Although the SEC has created 236 fair funds, there is one that hogged all of the attention: the WorldCom fair fund. WorldCom filed for bankruptcy protection soon after it revealed a massive accounting fraud back in 2002. The SEC fined the company $2.25 billion and collected, as an unsecured creditor, $750 million from the bankruptcy estate. It then distributed that amount to harmed shareholders through a fair fund. In effect, WorldCom's unsecured creditors ended up compensating its shareholders, turning bankruptcy priority upside down. 

How could this happen? The Bankruptcy Code subordinates shareholders' claims for damages related to securities fraud to claims by the debtor's unsecured creditors. Because bankrupt firms are, by definition, insolvent, the Code effectively precludes equity holders with securities fraud claims from collecting anything from the bankrupt company. As a result, securities class actions against bankrupt companies are ordinarily dismissed. The automatic stay does not preclude the SEC from pursuing an enforcement action agains the bankrupt firm, but stops the SEC from collecting any money judgment. The SEC's claim for civil fine and disgorgement is treated as an unsecured creditor claim and is distributed pro rata, along with other unsecured creditors. However, the Bankruptcy Code does not preclude the SEC from distributing monetary sanctions collected from the bankrupt company to defrauded shareholders. The ultimate result is that unsecured creditors recover less in bankruptcy, while shareholders receive more than they would without the fair fund provision.

This result upset many, in particular since bankruptcy filings are not uncommon among companies subject to enforcement proceedings for securities violations. But as it turns out, WorldCom is the exception, not the rule for fair fund distributions. 31 companies that were primary defendants in my fair funds study filed for bankruptcy within 2 years of the SEC's enforcement action. Of those, 16 were in accounting fraud cases where priority conflicts between creditors and shareholders are particularly likely (others were unregistered offerings of securities, where defrauded investors are the creditors). The SEC imposed a monetary penalty against the company and distributed it to defrauded shareholders through a fair fund in only 2 such cases: WorldCom and Nortel Networks. All other bankrupt companies either paid nothing to settle with the SEC or the SEC did not even initiate an enforcement action against them. Nortel paid $35 million to the SEC 14 months before it filed for bankruptcy. While its payment may have reduced unsecured creditors' ultimate recoveries, it did so far less directly than in WorldCom. 

Instead of targeting companies, the SEC targeted individual defendants, auditors and investment banks when the primary defendant was bankrupt. It collected $280 million from individuals and $492 million from secondary defendants, and distributed these amounts to shareholders through a fair fund. While the WorldCom fair fund cast a dark shadow over the SEC's distribution efforts, it is the exception, not the rule. It also demonstrates the relative flexibility of public securities enforcement compared with private securities litigation. 

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