When it comes to settlements with the SEC’s Division of Enforcement (“Enforcement Division”), a question respondents often ask is how the SEC arrives at a given penalty amount? This blog post will discuss the SEC’s current approach to determining penalty amounts, as recently articulated by Gurbir Grewal, the Director of the SEC’s Enforcement Division, and also considers how the SEC’s recent settlement with Global Infrastructure Management, LLC (“Global”) may be indicative of the SEC’s new approach to penalties.
Background of SEC Penalties
Congress first granted the SEC authority to impose penalties when it enacted the Remedies Act of 1990. Congress also prescribed penalty amounts by statutes, which are periodically updated to account for inflation. Under the relevant statutes, penalties are assessed based on whether the conduct was committed by an individual or entity; whether it involved fraud; and whether it caused substantial losses, created risk of losses, or resulted in any gains to the alleged wrongdoer. In practice, however, the statutory tables merely serve as a starting point for assessing the amount of penalties, and more often than not, the penalties disclosed in public settlements with the SEC bear little resemblance to the statutory amounts. The ultimate penalties revealed in settlements are the product of negotiations between the SEC and respondents, but the SEC has significant leverage in such negotiations.
SEC Enforcement Director Gurbir Grewal’s Approach to Penalties
In remarks provided to the PLI Broker/Dealer Regulation and Enforcement 2021 conference in October 2021, Grewal tacitly acknowledged the amount of discretion that the SEC has in imposing penalties, remarking that “[p]enalites are among the most important of our tools, in part because of our ability to tailor them to the violation.” Grewal noted that the SEC considers the following factors when determining penalty amounts:
- “the conduct at issue in light of elements including statutory tiers”;
- “Commission guidance and judicial opinions”;
- “resolutions in Commission actions involving comparable facts, violations, and parties”; and,
- “what penalty will appropriately deter future misconduct?”
With respect to this last factor—deterrence—Grewal explained that the agency “must design penalties that actually deter and reduce violations, and are not seen as an acceptable cost of doing business.” Deterrence is not merely a tool to punish a wrongdoer; rather, it seeks to “disincentivize market participants from engaging in [the wrongful conduct].” Recent settlements suggest that the current SEC may be placing more emphasis on the “deterrence” factor than prior administrations.
Analysis of the SEC’s $4.5 Million Penalty on Global
On December 20, 2021, the SEC disclosed a public settlement in which Global, an SEC-registered Investment Adviser, was ordered to pay a penalty of $4.5 million for overcharging its private fund clients. Specifically, the SEC alleged that Global failed to offset certain portfolio company fees it earned against its fund-level management fees. As an example, the settlement alleges that from December 2009 through March 2019, a portfolio company investment held by a Global-advised private fund paid $12.4 million in advisory fees for services provided to the portfolio company by Global employees and a consultant. Under the terms of the applicable limited partnership agreements and private placement memorandums, however, Global was required to credit 80% of those fees against the management fees owed by the limited partners, but failed to do so. Global voluntarily repaid $4.2 million plus interest to the limited partners. The settlement credited Global’s remediation efforts, enhanced fund disclosures, and improved procedures and controls around the calculation of fee offsets. The settlement found violations of Section 206(2) and 206(4) of the Advisers Act of 1940 (“Advisers Act”), and Rules 206(4)-7 and 206(4)-8 thereunder, but did not include a violation of Section 206(1), which would have required a showing of scienter.
A $4.5 million penalty is significant for any respondent in an SEC settlement, let alone an investment adviser who is not accused of fraud, and is not alleged to have violated Section 206(1) of the Advisers Act, or Section 10(b) of the Securities and Exchange Act of 1934 (“Exchange Act”) and Rule 10b-5 thereunder, or Section 17(a)(1) of the Securities Act of 1933, which are among the most serious statutory violations that can be alleged by the SEC. And it is extremely large when considered in the context of other recent SEC settlements with investment advisers who were accused of similar misconduct. For example, on April 22, 2020, the SEC settled with Monomoy Capital Management, L.P. (“Monomoy”), which allegedly failed to disclose to the limited partners of one of its privately managed funds that it had charged portfolio companies of the fund consulting fees for work performed by Monomoy employees. Monomoy was charged with violating Section 206(2) of the Advisers Act, and ordered to pay disgorgement of $1.5 million, plus prejudgment interest, and a penalty of $200,000—a fraction of the $4.5 million penalty imposed on Global. Similarly, on August 7, 2020, the SEC settled with Rialto Capital Management, LLC (“Rialto”), which allegedly overcharged two funds by $3 million for certain due diligence, accounting and valuation tasks performed by Rialto employees that should have been charged to co-investment vehicles. Rialto was accused of violating Sections 206(2) and 206(4) of the Advisers Act, and Rules 206(4)-7 and 206(4)-8 thereunder, and was ordered to pay a penalty of $350,000—again, just a fraction of the penalty imposed on Global.
So what accounts for the significant penalty imposed on Global, on the one hand, and the significantly lower penalties imposed on Monomoy and Rialto on the other hand? The simplest explanation is timing: the Monomoy and Rialto settlements were issued in 2020, under the leadership of Chairman Jay Clayton and SEC Enforcement Directors Stefanie Avakian and Steven Peikin, whereas the Global settlement was issued last month, under the current SEC leadership, which has made no secret of its efforts to implement a tougher SEC enforcement program. But it is also useful to keep in mind the four factors articulated by Director Grewal in determining penalty amounts (described above). If one were to merely assess the first three factors—“the conduct at issue in light of elements including statutory tiers”; “Commission guidance and judicial opinions”; “resolutions in Commission actions involving comparable facts, violations, and parties”—one would expect that the penalty imposed on Global would have been more in line with the Monomoy and Rialto penalties, perhaps in the higher six-figure range. That leaves us to consider the fourth factor: deterrence.
The SEC has been especially vocal over the past few years about investment adviser deficiencies in the area of expense allocations and fee offsets. On June 23, 2020, the SEC’s Division of Examinations issued a Risk Alert that highlighted certain common deficiencies and compliance issues that arose during examinations. “Monitoring/board/deal fees and fee offsets” were among the list of common compliance issues identified by the Division of Examinations. Furthermore, the Division of Examinations annually publishes a list of examination priorities, which routinely identifies RIAs to private funds as a focus of the examination program. In this context, it is reasonable to assume that the current SEC leadership will seek to extract stiffer penalties for violations that routinely arise, and of which the public has repeatedly been put on notice. In other words: the SEC felt that it needed to impose a significant penalty in this case to deter such violations in the future. A $4.5 million penalty is an eye-popping number, especially for conduct that may have previously only garnered a six-figure penalty.
We can expect that, beginning in 2022, we will continue to see larger penalties imposed by the SEC for conduct that, in the past, may have only resulted in nominal penalties. Only time will tell whether larger penalties will have the deterrent effect envisioned by Director Grewal.