SEC officials say they are going to start filing more civil suits against securities brokers based on claims of negligence only. This would be a significant deviation from their current practice of primarily suing firms for intentional fraud, which often carries steeper penalties, but also has a significantly higher burden of proof.
The SEC’s typical enforcement strategy is to file suits for intentional fraud against firms, rather than individual brokers. While the SEC often settles for claims of negligence, it rarely sues for negligence only. For instance, during the week of September 25th, the SEC News Digest reported updates on 29 of its enforcement proceedings, only one of which was for a suit based primarily on negligence. In addition, most of the SEC’s lawsuits resulting from the financial crisis, including its suits against Goldman Sachs and Bank of America, have been for intentional fraud and have not included penalties for any individual broker or executive. Moreover, individual brokers or company executives who participate in the alleged misconduct are often not named in the lawsuits or avoid being named as part of the settlement.
The SECs new strategy has two parts. First, lawsuit will be filed against company executives, brokers, and firms, rather than primarily firms. Second, the SEC says these claims will be negligence-based infractions. Negligence based infractions differ from intentional infractions in that the claims are based on instances when individuals should have known their conduct would mislead investors, rather than only those instances when individuals purposely or knowingly mislead investors. As a result of this lower standard, the SEC will likely pursue more litigation but collect smaller fines each time.
UC Berkeley School of Law of Professor Stavros Gadinis says the new strategy is likely an attempt to deter risky behavior by individual brokers who historically have been able to avoid punishment. While the firms likely will indemnify their brokers for any fines, says Gadinis, individuals could face other sanctions or harm to their reputation for facing a negligence lawsuit. Thus, it would be a way both to continue financially penalizing financial institutions and to more effectively punish the individuals who work for them.
Among the possible drawbacks to this policy is an increase in the total cost of litigation for the SEC. Professor Gadinis says that this effect will be dependent upon how expensive negligence based suits are compared to intentional fraud based suits. If they are significantly less expensive to pursue, for instance because of lower costs to collect evidence, then the increase in the total cost of litigation could be minimal. If, on the other hand, pursuing negligence suits is as costly as intentional fraud suits, the increase in total litigation costs could be substantial.
Moreover, it might prove harder for the SEC to maintain its high success rates on enforcement actions once it expands onto negligence lawsuits. Professor Gadinis says that to date, the SEC can boast that it wins about 95% of the actions it brings. But negligence lawsuits represent an uncharted territory for the agency.