SEC Commissioner Gallagher, The Bad Boy Provisions and Remedies

Waivers from the automatic disqualifications of the “bad boy” provisions which can come into play following the resolution of a Commission enforcement action is a topic of increasing concern. Consider the recent decision regarding Oppenheimer for example. There the Commission agreed to waivers based on certain conditions for a firm with a long history of violations and with what some view as a huge tone at the top problem over the dissent of two Commissioners.

Now Commissioner Gallagher is proposing a new approach to the use of these provisions. Under his approach the SEC consider the issue in conjunction with the resolution of the underlying enforcement action, not as a separate matter which is the current practice.

The bad boy provisions

The bad boy provisions generally refers to a collection of various provisions in the securities laws which are triggered by the resolution of a Commission enforcement action. Typically those provisions preclude the settling party from relying on exemptions that otherwise would be available to them. The first was created in the 1930s along with the Regulation A exemption. It contains an automatic disqualification for anyone subject to an injunction. In 1940 the Investment Company Act added Section 9(a). It contains an automatic disqualification from acting as an adviser to a registered investment company upon entry of an injunction.

In 1982 a Reg. A type provision was written into Regulation D. Rule 405, adopted in 2005, specified that issuers who have violated the anti-fraud provisions of the Federal securities laws are not eligible to be considered as well-known seasoned issuers. Similarly, Section 926 of Dodd-Frank directed the SEC to issue Rule 506(d), the provision of Regulation D, which precludes felons and other bad actors who have violated Federal and State securities laws from continuing to use the Rule 506 private placement process.

Purpose of the provisions

A critical question regarding these provisions, according to Commissioner Gallagher, is their purpose. Some may consider them backward looking sanctions for misconduct. Others may argue that they were meant to be forward looking and prophylactic. Since there is little legislative history for any of the provisions, guidance is sparse.

At the same time, a “common thread runs through the legislative and SEC records underlying each of these disqualification provisions: Congress and the SEC may be willing to allow for exemptions from otherwise applicable restrictions or burdens, but only to those persons who are unlikely to abuse that relief through fraudulent or other improper conduct. They recognize that the disqualifications were intentionally over-broad and thus necessitated an exceptive process to be employed when the facts and circumstances warranted a less heavy-handed approach . . .” according to the Commissioner.

The SEC’s historical approach followed this path. Traditionally, the staff approached disqualifications and waivers against a backdrop of reducing a repetition of wrongful conduct. Waiver requests were handled by the policy division staff on the merits pursuant to delegated authority separate and apart from the underlying enforcement action. At the same time the Commission remained free to take up any action it deemed appropriate.

Recently, according to the Commissioner, some have come to view these provisions as sanction enhancement. The SEC should resist this approach and not “conflate” disqualifications and enforcement sanctions he argues. This process is “exacerbated by the informal, non-Commission-approved, practice recently followed by the Enforcement Division of not allowing respondents to condition settlements on the granting of waivers. This makes no sense to me. If a disqualification is now a sanction, then the waivers must be part of the settlement process .. .” Commissioner Gallagher noted. This is because “I cannot fulfill my duty as a Commissioner to cast a vote in favor of a recommendation without the ability to accurately assess what punishments will be meted out . . . and whether those punishments are just given the nature of the violation . . .” the Commissioner stated.

The path forward

The “ideal” solution to the current cross-roads at which the Commission finds itself would be to return to the historical practice, according to Commissioner Gallagher. At this point, however, that does not appear possible. Accordingly, Commissioner Gallagher is calling for the SEC to amend its practice and consider the question of waivers in conjunction with the underlying enforcement action. If the Commission is unable to adopt this approach, then Congress should step in and mandate it.

Comment

The question of remedies is a critical question for the agency. Historically its equitable remedies served the purposes on which the federal securities laws are based. The injunction, equitable relief, and fashioning provisions which at once reformed a violating issuer and prevented a reoccurrence in the future were the approach of choice. Reforming corporate governance for the good of the shareholders was key.

The Remedies Act and the advent of monetary penalties changed the focus. Regardless of its intent, today large dollar penalties that generate headlines are the name of the game. More dollars, more headlines. Whether those headlines serve their preventative purpose is debatable. Nonetheless, they are a key part of the omnipresent, broken windows approach of the agency today.

Commissioner Gallagher’s comments on the use of the bad boy provisions only serves to highlight this trend. Provisions he describes as intentionally over broad and a blunt instrument are being administered as additional punishment after the settlement is done. That turns settlement into a game of roulette – maybe there is more punishment and maybe not. If fundamental fairness is to be the hallmark of an effective enforcement program, it is surely lacking from this approach.

What all of this points out, however, is not just that the approach to, and the application of, the bad boy provisions requires reconsideration, but all enforcement remedies. It is time for the agency to reconsider the purpose of its enforcement remedies as well as their application in an open and transparent way that allows for discussion and comment before any steps are taken. Initiating this process, and doing it in this manner, could do much to restore the image which has in recent years eluded the agency – that of a tough but fair enforcement authority.