Author: Enforcement Highlights

Jim Lundy Appointed as Independent Monitor in the CFTC v. 3Red Trading & Oystacher Manipulative Trading / Spoofing Matter

Chicago partner Jim Lundy was appointed by the Honorable Judge Amy J. St. Eve of the U.S. District Court for the Northern District of Illinois to serve as the independent monitor for one of the first “spoofing” manipulative trading enforcement actions instituted by the Commodities Futures Trading Commission (CFTC). Jim’s appointment is part of a settlement between the CFTC and 3Red Trading LLC and its principal, Igor B. Oystacher, entered on December 20, 2016. Over the next three years, Jim will be responsible for monitoring the trading of 3Red and Oystacher, and identifying any future violations of the Commodity Exchange Act and CFTC Regulations as charged and pursuant to a monitoring agreement.

The CFTC filed its initial complaint on October 19, 2015. In its complaint, the CFTC alleged the employment of manipulative trading / spoofing by the Defendants in the markets for E-Mini S&P 500, Copper, Crude Oil, Natural Gas, and VIX futures contracts on multiple exchanges.

In addition to the monitorship, as part of the settlement 3Red and Oystacher agreed to pay a $2.5 million penalty, jointly and severally. Judge St. Eve also ordered 3Red and Oystacher to employ certain compliance tools with respect to Oystacher’s futures trading on U.S. exchanges for an 18-month period, and permanently prohibited the Defendants from spoofing and the employment of manipulative or deceptive devices while trading futures contracts.

Additional information on the settlement and Jim’s appointment is discussed in Crain’s Chicago Business, “3 Red agrees to $2.5 million fine, monitoring.” (Log-in may be required).

Jim joined Drinker Biddle after working at the SEC for 12 years. During his tenure, he served in the Enforcement Division as a Senior Trial Counsel and a Branch Chief and in the Office of Compliance Inspections and Examinations as a Senior Regulatory Counsel, where he assisted with operating the SEC’s broker-dealer examination program for the Midwest Region. Prior to joining Drinker Biddle, Jim worked in-house at a futures and securities brokerage firm affiliated with a European-based global bank and represented his firm before futures regulators, FINRA, and the SEC.

In Jim’s practice he represents clients in matters involving the various regulatory bodies with enforcement, examination, and policy oversight of the securities and futures industries.

Department of Justice Obtains Its Second Spoofing Conviction and Its Novel Cooperation Agreement.

On the heels of its successful prosecution of Michael Coscia for spoofing, the Department of Justice (“DOJ”) recently secured a guilty plea and cooperation agreement in another high-profile “spoofing” case. By way of background, spoofing is the illegal practice of placing trades on the bid or offer side of a market with the intent to cancel them before execution in order to manipulate prices for personal gain. On November 9, 2016, Londoner Navinder Singh Sarao pleaded guilty to two criminal charges after losing his battle against extradition from the UK.  Despite being charged with 22 counts, including wire fraud, commodities fraud, and spoofing, Mr. Sarao pleaded guilty to just two counts—one count of wire fraud, 18 U.S.C. § 1343 (which carries a maximum of 20 years’ imprisonment and a fine of $250,000) and one count of spoofing, 7 U.S.C. § 6c(a)(5)(c) and 13(a)(2) (which carries a maximum of 10 years’ imprisonment). He also acknowledged unlawful gains of at least $12,871,587.26 in trading profit as a result of his criminal actions and has agreed to forfeit that sum as part of his sentence. In addition, he has agreed to cooperate with the government, as discussed in more detail below. Although Mr. Sarao’s stated advisory sentencing guideline range is 78 to 97 months imprisonment, the DOJ  will very likely seek a downward departure pursuant to Guideline § 5K1.1 as a result of his cooperation.

Mr. Sarao pleaded guilty to the following scheme. From January 2009 until at least April 2014, Mr. Sarao fraudulently traded E-mini S&P 500 futures contracts (the “E-mini”) on the Chicago Mercantile Exchange (“CME”). During the relevant time period, Mr. Sarao placed thousands of orders to buy or sell futures contracts of the E-mini on one side of the market with the intent to not execute those orders at the times that he placed them. Thus, he intended to manipulate the impressions of supply and demand for E-minis so as to induce other market participants to react and either buy or sell E-mini futures in response to his deception. When the market reacted accordingly, Mr. Sarao would execute genuine orders to buy or sell E-Mini future contracts on the opposite side of the market so as to generate significant trading profits.

Mr. Sarao generated these spoof orders both manually and using automated programs.  Manually, he used two techniques. In the first technique, he would place large spoof orders (2,000-Lot Spoof Orders) that he did not intend to execute on the opposite side of the market from his genuine orders to buy or sell, thereby inflating volume and, in turn, creating artificially high or low prices to his advantage. Mr. Sarao used this technique approximately 802 times and made at least $1,884,537.50 in profit as a result. His second manual technique involved placing hundreds of resting spoof orders one or two levels of price from the best bids or offers currently available on the market. Mr. Sarao thereby created a false sense of supply or demand and would then trade genuine orders on the opposite side of the market to take advantage of the artificially inflated or deflated price.

Mr. Sarao also used automated programs to further his scheme. He utilized a “dynamic layering technique” that generated a block of typically five “sell” orders that would appear in unison at different sequential price points above the then-current E-mini sell price. As the current sell price moved, Mr. Sarao’s five “sell” orders moved in concert to remain the same distance above the sell price as they originally began, which thus reduced the chance that his orders would be executed. He used this technique to artificially create market activity approximately 3,653 times between 2009 and 2014 and made at least $9,667,258.22 in profit as a result of trading on the opposite side of the market. Mr. Sarao also utilized a second automatic technique known as the “Back of the Queue” Function. This technique added one unit to a particular designated order to increase its size when another order from a market participant was entered at the same size and price point as Mr. Sarao’s order, thereby ensuring that his orders were always more expensive, bigger, and behind all the other more attractive orders that were available so that it would not be executed or purchased. This artificially inflated the volume and, in turn, the interest on one side of the market. Mr. Sarao activated this function approximately 758 times and fraudulently made at least $1,319,791.54 in profit as a result. In addition to his fraudulent and manipulative schemes, Mr. Sarao made materially false statements and misrepresentations to the Commodities Futures Trading Commission (“CFTC”), CME, and regulatory officials in the UK.

These are a few points of interest regarding this guilty plea:

  • The U.S. Attorney’s Office for the Northern District of Illinois, home of the Securities and Commodities Fraud Section that obtained Michael Coscia’s guilty verdict, was acknowledged by “Main Justice” for its assistance with the case. The efforts of DOJ Main Justice, in coordination with the Northern District’s Securities and Commodities Fraud Section and the CFTC, indicate the high level of importance that the federal government places on pursuing criminal manipulative trading cases, such as Sarao and Coscia.
  • Under the original indictment, the DOJ accused Mr. Sarao of reaping at least $40 million in profits as a result of these schemes. While the plea agreement required him to forfeit more than $12,000,000, on November 17, 2016, the CFTC announced in its parallel case that Mr. Sarao settled with the CFTC and agreed, among other relief, to pay $25,743,174.52 in monetary penalties and to submit to a permanent trading ban.
  • Despite having fought extradition for nearly 18 months, after he pleaded guilty, Mr. Sarao was released on bail and was permitted to return to London with an 11 p.m. to 4 a.m. curfew to continue his cooperation with the government. Such cooperation must be extraordinary for the DOJ to agree to his return to a foreign country immediately after it had obtained extradition and the guilty plea.

With its second successful prosecution of spoofing since it was formally criminalized by statute with the 2010 Dodd-Frank Act, the DOJ is clearly making deterrence of such techniques one of its primary goals. Of course it is yet to be seen what type of cooperation Mr. Sarao can provide, but his lawyer told the court at his guilty plea hearing that despite his severe Asperger’s Syndrome, he had extraordinary abilities of pattern recognition. Such statements indicate that Mr. Sarao may provide technical cooperation to the DOJ in multiple, ongoing investigations, as opposed to the more usual cooperation of informing on others. With Mr. Sarao’s conviction and the Coscia appeal pending, DOJ’s ongoing efforts in this space are currently not public; however, Mr. Sarao’s cooperation may accelerate these pending investigations. With the DOJ’s and CFTC’s strong commitments to cracking down on spoofing and manipulative trading, we can expect that more DOJ and CFTC cases will be forthcoming.

The criminal case is United States v. Sarao, Case No. 15-cr-00075 (N.D. Ill.). The civil case is United States Commodity Futures Trading Commission v. Sarao, Case No. 15-cv-03398 (N.D. Ill.).

The Supreme Court Appears Poised to Reaffirm Dirks v. SEC and Maintain Current Insider Trading Rules

For the first time in two decades, the Supreme Court heard oral argument in a case that could change the landscape for the government’s pursuit of insider trading violations. In Salman v. United States (Dkt. No. 15-628), the Court reviewed the government’s burden of proof when it prosecutes for insider trading. Specifically, the primary issue involves whether Salman’s “tipper” had received the kind of “personal benefit” required by precedent to hold Salman criminally liable for insider trading. The United States Court of Appeals for the Ninth Circuit affirmed Salman’s conviction. However, just two years ago, the United States Court of Appeals for the Second Circuit overturned the convictions of several insider traders because the government failed to establish that the insiders had received “a potential gain of a pecuniary or similar valuable nature.” In other words, the Second Circuit rejected governmental theories where insider tips were given to friends or even family members without any monetary gain to the insider. Thus, the Court’s ruling in Salman will also settle a current split between the Second and Ninth Circuits.

By way of background, for tipper–tippee cases, courts have determined that it is a crime for an insider with a duty of confidentiality (otherwise known as a tipper) to intentionally or recklessly provide confidential information (otherwise known as a tip) to another (otherwise known as the tippee) and to receive a personal benefit, directly or indirectly, from such action. The tippee, to be criminally liable, must also know about the confidential nature of the information (which has been breached) and the benefit the insider received. The Court specified much of these requirements in Dirks v. SEC, 463 U.S. 646 (1983), where it also stated “absent some personal gain, there has been no breach of duty to stockholders.” 

How is personal gain defined? This is the main question the Court must decide in Salman, thereby resolving the federal circuit split. In Salman, the Court seemed both unwilling to take steps away from its prior precedent and suspect of the additional sweeping arguments made by the petitioner and the government. During the petitioner’s argument, Salman’s attorney contended that a line needed to be drawn as to what constituted a personal benefit. She suggested that the Court require the benefit to be tangible—not necessarily monetary or personal—but tangible. Justice Breyer, however, countered that helping “a close family member is like helping yourself.” Justice Kennedy clarified that in the law of gifts “we don’t generally talk about benefit to the donor” but that giving to a family member “ennobles you.”

The Justices’ statements appeared to indicate that they seemed more comfortable agreeing with the government, that insider information packaged as gifts to close friends or family crossed the line into creating or manifesting personal gain for the tipper, consistent with precedent. But they appeared unwilling to go further than that, despite the government’s urging that insider trading occurs whenever the insider provides confidential information for the purpose of obtaining a personal advantage for somebody else, regardless of previous or future relationships between the tipper and tippee. The government seemed not to view the personal advantage as a gain or benefit as those words are used colloquially. Instead, the government contended that the access to and communication of the confidential information in breach of the duty of confidentiality is in and of itself “a personal gain,” “a gift with somebody else’s property.” This interpretation was met with skepticism by the Court and the government seemed to back away from its argument, stating instead that it would not seek to hold liable somebody who was “loose in their conversations but had no anticipation that there would be trading.”

Justice Alito commented disapprovingly that neither side’s argument was consistent with the Court’s precedent in Dirks. Indeed, the Court appeared worried that any outcome other than affirmance would require new lines to be drawn. Any change to the law, as a result of this case, would impact the Court’s own judicially created insider trading standard from Dirks. As Justice Kagan put it to the petitioner: “[y]ou’re asking us to cut back significantly from something that we said several decades ago, something that Congress has shown no indication that it’s unhappy with, . . . [when] the integrity of the markets are a very important thing for this country. And you’re asking us essentially to change the rules in a way that threatens that integrity.” By the end of the argument, the government basically summarized what seemed to many observers, the Court’s preference: “If the Court feels more comfortable given the facts of this case of reaffirming Dirks and saying that was the law in 1983, it remains the law today, that is completely fine with the government.”

In light of the arguments and interactions with the Justices, the Court seems most comfortable with reaffirming the standards established with Dirks. Thus, it appears that despite the ruling in Newman, Salman may have provided the Court with nothing more than an opportunity to affirm its long-standing precedent.

Latest Auditor Suspensions Illustrate Key SEC Enforcement Focal Points

On July 22, 2016, the SEC suspended an accounting firm and permanently suspended one of its former partners for conducting a defective audit for a publicly-traded company allegedly engaged in a fraud scheme that resulted in numerous material misstatements on its financial statements. Exchange Act Rel. No. 78393 (July 22, 2016). These suspensions derived from the SEC’s settlement with New York-based EFP Rotenberg, LLP and engagement partner Nicholas Bottini, CPA, for audit services performed on behalf of ContinuityX Solutions, Inc., which claimed to sell Internet services to businesses. The SEC found that EFP Rotenberg violated and Bottini aided and abetted and caused EFP Rotenberg’s violations of Sections 10A(a)(1) and 10A(a)(2) of the Securities Exchange Act of 1934 and Rule 2-02(b)(1) of Regulation S-X. It also concluded that the accounting firm and its former audit partner engaged in improper professional conduct pursuant to Section 4C(a)(2) of the Exchange Act and Rule 102(e)(1)(ii) and (iii) of the SEC’s Rules of Practice.

According to the Order, ContinuityX’s financial misstatements included impermissibly recognizing commission revenue from fraudulent sales transactions, recording assets belonging to third parties as its own and failing to disclose related party transactions. The SEC alleged that when auditing ContinuityX’s fiscal year 2012 financial statements, EFP Rotenberg and Bottini failed to perform sufficient audit procedures and repeatedly engaged in improper professional conduct that resulted in violations of PCAOB standards and demonstrated a lack of competence.  Specifically, the SEC found that the respondents failed to: “(1) appropriately respond to risks of material misstatement; (2) identify related party transactions; (3) obtain sufficient audit evidence; (4) perform procedures to resolve and properly document inconsistencies; (5) investigate management representations that contradicted other audit evidence; and (6) exercise due professional care.” Notwithstanding these shortfalls, the audit firm provided an unqualified opinion on the company’s annual financial statements.

The SEC supported its factual findings with numerous alleged instances in which EFP Rotenberg and Bottini either capitulated to the will of ContinuityX’s management or seemingly concluded their audit procedures prior to obtaining reasonable assurances. These alleged instances included:

  • Acquiescence to a scope limitation resulting from the company’s refusal to permit the auditors to obtain accounts receivable confirmations from third parties;
  • A failure of the engagement team to perform procedures sufficient to detect whether revenue was earned legitimately despite obtaining adequate documentation to do so;
  • An absence of audit workpaper documentation explaining the resolution of material inconsistencies between audit evidence and representations from management; and
  • A failure to insist that the company respond to an auditor inquiry regarding whether its chief financial officer had a related party relationship with a particular customer.

Without either respondent admitting or denying the SEC’s findings, EFP Rotenberg agreed to pay a $100,000 penalty and accept a one-year suspension from public company audits, conditioned upon the certification of an independent consultant that it has remedied the various causes behind its failure to detect ContinuityX’s fraud. Bottini agreed to a $25,000 penalty and a permanent suspension from appearing and practicing before the SEC as an accountant, which includes not participating in the financial reporting or audits of public companies. In imposing these penalties, the Order stated that these were not the respondents’ first SEC violations. Both EFP Rotenberg and Bottini each had settled an unrelated 2014 SEC proceeding involving an audit for a separate client that occurred during 2011. In that earlier proceeding, which also included violations of Section 4C(a)(2) and Rule 102(e)(1)(ii), EFP Rotenberg consented to a $50,000 penalty while Bottini agreed to pay $25,000 and accept a minimum two-year suspension. Exchange Act Rel. No. 72503 (July 1, 2014).

Given the presence of repeat offenders and numerous audit deficiencies, it is tempting to discount the overall significance in these particular proceedings, especially when compared to recent enforcement actions brought against more recognizable accounting firms. This would be a mistake, however, as this case serves as a cautionary tale concerning both the particularized financial reporting issues that are receiving heightened regulatory attention and the actions (or inactions) that potentially trigger “gatekeeper” culpability. As Andrew Ceresney, Director of the SEC’s Division of Enforcement, confirmed in a speech earlier this year, two of the central accounting issues in these proceedings – revenue recognition and related party transactions – remain high enforcement priorities. At the same time, Director Ceresney also signaled to the auditing profession that it “must be the bulwark against client pressure” and “demand objective evidence and investigation when they come across situations which suggest inaccuracies in the company filings.” Otherwise, as these proceedings reveal, the SEC intends to make examples of auditors who are found to have shirked these responsibilities and “fail[ed] to heed numerous warnings and red flags concerning alleged frauds.”

Update: IRS, SEC, and Courts Diverge on Nature of Disgorgement

We previously wrote about decisions in SEC v. Graham from the Eleventh Circuit,  __ F.3d __, No. 14-13562, 2016 WL 3033605 (11th Cir. May 26, 2016), and the U.S. District Court for the Southern District of Florida, 21 F. Supp. 3d 1300 (S.D. Fla. 2014), considering whether disgorgement claims and other remedies were subject to five-year statute of limitations on actions “for the enforcement of any civil fine, penalty, or forfeiture” codified in 28 U.S.C. § 2462. The Eleventh Circuit affirmed the decision of the lower court that the SEC’s disgorgement claims were time-barred, holding that “disgorgement” is synonymous with the plain meaning of “forfeiture” as it is used in the statute.

On May 6, 2016—shortly before the Eleventh Circuit issued its ruling in Graham—the IRS published non-precedential Chief Counsel Advice (“CCA”) on whether Internal Revenue Code Section 162(f) bars business expense deductions for disgorgement paid to the SEC of profits stemming from alleged violations of the Foreign Corrupt Practices Act (“FCPA”). The disgorgement payments were part of a consent agreement between the SEC and the taxpayer, whose subsidiary allegedly falsified accounting records in order to conceal gifts it made to officials of a foreign government in exchange for business benefits. The taxpayer paid additional penalties for which it specifically agreed it would not seek a tax deduction in a parallel agreement with the DOJ relating to the criminal case against taxpayer’s subsidiary. The IRS concluded that the taxpayer’s disgorgement payments were not deductible business expenses under § 162(f), which prohibits deduction of any “fine or similar penalty paid to a government for the violation of any law” as a business expense.

As explained in the CCA, § 162(f) has been interpreted to bar deductions of civil penalties where they are “imposed for purposes of enforcing the law and as punishment,” but to allow deduction of civil penalties if “imposed to encourage prompt compliance with a requirement of the law”—for example, “late filing charges or other interest charges”—or “as a remedial measure to compensate another party.”  Emphasizing that disgorgement in securities cases has deterrent aims, is a discretionary remedy, and might be required even if there is no injured party or in amounts exceeding actual losses, the IRS determined that whether disgorgement is primarily punitive or primarily compensatory for the purpose§ 162(f) is a fact-specific inquiry. Additionally, disgorgement imposed as a “discretionary equitable remedy” or where the proceeds are used to compensate victims might still be primarily punitive if it resembles forfeiture, which remains non-deductible even when used to compensate victims. With respect to the FCPA disgorgement the taxpayer had made to the SEC, the IRS concluded that its purpose was primarily punitive, and therefore it could not be deducted, because there was no evidence that it was meant to compensate the government or some other party for loss.

The SEC, the IRS, and the Eleventh Circuit have thus articulated three distinct characterizations of disgorgement. To avoid the limitations period of § 2462, the SEC’s position, adopted by the D.C. Circuit in Johnson v. SEC, 87 F.3d 484 (D.C. Cir. 1996), has been that disgorgement is a non-punitive equitable remedy. In the IRS’s view, disgorgement to the SEC may—but perhaps does not always—have a punitive purpose that bars tax deduction. The Eleventh Circuit has equated the statutory definitions of disgorgement and forfeiture, without commenting on whether disgorgement to the SEC is a “penalty.”

SEC Strikes a Harsh Tone on Receipt of Transaction-based Compensation by Private Equity Fund Managers

On June 1, 2016, the Securities and Exchange Commission (SEC) sent a warning to private equity fund managers who receive transaction-based fees in connection with the purchase and sale of portfolio companies by charging Blackstreet Capital Management (Blackstreet), a private equity fund advisory firm, and its principal, Murry Gunty with, among other things, acting as an unregistered broker-dealer. According to the SEC, Blackstreet received fees, separate and apart from its management fees, for performing “in-house brokerage services” in connection with the acquisition and disposition of portfolio companies for two private equity funds. The fact that Blackstreet Capital fully disclosed the fees did not affect the SEC’s conclusion that Blackstreet acted as an unregistered broker-dealer.

Blackstreet and Gunty settled, on a neither-admit-nor-deny basis, with the SEC and agreed to pay more than $3.1 million in disgorgement and civil penalties. Importantly, the $3.1 million settlement also reflects other charges such as failing to disclose other fees and failing to implement reasonably designed compliance policies and procedures to prevent violations of the Investment Advisers Act of 1940 and rules thereunder.

Section 15(a)(1) of the Securities Exchange Act of 1934, as amended (Exchange Act) makes it unlawful for any broker or dealer to use the mails or any other means of interstate commerce to “effect any transactions in, or to induce or attempt to induce the purchase or sale of, any security” unless that broker or dealer is registered with the SEC in accordance with Section 15(b) of the Exchange Act. “Broker” is defined in Section 3(a)(4) of the Exchange Act as “any person engaged in the business of effecting transactions in securities for the account of others.” Over the last several years, the SEC has included violations of 15(a) in numerous enforcement actions involving offering frauds and other situations involving the offer and sale of securities to retail investors.

In its Order against Blackstreet and Gunty, the SEC concluded that by being involved in the purchase or sale of securities, including soliciting deals, identifying buyers or sellers, negotiating and structuring transactions, arranging financing, executing the transactions and receiving transaction-based compensation, Blackstreet was performing brokerage services without having registered as a broker-dealer and, therefore, willfully violated Section 15(a) of the Exchange Act.

Private equity fund managers have recognized the potential that the SEC would take the position that they are acting as broker-dealers. In 2014, the SEC issued a no-action letter that relieved firms from the requirement to register as a broker-dealer in connection with facilitating a sale of a private company as long as they complied with a number of detailed conditions. The conditions included requirements that the manager must never have possession of customer funds or securities; that upon completion of the M&A transaction, the buyer must have control of the target; and that the manager should not provide financing for the transaction.

The SEC’s most recent action in the private equity space emphasizes the SEC’s renewed resolve to more strictly enforce non-fraud based violations and to bring Section 15(a) charges in situations beyond traditional transactions with retail investors. In fact, following the settlement, Mr. Robert B. Baker, Assistant Regional Director in the SEC’s Enforcement Division’s Asset Management Unit, stated “That’s the first case of a private-equity adviser violating section 15(a) of the [Exchange Act] for acting as a broker and failing to register as a broker.” However, even if Blackstreet had contemplated reliance on the no-action positon cited above and such position was available, it did not comply with at least one of the conditions of the no-action letter because, according to the Order, Blackstreet appears to have been involved in arranging the financing for the transactions. Moreover, while disclosure of the fees was important, the fact that they were disclosed had no significance to the SEC’s analysis of whether Blackstreet acted as an unregistered broker-dealer.

Fees related to the acquisition and disposition of portfolio companies are not uncommon in the private equity fund context. In light of the SEC’s action, private equity fund managers should reconsider whether they need to register as broker dealers, take care to comply with all of the provisions of existing no-action letters, seek no-action relief of their own or take other appropriate steps.

SEC Opens New Funding Options with Regulation A+

Regulation A+ goes into effect June 19, 2015, allowing funding of companies by non-accredited investors. Smaller companies can offer and sell up to $50 million of securities in a 12-month period, subject to eligibility, disclosure, and reporting requirements. See Amendments for Small and Additional Issues Exemptions under the Securities Act.

The regulations allow two tiers of potential offerings. Tier 1 allows security offerings of up to $20 million in a 12-month period. Tier 2 allows security offerings of up to $50 million in a 12-month period but also requires audited financial statements, annual, semi-annual, and current-event reports, and a limitation on the amount of securities non-accredited investors can purchase of no more than 10% of the greater of the investor’s annual income or net worth. Tier 1 limits offers to not more than $6 million by selling security holders that are affiliates of the issuers, and Tier 2 limits offers to not more than $15 million.

All offerings under Regulation A+ will still require electronic filing of offering materials and other current practices for registered offerings under Regulation A. Offerings will also permit companies to submit draft offering statements for non-public review by SEC staff and allow companies to use solicitation materials after filing the offering statement.

The states of Montana and Massachusetts have both challenged Regulation A+ as arbitrary under the Administrative Procedures Act. Regulation A+ exempts offerings sold under Tier 2 from state blue sky laws. The SEC denied a stay to the implementation of the rules pending the outcome of these challenges. The rules could still be overturned in court, although agencies are given great deference under the Administrative Procedures Act so the success of these challenges is doubtful.

These rules were adopted pursuant to Title IV of the Jumpstart Our Business Startups (JOBS) Act of 2012. The SEC plans to adopt crowdfunding rules pursuant to Title III later in 2015 or 2016. Title III will allow startups to solicit as many unaccredited investors as they wish, though solicitations will be limited to $1 million annually.

Smaller companies may view Regulation A+ as a way to broadly raise funds without undergoing the rigorous requirements of registration under the Securities Act. However, companies need to remember that any offerings will still be subject to various federal laws and regulations and could open up companies and individuals to SEC investigations. Any disclosure statements must be accurate and truthful. Any misleading or incomplete offering materials or disclosures could result in civil enforcement proceedings by the SEC and/or prosecution by the Department of Justice pursuant to criminal fraud statutes.

Regulation A+ expands on Regulation A, a longstanding but rarely used exemption to registration under the Securities Act of 1933. Part of the reason that Regulation A has been so rarely used is because of the significant costs associated with compliance with SEC regulations. Although Regulation A+ allows access to a broader range of individuals as investors, the compliance costs will still be high.

Numerous SEC investigations and enforcement actions in this area are likely. In adopting these rules, the SEC is going to conduct a study and provide a report within five years “on the impact of both the Tier 1 and Tier 2 offerings on capital formation and investor protection.” See SEC Press Release: SEC Adopts Rules to Facilitate Smaller Companies’ Access to Capital. A higher degree of protection may be needed for the non-accredited investors who will be participating in these offerings. It is very likely that offerings under Regulation A+ will face close scrutiny.

The SEC has published a Small Entity Compliance Guide to assist companies in raising funds under Regulation A+.

Settlement with Large Firm Audit Partner Reaffirms SEC’s Emphasis on Related Party Disclosures

The SEC’s Division of Enforcement has made a concerted effort in recent months to warn auditors and other corporate “gatekeepers” that it intends to scrutinize the adequacy of related party disclosures in financial filings. This emerging trend continued on April 29, 2015, when the SEC announced the settlement of an enforcement proceeding against McGladrey LLP partner Simon Lesser. See Exchange Act Rel. 74827 (Apr. 29, 2015). Lesser, who served as lead engagement partner during McGladrey’s financial statement audits of investment advisory firm Alpha Titans LLC and several related private funds over a four-year fiscal span, settled claims that he engaged in improper professional conduct within the meaning of Section 4C of the Securities Exchange Act of 1934 and Rule 102(e)(1)(iv)(B)(2) of the SEC’s Rules of Practice. The SEC also alleged that Lesser willfully aided and abetted and caused his audit client to violate Section 206(4) of the Investment Advisers Act of 1940 and Rule 206(4)-2 thereunder.

Lesser’s settlement derived from assertions that Alpha Titans failed to adequately disclose related party relationships and material related party transactions in accordance with generally accepted accounting principles (GAAP). Specifically, Alpha Titans’s chief executive officer and general counsel were alleged to have transferred more than $3.4 million in client assets among the various funds to pay for adviser-related operating expenses during fiscal years 2009 through 2012. These payments purportedly were not agreed to by fund clients or authorized under the various operating documents. As asserted, Lesser knew about these related party relationships and the underlying transactions, which should have been disclosed under Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 850, but, nonetheless, “gave his final approval for McGladrey to issue audit reports containing unqualified opinions.”

The SEC also claimed in the settlement that Lesser failed to ensure that McGladrey’s audits for each fiscal year were conducted in conformity with generally accepted auditing standards (GAAS). Lesser allegedly did not exhibit the requisite level of due professional care in that he “should have … place[d] greater emphasis on the related party relationships and transactions, and the adequacy of the related party disclosures.” The SEC further contended that Lesser did not obtain sufficient audit evidence or prepare audit documentation explaining adequately why he considered the financial statements GAAP compliant absent such related party disclosures. Without admitting or denying the SEC’s findings, Lesser agreed to a $75,000 civil penalty and a minimum three-year suspension from appearing or practicing before the SEC as an accountant.

Although the circumstances surrounding this particular proceeding were announced only last week, high-ranking SEC representatives began eluding to the likelihood of related party-based enforcement actions earlier this year. In late February, Julie M. Riewe, Co-Chief of the Division of Enforcement’s Asset Management Unit (AMU)—the same unit that conducted the investigation against Lesser—provided a revealing glimpse into AMU’s 2015 priorities during her presentation at the IA Watch 17th Annual IA Compliance Conference. Ms. Riewe cautioned:

For private funds—meaning hedge funds and private equity funds—the AMU’s 2015 priorities include conflicts of interest, valuation, and compliance and controls. On the horizon, on the hedge fund side, we anticipate cases involving undisclosed fees; all types of undisclosed conflicts, including related-party transactions; and valuation issues, including use of friendly broker marks.

(Emphasis added.)

Stephanie Avakian, Deputy Director of the Division Enforcement, provided parallel commentary in the context of auditors and other corporate “gatekeepers” during SEC Speaks 2015 in February. Ms. Avakian emphasized that accounting and financial reporting violations are considered an ongoing enforcement priority with particularized attention to related party disclosures.

Indeed, another recent enforcement proceeding further underscores that last week’s settlement with Lesser should not be construed as an isolated occurrence. The SEC announced a similar settlement with a Hong-Kong based auditing firm and two of its auditors in December 2014, involving an alleged “fail[ure] to uphold U.S. auditing standards and exercise appropriate professional care and skepticism with regard to numerous related-party transactions” not adequately disclosed by a Chinese-based oil company. See Press Rel. 2014-284, SEC Imposes Sanctions Against Hong Kong-Based Firm and Two Accountants for Audit Failures. The firm in that instance agreed to pay a $75,000 civil penalty with the two professionals agreeing to pay penalties of $20,000 and $10,000, respectively, and to accept three-year minimum suspensions. Accordingly, the enforcement action against Lesser is not the first recent settlement involving related party disclosures and, given the SEC’s pointed remarks earlier this year, it almost certainly will not be the last.

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