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The Business Lawyer

Summer 2023 | Volume 78, Issue 3

How Fair Funds Changed Public Compensation and Strengthened SEC Enforcement

Urska Velikonja

How Fair Funds Changed Public Compensation and Strengthened SEC Enforcement

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Twenty years ago, the Sarbanes-Oxley Act enacted the Fair Funds provision, a novel authority that has led the SEC to become an important source of investor compensation. This article contends that securities enforcement and compensation are codependent. Not surprisingly, strengthening enforcement can lead to greater success in returning funds to defrauded investors. But the obverse is true as well: efforts to return funds to defrauded investors have strengthened the SEC’s enforcement power by building political support for its mission.

I. Introduction

Throughout its history, the Securities and Exchange Commission (“SEC”) has prided itself in being an investor advocate. Its organic acts direct the agency to protect investors by adopting any necessary and appropriate rules and regulations, and by initiating investigations and enforcing those rules. Investor protection is embedded in modern securities regulation and has been a motivating force for the SEC throughout its history. Successive SEC chairs have declared their commitment to protecting “Aunt Millie,” “Mr. & Mrs. 401(k),” or simply “Main Street Investors” from fraud and financial abuse. For decades, the agency has invested significant resources in prevention of misconduct through periodic examinations and required disclosures, and in enforcement. Over its tenure, the SEC has become the model for securities enforcement that countries around the world have tried to emulate.

The SEC has focused its efforts on minimizing and deterring violations, trying to reduce investor harm indirectly. But for decades that was it: the SEC would go no further to redress investor harm directly. The SEC did not believe that investor compensation was a part of its mission. It believed that private actions are designed to compensate the victims of violations, not public enforcement.

That belief softened after the adoption of the Sarbanes-Oxley Act and the Fair Funds provision. The SEC embraced investor compensation as its new, albeit somewhat controversial, goal. Contrary to concerns expressed by conservative legislators, the defense bar, and legal academics, the new authority did not undermine and distort the SEC’s enforcement and its ability to protect capital markets. Although its initial efforts to compensate investors were contested and sometimes riddled with errors, the agency learned from its mistakes. Over time, the agency institutionalized, professionalized, and centralized collection and distribution functions. The latest evidence of this successful evolution is the creation, in late 2020, of a new Office of Bankruptcy, Collections, Distributions, and Receiverships in the Division of Enforcement.

Importantly, the focus on investor compensation also brought about unanticipated collateral benefits. It broadened public support for SEC enforcement: while disagreements about enforcement intensity and who enforcement should target are perennial, compensation enjoys broad bipartisan support. After the 2017 U.S. Supreme Court decision in Kokesh questioned the SEC’s right to order the defendant to pay disgorgement of ill-gotten gains, the SEC used the fact that it regularly compensates investors both as a litigation tactic as well as to build bipartisan political support for statutory amendments that expanded its disgorgement and enforcement authority.

We may never know whether the SEC stumbled on the strategy of using a popular compensation program to bolster political support for its mission generally or whether its decision was more deliberate. It is well understood internationally and domestically that political support is an indispensable prerequisite of effective securities enforcement. This article tells the (hi)story of the SEC compensation program and how the success of that program strengthened the SEC’s enforcement powers.

II. Controversial Fair Funds Authority

The Sarbanes-Oxley Act of 2002 included a true legislative innovation: the Fair Funds provision, a novel remedy that enabled the SEC to significantly increase the amounts it could distribute to investors as compensation for their losses. Section 308(a) of the Sarbanes-Oxley Act empowered the SEC to distribute to harmed investors civil fines in addition to disgorged profits whenever a distribution fund was created. In 2010, after several unsuccessful attempts, the Dodd-Frank Act amended the Fair Funds provision to authorize the SEC to distribute civil fines to investors even in cases where the SEC did not seek any disgorgement. Since the purpose of civil fines is to redress harm to the public interest, it is very unusual for a statute to direct that fines be paid as compensation to harmed private parties.

While the provision was added to the Sarbanes-Oxley Act late and without debate, it marks a whiplash-inducing paradigm shift in the goals for public securities enforcement. For generations, securities lawyers believed that the goal of SEC enforcement was to protect the public from fraud and other unlawful practices. Multiple strategic plans highlight, as the SEC’s primary goal, protection of working families and everyday investors against fraud, manipulation, and misconduct, and promise to do that through rulemaking, vigorous enforcement, and examination programs. There is no mention of investor compensation.

Although the ultimate result of SEC enforcement was that investors sometimes received compensatory payments, the SEC had long “taken the position that it is not a collection agency for victims of securities fraud.” William Cary, the SEC chair from 1961 to 1964, once voiced “clear-cut disagreement” with the suggestion that the SEC should bring recovery actions on behalf of harmed shareholders. In its 1976 annual report, the SEC is explicit that the purposes of disgorgement orders are the need to deprive defendants of profits from unlawful conduct and general deterrence, and “not to obtain damages for injured individuals.” In reports and litigation briefs filed during the 1980s and 1990s, the SEC repeatedly asserted that its role was to deter violations, not to compensate investors. Even after the passage of the Sarbanes-Oxley Act in 2002, the SEC explicitly subordinated investor compensation to its primary objectives: investor confidence in the fairness and transparency of securities markets, and deterrence of violations.

Although it was added to the Sarbanes-Oxley Act quietly, the Fair Funds provision generated substantial controversy soon after its adoption. SEC advocates worried that a focus on compensation would undermine and distort the SEC’s mission to deter misconduct; they feared that the agency would chase large-amount settlements that could result in large Fair Funds, instead of pursuing impactful cases. They fretted that expanding SEC authority into private remedies would weaken the agency’s enforcement and erode support for private litigation. To conservatives, the provision provided further evidence of the seemingly unstoppable growth of the administrative state. The provision upset the division of labor between public law, which is concerned with the pursuit of the hard-to-define public interest, and private law, which enables individuals to seek compensation. Securities lawyers voiced additional and more specific complaints that public compensation schemes that duplicated private remedies were wasteful, that they harmed investors, and burdened the court system.

Their concerns quieted over time as the worst predictions did not materialize. While the SEC’s publicly proclaimed enthusiasm for its compensation authority has waxed and waned, behind the scenes, the agency has been building a robust compensation infrastructure.

III. The Growing Pains of Developing the SEC’s Compensation Program

Every year, the SEC orders violators to pay billions in civil fines and disgorgement, and regularly collects at least half of that. Over the last decade, much of what it has collected, the SEC has attempted to distribute to harmed investors. During the aughts, the SEC set aside more than $11 billion to compensate harmed investors, many of whom would otherwise receive nothing, and it now regularly distributes $1 billion annually through its distribution funds. These distributions are in addition to monies refunded to victims by court-appointed receivers and in bankruptcy proceedings, not to mention private lawsuits that sometimes accompany SEC enforcement actions.

Compensation may be a core element of the SEC’s mission today, but it was not always so. I do not want to overstate the extent of the change: the SEC made efforts to return disgorgement awards to investors long before the Sarbanes-Oxley Act introduced the Fair Funds provision. As early as the 1940s, the SEC leveraged its right to enjoin a violation to obtain “voluntary” refunds for harmed investors. After the SEC began seeking court-ordered disgorgement of ill-gotten profits in the 1960s, it would distribute those profits to harmed investors when doing so was not particularly cumbersome: for example, when the SEC discovered the identity of harmed investors during its investigation. This effort grew over time so that between 1997 and 2002, during the five years before the adoption of the Sarbanes-Oxley Act, the SEC distributed disgorgement in over fifty civil actions, refunding more than a billion dollars.

The Fair Funds provision turbocharged the SEC’s interest in compensating investors. Between 2002 and 2005, the SEC staff created more than seventy-five fair funds, dwarfing earlier efforts. Unfortunately, the staff ’s enthusiasm was not accompanied by the necessary logistical steps. The SEC’s first report on distribution funds, published in 2003, noted that the agency was unable to collect most of ordered monetary penalties, which necessarily hampered its ability to distribute them to investors. A distribution presupposes a collection.

Subsequent efforts to create fair funds in dozens of cases revealed an even more profound shortcoming: no one had considered the complicated logistics of distribution in the sorts of cases where private lawsuits were uncommon. By 2005, the SEC had collected and set aside for distribution through fair funds nearly $5 billion in monetary penalties, but managed to distribute only $60 million. The agency had no method in place to track the amounts of monetary penalties ordered, collected, and distributed; SEC management asked staff attorneys to produce “ad hoc summaries” without implementing a standard reporting format.

Two years and many consultants later, the situation was not much improved. In 2007, the Division of Enforcement and the SEC continued to manage the program in a largely decentralized fashion, resulting in long delays. Following a practice carried over from the 1990s, when the SEC began distributing disgorgement orders more frequently, enforcement staff would serve as fund administrators in enforcement actions that they investigated and brought themselves. Enforcement attorneys, trained to investigate and to resolve actions, were expected to manage the distribution process. In relatively simple cases, staff attorneys would create the fund, identify harmed investors, contact them, and distribute the monies. In most cases, however, the SEC would hire a distribution consultant, but staff attorneys were expected to oversee the consultant, and to advise and petition the court presiding over the plan. Busywork with Fair Funds distributions could consume up to 75 percent of investigative attorneys’ time, “divert[ing] investigative attorneys from pursuing other cases.”

By late 2008, more than six years after the adoption of the Fair Funds provision, the SEC finally created the Office of Collections and Distributions and authorized twenty-five staff positions, but bungled its reporting structure. The Office was located within the Division of Enforcement. A couple of the staff reported to the Office’s director but most reported to the deputy director who, in turn, reported to the Director of Enforcement. The “dual reporting arrangement” led to confusion and further delay.

Delays were not always the result of poor implementation. Many of the distribution funds were created for violations where harm was either invisible or poorly visible to harmed investors, and for which private lawsuits were rare to non-existent, such as insider trading, market timing and late trading, or market manipulation. Thus, there was no established precedent (from private litigation or otherwise) for identifying who should be compensated, how to calculate their losses, how to contact them, or how to refund them. In addition, predicate new legal questions had to be answered before a distribution could proceed. One Fair Fund administrator waited a year for the Department of Labor to provide guidance on how to compensate retirement plans governed by the Employee Retirement Income Security Act of 1974 (ERISA). Another waited a full year for tax guidance from the Internal Revenue Service on how to treat Fair Funds payments for tax purposes. That latter issue proved to be so intractable that the SEC ultimately outsourced tax advice.

In addition to working without a precedent, the Fair Funds provision and the SEC’s distribution program were criticized—not entirely unfairly—for being poorly implemented. For a successful distribution, it seems obvious that the SEC must first enforce and collect the penalty, and only then can it distribute it. But more is required: the enforcement action, although primarily focused on the violator, must also identify the victims or classes of victims harmed by specific violations. At least initially, there was inadequate coordination between attorneys who investigated and settled enforcement actions, and those who would later try to compensate harmed investors. When the SEC collects monetary penalties for securities violations, it can distribute funds to the victims of the specific violations that are described in the complaint or in the administrative order instituting proceedings. In several novel cases against financial market intermediaries (i.e., the 2003 Global Research Analyst Settlement), the SEC enforcement action imposed a nine-figure monetary penalty but failed to provide sufficient detail about specific actions that violated securities laws. Without such detail, no investors could be identified as harmed by those vaguely described violations, and the multi-million-dollar settlements were remitted to the U.S. Treasury instead.

In other instances, the enforcement action included enough information to identify classes of victims but the defendant did not possess the necessary records to process refunds. In some market timing and late trading cases, refunds were paid to current investors, not to those who invested in the affected funds at the time that the violation occurred. As a result, those who were harmed did not receive redress, while some later fund investors received windfalls.

The “wrong” investors also received compensation through the fair fund created in WorldCom. Soon after it revealed a massive accounting fraud, WorldCom filed for bankruptcy protection. The SEC imposed a $750 million monetary penalty on WorldCom, collected it from the bankruptcy estate, and distributed it to WorldCom’s shareholders. By doing that, the SEC upset bankruptcy priority and de facto forced unsecured creditors to compensate shareholders, who otherwise would have received nothing in bankruptcy.

The ultimate upshot was high cost. Because their work was not coordinated and centrally managed, fund administrations duplicated work that easily could have been standardized. For example, each administrator produced their own letter to potential victims instead of using a form letter. Since most funds direct that administrative costs be paid from fund proceeds, harmed investors ended up bearing the cost of disorganization.

In some instances, concerns expressed shortly after the adoption of the Fair Funds provision proved accurate. After the disclosure of significant market abuses by mutual funds and stock exchange specialists, the SEC imposed very large civil fines and disgorgement orders against two dozen mutual funds and seven NYSE specialist firms, and created fair funds to compensate harmed investors. Those fair funds “were larger than any plausible loss to affected mutual funds.” Their size and the fact that the SEC moved so quickly to compensate investors crowded out private litigation and resulted in very small private settlements or orders of dismissal.

And finally, the SEC may have moved too aggressively for some. The express language of the 2002 Fair Funds provision included a legal constraint for the SEC: it limited its ability to distribute civil penalties to cases where it also distributed disgorgement, but not where no disgorgement was ordered. To overcome the statutory limitation, the SEC engaged in a bit of regulatory arbitrage, by adding a dollar in disgorgement to multi-million civil fines in cases where the defendant did not obviously profit from its violation, such as accounting fraud. Transparent legal manipulation is never a good look. As explained earlier, the Fair Funds provision was amended in 2010 to authorize distribution to investors even where no disgorgement is ordered, but the stench lingered.

By 2010, the program finally found its sea legs: $6.9 billion of $9.1 billion in collected monetary penalties had been distributed to harmed investors. That pattern has continued to hold: in recent years, the SEC has been able to average almost $1 billion in fair fund distributions annually. As time went on, the SEC has also remedied most of the problems that raised concerns. Enforcement attorneys are now instructed to determine whether a distribution to investors is likely while the case is progressing, rather than after the fact. In those cases, the settlement provides detailed facts that are subsequently used to identify and compensate actual victims of violations. Since WorldCom, the SEC has not created another fair fund where the defendant company was bankrupt, and it has paid closer attention to the existence of parallel litigation. In a study of SEC fair funds created until 2014, I reported that, in a majority of cases, “the SEC compensates investors for losses where a private lawsuit is either unavailable or impractical,” and is able to extract payments from defendants that private litigants do not or cannot easily pursue, such as executives, underwriters, and audit firms.

Perhaps the most important changes to the SEC’s compensation program have been the ones least visible to an outside observer. The SEC has continued to adjust the organizational structure to improve collection and distribution. In 2011, the Office of Collections and Distributions was separated into two offices, the Office of Collections and the Office of Distributions, headed by two different individuals. To avoid soliciting bids from compensation consultants each time the SEC outsourced distribution, a pool of nine fund administrators was selected to implement distribution plans over a five-year period. Finally, in October 2020, the SEC centralized all collection and distribution functions in a single Office of Bankruptcy, Collections, Distributions, and Receiverships. The new Office is headed by Nichola L. Timmons, who has been managing SEC distributions since 2008, providing the necessary expertise and continuity. Fortunately for the agency, this is the one door that did not revolve.

Process improvements accompanied institutional reforms. Decisions about when to create a distribution fund and how to administer it have become regularized, errors have been worked out, and reduced. During the five years before the Sarbanes-Oxley Act, the SEC distributed disgorgement to investors in over fifty cases; between 2010 and 2014, the SEC made a distribution in almost two hundred cases. Between 2010 and 2018, the SEC compensated investors through a distribution fund in almost 11 percent of actions, in which it imposed a monetary penalty. That relative share doubles if cases in which restitution is made in a parallel criminal action or through a receivership are included in the count.

These days, one of the most common complaints about SEC fair funds made by attorneys, journalists who cover the enforcement beat, and investors is why some investors are not compensated by the SEC. As explained earlier, only “investors who were harmed by the violation” identified in the SEC complaint and included in the calculation of the disgorgement and the civil monetary penalty are eligible for compensation from an SEC distribution fund. The majority of SEC actions are settled and corporate defendants, in particular, bargain over every part of the settlement. They negotiate over what individual violations are included in the enforcement action and how each instance of misconduct is described; they haggle over the emphasis in the press release on whether bad intentions were involved in the misconduct, and about the description of the harm done. As a result, there are often investors who allege that they were harmed by a defendant’s violations not outlined in the complaint who, consequently, cannot be compensated through an SEC distribution fund.

The path that the SEC took to build a successful compensation program may have been uphill. Nevertheless, it has benefitted not only investors who gained another potential source of compensation, but has also expanded the SEC’s ability to pursue all parts of its mission, and in particular enforcement.

IV. How the Focus on Compensation Strengthened SEC Enforcement

The story told thus far highlights administrative agility—something that I have written about previously. The SEC’s distribution program continues to provide evidence that under the right circumstances, federal enforcement programs can adapt quickly, and often more quickly than their private counterparts. This observation deserves highlighting because proposals from academics and attorneys alike have continued to advocate outsourcing core enforcement functions to private attorneys and bounty hunters, when there is no coherent theory and little evidence that privatization is what is needed.

Contrary to concerns expressed twenty years ago that greater focus on compensation would undermine SEC enforcement, the Fair Funds provision has strengthened the SEC’s enforcement program. Enforcement and compensation are codependent: “strengthening the Commission’s enforcement power generally … can lead to greater success in returning funds to defrauded investors.” My argument here is that the obverse it true as well: efforts to return funds to defrauded investors have strengthened the SEC’s enforcement power.

As foreseen by some of the original critics, the Fair Funds provision resulted in stricter enforcement directly: the prospect of distributing monetary penalties to harmed investors (rather than the U.S. Treasury General Fund) has led the SEC to impose larger monetary penalties. Larger penalties and improved collection efforts increased the deterrent bite of SEC enforcement—as a direct consequence of the SEC’s determination to distribute monetary penalties to harmed investors.

But the indirect impact has been more consequential, and surprising. High-quality public enforcement is resource intensive. It requires large and expert staffs, and that is typically expensive. Quality enforcement also requires political independence and freedom from commercial influence, so that the agency can bring consequential cases against financially powerful and politically connected firms, not just nickel-and-dime fraudsters. It takes strong political support to create and maintain an effective enforcement program. Using monetary penalties to compensate victims is popular and builds public support, which, in turn, can be used to build political support for enforcement.

The discussion that follows offers historical evidence of the bipartisan popularity of compensation. It starts by outlining in more detail the circumstances that led to the adoption of the Fair Funds provision. It then pivots to the last decade and shows how the SEC began highlighting its compensation successes to justify efforts to expand its enforcement authority after the U.S. Supreme Court in Kokesh questioned the SEC’s right to require a defendant to disgorge ill-gotten gains. The SEC employed this tactic strategically in litigation briefs, but also politically in Congress, as it sought statutory amendments. Finally, the discussion demonstrates that in doing so, the SEC has followed the footsteps of state securities regulators, who have for decades used popular restitution schemes to secure political support for their enforcement programs.

A. The Adoption of the Fair Funds Provision

The Fair Funds provision was included in the Sarbanes-Oxley Act late and after “scant” debate. It was added to the bill in conference, proposed by two Republican congressmen, Representatives Richard Baker and Michael Oxley. While it seems obvious that the purpose of the Fair Funds provision is to increase the amount of available funds to compensate investors, the provision also expressly makes the point that it is “for the benefit of the victims.” The final Sarbanes-Oxley Act passed with nearly universal support: 423 to 3 in the House and 99 to 0 in the Senate.

In May 2003 and again in 2006, Representative Baker (R-LA) introduced a follow-on bill in the House, which would allow the SEC to distribute civil penalties even in cases where no disgorgement was ordered. Like the Sarbanes-Oxley Act, the new bill had bipartisan support: its five co-sponsors included four Republicans, including Michael Oxley, and David Scott, a Democrat from Georgia. Neither bill became law, but the proposed amendment to the Fair Funds provision was ultimately enacted in the Dodd-Frank Act. The notion of using collected monetary penalties to compensate harmed investors continues to enjoy bipartisan support. In part, that is because when those funds are not distributed to investors, they are remitted to the U.S. Treasury, which neither the SEC nor legislators approve of. But mostly, the idea of compensating harmed investors appeals to notions of basic fairness.

The SEC has been able to leverage these sentiments to reinforce and strengthen its enforcement authority. Because agency compensation is predicated on successful enforcement. Strong enforcement is a prerequisite for an effective compensation program. This idea that the SEC could and would use its compensation authority to expand its enforcement authority is not new. In 2003, the SEC declared that it would “continue to try to develop the law of disgorgement in a manner favoring compensation of investors by pursuing all appropriate theories of disgorgement by wrongdoers.” Similarly, the SEC pushed to increase in the number of asset freezes from 2001 to 2002 by 55 percent, and temporary restraining orders by 50 percent, to facilitate an anticipated distribution to harmed investors. At the time, however, few expected that compensation would be used more directly to advance political arguments to preserve and expand the SEC’s enforcement authority.

B. The Fight for Disgorgement

The SEC used its authority to compensate investors much more explicitly during the recent fight to preserve and expand its right to order defendants to disgorge ill-gotten gains. When established in 1934, the SEC had no statutory authority to order any defendant to pay monetary penalties. In the 1960s, the agency began seeking novel and “exotic” forms of relief, including disgorgement. Finally, the Penny Stock Act of 1990 authorized the SEC to obtain civil penalties in all cases and disgorgement in administrative actions. Because courts “routinely ordered disgorgement” as equitable relief in cases that the SEC filed in court, it did not appear necessary to authorize such equitable relief by statute.

That amorphous origin of the SEC’s disgorgement authority in civil actions left it vulnerable to a constitutional challenge. In 2013 in Gabelli and four years later in Kokesh, the U.S. Supreme Court held that the five-year statute of limitations for SEC monetary penalties runs from the moment of commission, not detection. This presented a problem for the SEC. Whereas private parties can file a lawsuit the moment they learn of the violation and thereby toll the statute of limitations, the due process requirement bars the government from bringing an enforcement action without a prior investigation. Most securities violations are not discovered immediately and the median SEC investigation takes two years. As a consequence, the Gabelli and Kokesh decisions significantly curtailed the SEC’s authority to punish securities fraud.

More ominously, Kokesh also obliquely questioned the SEC’s authority to require a defendant to disgorge ill-gotten profits at all without express statutory authorization, and Liu later tackled that question directly. Departing from its historical insistence that the purpose of disgorgement is to deter, not to compensate, the SEC emphasized in its briefing in Kokesh that “disgorgement in SEC enforcement actions has a significant compensatory aspect.” In the brief that it filed in 2020 in Liu, the SEC was even more explicit: first, it emphasized the fact that during the most recent fiscal year, it distributed $1.7 billion of the total of $1.9 billion in collected monetary penalties to harmed investors. A few pages later, the SEC argued that forbidding courts to order disgorgement in its enforcement actions would harm defrauded investors because it would deprive them of an important source of compensation.

Invoking the fact that the SEC directs most of the monetary penalties it collects to investor compensation was not merely a litigation tactic, deployed to persuade the U.S. Supreme Court. The SEC also used that same fact to persuade Congress to amend securities laws. After Kokesh was decided in 2017, congressional Democrats introduced several bills to authorize disgorgement as a remedy in SEC actions filed in district court and to extend the statute of limitations for disgorgement orders. The SEC leadership testified in multiple hearings in House and Senate committees that oversee the SEC, and tried to persuade Congress to expand the SEC’s enforcement authority. In 2018, Stephanie Avakian, the Co-director of Enforcement, explained that the goals of enforcement are to “detect, deter, and punish wrongdoing and compensate harmed investors.” Her Co-director Peikin was even more explicit. He explained that the Kokesh decision hampered the SEC’s ability to both enforce the law and to compensate investors. In his testimony a month later, SEC Chair Jay Clayton agreed.

Remarkably, during those congressional hearings, representatives from both sides of the aisle, Democrats and Republicans, expressed concern about the SEC’s ability to prosecute violations and to compensate harmed investors. Chairman of the Subcommittee on Capital Markets, Securities, and Investment Bill Huizenga (R-MI) concluded his questioning of the SEC Co-directors of Enforcement by promising to “ensure that bad actors aren’t able to profit from their misbehavior and their fraudulent actions, and then get that remedy back to those investors.” From the other side of the aisle, Senator Warner (D-VA) signaled concerns about “the SEC’s ability to return illegally obtained funds to investors” after the Kokesh decision, while Senator Cortez Masto was worried that Kokesh “made SEC enforcement actions more difficult.” At a congressional hearing a year later, Representative Katie Porter (D-CA) observed that in addition to deterrence, SEC penalties have “an important compensatory and normative purpose,” and concluded that “increasing penalties is very important for compensation for victims.”

Congress amended securities laws in the National Defense Authorization Act for FY 2021, which ultimately became law on January 1, 2021, after Congress overcame President Trump’s veto. The amendments were quite generous to the SEC, and considerably more generous than amendments advocated by Republican witnesses during hearings. The amendments expressly authorizes the SEC to obtain disgorgement in SEC enforcement actions filed in court, it extends the statute of limitations to ten years when the violation was intentional, tolls the statute of limitations while the offender is outside of the United States, and applies these changes retroactively to open cases. Importantly, these expanded enforcement provisions apply to all SEC enforcement actions, not only those where the agency seeks to distribute collected monetary penalties to harmed investors.

Throughout the legislative process, SEC leadership invoked the existence of its successful investor compensation program, and comments by multiple legislators suggest that it was an important factor in their decision to vote for the bill.

C. Lessons from State Securities Regulators

The SEC may have stumbled into this strategy, but politically savvy state securities regulators have long used their universally popular compensation powers to bolster their enforcement program and to safeguard agency independence.

One of the best staffed state securities regulators in the United States, on a per capita basis, is the Alabama Securities Commission—often a surprise to those not in the know. Headed since 1994 by Joseph Borg, the Commission has a well-paid staff of more than sixty. By statute, its director is independent and can only be removed for cause, and the Commission has a stable and secure source of funding: it relies on fees charged investment advisers, and is not dependent on the fickle budgetary process. Its staffing is much larger than neighboring Georgia, which employs a staff of eight, or Texas, with a population six-times larger, which currently employs a staff of seventy-three.

Alabama may not be at the top of public spending charts generally, but savvy leadership empowered its securities regulator. Specifically, the Commission has focused on compensating investors to build political support. In his written response to Congress on the importance of state securities regulators, Director Borg highlighted that in Alabama, “hundreds of millions of dollars have been returned to hard-working Alabamians.” In fiscal year 2021 alone, the Alabama Securities Commission returned more than $14 million in restitution to harmed investors.

Not only does the Alabama Securities Commission focus on compensation, it also provides regular updates on the amounts refunded to harmed investors as a result of its efforts. The Alabama regulator annually tallies the amounts that it has paid out in compensation by ZIP code, and then shares that information with state legislators who represent those ZIP codes—as direct evidence of the value that the Commission generates for their voters. That and other acts of political shrewdness have strengthened political support for the Alabama Securities Commission and bolstered its ability to enforce the law.

V. Compensation as Investor Protection

The SEC cannot perp-walk fraudsters and splash the indictment over the front pages of the national newspapers, like the prosecutors for the Southern District of New York. Compensation is a way to make the SEC more populist and more popular. It is also the appropriate focus for an agency whose two-prong statutory mission includes the public interest and investor protection. Most investors in a typical fraud that the SEC prosecutes have neither the expertise nor the resources to sue for compensation. Importantly, they may not have the law either. Through successive Supreme Court decisions about the implied right of action under Rule 10b-5, private securities litigation has been curtailed to the point where successful actions all look alike: financial misrepresentation by a large public company. For all other frauds, investors may not be able to obtain redress through private actions.

To fully protect investors in the current legal and financial environment, a securities regulator should embrace compensation as a core goal. By doing that, the SEC is on the path to become a complete investor advocate. It is also the politically savvy path to remain one, because enforcement and compensation complement one another. Stronger enforcement can lead to improved success in compensating investors, but the obverse is also true: efforts to compensate can and have strengthened SEC enforcement.

I thank Jim Park, Miriam Baer, Stephen Bainbridge, Alex Lee, and other participants at the UCLA Symposium on the Twentieth Anniversary of the Sarbanes-Oxley Act, the Heyman Colloquium at the Benjamin N. Cardozo School of Law, the BYU Winter Deals Conference, and the Annual Meeting on Law and Society for their thoughtful comments, and Jill Smith for her outstanding research help.