Public Compensation for Private Harm: SEC’s Fair Fund Distribution

The following post comes to us from Urska Velikonja of Emory University School of Law.

The SEC’s success is conventionally measured by the number of enforcement actions it brings, the multimillion-dollar fines it secures, and the high-impact trials it wins. But the SEC does more than punish wrongdoing. Over the last twelve years, the SEC has quietly become an important source of compensation for defrauded investors. Since 2002, the SEC has distributed $14.33 billion [1] to defrauded investors via 236 distribution funds, usually called “fair funds” after the statute that authorizes them. [2]

Despite the SEC’s enthusiasm for the fair funds provision, the SEC’s compensation efforts have often been derided as a trivial supplement to private securities litigation and a waste of resources on duplicative cases. My paper, Public Compensation for Private Harm: Evidence from the SEC’s Fair Fund Distributions, forthcoming in the Stanford Law Review, is the first comprehensive empirical assessment of the SEC’s compensation efforts.

Firstly, the study reports the SEC distributes a surprisingly large amount of money to harmed investors through fair funds. While aggregate fair fund distributions are smaller than damages in securities class actions—$14 billion compared with $60 billion over the same period (2003–2012)—they are larger than previously thought. Additionally, the average fair fund is similar in size to the average class action settlement.

Secondly, public and private securities actions do not compensate investors for the same misconduct. Accounting fraud cases dominate private securities litigation: they constitute 60% of settlements, and 90% of settlement dollars. [3] By contrast, a large majority of fair funds compensate defrauded investors for what can best be described as consumer fraud or anticompetitive behavior by financial intermediaries. For example, fair funds have compensated the victims of interest rate fixing, undisclosed fees and false advertising, collusive arrangements between investment funds and broker-dealers, mutual fund market timing and late trading, pump-and-dump and other market manipulation schemes.

Fair Funds by SEC Classification (2002-2013)

SEC Classification Number of Funds (n=236) Total Amount in Fair Funds (in $M) Median Fund (in $M) Mean Fund (in $M) % of Fair Funds (by number) % of Enforcement Actions [4] (by number)
Broker Dealer 49 2,152.8 19.10 43.93 20.8 17.2
Insider Trading 15 100.9 2.62 6.73 6.4 8.5
Investment Adviser/Company 62 3,868.3 21.58 62.39 26.3 16.6
Issuer Reporting and Disclosure 70 6,322.5 23.83 90.32 29.7 25.8
Market Manipulation 9 25.7 1.35 2.85 3.8 6.5
Securities Offering 21 1,451.4 4.87 69.11 8.9 16.8
Municipal 7 240.2 34.32 31.48 3.0 n/a
Total 236 14,330.1 16.96 60.72 n/a n/a

As measured by compensation, there are two types of securities violations: accounting fraud cases, and all other securities violations. Almost all fair funds in accounting fraud cases are accompanied by private litigation. The SECs fair fund distributions represent a small share of investor recoveries, 15.5%. In all other securities cases, private litigation is usually unavailable or impractical. In 71.3% of fair fund distributions (excluding accounting frauds), defrauded investors received no compensation from private litigation. In the aggregate, investors harmed by financial intermediary misconduct recovered at least 80% of aggregate compensation from fair fund distributions. Public compensation, in large part, substitutes private litigation where private lawsuits do not serve their compensatory role.

Distribution of Parallel Class Action Settlements (2003-2013)

Filed Class Actions in FF Cases Successful Class Action in FF Cases Aggregate Class Action Recoveries (in $M) Fair Fund Distribution as % of Total Recovery
Broker Dealer 34 of 47 16 of 47 492.5 81.4
Insider Trading 2 of 15 0 of 15 0 100
Investment Adviser 32 of 61 19 of 61 409.1 90.4
Issuer Reporting and Disclosure 68 of 69 59 of 69 35,422.3 15.5
Market Manipulation 2 of 9 1 of 9 0.8 96.7
Municipal Securities 2 of 6 1 of 6 45.2 84.2
Securities Offering 7 of 19 4 of 19 416.4 77.7

Thirdly, the study reports that individual and secondary defendants contribute to fair fund distributions much more often than they pay damages to settle private securities litigation. Individual defendants are sanctioned in 67.8% of fair fund cases and contribute to the fair fund in 59.7% of cases, comprising 9.2% of the aggregate amount distributed through fair funds. Individuals are particularly likely to contribute in market manipulation, insider trading, and accounting fraud cases. Note that D&O insurance and indemnification generally do not cover civil penalties and disgorgement orders, so individuals’ contributions are usually out-of-pocket.

The securities enforcement literature generally concludes that compensation for securities violations is circular and thus futile. This study shows that investor compensation, at least as practiced by the SEC, is both possible and desirable. The fact that individuals pay monetary sanctions that are distributed to harmed investors eliminates circularity with respect to their share of compensation. Moreover, where the firm pays to settle an enforcement action for a securities violation from which it profited (e.g., broker dealer, investment adviser, market manipulation, securities offering and municipal securities cases), the sanction prevents the wrongdoing firm and its shareholders from profiting from misconduct. As the Supreme Court continues to limit the availability of private class actions for securities fraud, public compensation may increase in importance. If the SEC’s enforcement resources increase, investors may see no net loss in compensation.

The full article is available for download here.


[1] Unless otherwise specified, all figures are in 2013 dollars.
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[2] The Federal Account for Investor Restitution (FAIR) Fund Act is included in section 308 of the Sarbanes–Oxley Act of 2002. 15 U.S.C. § 7246. Section 929B of the Dodd-Frank Act amended the original provision. The SEC compensates investors in a variety of ways, not just through fair funds, though fair fund distributions are the largest public source of investor compensation. Other ways in which the SEC compensates investors include disgorgement funds, receiverships, coordinated prosecutions, and clawback actions.
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[3] See Cornerstone Research, Accounting Class Action Filings and Settlements: 2011 Review and Analysis 1, 11–12 (2012).
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[4] The percentage is calculated using an annual percentage of cases over a 10–year period, excluding delinquent filing enforcement actions and FCPA cases.
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