SEC Year-in-Review and a Look Ahead

2017 brought marked challenges to the SEC’s ability to aggressively enforce the securities laws, including the Supreme Court limiting the SEC’s ability to seek disgorgement and court action endangering the validity of its oft-used administrative proceedings. 2017 also saw a decrease in the SEC’s total enforcement statistics. [1] However, there is reason to believe that 2018 will see an uptick in enforcement actions and perhaps some clarity on the use of administrative proceedings. The SEC enters 2018 with a full complement of Commissioners and most senior Enforcement leadership positions filled, and it now has clearly articulated areas of focus, including protecting retail investors and prosecuting cyber cases. A recent Supreme Court cert grant should also help move to closure questions surrounding the use of administrative proceedings, historically an important enforcement mechanism. Below are a few observations from the past year, as well as key enforcement areas to keep an eye on in 2018.

Looking Back at 2017

The Supreme Court (Again) Unanimously Reined In The Commission’s Remedial Authority.

In June 2017, the Supreme Court unanimously held in Kokesh v. SEC that the five-year statute of limitations in 28 U.S.C. § 2462 for “enforcement of any civil fine, penalty, or forfeiture” applies to claims by the Commission for disgorgement of ill-gotten gains. The SEC’s Enforcement Division has long relied on disgorgement as a powerful tool grounded in the courts’ equity powers, securing more than $5.7 billion in court-ordered disgorgement during 2016 and 2017, compared to only $2.1 billion in penalties. Expanding on its 2013 unanimous holding in Gabelli v. SEC, finding that penalties are subject to the five-year limitations period, the Court determined that disgorgement closely resembles a “penalty” and is therefore also subject to a five-year limitations period. [2]

The Enforcement Division acknowledged the programmatic implications of this decision, in particular, to its ability to carry out longer-term, evidence-intensive inquiries, such as FPCA investigations. As Steven Peikin, Co-Director of Enforcement, observed in November 2017, in the wake of Kokesh, the Commission has “no choice but to respond by redoubling [its] efforts to bring cases as quickly as possible,” and we expect it to seek tolling agreements promptly and move more quickly, where possible, in enforcement matters.

The Department Of Justice Jettisoned A Key Defense To The Constitutionality Of SEC Administrative Proceedings.

In November 2017, the Department of Justice reversed course on its previous defenses of SEC administrative proceedings, submitting a brief to the Supreme Court, following a circuit split, taking the position that the SEC’s Administrative Law Judges (ALJs) exercise “significant authority pursuant to the laws of the United States” and thus are “officers” who must be appointed consistent with the Appointments Clause of the Constitution (i.e., by “the President alone, in the Courts of Law, or in the Heads of Departments”). [3] Until now, DOJ concurred that ALJs were not “officers” but simply “employees,” and agreed with the appropriateness of the merit-selection process and ultimate selection by the SEC’s Chief ALJ, instead of the Presidentially-appointed Commissioners themselves. [4] The Supreme Court granted certiorari on January 12, appointing counsel to argue as amicus curiae the Commission’s position that its ALJs were properly appointed and thus their proceedings are constitutional. [5] The SEC has scaled back on filing litigated administrative proceedings in view of the constitutional uncertainty. The Court can now put to rest this question and, possibly, a related constitutional challenge to SEC administrative proceedings. [6] From the agency’s standpoint, closure would be beneficial, allowing it to manage its litigation docket accordingly.

Insider Trading Law Swung Back In Prosecutors’ Favor.

In December 2016, the Supreme Court held in Salman v. United States that the “personal benefit” requirement of insider trading law may be met by “making a gift of confidential information” to a trading relative or friend. Following on this decision, in August 2017, the Second Circuit, in United States v. Martoma, clarified that insider trading does not require proof of a “meaningfully close personal relationship” between a tipper and the recipient who tips or trades on information. Martoma, issued by a divided panel, walked back much of the Second Circuit’s 2014 decision in United States v. Newman, which required “at least a potential gain of a pecuniary or similarly valuable nature,” a somewhat controversial decision at the time, viewed as a blow to prosecutors’ efforts to bring cases, particularly against down-stream tippees. While Martoma still requires, for a “personal benefit” finding, that the tipper discloses information with the expectation the tippee will trade on it, the decision likely clears the way for criminal convictions and findings of civil liability under the “gift” theory of insider trading. [7] The Martoma decision, delivered by a circuit court that is traditionally at the forefront of insider trading developments, will likely encourage SEC investigative staff to redouble their focus on insider trading, a traditional area of enforcement efforts. [8]

“Broken Windows” Enforcement Went On Life-Support.

In October 2017, Peikin signaled that the Commission would pull back from prior leadership’s focus on “broken windows” enforcement, stating, “[i]t may be the case that we have to be selective and bring a few cases to send a message rather than sweep the entire field.” It seems likely, particularly in the face of government-wide budget constraints, that the “broken windows” approach will be dialed back somewhat. In 2017, there were no major industry “sweeps” intended to deliver a message of deterrence to the securities industry in general, but where there may have been no (or no easily quantifiable) investor harm. 2017 did see the agency continue to bring non-scienter cases in the context of potential or actual harm to retail investors, but there has clearly been a shift away from a focus on the number of enforcement actions—a harbinger that broken windows will no longer be a guiding enforcement principle. Along these lines, in their message in the Enforcement Division’s 2017 Annual Report, Peikin and Co-Director Stephanie Avakian emphasized the importance of judging Enforcement’s effectiveness qualitatively, noting that mere statistics “provide a limited picture of the quality, nature, and effectiveness” of the Commission’s work.

Looking Ahead to 2018

Despite legal challenges to its remedial powers and its use of administrative proceedings, the Enforcement Division has passed the transition period and now has a near-full complement of senior leaders in key positions within Enforcement, and a new unit formed to address the quickly evolving world of cryptocurrencies and cybercrime. These areas and others present a number of questions to be resolved in the coming months.

How Will The SEC Deal With Limitations On Its Equitable Powers?

In the wake of Kokesh, the Commission has less leverage in settlement negotiations where unlawful gains older than five years make up part of the conduct, so it will be compelled to press forward through investigations more quickly. Moreover, it faces the risk that courts will expand Kokesh’s holding to other traditionally equitable forms of relief, such as industry bars, a potentially serious curtailment of the agency’s enforcement powers. Importantly, the Court in Kokesh expressly declined to address “whether courts possess authority to order disgorgement in SEC proceedings or … whether courts have properly applied disgorgement principles in this context.” As a result, the Commission will face challenges to its disgorgement authority in nearly every litigated case where that remedy—or other remedies traditionally understood as “equitable”—are sought. Indeed, one court has recently held that non-monetary components of SEC actions (including an “obey-the-law” injunction and a penny stock bar) constitute penalties. [9] With greater ammunition to argue that remedies like injunctive relief and bars are punitive, and thus subject to the same five-year limitations period, the Commission’s post-Kokesh hurdles will not end in the near future.

Has The Commission Made Its Point With Private Equity Cases?

In recent months, the Commission may have signaled a transition to a less aggressive stance toward private equity than in recent years. Since 2012, following Dodd-Frank’s requirement that private equity fund advisers register with the Commission and the Enforcement Division’s creation of specialized units in this arena, the SEC has brought aggressive cases targeting undisclosed fees and expenses, misallocation of expenses, and inadequate disclosures of conflicts of interest, including high-profile matters against The Blackstone Group and KKR in 2015 and WL Ross & Co. LLC in 2016. As of July 2017, though, Peter Driscoll, now Director of the Office of Compliance Inspections and Examinations, stated of the private equity industry, “I think we’ve hit that area pretty hard,” and reiterated that the Commission will generally “focus more on retail investors.” Moreover, given the long-term nature of the investments at issue and that the private equity industry has now had years to update disclosures, it is possible that, even if it wanted to, the SEC’s ability to bring similar cases against the industry has been curtailed by Kokesh.

Will We See Meaningful Cyber Cases Out Of The New Cyber Unit?

In late September, after Chairman Jay Clayton announced that the Commission itself had been the subject of hacking, the Enforcement Division announced the creation of a Cyber Unit focused on “targeting cyber-related misconduct.” It remains to be seen whether the unit will break new ground beyond the cyber-related market manipulation cases that were already a focus of the Division of Enforcement’s Market Abuse Unit, from which the new unit was largely spun out. [10] However, there appears to be an appetite within the Enforcement Division and the Commission more generally to make cyber-related securities issues, and cryptocurrencies in particular, a continued area of focus. Even before the formation of the Cyber Unit, the Commission had signaled a focus on cryptocurrency, issuing a 21(a) Report in July 2017 asserting that cryptocurrencies issued via “distributed ledger” (or “blockchain”) may constitute investment contracts and thus be securities under federal law. Since then, the Cyber Unit has continued to demonstrate a substantial concern around cryptocurrencies and initial coin offerings (ICOs), bringing an emergency action in early December to stop Canadian company PlexCorps’s ICO, alleging a misappropriation of investor funds and an illegal offering of securities. As recently as January 22 of this year, Clayton stated that he had “instructed the SEC staff to be on high alert for approaches to ICOs that may be contrary to the spirit of our securities laws and the professional obligations of the U.S. securities bar,” including (i) ICOs where counsel assists in structuring offerings with “the key features of a securities offering” while simultaneously claiming those products are not subject to the securities laws, and (ii) ICOs where counsel fails to thoroughly consider and advise their clients as to whether the securities laws apply, leaving clients to proceed outside the securities laws at their own risk. And, in an article by Clayton and CFTC Chairman Chris Giancarlo on January 25, Clayton expressed that the Commission “is devoting a significant portion of its resources to the ICO market,” in addition to “monitoring the cryptocurrency-related activities of the market participants it regulates, including broker-dealers, investment advisers and trading platforms.” The SEC has also formed a Distributed Ledger Technology Working Group, suggesting it intends only to increase its activity in the cryptocurrency space.

While the Cyber Unit’s activity in cybersecurity disclosure obligations—such as the reported investigation into Yahoo’s delayed notification to investors of data breaches—and other web-related misconduct still remains to be seen, expect to see more enforcement actions in this area.

How Will FinTech Be Regulated, And How Heavily?

A somewhat related issue is what the Commission’s enforcement approach toward FinTech is likely to be. Back in November 2016, the SEC held a forum discussing FinTech regulation, focusing in particular on robo-advisers, blockchain technology (discussed above), and online marketplace lending and crowdfunding.

In the realm of robo-advisers (automated investment advice technology), the Commission’s Division of Investment Management issued guidance in February 2017—in light of robo-advisers’ limited interaction with clients but expected key role in the future of the investment industry—focusing on (i) the substance of disclosures to clients regarding the adviser and its services, (ii) the obligation to obtain information from clients sufficient to provide suitable investment advice, and (iii) the necessity of effective compliance programs catered to automated advice, including the safeguarding of client data.

In relation to online marketplace lending, the Commission indicated its keen focus on investor protection, including the necessity of “full and fair disclosure of material information” to permit informed investment decisions. Relatedly, in February 2017, the SEC and the North American Securities Administrators Association (NASAA) signed an information-sharing agreement in an effort to build cooperation between the SEC and state regulators and better monitor against fraud in relation to the SEC’s rules allowing companies to offer and sell securities through crowdfunding.

Conclusion

2017 was a challenging year for Enforcement, with a reduced (but still respectable) number of enforcement actions and court decisions impinging on its authority. In 2018, expect the Enforcement Division to find a new footing of sorts, with a different mix of priorities and a keen focus on cases with quantifiable investor harm.

Endnotes

1For a fuller discussion of the SEC’s Fiscal Year 2017 Enforcement Division results, please see Cleary Gottlieb’s Nov. 20, 2017 Alert Memo, SEC Releases Enforcement Division FY 2017 Annual Report: Shift in Tone and Likely Approach.(go back)

2For a fuller discussion of Kokesh and its implications, please see Cleary Gottlieb’s Jan. 11, 2018 post, Kokesh v. SEC: Half a Year On.(go back)

3Raymond J. Lucia and Raymond J. Lucia Companies Inc. v. Securities and Exchange Commission (No. 17-130), available at https://www.justice.gov/sites/default/files/briefs/2017/11/29/17-130_lucia_resp_br.pdf(go back)

4The SEC promptly “ratified” the prior appointments of all of its ALJs, but may still face challenges to the validity of previously adjudicated matters. See https://www.sec.gov/news/press-release/2017-215(go back)

5For a fuller discussion of the Supreme Court’s grant of cert, please see Cleary Gottlieb’s Jan. 16, 2018 post, Supreme Court Grants Certiorari on the Constitutionality of SEC ALJ Appointments—What This Means for the Securities Industry.(go back)

6The Solicitor General also raised a constitutional question of whether limitations on the removal of SEC ALJs violate the separation of powers under Free Enterprise Fund v. Public Co. Accounting Oversight Bd., 561 U.S. 477 (2010), which prevents Congress from restricting the president’s power to remove officers. For additional discussion, see Cleary Gottlieb’s post, Supreme Court Grants Certiorari on the Constitutionality of SEC ALJ Appointments—What This Means for the Securities Industry.(go back)

7Mathew Martoma’s petition for rehearing or rehearing en banc remains pending in the Second Circuit.(go back)

8For a fuller discussion of Martoma, please see Cleary Gottlieb’s Aug. 24, 2017 post, Second Circuit Clarifies “Meaningfully Close Relationship” No Longer Required To Prove Insider Trading Under Gift Theory.(go back)

9SEC v. Gentile, No. 16 Civ. 1619 (JLL), 2017 WL 6371301, at *4 (D.N.J. Dec. 13, 2017).(go back)

10The new Cyber Unit, in large measure, appears to be staffed by Market Abuse Unit members, including a former Co-Chief of that unit.(go back)