Top 5 SEC Enforcement Developments

We summarize below some of the most important SEC enforcement developments from the past month. This post covers:

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

• Charges against the founder and three promoters of a cryptocurrency trading service operating as a Ponzi scheme;
• A ruling that a blockchain’s digital token qualifies as a security;
• An action against a registered investment advising firm for failing to follow its own ESG policies and procedures;
• The SEC’s remarks at the Securities Enforcement Forum, with a focus on the Commission’s enforcement trends for the 2022 fiscal year; and
• An overview of the SEC’s Strategic Plan for the 2022–2026 fiscal years.

1. SEC Charges Creator and Promoters of Alleged Crypto Ponzi Scheme

On November 3, 2022, the SEC accused the creator of a crypto trading service and three of its promoters of running a Ponzi scheme. In one of two simultaneously filed complaints, the SEC alleged that the founder of Trade Coin Club, Douver Torres Braga, and two of Trade Coin Club’s promoters, Joff Paradise and Keleionalani Taylor, executed a scheme to recruit new investors to join Trade Coin Club, and charged Braga and his promoters with violating Sections 10(b) and 15(a) of the Exchange Act, Sections 5(a), 5(c), and 17(a)(1), (2), and (3) of the Securities Act.

According to the SEC, from December 2016 to May 2018, Trade Coin Club collected more than 82,000 bitcoin, worth roughly $295 million. Braga and his promoters allegedly told potential investors that Trade Coin Club utilized a bot which performed millions of microtransactions every second, assuring daily profits for its investors. The SEC alleged, however, that blockchain analysis indicated that, during this time, 99.9% of investors’ bitcoin withdrawals were funded by the deposits of other investors. Prior to the collapse of Trade Coin Club, many investors were unable to withdraw their crypto assets, losing their principal. Further, the SEC alleged, the company sold membership packages as investment contracts, which the SEC alleged qualified as securities, without obtaining proper registration to do so. The SEC alleges that Braga received approximately $55 million of bitcoin, promoter Paradise received approximately $1.4 million in bitcoin, and promoter Taylor received approximately $2.6 million from Trade Coin Club Investors.

One of the promoters, Jonathan Tetreault, was named as a defendant in his own SEC complaint for allegedly soliciting investors and selling Trade Coin Club securities without satisfying the SEC’s registration requirements in violation of Sections 5(a) and 5(c) of the Securities Act, and Section 15(a) of the Exchange Act. On November 21, 2022, Tetreault agreed to pay nearly $781,000 to settle this complaint, which represents the money he made through his involvement with Trade Coin Club. In addition to Tetreault’s monetary penalty, the SEC has also barred Tetreault from promoting any crypto asset security for five years, unless the purchases and sales are from his own account.

#ponzischeme #cryptofraud #promoterliability

2. SEC Lands Crypto Win as LBRY Token Deemed a Security

On November 7, 2022, the District of New Hampshire ruled that digital tokens sold by LBRY, a blockchain-based file-sharing and payment network, qualify as securities. As discussed in greater detail in MoFo’s November 2022 client alert, the court thus granted summary judgment to the SEC on their claim that LBRY’s unregistered offerings of their digital tokens, or LBC, violate Sections 5(a) and (c) of the Securities Act.

The parties’ dispute turned primarily on whether LBC were investment contracts as defined by the so-called “Howey Test,” a standard set forth in the Supreme Court’s decision in SEC v. W.J. Howey Co., 328 U.S. 293 (1946). Under Howey, an investment contract constitutes a security “whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter of a third party.”

Judge Paul Barbadoro rejected LBRY’s argument that LBC do not meet this definition, holding that “no reasonable trier of fact could reject the SEC’s contention that LBRY offered LBC as a security, and LBRY does not have a triable defense that it lacked fair notice” its tokens were subject to federal securities laws. In reaching this determination, Judge Barbadoro looked to blog posts, a Reddit thread, and other public statements by LBRY representatives that he found demonstrated that the company tied the financial success of LBRY to the profitability of LBC. On the Reddit thread, for example, LBRY responded to a poster’s question asking how LBRY makes money, commenting that “LBRY Inc. has reserved 10% of all LBRY Credits to fund continued development and provide profit for the founders.” Judge Barbadoro held statements such as these indicative of “the objective economic realities of LBRY’s offerings of LBC . . . as a security.”

The LBRY decision follows victories by the SEC in other high-profile cases testing when crypto assets constitute securities, including in SEC v. Telegram Group Inc. and SEC v. Kik Interactive Inc. This question is also at the center of the pending SEC v. Ripple Labs, Inc. case currently before Judge Torres in the Southern District of New York.

#tokenasecurity? #HoweyTest #cryptouncertainty

3. SEC Charges Goldman Sachs Asset Management for Failing to Follow Its Policies and Procedures Involving ESG Investments

On November 22, 2022, the SEC charged Goldman Sachs Asset Management, L.P. (GSAM) for allegedly failing to follow its policies and procedures relating to two Environmental, Social, and Governance (ESG) mutual funds and one ESG investment account strategy. Based on GSAM’s alleged failure to follow its policies and procedures, the SEC charged GSAM with violations of Sections 203(e) and 203(k) of the Investment Advisers Act of 1940. Without admitting or denying the SEC’s findings, GSAM agreed to pay a penalty of $4 million to settle these charges.

The SEC alleged that GSAM’s failure to follow its policies and procedures began in April 2017 and continued until February 2020. Initially, the SEC stated, GSAM failed to have any written policies and procedures for ESG research, and once policies were established, GSAM did not follow them consistently. For example, GSAM allegedly required its employees to complete a questionnaire for every company they planned to include in each investment portfolio, prior to the selection of these companies, but GSAM employees allegedly completed many of these questionnaires after securities were already selected for inclusion in the portfolio. According to the SEC, GSAM failed to adequately convey the necessity of completing these questionnaires to its employees, who allegedly believed that completing the questionnaires was optional. The SEC further alleged that GSAM shared its procedures with third parties, including members of the funds’ board of trustees, but failed to consistently follow those procedures.

The SEC addressed similar conduct in May of 2022 by another investment adviser, charging that entity with making misstatements and omissions to investors surrounding its ESG policies and procedures. That adviser was ordered to pay a $1.5 million penalty. While the allegations in that matter could be read as describing more deceptive conduct than alleged here, the SEC noted the cooperation and remedial efforts by the adviser in the May 2022 case, which may have factored into its lower penalty, as discussed in our May 2022 Top 5 client alert.

#policiesandprocedures #consistentpractices #ESGtrends

4. Enforcement Director Grewal Reviews Highlights of 2022 Enforcement Program

On November 15, 2022 Gurbir Grewal, the Director of the Division of Enforcement, provided remarks at the Securities Enforcement Forum focused on the Enforcement Division’s effort to restore the public’s trust in the securities markets through high-profile matters involving the kinds of record penalties he suggested would deter misconduct and protect investors. The cases, Grewal noted, were pursued across a wide spectrum of market participants and potential harm and were intended to make clear the price of violating the federal securities laws exceeds the price of compliance.

Director Grewal emphasized the SEC’s commitment to seeking the appropriate penalties to deter misconduct, and explained that in Fiscal Year 2022, “the Commission issued[] orders imposing nearly $4.2 billion in penalties. This is the highest amount of penalties ever ordered in a year. And it is more than the prior three years combined.” The SEC highlighted these same high penalties and the breadth of its enforcement cases in its November 15, 2022 press release summarizing the Commission’s FY2022 enforcement results. The total monetary relief ordered in SEC actions—comprising civil penalties, disgorgement, and pre-judgment interest—set a record, totaling $6.439 billion, $4 billion more than last year.

The November 15 press release also focused on what the SEC described as the benefits obtained by companies and individuals who meaningfully cooperated with the SEC during investigations. The SEC has long maintained that if companies or individuals provide meaningful cooperation during an investigation, this cooperation will be taken into account when determining remedies. Both the SEC’s press release and Director Grewal’s remarks at the Enforcement Forum highlighted three instances of the SEC providing benefits to companies that cooperated, including decisions to substantially limit the penalty amount sought, or even to not seek a penalty at all. Although these examples indicate the value the SEC places on meaningful cooperation, there is not clear evidence of precisely how cooperation will be factored into penalty decisions. Absent such evidence, companies considering whether and how to cooperate with the SEC will continue to face difficult decisions, especially in light of the Commission’s increased willingness to seek significant penalties.

Finally, the November 15 press release discussed the importance of whistleblowers in these investigations, and the SEC’s commitment to reward and protect whistleblowers. The SEC’s Office of the Whistleblower issued approximately $229 million in 103 awards, the second-highest year in number of awards and dollar amounts. This came in a year where the Whistleblower Program received a record number of whistleblower tips alleging wrongdoing, more than 12,300 tips in FY2022.

#SECtrends #SECrecordyear #CommitmentToEnforcement

5. SEC Publishes FY22–26 Strategic Plan

On November 23, 2022, the SEC released its Strategic Plan for the fiscal years 2022–2026. A corresponding press release summarized the key aspects of the plan, including what the SEC described as its commitment to protect the investing public from fraud and other misconduct, the need to develop a robust regulatory framework that evolves with the changing markets and business models, and the SEC’s ongoing goal of promoting a skilled, diverse workforce.

For its first overarching goal, protecting the investing public, the SEC highlighted the importance of technology and data analytics in light of evolving markets driven by data and technology. As markets are becoming more complex and interconnected, the SEC stressed the need to build out its risk identification abilities, focusing on market knowledge and oversight tools. The SEC’s second key objective, developing a robust regulatory framework, is similarly tied to evolving markets and business models. The Strategic Plan remarked on the speed at which information travels between markets and the vast amount of capital that flows across markets, “amounts that would have been unimaginable only a few decades ago.” These market shifts can create significant regulatory and oversight challenges and will require the SEC to coordinate with foreign regulators.

The Strategic Plan cited the rise of crypto assets as an example of changing market trends and the need for the SEC to maintain flexible enforcement approaches. The SEC’s recent trends demonstrate its focus on crypto-related issues. In May of this year, the SEC nearly doubled the size of its Crypto Assets and Cyber Unit in its Division of Enforcement. The Unit has grown to approximately 50 dedicated positions and is tasked with addressing disclosures and controls relating to cyber-security risks and the many enforcement issues relating to crypto assets, decentralized finance (“DeFi”) platforms, non-fungible tokens (NFTs), and stablecoins.

The guiding themes that emerged in the SEC’s Strategic Plan focused on data and technology. Market participants should expect the SEC to explore new ways to apply old rules to increasingly complex transactions and to pursue new rules to regulate markets where old rules are deemed insufficient.