In order to provide an overview for busy in-house counsel and compliance professionals, we summarize below some of the most important and interesting SEC enforcement developments from the past month, with links to primary resources. This month’s topics include:

• The SEC’s crackdown on unlawful touting by a celebrity of a crypto asset security
• The SEC’s Acting Chief Accountant’s statement on the duties of auditors in detecting and preventing fraud
• Responses to the SEC’s rejection of a bitcoin ETF application
• An accounting fraud case against a consumer goods company that includes charges against a former audit partner
• A federal judge’s critique of the SEC’s “No-Deny” settlement orders

1. SEC Charges Kim Kardashian for Unlawfully Touting Crypto Security

On October 3, 2022, the SEC announced settled charges against Kim Kardashian totaling $1.26 million in penalties, disgorgement, and interest for unlawfully touting EMAX tokens, a crypto security asset offered and sold by Ethereum Max, on social media.

The SEC’s order found that on June 13, 2021, Kardashian asked her 330 million followers, “Are you guys into crypto????” in an Instagram story touting EMAX tokens and linking viewers to a site with instructions to purchase the tokens. While the post included the hashtag #AD, commonly used by celebrities and influencers to indicate when a social media post is sponsored, the SEC’s order found that Kardashian failed to disclose that she was paid $250,000 to promote the post in violation of federal securities laws.

Section 17(b) of the Securities Act of 1933 requires those who are paid to promote securities to “disclos[e] the receipt…of such consideration and the amount thereof.” In fact, five years ago, the Commission’s Division of Enforcement and Office of Compliance Inspections and Examinations issued a statement focused on celebrity-backed initial coin offerings reminding market participants of these obligations, explaining that “[a]ny celebrity or other individual who promotes a virtual token or coin that is a security must disclose the nature, scope, and amount of compensation received in exchange for the promotion. A failure to disclose this information is a violation of the anti-touting provisions of the federal securities laws.”

The $1.26 million Kardashian was ordered to pay includes disgorgement of $250,000, prejudgment interest, plus an additional $1 million civil money penalty. The order did not assess a penalty against Ethereum Max for sponsoring the endorsement.

#DutyToDisclose #CelebrityTouting

2. SEC Acting Chief Accountant Issues Statement on Auditor’s Responsibility for Fraud Detection

On October 11, 2022, the SEC’s Acting Chief Accountant Paul Munter issued a statement highlighting how auditors’ responsibilities for fraud detection are incorporated in Public Company Accounting Oversight Board (PCAOB) standards and reminding auditors of good practices.

Particularly of note, Munter flags three common auditor shortcomings:

• Insufficient application of due professional care and skepticism by auditors when considering fraud, including:
  • Failing to assess and/or identify revenue recognition as a potential fraud risk; and
  • Not communicating fraud risks to audit committees.

• Improper conduct by auditors with respect to fraud risks, including ignoring red flags and contradictory information and failing to obtain sufficient and appropriate audit evidence.

• Troubling feedback from stakeholders that auditors frame the discussion of their responsibilities related to fraud by describing what is beyond the auditor’s responsibilities and what auditors are not required to do with respect to fraud, rather than focusing on affirmative requirements to obtain reasonable assurances about whether the financial statements are free from material misstatement. Munter described this “attitude of focusing on the limits of the auditor’s responsibility at the outset” as “deeply concerning.”

Munter’s statement also explained that a mindset of “trust but verify” “anchored in the belief that management is honest and has integrity” may interfere with an auditor’s ability to effectively evaluate signs of fraud when evaluating misstatements or to objectively challenge evidence presented by management. Munter contrasted that “trust but verify” approach with the exercise of “professional skepticism”—the long-held standard of care for auditors.

In summary, Munter’s statement emphasizes auditors’ roles as gatekeepers and serves as a strong reminder that the Office of Chief Accountant is expecting auditors to exercise professional skepticism and to apply an appropriate fraud lens throughout the audit.

#AuditorsAreGatekeepers #AuditorUseOfFraudLens

3. Grayscale Files Brief Challenging Rejection of ETF Conversion

On October 11, 2022, Grayscale Investments, LLC, a digital currency investing services company filed its opening brief in the U.S. Court of Appeals for the D.C. Circuit supporting its petition for review after the SEC rejected the application by NYSE Arca, Inc. to list shares of Grayscale’s flagship Bitcoin Trust, a proposed spot bitcoin exchange traded product (ETP). Grayscale’s petition argues that the SEC’s rejection was arbitrary, capricious, an abuse of discretion, and in violation of the Administrative Procedure Act given the SEC’s recent decisions to approve proposals for ETPs that hold bitcoin futures. Grayscale’s brief argues that the price of bitcoin futures is subject to the same risk of fraud and manipulation as the spot price of bitcoin and that its rejection of Grayscale’s spot bitcoin ETP creates “unfair discrimination between . . . issuers[.]”

On October 18, 2022, five amicus briefs were filed in support of Grayscale’s petition.

One brief was filed by a group of former regulators, law and finance professors, and scholars; another by the U.S. Chamber of Commerce; one by the Blockchain Association, the Chamber of Digital Commerce, the Chamber of Progress, and Coin Center; one from NYSE Arca, Inc.; and one by Coinbase, Inc. (the latter drafted by Morrison Foerster).

The amicus briefs point out, among other contributions:

• The SEC’s failure to consider that bitcoin markets are inherently resistant to price manipulation and fraud;

• The SEC’s disparate and discriminatory treatment of spot Bitcoin ETPs compared to Bitcoin futures ETPs and ETPs that hold non-digital assets; and

• Harm caused to investors and the market generally by failing to approve Grayscale’s application.

The SEC must submit its brief by December 9, 2022, and final briefs are expected to be submitted by February 2023.

#BitcoinETF

4. SEC Charges Mattel with Financial Misstatements and Former Audit Partner with Improper Professional Conduct

On October 21, 2022, the SEC announced a $3.5 million settlement with Mattel Inc. for charges relating to misstatements in its third and fourth quarter 2017 financial statements. In a related action, the SEC also initiated litigation against a former audit partner to determine whether he engaged in improper professional conduct and violated auditor independence rules.

The SEC alleged that Mattel understated its tax-related valuation allowance for the third quarter of 2017 by $109 million and overstated the tax expense for the fourth quarter of 2017 by the same amount. On October 29, 2019, Mattel announced that it would restate its financial results for Q3 and Q4 2017. The SEC also found that Mattel had no internal control specifically related to calculating a valuation allowance, and for two years, until the restatement, the $109 million tax expense error remained uncorrected, and the lack of internal control related to the error remained undisclosed.

On the heels of the Acting Chief Accountant’s statement issued just ten days prior regarding the professional duties of auditors (see No. 2 above), the order instituting proceedings against the former audit partner alleges that he violated numerous professional standards in the third quarter 2017 interim review and the 2017 annual audit of Mattel’s financial statements, failing to verify that the uncorrected $109 million error was documented, despite knowing of it, and failing to communicate the error to Mattel’s audit committee. Additionally, the order alleges that the former audit partner failed to maintain independence from his audit client by engaging in prohibited human resource services for Mattel, including ranking candidates for management positions.

The settlement with Mattel includes findings that the company violated the negligence-based antifraud provisions of the Securities Act and the reporting, books and records, and internal controls provisions of the Exchange Act. Without admitting or denying these findings, Mattel agreed to a cease-and-desist order and to pay a $3.5 million civil penalty. The order also notes that, in settling, the SEC took into account Mattel’s cooperation with the SEC’s investigation and its remediation efforts, including Mattel’s prompt response to the whistleblower complaint, immediate termination of its senior notes offering, prompt instigation of an internal investigation, and restatement of its financials just three months after being made aware of the whistleblower complaint. The order further mentions Mattel’s implementation of new policies regarding, among other things, evaluating the materiality of errors and its internal controls, as well as its timely announcement of the departure of its CFO.

#SECMattelSettlement

5. Federal Judge Criticizes SEC’s Use of “No-Deny” Deals

On October 25, 2022, U.S. District Judge Ronnie Abrams from the Southern District of New York issued an order criticizing the SEC’s use of “no-admit, no-deny” settlements. Judge Abrams ultimately approved a settlement agreement at the request of the parties but did so “with reluctance in light of the SEC’s continued and misguided practice of restraining speech.”

A “no-admit, no-deny” settlement refers to an order that does not require defendants to admit wrongdoing, but also bars them from ever publicly denying the allegations. The SEC officially began requiring the inclusion of these provisions in judgments and orders used to settle enforcement actions in 1972.

The underlying case here, SEC v. Moraes, involved insider trading. The parties reached a settlement but, before approving it, Judge Abrams asked the SEC to explain “the purpose and necessity” of the no-deny provision and “why it is not a prior restraint on speech.”

The SEC argued in its response that the provision was necessary to allow the Commission to reopen its case and to “avoid misleading impressions that could result if defendant could settle one day without admissions and publicly deny the allegations the next.” Unpersuaded by the SEC’s position, Judge Abrams critiqued the Commission’s practice of including such provisions in its orders:

“Perhaps most concerning, the federal judiciary is made complicit in this practice—normalizing lifetime gag orders in the process. Courts are called upon to turn a blind eye to First Amendment rights being used as a bargaining chip; to endorse consent decrees, giving no-admit, no-deny provisions the imprimatur of judicial sanction, and to enforce them should defendants ever step out of line. This is troubling indeed.”

Bound by Second Circuit precedent, Judge Abrams ultimately approved the settlement at the request of the parties. “No-deny” deals have been under fire in the Second Circuit for over a decade, with Judge Rakoff famously rejecting a “no-deny” settlement in SEC v. Citigroup Global Markets, Inc. in 2011, which was overturned by the Second Circuit in 2014, finding the rejection an “abuse of discretion.” In June of 2022, the Supreme Court denied certiorari in SEC v. Romeril, a 2021 case in which the Second Circuit rejected a similar argument that a no-deny provision in a consent decree violated the First Amendment.

Until the SEC changes its approach or a more senior court reverses course, litigants should expect to be held to their agreements, even if those limit speech in ways that might in other contexts raise constitutional questions.

#NoDenyDealsUnderScrutiny

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