The U.S. Securities and Exchange Commission (the “SEC” or the “Commission”) held its annual SEC Speaks conference via Webex on October 8 and 9, 2020. The conference featured remarks from the Chairman and several commissioners, discussions regarding current enforcement initiatives and enforcement priorities for the upcoming year, and an update on litigation, judicial and legislative developments.
Highlights from this year’s conference included insight into the SEC’s substantive and procedural approach to investigations and litigation in light of COVID-19-related challenges and discussion of the significant ongoing impact of Kokesh v. SEC and Liu v. SEC.
Chairman’s Speech and Commissioners’ Remarks
Chairman Jay Clayton focused his opening remarks on the SEC’s response to the COVID-19 pandemic. He noted the high stress that COVID-19 has placed on both the U.S. financial markets and SEC operations, and he highlighted the SEC’s response in remaining fully operational and meeting head-on challenges in the areas of market function, market monitoring, and corporate disclosures.
To that end, Chairman Clayton spent the majority of his remarks describing the accomplishments of the SEC during the 2020 fiscal year. Chairman Clayton noted that during this unique time, SEC enforcement work continued, oversight of the financial markets increased, and the SEC provided relief in several areas including (1) the filing of around 700 enforcement actions, including over 150 COVID-19 related actions, (2) the recovery of over $4 billion in financial penalties (an increase from the 2019 fiscal year), (3) the enactment of three dozen trading suspensions to stabilize the U.S. financial markets, and (4) paying out over $175 million in awards to a record 39 whistleblowers.
Chairman Clayton praised several internal SEC divisions including the Office of Compliance Inspections and Examinations (“OCIE”), which examined over 15% of Registered Investment Advisers (RIAs) and released eight Risk Alerts, which Chairman Clayton highlighted as being important to the prevention of future problems and violations of federal securities laws. He also noted that the SEC’s Division of Corporation Finance processed over 800 initial public offerings, and he described the Office of the Secretary’s work in cooperating with foreign regulators.
Chairman Clayton took time to discuss the recent initiatives of the President’s Working Group on Financial Markets (the “PWG”) of which the SEC is a member along with the Commodities Futures Trading Commission, the Federal Reserve and the U.S. Department of the Treasury. Chairman Clayton discussed the PWG’s efforts to protect U.S. investors from significant risks in the area of emerging market investments, especially in China. Recent actions taken by the PWG include the August 2020 “Report on Protecting United States Investors from Significant Risks from Chinese Companies,” which recommended improving disclosures and consideration by fiduciaries and other market professionals of Chinese investment risks.
Chairman Clayton concluded his remarks by discussing the SEC’s recent initiative to gain a greater understanding of the $54 trillion U.S. credit markets and the negative impact on these markets due to COVID-19. The SEC recently released an October 5, 2020 report detailing its findings from this initiative titled “U.S. Credit Markets: Interconnectedness and the Effects of the COVID-19 Economic Shock.” Chairman Clayton further noted that the SEC will be hosting an October 14, 2020 roundtable to discuss issues raised in the report. Chairman Clayton concluded his remarks by acknowledging the SEC’s Diversity Council and Office of Minority and Women Inclusion and his eagerness to continue working with and growing both these departments in the coming fiscal year.
In discussing his views on the SEC’s approach to the enforcement of federal securities laws, Commissioner Elad Roisman first noted that he has participated in decisions on over 2,000 individual enforcement recommendations since joining the SEC. When considering a recommendation from the Division of Enforcement, he stated that he focuses first on the recommended outcome. Specifically, he noted that he asks whether such an outcome meaningfully supports the SEC’s three-part mission: protecting investors; maintaining fair, orderly, and efficient markets; and facilitating capital formation. Commissioner Roisman said that he takes this approach to avoid falling into the trap of measuring enforcement success solely by looking at quantitative metrics, and to ensure that remedies proposed by the Division of Enforcement appropriately address the relevant misconduct and make victims whole.
Commissioner Roisman observed that the vast majority of cases he reviews involve straightforward interpretations of rules and laws, but that evolving markets and development of new business practices can result in matters of first impression. Commissioner Roisman stated that he considers it his responsibility to question whether matters involving new interpretations of laws and rules—especially settlements “where the Commission itself acts as a prosecutor and final arbiter”—can be resolved through non-enforcement means. Specifically, he pointed to the SEC’s regulatory role as an appropriate alternative to “regulation by enforcement.” He noted that he believes that utilizing this regulatory authority—including by conducting examinations, identifying exam priorities, issuing risk alerts, issuing investor bulletins, and promulgating new rules—avoids subverting the rulemaking process set forth in the Administrative Procedure Act. Moreover, utilizing rulemaking instead of regulating via enforcement ensures that interested parties can review and comment on proposed rules, which provides valuable insight to the SEC. Commissioner Roisman further commented that he thinks the SEC should make more frequent use of its authority to issue Reports of Investigation pursuant to Section 21(a) of the Exchange Act. Such reports can be issued at the end of an investigation and allow the SEC to share its views without imposing sanctions on the entity or individual(s) being investigated.
Commissioner Roisman also stated that he believes that compliance with complex securities laws and rules should be encouraged by first utilizing tools other than enforcement. In other words, “enforcement should be the last resort, not a first resort.” He explained that among the “first resorts” at the SEC’s disposal are the Division of Corporation Finance (which engages with potential and existing issuers to facilitate complete and accurate disclosures), the Office of Compliance Inspections and Examinations, the Office of Credit Ratings (which examines statistical rating organizations), and the SEC’s lawyers, accountants, and experts. He stated that these “first resort” tools can generate referrals to the Division of Enforcement, if necessary.
Commissioner Roisman noted that while the SEC should use these tools to promote compliance, he strongly believes that the SEC should not be in the business of seeking to set compliance “cultures” among registrants and issuers. He stated that efforts to establish a culture can lead to overreach and may disregard the “incentives, personalities, ideals, and idiosyncrasies” that are unique to each entity.
Commissioner Roisman ended by addressing the topic of corporate civil penalties, noting that such penalties—when assessed against public companies—can penalize innocent shareholders who may have already been harmed by the underlying misconduct. That being said, he acknowledged that there are circumstances in which such penalties are appropriate, and uses the SEC’s 2006 Statement Concerning Financial Penalties as a guide. He noted specifically that corporate civil penalties may be appropriate when there has been a quantifiable benefit to a company based on the misconduct at issue, when a corporate benefit is clear despite not being quantifiable, or when a company is a repeat offender and shareholders may thus be deemed to have been on notice of the potential risk of continuing to hold that company’s stock. He stated that he prefers that money collected by the SEC—via civil penalty or otherwise—go to a Fair Fund rather than to the Department of Treasury.
Commissioner Allison Herren Lee’s remarks focused on her concern of a declining public market. In particular, she addressed the significant decline in initial public offerings (“IPOs”), potential causes of this trend, and developments that may help draw investors and firms back into the public market.
She began by explaining that, while recent data indicates an increase in the average proposed value of an IPO, the frequency of IPOs is dropping as businesses turn to the private market for investment opportunities. Put simply, fewer smaller IPOs are happening, which is concerning, she added, because it reduces opportunities for investors to participate in potentially high-growth companies. Commissioner Lee expressed concern over this trend, highlighting that investment transactions taking place in the private market often lack important safeguards that the public market has in place such as the added transparency due to disclosure requirements. She also reminded the audience that IPOs provide reliably positive risk-adjusted returns for investors over time.
Commissioner Lee cautioned against blaming increased regulation of the public market as the sole driver of this trend. While fee regulations may be reducing the incentive for firms to enter public markets, she cautioned that other factors such as a decrease in demand for small IPOs among the nation’s largest mutual funds may be influencing this trend as well. She stated that another factor could be underwriters imposing a “middle-market IPO tax” on smaller companies, thereby dissuading smaller company IPOs. Commissioner Lee then stated that gaining a clearer understanding of this trend requires more research on the interplay between the public and private markets to understand how the two are influencing each other.
Commissioner Lee remarked that certain developments may help bolster the public market. She first mentioned direct listings as offering a potential incentive to bring firms back into the public market. She explained that direct listings allow firms to avoid engaging with an underwriter, thereby allowing private owners to file their IPO directly on the stock exchange. While she stated that direct listings offer a less expensive path to the public market, she warned that a potential drawback of this approach is that the omission of an underwriter puts more onus on legal and financial advisors to use greater care in conducting due diligence for the transaction to combat the greater risk of legal liability. Commissioner Lee also stated that direct listings may make it difficult for a plaintiff to bring a claim under Section 11 of the Securities Act of 1933 in the event of material misstatements or omissions in a registration statement. Specifically, because direct listings may involve sales by both shareholders and issuers, it may impede a plaintiff’s ability to satisfy the “traceability” requirement under Section 11.
Commissioner Lee concluded with her thoughts on special purpose acquisition companies (“SPACs”), another potential avenue for private issuers to enter the public markets. Lee explained that a SPAC is a shell company that raises capital in the public markets with the sole intention of identifying and merging with a target operating company. Such a merger provides the operating company with capital that it might otherwise raise in a traditional IPO. Commissioner Lee stated that, while SPACs might be a great device for bolstering the public markets, SPAC disclosures should be carefully scrutinized.
Commissioner Caroline A. Crenshaw, who was recently sworn in on August 17, 2020, engaged in a Q&A with the Director of the Division of Investment Management, Dalia Blass. Their conversation focused on Commissioner Crenshaw’s work-life balance, her thoughts on how women in leadership roles are supported in government, and her regulatory and enforcement priorities.
Commissioner Crenshaw first addressed her transition to commissioner and the unique challenges of balancing that role with her JAG and family responsibilities. Though it keeps her quite busy, she noted that her JAG work also helps her in her role as a commissioner by exposing her to different leadership styles and provides her with invaluable insight on how soldiers think about investing and what the questions are that they may have.
Commissioner Crenshaw was asked about her thoughts on the SEC’s support of women within the organization and about how organizations, in general, can support women in leadership roles. She noted that diversity and inclusion have been, and remain, a priority at the SEC. She said that she believes the SEC has done a good job of recognizing and promoting women within the organization. She noted that this year, the SEC has a majority-women Commission for the first time since 2011 and that 40 percent of senior roles in the SEC are held by women, which she noted is a figure continuing on an upward trend. Commissioner Crenshaw stated that it is important for organizations to treat closing gender gaps and increasing racial diversity like any other business objectives. She commented that she believes organizations need to set specific goals, make a plan, and identify the metrics to track their progress. She recognized that part of the challenge lies in confronting and expanding cultural perceptions of success and leadership. She stated that organizations should focus on identifying talent and ensuring women receive access to the same career-defining opportunities as their male counterparts. She encouraged organizations to recognize women for their leadership skills, which can be manifested in many ways.
Commissioner Crenshaw addressed her regulatory priorities next. She stated that her focus is on investors, particularly retail investors, noting that investor protection is one of the Commission’s core and basic mandates. She explained that as investors increasingly rely on themselves to contribute to their 401(k), find their financial advisors, and assume responsibility for their retirement savings, it is critical that investors receive the best advice and products. She emphasized that she is particularly interested in the Commission’s Regulation Best Interest, which was recently implemented. She stated that the SEC needs to ensure financial professionals are not being paid to give bad advice. She explained that to the extent incentives are misaligned, the SEC needs to hold firms accountable.
She also emphasized the need to focus on the disclosure section of Form CRS. She stated that there are important questions that need to be raised regarding these disclosures such as: Do the disclosures enable informed decision making? Are the investors reading and understanding the disclosures and making good use of them? She also noted that the Division of Investment Management recently submitted a proposal on August 5, 2020 which would modernize the disclosure framework for open-end funds.
Finally, Commissioner Crenshaw addressed her enforcement priorities. She stated that she believes it is important that the Commission maintain its vigorous enforcement program, as it is the clearest way to show investors that the Commission is working toward protecting them. She explained that it is important to provide resources to effectively deter fraudsters and hold individuals accountable. One of the areas she believes the Commission has effectively devoted those resources to is the Share Class Selection Disclosure Initiative. She noted that this initiative was created in response to investment advisory firms that failed to make required disclosures relating to the selection of mutual fund share classes when lower-fee share classes for the same funds were available to the clients, and that the orders issued by the Commission pursuant to this initiative included approximately $139 million to be paid back to clients. She further noted that most firms have converted clients to lower-cost share classes or have rebated fees. Commissioner Crenshaw praised the result and stated that it would continue to help generate significant cost savings for retail investors going forward.
Commissioner Crenshaw concluded her remarks by stating that the Commission should be willing to take risks and litigate important Commission priorities. She stated that she is supportive of litigating if the alternative is an inadequate settlement. Moreover, she commented that litigation helps develop the law and protect investors.
Division of Enforcement
The conference also included a panel featuring members of the Division of Enforcement. This panel addressed COVID-19-related impacts on enforcement activity and identified enforcement priorities.
Response to COVID-19
Stephanie Avakian, Director of the Division of Enforcement, noted that the COVID-19-era environment has forced the SEC staff (the “Staff”) to modify its practices to meet new challenges, including by doing more streamlined, targeted, and strategic investigations. She noted that the Staff is trying to be flexible whenever possible; however, they will not permit the crisis to serve as a cover for gamesmanship. She also noted that the Division of Enforcement has focused on the microcap space recently and has suspended many issuers over COVID-19-related matters.
Mark Berger, the Deputy Director of the Division of Enforcement, noted that the Staff has been in a full telework environment since mid-March. The Division of Enforcement brought more than 490 enforcement actions from mid-March 2020 through the end of the SEC’s fiscal year, and opened 640 new matters during that same time period (over 150 of which relate to COVID-19 in some way). The newly opened matters represent a 7% increase from the same time period last year. Additionally, the SEC has received approximately 15,000 tips, complaints, and/or referrals in that time period, marking a 68% increase from last year.
Mr. Berger went on to note the following specific areas of focus for the Staff during the pandemic affecting retail investors:
insider trading, including proactively monitoring the financial markets during recent extreme movements and tracking public statements and disclosures that have market-moving impact;
issuer disclosures on financial statements, particularly valuations, impairments, and related disclosures that may be disguising previously undisclosed problems;
registered investment advisers’ and investment companies’ failure to honor investor redemption requests; and
monitoring the impact of COVID-19 on the performance of complex products, that were perhaps improperly marketed to retail customers prior to the global pandemic.
Mr. Berger noted that in addition to bringing fast, impactful COVID-19-related fraud cases, the Staff has communicated with the investing public, registrants, and issuers. By way of example, he pointed to a recent Investor Alert issued by the SEC’s Office of Investor Education and Advocacy (“OIEA”) and the Division of Enforcement’s Retail Strategy Task Force, which sought to educate retail investors about current investment frauds, including scams related to the COVID-19 pandemic.
Financial Fraud/Issuer Cases
The Division of Enforcement continues to treat financial fraud and other issuer-related fraud as high priorities. Ms. Avakian noted that the Staff remains focused on filing cases closer in time to when the misconduct occurred, which makes the enforcement actions more impactful. She stated that the Staff is especially focused on timing in financial fraud and issuer disclosure cases because they represent some of the most complicated Division of Enforcement investigations and take a long time to complete due to factors such as the volume of documents, number of witnesses, and technical nature of the testimony. She noted that it had been taking around three years to bring these types of cases, and that the Staff is trying to shorten that timeline through a variety of tactics. This includes streamlining investigations, increasing staffing on appropriate matters, leveraging work already being done by issuers and their counsel to understand the issues, making earlier decisions about whether an issue merits further pursuit or whether to narrow the issues, conducting proffers more frequently and earlier on in investigations, sending more targeted information requests at the outset of an investigation, and more substantively engaging on the issues early-on in investigations. The Staff may ask to talk to key individuals in an organization before requesting documents, and is looking to other ways of obtaining information, such as through interrogatory requests. According to Ms. Avakian, the Staff is also contacting auditors and outside consultants earlier and more quickly than they otherwise would in order to obtain the most relevant information sooner.
Anita Bandy, Associate Director, Home Office, added that the Division of Enforcement is focused on non-GAAP measures as well as more traditional areas of financial fraud. Ms. Bandy identified the SEC’s cases against Valeant Pharmaceuticals and BGC Partners as recent examples of non-GAAP-related enforcement actions. She identified cases against Fiat Chrysler and HP as examples of recent financial disclosure cases, and cases against Revolution Lighting and Iconix Brand Group as recent examples of more traditional financial fraud cases. Ms. Bandy also noted that the Division of Enforcement is closely monitoring COVID-19-related impacts on this area and taking cues from the 2008 financial crisis. This includes focusing on MD&A disclosures, business and risk reporting, judgments and estimates regarding matters such as impairment, debt modifications, and going concerns, and asking whether the current financial situation is exposing underlying issues that should have been disclosed earlier.
Ms. Bandy noted that the Division continues to use an analytics platform that was announced in September to analyze issuer filings to look for outliers relative to corporate peers. For example, she noted that they are using it to analyze accounting adjustments that may be used to meet or beat EPS estimates as part of the SEC’s EPS Initiative. She observed that these cases are very difficult to detect without analytics. She referenced the SEC’s cases against Interface Inc. and Fulton Financial Corporation as the first examples of such cases. Ms. Bandy also noted that the Division of Enforcement uses this analytics platform to look for anomalous activity regarding executive compensation, and referenced the SEC’s case against Hilton Worldwide Holdings Inc. as a recent example.
Ms. Bandy noted that recent insider trading cases brought by the SEC reflect how complex such schemes have become, often involving multiple traders or tippers and foreign jurisdictions. She noted that cases now being brought by the SEC would have been impossible to detect just a few years ago. The data analysis tools now at the SEC’s disposal allow for better resource allocation, bringing cases more quickly, and focusing on the most serious offenders. As examples of the SEC’s recent work in this area, Ms. Bandy pointed to the SEC’s cases against former London-based investment bankers and Switzerland-based traders involved in an international insider trading scheme, and the SEC’s case against 18 China-based traders who manipulated over 3,000 U.S.-listed securities.
Retail Investor Cases
Mr. Berger noted that the Division of Enforcement remains focused on bringing cases stemming from misconduct involving interactions with retail investors. He discussed a recent case stemming from failure to supervise investment advisors and registered representatives who did not fully understand the risk of loss associated with complex products. He also pointed to the SEC’s case against VALIC Financial Advisors (“VALIC”) as an example of the SEC’s focus on protecting teachers (as well as active-duty military personnel and veterans). He noted that VALIC had failed to, among other things, disclose conflicts of interest to its teacher clients, and that VALIC agreed to cap its advisory fees for teachers as part of its settlement with the SEC.
Mr. Berger noted that the SEC also continues to see Ponzi schemes and offering frauds targeting retail investors, and that affinity fraud continues to be a big concern. He noted that affinity fraud can be particularly devastating because victims trust people in their own communities and may not realize they are being defrauded until it is too late. During the past fiscal year, the SEC has brought affinity fraud cases in which the targets of the fraud included the hearing impaired, African immigrants, Amish and Mennonite communities, and military members.
Remote Testimony, Depositions, and Trials
The Staff noted it has been moving forward with all aspects of its mission during the pandemic, including document production, taking formal testimony, conducting interviews and proffers, engaging in the pre-Wells and Wells process, settling cases, and bringing charges. The Staff has continued their operations remotely by taking testimony and interviews by video, holding Wells meetings by conference call and video, negotiating settlements, and recommending actions to the Commission.
Ms. Bandy noted that witnesses have willingly participated in remote testimony in the vast majority of cases. For the infrequent cases in which a witness will not agree to remote testimony, and if the Staff has determined that there is no other way to get the desired information, the Staff will move forward with the Wells process without testimony. She noted that the Staff is mindful of the risks of proceeding like this, but that they weigh such risks against the entire record.
Bridget Fitzpatrick, Chief Litigation Counsel for the Division of Enforcement, noted that, to date, federal district courts have generally not been receptive to defendants’ attempts to avoid participating in remote depositions. Ms. Fitzpatrick referenced a recent opinion from SEC v. Commonwealth Equity Services, LLC (D. Mass.) in which a judge denied a motion for protective order and required virtual depositions to go forward. She stated that the ruling contains a thoughtful description of best practices for remote depositions. Ms. Fitzpatrick noted that the Staff is committed to working with defendants and witnesses to ensure that the technology needed for depositions is working smoothly. In general, the Staff is seeing approximately one-to-two months added to discovery schedules to work out details and hiccups surrounding remote discovery issues.
Ms. Fitzpatrick also noted that the SEC had its first virtual trial—a bench trial in the United States District Court for the Southern District of New York—in late summer. Despite witnesses, lawyers, court reporters, and the judge being in different locations, the remote trial process generally worked, and both sides were able to present their case.
Virtual Wells Meetings
Ms. Avakian noted that during the COVID-19 pandemic, the Staff has participated in a large number of virtual Wells meetings, and have found them to be equally as effective as in person. She noted that it is much easier to schedule virtual meetings that do not involve travel. She also stated that scheduling such meetings with company counsel and individual counsel close in time has been extremely helpful and effective for the Staff to quickly consider the issues discussed and move things forward, which is in everyone’s best interest.
In terms of substance, Ms. Avakian emphasized that the Wells process and the related meetings are incredibly helpful for the Staff, as the Staff does not want to be surprised in litigation, and would much prefer to be aware of all issues upfront and adjust accordingly. She noted that Wells meetings may meaningfully change outcomes in many cases, and that outcomes have ranged from reduced charges, termination of the investigation resolution through settlement, or the Staff determining to stay the course. Ms. Avakian encouraged counsel to focus on the issues that are most meaningfully in dispute, stating that often times it is more realistic to focus on changing the charges or the terms of resolution rather than to swing for the fences and seek termination. She said that she fully prepares for Wells meetings by reading submissions and meeting with the Staff that conducted the investigation.
Attorney-Client Privilege Issues
Mr. Berger discussed recent issues involving the attorney-client privilege that have arisen in Division of Enforcement matters. First, regarding document productions, investigative staff will appropriately and carefully review privilege logs provided by defense counsel. The Staff has seen a few recent examples in which after some questions from the Staff, there was an insufficient basis for the assertion of privilege over a large number of documents that were ultimately produced. Mr. Berger noted that these were not situations involving close calls, and asks that counsel be mindful when making privilege designations and to expect the Staff to ask appropriate questions.
He also noted recent timing issues involving production of a large volume of documents that were initially withheld based on privilege. These scenarios involved a second-level review of privileged items by defense counsel that resulted in a significant supplemental document production after key witnesses had testified, which the Staff noted is less than ideal both for the Staff and for companies.
Finally, Mr. Berger noted that when raising an advice of counsel defense, the Staff expects to receive more support than a mere assertion of the defense or a calendar entry showing a meeting with counsel. In such cases, the Staff may consider assertion of this defense as part of its risk factors for litigating the case, or may consider it as a factor in an analysis of intent, but cannot fully credit this defense without supporting evidence. Further, it is not good for either side if an advice-of-counsel defense is raised for the first time in litigation.
Ms. Bandy noted that the Commission still relies on the Seaboard factors in assessing cooperation, and that those factors are just as relevant today as they were when announced in 2001. She stated that the Staff’s seminal consideration is whether a company’s cooperation substantially enhanced the quality of the Staff’s investigation.
Ms. Bandy highlighted a recently settled action against BMW as an example of the SEC rewarding meaningful cooperation. She noted that it was a complex matter spanning multiple improper sales practices over several years, and implicating jurisdiction issues gathering evidence and complications from the global impact of the COVID-19 pandemic. She observed that BMW was forthcoming and proactive, which enabled the Commission to conserve resources and move quickly; the settled action was brought within ten months despite the ongoing pandemic. She noted that BMW’s cooperation included producing documents from Germany within weeks of receiving requests from the SEC, as well as quickly producing witnesses for interviews. Additionally, she stated that BMW voluntarily reported certain misconduct and promptly undertook remedial measures. As a result, Ms. Bandy noted, the Commission order recognized in detail the steps BMW took to cooperate with the Staff’s investigation and imposed a reduced penalty. She stated that this case provides a good example of how cooperation is credited and the Staff’s expectation that companies find ways to be proactive and forthcoming.
The SEC’s recent cases against PPG Industries and Transamerica Asset Management were also cited as cases in which self-reporting and/or prompt remedial action had a significant impact on the remedies sought by the SEC. Ms. Avakian noted that it is important for companies to self-report as quickly as possible, because the Staff may independently discover the issue through other means. Once the Staff deploys resources on its own, a company’s opportunity to earn cooperation credit is decreased.
Ms. Avakian expressed the importance of rewarding whistleblowers in a timely manner and noted that the SEC has implemented changes over the past year to make this process more efficient. She believes that the fiscal year 2020 results speak for themselves: the Commission awarded around $175 million to 39 individuals, which marked a roughly 200% increase in the number of awards issued in a single year as compared to the next highest year, accounted for nearly one-third of all money ever awarded to SEC whistleblowers, and amounted to about one-third of all individuals to ever receive whistleblower awards from the SEC. Whistleblower tips resulted in over $765 million in financial remedies in fiscal year 2020.
Ms. Avakian advised companies to take whistleblower allegations seriously because whistleblowers often approach the SEC with their concerns if they do not think their company is responding appropriately. She noted that approximately 85% of employees or former employees who are SEC whistleblowers also reported internally to their company. Further, she advised that companies should, as always, avoid engaging in a quest to determine a whistleblower’s identity and avoid taking retaliatory steps against a whistleblower. Ms. Avakian noted that the SEC brings enforcement actions against companies that retaliate against whistleblowers or try to prevent them from approaching the Commission.
Liu v. SEC
This year’s SEC Speaks conference contained a significant amount of discussion on Liu v. SEC, including during both the Enforcement panel and Judicial and Legislative Developments panel.
Michael Conley, Solicitor for the Office of General Counsel (“OGC”), led a discussion regarding the Supreme Court’s recent decision in Liu v. SEC, which concerned courts’ ability to award disgorgement as a remedy in SEC actions. The petitioners in Liu were a husband and wife who claimed they were going to build a state-of-the-art cancer treatment center and raised approximately $27 million from investors, but lied in the offering documents about the way they intended to use the funds. The SEC alleged that petitioners spent or misappropriated most of the money and made little progress on the project, leaving only $300,000 of the original $27 million. On summary judgment, the court found the petitioners had violated Section 17(a)(2) and ordered disgorgement of $26.7 million as the amount causally connected to their violation. Petitioners then appealed to the Ninth Circuit, where the district court’s ruling was upheld in an unpublished opinion containing little discussion of disgorgement. Petitioners then appealed to the United States Supreme Court.
The issue before the Court in Liu related back to the Court’s decision in Kokesh v. SEC, in which the Court held that disgorgement is a penalty within the meaning of 28 U.S.C. § 2462, and therefore, is subject to § 2462’s five-year statute of limitations on penalties. In its decision in Kokesh, the Court included a footnote stating that it was not deciding whether courts have authority to order disgorgement in SEC actions or whether courts had properly applied disgorgement principles in the context of that case. The petitioners in Liu argued that disgorgement is not a permissible remedy in SEC actions because Congress had not granted the SEC authority to seek disgorgement, and that the Kokesh decision foreclosed the SEC’s argument that its ability to seek equitable and injunctive relief extended to disgorgement. Petitioners further argued that disgorgement was not historically a remedy available in equity, and that a finding that the SEC lacked authority to order disgorgement would not have a significant impact on the SEC. The SEC, in turn, argued that Section 21(d)(5) of the Securities and Exchange Act of 1934, which authorizes “any equitable relief that may be appropriate or necessary for the benefit of investors,” encompasses disgorgement. The SEC further argued that numerous other statutes presuppose the availability of disgorgement, and that forbidding courts to order disgorgement would allow wrongdoers to keep their ill-gotten gains.
The Court in Liu held that a disgorgement award that does not exceed a wrongdoer’s net profits and is awarded for wronged victims is equitable relief permissible under Section 21(d)(5). In its decision, the Court noted that (1) equity generally requires disgorgement of wrongful gains for the benefit of victims; (2) although liability is generally imposed only for profits accrued to the defendant themselves, joint and several liability is available when partners engage in concerted wrongdoing; and (3) courts limit awards to the net profits of wrongdoing which must include deduction of legitimate expenses. While the Court agreed with the SEC that disgorgement is a permissible equitable remedy, it vacated and remanded the decision to the lower court to determine the appropriate amount of disgorgement based on the principles articulated. The OGC noted three lower court decisions that have already applied the holding in Liu. In SEC v. Janus Spectrum LLC, the Ninth Circuit remanded to the lower court for reconsideration of the disgorgement award, but noted that the imposition of joint and several liability as to disgorgement is still permissible if it is consistent with Liu’s equitable principles. In SEC v. SFRC in the Northern District of California, the court held that Liu has no bearing on the propriety of a disgorgement award against a relief defendant. And in SEC v. Mizrahi in the Central District of California, the court held that defendants must identify a legitimate purpose for business expenses in order for them to be deducted from any disgorgement award.
The OGC stated that there are three main areas the Liucase left open for further refinement: (1) the question of disbursement of the disgorged funds when it is not feasible to identify the wronged investors; (2) the scope of joint and several liability; and (3) the identification of net profits given Liu’s holding that legitimate business expenses must be deducted before ordering disgorgement, while recognizing purported expenses may be wrongful gains under another name or used for wholly fraudulent enterprises.
Joseph Brenner, Chief Counsel for the Division of Enforcement, noted that the Staff’s takeaway from the Liudecision is that a disgorgement award that does not exceed the amount of wrongfully obtained profits and helps victims is considered equitable relief. He stated that, going forward, the Staff will consider the following relevant principles from the ruling: (1) when calculating net profits, legitimate expenses should be deducted; (2) typically personal liability will be imposed, but joint and several liability is appropriate for “concerted wrongdoing”; and (3) disgorgement should be for the benefit of harmed investors.
Mr. Brenner stated that, post-Liu, the Staff is focused on identifying legitimate expenses that should be deducted from disgorgement awards. He noted that the Court provided some guidance, and that expenses incurred for purposes of furthering a fraudulent scheme should not be deducted. The Staff is currently trying to apply the principles set forth in Liu to specific fact patterns in ongoing settlements.
Mr. Brenner stated that defense counsel advocating for deduction of certain expenses should address the following:
What makes an expense legitimate within the Court’s framework? Did the expense provide value to investors independent of the fraudulent scheme, or is it really just disguised profits?
If a legitimate expense, how closely is it tied to unlawful profits? As not every legitimate expense is properly set off, why do you think the expense is properly deducted?\\
What is the proper amount for the offset? Mr. Brenner noted that the Staff often will not have visibility into the calculation and believes that defense counsel can play a very constructive role in conducting an analysis and sharing it with the Staff. He stated that it is not effective for defense counsel to argue in favor of deductions without providing support for such deductions, to claim that it is too expensive or burdensome to prepare a supporting analysis, or to state that the supporting analysis is attorney work product that cannot be shared with the Staff.
Ms. Avakian stated that post-Liu, defendants should expect some changes in the balance between penalties and disgorgement sought by the Commission. She noted that the SEC always considers a variety of factors when determining appropriate remedies, including the amount of disgorgement. She stated that penalties sought may be higher in some cases where the statutory scheme permits, and that the Staff’s recommendations will be consistent with Liu but also will honor the SEC’s mission.
From a litigation perspective, Ms. Fitzpatrick stated that the Staff will make a complete record going forward on the issues identified in Liu. For example, defendants can expect to receive questions about business expenses and the feasibility of distribution of funds to investors, and for the Staff to conduct active discovery on these issues.
The OGC also discussed challenges to the Commission’s recently adopted Regulation Best Interest (“Reg BI”), which articulated standards of conduct for broker-dealers making recommendations to retail investors about securities transactions or investment strategies involving securities. Under Reg BI, a broker-dealer making a recommendation to a retail customer must act in the retail customer’s best interest and cannot place its own interest above the customer’s interest. To meet this obligation, broker-dealers must comply with four component obligations: (1) a disclosure obligation that requires full and fair disclosure of all material facts about the scope and terms of its relationship with the customer and any conflicts of interest either before or at the time of the recommendation; (2) a care obligation that requires reasonable diligence, care and skill when making a recommendation; (3) a conflict of interest obligation that requires a broker-dealer to establish, maintain and enforce written policies and procedures reasonably designed to address conflicts of interest associated with its recommendations; and (4) a compliance obligation that requires a broker-dealer to establish, maintain and enforce written policies and procedures that are reasonably designed to achieve compliance with Reg BI as a whole.
Two sets of petitioners brought challenges to Reg BI. The first set of petitioners was comprised of seven state governments and the District of Columbia, and the second set was comprised of an organization of financial planners and one of its members. The cases were consolidated before the Second Circuit as State of New York, et al. v. SEC. Petitioners challenged Reg BI on the bases that (1) it exceeded the SEC’s statutory authority under Section 913 of the Dodd-Frank Act and the Investment Advisers Act of 1940 and (2) the SEC acted arbitrarily and capriciously in adopting Reg BI as opposed to adopting a uniform fiduciary duty that would apply to both broker-dealers and investment advisors. The Second Circuit rejected both challenges and upheld Reg BI. Specifically, the court found that Section 913 provided authority for the SEC to promulgate rules, that Reg BI fell within the broad grant of discretionary authority in Section 913(f) (providing that the SEC may address standards of care for broker-dealers) and that 913(f) was not narrowed by 913(g) (which authorized the SEC to promulgate a rule adopting a uniform standard for broker-dealers and investment advisors). The court further found that the SEC adequately explained its policy choices and therefore did not act arbitrarily or capriciously. The petitioners’ deadlines to seek rehearing by the Second Circuit or to appeal to the United States Supreme Court have passed and the SEC considers this case to be over.
SEC v. Gentile
Turning back to the implications of the Kokesh decision, the OGC next discussed the Third Circuit’s decision in SEC v. Gentile. This case involved two “pump and dump” schemes involving penny stocks orchestrated by Gentile in 2007 and 2008. Gentile was arrested by the FBI, admitted to his role in the schemes, and agreed to cooperate with the government’s investigation by acting as an informant. The cooperation agreement eventually broke down and the DOJ indicted Gentile, but the indictment was dismissed as untimely. Gentile then announced his intention to expand a brokerage firm he owned in the Bahamas, at which point the SEC sought an injunction prohibiting future violations of federal securities laws and an order barring Gentile from participating in any future offerings of penny stocks.
The district court applied Kokesh and found that the remedies sought by the SEC constituted a penalty under 28 U.S.C. § 2462, subject to a five-year statute of limitations, and dismissed the SEC’s claims as untimely. The Third Circuit vacated the district court’s decision, finding that injunctions are generally issued to prevent future harm rather than to address past wrongdoing, and that injunctions in SEC actions are consistent with this theory. With respect to the principles set forth in Kokeshfor determining whether a remedy is a penalty, the court looked at whether the remedies sought by the SEC were a consequence of violating public law and whether the remedies were intended to deter rather than compensate. The court held that the SEC’s action intended to enforce public laws, but determined that this factor alone was not enough to render the desired injunctive relief a penalty and thus moved to the second factor. The court held that injunctions sought by the SEC are different than disgorgement in that injunctions are focused on preventing future harm as opposed to punishing past conduct or deterring others from engaging in similar conduct. Injunctions must be supported by proof of threatened harm caused by the defendant and courts would be abusing their discretion if they issued or broadened injunctions to have a general deterrent effect on others.
Twin Rivers Paper Co., LLC v. SEC
The OGC noted that the D.C. Circuit heard oral arguments this year in a petition for review of the Commission’s Rule 30e-3 (under the Investment Company Act) brought by Twin Rivers Paper Company and a number of business and consumer organizations in the paper, printing and mailing industries. The rule permits mutual funds that qualify to distribute most shareholder reports online, but investors may opt to continue to receive paper copies of the reports. Twin Rivers challenged the rule on a number of grounds, including that it was arbitrary and capricious, unnecessarily and inappropriately prioritized cost savings to funds over benefits to investors, and that the Commission failed to adequately respond to recommendations from the Investor Advisory Committee. The OGC explained that the issues in this case included where to draw the line on requiring quantification of particular component costs of Rule 30e-3 as opposed to a holistic assessment of the Commission’s analysis and how far the Commission’s obligation goes to derive its own data when it has sought data through the comment process but did not receive any. This case was ultimately decided on the issue of standing, with the court finding that the consumer group lacked constitutional standing and the paper industry lacked prudential standing because they were asserting interests that fell outside the scope of those protected by the securities laws.
Nasdaq Stock Market LLC v. SEC
Next, the OGC discussed the decision in Nasdaq v. SEC, in which the D.C. Circuit vacated a Commission decision setting aside certain market data fees. At issue in this case was “depth of book” data, which shows which bids and offers stand behind the best bids and offers on an exchange, translating to the liquidity of a market for a security. The D.C. Circuit found that the Securities Industry and Financial Markets Association could not challenge generally applicable fee rules as improper under Section 19(d) of the Securities Exchange Act of 1934.
New York Stock Exchange LLC v. SEC
Finally, the OGC discussed the decision in NYSE v. SEC, in which the D.C. Circuit held that the SEC lacked authority to go forward with a pilot program under Rule 610T because the SEC was not taking a position on whether U.S. stock exchanges’ current fee and rebate structure was harmful, but rather was merely seeking to gather data.
Junaid A. Zubairi, Marie E. Christiansen, Brooke E. Conner, Nusra Ismail, Jani K. Mikel, Joshua Nichols, David W. Soden, Nicholas Vera and Nate Wright contributed to this article.