It was recently announced that the SEC has reached a settlement in its lawsuit against Freddie Mac executives Richard Syron, Patricia Cook, and Donald Bisenius.  The basic allegation in the case was that these executives violated Section 17 of the Securities Act and Section 10(b) of the Exchange Act by dramatically understating Freddie Mac’s exposure to subprime mortgages.  The executives falsely claimed that Freddie Mac’s portfolio included $2 to $6 billion of subprime loans, when the true figure was closer to $141 billion to $244 billion.  Freddie Mac’s exposure to subprime loans ultimately caused it to experience dramatic losses, thus harming investors.

The SEC ran into difficulty because there is no accepted definition of “subprime.”  The SEC alleged that investors understood the term to refer to certain loans issued with a high likelihood of default, such as loans with high loan to value and debt to income ratios.  The executives, however, claimed that “subprime” was understood by investors only to refer to loans that were designated as subprime by their originators.

The case has now settled, and, under the terms of the settlement, the executives will make payments to a Fair Funds account for the benefit of investors, in the amounts of $250K, $50K, and $10K, respectively. 

Unusually, this is not your classic “no admit, no deny” settlement.  Instead, it appears to be straight up “no admit,” because after the settlement was reached, Bisenius said that “The dismissal of the case today under these terms vindicates me completely.”

Perhaps even more unusually, the payments are characterized as neither fines nor disgorgements.  Instead, they are described as “donations.”  Meanwhile, the amounts – coincidentally! – were calculated in proportion to the stock and options granted to the defendants during the (alleged) fraud period.

So what gives?

As far as I can tell, the euphemism is because of who’s paying.  The settlement amounts will be paid by insurance (which itself is paid for by Freddie Mac).  D&O insurance tends to exclude coverage for disgorgement and regulatory fines, see Lawrence J. Trautmana & Kara Altenbaumer-Price, D&O Insurance: A Primer, 1 Am. U. Bus. L. Rev. 337 (2011-12); Jon N. Eisenberg, How Much Protection Do Indemnification and D&O Insurance Provide?, and the SEC has taken the position that contracts to indemnify for Securities Act violations are unenforceable as against public policy.  See 17 C.F.R. §229.512. 

But I guess the SEC doesn’t feel too strongly about it, because by characterizing the payments as donations rather than fines or disgorgement, the defendants are able to get the benefit of insurance and avoid paying out of pocket.

Though the SEC’s fair funds statute does contemplate that donations may be included in a fund, see 15 U.S.C. § 7246(b), the settlement is an outlier, by SEC standards.  According to Urska Velikonja’s article, Public Compensation for Private Harm: Evidence from the SEC’s Fair Fund Distributions, 67 Stan. L. Rev. 331 (2015), executives who pay fines and disgorgement to an SEC fair fund typically pay out of pocket – an important feature, if the SEC is to avoid the criticism that fair fund distributions suffer from the same “circularity” problem that plagues private lawsuits. 

Given all of this, one wonders why the SEC even bothered.  If they thought they had a case, they could have just taken it to trial, risks be damned. And if they had doubts about the merits of the case, they should have simply dropped the matter.

One possibility is that the SEC believed its legal case was too weak for trial but that the reimbursement to investors was worth it – after all, circularity criticisms notwithstanding, not all investors are diversified, and some may have suffered losses that they did not make up in gains elsewhere.  But that’s not the motivation here, because the SEC will not establish a new fund to compensate investors for the alleged fraud.  Instead, the defendants’ donations will be added to an existing fair fund that was set up for the SEC’s earlier case against Freddie Mac, brought in 2007, regarding accounting fraud that took place from 1998 through 2002.  Which apparently means that the SEC will not even pretend to distribute the funds to the investors who were harmed by the more recent misconduct. 

(I suspect this is because the SEC believes it lacks authority to establish a fund consisting solely of donations, with no penalties or disgorgements.)

In any event, $310K is a rather paltry sum if investor compensation was the goal; according to the parallel private lawsuit (dismissed on the pleadings, see Ohio Pub. Emples. Ret. Sys. v. Fed. Home Loan Mortg. Corp., 2014 U.S. Dist. LEXIS 155375 (N.D. Ohio Oct. 31, 2014)), Freddie Mac’s misrepresentation of its subprime exposure resulted in over $6 billion in losses to shareholders.

So the point is, if paid by insurance, the amounts aren’t large enough to deter, and as it stands, they are facially not even intended to compensate.  Instead, the settlement seems an exercise in face-saving – the SEC believed it had a weak legal case (though possibly a strong moral one) but didn’t want to exit the field with nothing at all.  The whole adventure thus raises the question whether face-saving payments are appropriate for regulators to collect (as well as the question whether much face-saving was actually accomplished).