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A fine line for SEC penalties

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

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

• 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

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

? 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

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