Enforcement Highlights

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.

Update: SCOTUS Will Consider Statute of Limitations on Disgorgement

We previously wrote about how the SEC urged the Supreme Court to grant certiorari in Kokesh v. SEC, and on Friday, January 13, the Court did just that. In an order without comment, the Court granted certiorari after both the petitioner and the SEC requested the Court’s review, albeit for different reasons. While the petitioner believes he should not be subject to disgorgement for ill-gotten gains that were obtained more than five years ago, the SEC wants the Court to bring clarity to the circuit split that has developed since the Eleventh Circuit’s decision in SEC v. Graham, which held that the five-year statute of limitations applies to disgorgement. As we previously noted, the SEC argued that Graham impedes its ability to achieve uniformity in the administration of securities laws.

We will continue to monitor developments in this case, which is sure to shape the timing of future SEC enforcement investigations and actions and the remedies it will seek.

Congresswoman Seeks to Add Accountability to SEC Regulations, Past and Future

Republican Congresswoman Ann Wagner has sponsored the SEC Regulatory Accountability Act, H.R. 78, which requires the U.S. Securities and Exchange Commission to engage in more rigorous cost–benefit analysis before it can move forward with new regulations. Congresswoman Wagner called the bill “common-sense legislation” that regulators should already engage in.

Specifically, the Act requires the SEC to identify the nature, source, and significance of the problem each proposed regulation is intended to address; to adopt a regulation only after a reasoned determination that the regulation’s benefits justify its cost; to identify and assess available alternatives to additional regulation (including the alternative of not regulating); and to ensure that regulation is accessible and easy to understand. Under the Act, cost–benefit analysis requires the SEC to consider the impact of any regulation on investor choice, securities’ market liquidity, and small businesses. Costs and benefits are “both qualitative and quantitative.”

The Act also mandates additional action if the SEC amends or adopts a “major rule” in terms of economic impact. See U.S.C. § 804(2). Such amendment or adoption of a major rule requires the SEC to state (1) the regulation’s purposes and intended consequences, (2) metrics for measuring the regulation’s economic impact, (3) the plan to be used to assess whether the regulation has achieved its stated purposes, and (4) any foreseeable unintended or negative consequences of the regulation.

The Act, however, does not apply only to future SEC regulation. It also requires the SEC to review its existing regulations and modify, streamline, expand, or repeal those regulations that are outmoded, ineffective, insufficient, or excessively burdensome. The review must be completed within one year of the date of the SEC Regulatory Accountability Act’s enactment and every five years thereafter.

Congress passed H.R. 78 on January 12, 2017, but a motion to reconsider was laid on the table and agreed to without objection that same day. The bill is part of the Republican regulatory reform and will make it more difficult for the SEC to promulgate regulation. It has been attacked as protecting Wall Street interests and undermining investor protections.

Republican lawmakers have proposed the legislation before but have never cleared the Senate.

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.

10th Circuit Creates Split, Finds SEC’s Use of Administrative Law Judges Unconstitutional

The 10th Circuit recently found that the SEC’s use of Administrative Law Judges (“ALJs”) violates the Appointments Clause of the Constitution, creating a split amongst federal appellate courts and making it likely the Supreme Court will weigh in on the controversy that has been building over the last two years. More specifically, the court, in Bandimere v. SEC, held in a 2-1 decision that an SEC Administrative Law Judge is an inferior officer who must be constitutionally appointed.

Bandimere, a respondent in an SEC administrative proceeding, filed a petition for review after the SEC affirmed an initial decision entered by an ALJ that found Bandimere liable for violating a number of securities laws and imposed civil penalties against him. Bandimere raised a constitutional argument before the SEC, contending that the ALJ who presided over his hearing “was an inferior officer who had not been appointed under the Appointments Clause.” Op. at 3. The SEC rejected this argument, conceding that its ALJs are not constitutionally appointed, but ruling that they are not inferior officers subject to the requirements of the Appointments Clause.

Diverging from other federal courts, the 10th Circuit set aside the SEC’s opinion affirming the ALJ’s decision, holding that SEC ALJs are inferior officers who must be constitutionally appointed. In doing so, the court relied almost exclusively on Freytag v. Comm’r of Internal Revenue, 501 U.S. 868 (1991), in which “a unanimous Supreme Court concluded [that Tax Court] STJs [special trial judges] were inferior officers.” Op. at 13–14. The Bandimere court found that “Freytag held that [special trial judges appointed by the Tax Court] were inferior officers based on three characteristics”: (1) their position was “established by law”; (2) “the[ir] duties, salary, and means of appointment . . . are specified by statute”; and (3) they “exercise significant discretion” in “carrying out . . . important functions.” Op. at 18 (quoting Freytag, 501 U.S. at 881–82). The court concluded that like STJs, SEC ALJs possess all three characteristics. Specifically, the court found that the ALJ position was established by the APA and cited various statutes that “set forth SEC ALJs’ duties, salaries, and means of appointment.” Op. at 18. As to the third factor, the court focused on an SEC ALJ’s ability “to shape the administrative record by taking testimony, regulating document production and depositions, ruling on the admissibility of evidence, receiving evidence, ruling on dispositive and procedural motions, issuing subpoenas, and presiding over trial-like hearings.” Op. at 19. The court also highlighted an SEC ALJ’s authority to render initial decisions, determine liability, impose sanctions, enter default judgments, and modify or enforce temporary sanctions imposed by the SEC. Thus, because it determined that all three factors were satisfied, the court ruled that SEC ALJs “are inferior officers who must be appointed in conformity with the Appointments Clause.” Op. at 22. Because they are not constitutionally appointed, as the SEC conceded, the court held that SEC ALJs hold their office in violation of the Constitution.

In reaching this conclusion, the Bandimere court rejected the SEC’s position that its “ALJs are not inferior officers because they cannot render final decisions and the agency retains authority to review ALJs’ decisions de novo” and disagreed with the D.C. Circuit’s holding in Raymond J. Lucia Cos., Inc. v. SEC, 832 F.3d 277 (D.C. Cir. 2016), which used the same reasoning to conclude that SEC ALJs are employees rather than inferior officers. Op. at 23–24. The Bandimere court found that this argument misreads Freytag and “place[s] undue weight on final decision-making authority.” Op. at 24. The court held that while “[f]inal decision-making power is relevant in determining whether a public servant exercises significant authority . . . that does not mean every inferior officer must possess final decision-making power.” Op. at 28. Rather, the proper focus is the extent of discretion exercised and the importance of the duties carried out by an ALJ, both of which, the court found, weighed in favor of finding that SEC ALJs are inferior officers.

Similarly, the court also refuted the dissent’s attempt to distinguish SEC ALJs from Tax Court STJs by contending that unlike those of SEC ALJs, STJs’ initial decisions were binding even when the STJs did not technically enter a final decision. Contrary to the dissent, the majority found that the Tax Court did not merely rubber stamp STJs’ initial decisions, but rather ultimately “adopted opinions they had a hand in supervising and producing.” Op. at 34. Moreover, the majority found that approximately ninety percent of SEC ALJs’ initial decisions “become final without any review or revision from an SEC Commissioner.” Op. at 35.

The dissent also expressed concern that the majority’s decision “effectively rendered invalid thousands of administrative actions.” Dissent at 11. But the majority disagreed, and stated in response that “[n]othing in this opinion should be read to answer any but the precise question before the court: whether SEC ALJs are employees or inferior officers. Questions about officer removal, officer status of other agencies’ ALJs, civil service protection, rulemaking, and retroactivity . . . are not issues on appeal and have not been briefed by the parties.” Op. at 36.

Furthermore, Judge Briscoe’s concurrence suggests the dissent’s concern that the majority’s decision will have a wide-sweeping detrimental effect because it calls into question the constitutionality of past decisions rendered by ALJs is likely overstated. Citing Free Enter. Fund v. Public Co. Accounting Oversight Bd., 561 U.S. 477 (2010), the concurrence highlighted that “courts normally are required to afford the minimum relief necessary to bring administrative overreach in line with the Constitution.” Concurrence at 4. For example, in Free Enterprise Fund, the Supreme Court found the SEC’s Public Company Accounting Oversight Board (“PCAOB”) created by Sarbanes-Oxley violated Article II because the Act provided for dual for-cause limitations on the removal of board members. Specifically, PCAOB members could not be removed by the SEC except for good cause shown, and SEC Commissioners themselves cannot be removed except for inefficiency, neglect of duty, or malfeasance in office. The Supreme Court noted that “such multilevel protection from removal is contrary to Article II’s vesting of the executive power in the President” and that the President “cannot ‘take Care that the Laws be faithfully executed’ if he cannot oversee the faithfulness of the officers who execute them.” Free Enter. Fund, 561 U.S. at 484. The Supreme Court, however, did not find the PCAOB unconstitutional; it merely severed the for-cause removal provision of the PCAOB appointment clause, leaving the Board itself intact. Moreover, the Court rejected the petitioner’s argument that the constitutional infirmity made all of the Board’s prior activity unconstitutional.

In addition, this principle was recently applied in PHH Corp. v. Consumer Fin. Prot. Bureau, 839 F.3d 1 (D.C. Cir. 2016), in which the D.C. Circuit, rather than abrogating the entire Consumer Financial Protection Bureau (“CFPB”), “struck the single offending clause from the CFPB’s implementing legislation [the Dodd-Frank Act]” and simply altered the structure of the CFPB so that it conformed with constitutional requirements. Concurrence at 5. As an initial matter, the D.C. Circuit found that the CFPB’s construction as an independent agency led by a single Director (as opposed to a typical multi-member board or commission) who was removable by the President only for cause violated Article II of the Constitution because the Director exercised significant executive power largely unchecked. That is, the court found that the CFPB was “unconstitutionally structured” because it lacked the “critical substitute check on the excesses of any individual independent agency head” that a traditional multi-member structure would provide. PHH, 839 F.3d at 8. But rather than “shut down the entire CFPB . . . [t]o remedy the constitutional flaw,” the court “simply sever[ed] the statute’s unconstitutional for-cause provision from the remainder of the statute.” Id. The result was that the President was given “the power to remove the Director at will, and to supervise and direct the Director” as the head of an executive agency without otherwise disturbing “the ongoing operations of the CFPB” or its ability to uphold previously entered orders. Id. at 8, 39.

These decisions suggest that even if the Supreme Court agrees with the Bandimere decision, the probable remedy will be to modify the unconstitutional characteristics of the SEC ALJ structure. For example, it may consider altering certain conditions of the ALJs’ employment relationship. See Concurrence at 5–6. Moreover, as the dissent recognized, the Supreme Court could also make “an explicit statement that the opinion does not apply retroactively.” Dissent at 15 n.9.

Since 2010, in the wake of Dodd-Frank, the SEC has consistently increased its use of administrative proceedings. It seems likely now that there is a circuit split, and Supreme Court review seems certain, the SEC may well scale back its reliance on administrative proceedings until this constitutional issue is settled.

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.

SEC Urges Supreme Court to Consider Nature of Disgorgement

We previously posted about how the Southern District of Florida’s and Eleventh Circuit’s decisions in SEC v. Graham undermined the SEC’s long-held position that disgorgement was not subject to the five-year statute of limitations. The SEC recently asked the Supreme Court to examine that decision by joining the petitioner’s request for certiorari in Kokesh v. SEC, a case in which the Tenth Circuit affirmed an award of disgorgement, holding that the five-year statute of limitations did not apply.

In Kokesh, the SEC obtained a final judgment in 2014 that included nearly $35 million of disgorgement that covered ill-gotten gains obtained as far back as 1995. The Tenth Circuit affirmed the final award, diverging with Graham, and holding that disgorgement was not a penalty or forfeiture to which the five-year statute of limitations applied. Kokesh applied for certiorari.

Last week, the SEC urged the Supreme Court to take the case. While briefly stating that the Tenth Circuit correctly ruled that disgorgement is not a penalty or forfeiture to which the statute of limitations applies, the SEC argued that “the issue is important to the administration of the securities laws, and the courts of appeals have reached conflicting conclusions” thereby warranting the Court’s review. Without the Supreme Court’s resolution, the SEC argued that it “is currently impeded by the decision in Graham from obtaining the full disgorgement remedies to which it is entitled” and described Graham as “a significant obstacle to national uniformity in administration of the securities laws.”

If the Supreme Court takes the case, the decision will directly impact the timing of SEC enforcement investigations and actions, as well as the types of remedies the SEC will seek. If the Court declines to grant certiorari, the SEC will likely try to seek different remedies in different jurisdictions for the same conduct. In the meantime, the SEC has increased its requests for tolling agreements in ongoing investigations in an apparent attempt to preserve its ability to seek the full range of remedies in the event that the investigation leads to the filing of an action.

Supreme Court Reaffirms Dirks and Tosses Prosecution a Win

In Salman v. United States, 580 U.S. __ (2016), the U.S. Supreme Court upheld Bassam Salman’s conviction, giving prosecutors a win on the first insider trading case to be heard by the Court in nearly two decades. The unanimous decision, written by Justice Samuel Alito, is short and to the point. The Court reaffirmed the continued validity of Dirks v. S.E.C., 463 U.S. 646 (1983), and determined that a tipper receives a personal benefit by providing insider information to a “trading relative or friend.”

In Dirks, the Court ruled that a tippee’s liability for trading on inside information hinges on whether the tipper breached a fiduciary duty by disclosing the information. The fiduciary duty is breached when the insider will personally benefit, directly or indirectly, from his disclosure. In Salman, the Supreme Court stated that the benefit did not have to be money, property, or something of tangible value, because “giving a gift of trading information is the same thing as trading by the tipper followed by a gift of the proceeds.”

This decision resolved a circuit split between the Ninth Circuit, which had affirmed Salman’s conviction, and the Second Circuit, which ruled in United States v. Newman, 773 F.3d 438 (2d Cir. 2014), that prosecutors had to prove that insiders received monetary or some sort of valuable benefit in exchange for disclosing information in order to convict the tippee who had used said information. The Supreme Court found that “[t]o the extent the Second Circuit held that the tipper must also receive something of a ‘pecuniary or similarly valuable nature’ in exchange for a gift to family or friends, Newman 773 F.3d at 452, we agree with the Ninth Circuit that this requirement is inconsistent with Dirks.” Yet, the Supreme Court seemed careful to imply that some portions of Newman remain good law, such as the requirement that the tippee knows the insider received a personal benefit from providing the inside information.

Despite, or perhaps because of the brevity of the opinion, questions still remain about what exactly is a benefit to the tipper. Clearly, familial connections or close friendships between the tipper and the tippee mean that prosecutors do not have to prove a specific pecuniary benefit occurred for the tipper, but would the same hold true if the tippee was a neighbor? Or, as the Second Circuit opined in Newman, an acquaintance from church or business school? The Supreme Court dodged these questions and more by deciding Salman narrowly on the facts, a model of judicial restraint in the wake of far ranging decisions like McDonell v. United States that essentially rewrote how prosecutors handle corruption cases.