SEC Settles Charges of Auditor Independence Violations for $8 Million

The SEC announced settlements with an auditing firm (the “Firm”) and one of its partners relating to violations of certain auditor independence rules involving nineteen audit engagements with fifteen SEC-registrant issuers.

More specifically, the SEC found the Firm and its partner violated the Commission’s and Public Company Accounting Oversight Board’s (“PCAOB”) auditor independence rules. The alleged conduct involved performing prohibited non-audit services, including exercising decision-making authority in the design and implementation of software relating to one of its issuer client’s financial reporting as well as engaging in management functions for the company. The partner was responsible for supervising the performance of the prohibited non-audit services. Additionally, the SEC charged additional PCAOB-rule violations for failing to notify the clients’ audit committees about the non-audit services. The SEC described these failures as “mischaracterized non-audit services” despite the services involving financial software “that were planned to be implemented in a subsequent audit period and providing feedback to management on those systems—areas outside the realm of audit work.” The partner was also charged with providing material, non-public information concerning an issuer to a software company without the issuer’s consent.

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CFTC v. Kraft

In a Consent Order entered on August 15, Kraft Foods Group, Inc, and its subsidiary Mondelez Global LLC agreed to pay $16 million to settle the CFTC’s complaint alleging the firms manipulated the December 2011 wheat futures markets. The settlement was thought to have ended the litigation, begun in 2015, however, shortly after the entry of the Consent Order, the firms filed a motion seeking contempt sanctions against the CFTC and Commissioners Berkovitz and Behnam. Kraft’s emergency motion alleges the Commission’s statements, and individual Commissioner statements filed concurrently with the Consent Order violated the terms of the settlement.

The Consent Order contained two unusual aspects. First it contained no factual findings or conclusions of law. Second, it contained a clause limiting the parties’ ability to speak publicly on the litigation.

Under the Consent Agreement, both parties agreed to refrain from making any public statements, other than to refer to the terms of the settlement. The CFTC issued a press release outlining the initial claims brought against the firms, and touting the $16 million fine as “approximately three times the defendants’ alleged gain.” The CFTC simultaneously released two other statements regarding the Consent Order, one from the Commission itself, and a joint statement by Commissioners Berkovitz and Behnam.

In their release, the Commissioners stated that the “consent order only limits statements of the Commission as a collective body. Individual Commissioners, speaking in their own capacities, retain their right and ability to speak fully and truthfully about this matter.” The statement goes on to “explain to Congress and the public the basis for the sanctions obtained, as well as the rationale for entering into a settlement agreement rather than pursuing litigation.”

In their motion for contempt, filed last Friday, Kraft argued that the three statements by the CFTC were willful violations of the Consent Order. According to their memorandum in support of the motion, the three statements were released simultaneously in an orchestrated effort to violate the Consent Order, arguing that even if only the CFTC were bound by the Consent Order the Commission violated it “when it endorsed the statements of its Commissioners by identifying them in the CFTC’s official press release, linking to them, and posting them prominently on the CFTC’s webpage announcing the settlement.” Kraft further argued that not only did the violation of the Consent Order harm Kraft, but allowing Commissioners to speak publicly on issues the Commission is prohibited by the Consent Order from discussing will harm future litigants. “There will be no reason for future parties to agree to settlements if the Commissioners – the only parties with the power to bind the CFTC to an agreement in the first place – may simply disregard the agreement without consequence.”

The Commission has since voluntarily removed the press release, Commission statement, and Commissioners’ statement from its website. Judge Blakely has ordered Commissioners Behnam and Berkovitz to appear before the court in person at an evidentiary hearing scheduled for September 12, 2019.

SEC Releases SCSD Self-Reporting Initiative Settlements

On March 11, 2019, the SEC announced and released settlements against 79 self-reporting registered investment advisers (RIAs), touting $125 million being returned to investors. The actions stem from the SEC’s Share Class Selection Disclosure Initiative (SCSD Initiative). The SCSD Initiative incentivized RIAs to self-report violations resulting from undisclosed conflicts of interest, to promptly compensate investors, and to review and correct fee disclosures. Specifically regarding Rule 12b-1 fees, the SEC’s orders found that the RIAs failed to adequately disclose conflicts of interest related to the sale of higher-cost mutual fund share classes when a lower-cost share class was available.

SEC Chairman Jay Clayton commented: “I am pleased that so many investment advisers chose to participate in this initiative and, more importantly, that their clients will be reimbursed. This initiative will have immediate and lasting benefits for Main Street investors, including through improved disclosure. Also, I am once again proud of our Division of Enforcement for their vigorous and effective pursuit of matters that substantially benefit our long-term, retail investors.”

While the SEC and its Division of Enforcement may be pleased, the various industry reactions during the course of the SCSD Initiative included frustration–and at times reasonably so. Tempering that frustration, is that the SEC’s focus on RIA conflicts of interest and disclosures continues. First, there is an expectation that the SEC will announce more settlements in the future for additional SCSD Initiative participants and that this may involve a grouping of a “second wave” of settlements. Second, Enforcement’s Asset Management Unit has already opened investigations into RIAs who did not self-report. Lastly, these investigations included requests for documents and information regarding revenue sharing practices and disclosures.

In conclusion, it is expected that the SEC’s aggressive enforcement efforts regarding RIA conflicts of interest and disclosures to Main Street investors will continue and has already expanded to include revenue sharing.     

The CFTC Settles Another Spoofing Case

On July 26, 2017, the U.S. Commodity Futures Trading Commission (“CFTC”) issued an order finding that Simon Posen engaged in the “disruptive practice of ‘spoofing’ (bidding or offering with the intent to cancel the bid or offer before execution).” The CFTC’s findings, which spanned more than three years, beginning at least in December of 2011, indicated that Posen, based in New York City, had traded from his home, using his own account, in violation of Section 4c(a)(5)(C) of the Commodity Exchange Act (7 U.S.C. § 6c(a)(5)(C)), which explicitly outlaws spoofing.

The CFTC found Posen placed thousands of orders in gold, silver, copper, and crude oil futures contracts with the intent to cancel them before execution. These orders were placed so as to move the market prices so that smaller orders, which he would also place on the other side of the market, would be filled.

The CFTC permanently banned Posen from trading in any market regulated by the CFTC and from applying for registration or claiming exemption from registration with the CFTC, ordered him to cease and desist from spoofing, and penalized him $635,000. Posen settled without admitting or denying any of the CFTC’s findings or conclusions. James McDonald, Director of the CFTC’s Division of Enforcement, made clear that spoofing prosecutions remain a priority for the CFTC and people, like Posen, “will face severe consequences.”

Under the new leadership at the CFTC — the future marches on —with a continuing aggressive emphasis on the investigation and civil prosecution of manipulative trading and in particular spoofing. The CME Group had initially investigated aspects of Posen’s trading on two occasions and ordered a $75,000 fine and five-week trading bar and subsequently, for other activity, ordered a $90,000 fine and four-week trading bar. Drinker Biddle will continue to monitor the CFTC’s and CME’s actions so as to provide continuing analysis and counseling for our clients.

Broker Pays $2.5 Million Fine for Using Market Volatility to Hide Markups Yielding Unearned Commissions

Last week, Louis Capital Markets, L.P. (“LCM”) agreed to disgorge $2.5 million in settlement of charges that it charged false execution prices to its customers in order to generate secret commissions.

LCM executed orders to purchase and sell securities for its clients, without holding any securities in its own account and thus bore no market risk, i.e., riskless principal trades. It purported to generate profits by charging customers small commissions, typically between $0.01 and $0.03 per share. LCM, however, unbeknownst to customers, inflated those commissions, by embedding undisclosed markups and markdowns into reported execution prices. LCM provided those false execution prices—either lower sales prices or higher purchase prices than LCM actually obtained in the market—to its customers. Critically, LCM did not engage in this deceptive behavior for every trade, rather “LCM opportunistically added markups/markdowns to trades at times when customers were unlikely to detect them, for example, during periods of market volatility.” (Order ¶ 13.) By engaging in these acts, LCM “unlawfully obtained millions of dollars from its customers.” (Order at 2.)

Without admitting or denying the findings, LCM agreed disgorge $2.5 million and to cease-and-desist violating Section 15(c)(1), which prohibits fraudulent conduct by broker-dealers. The SEC noted that while the conduct would support a civil penalty, it considered LCM’s financial status and accepted LCM’s offer that did not include one. Interestingly, LCM’s customers were “primarily large foreign institutions and foreign banks,” demonstrating the SEC’s commitment to eradicate fraud regardless of sophistication of investors.

A GAAP-Happy Month in SEC Enforcement

In January, the SEC settled no fewer than seven enforcement proceedings with companies that involved alleged violations of generally accepted accounting principles (GAAP). While the sheer number of settlements would have been remarkable on its own, when examined individually, these proceedings reveal both emerging enforcement initiatives and recent historical trends in accounting-based actions. This article spotlights three particularly noteworthy observations from the first month of 2017.

  1. The Emergence of Non-GAAP Financial Measures

In 2016, the SEC placed growing emphasis on perceived abuses of non-GAAP financial measures under Regulation G and Item 10(e) of Regulation S-K. This included the Division of Corporation Finance’s (CorpFin) Compliance & Disclosure Interpretations in May and former Chair Mary Jo White’s speech before the International Corporate Governance Network in June. On January 18, 2007, the SEC settled its first enforcement action predicated on this alleged activity. Exchange Act Rel. No. 79823.

The SEC claimed specifically that MDC Partners, Inc., a publicly traded marketing firm, violated Item 10(e)(1)(i)(A) of Regulation S-K, which requires issuers disclosing non-GAAP financial measures to present “with equal or greater prominence” the most directly comparable GAAP-based financial measure or measures. According to the Order, MDC Partners’ quarterly earnings releases for 2013 and 2014 improperly emphasized EBITDA, EBITDA margin, and free cash flow—all non-GAAP benchmarks—without satisfying this prominence requirement. Moreover, the SEC alleged that CorpFin had raised this particular concern with the company in 2012, but, despite representations to the contrary, the violation remained uncorrected.

The SEC contended that MDC Partners also ran afoul of Item 10(e)(1)(i)(B) of Regulation S-K, which requires issuers to reconcile “by schedule or other clearly understandable method” the differences between the disclosed non-GAAP financial measures and the most directly comparable GAAP-based financial measure or measures. MDC Partners purportedly violated this provision in 2012 and 2013 when it disclosed a non-GAAP metric known as “organic revenue growth.” The SEC alleged that the company omitted reference to one of the metric’s three reconciling items, and, had it been calculated consistent with the only two reconciling items that were disclosed, the metric would have been lower. Further, the company purportedly failed to include tabular reconciliations to GAAP revenue in its periodic reports and earning releases.

The SEC found that MDC Partners’ non-GAAP disclosures violated Section 17(a)(2) of the Securities Act, Section 13(a), 13(b)(2)(A), and 13(b)(2)(B) of the Exchange Act (and Rules 12b-20, 13a-1, 13a-11, and 13a-13 thereunder), and Rule 100(a)(2) of Regulation G. The company paid a $1.5 million civil penalty to settle these and other alleged violations.

  1. A Non-Reliance on Financial Statement Materiality

As in MDC Partners, there were two additional settlements last month that symbolized the SEC’s willingness to bring enforcement actions absent any quantitatively material misstatements in a company’s financial statements. A January 18, 2017 settlement with General Motors Company (GM) involved the automaker’s 2014 recall of more than 600,000 vehicles with defective ignition switches. Exchange Act Rel. No. 79825. The SEC alleged that GM engineers understood in 2012 that the ignition switches created a safety concern, but delayed more than a year in notifying those persons at the company responsible for assessing whether this concern gave rise to a loss contingency pursuant to Accounting Standards Codification (ASC) 450. ASC 450 requires issuers to evaluate whether a loss is “probable” or “reasonably possible” and, if so, sets forth when an estimated loss must be recorded or otherwise disclosed.

Interestingly, while the Order stated that GM recorded approximately $41 million for potential recall costs shortly after the internal notice was provided, it sidestepped the issue of whether GM had a probable or reasonably possible loss contingency at any time during the alleged period of delay. It also made no determination on the material accuracy of any financial statement or disclosure that may have been impacted. Instead, the SEC charged GM with possessing insufficient internal accounting controls in violation of Section 13(b)(2)(B) that stemmed from the delay in evaluating whether a loss contingency existed. GM agreed to pay a $1 million civil penalty to resolve the matter.

The SEC’s January 19, 2017 settlement with HomeStreet, Inc. provides another example. Exchange Act Rel. No. 79844. The SEC contended that the diversified-services company entered into interest rate swaps to hedge its exposure to changes in fair market value on approximately 20 fixed-rate commercial loans. The Company sought to apply hedge accounting pursuant to ASC 815, which allows qualifying issuers to record the fair value of both the hedged and hedging items, thereby alleviating potential income statement volatility from market fluctuations. The SEC contended that, between 2011 and 2014, certain HomeStreet commercial loans and interest-rate swaps periodically failed to meet the effectiveness ratio designed to test whether the necessary hedge correlation actually existed.

The order claimed that the company’s balance sheets and income statements were misstated during this period, because hedge accounting was applied to certain loans when the hedge associated with those loans failed to qualify. Notably, the order did not allege any of these misstatements were material; to the contrary, it acknowledged that the company and its outside auditors had concluded that the accounting errors were not material in any reporting period and no restatements were necessary. The SEC charged HomeStreet with books and records and internal control violations under Sections 13(b)(2)(A) and 13(b)(2)(B) for these GAAP-based deficiencies and imposed a $500,000 civil penalty for these and other violations.

  1. An Absence of Fraud Allegations

The SEC has pursued fraud-based claims in accounting matters with less regularity in recent years and, in turn, has increased its reliance on the less-imposing strict-liability provisions under Section 13 and negligence-based antifraud provisions under Section 17. January was no exception. None of the accounting settlements during the month included alleged fraudulent conduct, even though, in several instances, the tenor of the settlement language arguably signaled a more culpable state of mind than the violations required. In HomeStreet, the SEC also settled claims against the company’s chief investment officer, Darrell van Amen, who allegedly instructed a subordinate to make “unsupported adjustments” to the effectiveness ratio “for the purpose of making the testing results ‘effective.’” The Order also stated that the company made these adjustments to achieve effectiveness 64 times during the relevant period. The SEC charged van Amen under Sections 13(b)(2)(A) and 13(b)(2)(B). He agreed to pay a $20,000 civil penalty.

The HomeStreet settlement was not alone in this regard. The SEC instituted proceedings against L3 Technologies, Inc., an aerospace contractor, and Orthofix International, a medical device company, on January 11 and January 18, respectively. Exchange Act Rel. Nos. 79772, 79815. Both of these enforcement actions centered on allegations of improper revenue recognition in violation of ASC 605 and the recording of sales revenues before collectability was reasonably assured. In L3 Technologies, the order attributed this prohibitive conduct to “pressure from certain supervisors” to satisfy an annual operating plan, while the Orthofix order cited “a culture of aggressively setting internal sales targets and imposing pressure upon its sales personnel to meet those targets.” Both orders recounted material overstatements in revenue and attributed subsequent restatements to these improper deviations from GAAP.

Until recent years, these types of allegations routinely served as a blueprint for fraud-based claims. Then, the ensuing legal battle concentrated frequently on whether the SEC could establish the requisite state of mind. Now, under the current enforcement landscape, the absence of non-fraud claims renders the basic defense argument ineffective and, accordingly, often incentivizes cooperation and settlement. These two revenue recognition settlements in January are reflective of this trend. The SEC imposed a $1.6 million penalty on L3 Technologies for alleged Section 13(b)(2)(A) and 13(b)(2)(B) violations. Orthofix paid $8.25 million for its purported violations under Sections 17(a)(2) and 17(a)(3); Sections 13(a), 13(b)(2)(A), and 13(b)(2)(B); and Rules 12b-20, 13a-1, 13a-11, and 13a-13 thereunder. In each instance, the SEC recognized the company’s cooperation with its investigation.

Conclusion

January 2017 offered several prime examples of the current state of SEC enforcement in accounting-based actions. Of course, it also ushered in a new presidential administration and the prospect of substantial changes in policy and focus as SEC leadership readies to change. The coming months will offer an initial indication whether these emerging initiatives and recent trends continue to remain at the forefront of the SEC’s enforcement approach.

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.

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.