Category: Investment Advisers and Broker Dealers

The SEC’s Most Detailed Cybersecurity Guidance to Date

The SEC, through its Office of Compliance Inspections and Examinations (“OCIE”), recently issued its most detailed cyber guidance to date. OCIE had previously issued several cybersecurity risk alerts over the past few years. This most recent release, however, offers much more than a risk alert. OCIE’s “Cybersecurity and Resiliency Observations” goes into significantly more detail than OCIE’s prior risk alerts in this area and is fashioned in a vastly different and more user-friendly format. Thus, it is required reading for SEC regulated entities because, rest assured, it will be closely followed and applied by OCIE staff conducting cyber examinations, as well as by the Division of Enforcement’s “Cyber Unit.”

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The SEC Lays Down a Bet in a Nevada Court

The college football bowl season is upon us, NFL teams are jockeying for playoff seeding, and with the college basketball season underway fans of that game are looking longingly towards March for how their brackets may look for the 2020 tournament. Thus, sports and the gambling associated with it are all around us. In recent years, this gambling has risen from the shadows and is now openly discussed throughout society. So this industry has evolved and continues to evolve, since the times when gamblers needed to travel to Las Vegas or Atlantic City to legally gamble. Over the years, state laws have expanded such that today numerous states allow gambling in some form. Further accelerating this expansion, in the spring of 2018, the U.S. Supreme Court struck down the Professional and Amateur Sports Protection Act.

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The SEC in 2019: Doing More With Less

Facing a 35-day government shutdown and new restrictions on the ability to recover disgorgement, it would be perfectly understandable if the SEC’s Division of Enforcement suffered a lackluster year. Nevertheless, according to their recently released Annual Report, the Division of Enforcement defied the odds and turned in an impressive year by most metrics. The full report is available here, but we address several key aspects of the report below.

In fiscal year 2019 (which runs from October to September), the SEC reported a total of 862 enforcement actions, including 526 “standalone” actions filed in either federal court or as administrative proceedings, which was its highest number of standalone actions since 2016. The SEC also filed 210 “follow-on” proceedings seeking the barring of individuals based on actions by other authorities or regulators. This number of “follow-on” proceedings matched the prior year’s total, and was about 10% higher than the number of such actions filed in 2016 or 2017. Though the Report laments the handcuffs placed on the Enforcement Division by the Supreme Court’s ruling in Kokesh v. SEC, which tied recoverable disgorgement to the five-year statute of limitations, the SEC nevertheless secured $3.248 billion in disgorgement – a five-year high. In addition, while 2019’s $1.101 billion in penalties was more than $300 million lower than what was ordered in 2018, it nonetheless surpassed the 2017 numbers, and contributed to a total amount of money ordered paid in 2019 (between disgorgement and penalties) that represented another five-year high for the SEC. Despite these metrics revealing a very solid year for the Enforcement Division, the Report made it a point to highlight that the SEC estimates that it has had to forgo more than $1.1 billion in disgorgement in filed cases as a result of Kokesh.

The strong financial results for 2019 were buoyed by several major actions settled in 2019. Indeed, in separate actions initiated against Mylan, Fiat Chrysler, Hertz, and two other major corporations, the SEC secured more than $200 million in penalties alone. In addition, in actions over the past two years against a variety of financial institutions relating to the early release of the American Depository Receipts, the SEC actions resulted in orders for more than $425 million in disgorgement and penalties. While these large actions contributed to the substantial financial achievements of the SEC in 2019, the report noted that in actions in which money was ordered to be paid the median amount of such total payments rose from $362,858 last year to $554,003 this year.

The SEC’s overall numbers were undoubtedly bolstered by successful implementation and conclusion of its Share Class Selection Disclosure Initiative. The Initiative, which permitted investment advisory firms to self-report failures to disclose conflicts of interest associated with the selection of fee-paying share classes as opposed to low-fee or no-fee share classes, allowed self-reporters to obtain standardized (and relatively favorable) settlement terms. The Initiative generated settlements against 79 advisers in March 2019, and another 16 advisers settled in September 2019. In total, the 95 advisory firms agreed to return more than $135 million to affected investors.

In addition to emphasizing all of these key metrics, the Report reiterated several themes that have been hallmarks of the SEC under Chairman Clayton. At the top of the list is “protecting main street investors,” as evidenced by the Share Class Initiative mentioned above, as well as the continued operation of the SEC’s Retail Strategy Task Force as a source for both providing education and generating new investigations. The Report also highlighted the continuing emphasis that the SEC would be placing on holding individuals accountable for wrongdoing, and highlighted several cases from the past year in which C-level executives were charged in both settled and litigated fraud actions. Digital assets, cryptocurrency, and other distributed ledger technology cases also played a prominent role in the report, as the SEC acknowledged that its enforcement actions in this space “matured and expanded” over the past year. Finally, the Enforcement Division also explained that it was working diligently to accelerate the pace of its investigations. Not only would this faster pace decrease the chance of encountering Kokesh problems when seeking disgorgement, but it also helps speed the pace at which harmed individuals and investors can recover their losses.

In a year in which it lost more than a month due to the government shutdown and just recently regained the ability to hire new staff, the Enforcement Division appeared to work both harder and smarter to generate results that met or exceeded its recent historical benchmarks. Going forward, it will be interesting to see whether the SEC can replicate or improve on these results with the benefit of additional time and a more complete complement of attorneys and other professionals.

The SEC’s SCSD Initiative Second Wave and the Applicability of the President’s Recent Executive Order

On September 30, 2019, the SEC ordered an additional 16 self-reporting investment advisory firms to pay nearly $10 million in disgorgement. Some have referred to this as the “second wave” of the SEC Division of Enforcement’s Share Class Selection Disclosure Initiative (“SCSD Initiative”). It’s unclear if there will be another “wave” of SCSD Initiative settlements. What is clear, though, is that the number of self-reporting firms charged by the SEC so far totals ninety-five. When the SCSD Initiative was first announced many anticipated that the tally of firms charged would number in the hundreds, but the number remains under 100.

While the number of self-reporting firms is still significant and indicates that this was an industry issue, it may also signal that many firms elected to take their chances and not self-report. Along those lines, the SEC also announced that same day a settlement against a firm that did not self-report. Many will recall that the Division of Enforcement touted in the SCSD Initiative announcement and in public statements thereafter that qualifying firms that did not self-report could face significant penalties, additional charges, and possible charges against individuals. Yet, the settlement released with this “second wave” had none of that. The civil penalty ordered against this firm was not a multiple of the disgorgement amount–but rather a fraction–approximately one-third. This ratio is in the general range of the penalty-to-disgorgement ratios that the SEC typically seeks in standard settlements that do not involve the issue of whether a qualifying firm failed to self-report. That said, the order did specifically advise that the SEC considered the cooperation and remedial acts promptly undertaken taken by the respondent.

Many have voiced the opinion that the SCSD Initiative was a prime example of “regulation by enforcement.” Interestingly, on October 9, 2019, the President issued an “Executive Order on Promoting the Rule of Law Through Transparency and Fairness in Civil Administrative Enforcement and Adjudication.” While Executive Orders do not technically apply to the SEC, or other independent regulatory agencies, in practice the head of an independent regulatory agency may determine to honor the spirit and/or letter of a presidential directive.

This Executive Order provides:

The rule of law requires transparency. Regulated parties must know in advance the rules by which the Federal Government will judge their actions.
* * *

No person should be subjected to a civil administrative enforcement action or adjudication absent prior public notice of both the enforcing agency’s jurisdiction over particular conduct and the legal standards applicable to that conduct.
* * *

Sec. 4. Fairness and Notice in Administrative Enforcement Actions and Adjudications. When an agency takes an administrative enforcement action, engages in adjudication, or otherwise makes a determination that has legal consequence for a person, it may apply only standards of conduct that have been publicly stated in a manner that would not cause unfair surprise. An agency must avoid unfair surprise not only when it imposes penalties but also whenever it adjudges past conduct to have violated the law.

While this may not technically apply to the SEC, the tone and language of this Executive Order is similar to the views expressed by SEC Commissioner Hester M. Peirce in her SECret Garden speech at SEC Speaks this past spring. With the SCSD Initiative hopefully fading into the past, perhaps the leadership at the SEC will scrutinize “regulation by enforcement” initiatives in the future more closely.

The SEC Files Another Litigated Disclosure Case – With More Violations

On August 29, 2019, the SEC filed a complaint against a registered investment adviser alleging failures to disclose four categories of conflicts of interest and seeking disgorgement of $10 million in undisclosed compensation. This litigated action was filed within a month of the SEC filing a litigated complaint against another firm alleging failing to disclose material conflicts of interest related to revenue sharing, despite that advisory firm having self-reported pursuant to the SEC’s Share Class Selection Disclosure Initiative (“SCSD Initiative”).

Based on these litigated actions (and despite the SCSD Initiative being over 18 months old), the SEC’s Division of Enforcement continues to focus its investigative and litigation resources on “Main Street” and to aggressively pursue registered investment advisory firms for disclosure violations involving actual or potential conflicts of interest.

In this most recent litigated action, not surprisingly, the SEC’s allegations with respect to share class selection conflicts and disclosure violations are consistent with the guidance released with the SCSD Initiative. This firm, however, did not fail to self-report its 12b-1 fee purported violative conduct. Rather, this alleged violative 12b-1 fee conduct was apparently uncovered during an examination by the SEC’s Office of Compliance Inspections and Examinations (“OCIE”). The SEC also alleged disclosure violations related to revenue sharing, a longstanding priority for the SEC that has continued to expand since the SCSD Initiative.

The SEC’s ongoing efforts on disclosure violations about share class selection and revenue sharing have been discussed widely in the financial press and by industry groups.

The latter two alleged disclosure theories, however, have not received similar attention, but provide information and insight into other legal theories that OCIE and Enforcement may now be prioritizing in their examination and enforcement programs. Specifically, the third group of alleged disclosure violations relate to the adviser’s receipt of administrative service fees. While Enforcement has brought cases using similar fee disclosure theories in the past, the number of cases focused on the disclosures and conflicts for these types of fees, as opposed to 12b-1 fees and revenue sharing, pales by comparison. Lastly, the SEC also alleged that the adviser failed to disclose compensation that it received in the form of non-transaction-based mark-ups on charges imposed by the clearing firm. The first time that we observed the SEC charge this type of undisclosed mark-up theory was just within this past year, in December 2018.

For both of these recent SEC actions, the advisers have apparently chosen to litigate and fight the SEC’s ever expanding efforts to regulate specific disclosure language, despite the D.C. Circuit’s ruling in Robare. The D.C. Circuit’s ruling, while troublesome for the SEC as it related to “willfulness” and that aspect of the opinion, supported and favored the SEC’s disclosure theory relating to the use of general disclosure terms such as “may” when, in fact, the adviser “was” receiving compensation. Interestingly though, the SEC chose to not file these two recent matters as administrative proceedings. Doing so would have allowed for the D.C. Circuit’s Robare opinion to serve as precedent. The SEC instead chose to file these as civil complaints in U.S. District Courts outside of the D.C. Circuit. Thus, potentially opening the door for the defendants to attempt to minimize that aspect of Robare by arguing that this opinion is not precedential in those appellate circuits, but only persuasive.

We will continue to follow these litigated matters and report back on any developments likely to impact the industry.

Federal Prosecutor Faces Accusations that it Used the SEC to Collect Evidence for its Criminal Investigation

In a ruling handed down on Tuesday, a Southern District of New York judge ordered the U.S. Attorney’s Office for the Southern District of New York (“USAO”) to submit a full account of their communications with the SEC after defendant Jason Rhodes accused the USAO of using the SEC to develop its criminal case against him.

Rhodes was charged with four counts, including conspiracy to commit securities fraud and wire fraud, securities fraud, wire fraud, and investment advisor fraud, in what the government alleges was an elaborate $19.6 million scheme to defraud investors. Notably, the charges against Rhodes were brought almost two years after the government charged all other co-conspirators. During that time, the SEC initiated an investigation involving Rhodes.

In a motion filed back in March of this year, Rhodes argued that the USAO may have violated his due process rights by using the SEC civil process to further its criminal investigation against him. During the SEC’s investigation, it used its investigatory authority to obtain documents from Rhodes, including communications and data from his cellphone. These documents were then turned over to the USAO and the substance of certain of those documents was subsequently included in the criminal complaint against him. Rhodes asserted in his motion, as soon he was arrested, the SEC stopped investigating him.

Given that timeline, the court insisted the USAO submit an affidavit outlining its relationship with the SEC regarding its civil investigation and its criminal charges against Rhodes. After one AUSA submitted an affidavit, the court held that as of now, Rhodes had not shown the government acted in bad faith. The court went on to say, however, that the submitted affidavit “d[id] nothing to advance the ball.” While the AUSA insisted that he did not request the issuance of the SEC subpoena, the affidavit was silent regarding the involvement of others in the USAO. As a result, the court ordered that the USAO submit a new affidavit “detailing, with specificity, the nature and extent of any and all communications between the SEC and those involved in the criminal investigation of Rhodes.” Only then will the court determine whether the materials should be turned over to Rhodes.

The SEC and U.S. Attorney’s Office across the country often conduct parallel investigations and the SEC regularly shares the information it gathers with those offices. While there is nothing to prevent the government from conducting parallel investigations, the government must act “in good faith and with the proper procedures.” See United States v. Kordel, 397 U.S. 1, 6(1970). Indeed, the SEC warns in its “Form 1662” that it may share the information and documents produced pursuant to a subpoena (or voluntarily) to a host of other agencies, including, but not limited to, state and federal criminal authorities. It is, however, well-settled law at this point that the criminal authorities cannot direct the SEC’s investigation and that any action taken by the SEC, including subpoenas for documents, testimony and other evidence, must be supported by the SEC’s independent decision making and must be in furtherance of its investigation; not the criminal authority’s investigation. See, e.g., United States of America v. Stringer, 408 F. Supp. 2d 1083 (Dist. Or. 2006); United States of America v. Scrushy, 366 F. Supp. 2d 1134, 1140 (N.D. Ala. 2005.

The Final Reg BI Package: What to Know and What’s Next

To nobody’s great surprise, on June 5, the SEC approved the “Reg BI Package,” which includes a series of new standards governing the fiduciary responsibilities of broker-dealers and investment advisers. The approved items consisted of the Regulation Best Interest – Standard of Conduct for Broker-Dealers; Form CRS Relationship Summary; Standard of Conduct for Investment Advisers; and Interpretation of “Solely Incidental,” all of which seem likely to have considerable impact on the industry going forward.

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The SEC’s Reg BI Package Time to Vote

On June 5, the SEC will hold an Open Meeting to consider whether to adopt certain measures to reform retail investment standards. In this alert, the Best Interest Compliance Team provides a brief preview of the key topics and potential concerns about the proposed standards.

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