The SEC’s Division of Enforcement issued its annual report on November 2, 2020. According to the report, fiscal year 2020 saw the SEC file a total of 715 enforcement actions, representing a whopping 17% drop from the 862 enforcement actions it brought during the 2019 fiscal year. Indeed, the FY 2020 figure was the lowest in the past six years. The number of SEC enforcement actions filed against public companies (61) declined to a six-year low, representing the lowest number since 2014.
The number of public company and accounting fraud cases filed under SEC Chair Jay Clayton has declined. The SEC, however, continues to selectively pursue these types of cases. In the latest example, in aggressive parallel actions, on October 8, 2020, the SEC filed charges against SAExploration Holdings, Inc. (“SAE”) and four of its former executives – CEO and Chairman Jeffrey Hastings, CFO and General Counsel Brent Whiteley, CEO and COO Brian Beatty, and VP of Operations Michael Scott – with an accounting fraud that inflated company revenues and concealed the true nature of the relationship between SAE and one of its large customers.
In February 2020, SAE issued restated financial statements reaching as far back as 2014 which, among other things, corrected a $100 million overstatement of revenue and resulted in a $35 million reduction in the value of the company’s assets. Perhaps unsurprisingly, in August 2002, SAE filed a voluntary Chapter 11 bankruptcy petition in the Southern District of Texas.
SEC Chairman Jay Clayton has repeatedly touted his focus on “Main Street.” In doing so, he unleashed the Division of Enforcement’s Asset Management specialty unit on the investment advisory industry and finalized and implemented the “Reg BI” rulemaking, the SEC’s most significant sales practice regulatory development for the brokerage industry in decades. But the Division of Enforcement did not slow down its efforts in one of its core focus areas: the investigation and civil prosecution of accounting fraud by public companies and their senior officers.
The SEC has suspended the trading of eleven companies for issues related to the COVID-19 pandemic since February 7, 2020. Of those eleven suspensions, seven have come since April 3rd. Most of the suspensions follow the recent statement from the co-directors of the SEC’s Division of Enforcement that “the Enforcement Division is committing substantial resources to ensuring that our Main Street investors are not victims of fraud or illegal practices in these unprecedented market and economic conditions.” In addition, the SEC this week updated an investor alert about possible investor scams related to the pandemic.
The reasons for the suspensions range from possible confusion about the name of a company to suspicious statements from companies about having “FDA-approved” at-home COVID-19 test kits, supposed new technology for non-contact human temperature screening, or the ability to produce a vaccine or protective gear.
With the aim of eliminating certain duplicative disclosures, and modernizing and enhancing Management’s Discussion and Analysis (MD&A) disclosures for the benefit of investors while reducing the compliance burden on companies, the Securities and Exchange Commission (SEC) has proposed amendments to simplify and enhance certain financial disclosure requirements in Regulation S-K. The proposed amendments, released January 30, 2020, are part of an ongoing re-evaluation of the current disclosure regime per the SEC’s recommendation in the Report on Review of Disclosure Requirements in Regulation S-K, which was mandated by Section 108 of the JOBS Act, adopted in 2012.
The proposed amendments would eliminate Items 301 (Selected Financial Data), 302 (Supplementary Financial Information) and 303(a)(5) (Tabular Disclosure of Contractual Obligations in MD&A) of Regulation S-K, as well as revise a number of disclosure obligations under Item 303 (Management’s Discussion and Analysis of Financial Condition and Results of Operations).
When confronted with government inquiries, public companies commonly grapple with the issue of when events have escalated to the point that they are subject to disclosure obligations—or, further yet, require recognition as a loss reserve in the financial statements. Is one or both of these requirements triggered when the government initially informs the company of the inquiry’s existence? When the magnitude and frequency of the government’s informational requests provide reasonable notice of a full-blown investigation? When the government rejects the company’s efforts to discontinue the investigation? Or when the government and company commence settlement discussions? While the seminal moment when each of these obligations solidifies can be quite fact-specific, the Division of Enforcement provided its own guidepost last week as to when disclosure and loss recognition become necessary.
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.
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.