Ability to Pay Arguments in SEC Penalty Negotiations.

Generally, yes, provided you can adequately demonstrate a lack of funds to pay the civil monetary penalty. The SEC’s Enforcement Manual expressly places the burden of proving an “inability-to-pay” on the respondents, and it instructs SEC staff to “generally” decline to impose a penalty where a respondent “demonstrates an inability to pay such penalty.” However, as in almost all areas of federal law enforcement, this is also an extremely high bar, and respondents should be prepared to meet it with complete financial evidence.

When Should Respondents Make Ability-to-Pay Arguments?

Respondents should raise the issue of inability to pay as early as possible, and in most cases, at least before the SEC staff has time to finalize its recommended settlement terms. If a respondent can make a timely and effective ability-to-pay argument, it may be able to avoid (or at least reduce) a civil penalty in addition to avoid a trial at the U.S. District Court.

What Does the SEC Consider in an Ability-to-Pay Analysis?

While, as a broad rule, a respondent needs to demonstrate that it does not have the money to pay its SEC penalty, the SEC will scrutinize not only the respondent’s current financial statements. Specifically, the SEC has instructed its Enforcement Division staff to conduct an exhaustive ability-to-pay analysis, “including as applicable any: insurance, indemnification, advancement, or other third-party payment resources.”

What Financial Disclosures Should Be Disclosed as Part of an Ability-to-Pay Analysis?

To properly disclose its inability to pay, a respondent must be completely candid about all potential sources of funds, including “indirectly held assets and assets transferred to any related parties.” While respondents should disclose all assets in the SEC’s possession, respondents should also work to identify all assets and resources not in the SEC’s possession.

What Does “Inability to Pay” Actually Mean to the SEC?

While the SEC’s Enforcement Manual does not specifically define “inability to pay,” several other provisions of the manual explain the circumstances under which respondents are considered “unable to pay” as well as the steps that SEC staff should take to make sure that the circumstances warrant this determination. Specifically, the Manual discusses:

Illiquidity and Insolvency

In the Enforcement Manual, the SEC defines these concepts as follows:

• Illiquidity: “The condition in which an entity or individual does not have sufficient cash or cash equivalents to pay a debt when it comes due and cannot readily convert other assets into cash to do so.”
• Balance-Sheet Insolvency: “The condition in which the total value of an entity’s or individual’s liabilities exceeds the fair market value of all its assets.”
• Cash-Flow Insolvency: “The condition in which an entity or individual does not have sufficient cash or cash equivalents to pay its debts when they come due.”

When facing an Enforcement action, the circumstances that constitute an inability to pay an SEC penalty are usually these types of financial hardship. If a respondent can effectively establish that it is illiquid or insolvent, this can often mitigate (and in some cases eliminate) any civil penalties that might otherwise be imposed.

Personal Illiquidity and Availability of Funds

In cases involving individual respondents, personal illiquidity does not necessarily mean that a respondent is considered “unable to pay” in all cases. The SEC’s Enforcement Manual explains:

• “A respondent’s inability to pay should be scrutinized in light of its or their current financial statements, tax returns, and other pertinent financial information, including (but not limited to) their current and past income and other source(s) of wealth.”
• “A respondent’s personal illiquidity does not, per se, establish that the respondent does not have the means to pay, given the possibility that the respondent could borrow funds or obtain funding from third parties.”

Inability to Borrow

While, as the SEC’s Enforcement Manual notes, “an individual respondent’s personal illiquidity does not, per se, establish that the respondent does not have the means to pay,” unsuccessful attempts to borrow funds can often be used to support an “inability-to-pay” argument in SEC penalty negotiations. With this in mind, the SEC’s Enforcement Manual also specifies:

• “To support a claimed inability to borrow or raise funds, an individual respondent should ideally provide documentation showing a rejection of a loan application (or other similar efforts to obtain funds).”
• “These are not the only means of establishing a respondent’s inability to pay, and, as the Enforcement Division Manual makes clear, they are provided to offer examples of evidence that may support an ability-to-pay argument.”

Ultimately, while the SEC’s Enforcement Manual sets the overall framework for conducting an “ability-to-pay” analysis, individual enforcement officers and legal personnel have considerable discretion. If an Enforcement action is pending, any respondents should be prepared to present their case for receiving a penalty reduction or elimination to the SEC Enforcement Division promptly.

What Financial Proof Does the SEC Expect From Me?

While the SEC Enforcement Manual explicitly states that it provides respondents with examples rather than a set list of requirements when establishing an “inability to pay,” hardship claims ordinarily require sworn financial disclosures and supporting records. Generally speaking, the SEC expects individuals and organizations to fill out one of the SEC’s financial-disclosure forms, either:

• Form D-A (for individual respondents)
• For corporate or organizational respondents, the Commission may require another form or other financial information

Additional records supporting the claims in a respondent’s financial disclosure are also ordinarily required. For example, tax returns can provide corroboration of a respondent’s (i) income, (ii) assets, (iii) liabilities, and (iv) claim of financial hardship.

Does the SEC Seek Proof of Hardship Outside of What I Provide?

The SEC expects staff to corroborate information disclosed in respondents’ financial disclosures to the extent practicable, including by using other relevant information sources. For example, the SEC Enforcement Manual states:

• “Staff should corroborate the information disclosed on the respondent’s ability-to-pay form(s) to the extent practicable.”
• “While staff may use other information sources to verify any financial information disclosed in respondents’ ability-to-pay forms, they may seek information from other sources not provided by the respondents as well.”

What Will the SEC Do If I Provide Incomplete Financial Information?

In cases involving individual and corporate respondents’ inability to pay, the SEC expects comprehensive and accurate financial information disclosures. While, as a broad rule, the SEC is prepared to consider an “ability-to-pay” argument when a respondent makes a comprehensive disclosure, it is prepared to reject incomplete information disclosures as well. This makes it extremely important for respondents to work closely with their SEC defense counsel, and to proactively identify and address any missing or incomplete financial information in a respondent’s disclosures.

While the SEC’s financial-disclosure forms are an important part of many respondents’ ability-to-pay presentations, the SEC also accepts other forms of evidence of financial hardship. To this end, the SEC’s Enforcement Manual explains:

• “As noted, these forms are examples of documentation that may (but do not necessarily) support an ability-to-pay argument.”
• “While these examples of documentation are instructive, these are not the only sources of information staff may and should use to make ability-to-pay determinations.”

What Information Should I Include in Asset Valuations?

The SEC accepts asset valuations as part of many respondents’ ability-to-pay presentations. While there are no specific rules for providing asset valuations in SEC penalty negotiations, the following information should generally be included in a respondent’s asset valuations:

• Date (or dates) of valuation
• Valuation method(s) used
• Documentation supporting the respondent’s valuation(s)

What Should Respondents Do When Facing an Enforcement Action?

In general, when facing an Enforcement action, the steps that respondents should take should be based on the particular facts and circumstances at hand. However, among the most important steps that respondents can take include:

• Promptly engage SEC defense counsel with a clear understanding of the SEC’s investigation’s potential implications
• Carefully review and analyze the evidence at hand to determine what it indicates about the nature of the underlying securities law allegations
• Work closely with SEC defense counsel to establish a clear understanding of how long the case might take, as well as the potential risks and benefits of negotiating a favorable settlement or proceeding to trial

Spodek Law Group, led by managing partner Todd Spodek, defends clients in federal criminal and white collar matters.

What Relief Can a Successful Ability-to-Pay Argument Produce?

An ability-to-pay argument is primarily aimed at reducing or eliminating a respondent’s civil penalty. As discussed below, however, an ability-to-pay argument can generally reduce other types of financial liabilities under the securities laws as well.

Civil Penalties

The SEC’s Enforcement Manual explains that “civil penalties are intended to serve as punishment for issuers’ and individual’s prior misconduct and to deter future misconduct, and, as such, are computed based on the nature, extent, and severity of the securities law violations.” The Manual notes, however, that “civil penalties are different from other types of financial liabilities; for example, the amount of civil penalties are also subject to the availability of funds of the respondent in appropriate circumstances.”

Under the Securities Exchange Act of 1934, specifically Section 21B(c), the SEC determines whether a civil penalty is in the public interest by considering whether the act or omission involved fraud, deceit, manipulation, or deliberate or reckless disregard of a regulatory requirement; the harm to other persons resulting directly or indirectly from the act or omission; the extent to which any person was unjustly enriched; whether the respondent has previously been found to have violated the securities laws, been enjoined by a court, or been convicted of such violations or of any felony or misdemeanor; the need to deter the respondent and others from committing such acts or omissions; and such other matters as justice may require. Section 21B(d) separately provides that a respondent may present evidence of an inability to pay, including the extent of the respondent's ability to continue in business and the collectability of a penalty, which the Commission may consider in determining whether a penalty is in the public interest. While, as discussed above, the fact that a respondent does not have sufficient funds to pay the SEC’s suggested civil penalty will not necessarily reduce the penalty, it can be an important factor in mitigating civil monetary penalties in many cases.

Disgorgement

In general, the SEC distinguishes “civil penalties” from “disgorgement” by explaining that civil penalties “serve as punishment and deterrents,” while disgorgement “targets the proceeds of ill-gotten gains obtained as a result of securities law violations.” As the Enforcement Manual also notes, “the ability to pay is not generally a defense to disgorgement.” Accordingly, the extent to which an ability-to-pay argument can reduce or eliminate a respondent’s disgorgement liability will depend on the facts at hand.

If a respondent does not have sufficient funds to pay the SEC’s suggested disgorgement amount, this can make an inability-to-pay argument more effective in many cases. For example, in many cases, a successful ability-to-pay argument can lead to an SEC settlement order that waives a respondent’s disgorgement payment if the respondent makes a sworn financial statement establishing that, “by the time of enforcement settlement, he or she had been deprived of all previously ill-gotten gains and is currently broke.”

Prejudgment Interest

Disgorgement includes, or is accompanied by, prejudgment interest in most cases. While the SEC’s Enforcement Manual does not explicitly discuss prejudgment interest, the SEC treats prejudgment interest as a distinct financial liability, meaning, for example, that the Enforcement Division’s ability to mitigate or waive prejudgment interest is based on the same factors that apply to civil penalties.

Installment Schedules

Under the Securities Exchange Act of 1934, the SEC can impose both “administrative” and “judicial” penalties. While the SEC has less leeway to set payment terms under the judicial process, under the administrative process, the SEC can, and often will, include language in a respondent’s settlement order providing for the payment of civil monetary penalties in installments. While the SEC typically allows respondents to pay through installment schedules, failing to meet payment deadlines can have significant consequences. For example, the Enforcement Manual explains that, “defaulting on an installment payment may accelerate the remaining balance of civil monetary penalties owed, and can also trigger additional interest payments to the U.S. Treasury.”

Ability to Pay, Cooperation, and Other Factors

While an “ability-to-pay” argument is one way to reduce the amount of any civil monetary penalties imposed in an Enforcement action, it is not the only way. Specifically, respondents who demonstrate “extraordinary cooperation” with the Enforcement Division during the government’s investigation may also support reductions in their civil monetary penalties. These are separate considerations, and, when appropriate, respondents should work with their defense counsel to aggressively seek reductions from the SEC based on both cooperation credit and inability to pay.

What Are the Risks of Submitting SEC Financial Disclosures?

While making an ability-to-pay argument can be a powerful strategy for mitigating civil penalties in SEC enforcement actions, there are also various risks associated with submitting financial disclosures. Among these risks are:

• Materially false financial disclosures. Under 18 U.S.C. §1001, knowingly and willfully “making any materially false, fictitious, or fraudulent statement or representation to any department or agency of the United States” during the course of the agency’s investigation and administration of the law can expose individuals and organizations to civil and criminal liability. This means that while respondents should use the “ability to pay” defense when appropriate, any information they provide to the SEC must be complete and accurate.
• Perjury. If a respondent’s ability-to-pay argument includes a sworn declaration (i.e., one that is signed under the penalties of perjury), making materially false statements in that declaration can expose the respondent to potential liability under 18 U.S.C. §1621, which prohibits perjury.
• Reopening of a settlement. Even in cases where the SEC agrees to a financial-condition settlement that reduces or eliminates a respondent’s civil penalty, this will not necessarily shield the respondent from liability in the future. According to the Enforcement Manual, settlement orders that mitigate civil monetary penalties based on a respondent’s financial condition “should specifically provide for the matter to be reopened if the financial condition disclosures provided to the agency are found to be materially inaccurate or incomplete, or if a respondent’s financial condition significantly improves during the term of the installment payment agreement.”

How Are SEC Investigations Protected from Public Disclosure?

The SEC’s Enforcement Manual notes that the SEC’s investigations remain nonpublic, unless disclosure is authorized pursuant to 17 C.F.R. §203.5. With this in mind, once an investigation is concluded and the matter becomes public, the SEC’s Enforcement Division can release information from the case files. However, the Enforcement Manual also states, “If a respondent provides a Rule 83 request for confidential treatment, the SEC will have to determine whether the information has a reasonable expectation of remaining private.”

Can Respondents Assert Confidential Treatment for Their Financial Disclosures?

The answer is yes, if necessary. Under SEC Rule 83, 17 C.F.R. §200.83, anyone whose information is used as part of an SEC investigation and who believes that the information is commercially sensitive or could otherwise be used for an unfair competitive advantage can request confidential treatment. The Enforcement Manual notes, however, that “While the SEC will consider Rule 83 requests, these requests are not entitled to automatic approval.” If a Rule 83 request is denied, then the information provided in a respondent’s financial disclosures can potentially become public or be accessible through a Freedom of Information Act request. This makes it critical that respondents carefully consider their decision to provide financial information to the SEC, particularly when considering providing such information in a federal enforcement investigation targeting a corporate or organizational entity. Respondents should also work with their SEC defense counsel to determine the risks and benefits of making an ability-to-pay argument and, if appropriate, seek reductions from the SEC based on an ability-to-pay defense.

Who Actually Decides the Amount of an SEC Penalty?

While SEC enforcement staff propose figures for civil monetary penalties, they do not have the authority to decide the amount that an individual or company must pay. Instead, SEC enforcement staff recommend figures to either (i) the Commission or (ii) a federal court. Under the Securities Act of 1933 (Section 20(d)) and the Securities Exchange Act of 1934 (Section 21(d)(3)), the federal government has the authority to seek penalty amounts from a federal court in addition to damages.

Administrative Settlements

In cases in which the SEC pursues an administrative enforcement action, the respondent typically has the option to accept the Enforcement Division’s figures in a settlement order and consent to the administrative proceedings. In such cases, the Commission approves the proposed penalty and the respondent avoids litigation in federal district court.

How the SEC Calculates Penalties

While federal courts and the Commission have broad discretion in determining a respondent’s civil monetary penalty, they must comply with statutory maximums. The federal securities laws establish a statutory tier system for civil monetary penalties, with tiers establishing maximum amounts the SEC can seek for first-tier, second-tier, and third-tier offenses. When imposing civil penalties, federal courts may alternatively measure penalties based on a defendant’s “gross pecuniary gain from the violation.”

The “80/20 Rule”

We are often asked whether the SEC uses an “80/20 rule” to calculate civil penalties. However, neither the federal securities laws nor the SEC’s regulations define or refer to an “80/20 rule” in regard to monetary penalties. While the SEC takes respondents’ ability to pay into account, this is only one of many factors that it will use when determining appropriate penalties.

Determining “Penalty Units”

There is no automatic “80/20 rule” for determining the number of “penalty units” applicable to a violation under the federal securities laws. While this varies by case, SEC staff generally identify penalty units based on the distinct acts or omissions that constitute a violation, and not solely based on the number of investors impacted.

Other Factors and History

While Congress strengthened the SEC’s monetary-penalty authority in the 1990 Remedies Act, this legislation does not change the legal standard that applies. When facing an enforcement action, respondents should engage experienced SEC defense counsel to determine their rights and protections under the law and negotiate based on these protections as well as other mitigating factors.

Speak With a Federal Defense Lawyer

If you are dealing with any part of what this article describes, the next step is a conversation with a lawyer who handles these cases. Spodek Law Group is a second generation criminal defense firm practicing since 1976, representing clients nationwide from offices in New York, Brooklyn, Queens and Los Angeles. Call 212-300-5196 to speak with our team.