Fines, Without Explaining How They Were Calculated

A standard part of enforcement actions against companies these days is the multimillion-dollar – or even multibillion-dollar – penalty. What can be perplexing is figuring out how those penalties were determined, and whether they have much if any direct relationship to either the gains realized from the violations or the harm inflicted.

Recent settlements by JPMorgan Chase are good examples of the significant payments required as part of the atonement for misdeeds. The bank paid a $200 million civil penalty to the Securities and Exchange Commission for violations related to its internal controls in the so-called London whale trading loss, and $2 billion to the Justice Department as part of the broad settlement over sales of mortgage securities.

How did the cases result in such nice round penalty figures? The answer appears to be only vaguely connected to the statutes authorizing civil penalties for the violations involved.

The $2 billion civil penalty in the mortgage securities case is based on a provision of the Financial Institutions Reform, Recovery and Enforcement Act that permits the government to pursue mail and wire fraud violations that affect a financial institution. The law limits the penalty to the amount of the loss from the misconduct if it is greater than $1 million, or $5 million for a continuing violation.

There is a great deal of flexibility in determining the penalty because each mailing or wire transmission can be the basis for a separate claim. JPMorgan could theoretically have been held liable for thousands of communications in connection with the issuance of the mortgage securities, so the $2 billion payment does not exceed what the statute authorizes.

Yet the settlement agreement does not quantify the losses that form the basis for the civil penalty, or even provide an indication of how many violations the government determined occurred in connection with the issuance of the mortgage securities. The final amount looks to be the product of negotiations between the Justice Department and JPMorgan rather than an assessment for particular violations.

For violations of securities laws, the S.E.C. can impose three tiers of penalties depending on the seriousness of the misconduct. The penalties can reach as high as $160,000 for individuals and $775,000 for companies that engage in fraud that results in substantial gains or losses. A recent decision by the United States Court of Appeals in Washington sheds some light on how much flexibility the S.E.C. has in determining the amount of a civil penalty.

In S.E.C. v. Collins, the appeals court upheld a $310,000 penalty for an individual who failed to supervise a broker selling inappropriate investments to elderly customers. In reviewing the penalty, the court looked at whether the agency was “arbitrary and capricious” in reaching its decision.

The S.E.C. ordered repayment of $2,915 in commissions from the transactions, and the defendant argued that a civil penalty more than 100 times the amount of the improper gains was disproportionate. The appeals court noted that “if we focus solely on the disgorgement amount, the civil penalty here looks high relative to S.E.C. precedents.” In those instances, the agency had imposed penalties ranging from one-half to 25 times the amount a defendant had to repay.

But it rejected a mechanical approach to measuring the appropriate penalty because “the relation between the civil penalty and disgorgement (and other measures of injury) is informative, particularly in comparison with other cases, but hardly decisive.” In assessing the fairness of a penalty, the S.E.C. can look at factors beyond just the amount involved by considering harm to others, the need for deterrence and, in a nice catchall, “such other matters as justice may require.”

There is also a constitutional limitation on how much of a penalty an administrative agency can impose. The Eighth Amendment prohibits “excessive fines,” which the Supreme Court described in United States v. Bajakajian as fines that “would be grossly disproportional to the gravity of” the offense.

The District of Columbia Circuit Court, however, did not find such a violation in the $310,000 penalty in the case of the individual who failed to supervise a broker because the constitutional limitation is only available in rare cases. The appeals court noted that there were only two decisions striking down extremely large penalties for minor misconduct, and that “the Commission’s penalty here does not belong in that small club.”

For an individual, it is difficult to resist the broad authority granted to the S.E.C. to impose significant monetary penalties. For companies, the civil penalty is more a matter of how much they are willing to pay because limitations on the amount of a penalty seem to be largely irrelevant to the final settlement.

When JPMorgan paid a $200 million penalty to settle the S.E.C. case related to the London whale trading, it acknowledged violating the books-and-records provisions of the securities laws by not properly reporting the losses in its chief investment office. The bank lost over $6 billion from the transactions, something shareholders had to bear on top of the civil penalty.

It is difficult to see how the penalty relates to the statute authorizing a maximum penalty of $800,000 for each violation, especially when the case did not involve any claim of fraud or reckless conduct. JPMorgan was unwilling to fight the S.E.C., which described only a limited set of violations but still extracted a substantial penalty.

When the government agrees to a settlement imposing civil penalties on a company, the amount appears to have been reached through negotiation without any effort to explain how the payment was calculated. Of course, the beneficiary is often the United States Treasury because some penalties, like the $2 billion for the mortgage securities settlement, go straight to the government’s coffers.