The first half of 2017 was unusually quiet for the SEC’s Division of Enforcement. This undoubtedly stemmed from the change in administration following the November election. With Chair Mary Jo White and various other members of the agency’s senior leadership (including the Director of the Division of Enforcement) stepping down, and only two sitting Commissioners for much of the period, authorization of new cases slowed somewhat.
Pending the Senate’s confirmation of the new Chair in May, the SEC generally avoided novel or controversial matters. In contrast to recent years, there were no groundbreaking cases involving private investment funds (and, indeed, few investment adviser cases, period) or headline-generating sweeping enforcement initiatives. On the other hand, the trend towards a growing number of public company financial reporting cases continued unabated, though such cases remained on the smaller side. Insider trading cases likewise continued apace. But much of the action was in the realm of non-controversial retail fraud—Ponzi schemes, penny stock pump and dump schemes, and so forth.
However, by May the Commission was again firing on all cylinders—or at least most cylinders, as two of the five Commission seats remain vacant (for what is now going on two years). What remains to be seen is how much the new Chair and new Enforcement leadership team will reshape enforcement practices and priorities.
I. Significant Developments
A. New Leadership; New Directions?
On May 2, 2017, the Senate confirmed Jay Clayton as the new Chair of the SEC. Clayton joined the agency from private practice, where he had spent most of his career as a big-law corporate attorney specializing in mergers & acquisitions and capital markets work. While he has written critically about Foreign Corrupt Practices Act (FCPA) enforcement, his views on other enforcement-related issues remain largely unknown. However, it may be telling that the SEC press release announcing his swearing-in led with his statement, “The work of the SEC is fundamental to growing the economy, creating jobs, and providing investors and entrepreneurs with a share of the American Dream.” Contrast this with the far more enforcement-oriented swearing-in statement from his predecessor, Chair White: “Our markets are the envy of the world precisely because of the SEC’s work effectively regulating the markets, requiring comprehensive disclosure, and vigorously enforcing the securities laws.”
Chairman Clayton’s public statements to date have focused more on issues of capital formation than enforcement. In his first public speech as Chairman, his discussion of enforcement identified as a priority the protection of “Main Street” investors from perpetrators of affinity, microcap and pump and dump frauds. The Chairman also noted the importance of maintaining market integrity and efficiency through oversight of professional market participants. With respect to cybersecurity, the Chairman sounded a note of restraint, expressing the need for the SEC to be cautious about punishing companies who are the victims of cyber attacks.
In June, Clayton appointed his law firm partner Steven Peiken as Co-Director of the Enforcement Division, where he will join Stephanie Avakian, who had served as Deputy Director under prior Division Director Andrew Ceresney. Avakian’s retention as Co-Director suggests some continuity, though Peiken’s impact on enforcement is not easily susceptible to prediction. While, like Clayton, he joins the agency from the defense bar, he had also spent eight years as an Assistant U.S. Attorney in the Southern District of New York (an experience he shares with Ceresney).
Of course, most of the work of the Enforcement Division is relatively non-controversial; whether to sue crooked stock promoters, insider traders, or corporate officials who falsify financial statements is not a matter of political ideology. The real question is the extent to which the new administration will pursue some of the more aggressive enforcement practices of the prior administration, including:
- Demanding admissions of wrongdoing from selected defendants as a condition of settlement;
- Far-reaching “sweeps” against multiple parties for technical, non-fraud securities law violations;
- Significant monetary penalties from public companies in corporate misconduct cases;
- Expansive fee and expense disclosure requirements for private fund managers;
- Broad use of in-house administrative proceedings in lieu of federal court trials; and
- Enhanced whistleblower protection, including continuing crackdown on routine corporate confidentiality agreements.
In their initial weeks in office, neither Avakian or Peiken have given any speeches providing insight into their priorities. In their lone joint interview upon their appointment, Avakian and Peiken heralded cybersecurity as a major enforcement priority for the Division. They noted an uptick in the number of SEC investigations involving cyber crime in recent years, leading the agency to start collecting relevant statistics to detect broader market-wide issues. Among other things, the Division is looking at individuals stealing information for the purpose of insider trading or hacking into accounts to steal assets, place unauthorized trades, or manipulate markets. But the interview made no reference to broader Enforcement priorities or potential changes to SEC practices.
Indeed, the most significant practical change in Enforcement tactics was made prior to the new Chair’s appointment, under Acting Chair Michael Piwowar. According to news reports, Piwowar revoked the authority that had been delegated to senior Enforcement Division officials nationwide to issue formal orders of investigation, which had allowed for more expedited issuance of subpoenas requiring witnesses to testify under oath and produce documents to the SEC staff. This procedural change reverses then-Chair Mary Schapiro’s 2009 decision to give more investigative authority to senior enforcement attorneys in response to the financial crisis. Now, only the Co-Directors of Enforcement can authorize formal orders on behalf of the Commission. This may be a first step towards eliminating delegated authority entirely and returning to the pre-2009 procedures, under which the SEC Commissioners themselves would need to approve all formal investigations. While the Commissioners rarely if ever rejected formal order requests in the past, this change would certainly slow investigations and provide the Commissioners with greater oversight of the Enforcement Division’s investigative docket.
Ultimately, the pace and scope of the Enforcement Division’s work may be driven less by policy changes than by budgetary ones. Chairman Clayton (and the Administration) have proposed a 2018 budget of $1.6 billion—essentially unchanged from 2016 and 2017. The proposed budget would reduce the size of the Enforcement Division staff by a few dozen, which could impact the number of new investigations pursued by the Division. By contrast, prior to leaving the SEC, former Chair White had proposed a preliminary fiscal increase for 2018 of $445 million over the agency’s request for 2017. Under the current budget proposal, the Division of Enforcement is facing a $10 million decrease from 2017. That said, the SEC’s budget has essentially doubled over the past decade, and the agency is certainly better situated than other federal agencies facing massive proposed cuts under the new Administration.
The SEC continued to roll out multi-million dollar whistleblower awards throughout the first six months of the year, including:
- On January 6, the SEC announced an award of more than $5.5 million to a company employee who provided “critical” information that allowed the SEC to uncover the employer’s ongoing scheme.
- On January 23, the SEC rewarded three whistleblowers for their assistance in the agency’s successful prosecution of an investment scheme by giving $4 million to the whistleblower responsible for the SEC opening its investigation, and splitting $3 million between two additional whistleblowers who contributed new information during the investigation.
- On April 25, the SEC disclosed an award of nearly $4 million to a whistleblower who gave the agency “detailed and specific information about serious misconduct,” then assisted during the investigation itself by offering their industry expertise.
- And on May 2, the SEC authorized more than $500,000 to a company insider whose information revealed hard-to-detect securities laws violations.
The SEC also continued its crackdown on corporate confidentiality agreements perceived as impeding potential whistleblowers from coming forward. The SEC brought a pair of settled actions involving severance agreements which removed the financial incentives for blowing the whistle. In a settled cease-and-desist order, the SEC criticized a financial services firm for “directly target[ing] the SEC’s whistleblower program” by including provisions in its separation agreements that forced departing employees to waive “any right to recovery of incentives for reporting of misconduct” before the employees could receive separation payments from the company. The firm agreed to pay a $340,000 penalty, in addition to taking other remedial actions.
Two days later, the SEC announced another settled action against a company that had allegedly taken actions that could potentially discourage whistleblowers. First, the company’s severance agreements included provisions that waived a departing employee’s entitlement to monetary rewards for reporting issues to government entities. Second, according to the SEC, the company took steps to identify an employee whistleblower it assumed existed after the SEC requested the company produce documents related to certain accounting issues. Without admitting any wrongdoing, the company agreed to pay a $500,000 penalty to settle the case (including the part of the case arising out of the underlying accounting issues).
Recent weeks also saw a significant legal development involving whistleblower retaliation. In June, the Supreme Court granted cert in a case expected to resolve a circuit split among the Second, Fifth and Ninth Circuits as to whether Dodd-Frank’s anti-retaliation provision for “whistleblowers” extends to internal whistleblowers—that is, those who have not reported the alleged misconduct to the SEC. Digital Realty Trust Inc. v. Paul Somers arose from claims by a former executive that the company terminated him after he had complained to senior management about an executive who had eliminated certain internal company controls. The district court denied the company’s motion to dismiss the complaint, and a divided Ninth Circuit upheld the decision on the grounds the anti-retaliation provision in Dodd-Frank protected “unambiguously and expressly” internal whistleblowers, as well as those reporting to the SEC. The decision is at odds with a Fifth Circuit panel that said only those who report to the SEC are protected under the provision.
C. Administrative Proceedings
Throughout the past administration, the SEC’s increasing use of its administrative forum for litigated enforcement actions—and the subsequent reversal of this trend—was a consistent theme of our posts. The phenomenon led to constitutional challenges to SEC administrative proceedings, and one issue—the manner in which the SEC appoints its administrative law judges—now appears likely to be headed to the Supreme Court.
In late 2016, the Tenth Circuit Court of Appeals, in Bandimere v. SEC, held that these appointments violated the Appointments Clause of the U.S. Constitution. In May, the Tenth Circuit denied the SEC’s petition for an en banc rehearing. Two weeks later, the SEC stayed all administrative proceedings assigned to an administrative law judge in which a respondent has the option to seek review in the Tenth Circuit (with certain exceptions). The stay went into effect immediately and will remain in effect until the expiration of the government’s deadline to file a petition for a writ of certiorari in Bandimere, the resolution of any such petition and any decision issued by the Supreme Court in Bandimere, or further order of the SEC.
In contrast to Bandimere, the D.C. Circuit Court of Appeals had come to the opposite conclusion in August 2016, upholding the constitutionality of the SEC’s administrative law judge appointments in Lucia v. SEC. On June 26, 2017, the D.C. Circuit divided evenly on the respondent’s en banc rehearing petition; as a result, the original panel decision remains in place, leaving a split between the D.C. and Tenth Circuits that may be heading toward the Supreme Court for resolution.
Amidst the judicial challenges to SEC administrative proceedings, as well as questions being asked about the overall fairness of such proceedings, the Division of Enforcement appears to have shifted back towards pursuing more litigation in federal court. According to one report, SEC administrative law judges issued only eight initial decisions in the first quarter of 2017—half as many as in the first quarter of 2016.
D. Other Significant Court Rulings
On June 5, 2017, the Supreme Court issued a significant decision applying a five-year statute of limitations to SEC claims for disgorgement. In Kokesh v. SEC, the Court unanimously held that “[d]isgorgement in the securities-enforcement context is a ‘penalty’ within the meaning of” 28 U.S.C. § 2462, and thus SEC enforcement actions seeking disgorgement “must be commenced within five years of the date the claim accrues.” The ruling follows the Court’s earlier unanimous decision applying § 2462’s five-year limitations period to SEC claims for civil money penalties.
The Court’s unanimous decision terminates the SEC’s longstanding practice of seeking disgorgement based on conduct that occurred more than five years before filing. No less significantly, the Court’s broad reasoning in Kokesh would appear on its face to apply equally to SEC claims for other relief that may operate as a penalty—such as associational or practice bars and injunctions—which the SEC has historically contended are not subject to the statute of limitations (with mixed results in the lower courts). However, in a decision shortly after Kokesh came down, the Eighth Circuit Court of Appeals concluded that an “obey the law injunction” did not constitute a penalty subject to the five-year statute of limitations. In Collyard v. SEC, the court acknowledged Kokesh‘s broad language, but while contending it did not need to resolve the issue, concluded that the injunction was purely remedial and not punitive and thus outside the scope of § 2462.
E. Potential Legislation
On June 8, 2017, the Republicans in the U.S. House of Representatives passed H.R. 10, the “Financial CHOICE Act,” which would repeal a number of reforms established by the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act. While much of the attention on the legislation has focused on its impact on Dodd-Frank’s banking regulations, the bill also has a number of provisions aimed at SEC enforcement practices. Although the CHOICE Act is not expected to pass the U.S. Senate, the bill reveals which current SEC enforcement policies and tactics may subject to scrutiny under a Republican-controlled Congress and administration.
For example, the Act targets the Enforcement Division’s use of administrative proceedings rather than federal court for litigated actions, as referenced above. Currently, the SEC has the discretion to choose whether to pursue an enforcement action in federal court or in an administrative proceeding (AP); the CHOICE Act effectively eliminates this discretion by permitting AP respondents to petition the SEC to file the case in federal court instead. In addition, for those respondents who choose to litigate in the administrative forum, the legislation would require the Enforcement Division to prove its case through clear and convincing evidence, rather than the lower preponderance of the evidence standard currently applicable in federal court and APs.
The CHOICE Act also includes several other provisions aimed at providing greater oversight of SEC investigations and enforcement actions, including:
- Requiring additional economic analysis before monetary penalties can be imposed on public companies, and curtailing other sanctions, including officer and director bars;
- Giving the recipient of a Wells notice—the indication from the Enforcement staff of its intention to recommend that the Commission authorize an enforcement action—the right to make an in-person presentation to the SEC staff, and permitting the Commissioners themselves to attend such a presentation if they choose;
- Prohibiting the SEC from bringing an enforcement action absent specific guidance that the conduct in question violated the federal securities laws; and
- Appointing an “Enforcement Ombudsman” for persons under investigation by the SEC.
II. Public Company Reporting and Accounting Cases
A. Revenue Recognition Cases
For anyone who thought revenue recognition-related fraud was a thing of the past, 2017 provided a rude awakening, with a significant number of accounting fraud cases involving efforts to prematurely record revenue or otherwise artificially boost revenue through financial tricks.
In January, the SEC instituted settled proceedings against a Texas-based medical device company alleged to have improperly recorded revenue for contingent transactions and for sales subject to significantly extended payment terms. According to the SEC, the misconduct was widespread and continued for several years. The SEC simultaneously accused the company of violating the Foreign Corrupt Practices Act. The company agreed to admit wrongdoing (despite receiving credit for its cooperation) and to pay over $14 million in disgorgement and penalties (of which $8.25 million was attributed to the accounting issues). In related settlements, a former accounting executive agreed to pay a $20,000 penalty and to be suspended from appearing before the SEC as an accountant for two years, and two former sales executives agreed to pay penalties of $40,000 and $25,000. The company’s former CFO agreed to reimburse the company for bonuses he received during the period when the company committed accounting violations and to pay a $35,000 penalty. The CEO, who was not charged with wrongdoing, already had reimbursed the company for cash bonuses and stock awards during the period in question and thus the SEC did not seek a clawback.
Also in January, the SEC instituted settled proceedings against a government contractor for its failure to maintain proper internal controls related to revenue recognition. According to the SEC, the company improperly recorded millions of dollars in revenue by creating invoices associated with unresolved claims against the U.S. Army that were never paid, and whose payment was still known to be in dispute. The SEC noted that personnel alerted internal audit of the issue by filing an ethics complaint, but internal audit failed to uncover the improper billing due to a failure to understand the complicated billing procedures. Without admitting wrongdoing, the company agreed to pay a $1.6 million penalty. The SEC subsequently pursued charges against two company executives; a division president agreed to pay a $25,000 penalty, while a vice president is litigating against the agency.
In February, the SEC filed a litigated case against the former CFO and director of accounting of a California-based computer network testing company, while simultaneously settling with the company and CEO. The SEC alleged that the company artificially divided revenue from software sales and related training and professional services in order to accelerate revenue recognition. Without admitting or denying the allegations, the company agreed to pay a $750,000 penalty, and the CEO agreed to a five-year officer-and-director bar and a $100,000 penalty. In its ongoing litigation against the CFO and director of accounting, the SEC alleges that the executives enabled and implemented the policy and then concealed the practice from auditors.
The SEC announced a settlement in March with the former CFO of a Colorado-based environmental solutions company, alleging that he oversaw the inaccurate recording of multiple transactions, including prematurely recognizing revenue on long term contracts as well as failing to record a significant loss contingency in connection with an adverse arbitration ruling and failing to properly account for warranty accruals. The CFO agreed pay disgorgement and penalties totaling almost $250,000 and to be barred from serving as an officer or director of a public company or appearing before the SEC as an accountant for five years. Without admitting the allegations, the company agreed to pay a $500,000 penalty.
Also in March, the SEC alleged that one of Mexico’s largest homebuilders, a NYSE-listed company, overstated revenue by about $3.3 billion by reporting fake sales of homes for a more than three-year period. According to its press release announcing the action, the SEC used satellite imagery to demonstrate that the company had not even broken ground on many homes for which it had reported revenues, and asserted that the company’s financial results were “almost completely made up.” Without admitting or denying allegations, the company agreed to be prohibited from offering securities in U.S. markets for at least five years.
In May, the SEC instituted settled proceedings against a South Korean semiconductor manufacturer and its former CFO for allegedly inflating revenue through incomplete shipments, and managing earnings through improper round-trip transactions and delayed booking of obsolete inventory. Without admitting wrongdoing, the company agreed to pay a $3 million penalty, and the CFO agreed to pay a $135,000 penalty and to be barred from serving as an officer or director or from appearing as an accountant before the SEC.
B. Earnings Management and Other Financial Fraud
The SEC also brought a number of cases alleging various earnings irregularities. In January, following an earlier settlement with a Kentucky wire and cable company, the SEC charged the former CEO and CFO of a foreign division with fraudulently concealing inventory accounting errors from executive management. The complaint alleged that, in addition to concealing tens of millions of dollars of missing inventory, these executives directed subordinates to destroy documents and conceal accounting problems in furtherance of the fraud. A former senior vice president separately agreed to cooperate with the SEC’s investigation and to settle the charges against him.
Also in January, the SEC charged a shipping conglomerate and its former CFO with inflating earnings by failing to recognize hundreds of millions of dollars in tax liabilities. According to the SEC, the company had accumulated $512 million in unrecorded tax liabilities over a 12 year period. Without admitting the allegations, the company agreed to pay a penalty of $5 million, and the former CFO agreed to pay a $75,000 penalty.
In late June, the SEC filed a complaint against an oil and gas company and its top finance executives alleging an extensive, multi-year accounting fraud. Multiple top executives, including the former CFO, allegedly moved hundreds of millions of dollars in expenses to capital expenditure accounts to artificially reduce operating costs. The former operations controller is cooperating with the SEC and has agreed to settle with a permanent injunction, suspension, and officer-and-director bar. The SEC’s litigation against the other executives—the former CFO and former vice president of accounting and reporting—is ongoing. The SEC also noted that two former CEOs, who were not charged, had already reimbursed the company for bonuses and stock awards and thus no clawback proceedings were necessary.
Also in June, the SEC charged two executives from a Chicago-area information technology company with siphoning millions of dollars out of the company through an accounting fraud scheme. The company agreed to settle the case subject to terms to be set by the court, while the former CEO and CFO face both the SEC action as well as related criminal charges filed by the U.S. Attorney’s Office. And in another litigated action filed in June, the SEC charged a Las Vegas-based hemp oil company and its CEO with overstating the company’s assets by reporting the purchase of another company at a highly inflated value.
C. Internal Controls and Disclosures
In January, the SEC instituted settled proceedings against a U.S. automobile manufacturer for its alleged failure to properly assess the potential impact of a defective ignition switch. According to the SEC, as a result of the company’s deficient internal controls, an internal investigation into the defective switches proceeded for 18 months without notifying accountants at the company of a possible recall, preventing the company from properly evaluating potential losses from such a recall. Without admitting the allegations, the company agreed to pay a $1 million penalty.
Also in January, the SEC instituted settled proceedings against a New-York based marketing company for improper disclosures of a non-GAAP financial measure as well as failures to disclose certain perks enjoyed by its then-CEO. The company presented a metric called “organic revenue growth” that measured revenue absent the effects of two reconciling items. However, without informing investors, the company added a third reconciling item into its calculation, which inflated organic revenue growth results. The company also failed to give GAAP measures equal or greater prominence than related non-GAAP metrics in its earnings releases. Finally, the SEC alleged that the company had disclosed an annual perquisite allowance of $500,000 for its CEO, but failed to disclose additional personal benefits including the company paying for private aircraft usage, club memberships, cosmetic surgery, and other personal expenses. The CEO resigned and returned over $11 million to the company. Without admitting or denying the allegations, the company agreed to pay a $1.5 million penalty to settle the case. The SEC subsequently settled with the CEO for $5.5 million in disgorgement and penalties and a five-year officer and director bar.
In June, the SEC instituted settled non-fraud proceedings against the former CEO and CFO of a Southern California freight forwarding and logistics company (subsequently acquired by a Danish entity) for failing to include adequate information in the company’s MD&A regarding the company’s liquidity and future prospects. According to the SEC, the company’s internal operating system was causing late invoices and delayed payments, but the company failed to report the cause of its cash flow problems. The two former officers agreed to pay penalties of $40,000 each.
D. Corporate Control Cases
In addition to more traditional accounting cases, the SEC also pursued a number of cases against public companies for issues arising out of changes in corporate control. In January, the SEC announced that a subsidiary of a large Ireland-based drug manufacturer agreed to admit securities law violations and pay a $15 million penalty for disclosure failures in the wake of a hostile takeover bid. The company received a tender offer in June 2014, in response to which it filed a Schedule 14D-9 with the SEC stating that the offer was inadequate and that the company was not undertaking or engaged in negotiations that could result in an “extraordinary transaction.” However, after this disclosure, the company engaged in negotiations with other potential bidders, culminating in a November 2014 merger announcement. The SEC alleged that the company failed to amend its earlier filing even though material changes had occurred.
On Valentine’s Day, the SEC announced a pair of cases also involving disclosures during battles for corporate control. In one case, the SEC alleged that a Texas-based oil refinery company had failed to adequately disclose the material terms of its “success fee” arrangements worth $36 million with two investment banks it retained to fend off a hostile takeover bid. The SEC alleged that the company did not adequately inform shareholders of potential conflicts of interest that stemmed from the fee arrangements—namely that the banks could still earn success fees even if the hostile bidder secured control. The company settled the case without admitting the allegations and avoided a penalty because of its remedial acts and extensive cooperation with the SEC’s investigation. In the other case, the SEC alleged that groups of activist investors failed to adequately disclose information during a series of campaigns to exert influence over public microcap companies. According to the SEC, the investors (including individuals and fund managers) collectively owned more than five percent—and sometimes more than ten percent—of the companies’ outstanding common stock, yet their disclosures of ownership percentages required by Sections 13(d) and 13(g) of the Exchange Act were either incomplete, untimely, or absent. Without admitting the SEC’s allegations, the investors consented to penalties ranging from $30,000 to $180,000.
E. Auditor Cases
In contrast to past years, the SEC brought relatively few cases against auditors, and the few cases it did pursue involved smaller firms auditing primarily brokers and advisers, rather than public companies. However, the Enforcement Division’s focus on accounting fraud investigations would make this appear to be more of an anomaly than a trend.
In May, the SEC instituted a settled proceeding against the engagement partner of an accounting firm for his audit of an oil and gas investment fund. The SEC alleged that the partner failed to adequately plan the audit, which resulted in certain deficiencies in auditing the fair value of the fund’s assets, and failed to adequately supervise the audit team. Without admitting the allegations, the partner agreed to a two-year bar from appearing before the SEC.
And in June, the SEC instituted settled proceedings against an auditor based on his failure to obtain engagement quality reviews for his audits of multiple broker-dealer clients, as well as auditor independence deficiencies. The auditor and his firm agreed to be barred from appearing before the SEC for seven years and to pay a $35,000 penalty.
III. Investment Advisers and Funds
A. Conflicts of Interest
In January, the SEC instituted settled proceedings against the principal of a Connecticut-based investment adviser and broker-dealer for an undisclosed referral fee arrangement. The SEC alleged that the principal had paid a lawyer to refer a wealthy client, and then failed to disclose the solicitation arrangement and the resulting conflict of interest to the client. According to the SEC, the adviser also made false statements to clients regarding the SEC investigation, and misled the SEC staff during the course of their investigation. Having admitted to both the facts set forth in the Order and that his conduct violated the federal securities laws, the principal agreed to pay disgorgement and penalties of $550,000 and to be barred both from the industry and from practicing or appearing before the Commission as an attorney. The US Attorney brought criminal charges against the principal for his alleged obstruction. The SEC also instituted settled proceedings against the attorney who had referred the client for submitting false legal invoices to conceal the referral payments. Without admitting or denying the allegations, the attorney agreed to pay disgorgement and penalties of nearly $90,000 and to be barred both from the industry and from practicing or appearing before the Commission as an attorney.
Also in January, the SEC announced that a Massachusetts-based investment adviser agreed to be barred from the securities industry for engaging in an illegal cherry-picking scheme, allocating profitable trades to his own account and unprofitable trades to the accounts of his clients. The SEC alleged that the scheme affected at least 30 clients and resulted in approximately $1.3 million in losses to those clients. The SEC used the case to emphasize in its press release that the misconduct was uncovered through data analysis used to detect suspicious trading patterns. The US Attorney’s Office for the District of Massachusetts filed criminal charges against the adviser based on the same conduct.
In April, the SEC filed a litigated case against a Massachusetts-based portfolio manager for conducting a matched-trades scheme, through which he prearranged the purchase or sale of call options between his own accounts and the brokerage accounts of his client fund. The SEC’s complaint alleges that, as a result of trades that were advantageous to the portfolio manager and disadvantageous to the fund, the manager diverted at least $1.95 million to his personal account. The SEC’s complaint seeks disgorgement, civil penalties, and injunctive relief.
B. Client Overcharges
In the first half of 2017, the SEC brought multiple cases relating to alleged over-billing by investment advisers. In January, the SEC alleged that a large financial services firm had failed to adopt and implement policies designed to ensure that clients were billed in accordance with their advisory agreements—and inadvertently overcharged certain accounts as a result. The SEC also alleged that the firm violated the Custody Rule by not ensuring that surprise examinations by independent public accountants were properly conducted and violated additional Advisers Act rules by not properly preserving client contracts. Without admitting or denying the SEC’s findings, the firm agreed to pay a $13 million civil penalty. The Commission noted that the settlement was based in part on remedial acts undertaken by the firm.
And in a second January case based on similar allegations, the SEC alleged that faulty procedures at a large financial services firm led the firm to overcharge certain accounts by failing to confirm the accuracy of billing rates entered into its computer system. This firm was also alleged to have failed to properly preserve client contracts. In addition to certain remedial undertakings, the firm agreed to pay over $18 million in disgorgement and penalties.
In May, the SEC brought yet another case against a large financial institution for alleged billing issues. According to the SEC, some client accounts paid excess fees due to miscalculations and billing errors by the firm, while other accounts were overcharged because the firm failed to provide due diligence and monitoring services that it represented to clients (including in the brochures the firm attached to its Form ADV) that it was providing. The SEC further alleged that the firm collected excess fees by selling certain customers more expensive mutual fund share classes when less expensive share classes were available and did not disclose the conflict of interest inherent in those recommendations. Without admitting or denying the SEC’s allegations, the firm agreed to pay disgorgement and penalties of more than $97 million. The SEC indicated that this settlement was based in part on the firm’s remedial undertakings.
C. Other Compliance Issues
The SEC initiated settled administrative proceedings against a large financial services firm in February stemming from its sale of single-inverse exchange-traded funds (ETFs). The SEC alleged that the firm failed to follow compliance policies designed to ensure that clients and financial advisers were aware of the risks associated with those products. The firm admitted wrongdoing and agreed to pay an $8 million penalty.
The SEC also pursued a pair of enforcement actions stemming from noncompliance with Rule 12b-1 plans, under which advisers may charge a fund for certain distribution and marketing expenses. In the first case, instituted in May, the SEC alleged that a Chicago-based mutual fund manager improperly charged the funds $1.25 million in expenses incurred in connection with services provided by several financial intermediaries. The SEC also alleged that the firm had caused its mutual funds to pay other fees beyond those approved by the funds’ board. Without admitting the allegations, the firm, which had refunded the excess fees, agreed to pay a $4.5 million penalty. The following day, the SEC instituted settled proceedings against a Maryland-based mutual fund adviser for similarly charging the funds nearly $15 million for distribution-related services that should have been paid by the firm. Without admitting wrongdoing, the firm disgorged the improper payments and agreed to pay a $1 million penalty, which the SEC announced was reduced based on the firm’s self-reporting of the improper payments and prompt remediation.
D. Fraud & Misappropriation
In February, the SEC instituted settled administrative proceedings against a private equity fund adviser who improperly withdrew 16.25 million pounds from the accounts of two private equity fund advisory clients. The payments were purportedly for fees owed to an affiliate for services performed between 2006 and 2013. But neither the alleged fees nor any fee agreement was disclosed to the clients or the fund investors until the money was withdrawn in 2014. Without admitting or denying the SEC’s allegations, the firm’s principal agreed to an industry bar and to pay a $1.25 million civil penalty.
IV. Brokers and Financial Institutions
A. Disclosure and Misrepresentation Cases
The first half of 2017 saw several cases involving alleged misstatements concerning the manner in which brokers provided trading services customers. In January, the SEC accused a Chicago-based broker-dealer of making misleading statements about the way it priced trades. According to the SEC, the firm made certain representations about algorithms it used to “internalize” retail orders at the best price available in the marketplace. The SEC alleged that certain of the firm’s algorithms (since discontinued) did not live up to their promise, failing to obtain the best available pricing. The broker-dealer settled the charges for $22.6 million in disgorgement and penalties without admitting or denying the allegations.
Later that month, the SEC instituted settled proceedings against two brokerage firms relating to their foreign exchange trading programs. For almost one year, registered representatives at both firms gave verbal and written presentations on the program based on the program’s past performance and risk metrics. However, the SEC alleged that the presentations failed to mention that the investors could be placed into the program using substantially more leverage than advertised and markups would be charged on each trade. Without admitting or denying the allegations, the two firms agreed to pay almost $3 million apiece.
In May, the SEC charged two former traders who ran the commercial mortgage-backed securities desk at a financial holding company for misrepresenting price information to customers while acting as intermediaries on trades. According to the SEC, the traders improperly inflated the profits of the desk, resulting in substantial bonuses to the traders. Without admitting or denying the charges, one of the traders agreed to pay over $200,000 and to be barred from the securities industry with the right to reapply after three years; the other trader continues to litigate the case.
B. Manipulation Schemes
The SEC initiated several actions against brokerage firms for either participating in market manipulation schemes or failing to file Suspicious Activity Reports (SARs) in response to potential trading irregularities.
In March, the SEC filed a litigated action against a Ukraine-based trading firm and two related individuals for manipulating the U.S. markets, and a New York-based brokerage firm and its owner for assisting in the scheme. The parties allegedly made more than $28 million in illicit profits by engaging in layering, a scheme in which orders are placed but later canceled after others are tricked into buying or selling stocks at artificial prices, and through cross-market manipulation, a scheme in which the firm traded U.S. stocks at a loss to manipulate the prices of the stock and its corresponding options so that it could later profitably trade at artificial prices. The New York firm allegedly made the scheme possible by providing the foreign traders with access to U.S. markets and relaxing its layering controls after the traders complained. The SEC obtained an emergency court order freezing and repatriating funds.
In January, the SEC instituted litigated administrative proceedings against a New York brokerage firm and its former anti-money laundering officer for failing to file SARs for $24.8 million in suspicious transactions. The SEC alleged the firm should have known about the suspicious circumstances behind transactions occurring in customer accounts, such as transactions where customers deposited large blocks of penny stocks, liquidated them during substantial promotional activity, and then transferred the proceeds away from the firm. (In a related action, the SEC separately filed a complaint in federal court against five individuals, including two of the firm’s customers, for participating in a pump-and-dump scheme.) And in June, the SEC charged a Salt Lake City brokerage firm for its role in clearing transactions for microcap stocks that were used in market manipulation schemes. According to the SEC, the firm routinely and systematically failed to file SARs for transactions it flagged as suspicious, and when it did file the reports, it omitted information explaining why the transaction was suspicious. This case is also being litigated.
C. Supervisory Controls
In January, a Wall Street brokerage firm agreed to settle charges that it borrowed and then lent “pre-releases” of American Depository Receipts (ADRs) without owning, or confirming that its broker-dealer counterparties owned, the requisite number of ordinary shares of foreign stock underlying the ADRs. These transactions were alleged to create the possibility that the ADRs could be used improperly for short-selling or dividend arbitrage. The firm was also charged for failure to establish and implement effective policies and procedures for its securities lending desk to prevent the violations. Without admitting or denying the allegations, the firm agreed to pay more than $24.4 million to settle the charges. Later in June, the SEC announced additional charges against the former managing director and head of operations at the firm for failing to reasonably supervise members of the securities lending desk. He settled the charges for $100,000 and is prohibited from acting in a supervisory capacity for at least 18 months.
Also in January, the SEC announced charges against a financial institution based on its miscalculations of its risk-based capital ratios and risk-weighted assets in its annual and quarterly reports. According to the SEC, the firm had improperly excluded approximately $14 billion of collateralized loan obligation assets without obtaining prior authorization from the Federal Reserve Board as required under new rules. The SEC alleged that the firm lacked adequate internal controls to ensure its risk-weighted assets were properly reported to investors. Without admitting or denying the allegations, the firm agreed to pay a $6.6 million penalty.
In February, the SEC instituted settled proceedings against a New York brokerage firm for its failure to establish and enforce policies and procedures to prevent the misuse of material nonpublic information. According to the SEC, the firm had no written policies or procedures in place covering those making investment decisions for an affiliated hedge fund trust that invested in issuers that were covered by the firm’s research department and issuers for which the firm provided investment banking services. As a result, there were over a hundred instances when the hedge fund traded in stocks that should have been restricted. Without admitting the allegations, the firm agreed to pay a $100,000 penalty.
Finally, in May, the SEC instituted settled proceedings against two traders of residential mortgage-backed securities for charging undisclosed excessive mark-ups, while simultaneously settling with their former brokerage firm for failing to implement adequate supervisory procedures to detect and prevent the mark-ups. Without admitting the allegations, the firm agreed to disgorge the mark-ups and to pay a $1 million penalty, and to implement procedures to prevent such conduct in the future. The SEC called out the firm’s significant cooperation, including preparing detailed trade information “essential to understanding the transactions.”
D. Cases Against Individual Brokers
The first half of 2017 also saw several enforcement actions against individual brokers. In January, the SEC filed a litigated action against two individual New York-based brokers for their use of an “in-and-out” trading strategy designed to maximize their commissions—at their customers’ expense. The brokers’ strategy involved selling securities within weeks or less of purchase and allegedly resulted in substantial losses for twenty-seven customers. The SEC alleged that the brokers did no diligence regarding whether this strategy would benefit their customers at all, and instead racked up “hefty” commissions for themselves on account of the frequency of sales and purchases. In connection with the charges, the SEC also released an Investor Alert, advising investors to be wary of excessive trading or fees in brokerage accounts and to investigate suspicious activity with their brokers.
In April, the SEC charged an individual broker with trading unsuitable investment products on behalf of five unsophisticated customers, netting approximately $150,000 in losses. The transactions at issue involved exchange traded funds (ETFs) and exchange traded notes (ETNs), which the SEC alleges are inherently risky, complex, and volatile—inappropriate for unsophisticated investors with modest financial resources. The broker also allegedly misappropriated more than $170,000 of customer funds to pay his personal expenses. This case is also being litigated.
Finally, in June 2017, the SEC took further enforcement measures against a broker who continued to run the day-to-day operations of a broker-dealer firm as a consultant, even though he was subject to a 2013 order barring him from associating with any broker or dealer for five years. According to the SEC, the defendant in 2013 resigned from his roles as CEO, CFO, and financial operations principal of the broker-dealer firm—but the very next day signed a consulting agreement with the firm to continue to run its operations. The broker agreed to a permanent bar and to pay $30,000 in disgorgement and penalties.
V. Insider Trading
A. Classical Trading & Tipping
In February, a U.S. citizen based in Australia agreed to settle allegations that he traded on information received from his sibling, a company officer. The company officer told his brother that the company was going to sell a subsidiary to a publicly held insurance company. Based on the information he received, the trader purchased shares in his brother’s company, realizing approximately $15,000 in illegal profits. Without admitting or denying the allegations, the trader agreed to pay approximately $30,000 in disgorgement and penalties.
The following month, the SEC brought another case against a tippee who received material nonpublic information from a relative. According to the SEC, a pharmaceutical company employee tipped news of a planned acquisition to a relative, who purchased shares in the target company and garnered a profit of nearly $60,000. Without admitting or denying the SEC’s allegations, the trader agreed to disgorge his ill-gotten gains and pay penalties.
In another pharmaceutical industry case, the SEC announced charges in late June against two former senior employees and the spouse of a former employee of a pharmaceutical company. The SEC alleges that the defendants traded in advance of multiple announcements about U.S. Food and Drug Administration (FDA) decisions. The defendants were able to avoid losses by selling in advance of adverse company announcements and to reap profits by purchasing shares in advance of positive announcements. Two of the three defendants have reached settlements with the SEC.
B. Misappropriation by Professionals
The first half of the year also saw multiple cases in which bankers, lawyers, accountants and other professionals misappropriated material nonpublic information. In March, the SEC instituted settled proceedings against a Silicon Valley-based auditor who traded in advance of a client’s upcoming merger. According to the SEC, the auditor used information about a pending acquisition by his audit client to purchase out-of-the-money call options in the target company, and also encouraged his mother to invest. Without admitting or denying the allegations, the trader agreed to pay more than $87,000 in disgorgement, civil penalties, and interest, and to be suspended from appearing and practicing as an accountant before the SEC for at least five years. In June, the SEC settled a similar matter involving an accountant trading ahead of an audit client’s planned acquisition.
The SEC also instituted settled proceedings against an accountant who was asked to provide tax accounting advice in connection with a merger and used the information to purchase stock in the target company as well as to tip a friend; the accountant agreed to pay over $80,000 in disgorgement and penalties and to be barred from practicing before the SEC. Notably, the SEC pursued a separate action against another tax professional involved in the case for falsely informing FINRA, which was reviewing the trading activity, that she had no information about the identified traders. This individual agreed to be barred from practicing before the SEC for one year.
In April, the SEC charged a vice president of a New York-based investment bank with trading securities in secret brokerage accounts in advance of a merger. The investment bank at which the vice president worked was approached by a private equity firm to finance the acquisition of a publicly traded technology company. Upon learning of the future acquisition, the vice president established two brokerage accounts in which he traded securities of the target company, amassing a profit of approximately $48,000. The United States Attorney also filed parallel criminal charges against the trader.
In May, the SEC charged a former partner at an international law firm and his neighbor with trading prior to corporate announcements. According to the SEC, over the course of a year, the partner allegedly traded in advance of at least eleven impending announcements involving law firm clients. The partner also tipped his neighbor so that the neighbor could make similar trades. The SEC alleges that the trades caused the partner and his neighbor to realize profits totaling more than $1 million. The United States Attorney announced parallel criminal charges against the pair.
The SEC also pursued cases against others for alleged misappropriation. In June, the SEC instituted settled proceedings against a consultant who allegedly misappropriated information he learned about an impending merger involving one of his clients, an energy construction company. And in an unusual case, the SEC in March charged a security professional with trading on information he misappropriated while working at the home of a target company’s board member. According to the SEC’s complaint, the individual worked in the board member’s home, where his responsibilities included answering phone calls and reviewing incoming emails. Shortly after the board member received a message regarding the potential acquisition, the security professional purchased stock and call options in the target company, reaping a profit of approximately $44,000. The matter is being litigated.
C. Other Novel Cases
In a somewhat novel case, the SEC in February brought charges relating to trading in contracts-for-difference (CFDs), an unusual type of derivative, charging a former employee of a California-based technology company for trading in CFDs of the company. The SEC alleged that, on three different dates after the employee left the company, he traded in advance of company earnings announcements by purchasing common stock, call options, and CFDs in both U.S. and foreign brokerage accounts. In each instance, he obtained a leveraged long position prior to quarterly earnings announcements, garnering $1.6 million in profits. The SEC obtained an asset freeze and is litigating the action. Interestingly, the SEC’s complaint does not allege how the trader obtained material nonpublic information, instead drawing an inference from the highly suspicious trading pattern.
And in an unusual case involving political intelligence, the SEC in May brought charges in connection in an alleged scheme to tip confidential information about government plans to cut Medicare reimbursement rates. According to the SEC, an employee at the Centers for Medicare and Medicaid Services (CMS) tipped his friend, a political intelligence consultant, about at least three pending CMS decisions. The political intelligence consultant then tipped two analysts at a hedge fund advisory firm that retained his consulting services. The analysts then used the tip to advocate that their firm trade in the stocks of health care companies whose prices would likely be affected by the CMS decisions. The scheme was alleged to have resulted in over $3.9 million in illegal profits. The United States Attorney’s Office of the Southern District of New York filed parallel criminal charges.
D. Emergency Actions
The first half of this year has entailed a number of cases in which the SEC has frozen assets in brokerage accounts used to effectuate alleged insider trades. In February, the SEC alleged that a partner in a Hong Kong-based private equity firm amassed millions of dollars’ worth of stock of a company that was the target of a nonpublic acquisition. The SEC alleges that the defendant attempted to hide his trading by placing the trades in the U.S. brokerage accounts of five Chinese nationals. The SEC’s press release stated that the agency used the SEC’s “data analytic investigative tools” to determine the identity of the trader. The SEC froze the brokerage accounts and is litigating the matter.
Also in February, the Commission obtained an emergency court order to freeze the assets of unknown customers of a Singapore-based and a UK-based broker-dealer. According to the SEC, these unknown customers were in possession of material nonpublic information prior to purchasing shares in the target company. The customers of the Singapore-based broker-dealer stood to profit $1.7 million, and the customers of the UK-based broker-dealer stood to profit $1.9 million.
In late March, the SEC obtained an emergency court order freezing the assets of two Israeli traders who allegedly traded based on material nonpublic information prior to an acquisition announcement. The pair used brokerage accounts in the U.S. to effectuate their trades, reaping a profit of nearly $5 million. Approximately two weeks later, the SEC obtained a second round of asset freezes relating to this merger of technology companies. The SEC does not allege how either group of traders obtained the material nonpublic information, and instead appears to have filed emergency actions based on the suspicious nature of the trading.
And in April, the SEC announced that it had frozen UK- and Lebanon-based brokerage accounts of US-based trading firms use to purchase call options ahead of a merger of two telecom companies. After the announcement, customers of the brokerage accounts sold the majority of their contracts, potentially reaping $1 million in ill-gotten profits. The foreign accounts’ assets in the U.S. brokerage accounts remain frozen while the SEC endeavors to identify the traders involved.
VI. Municipal Securities and Public Pensions Cases
The SEC pursued a small number of eclectic actions involving municipal securities offerings and pension funds in the first half of the year, although as in past periods the contribution of such cases to the overall enforcement docket was boosted by another broad sweep.
In January, the SEC announced that the Port Authority of New York and New Jersey agreed to settle charges of alleged negligence in connection with municipal bond offerings. The SEC alleged that the municipal entity had not adequately disclosed risks regarding the scope of authority to pursue certain roadway projects, noting that counsel had advised that the statutory construction authorizing the projects was not without doubt. The SEC acknowledged in its press release that the projects proceeded as planned.
Also in January, the SEC instituted settled proceedings against 10 investment advisory firms for alleged violations of the SEC’s investment adviser “pay-to-play” rule. Firms providing investment advisory services to pension funds are prohibited from receiving fees for two years after making political contributions to a candidate who could influence the investment adviser selection process. The SEC alleged that the firms violated the two-year timeout by accepting fees from city or state pension funds after their associates made campaign contributions (in amounts of $400 to $10,000) to elected officials or political candidates with the potential to wield influence over pension funds. Without admitting the allegations, the firms agreed to pay penalties ranging from $35,000 to $100,000.
Finally, in April the SEC filed a settled action against an Arizona-based brokerage firm, its CEO, and its former underwriter’s counsel stemming from municipal bond offerings they underwrote that were later found to be fraudulent. According to the SEC, the parties failed in their role as gatekeepers to conduct reasonable due diligence when underwriting bond offerings to purchase and renovate nursing homes and senior living facilities. The offerings were managed by an Atlanta-based businessman who was later charged by the SEC with fraud. According to the SEC, the firm failed to ensure that the issuer was in compliance with its continuing disclosure obligations. The underwriter’s counsel was also charged with failing to disclose that he was not actually authorized to practice law at the time. The firm and its CEO agreed to pay nearly $500,000 in disgorgement and penalties, and the CEO was barred from the securities industry for three years; the lawyer agreed to pay nearly $45,000 and to be barred from appearing and practicing before the SEC as an attorney. The SEC also noted that, had the firm self-reported under the SEC’s recent Municipalities Continuing Disclosure Cooperation Initiative, its penalties would have been halved.
VII. Miscellaneous Cases
The SEC continued its initiative to curb abuses of the government’s EB-5 program, which provides foreign nationals who invest a requisite amount of capital in the United States a method for obtaining a green card, while simultaneously creating jobs for U.S. workers. Already this year the SEC has brought four actions based on the misappropriation and misuse of funds obtained from foreign investors under the program. In January, the SEC brought fraud charges against a businessman who raised $100 million from foreign investors for various EB-5 businesses such as a nursing facility and dairy operation, only to spend more than $17 million to purchase his home and personal items, to fund several personal business projects, and to pay overseas marketing agents. In March, the SEC filed a complaint against a Washington-based businessman and his company for his misappropriation of almost all of the $14.5 million he had raised from foreign investors for the use of himself and his family, to satisfy margin calls, to pay the lease on his luxury car, and to increase his own borrowing capacity, among others misuses. An Idaho businessman and his bookkeeper agreed to pay over $8.5 million in disgorgement and penalties to settle allegations that they misappropriated over $5 million of the $140 million of investor funds they had raised and spent it on a zip line operation, two personal residences, and two luxury cars. Most recently, in June, an immigration attorney in Chicago was charged with misusing millions from the $88.7 million raised from over 220 foreign investors for the alleged purpose of constructing a senior living project in Chicago or Florida. The attorney diverted the funds toward other of his projects, for unrelated payments, and for the benefit of himself, his brother, and his companies.
In April, the SEC filed a large sweep focused on stock promoters who failed to disclose payments received companies for the publication of bullish reports. The agency instituted enforcement actions against 27 individuals and entities, including public companies, CEOs, and writers, for the various stock promotion schemes. The writers did not disclose the companies’ payments, with over 250 articles going so far as to say they had not been compensated by the companies they wrote about. One writer wrote under both his name and several pseudonyms. At least one firm encouraged this behavior, requiring its writers to sign non-disclosure agreements that prevented the writers from disclosing their compensation. 17 parties settled, agreeing to pay disgorgement and penalties ranging from $2,200 to almost $3 million.
Finally, in a colorful case showing the SEC’s willingness to pursue its own personnel for wrongdoing, the agency charged a former staff accountant from the Division of Corporation Finance for his alleged concealment of his personal securities trading from the SEC’s ethics office and the Office of Inspector General. SEC rules prohibit employees from trading in options and certain other securities, and require employees to obtain pre-clearance before trading in non-prohibited securities. According to the SEC, the former staffer did not obtain such pre-clearance, traded in prohibited securities on behalf of himself and others for several years, often during office hours, and made false filings about his holdings. He settled the charges for over $100,000 in disgorgement, interest, and penalties.