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Cutler Testifies on Sarbanes-Oxley Fair Fund Provisions

The SEC has already begun to use the fair fund provision of the Sarbanes-Oxley Act to return funds to defrauded investors, SEC Enforcement Director Stephen M. Cutler told the House Capital Markets subcommittee in recent testimony. Section 308(a) of the act allows the Commission, in appropriate cases, to distribute civil money penalties to harmed investors. Prior to the act, when the Commission received payment of a penalty, it was required to transmit the funds to the Department of the Treasury. Thus, penalty amounts could not be paid to harmed investors.

Section 308(a) provides that, in SEC actions where both disgorgement and penalties are obtained against a defendant, the amount of the penalty may be added to the disgorgement fund for the benefit of victims of the violation. Within the first six months of enactment, stated Mr. Cutler, the Commission has authorized the Division of Enforcement to seek federal court approval of fair fund distributions on at least a dozen occasions. And, the director pledged that the Commission would use the fair fund provision whenever economically feasible, consistent with its mission to protect investors.

He also indicated that the provision has given the SEC much greater flexibility. For example, prior to the fair fund provision, the Commission pursued the collection of disgorgement before penalties in order to maximize the amount of money that could be returned to defrauded investors. Since enactment of the Sarbanes-Oxley Act, although different types of proceedings to collect penalties and disgorgement are still necessary, those proceedings can now be initiated simultaneously, or an action to recover penalties can be initiated first.

Under the fair fund provision all monies recovered from either a disgorgement or penalty proceeding can be returned to investors. Accordingly, the Commission has greater flexibility to choose the most advantageous collections venue. According to the director, however, the fair fund provision cannot address another difficulty in collecting disgorgement judgments. To execute on disgorgement judgments, the Commission must employ state law procedures, requiring the staff to become proficient in the law and procedures of multiple jurisdictions. Developing such proficiency takes staff time away from investigating and stopping other violations of the federal securities laws.

To conserve staff resources, the Commission recommended in a report to Congress mandated by Section 308(c) of the Sarbanes-Oxley Act that it be authorized to hire private collection attorneys located in the relevant states who would have the necessary expertise. Mr. Cutler also noted that there is a technical limitation in the wording of the fair fund provision limiting its utility in some circumstances. The provision only permits the Commission to add penalty amounts to disgorgement funds when a penalty is collected from the same defendant that has been ordered to pay disgorgement.

There are cases, however, where some defendants may not be ordered to pay disgorgement and it would be beneficial if the Commission could distribute penalties collected from these defendants to harmed investors in that case. Indeed, in some cases, the Commission may not obtain disgorgement from any defendant, but may obtain civil money penalties. In such cases, emphasized Mr. Cutler, it might nevertheless be feasible to create a distribution fund for the benefit of victims in that case. Thus, he asked Congress to amend the fair fund provision to permit the Commission to use penalty money for distribution funds in these additional circumstances.