How Does a SEC Investigation Work?

The Securities and Exchange Commission (SEC) is investigating Bally, but as of press time, the SEC hadn't reported its findings, and Paul Toback, Bally CEO, declined to comment on the ongoing investigation. The SEC began investigating Bally after its former CFO resigned in April 2004 and it announced that it planned to change its financial reporting and restate its financial results, raising a number of red flags, said John Maxwell, managing director of fixed income research for Merrill and Lynch.

Donald Langevoort, a law professor at Georgetown University, said financial restatements often trigger regulatory review, but if the SEC discovers fraud, then it will often fine the company and take it to court.

“If a corporation is trying to make its earnings per share look better and the stock go higher, then it's securities fraud,” he said. “The SEC can bring out some very big guns and cause shakeup of the company management and significant financial penalties to the company, the officers and the directors.”

The SEC has the power to seek an officer director bar, which says that the responsible executives are prohibited from serving as the director of a public company ever again. This punishment is reserved for situations of serious fraud rather than bad judgment, Langevoort said.

“The SEC can and will seek to end the careers of people who do serious wrong,” he said.

The SEC commission can also sue suspected wrongdoers, but Langevoort estimated that 95 percent of all the SEC enforcement proceedings are settled rather than litigated.

“The SEC is underresourced and there's not enough accountants and lawyers to try all the cases,” he said. “By settling, the companies are not forced to admit fraud and it gives them ample room to negotiate.”

The amount that any individual or company is fined depends on which tier an entity ends up in — Tier 1 (violation), Tier II (violation with fraud) or Tier III (violation with fraud and investor loss).

If the SEC determines it's just a case of misjudgment, they'll fall into Tier I, but if fraud is involved, they'll ramp up to Tier III, which carries the most severe financial penalties. Langevoort said the fines quadruple from Tier I to Tier III. The SEC often fines a company a few million dollars per violation, which can add up quickly, he said.

“If a company is in Tier III, the SEC will want the fine to hurt badly,” he said. “The more important thing is that it will often already have triggered a class action that will be seeking billions of dollars if there was fraud. The SEC fines will only be the beginning.”