2014 Year-End Securities Enforcement Update

The close of 2014 saw the SEC’s Division of Enforcement take a victory lap. Following the release of the statistics for the fiscal year ended September 30, Division Director Andrew Ceresney touted a few records—the largest number of enforcement actions brought in a single year (755); the largest total value of monetary sanctions awarded to the agency (over $4 billion); the largest number of cases taken to trial in recent history (30). As Ceresney noted, numbers alone don’t tell the whole story. And it is in the details that one sees just how aggressive the Division has become, and how difficult the terrain is for individuals and entities caught in the crosshairs of an SEC investigation under the current administration.

The SEC has continued to roll out a steady flow of settlement agreements under which defendants are compelled to admit their legal violations. The Division has increased the number of litigated actions pursued in the administrative forum, where defendants enjoy far fewer rights than in civil district court actions. The size of monetary sanctions and the length of industry bars continue to rise. And the Division has been executing the Chair’s “broken windows” policy, filing suit to enforce even minor, rarely-enforced provisions of the federal securities laws, often in broad sweeps targeting dozens of defendants (a phenomenon which may help explain the record number of cases brought last year).

Substantively, the Division has maintained its focus on the investment advisor industry (particularly private fund managers), as well as brokers and financial institutions. Meanwhile, the Division’s renewed scrutiny of financial reporting by public companies—which saw a significant slowdown in activity during the years of the financial crisis—continues its slow but steady return to the forefront, with several accounting fraud cases drawing headlines in recent months.

Before turning to our analysis of significant case developments from the past six months, we will address some of the overriding enforcement trends from the past year.

Significant 2014 Developments

The AP Explosion

Our Mid-Year Securities Enforcement Update addressed the SEC’s growing use of administrative proceedings (APs) as an alternative to civil actions filed in federal court. As noted above, the SEC is litigating an increasing number of cases (arguably stemming in part from its hardline settlement demands), and the streamlined administrative proceeding process, with cases lasting months rather than years, helps the agency conserve limited resources. But the forum can also work to the disadvantage of defendants.

Among other things, there is little or no discovery in these proceedings, meaning defendants are essentially limited to whatever evidence the enforcement staff collected during its investigation. Defendants who lose in front of the administrative law judge (employed by the SEC) face an uphill battle on appeal, with any appeal first heard by the SEC itself (i.e. the very Commissioners who originally voted to authorize the enforcement action), and only later by a federal court of appeals, which tends to be deferential to agency determinations.

Moreover, many believe these proceedings offer the Division of Enforcement a home court advantage. Indeed, a Wall Street Journal study this fall found the Division had a 100% success rate in administrative proceedings over the past twelve months—not exactly encouraging for parties choosing to litigate against the agency. In contrast, as Ceresney noted in his November Speech, the Division has about an 80% success rate in litigated actions overall, suggesting far more trial losses for the agency in federal court.

Notwithstanding pushback on these proceedings by the defense bar and some commentators, including repeat SEC critic Judge Rakoff of the Southern District of New York, the SEC has stood by the continued use of the administrative forum. In his November Speech, Ceresney vigorously defended the fairness and utility of the administrative forum in a lengthy discourse, noting that the agency filed 43% of its litigated cases administratively in 2014 and had no intentions of reversing course. Indeed, in late 2014 the SEC took steps to prepare for the increased administrative caseload, adding two new administrative law judges, bringing the total to five.

Several parties to SEC administrative proceedings have sued the agency in federal court, alleging such proceedings, among other things, violate their Due Process rights; however, these challenges have been largely unsuccessful. In the most recent ruling, a New York federal court dismissed the action, holding that while defense concerns about administrative proceedings may be legitimate, they needed to be resolved in the administrative proceeding itself—and, if unsuccessfully asserted there, on subsequent appeal of the administrative law judge’s decision, rather than in a stand-alone injunctive action against the SEC. Hence, while several similar cases remain pending, it appears that it will be some time—perhaps years—before an appropriate challenge to administrative proceedings becomes ripe for resolution. In the interim, parties to SEC investigations need to anticipate a growing likelihood that an enforcement action will be filed administratively, and prepare in advance for the abbreviated timeframe and limited discovery of such proceedings.

Sweeping Up “Broken Windows”

In late 2013, SEC Chair Mary Jo White proclaimed a “broken windows” strategy of enforcing even minor, frequently overlooked violations, underscoring that it was “important to pursue even the smallest infractions.” The Division of Enforcement made good on this commitment in the latter half of 2014, bringing a number of enforcement “sweeps” in which it simultaneously charged multiple companies and individuals with violations of non-fraud securities law provisions not historically viewed as high-priority by the agency. All told, 5 sweeps in the last few months entangled 80 defendants.

In September, the SEC charged 34 companies and individuals with failing to timely file personal securities transaction reports with the SEC. Of the 34 respondents named in the orders, 33 settled the claims and agreed to pay financial penalties in the aggregate amount of $2.6 million. These securities law provisions—Sections 13(a) and 16(a) of the Exchange Act and related rules—had rarely been the subject of stand-alone enforcement actions in the past decade, typically appearing (if at all) as part of larger, more serious cases. But the SEC set out to highlight its focus on even lesser, unintentional violations, noting that “inadvertence is no defense to filing violations, and we will vigorously police these sorts of violations through streamlined actions.”

One week later, the Commission charged 19 investment advisory firms (and one individual trader) for violations of Rule 105 of Regulation M of the Exchange Act, which prohibits short-selling an equity security shortly before participating in an offering of the same security. Each of the respondents agreed to settle the charges, cumulatively paying more than $9 million in disgorgement and penalties. This was the SEC’s second Rule 105 sweep, following a prior action almost exactly one year earlier which had netted an additional 23 firms.

In November, venturing into the muni bond arena, the SEC sanctioned 13 securities dealers for selling non-investment grade bonds issued by the Commonwealth of Puerto Rico to customers below the minimum denomination of the issue, in violation of Municipal Securities Rulemaking Board (MSRB) rules. The sweep represented the SEC’s first enforcement action under this MSRB provision. The firms paid penalties ranging from under $55,000 to $130,000.

Later that same week, the SEC initiated settled enforcement actions against 10 small public companies for failing to file a Form 8-K disclosing financing arrangements or other unregistered securities sales that had the effect of diluting the company’s stock. The companies agreed to pay penalties ranging from $25,000 to $50,000.

Finally, in December, the SEC initiated settled proceedings against eight small accounting firms for violating auditor independence rules in connection with their audits of brokerage firm clients. According to the SEC, the auditors also participated in the preparation of their respective clients’ financial statements, improperly playing the role of both preparer and auditor. A total of $140,000 in penalties was assessed.

The Division of Enforcement is clearly enthusiastic about these sweeps, and likely to initiate more in 2015. The cases give the SEC an opportunity to send a “message” about aggressive enforcement of the securities laws, even the low-level “broken windows” offenses championed by the Chair, while allowing the Division of Enforcement to announce record-breaking case filings without the same resource expenditures as individual investigations. Moreover, the sweeps put defendants in a difficult position; by focusing on strict-liability or negligence-based violations with limited defenses, and setting penalty thresholds that are significant but still lower than typical litigation costs, most defendants have little choice but to accept a settlement. Notably, at least one Commissioner has expressed some concern about the broken windows strategy, urging the agency to instead focus on higher priority issues.

With no guidance as to where the next SEC sweep may land, participants in securities markets need to be attuned to compliance with even low-level, rarely-enforced securities regulations, complicating efforts to have a more risk-based compliance program prioritizing more serious issues.

Financial Fraud Is Back, Maybe…

Since assuming their leadership positions in 2013, Chair White and Enforcement Director Ceresney have touted the agency’s renewed focus on public company reporting. With resource-intensive financial crisis-related investigations largely wound down, the SEC has demonstrated an eagerness to expand its forays back into financial reporting matters, most notably with the creation of a dedicated Financial Reporting and Audit Task Force. The SEC is now proactively looking for potential financial fraud, rather than waiting for self-reporting by issuers on the cusp of a restatement, and allocating resources to probing even the smallest companies and lesser violations. Of course, it is an open question whether there is a groundswell of fraud waiting to be found by the agency; the jury is still out on whether the dramatic decline in financial fraud cases in recent years reflected the SEC’s failure to find them (perhaps due to a redirection of limited resources into other areas), or a reduction in misconduct by public companies (either because of improved practices in the years after Sarbanes-Oxley, or simply cyclical market forces that reduced the incentives for earnings management during a financial downturn).

It is too soon to judge the impact of the Division’s new efforts. However, the sense among practitioners is that the agency is opening a growing number of financial reporting investigations, and we did see an apparent uptick in accounting fraud cases in recent month, including several revenue recognition matters. (See discussion of cases below.) While the cases to date have been on the small end of the spectrum, and a far cry from the accounting scandals of the Enron/Worldcom era, there are some hints of larger cases on the horizon. For example, in the closing days of 2014, one public company disclosed that it had reached a tentative agreement with the SEC staff, still awaiting Commission approval, under which the company, without admitting wrongdoing, would pay a $190 million penalty. If approved, this would be a significant penalty for a non-FCPA, non-financial institution case.

That said, the always-controversial issue of corporate penalties is likely to re-emerge as a point of contention. During the stock option backdating scandal several years ago, divisions arose among Commissioners as to whether assessing penalties against public companies was a necessary tool to deter fraud, or an unfair cost borne by the company’s shareholders. The SEC adopted guidelines on corporate penalties in 2006 designed to provide greater rigor around the penalties, though some saw the guidelines as making it more difficult for the Enforcement staff to seek penalties at all. The debate quieted down in recent years with the fall-off in public company fraud cases, but will undoubtedly return as more such cases are brought. Chair White is on record as defending such penalties, noting that “we must make aggressive use of our existing penalty authority, recognizing that meaningful monetary penalties—whether against companies or individuals—play a very important role in a strong enforcement program.” In contrast, Commissioner Piwowar, in an October 2014 speech, expressed concerns about corporate penalties, and urged at minimum closer adherence to the 2006 guidelines. His fellow Republican appointee, Commissioner Gallagher, was even blunter, referring to corporate penalties as “shareholder penalties.”

Whistleblowers Cash In

The second half of 2014 featured several significant landmarks for the SEC’s whistleblower program, offering critical reminders to companies of the risks posed by the post-Dodd-Frank bounty system. In September, the agency announced its largest whistleblower award since the program’s 2012 inception–$30 million to be paid to a single individual. This more than doubled 2013’s previous record of $14 million. Because of the requirement that information about whistleblowers be kept confidential, the SEC did not disclose the nature of the case, but did note that the whistleblower lives outside the United States, and that the award could have been even higher but for the whistleblower’s “unreasonable” delay in reporting the violations.

The SEC also reported awards in two cases where the whistleblower had previously reported concerns internally, and reached out to the SEC only when the matter was not addressed by the company. In July, the SEC awarded $400,000 to a whistleblower, noting that “[t]he whistleblower had tried on several occasions and through several mechanisms to have the matter addressed internally at the company.” And in August, the SEC announced a $300,000 award to a whistleblower who “reported concerns of wrongdoing to appropriate personnel within the company,” but “when the company took no action on the information within 120 days, the whistleblower reported the same information to the SEC.” Significantly, the latter case was the first award made to an employee serving an audit or compliance function at a company.

The SEC’s 2014 Annual Report on the whistleblower program, issued in November, highlighted the continuing growth in importance of whistleblowers to the SEC. The number of whistleblower tips rose to 3,620 in fiscal 2014 from 3,238 the prior year. Corporate disclosures and financials continued to be the leading category of complaints (at about 17%), aligning with the Division of Enforcement’s growing focus on public company reporting cases.

Admissions

Finally, the SEC’s policy of selectively seeking admissions of wrongdoing as a condition of settlement, implemented in mid-2013 in the wake of public (and judicial) criticism of the agency’s long-standing policy of settling cases with defendants neither admitting nor denying the SEC’s allegations, remains in full force. As promised by Enforcement Director Ceresney, admissions have been required infrequently, in just over a dozen cases to date, with the vast majority of SEC settlements continuing to be resolved on a neither-admit-nor-deny basis. However, contrary to earlier suggestions, it does not appear that admissions have been limited to the most egregious securities law violations. Indeed, in 2014, several of the world’s largest financial institutions settled SEC actions with admissions of wrongdoing where the SEC did not allege scienter-based violations or even fraud.

It is thus difficult to predict in which cases the Division of Enforcement will demand party admissions. While egregiousness and investor harm may be factors, many of these settlements appear to involve situations where, as Ceresney has explained, “admissions would significantly enhance the deterrence message of the action.” As a practical matter, this appears to be based in part on the size and name-recognition of the settling party. One thing the Division has made clear, though, is that whether an admission will be required as part of the settlement is wholly at the discretion of the SEC and not subject to negotiation.