The SEC: The Future Path of Enforcement (Conclusion)


Parts I and II of this series looked back at select cases brought by the Commission during 2013. Part III considered the projected path of SEC Enforcement based on remarks by members of the Commission and new initiatives. This segment analyzes the projected path of SEC Enforcement based on those items.

Analysis and conclusions

The SEC is crafting a new “get tough/omnipresent” SEC enforcement doctrine and program. Promises have been made that enforcement will be bold, unrelenting and everywhere. New initiatives have been announced. At the same time the number of cases being filed is dwindling. The critical questions are the future direction of the program and its effectiveness.

Part of the answer to those questions lies in the cases brought in the last year. Those actions, an outgrowth of earlier initiatives, focus on areas such as exchanges and SROs, insider trading, municipal issuers, PRC based issuers, funds and the FCPA. Analysis of those actions helps to define probable future avenues for the enforcement program at least in the near term. For example:

Exchanges/SROs: These actions center largely on market structure issues. The action against the NYSE concerned the fairness of how nonpublic market data was disseminated; the action concerning NASDAQ involved questions about how the Facebook IPO was handled; and the case against the CBOE, which resulted in the first fine imposed on such an organization based on its regulatory functions, involved questions about how the organization implemented procedures to monitor the implementation of SEC rules. With an increasing number of exchanges and trading platforms, and additional market disruptions from failures such as the outage late last summer, it seems clear that SEC Enforcement will continue to be involved in these issues.

Insider trading: The Commission can be expected to continue pushing the edge in insider trading cases. While the U.S. Attorney’s Office in Manhattan may bring more criminal actions in the fund industry, those cases are typically built on wire taps and/or cooperating witnesses and involve the use of information which is well within traditional notions of insider trading such as earnings releases and M&A details. While the SEC typically is involved in those actions, the more significant trend for many is reflected in cases such as Bauer which has the potential to expand and extend the boundaries of what constitutes insider trading, building on actions such as Knight and Obus (discussed in Part I of this series).

Municipal issuers: Last year the SEC brought a series of cases in this area and issued a Section 21(a) report of investigation. These cases typically centered on what might be called procedural issues – that is, the lack of procedures for ensuring effective disclosure. In some instances they involve questions about the accuracy of material statements made by officials as discussed in the recent Section 21(a) Report issued by the Commission (discussed in Part I of this series). As these markets continue to evolve it seems clear that SEC enforcement will focus on them.

PRC issuers: Last year, and in prior years, the Division brought a number of cases in this area. Frequently they focused on the quality of the financial reporting as well as self-dealing transactions by corporate officials which were not properly accounted for in the financial statements. The pending industry wide proceeding against the PRC affiliates of five international accounting firms (discussed in Part II of this series) may have a significant impact here if orders are entered precluding those firms from appearing and practicing before the Commission. That could inhibit the ability of PRC based issuers to utilize the U.S. capital markets. Such an order might spur PRC regulators to revise their policies and effectively implement the MOU executed with the PCAOB and agree to inspections as required by SOX. At the same time the number of cases brought in this area, in probability, will decline in the wake of the industry wide proceeding.

Funds: The Division continued to focus on procedural issues at funds last year, perhaps as an outgrowth of its enhanced partnership with OCIE. Alderman (discussed in Part II of this series) is a good example of the type of cases brought in the past and which may be in the pipeline for the future. There the action centered on the lack of procedures for the board to fully comply with its obligations. Variations of this theme can be expected to include proceedings where fund policies and procedures are not properly applied and valuation issues concerning illiquid assets which was, in fact, the underlying issue in Alderman.

FCPA: This enforcement staple can be expected to be a continued as an area of focus in the future. Despite dwindling numbers of cases in recent years, the actions last year against Total, Weathford and Diabold should be more than sufficient to dissuade anyone of the notion that the new era of FCPA enforcement is drawing to a close. This is particularly true since two of those cases made the FCPA top ten list. Perhaps more important for the future, however, is the scrutiny on cooperation and remediation evidenced in Weathford and Diabold. In the former, the company was penalized for a lack of cooperation while in the latter enforcement officials were critical of the lack of remedial efforts by the company. Together these cases suggest that issuers considering self-reporting, or those involved in on-going investigations, carefully assess their efforts if earning cooperation credit is an important part of the overall strategy. Indeed, in that context issuers may want to consider the approach to that issue used by companies such as Siemens and Johnson & Johnson who became corporate whistleblowers, developing evidence of wrongful conduct on others, to earn extra cooperation credits. See, e.g., Thomas O. Gorman & William P. McGrath, Jr., “The New Era of FCPA Enforcement: Moving Toward a New Era of Compliance, 40 Sec. Reg. L.J. 341,354-356 (2012)(discussing this trend); see also Remarks of Deputy AG James Cole to The Foreign Corrupt Practices Act Conference (Nov. 19, 2013)(calling for increased cooperation from issuers in FCPA cases).

While the trends reflected in these areas can be expected to continue in 2014, the central question going forward will be the implementation of the new “get tough/omnipresent” approach, implemented through the announced new initiatives. Stated differently, the key question may well be whether this approach will bring back the swagger for the enforcement program.

The “get tough/omnipresent” approach appears to be a composite of proposals and announced initiatives. Read together, the remarks of the new SEC Chair and various Commissioners, along with press releases announcing new initiates, appear to define the contours of the new enforcement program. It has six key facets:

Admissions: Settlements with “teeth” are a critical part of the program to engender deterrence. Accordingly admissions will be required in select cases. The settlements with Mr. Falcone and his entities and JPMorgan are examples (discussed in Part III of this series). Yet as Ms. White noted, the majority of SEC settlements will be based on the traditional “neither admit nor deny” approach.

Operation Broken Gate: Holding gate keepers such as accountants and other professionals responsible is a critical part of the overall strategy. Under this approach if gatekeepers are halted other possible violations are stopped.

Manipulative short selling:  Another key aspect of the strategy to police the markets. The announced strategy is to rely on Rule 105.

The custody rule:  Another focus will be on the custody rule which governs the manner in which investment advisers care for the assets of investors. This part of the program appears to be an extension of recent efforts to carefully police the implementation of policies and procedures of funds.

Financial statement fraud task force/microcap fraud task force: The former refocuses SEC enforcement into a traditional area. Past efforts such as those following former Chairman Levitt’s “Numbers Game” Speech yielded a series of high profile financial fraud actions. See, e.g., Thomas O. Gorman, The SEC’s New Financial Fraud Task Force, 45 SRLR 2132 (Nov. 18, 2013)(reviewing cases brought in the wake of the speech). This effort will be aided by a computer analytics group. The latter appears to be an extension of existing programs focused on manipulative actions in penny and pink sheet stocks.

Trial: Winning at trial is critical to the credibility of the program, according to Ms. White.

While the proposals for the get tough program focus on omnipresence or being everywhere, Ms. White and Commissioner Gallagher appear to agree that SEC enforcement cannot achieve that result. At the same time Chair White insists that by leveraging the Commission’s resources in various ways, such as through computers and relationships with other regulators, this program can be implemented to effectively cover the market.

Closer examination raises critical questions. Initially, the notion of leveraging the Commission’s limited resources is hardly new. From virtually the beginning of the Division, the agency has sought to leverage its resources. While this approach can facilitate some actions, there is nothing to suggest that revisiting this time worn notion now is going to somehow make the enforcement division omnipresent today.

There are similar questions regarding the effectiveness of Operation Broken Gate. Again, this is a time worn notion. Again, from the earliest days of the Enforcement Division the agency has attempted to enlist gatekeepers such as outside auditors as a kind of front edge of enforcement with little success. As the court in SEC v. Arthur Young, 590 F. 2d 785, 788 (9th Cir. 1979)stated over 30 years ago: “We can understand why the SEC wishes to so conscript accountants. Its frequently late arrival on the scene of fraud and violations of securities laws almost always suggests that had it been there earlier with the accountant it would have caught the scent of wrong-doing and, after an unrelenting hunt, bagged the game. What it cannot do, the thought goes, the accountant can and should. The difficulty with this is that Congress has not enacted the conscription bill that the SEC seeks to have us fashion and fix as an interpretive gloss on existing securities laws.” (emphasis original).

Likewise, focusing on “manipulative short selling” and the custody rule is unlikely to achieve the kind of cop on the beat/market presence being sought for the enforcement program. Manipulative short selling as illustrated by the cases cited in the Release is based on Rule 105 whose application is limited to those who trade in a small time window prior to a secondary offering. The custody rule is of concern only when the adviser actually holds the assets of the client, not to the many who do not. Rules such as these with limited application should clearly be enforced. In view of the limited application they are not likely to generate market wide presence even if the actions are viewed in conjunction with others.

In contrast, the financial fraud task force has the potential to significantly impact in the market place. This is a traditional area of emphasis for the Division. As the market crisis unfolded and resources were shifted to investigations on those issues, the number of financial fraud cases dwindled. If the agency is able to rekindle the kind of efforts brought in the past, it may be able to bring a significant number of actions which can impact a large segment of the financial markets. Those actions, in conjunction with others in areas such as insider trading, funds and FCPA may well create the kind of market impact the program seeks.

Critical to that effort, however, will be the charging process and the remedies employed, both of which can impact settlement and trial. In the charging process the Commission has an array of choices and multiple options when assessing the potential liability of an issuer and/or individuals. If, for example it is a financial fraud action the traditional fraud provisions and filing provisions can be used as to the company. In considering the individuals multiple avenues are available including aiding and abetting, causing, control person liability and the SOX claw back provisions. How the case is charged, and whether the allegations in the complaint are factual and match the charges or are overstated and mismatched sends a critical message to the market. See, e.g., SEC v. Citigroup Global Markets, Inc., Civil Action No. 11 Civ. 7388 (S.D.N.Y.)(court noted the allegations were of intentional fraud but the charges were negligence).

Equally important is the selection of remedies, particularly since most cases settle. While the new admissions policy may have its uses, and large fines can in select circumstances be effective, the critical point here is to marshal all of the tools available to the agency. Admissions will, by definition, only be used in very select cases. Fines, as Judge Rakoff has noted, are often viewed as a cost of doing business. Increasing the Commission’s fining authority is not likely to change this fact.

To be effective the Commission needs to move past the headlines garnered from these new policies and employ the other, more effective available tools. Fashioning relief which stops the wrongful conduct with an injunction and does more, such as reforming the policies and procedures of the organization or even the culture which permitted and perhaps fostered the wrongful conduct, can be very effective in preventing future violations. In the past the Commission has utilized these tools effectively. If the enforcement program is going to be an effective part of a regulatory program in the future – not a prosecutor seeking deterrence through punishment – it is critical that the agency utilize these tools to reform the market place, crafting a better future for investors and the markets. The SEC has the tools; it has the talent; now is the time.