company, Applix Inc.
• McAfee had engaged in ‘channel stuffing’ and had overstated its revenues by more than $620m over a period of years. It is being fined (subject to court approval) $50m.
• Applix Inc engaged in fraudulent revenue recognition schemes on two occasions, each time for less than $1m and, while action is being pursued against the directors, there is no fine being sought against the company.
A statement issued at the beginning of January spells out the SEC’s current policy on financial penalties against companies (as opposed to individuals). The regulator was given the power to fine companies in the 1990 Securities Enforcement Remedies and Penny Stock Reform Act (known as the Remedies Act, which also enhanced its power to fine individuals). Penalties, says the SEC, may act as a valuable deterrent and encourage companies to develop good compliance programmes.
The SEC says that there are two principle issues for it to consider when deciding whether to seek a penalty against a company:
• A key question is whether the shareholders have benefited from the violation committed by the company or whether the shareholders are the victims. The strongest case for a penalty is where the shareholders have received an improper benefit; the weakest is where the current shareholders are the principle victims, in which case the SEC is expected to pursue the individuals responsible.
• The degree to which the penalty will recompense or further harm the injured shareholders is important. The Sarbanes-Oxley Act created the ‘fair funds’ concept under which penalties may be redistributed to shareholders who had been harmed by the violations, though recognising that shareholders will also be ‘harmed’ as a result of levying the penalty in the first place. The opportunity to use a penalty as a source of compensation to injured shareholders would increase the likelihood of a penalty being levied, unless such a penalty would unfairly injure investors, the corporation or third parties.
There are additional factors that might also be allowed for:
• The need to deter the particular type of offence;
• The extent of the injury to innocent parties and the extent of societal harm if the corporation’s wrongdoing goes unpunished;
• Whether complicity in the violation is widespread throughout the corporation: isolated incidents conducted by just a few individuals would mitigate against a penalty;
• The level of intent on the part of the perpetrators: a penalty is less likely if the violation is not the result of deliberate, fraudulent conduct;
• The degree of difficulty in detecting the particular type of offence: offences that are difficult to detect call for higher levels of deterrence;
• Presence, or lack of remedial steps by the corporation: exemplary conduct by management will weigh against the imposition of a penalty;
• Extent of cooperation with the SEC and other law enforcement agencies.
Case-by-case comparison:
Applix Inc – Fine: nil
The SEC said in early January that three executives at Massachusetts software company Applix Inc used fraudulent revenue recognition schemes on two occasions, but that it wouldn’t levy a civil penalty against the company.
In the first instance, 2001 revenues were artificially boosted by $898,000 which was enough to lift annual revenues to a published year-end goal of $40m. In 2002, Q2 revenues were fraudulently inflated by $341,000 by prematurely recognising a sale to a customer which had a six-month right to return the software. On both occasions, executives earned performance-related bonuses as a result.
The company agreed in February 2003 to restate its accounts. In a legal action brought by the SEC against the executives responsible, the regulator is seeking:
? To permanently bar the executives responsible from being officers or directors of any public company;
? Disgorgement of the bonuses they earned;
? The imposition of civil penalties.
McAfee Inc – Fine: $50m
The SEC says that the anti-virus software group McAfee, formerly known as Network Associates, overstated its revenues by a cumulative $622m between 1998 and 2000; in 1998 alone, revenues were overstated by $562m – 131%. When the scheme began to unravel in December 2000, the market slashed more than $1bn off the company’s market capitalisation.
In the meantime, McAfee had made a number of acquisitions using its over-valued shares.
The SEC says that McAfee engaged in ‘channel stuffing’ by aggressively overselling its products to distributors, recording such sales as revenue, while offering deep discounts, rebates and secret payments to encourage distributors to stockpile and not return unsold McAfee products. A secret subsidiary was also used to repurchase surplus stock.
McAfee has agreed to pay a $50m penalty, without either admitting or denying the allegations. Under the ‘Fair Funds’ provisions of the Sarbanes-Oxley rules, the $50m penalty will be distributed by the SEC to ‘harmed investors’.
McAfee has also agreed to appoint an independent consultant to examine and advise on the company’s internal controls and accounting practices. Separate legal action is being taken against the former chief financial officer and others.
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