The SEC: The Future Path of Enforcement (Part III)

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Parts I and II of this series looked back at 2013 and examined select cases which may influence the future path of SEC enforcement. This segment focuses on the path being charted for the Enforcement Division by a new Commission.

A Look Forward: Where The Enforcement Division is Going

The SEC has a new Chair and new Commissioners. As the enforcement program transitions from the market crisis, its future path has been outlined in remarks by New SEC Chair Mary Jo White and the other Commissioners. The Commission has also announced a number of new initiatives which will be part of the Enforcement Division’s focus. Collectively these initiatives, along with the views of the Commissioners, suggest the future path of enforcement.

The White enforcement doctrine

Ms. White has made the most extensive comments regarding the future path of SEC enforcement. She began during her Senate confirmation hearings, declaring SEC Enforcement must be “bold and unrelenting.” Building on that theme, she outlined her vision in a number of presentations which include remarks to the Council of Institutional Investors (Sept. 26, 2013) and at the Securities Enforcement Forum (Oct. 9, 2013).

At the Council of Institutional Investors Ms. White declared that “A robust enforcement program is critical to fulfilling the SEC’s mission . . . [since] In many ways, [it is] the most visible face of the SEC . . .” She outlined five key principles as the predicate for her vision of enforcement. First, the program will be “aggressive and creative . . .” bringing the “tough cases” and have settlements with “teeth” that send a “strong message of deterrence.” Penalties will be considered in every corporate case. While Ms. White supports the earlier Commission Release on corporate penalties, she also called on Congress to increase the authority of the agency in this area.

Second, the Commission “should consider whether to require the company to adopt measures that make the wrong less likely to occur again.” Third, there must be accountability. This means that in some instances the settling party will be required to make admissions. While most cases will be resolved using the traditional “neither admit nor deny” formula in select instances admissions will be required.

Fourth, individuals must be held accountable. Fifth, the program must cover the “whole market.” In her remarks to the Council of Institutional Investors Ms. White defined four key areas to amplify this point: 1) investment advisers at hedge funds and mutual funds; 2) financial statement and accounting fraud; 3) insider trading; and 4) microcap fraud. At the same time it is critical that the agency continue to adopt to a diverse and rapidly changing market place she noted.

At the Securities Forum Ms. White amplified her thoughts on how the enforcement program could cover the whole market or, in effect, be omnipresent, detailing four key points: 1) The agency will expand its reach by leveraging its resources and using technology; 2) there will be a focus on gatekeepers; 3) by adopting an approach where no violation too small to prosecute, respect for the law will be encouraged; and 4) the SEC will prioritize its cases.

Finally, the agency must win at trial. As Ms. White told the Council of Institutional Investors: “For us to be a truly potent regulatory force, we need to remain constantly focused on trial redress . . .” since consistent wins at trial give the program “credibility.”

Other Commissioners

Other Commissioners have discussed aspects of the program. For example, Commissioner Aguilar, in remarks delivered to the 20th Annual Securities Litigation and Regulatory Seminar (Oct. 25, 2013), discussed deterrence in terms similar to those used by the new Chair. In this regard Commissioner Aguilar declared: “[I]t is customary for Commission representatives to talk the tough talk about enforcement, I am optimistic that the current Commission will walk the walk.”

Moving beyond the Commission’s prior statement on corporate penalties which Ms. White seemed to adopt, the Commissioner noted that the agency should not be limited by the notion that such a fine may only cause further harm to the shareholders since their company pays it. Rather, the Commission should refocus its corporate penalty policy on the misconduct, the nature of the defendant, self-reporting and equitable concerns. The Commissioner also expressed support for the new admissions policy, noting that it will strengthen the program.

A different tone was stuck by Commissioner Daniel Gallagher in remarks at the FINRA Enforcement Conference (Nov. 6, 2013). In his remarks the Commissioner carefully traced the evolution of the SEC Enforcement Program concluding that from the start: “Punishment was not the Commission’s primary enforcement mission; rather, that mission belonged to the Department of Justice. The Commission’s original enforcement mission was to stop ongoing violations and to prevent further harm to investors and the markets.”

Over time the Commission’s enforcement authority has evolved. With the passage of the Remedies Act in 1990 the agency was given “robust penalty authority against individuals and nuanced penalty authority, to be used judiciously, against corporate issuers,” Commissioner Gallagher noted.

Turing to the question of an “omnipresent” enforcement program, Commissioner Gallagher stated that many have espoused this approach and the “cop on every corner” analogy for a tougher program. It is, however, unworkable, since the agency clearly cannot be everywhere. Perhaps more importantly, the SEC is a “capital markets regulator, and its enforcement function should support its efforts to maintain and improve our capital markets.” While the enforcement program should be robust, it is essential that it focus on the mission of the agency and leave the criminal cases to the Department of Justice, according to Commissioner Gallagher.

Finally, Commissioner Michael S. Pinwowar offered his thoughts on the enforcement program in remarks before the Los Angeles County Bar Association (Nov. 22, 2013). Viewing the Commission’s obligations through its Code of Ethics, Commissioner Pinwowar noted that the enforcement program is a “core part of our functions.” In exercising its broad authority in this area the agency has an obligation to protect investors, maintain fair and orderly markets and facilitate capital formation. In undertaking this task the Commission cannot “allow public outcry, agency morale, politics, or jurisdictional turf battles to become reason for pursuing, or not pursuing, an enforcement action.” Rather, the exercise of that authority should be guided by the facts, the law, due process and economic analysis.

Commissioner Pinwowar illustrated the application of these principles with two examples. First, when the authority to issue a formal order was delegated, the Director of Enforcement represented that in some instances it may be appropriate to still bring the question to the Commission. Yet there are no standards for doing this and it has not been done. In view of the impact such an order can have, it may be appropriate to permit the public to comment on the question of delegating this authority, although it is not required.

Second, on the question of retroactivity the Commission last year adopted the position that Dodd-Frank collateral bars can be applied to conduct which occurred before the passage of that Act. This is based on the theory that such a bar is not retroactive because its application is forward looking, according to Commissioner Pinwowar. Yet the key question here is one of fundamental fairness the Commissioner stated. Accordingly he would like to revisit this issue.

New initiatives

Since Ms. White became SEC Chair a number of new initiatives have been announced which may impact the future path of the Enforcement Program. These include: 1) Admissions in select cases; 2) Operation Broken Gate; 3) a focus on manipulative short selling; 4) the custody rule; and 5) the Financial Statement Fraud Task Force.

Admissions: Admissions will now be required in select cases. This departs from the Commission’s long standing rule that settlements are based on the defendant “neither admitting nor denying” the facts and allegations in the charging document with the exception of those relating to jurisdiction.

Under the new policy a settling person will be required to make specific admissions of fact in select cases. This policy builds on a modification made to the SEC’s settlement policy in 2012 under which admissions are required where they have been made in a parallel action.

The new policy will be applied on a case by case basis. Thus the standards for its application are evolving. At the same time, Ms. White defined the key considerations for application of the policy in her remarks to the Council of Institutional Investors. Admissions may be appropriate when: 1) There are a large number of investors who have been harmed; 2) if the conduct is egregious or if the conduct presented a significant risk to the market or investors; 3) if admissions would aid investors in future decisions; or 4) if reciting the facts would send an “unambiguous” message.

To date the SEC has applied the new admissions policy in two instances. The first was in the settlement of two actions tied to hedge fund manager Philip Falcone. SEC v. Falcone, Civil Action No. 12 CIV 5027 (S.D.N.Y. Filed June 27, 2012)(manipulation allegations centered on a short squeeze); SEC v. Harbinger Capital Partners LLC, Civil Action No. 12 CIV 5028 (S.D.N.Y. Filed June 27, 2012)(action centered on wrongful use of investor funds and improperly favoring certain investors).

To resolve these actions the defendants admitted to a series of facts contained as an annex to the consent. Those admissions track many of the allegations in the complaints. As part of the settlements Mr. Falcone also agreed to the entry of an order which requires him to pay $6,507,574 in disgorgement along with prejudgment interest and a $4 million penalty. The entity defendants agreed to pay a $6.5 million penalty. In addition, Mr. Falcone was barred from association with any broker, dealer, investment adviser, municipal securities dealer, municipal advisor, transfer agent, or nationally recognized statistical rating organization with the right to reapply after five years.

The second is the settlement in In the Matter of JPMorgan Chase & Co., Adm. Proc. File No. 3-15507 (Sept. 19, 2013)(action based on the “London Whale” trading). JPMorgan settled the action, consenting to the entry of a cease and desist order based on the Sections cited in the Order. The financial institution also agreed to pay a civil penalty of $200,000. The Commission acknowledged the cooperation of JPMorgan.

JPMorgan did not admit the facts and allegations in the Order. Annex A to the Order, however, states, that “JPMorgan Chase & Co. admits to the facts set forth below and acknowledges that its conduct violated the federal securities laws.” The Annex goes on to present a detailed chronology of the events surrounding the matter. The Annex does not identify any individuals. It does not allege or otherwise state that any specific provision of the federal securities laws was violated.

Gatekeepers: Operation Broken Gate is the SEC’s effort to hold gatekeepers accountable as part of the omnipresent enforcement approach. In announcing the initiative, the agency filed three actions involving auditors. Two were settled while a third litigated for a period and then settled. In the Matter of John Kinross-Kennedy, CPA, Admin. Proc. File No. 3-15536 (Filed Sept. 30, 2013); In the Mater of Wilfred W. Hanson, CPA, Adm. Proc. File No. 3-15537 (Filed Sept. 30, 2013); In the Matter of Malcolm L. Pollard, CPA, Adm. Proc. File No. 3-15535 (Filed Sept. 30, 2013). The remedies in these cases centered on the entry of cease and desist orders as well as an order denying the auditor the right to appear and practice before the Commission as an auditor.

Manipulative short selling: Based on Rule 105 of Regulation M, which prohibits short selling in a window prior to a secondary offering, the Commission is focusing on halting manipulative short selling. The initiative was announced with a press release listing twenty-two actions. A broad spectrum of entities were involved in the proceedings. They included Blackthorn Investment Group, D.E. Shaw & Co., Deerfield Management Company, Hudson Bay Capital Management, Southpoint Capital Advisors and the Ontario Teachers’ Pension Plan Board. Each of the settling firms agreed to pay disgorgement, prejudgment interest and a penalty. The largest amount of disgorgement was paid by JGP Global Gestao de Recursos at $2,537,114.00. The smallest amount was paid by Credentia Group at $4,091.00.

Penalties ranged from a high of $679,950.00 paid by Manikay Partners on disgorgement of $1,657,000.00 to a low of $65,000 paid by eight firms: Claritas Investments Ltd, disgorged $73,883; Credentia Group paid the smallest amount of disgorgement; Merus Capital Partners paid $8,402.00; PEAK6 Capital Management disgorged $58,321.00; Philadelphia Financial Management of San Francisco paid $137,524.38; Soundpoint Advisors disgorged $346,568.00; Talkot Capital disgorged $17,640 and Western Standard which paid $44,980.00.

Custody rule: Another grouping of cases focused on the application of the custody rule which generally governs the manner in which investment advisers hold client assets. At the time the Commission announced this initiative it filed three settled cases based in whole or part on the Rule. In the Matter of Further Lane Assets Management, LLC, Adm. Proc. File No. 3-15590 (Oct. 28, 2013); In the Matter of GW & Wade, LLC, Adm. Proc. File No. 3-15589 (Oct. 28, 2013); In the Matter of Knelman Asset Management Group, LLC, Adm. Proc. File No. 3-15588 (Oct. 28, 2013).

Financial statement fraud task force: A key initiative of the new enforcement program is the formation of a Financial Reporting and Audit Task Force. Its purpose is to detect “fraudulent or improper financial reporting” and “enhance the [Enforcement] Division’s ongoing enforcement efforts related to accounting and disclosure fraud.” At the same time the Commission announced the formation of a similar group focused on microcap fraud and the creation of the Center for Risk and Quantitative Analysis. The new Center for Risk and Quantitative Analysis will work in close coordination with the Division of Economic and Risk Analysis and “serve as both an analytical hub and a source of information about characteristics and patterns indicative of possible fraud or other illegality.” Focusing on this area represents a shift from the market crisis cases which have been a key area of concern and a return to a traditional priority of SEC Enforcement and a return to a traditional SEC enforcement priority. See, e.g., Remarks of SEC Chairman Arthur Levitt, “The Numbers Game” (1998)(initiating a focus on financial statement fraud cases); see also Remarks of Richard H. Walker, Director, Division of Enforcement, addressing 27th Annual National AICPA Conference on Current SEC Developments (Dec. 7, 1999)(detailing a significant increase in the number of financial statement fraud actions being brought against issuers such as Waste Management, WorldCom, Tyco International, Enron, Xerox Corporation). To date the Financial Statement Fraud Task Force, along with Operation Broken Gate and the other recently announced initiatives, coupled with the statements of the Chair and the Commissioners define the new get tough, omnipresent enforcement approach.

Next: Analysis and Conclusions. This will be the concluding segment to this series.