Acting SEC Chairman Limits Delegated Formal Order Authority

Acting SEC Chairman Michael Piwowar has apparently revised the staff’s ability to subpoena records and investigative testimony (“formal order authority”) by returning the authority to grant formal order authority to the agency’s Director of Enforcement. While the SEC has not formally recognized this policy shift, multiple sources, including Law360 and the Wall Street Journal, have reported that Acting Chair Piwowar has recently implemented this change, which revokes the delegated authority to regional directors and enforcement associate directors to approve the staff’s requests for formal order authority.

In 2009, under Chair Mary Schapiro and as part of certain initiatives to enhance enforcement’s capabilities in the aftermath of the financial crisis, the SEC delegated its authority to authorize formal order authority to the Director of Enforcement. The Director of Enforcement, in turn, delegated this authority to regional directors and enforcement associate directors. As a result, the staff could, within an hour (when necessary) obtain formal order authority, as compared to the days, weeks, or at times months, that it had historically taken to obtain formal order authority from the Commission. Not unexpectedly, the number of formal investigations opened by the staff dramatically increased.

Acting Chair Piwowar’s recent move eliminates the second layer of delegation by limiting the 2009 delegated authority to the Director of Enforcement. While the effect of this change on the number of SEC investigations remains uncertain, multiple sources report that Acting Chair Piwowar enacted the policy not to reduce that number, but to bring greater oversight and consistency to the investigation process. Further, while he is not authorized to take the step alone, as it would require a vote of the Commission which is currently comprised of only two members, Acting Chair Piwowar and Commissioner Kara Stein, the acting chair has asked the SEC’s general counsel to consider whether the agency should further restrict formal order authority by returning the power to grant it to the SEC Commissioners. Thus, at Acting Chair Piwowar’s direction, the SEC is considering a return to the pre-2009 formal order authority review and approval process.

The revocation of the regional and associate directors’ delegated ability to approve formal order authority is the latest action taken by Acting Chair Piwowar, who stepped in as acting chairman after former Chair Mary Jo White stepped down at the conclusion of the Obama administration. His actions have included requesting that all authorities granted to staff members be reviewed and that public disclosure rules required by Dodd-Frank be reconsidered.  Such actions indicate efforts to begin the reshaping of the agency as it awaits the confirmation of President Trump’s nomination for chairman, Jay Clayton.

FINRA Releases its 2017 Annual Regulatory and Examination Priorities Letter

Earlier this month, FINRA published its Annual Regulatory and Examination Priorities Letter (the “Letter”). This is the first Letter under the tenure of new FINRA President and CEO Robert W. Cook. Notably, Mr. Cook introduced FINRA’s annual Letter with his own “cover letter” in which he shared several thoughts with the broker-dealer industry, including a common thread running through FINRA’s Letter—specifically a focus on core issues of compliance, supervision, and risk management. Mr. Cook also discussed his “listening tour” to meet with member firms, regulators, and investor groups since joining FINRA in August. In doing so, he shared two takeaways. First, starting this year, FINRA will publish summary reports that outline key findings from examinations in selected areas to serve as additional tools that firms can use to strengthen their controls. Second, in response to feedback from smaller firms, FINRA will start providing more, and perhaps different, compliance tools to assist smaller firms in complying with regulatory requirements.

Turning to the Letter, FINRA annually publishes such a letter to provide its member firms with helpful insight into the focus areas for the upcoming year’s examinations. Though we encourage all clients, blog readers, and interested parties to review the Letter in its entirety, we have highlighted certain topics and points that we believe are the most important for our clients and followers, as discussed in more detail below. At the offset, however, we should note that in its introduction FINRA advised that starting in 2017 it will conduct electronic, off-site reviews in addition to traditional on-site examinations. These new electronic reviews will involve a select group of firms that are not currently scheduled for a cycle examination in 2017. These reviews will focus on selected areas including those identified in the Letter. In another change for 2017, FINRA will release a “compliance calendar” and a directory of compliance service providers, with the goal of helping small firms better meet their regulatory requirements.

In the body of the Letter, FINRA provides several broad categories for its priorities: (1) High-risk and Recidivist Brokers; (2) Sales practices; (3) Financial Risks; (4) Operational Risks; and (5) Market Integrity. Within these broad categories, FINRA also identified sub-categories. For ease of referencing the Letter, our summary below follows the organization of the Letter.

High-risk and Recidivist Brokers

Not surprisingly, FINRA will continue to devote particular attention to the member firms that hire high-risk and recidivist brokers and apply greater scrutiny to such firms. First, FINRA recently established a dedicated examination unit whose sole mission is to rigorously review and monitor high-risk and recidivist brokers’ interactions with customers. Second, FINRA will also focus on the ways that firms hire, retain, and monitor statutorily disqualified and recidivist brokers, and will also focus on firms that have a high concentration of brokers with significant disciplinary records, complaints, or arbitrations. Third, and more generally, FINRA is committed to ensuring that firms have sufficient inspection programs and supervisory systems for their branch offices and non-branch office locations, including independent contractor branches.

Sales Practices

  • Senior Investors – FINRA will continue to closely evaluate recommendations that senior investors purchase speculative or complex products, particularly in light of the investor’s profile and risk tolerance. Last year, fraud schemes involving microcap (or “penny”) stocks were on the rise, and often targeted senior investors. FINRA encourages firms to take steps to protect elderly customers from such fraud by contacting these customers to verify those types of transactions.
  • Product Suitability and Concentration – FINRA will continue to assess how firms conduct reasonable-basis and customer-specific suitability reviews, and will increase its focus on the controls firms have in place for recommending new products and for recommendations that result in excess concentration in customers’ accounts. FINRA makes specific reference to ETPs, non-traded REITS and BDCs. Furthermore, firms should be prepared to discuss how changes in the interest rate environment impact their recommendations to clients.
  • Excessive and Short-term Trading of Long-term Products – FINRA is clearly concerned about excessive and short-term trading of long-term products, as such activity is detrimental to clients but can bolster sales credits for registered representatives. FINRA makes specific reference to UITs. In addition to FINRA’s examination of this activity, FINRA urges firms to determine whether their control systems are sophisticated enough to detect deliberate attempts to avoid automatic surveillance for excessive switching activity.
  • Outside Business Activities and Private Securities Transactions – FINRA will continue to focus on firms’ controls, documentation, and evaluation of written notifications of proposed outside business activities by registered representatives and associated persons. In addition, FINRA will focus on associated persons’ notification of private securities transactions and firms’ ongoing supervision of approved private securities transactions.
  • Social Media and Electronic Communications Retention and Supervision – FINRA makes clear that both SEC and FINRA record-retention requirements extend to all business-related communications, regardless of the devices or networks used. FINRA will ensure that firms are complying with these retention requirements, as they are essential to a firm’s ability to detect inappropriate business conduct.

Financial Risks

  • Liquidity Risk – FINRA’s 2016 assessment of liquidity management practices at firms identified a variety of issues. As a result, in 2017 FINRA intends to focus on firms’ funding and liquidity plans to determine whether firms adequately evaluate their liquidity needs, develop contingency plans to handle market stresses, and effectively test those contingency plans.
  • Financial Risk Management – Furthering its attempts to understand how larger firms manage risk across their organizations, FINRA will ask a select group of firms to explain how they would react to specific stress scenarios, considering the areas of readiness, communication plans, risk metrics, and contingencies.
  • Credit Risk Policies, Procedures and Risk Limit Determinations Under FINRA Rule 4210 – On December 15, 2016, the first phase of the new amendments to FINRA Rule 4210 became effective. In 2017, FINRA will evaluate firms’ compliance with the first phase of the rule amendments and the corresponding supervision, policies, procedures and processes.

Operational Risks

  • Cybersecurity – According to FINRA, cybersecurity threats are one of the most significant risks for many firms. FINRA will focus on reviewing firms’ data systems, the controls designed to protect those data systems (including from insider threats), the strength of controls and practices at branch offices and independent contractor branch offices (which tend to be weaker), and firms’ compliance with Securities Exchange Act of 1934 (SEA) Rule 17a-4(f), which requires the use of write once read many (aka “WORM”) format.
  • Supervisory Controls Testing – FINRA reminds all firms of their obligations with respect to supervisory controls testing and chief executive officer certifications with specific reference to FINRA Rules 3120 and 3130.
  • Customer Protection/Segregation of Client Assets – Compliance with SEA Rule 15c3-3 is also a priority. FINRA will assess the sufficiency of firms’ documentation of the absence of liens and encumbrances on securities. In addition, FINRA will be examining whether firms are engaging in transactions that are designed, in whole or in part, to reduce a firm’s reserve or segregation requirements.
  • Regulation SHO – Close Out and Easy to Borrow – Due to recent SEC enforcement actions regarding SEC Regulation SHO, FINRA will focus on the locate processes employed by firms in connection with short sales, and emphasized that firms should closely monitor their close-out process to ensure they are complying with Rule 204 of Regulation SHO.
  • Anti-Money Laundering and Suspicious Activity Monitoring – Anti-money laundering programs will continue to be a FINRA focus in the upcoming year. Firms must incorporate anti-money laundering red flags into their trading surveillance systems, and should evaluate their controls around accounts held by nominee companies.
  • Municipal Advisor Registration – Firms that advise state and local governments on municipal securities should ensure that they are registering correctly with the SEC and the Municipal Securities Rulemaking Board and that individuals engaging in municipal advisory activities pass the Series 50 Examination made available on September 12, 2016. Firms that do not register but still provide services to municipal customers should ensure that they meet the appropriate statutory exclusions and regulatory exceptions.

Market Integrity

  • Manipulation – Manipulation is a perennial top priority for FINRA and FINRA is taking several steps to detect and deter such manipulation, including: (1) enhancing its layering pattern detection capabilities to look for larger groups of market participants engaging in this manipulative activity; (2) enforcing the recent amendments to the Order Audit Trail System (OATS) rules; (3) monitoring potentially manipulative trades surrounding market open and close; and (4) expanding cross-product manipulation surveillance to include exchange-traded products. Lastly, in 2016, FINRA introduced the Cross Market Equity Supervision Report Cards for layering and spoofing activity as a compliance tool to complement firms’ supervisory systems and procedures to detect and deter manipulative conduct by a firm or its customers.
  • Best Execution – FINRA emphasizes the importance of Regulatory Notice 15-46 and the importance of providing accurate payment for order flow disclosures. FINRA further advises that firms need to consider how the continuing automation of the markets for equity securities, standardized options and advances in fixed income markets affect order handling decisions, and factor these changes into their review of execution quality.
  • Audit Trail Reporting Early Remediation Initiative and Expansion – FINRA expects firms to address potential equity audit trail issues identified through the Audit Trail Reporting Early Remediation Initiative. If firms take quick corrective measures in response to these alerts and the problem is limited in scope, it is possible that a formal investigation can be avoided.
  • Tick Size Pilot – The Tick Size Pilot will continue in 2017, and FINRA notes that it is “critical” that firms submit accurate OATS and market maker data. FINRA intends to monitor compliance with these data requirements, and restrictions on quoting and trading.
  • Market Access Rule – Firms should focus on improving their compliance with the Market Access Rule. In this subsection, FINRA provides a list of best practices, including: implementing, memorializing, and monitoring pre-trade and post-trade controls; implementing procedures for the supervision, development, testing and employment of algorithmic trading, including code development or changes; and maintaining reasonable processes to monitor whether trading algorithms operate as intended, and processes to disable algorithms or systems that malfunction. FINRA directs firms to Regulatory Notice 15-09 for further discussion of effective electronic trading practices.
  • Trading Examinations – Conflicts of interest, the adequacy of alternative trading systems’ disclosures, and the handling of manual option orders by floor brokers and upstairs firms under their best execution obligations will be examination priorities this year. Also, FINRA intends to begin a pilot trading examination program to determine whether targeted examinations of smaller firms are worthwhile.
  • Fixed Income Securities Surveillance Program – FINRA will continue to focus on surveilling wash sales and interposing activity, and will review written supervisory procedures and systems designed to detect non-bona fide trading to create an artificial price level in a bond, in order to hide an excessive mark-up to a customer trade or reset the aging of positions held by the firm. FINRA will also continue its focus on securitized products. Also, in light of the TRACE reporting requirements, which are scheduled to become effective in July 2017, FINRA will develop ways to monitor compliance with rules applicable to U.S. Treasury securities.

Drinker Biddle Conclusion

Mr. Cook’s cover letter is revealing in terms of his initial views as FINRA’s new leader. Mr. Cook appears to aspire for increased and better communication with FINRA’s members. He also stated that one of his areas of focus will be the role that member firms “…play in facilitating capital formation by small and emerging growth companies, which are vital engines of our economy and job creation.” Turning to FINRA’s Letter, consistent with its mandate as the main self-regulatory organization for broker-dealers, the Letter and priorities ambitiously seek to cover all corners of the broker-dealer industry. That said, many of the plans discussed are continuations of long-standing efforts, though others are new priorities that demonstrate the ways in which FINRA’s oversight is evolving, expanding, and improving, such as the increased discussion of electronic and algorithmic trading. For our clients and readers, we will continue to monitor the way that FINRA’s priorities unfold over the course of 2017. In the meantime, if you have any questions about any of the topics covered in the Letter, please contact Sandy Grannum or Jim Lundy.

President–Elect Trump Nominates Jay Clayton For SEC Chair

On January 4, 2017, President-Elect Donald Trump announced that he intends to nominate Walter “Jay” Clayton for Chairman of the Securities and Exchange Commission (SEC). In response, Mr. Clayton stated that, “If confirmed, we are going to work together with key stakeholders in the financial system to make sure we provide investors and our companies with the confidence to invest together in America. We will carefully monitor our financial sector, as we set policy that encourages American companies to do what they do best: create jobs.”

Of the three pillars of the SEC’s mission statement – 1) protect investors; 2) maintain fair, orderly, and efficient markets; and 3) facilitate capital formation – Mr. Clayton’s deep experience as a “dealmaker” most closely aligns with the facilitation of capital formation pillar.  Chair Mary Jo White’s primary prior experience as a federal prosecutor, in contrast, most closely aligned with the protection of investors. That said, while this announcement clearly indicates the incoming administration’s focus on that third pillar, with the latter part of this statement in his announcement, the President-Elect reminded the securities industry that the Chair and SEC will remain responsible for ensuring that the rules and regulations are followed, “Jay Clayton . . . will ensure our financial institutions can thrive and create jobs while playing by the rules at the same time.”

While Mr. Clayton has strong industry knowledge and experience, his lack of enforcement experience is comparable to Chair White’s lack of experience in the SEC’s regulatory and policy areas when she was appointed. Consequently, if his nomination is affirmed, Mr. Clayton’s choice for the next Director of the Division of Enforcement will reveal much about his enforcement objectives. In the meantime, one area that Mr. Clayton appears primed to de-emphasize is the SEC’s enforcement of the Foreign Corrupt Practices Act, based on this New York City Bar Association paper that he assisted in drafting. The President-Elect will also have more to say on the future direction of the SEC with his upcoming nominations to fill the two remaining open seats on the Commission.

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 SEC’s First Risk Alert of Fiscal Year 2017 Targets Registrant Rule 21F-17 Compliance

The Securities and Exchange Commission (SEC or Commission) Office of Compliance Inspections and Examination (OCIE) issued a Risk Alert on October 24, 2016, titled “Examining Whistleblower Rule Compliance.” This recent Risk Alert continues the SEC’s aggressive efforts to compel Rule 21F-17 compliance and puts the investment management and broker-dealer industries on formal notice that OCIE intends to scrutinize registrants’ compliance with the whistleblower provisions of the Dodd–Frank Wall Street Reform and Consumer Protection Act (Dodd–Frank). By way of background, Dodd–Frank established a whistleblower protection program to encourage individuals to report possible violations of securities laws. Importantly, in addition to providing whistleblowers with financial incentives, Rule 21F-17 provides that no person may take action to impede a whistleblower from communicating directly with the SEC about potential securities law violations, including by enforcing or threatening to enforce a severance agreement or a confidentiality agreement related to such communications. As discussed in our prior publications, the SEC’s Division of Enforcement (Enforcement) has instituted several settled actions against public companies for violating the “chilling effect” provisions of Rule 21F-17. During the past two months, the SEC has filed two additional settled enforcement actions, as summarized below. Thus, as the SEC embarks on the start of its 2017 fiscal year (FY2017), Rule 21F-17 remains an agency-wide priority, and issuers, investment management firms, and broker-dealers—if they have not done so already—need to take heed and proactively remediate any vulnerabilities that they may have regarding their Rule 21F-17 compliance.

OCIE Alerts Registrants

As described previously, the SEC’s most recent annual report stated that assessing confidentiality terms and language for compliance with Rule 21F-17 was a top priority for fiscal year 2016 and that staff had started the practice of examining company documents for such compliance. Now, less than one month into FY2017, OCIE has formalized this practice and notified the registrant community accordingly.

The Risk Alert spells out how OCIE plans to examine documents for these compliance issues. First, OCIE staff will examine whether any terms that are contained in company documents “(a) purport to limit the types of information that an employee may convey to the Commission or other authorities; and (b) require departing employees to waive their rights to any individual monetary recovery in connection with reporting information to the government.” Second, regarding the books and records to be examined, staff will analyze the following types of documents: compliance manuals; codes of ethics; employment agreements; and severance agreements. Finally, the Risk Alert identifies provisions that may contribute to violations of Rule 21F-17 or may impede employees or former employees from communicating with the Commission, such as provisions that:

  1. require an employee to represent that he or she has not assisted in any investigation involving the registrant;
  2.  prohibit any and all disclosures of confidential information, without any exception for voluntary communications with the Commission concerning possible securities laws violations;
  3. require an employee to notify and/or obtain consent from the registrant prior to disclosing confidential information, without any exception for voluntary communications with the Commission concerning possible securities laws violations; or
  4. purport to permit disclosures of confidential information only as required by law, without any  exception for voluntary communications with the Commission concerning possible securities laws violations.

Enforcement Update

Since August 16, 2016, the SEC has instituted two additional enforcement actions for violations of Rule 21F-17 based on prohibitions contained in severance agreements. First, in the Health Net, Inc., matter, the relevant violations involved release language in severance agreements that required employees to waive their right to any monetary recovery resulting from participating in a whistleblower program, among other issues. As part of the settlement, Health Net agreed to pay a $340,000 civil penalty and to engage in undertakings similar to those in the prior Rule 21F-17 cases. A review of the SEC’s Rule 21F-17 stand-alone cases reveals that the penalties have increased with each matter and that Health Net payed the largest fine to date. More recently, and within a month of OCIE’s Risk Alert, an international beverage conglomerate agreed to pay a civil penalty for violations of Rule 21F-17, among other charges. The Rule 21F-17 violations were related to a liquidated damages provision in the company’s separation agreement that did in fact cause an employee to stop communicating with the SEC until he received a subpoena. In this case, the primary charges involved books and records violations and internal control infractions that arose under the terms of the Foreign Corrupt Practices Act of 1977. Consistent with one other Rule 21F-17 case, the SEC appears to routinely investigate possible Rule 21F-17 violations while investigating other charges.

Takeaways

OCIE’s first Risk Alert of FY2017 puts the investment management and broker-dealer industries on notice that OCIE staff will examine and scrutinizing company documents for Rule 21F-17 compliance. More importantly and not stated in the Risk Alert—when coupled with Enforcement’s ongoing and aggressive interest—this combination indicates that OCIE staff will be looking to refer violations of Rule 21F-17 to their receptive Enforcement colleagues. Thus, investment management and broker-dealer registrants need to be proactive in assessing their risks and in reviewing all agreements, policies and procedures that may create exposure to SEC Rule 21F-17 violations. If there are any potential violations, Registrants should then execute a remediation plan. Cleary, this Risk Alert serves as a “notice,” and registrants who fail to act will likely be subjected to an OCIE referral to Enforcement.

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.