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.

SEC Affirms Commitment to FCPA Enforcement Actions

Andrew J. Ceresney, Director of the Division of Enforcement, reaffirmed the SEC’s focus on FCPA enforcement actions at the International Conference on the Foreign Corrupt Practices Act. Mr. Ceresney’s speech focused on companies’ need to self-report violations.

Mr. Ceresney stated that the SEC uses “a carrot and stick approach to encouraging cooperation,” where self-reporting companies can receive reduced charges and deferred prosecution and non-prosecution agreements, while companies that do no self-report do not receive any reduction in penalties. Mr. Ceresney warned that “companies are gambling if they fail to self-report FCPA misconduct.”

Mr. Ceresney gave examples of how this policy has benefited companies recently. Mr. Ceresney highlighted the SEC’s decision not to bring charges against the Harris Corporation after it self-reported violations and mentioned to examples where the SEC entered into non-prosecution agreements as a result of self-reporting.

Mr. Cerseney stated that the SEC’s “actions have sent a clear message to the defense bar and the C-Suite that there are significant benefits to self-reporting [to] and cooperation with the SEC” and that he expects “the Division of Enforcement will continue in the future to reinforce this message and reward companies that self-report and cooperate.”

Mr. Cerseney also spoke about recent cases that highlight “the Enforcement’s Division’s renewed emphasis on individual liability in FCPA cases[,]” noting that seven actions in the past year involved individuals. Mr. Cerseney stated that “pursuing individual accountability is a critical part of deterrence and . . . the Division of Enforcement will continue to do everything we can to hold individuals accountable.”

Mr. Cerseney’s remarks demonstrate that the Division of Enforcement does not expect to change its recent focus on FCPA violations and individual liability as it transitions to the new administration.

Private Equity Fund Advisers Agree to Settle Charges of Improperly Disclosing Acceleration of Monitoring Fees and Improperly Supervising Expense Reimbursement Practices

In a recent action, the SEC demonstrated its continuing focus on private equity fund advisers’ fees. On August 23, 2016, Apollo Management V, LP, Apollo Management VI, LP, Apollo Management VII, LP, and Apollo Commodities Management, LP (collectively, “Apollo”), agreed to settle charges brought by the SEC for “misleading fund investors about fees and a loan agreement and failing to supervise a senior partner who charged personal expenses to the funds” in violation of Sections 206 and 203 of the Advisers Act. Press Release No. 2016-165.

According to the SEC Order, Apollo advises a number of private equity funds that own multiple portfolio companies. Like most private equity fund advisers, Apollo charges annual management fees and certain other fees to the limited partners in its private equity funds and charges monitoring fees to certain portfolio companies under separate monitoring agreements. Release No. 4493. Investors benefit from the monitoring fees in that a certain percentage of the monitoring fees are used to offset a portion of the annual management fees. The SEC found that the monitoring agreements allowed Apollo, upon the triggering of certain events, to terminate the agreement and accelerate the remaining years of the monitoring fees to be collected in a present value lump sum termination payment. Triggering events included the private sale or IPO of a portfolio company. The SEC found that the accelerated fees created a conflict of interest for the adviser and noted that while the accelerated monitoring fees reduced annual management fees paid by the funds, the accelerated payments reduced the portfolio companies’ value prior to their sale or IPO, thereby “reducing the amounts available for distribution to the” the funds’ investors. The SEC found that Apollo did not disclose to the limited partners “its practice of accelerating monitoring fees until after Apollo had taken accelerated fees.” Id.

In addition, the SEC found that in June 2008, the general partner of one of Apollo’s funds entered into a loan agreement between the fund and four parallel funds in which the parallel funds loaned an amount to fund equaling the carried interest due to the fund from the recapitalization of two portfolio companies owned by the parallel funds. Until the loan was extinguished, taxes owed by the general partner on the carried interest were deferred and the general partner was required to pay accrued interest to the parallel funds. While the parallel funds’ financial statements disclosed the interest, Apollo’s failure to disclose that the accrued interest would be allocated solely to the account of the general partner was determined to be materially misleading.

The SEC further found that a former Apollo senior partner, on two occasions, improperly charged personal expenses to Apollo-advised funds and the funds’ portfolio companies, and in some instances, fabricated information to conceal his conduct. Upon discovery of the partner’s conduct, Apollo orally reprimanded the partner but did not take any other remedial or disciplinary steps.

Finally, according to the SEC, Apollo also failed to adopt and implement written policies and procedures reasonably designed to prevent violations of the Advisers Act arising from the undisclosed receipt of accelerated monitoring fees and failed to implement its policies and procedure concerning employees’ reimbursement of expenses.

Without admitting or denying the SEC’s findings, Apollo agreed to pay $40,254,552, consisting of a disgorgement of $37,527,000 and prejudgment interest of $2,727,552. In addition, the SEC assessed a $12.5 million civil penalty,  stating that the penalty is not higher due to Apollo’s cooperation during the investigation and related enforcement action. The SEC reserved the right to increase the penalty should it be discovered that Apollo knowingly provided false or misleading information or materials to the staff during the course of its investigation.

Registered Investment Advisor Agrees to Settle Charges of Failing to Clearly Disclose Transaction Costs Beyond “Wrap Fees” to Investors

On July 14, 2016, RiverFront Investment Group, LLC (“RiverFront”) agreed to settle charges brought by the SEC for failing to “properly prepare clients for additional transaction costs beyond the ‘wrap fees’ they pay to cover the cost of several services bundles together.” Press Release No. 2016-143. According to the SEC, participants in wrap fee programs usually pay an annual fee “which is intended to cover the cost of several services ‘wrapped’ together, such as custody, trade execution, portfolio management, and back office services.” Release No. 4453. The SEC found that under these wrap programs, a sponsoring firm will offer clients a selection of third-party managers, referred to as subadvisors, to have discretion over the clients’ investment decisions. When subadvisors execute trades on behalf of clients through a sponsor-designated broker-dealer, the transaction costs associated with the trades are included in the wrap fee. On the other hand, if a subadvisor sends a trade to a non-designated broker-dealer, a practice known as “trading away,” clients incur additional transaction costs beyond the wrap fee. Continue reading “Registered Investment Advisor Agrees to Settle Charges of Failing to Clearly Disclose Transaction Costs Beyond “Wrap Fees” to Investors”

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.

Third-Party Service Provider to Private Equity Funds Pays More Than $350,000 for Gatekeeping Failures

On June 16, 2016, Apex Fund Services (US), Inc., settled charges that it ignored clear indications of fraud while keeping records and preparing financial statements and investment account statements for private funds managed by EquityStar Capital Management, LLC, and ClearPath Wealth Management, LLC, each of which has previously been charged with fraud in SEC enforcement actions. Press Release 2016-120. The settlement highlights the SEC’s focus on gatekeepers and the importance of gatekeepers monitoring red flags, especially when their role includes providing financial information to investors.

With respect to EquityStar, Apex settled charges that it made materially false and misleading statements to investors when it improperly accounted for undisclosed withdrawals from funds (made by EquityStar and manager Steven Zoernack) as receivables even when Apex possessed evidence that neither EquityStar nor Zoernack were willing or able to repay the withdrawals, which totaled over $1 million. After Zoernack stated his intent to repay an initial withdrawal, Zoernack continued to make withdrawals (without making repayments) that Apex repeatedly treated as “receivables,” rather than withdrawals by Zoernack, in the Net Asset Value (“NAV”) reports. Eventually, the “receivables” accounted for nearly 54% of the NAV of one fund and more than 26% of another fund. During this time, Apex learned that Zoernack had previously been convicted for wire fraud. According to the SEC, Apex repeatedly asked Zoernack to make disclosures about the withdrawals that he did not make. The SEC also found Apex ultimately determined that Zoernack would not be able to repay them. Nevertheless, Apex continued to report materially inaccurate NAVs. Release No. 4429.

ClearPath was charged with securities fraud violations relating to a misappropriation scheme last year in the District of Rhode Island. With respect to ClearPath, the SEC found Apex (i) “failed to act appropriately after detecting undisclosed brokerage and bank accounts, undisclosed margin and loan agreements, and inter-series and inter-fund transfers made in violation of the fund offering documents”; (ii) failed to correct prior financial reports and continued to issue “materially false reports and statements” to ClearPath and an independent auditor; and (iii) used those false reports in communication financial performance to investors. Release No. 4428.

Without admitting or denying the SEC’s findings, Apex agreed to retain an independent consultant to conduct a review of Apex’s policies and procedures and recommend corrective measures. Additionally, Apex will pay a total of $352,449, which includes (i) disgorgement of $89,050, plus $7,786 in interest and a $75,000 penalty for its actions with respect to EquityStar; and (ii) disgorgement of $96,800, plus $8,813 in interest and a $75,000 penalty for its actions with respect to ClearPath.

Commissioner’s Concerns About Civil Penalties Temper SEC’s Release of FY14 Enforcement Results

On October 16, the SEC publicized its preliminary enforcement results for fiscal year 2014. In what it described as a “successful enforcement year,” the Commission brought a record 755 actions and obtained $4.16 billion in penalties and disgorgement. These 2014 figures translate to an average of $5.5 million per action, which is 11% higher than the penalties and disgorgement obtained per action in fiscal year 2013 and a whopping 30% upsurge from just two fiscal years ago. It is not a coincidence that these developments correspond neatly with the appointment of Mary Jo White as SEC Chair in 2013. In fact, Chair White has been candid from the outset of her tenure about the Commission’s intention, under her direction, to “make aggressive use of our existing penalty authority, recognizing that meaningful monetary penalties—whether against companies or individuals—play a very important role in a strong enforcement program.”

It would appear, however, that at least one high-ranking SEC official has become uneasy during this era of heightened civil penalties. Speaking at the Securities Enforcement Forum in Washington, D.C., just two days before these results were released, Commissioner Michael S. Piwowar openly questioned whether the manner in which the SEC now administers penalties might be encroaching upon due process protections. As Commissioner Piwower explained:

In recent months, I have become concerned by the increasing number of staff recommendations that have not been accompanied by analysis of the principal factors described in the 2006 penalty statement. If we were a publicly-traded company, then we would likely be subject to an investigation if we knowingly permitted a misleading statement to remain outstanding without corrective disclosure. More importantly, we will have not accorded appropriate due process if we fail to follow our own publicly-announced framework for monetary penalties.

. . .

Thus, for purposes of transparency, clarity, and, most importantly, due process, the Commission should be forthcoming as to the appropriate analytical framework for corporate penalties.

The “2006 penalty statement” referenced in Commissioner Piwowar’s speech represents the Commission’s most recent effort to provide the investing public with “the maximum possible degree of clarity, consistency, and predictability in explaining the way that its corporate penalty will be exercised.” While this pronouncement set forth nine factors that may be weighed, the appropriateness of a penalty reportedly hinges on two principal considerations: – (1) whether the company received a direct benefit as a result of the violation and (2) whether the penalty will recompense or further harm the injured shareholders. This latter consideration, in particular, is inherently controversial. As the SEC acknowledged in the 2006 Statement, the penalties it imposes on public companies are costs frequently endured by innocent shareholders who already have been harmed by the company’s purported misconduct. Hence, SEC penalties should not be perceived as adding further insult to the financially injured.

Based on Commissioner Piwowar’s comments, the SEC may be drifting away from these factors, even though it has published no further guidance explaining which factors might now be disfavored or what other considerations could apply. If so, these recent developments cast a renewed spotlight on comments that Chair White made regarding the SEC’s 2006 Statement during a September 2013 speech to the Council of Institutional Investors. Most notably, Chair White stated:

While it is not a binding policy, the 2006 press release in my view sets forth a useful, non-exclusive list of factors that may guide a Commissioner’s consideration of corporate penalties, such as the egregiousness of the misconduct, how widespread it was, and whether the company cooperated and had a strong compliance program. The enforcement staff still references these factors as well as other inputs when analyzing and proposing their own recommendations to the Commission.

Ultimately, however, each Commissioner has the discretion, within the limits of the Commission’s statutory authority, to reach his or her own judgment on whether a corporate penalty is appropriate and how high it should be.

Interestingly, Commissioner Piwowar’s comments seem to reflect a general apprehension, at least on his part, to exercising discretion that is limited only by statutory constraints when the factors and “other inputs” used to determine the appropriateness of such penalties have not been disclosed publicly. To remedy this perceived problem, Commissioner Piwowar advocated that any revision to the 2006 Statement should be made through an interpretative release that would be subject to a notice-and-comment process. In his view, “This approach will satisfy any due process concerns, allow all interested persons to express their comments on the proposed framework, and provide a stronger defense of our approach should it be challenged in the future.”

Absent such an administrative undertaking or an unexpected reversal of policy, it likely will be left to the judiciary whether to impose any additional limitations on future SEC penalties. If the United States Court of Appeals for the District of Columbia’s decision in Collins v. SEC, No. 12-1241 (D.C. Cir. Nov. 26, 2013), provides any foresight, courts may be receptive to tethering future penalties so that they reasonably align with prior outcomes under similar circumstances. In Collins, the appellant challenged the SEC’s imposition of a penalty on grounds that it was arbitrary and capricious and violated the Excessive Fines Clause under the Eighth Amendment. Id. at *6. While the penalty was upheld, the appellate court made clear that the Commission cannot be “oblivious to history and precedent” and that a penalty could be deemed “arbitrary and capricious” if “the sanction is out of line with the agency’s decisions in other cases.” Id. at *8 (quoting Friedman v. Sebelius, 686 F.3d 813, 827-28 (D.C. Cir. 2012)). It remains to be seen, of course, what circumstances could trigger such a decision, although additional appeals – and judicial insights – seem likely in fiscal year 2015, particularly if the financial stakes continue to rise. In the meantime, the SEC appears more focused on making history and precedent, in part through the imposition of larger civil penalties, than being closely guided by it.