SEC Levies Disgorgement and Civil Penalties for Violations of the Consumer Protection Rule and the Dodd-Frank Whistleblower Protection Rule

On June 23, 2016, Merrill Lynch, Pierce, Fenner & Smith Incorporated and Merrill Lynch Professional Clearing Corp. (collectively, “Merrill Lynch”) agreed to pay $415 million and admit wrongdoing to settle charges of rules based violations, including Exchange Act Rule 15c3-3, the Consumer Protection Rule (the “Consumer Protection Rule”) and Exchange Act Rule 21F-17 (“Rule 21F-17”), which prohibits any action impeding an individual from communicating directly with Commission staff about possible securities laws violations. See Release No. 78141.

Exchange Act Rule 15c3-3, known as the Consumer Protection Rule, was enacted to “protect broker-dealer customers in the event a broker dealer becomes insolvent” by eliminating the “use by broker-dealers of customer funds and securities to finance firm overhead and such firm activities a trading and underwriting through the separation of customer related activities from other broker-dealer operations.” To safeguard assets, the Consumer Protection Rule requires broker-dealers to “maintain a reserve of funds and/or certain qualified securities in an account at a bank that is at least equal in value to the net cash owed to customers” and to “promptly obtain and thereafter maintain physical possession or control over customers’ fully paid and excess margin securities . . . . in one of several locations . . . held free of liens or any other interest that could be exercised by a third-party to secure an obligation of the broker-dealer.” The Consumer Protection Rule also imposes a self-reporting requirement where, in the event that a broker-dealer fails to maintain sufficient reserves, it must immediately notify the Commission and FINRA.

Signaling that the SEC may suspect that other broker-dealers may have also violated the Consumer Protection Rule, Michael J. Osnato, Chief of the SEC Enforcement Division’s Complex Financial Instruments Unit, announced in a press release: “Simultaneous with today’s action, SEC staff will begin a coordinated effort across divisions to find potential violations by other firms through a targeted sweep and by encouraging firms to self-report any potential violations of the Customer Protection Rule.” Press Release No. 2016-128. In light of the significant civil penalty imposed by the SEC against Merrill Lynch, broker-dealers should take a hard look at their own compliance with the Consumer Protection Rule and seriously consider self-reporting if they find violations as required by the Consumer Protection Rule itself.

Rule 21F-17 was enacted to “evince[] a Congressional purpose to facilitate the disclosure of information to the Commission relating to possible securities law violations and to preserve the confidentiality of those who do so.” “Implementation of the Whistleblower Provisions of Section 21F of the Securities Exchange Act of 1934,” Release No. 34-64545, at p. 198 (Aug. 12, 2011). The SEC acknowledged that it did not discover any instance where a Merrill Lynch employee was prevented from directly communicating with the Commission regarding potential securities law violations, certain Merrill Lynch policies, procedures, and agreements with employees included language that the SEC claimed did not permit an individual to voluntarily disclose confidential information. The Order further states that Merrill Lynch promptly took “substantial remedial acts” to address any Rule 21F-17 violations, including revising its severance agreements. Notably, this is the second time the Commission has held proceedings for Rule 21F-17 violations without any evidence that any employee had been prevented from disclosing confidential information to the government. See In the Matter of KBR, Inc., Release No. 74619. Given that the Consumer Protection Rule violation seems unrelated to the Rule 21F-17 violation, it seems likely we will see the staff asking about language included in employment agreements, severance agreements and other employment policies during investigations even in the absence of specific whistleblower concerns.

While Merrill Lynch admitted to wrongdoing, the settlement involves rules based violations as opposed to fraud based violations. Merrill Lynch did not admit to any fraudulent conduct. Notably, some of the largest “admit” settlements have been grounded in rules based violations. See Press Release No. 2013-187 (JPMorgan Chase admits to wrongdoing and pays $200 million and $920 million worldwide to settle SEC charges); see also Press Release No. 2014-17 (Scotttrade admits to wrongdoing and pays $2.5 million to settle SEC charges). The Commission also announced on June 23rd, a litigated administrative proceeding against William Tirrell, Merrill Lynch’s former Head of Regulatory Reporting, related to the Consumer Protection Rule violations. See Release No. 78142. The proceeding will be scheduled for a public hearing before an administrative law judge.

SEC Announces Highest Whistleblower Award to Date

The SEC recently announced a record-breaking whistleblower award of $30-35 million, which shattered the previous high award of $14 million. See SEC Awards More Than $14 Million to Whistleblower. Not only is this award noteworthy for its size, but also because it was made to a foreign resident and it could have been even higher if the whistleblower did not unreasonably delay in reporting the violations.

This was not the first award made to foreign residents, but it was the first award made to a foreign resident since the Court of Appeals for the Second Circuit found that the anti-retaliation protections of Section 21F(h) of the Dodd-Frank Act do not apply to foreign whistleblowers who experience retaliation overseas from foreign employers. Liu v. Siemens, __ F.3d __, 2014 WL 3953672 (2d Cir. Aug. 14, 2014); see also Made for the U.S.A. Only: Second Circuit Holds That the Dodd-Frank Act’s Antiretaliation Provision Applies Only Domestically. In making this award, the SEC reiterated that any extraterritorial aspects of tips, such as a whistleblower’s foreign residency or alleged misconduct that occurs abroad, do not matter when there is a “sufficient U.S. territorial nexus”—i.e., “whenever a claimant’s information leads to a successful enforcement of a covered action brought in the United States, concerning violations of the U.S. securities laws, by the Commission, the U.S. regulatory agency with enforcement authority for such violations.” Order Determining Whistleblower Award Claim, Whistleblower Award Proceeding, File No. 2014-10 (Sept. 22, 2014). It found that the Second Court’s holding in Liu v. Siemens, __ F.3d __, 2014 WL 3953672 (2d Cir. Aug. 14, 2014), was not controlling and that “the whistleblower award provisions have a different Congressional focus than the anti-retaliation provisions, which are generally focused on preventing retaliatory employment actions and protecting the employment relationship.”

In announcing the award Sean McKessy, Chief of the Office of the Whistleblower, underscored the extraterritorial reach of the program: “This award of more than $30 million shows the international breadth of our whistleblower program as we effectively utilize valuable tips from anyone, anywhere to bring wrongdoers to justice. Whistleblowers from all over the world should feel similarly incentivized to come forward with credible information about potential violations of the U.S. securities laws.” See SEC Press Release: “SEC Announces Largest-Ever Whistleblower Award.”

Further, this already staggering award amount had the potential to be even higher if the whistleblower did not unreasonably delay in reporting to the SEC. The whistleblower delayed for an undisclosed period of time after first learning of the violations, which the SEC said caused investors to suffer significant losses that might have been avoided. The SEC found that the whistlblower’s delay was unreasonable under the circumstances and reduced the award from the maximum percentage allowed under the statute. It rejected the whistleblower’s argument that the percentage awarded was below the average percentage awarded to other whistleblowers as irrelevant. The SEC, however, did not apply the unreasonable delay consideration as severely as it otherwise might have done because a period of the delay occurred before the implementation of the whistleblower program established by the Dodd-Frank Act.

This latest award shows the SEC’s willingness to make awards to whistleblowers across the globe.