The U.S. Securities and Exchange Commission (SEC) touted an expansive regulatory agenda at this year’s “SEC Speaks” conference, held February 20-21, 2015, in Washington, D.C. At this year’s Speaks, SEC representatives reviewed the agency’s efforts in 2014 and previewed the year to come, with senior leadership highlighting broad initiatives ranging from broker-dealer duties and disclosure requirements, to cybersecurity readiness and anti-corruption enforcement. Given this aggressive agenda, Commissioner Michael Piwowar jested that the SEC has invented a “new stove with 50 front-burners.” However, he went on to caution the agency to set priorities in line with its core mission.
Below we have summarized some of the key discussions during this year’s SEC Speaks.
Chairman White Touts 2014 Wins, Warns SEC Will Target Financial Fraud in 2015
In her opening remarks, SEC Chairman Mary Jo White observed that 2014 was a year of significant accomplishment across all areas of the agency’s responsibility, including a number of policy reforms that continue to address fallout from the financial crisis and vulnerabilities in market integrity.
Record Number of Enforcement Cases and Monetary Relief. For example, Chairman White noted that the agency brought a record 755 enforcement cases over the past year, and obtained a record $4.1 billion in monetary relief through its efforts. Chairman White added that the staff was focused on bringing innovative, high-impact cases, including “first of its kind” cases against entities ranging from high-risk frequency traders and dark pool investment platforms to private equity firms and broker-dealers. According to White, in 2014, the SEC sought to deliver a clear message to would-be fraudsters by obtaining an increased number of settlements with admissions of wrongdoing, as opposed to its more routine “no admit-no deny” resolutions.
Increased Investor Protection Activity. Turning to investor protection, Chairman White praised the Office of Compliance Inspections and Examinations (OCIE) for conducting 1,855 exams in 2014, which reflects a 15 percent increase from 2013. This figure includes a cybersecurity initiative involving 100 registrants aimed at assessing their preparedness for cyberattacks. The Chairman also highlighted the continued integration of technology, such as the National Exam Analytics Tool (NEAT), into the OCIE testing program.
Increased Emphasis on Enforcement for Financial Reporting and Auditing Fraud. Chairman White predicted that in 2015, the SEC will continue to prioritize enforcement actions related to financial reporting and auditing fraud, and highlighted a 40 percent increase in such cases in 2014. She added that the SEC’s recent cases in this area have focused on violations involving improper revenue recognition, lack of auditor independence, false and misleading financial disclosures, and violation of broker-dealer gatekeeper duties under Section 5 of the Securities Act. Chairman White further observed that the SEC continues to consider the adoption of rules that would hold broker-dealers to the same fiduciary standards as advisors, a proposition opposed by many in the investment community.
Additional Priorities for 2015. Chairman White concluded by addressing her other priorities for 2015, which include the following areas:
Market structure fundamentals, such as disclosure and transparency in the equity markets;
Capital raising for small issuers and related JOBS Act rulemaking; and
Completion of Dodd-Frank Act (DFA) rulemaking, largely in the areas of derivatives and executive compensation.
Full Steam Ahead for Enforcement
Senior staff from the SEC’s Division of Enforcement highlighted the agency’s recent successes and its plans to continue to focus on core program areas and file impactful actions in 2015. Several commentators added that enforcement efforts in the upcoming year will be bolstered by the SEC’s continuing use of data analytical tools to detect and prosecute fraud.
FCPA Unit Discusses Enforcement Focus in 2015, Stresses Cooperation Credit. Kara Brockmeyer, Chief of the SEC’s Foreign Corrupt Practices Act (FCPA) Unit, noted that while the SEC brought only seven cases in fiscal year 2014, this relatively low number did not reflect a decrease in foreign corruption. To the contrary, the SEC has already filed as many cases in the first five months of fiscal year 2015 as it did in all of fiscal year 2014. While the SEC continues to focus on bribery hot spots, such as China and Africa, Brockmeyer stressed that corruption continues to be a worldwide problem that is highly dependent on the bureaucracy in place, even in historically low-risk regions.
In 2015, Brockmeyer expects that the SEC will continue to focus on large multinationals, and will also increase its scrutiny on small and medium-sized companies, including those entering international markets for the first time. She said the SEC will also broaden its review to include industries that may not have been the focus of FCPA investigations in the past.
Turning to the area of cooperation credit, Brockmeyer stated that over the past year, the SEC has tried to give meaningful credit to companies that assist the SEC in its investigations. In some cases, this credit is reflected in reduced penalties for the company. In the Bio-Rad matter, for example, the California-based life science company self-reported misconduct involving $7.5 million in bribes paid to foreign officials in Russia, Vietnam and Thailand. Bio-Rad also cooperated extensively during investigations by the SEC and Department of Justice (DOJ), and ultimately agreed to pay $40 million in disgorgement to the SEC and $14 million in criminal fines to the DOJ. Brockmeyer noted that this result, including the $14 million fine—which is relatively modest by FCPA standards—reflected the government’s recognition of the company’s cooperation throughout the investigations.
Brockmeyer added that such cooperation credit is especially appropriate when a company assists the SEC by:
Reporting its investigative findings in real time, which allows the SEC to leverage that information and use it in its own investigation;
Providing English translations of key documents;
Facilitating interviews of foreign employees, including by bringing such employees to the U.S. or other jurisdictions for interviews;
Facilitating interviews of former employees, e.g., by informing the SEC before termination or locating former employees if termination has already occurred; and
Thinking creatively to assist the SEC in obtaining foreign documents that may be protected by foreign data privacy laws, rather than using such laws to block the SEC’s access to such documents.
According to Brockmeyer, the SEC has also observed an increase in self-reporting and has seen an improvement in the quality and nature of the reports. Brockmeyer observed that this uptick in self-reporting suggests that many companies have adopted robust internal controls that are capable of identifying issues while still in their infancy. This relative strength of internal controls has translated into fewer corporate compliance monitorships—only two in fiscal year 2014, since companies appear to be well positioned to self-monitor after reporting misconduct to the SEC.
Whistleblower Program “Tremendously Successful” in 2014. During his remarks, David Glockner, Director of the Chicago Regional Office, called 2014 a “tremendously successful” year for the SEC’s whistleblower program. He noted that in fiscal year 2014, the program issued awards to more individuals than in all previous years combined. He added that the magnitude of the award payments also reached historic heights. In September 2014, the SEC authorized an award of $30 million to a non-U.S. resident, the largest award payment to date and the first to a foreign national.
Glockner further observed that in 2014, the SEC brought its first action under the anti-retaliation provisions of the Dodd–Frank Act, ordering Paradigm Capital Management to pay $2.2 million to settle anti-retaliation and other charges. Glockner noted that the SEC will continue to bring similar actions as they arise and it will also work to identify and investigate the use of employee confidentiality, severance and other kinds of employment agreements to discourage whistleblower reporting.
More Accounting Enforcement on the Horizon. The Enforcement Division’s Chief Accountant, Michael Maloney, indicated that his pipeline has been filled by tips, complaints, whistleblower reports, restatements and internal referrals within the SEC. Maloney noted that the SEC has applied increased scrutiny to complex business structures, foreign operations, excessive employee loyalty and overreliance on internal controls. For smaller and growing companies, factors that increase the likelihood of investigation and enforcement include less-established controls, unreasonable growth targets, increasing complexity that outpaces controls, and too much control by management over accounting functions. On the other hand, factors that decrease the likelihood of enforcement include, unsurprisingly, enhanced internal controls, active and aware boards of directors and committees, and depth of experience in key positions.
Finally, Maloney noted that he anticipated several areas of enforcement emphasis in the upcoming year, which included the following areas:
Revenue recognition (e.g., accelerated revenue recognition, accounting for long-term contracts, and sales rebates and allowances);
Expense recognition (e.g., improper expense deferrals and capitalization);
Valuations (e.g., faulty valuation assumptions by management and auditors, as well as the retention of third-party specialists to make those valuations); and
Disclosures (e.g., insufficient or missing disclosures and the adequate disclosure of related-party transactions).
SEC’s Litigators Will Continue to Throw “Hard Punches” in 2015. Matthew Solomon, Chief Litigation Counsel, noted that the Enforcement Division’s litigation unit tried 30 cases nationwide in fiscal year 2014, the majority in federal court. This represents a high-water mark for trials over the last 10 years, with the unit trying five times more cases in front of a jury in 2014 as it did in 2013. Solomon noted that the SEC has enjoyed an 80 percent win rate during this time and has won 10 of its last 12 jury trials. He added that even in its losses, the litigation unit has received positive feedback that it does not shrink from a fight and said it will continue to throw “hard punches,” make the best possible arguments and meet the challenges ahead in 2015.
Enforcement Division Continues to Expand Its Use of Data Analytics. The Enforcement Division observed that the SEC’s continued use of data analytics has helped it to bring better, faster cases. In his remarks, Glockner noted that over the past year, the SEC has improved its search capabilities and analytical functions, and it has worked to make these data analytic tools available to all of its regional offices. Stephanie Avakian, Deputy Director of Enforcement, echoed these sentiments and noted that the SEC’s efforts to leverage big data and technology have resulted in a number of high-quality cases in the pipeline. Indeed, these tools have resulted in more effective and efficient investigations that have enabled various enforcement units and task forces to identify and bring cases more quickly.
Chyhe Becker, Assistant Director of the Division of Economic and Risk Analysis (DERA), also noted the importance of data analytical tools to the SEC’s litigation efforts. Becker reflected on two recent cases in which DERA was able to use data analytics to support the SEC’s positions. In the first case, DERA’s expert testimony helped obtain a finding that the SEC’s proposed sanctions were not excessive, a finding that ultimately resulted in both a large monetary settlement and an admission by the parties. In the second case, data generated by DERA helped the SEC prove an investment advisor’s illegal cherry-picking scheme, whereby the investment advisor traded on securities and allocated profitable trades to his own accounts and unprofitable trades to clients.
SEC Discusses Recent Appellate Decisions in Newman and Halliburton
The SEC’s General Counsel, Anne Small, moderated a discussion about two major judicial decisions in 2014—the U. S. Court of Appeals for the Second Circuit’s decision in United States v. Newman and the U.S. Supreme Court’s decision in Halliburton v. Erica P. John Fund.
United States v. Newman. In Newman, the Second Circuit vacated the convictions of, and dismissed with prejudice indictments against, two insider- trading defendants allegedly involved in a remote tippee chain leading back to insiders at multiple companies. The Second Circuit held that in order to be subject to derivative liability, a tippee must be aware of the tipper’s breach of fiduciary duty and must also know that the tipper derived a personal benefit from that breach. The U.S. Attorney’s Office for the Southern District of New York has petitioned for an en banc review of the Newman decision. SEC General Counsel Small indicated that the agency believes the decision should be overturned because Newman’s multipart standard is likely to lead to confusion and may impact the SEC’s enforcement programs.
Current Status of Newman. Last month, the SEC filed an amicus brief in support of the DOJ’s petition for en banc review. Members of the defense bar, including the New York Council of Defense Lawyers and the National Association of Criminal Defense Lawyers, have moved to file amicus briefs opposing the petition for rehearing. Mark Cuban, whose recent personal experience with the SEC led him to attend SEC Speaks last year, has similarly moved to file an amicus brief opposing the request for rehearing.
Halliburton v. Erica P. John Fund. In Halliburton Co. v. Erica P. John Fund, the Supreme Court upheld the use of the “fraud on the market theory” used to establish reliance in investor class actions under Section 10(b) and Rule 10b-5. However, the Court went on to state that even if plaintiffs do not need to directly prove that misrepresentations affected the stock price to receive a presumption of reliance, defendants may defeat the presumption at the class certification stage through evidence that the misrepresentation did not affect the stock price. The SEC noted that it does not need to prove reliance in its own enforcement actions under Section 10b and Rule 10b-5, but it maintains an interest in Halliburton and its effects on meritorious investor-initiated litigation.
Office of Compliance and Inspections Exams Continues to Refine Scope
Deputy Director Marc Wyatt indicated that in 2015, OCIE will focus on its risk-based approach to the selection of examinees and areas of examination based both on qualitative and quantitative factors. Qualitatively, OCIE looks at such factors as a registrant’s prior SEC filings, asset management footprint, outlier behavior and examination history. Quantitatively, OCIE considers the registrant’s financial stress, leverage, liquidity, dividend volume and time since the last exam. OCIE’s second objective is to employ more data analytics in examinations. NEAT, which has now been implemented in each regional office, has over 100 standardized queries that can be run against billions of transactions to find signals of wrongdoing, such as churning, wash trades, parking, front running or insider trading.
Emphasis for 2015. Aside from these more process-driven objectives, Wyatt described several subject matters emphasized for 2015, which include the following areas:
NRSROs. The Office of Credit Ratings (OCR) within OCIE will examine 100 percent of all Nationally Recognized Statistical Rating Organizations (NRSROs), as required by Dodd–Frank. These examinations will emphasize a “culture of compliance,” by focusing on requirements for independent directors, conflicts of interest, competency of key personnel and disclosure of credit analysis processes for investors.
Retirement Products. OCIE’s 2015 examinations will focus on products geared towards retirement, including analysis of fees, suitability and sales and marketing of those products.
Cybersecurity. Exams over the past year determined that most registrants were the target of some sort of cybersecurity attack in 2014, which required continuing examination.
Alternative Mutual Funds. Another area of emphasis in 2015 will be alternative mutual funds. As these funds are a new product, OCIE wants to assess whether registrants have sufficient expertise to offer and manage alternative mutual funds. Also, because such products have higher redemption obligations, OCIE will scrutinize the liquidity and leverage of those products to assess whether they are sound.
Investment Management Harbingers Change for Money Market Funds
The Division of Investment Management highlighted two upcoming changes for money market funds. First, the implementation of a floating net asset value (NAV) for institutional prime money market funds, which will allow the daily share prices of funds to fluctuate along with changes in the market-based value of fund assets and provide non-government money market fund boards new tools, such as liquidity fees and redemption gates to address runs.
Currently, the division is still in the planning phase of these reforms, and anticipates the changes will take place in October 2016. The second major change will be to disclosure requirements, which will result in increased transparency by requiring fund managers to disclose on their websites key metrics about the funds. Along with metrics about diversification, funds will be required to display the results of stress tests required by the SEC. Though the division will formally implement the requirements in the near future, many of the larger changes will be stayed until October 2016 to give funds time to adjust. The division acknowledged the resources required for implementation, and noted that it may also issue no-action letters to alleviate the strain.
Rulemaking Initiatives for 2015. Looking forward to 2015, the division will pursue rulemaking initiatives in these five areas:
Data gathering to increase investor understanding of investment products;
Updates to data delivery platforms so information is more easily accessed by investors;
Portfolio composition and how funds manage portfolio risk, with a particular emphasis on funds’ use of derivatives;
Business continuity planning; and
Stress testing, which will be coordinated with the Federal Reserve.
Corporate Finance Focuses on Disclosures and Rulemaking
The Division of Corporate Finance’s 2015 priorities will include further implementation of the Dodd–Frank Act and JOBS Act, as well as ongoing efforts to make disclosures more effective for investors. Members of the division repeatedly emphasized that they view the role of an examiner as collaborative and that issuers should reach out to work with division staff.
Update on Bad Actor Waivers. Elizabeth Murphy, an associate director of the Division of Corporation Finance, said her unit plans to issue a statement on how the division handles requests from market participants for relief from automatic disqualifications under Rule 506 of Regulation D—so-called “bad actor waivers.” Under rules finalized in 2013, individuals and entities targeted by certain enforcement actions, injunctions and felony convictions are automatically barred for five years from activities, such as sponsoring hedge funds or soliciting interests in private securities unless the SEC agrees to a waiver of the ban.
Industry and Officer and Director Bars Potent Remedies. In his statements, Commissioner Luis A. Aguilar described permanent industry and officer and director bars as one of the most potent enforcement remedies available. He noted that such bars protect investors and send a strong message to other potential wrongdoers, and urged the SEC to use these tools more aggressively.
Encouraged Effective Issuer Disclosures. The division encouraged issuers to make their disclosures as effective as possible, and to reduce the repetition in filings as much as possible. Members of the division noted that some people have expressed trepidation about removing information from filings, worried that it would invite a staff comment. The division noted, however, that the staff would look favorably on issuers who had thoughtfully removed unnecessary information.
Additional Guidance For Issuers. The division provided insight into several areas of interest to issuers:
Metrics. Metrics should be clearly defined and issuers should discuss how they have been calculated, any limitations on them, any assumptions made in calculating the metrics and applicable explanations for changes in metrics over time.
Reporting on gross vs. net revenue. The division noted this is particularly challenging in the technology industry, where there are often several vendors involved in a transaction. Factors driving whether to use gross or net figures include whether the issuer is the primary obligor for goods/services being purchased, whether the issuer has the primary and/or inventory risk, and to what extent the issuer has latitude over pricing to the end user.
Changes in commodity prices. The division noted that a drop in commodity prices can have a material impact on many industries and should be addressed by issuers where applicable.
REITs. The division noted a huge increase in the popularity of real estate investment trusts (REITs) over the past few years. Operating companies have spun off real estate holdings and then leased them back, and the division warned that this activity may require a number of separate disclosures.
Fee shifting in corporate bylaws. When corporations include fee-shifting provisions for shareholder derivative suits, they have a chilling effect on bringing litigation. While courts are still looking at this practice, the commission is focused on disclosure requirements. Issuers are advised to disclose fee-shifting provisions, including the level plaintiffs’ recovery must meet to avoid such provisions, and persons covered by the provisions.
Looking Ahead to 2015 and Beyond
The 2015 SEC Speaks focused as much on what the agency expects from those it regulates, as it did on the agency’s priorities for the upcoming year. What unfolded was a myriad of challenges for both sides. To level the playing field for investors, the SEC plans to focus on broker-dealer duties, disclosure requirements and the accessibility of periodic issuer reports. Several SEC representatives stated that corporate and registrant gatekeepers should expect increased scrutiny in the upcoming year. The agency also plans to be aggressive in bringing enforcement actions, from the investigation stage through litigation, and has set a high bar for individuals and entities seeking leniency through cooperation credit, as evidenced by its settlements in the past year.
The SEC appears to be turning a corner in the wake of the overwhelming rulemaking mandates that it has absorbed in the years since the financial crisis. At the same time, the SEC continues to struggle to refine its focus and to demonstrate how it will utilize the expansive new resources at its disposal to prioritize its enforcement activities in 2015 and beyond.
This update summarizes key discussions from the SEC Speaks conference held February 20-21, 2015, in Washington, D.C. The full text of the speeches is available here. Additional information about these issues and discussions of other recent speeches, cases, laws, regulations and rule proposals of interest to public companies is available here.