In This Issue
In this newsletter, we look at SEC enforcement trends for 2016, starting with a recap of key SEC enforcement developments from 2015.
Financial reporting and accounting fraud reemerged as a key priority of the SEC Enforcement Division during 2015.
Enforcement of the Foreign Corrupt Practices Act (“FCPA”) has continued to be an important area of regulatory focus.
In 2015, the SEC continued to bring large numbers of broker-dealer enforcement actions, with a focus on market structure enforcement cases and fraud and registration related cases.
The Second Circuit’s decision in United States v. Newman is undoubtedly one of the biggest developments in insider trading law as demonstrated by the impact it continues to have on rulings in the nation’s lower courts.
We expect the SEC to continue filing a steady stream of enforcement cases in 2016.
SEC Enforcement Trends for 2016
Welcome to the latest edition of Fenwick and West’s Securities Litigation and Enforcement Newsletter. In this newsletter, we look at SEC enforcement trends for 2016, starting with a recap of key SEC enforcement developments from 2015.
This issue of the newsletter was written and edited by securities litigation partners Catherine Kevane and Michael Dicke, formerly the head of enforcement for the SEC’s San Francisco office, and by associates Kaitlin Keller and Shannon Raj.
Before kicking off our discussion of significant SEC enforcement cases in several areas, we note a few overarching themes from 2015—a year of aggressive and innovative SEC enforcement—which we see continuing into 2016.
Aggressive Enforcement. SEC top leadership continued to push for aggressive enforcement, which led to a record number of cases filed and to near-record penalties being assessed in 2015.
The numbers further reveal that the SEC remains focused on accounting, issuer disclosure, and audit cases. In 2015, the SEC filed nearly double the number of such cases brought in 2013.1 The nature of the cases also signaled a tougher, more searching inquiry into the conduct of outside auditors and individual audit partners, as we discussed in our last newsletter.
Innovative Cases. The types of cases brought in 2015 included a sizeable number of first-of-their kind cases, including
- the first case against a public company alleging that the firm’s confidentiality agreements impeded whistleblowing to the SEC;
- the first case in which an audit firm was forced to admit wrongdoing as part of an SEC settlement;
- the first case applying Dodd-Frank provisions limiting the sale of security-based swaps against a Silicon Valley startup; and
- the first case against a private equity adviser for misallocating broken deal expenses.
New Tools. In 2015, the SEC continued to develop and sharpen the tools at its disposal.
- Since the advent of the SEC’s Dodd-Frank whistleblower program in July 2010, the number of awards and the amount of the whistleblower bounties have continued to increase. In March, the SEC announced the first-ever award to a former company officer, finding that the officer met the exception for corporate officers to be eligible for bounties because the officer had first reported the issue internally and insufficient action had been taken to resolve the issue.
- The continued and deliberate shift to bring more cases in the SEC’s own administrative courts has expanded to increasingly include cases against non-registrants who, before Dodd-Frank, largely had not found themselves subject to the SEC’s in-house courts.
- The SEC’s investment in “big data” and emphasis on data-driven analysis has also translated into enforcement cases. As Chair Mary Jo White noted, the strong 2015 enforcement results were aided significantly by the “[t]he Enforcement Division’s leveraging of data, quantitative analytics, and the expertise of our other divisions.” The data initiative demonstrates the increasing collaboration between the Division of Enforcement and the SEC’s Division of Economic and Risk Analysis. In addition, in 2013, the Enforcement Division also launched its own internal group dedicated to harnessing data analytics, dubbing the group the Center for Risk and Quantitative Analytics (“CRQA”). The so-called “quants” and other experts also have been embedded in specialized enforcement units, notably the Market Abuse Unit, as well as the Financial Reporting and Audit Task Force. These initiatives have helped the agency crack an international insider trading ring that stole market-moving information by hacking into newswire services, and led to several high-profile enforcement actions this past year. See, e.g., “SEC Charges 32 Defendants in Scheme to Trade on Hacked News Releases,”; “SEC Charges Bitcoin Mining Companies”.
Every Action Has an Equal and… Newton’s third law also came into play in 2015, with the SEC’s aggressive tactics provoking pushback from some quarters.
The municipal securities industry continued its steady criticism begun in 2014 of the Enforcement Division’s Municipalities Continuing Disclosure Cooperation Initiative (“MCDC”), which requires municipal bond issuers and underwriters to self-report violations of an Exchange Act rule requiring issuers to provide continuing disclosure about certain financial and other data. See “GFOA’s Watkins: MCDC Cost Issuer; SEC Initiative ‘An Abuse of Power,’” The Bond Buyer, June 2, 2015. On February 2, 2016, the SEC completed its MCDC initiative, announcing that, in total, 72 underwriters—representing approximately 96 percent of the market share for municipal underwritings—were charged with providing inaccurate information to investors about compliance with continuing disclosure obligations.
Much of the pushback this past year was focused on the perceived due process unfairness stemming from the SEC’s increased use of its administrative courts, rather than filing cases in federal district court. Numerous defendants in SEC administrative proceedings sought relief in federal court, seeking to stay the administrative proceedings. To date, most of those challenges have been rejected, but two district courts have ruled on fairly technical grounds that the appointment of the SEC’s administrative law judges is unconstitutional, and stayed the administrative proceedings. See Duka v. SEC, 2015 WL 4940057 (S.D.N.Y. Aug. 3, 2015); Hill v. SEC, 2015 WL 4307088 (Dist. Ga. June 8, 2015). Under fire, the Commission in September announced that it will amend its rules governing administrative proceedings, but this did little to calm critics.
Finally, perhaps the sharpest rebuke to the SEC occurred in December, when the Third Circuit Court of Appeals reversed a decision by the full Commission, finding that that Commission “misread” key evidence. The court held that when the Commissioners overrule on appeal one of their own ALJs, the federal appeals court’s review would be “slightly less deferential than it would be otherwise.” The court then marched through the evidence and pointedly identified numerous instances where the evidence was “thin” or did not support the Commission’s reading. The court concluded that “the Commission abused its discretion” and vacated the Commission’s order.
SEC Enforcement of Financial Reporting & Accounting Violations
Public Company Accounting, Disclosures and Internal Controls
Financial reporting and accounting fraud reemerged as a key priority of the SEC Enforcement Division during 2015. Though the past decade saw a decline in the number of SEC cases in this area, in the past two years, the SEC has shown a renewed interest in financial reporting cases as many of the financial-crisis investigations wound down and the SEC introduced its Financial Reporting and Audit Task Force. In 2015, the SEC brought a number of notable enforcement actions and introduced a cutting-edge data analytics program, the Corporate Issuer Risk Assessment (“CIRA”), which uses over 100 different metrics to help SEC investigators detect financial reporting anomalies.
The eye-popping settlement in June with Computer Sciences Corporation (“CSC”) and five of its former executives for a $190 million penalty in connection with their alleged accounting and disclosure fraud highlights the trend. According to the SEC, after CSC realized that it would lose money on its largest contract, CSC altered its accounting models to artificially increase its profits and mask what would otherwise be a substantial hit to earnings. CSC also engaged in improper accounting practices in several of its foreign subsidiaries, including overstating assets, using “cookie jar” reserves and improperly capitalizing expenses, among other things. In addition to the $190 million penalty, CSC agreed to retain a consultant to examine its compliance programs. CSC’s CEO and CFO agreed to a clawback of over $4 million in incentive compensation, as well as significant monetary penalties.
In September 2015, the SEC filed another notable case against Bankrate, Inc., and three of its former executives for improper earnings management. The SEC alleged that Bankrate’s executives directed various company divisions to book unsupported revenue and improperly reduce certain expenses. Without admitting or denying these allegations, Bankrate paid $15 million to settle the matter, and Bankrate’s vice president was barred from practicing before the SEC and from serving as a public company officer or director for five years in addition to personally paying a $180,000 fine. Bankrate’s CEO and director of accounting continue to litigate the matter.
Less than a month later, the SEC settled charges against the former CEO and former CFO of now-bankrupt OCZ Technology Group, Inc., in connection with its alleged improper revenue recognition scheme, which included “channel stuffing,” mischaracterizing discounts, concealing product returns, and misclassifying expenses. The CFO agreed to an officer and director bar and to pay $130,000 to settle the matter, while the CEO continues to litigate against the SEC.
The SEC also charged Miller Energy Resources, Inc., two of its executives and its audit team leader for allegedly overstating the value of recently acquired oil and gas properties, causing Miller Energy Resources to transform from a penny-stock company to a NYSE-listed company. On January 12, Miller Energy settled the matter by agreeing to pay a $5 million penalty. Likewise, the SEC charged the former CEO and former CFO of another now-bankrupt company, KIT Digital, for allegedly falsifying financial statements and using an off-the-books slush fund to generate fraudulent payments to the company, among other improper tactics designed to make the company appear more profitable than it was. The two former KIT Digital executives now face criminal charges in a parallel proceeding as well.
In addition to these accounting fraud cases, the SEC made headlines this year for its focus on executive perk disclosures. As covered in our November 19, 2015 Newsletter (“Baby You Can Drive My Car… Or Corporate Jet: SEC Scrutiny of Executive Compensation Perks Disclosures”), the SEC brought enforcement actions against Polycom, Inc., and MusclePharm Corporation for failing to disclose executive perks, which ranged from lavish trips to club memberships and personal tax services. Polycom agreed to settle for $750,000, while MusclePharm agreed to settle for $700,000 and to hire an independent consultant to review its disclosure policies. Notably, the SEC took the provocative step of charging MusclePharm’s audit committee chair as well, claiming that he “had reason to know” the perks had not been fully disclosed.
Finally, the SEC revealed its willingness this year to prosecute companies for failing to maintain adequate internal controls, even in the absence of egregious misconduct. For example, the SEC imposed (1) a $2.75 million penalty on real estate developer The St. Joe Company for inadequate internal controls and improper accounting of its real estate developments’ declining values; (2) a $1.5 million penalty on Home Loan Servicing Solutions, Ltd., for its inadequate internal controls, misleading statements regarding related-party transactions, and improper accounting method used to value its primary asset; and (3) a $800,000 penalty on discount retailer Stein Mart, Inc., for its inadequate internal controls and improper valuation of its discounted inventory, in part because it delegated decisions regarding markdowns to personnel who lacked sufficient accounting knowledge.
Taken all together, these enforcement actions signal that the SEC will continue to invest resources in identifying and prosecuting financial reporting and accounting violations throughout the coming year. And now armed with CIRA—described as the SEC’s earlier fraud-detection tool “on steroids”—the SEC is positioned to command a growing presence and success rate in this enforcement area during 2016.
Auditor Enforcement Actions
Along with the SEC’s renewed attention on financial reporting and accounting fraud, the SEC demonstrated that it will continue to crack down on gatekeepers, including auditors. As detailed in our September 17, 2015 Newsletter (“A CD or not a CD, That Is the Question … That the Auditors Should Have Answered”), SEC initiated a headline-grabbing enforcement action against national audit firm BDO USA and five of its partners for their failure to investigate a suspicious bank CD, which indeed was fraudulent. To settle the matter, BDO was forced to admit wrongdoing, pay over $2 million, and undertake remedial actions. By requiring BDO to admit wrongdoing as part of its settlement, the SEC championed a “first-of-its-kind” settlement.
But BDO was not the only audit firm required to admit wrongdoing this year. In December, the SEC brought and settled charges against Grant Thornton and two of its partners for their role in accounting violations at two publicly traded companies, Assisted Living Concepts, Inc., and Broadwind Energy, Inc. According to the SEC, the former CEO and former CFO of Assisted Living Concepts had falsified resident counts in the company’s senior living residences to meet certain lease covenants, and had falsely certified that the company met those covenants. Meanwhile, Broadwind Energy and its executives had failed to timely disclose the impairment of intangible assets related to two of its customers, and allegedly had engaged in accelerated revenue recognition practices to avoid various consequences associated with the impairment. In connection with these violations, Grant Thornton and its partners became aware of repeated red flags, yet failed to take reasonable steps to investigate them, according to the SEC. As a result, Grant Thornton admitted wrongdoing, forfeited approximately $1.5 million in audit fees, and paid a $3 million penalty, signaling again the SEC’s message that “audit firms need, when they see red flags, to ensure that they receive reasonable and coherent answers... before they sign off” on financial statements. Reverberations of this message will likely lead audit firms to insist on more audit committee investigations when red flags arise in the upcoming year.
Relatedly, the SEC also continued to enforce its rules requiring auditors to remain independent from their clients to ensure impartiality. The SEC settled charges against Deloitte & Touche for over $1 million in connection with a business relationship that violated the auditor independence rules. Similarly, the SEC settled charges against Grant Thornton India and Grant Thornton Audit Pty Ltd. for approximately $350,000 in connection with payments that violated these same rules.
Key Developments in Foreign Corrupt Practices Act Enforcement
Enforcement of the Foreign Corrupt Practices Act (“FCPA”) has continued to be an important area of regulatory focus. Recent years have witnessed aggressive government tactics in this area and an increasing amount of cooperation between U.S. regulators and their overseas counterparts. The SEC and DOJ brought a combined total of 16 actions, and more than 100 companies were reported to be conducting FCPA-related internal investigations in 2015.
Leading FCPA Cases and Settlements
Leading the charge in headline-making FCPA settlements was this year’s agreement between the SEC and global resource companies BHP Billiton Ltd. and BHP Billiton Plc. (collectively “BHP Billiton”). The SEC accused BHP Billiton of extending nearly 200 invitations and four-day “hospitality packages” to the 2008 Beijing Summer Olympics to government officials and employees of state-owned enterprises while they were in a position to assist BHP Billiton with its business or regulatory endeavors. In May 2015, BHP Billiton agreed to settle the SEC charges for a $25 million civil penalty and a year of self-reporting on its FCPA and anti-corruption compliance program. The settlement drew attention as it did not include a charge under the anti-bribery provisions of the FCPA, and instead focused on the purported lack of proper internal controls and failures of BHP Billiton’s compliance programs.
Another noteworthy FCPA case this year was the settlement between the SEC and the Bank of New York (“BNY”) Mellon, which was charged with providing valuable student internships to family members of foreign government officials affiliated with a Middle Eastern sovereign wealth fund. According to the SEC, family members of the sovereign wealth fund did not meet the criteria for BNY Mellon’s highly competitive internship program, but were hired regardless in an attempt to influence foreign officials and obtain contracts with the fund. In exchange for the settlement, BNY Mellon agreed to pay $8.3 million in disgorgement, $1.5 million in prejudgment interest, and a $5 million penalty. The case highlights that the government reads the FCPA’s language prohibiting improperly influencing foreign officials with “anything of value” quite broadly.
In another key action this year, the SEC alleged that the Chinese subsidiary of Mead Johnston Nutrition Company made improper payments to health care professionals at government-owned hospitals in order to secure recommendations for its infant formula. According to the SEC, employees of Mead Johnston’s Chinese subsidiary funneled improper payments through third-party distributors to health care professionals in China who would recommend the company’s products to new or expectant mothers. The SEC charged the company with violating the books and records and internal control provisions of the Securities Exchange Act of 1934, and Mead Johnston agreed to settle the charges for a reported $12 million this summer. As with BHP Billiton, there was no allegation that Mead Johnston violated the FCPA’s anti-bribery provisions, and the case highlights the importance of closely monitoring distributor relationships and payments as an integral part of a successful compliance program.
And, in an especially novel case, the SEC settled a FCPA enforcement action against Hitachi Ltd., in September of this year, which allegedly bribed not a foreign official but a foreign political party—South Africa’s African National Congress (“ANC”). Hitachi was alleged to have inaccurately recorded improper payments in connection with contracts to build two multi-billion dollar power plants, directing payments to a front company that was actually a funding vehicle for the ANC. The charges, also brought under the internal accounting controls and books and records provisions, were settled with a $19 million penalty.
Important Focus on Individual Accountability
For some time, the SEC has noted its commitment to hold individuals accountable under the FCPA, an intention the SEC’s Director of Enforcement reiterated in his November 17, 2015, FCPA Conference Keynote Address, where he stated that “[h]olding individuals accountable for their wrongdoing is critical to effective deterrence” and is considered “in every case.” See ACI’s 32nd FCPA Conference Keynote Address, Andrew Ceresney, Director, Division of Enforcement (Nov. 17, 2015). For its part, the DOJ released a memo under the signature of Deputy Attorney General Sally Yates in September, which, among other things, required that prosecutors only give corporations credit where the corporation has provided “all relevant facts about the individuals involved in corporate misconduct.” See Memorandum re: Individual Accountability for Corporate Wrongdoing, Sally Quillian Yates, Deputy Attorney General (Sept. 9, 2015). In addition, absent extraordinary circumstances, the DOJ is not to release culpable individuals from liability when resolving a matter with a corporation, nor should DOJ attorneys reach a resolution with a corporation “without a clear plan to resolve related individual cases.” Id.
Underscoring the SEC’s focus on individuals, it pursued both corporate enforcement charges and related individual enforcement actions against the employees of FLIR Systems, a company producing thermal imaging and night vision equipment. According to the SEC, FLIR employees provided unlawful travel, gifts, and entertainment to foreign officials in Saudi Arabia in order to obtain or retain business, and FLIR lacked sufficient internal controls to detect or prevent the violations. Ultimately, FLIR paid $7.5 million in disgorgement and $1 million in penalties, and the employees were fined $20,000 and $50,000. These individual fines, in particular, which are relatively small in comparison to the potential yield of other government actions, demonstrate the SEC’s commitment to pursue individual accountability in parallel with corporate enforcement actions.
Voluntary Disclosures and FCPA Cooperation
It bears noting that, of the SEC and DOJ enforcement actions under the FCPA, most were the product of voluntary self-reporting by the companies at issue. Under the DOJ and SEC’s cooperation programs, corporations can obtain declination, non-prosecution agreements or deferred prosecution agreements, when certain conditions are met. Generally speaking, companies have avoided the full brunt of government action when they self-disclose, make employees available for interviews, voluntarily produce documents, conduct risk assessments and internal investigations, and engage in early and extensive remediation. As the Director of the SEC’s Division of Enforcement recently put it, “companies are gambling if they fail to self-report FCPA misconduct.” See ACI’s 32nd FCPA Conference Keynote Address, Andrew Ceresney, Director, Division of Enforcement (Nov. 17, 2015).
The SEC highlighted the benefits of cooperation in its announcement of a settlement with Goodyear Tire & Rubber, which was accused in February 2015 of failing to detect and prevent some $3.2 million worth of bribes paid in connection with tires sales at its Kenyan and Angolan subsidiaries, where employees allegedly reported the bribes as legitimate business expenses. According to the government, Goodyear violated the FCPA by failing to implement adequate internal controls that could have prevented or detected the improper payments. Although Goodyear ultimately paid some $16 million in disgorgement, it paid no civil penalties as a result of its significant cooperation with the government, which included self-reporting, prompt remedial acts, and assistance with the SEC investigation. Further, not only did Goodyear voluntarily produce documents and respond to requests for information, but it also divested its ownership in its African subsidiaries, disciplined employees with oversight responsibilities, expanded its anti-corruption training, and instituted internal audits and self-assessment questionnaires regarding its subsidiaries’ business.
SEC Enforcement Actions Involving Regulated Entities
In 2015, the SEC continued to bring large numbers of broker-dealer enforcement actions, with a focus on market structure enforcement cases and fraud and registration-related cases. The escalating number of market structure enforcement actions reflected the SEC’s concern that evolving markets pose new and complex concerns, including a surge in trading venues, automated trading, and the development of high-frequency trading. As Andrew Ceresney, director of the SEC’s Division of Enforcement, explained, today’s markets present issues which “simply did not exist and would have been difficult to conceptualize just ten years ago.” Within this ever-complex market, broker-dealers are often seen as the gatekeepers.
In an effort to tackle some of these issues, the SEC sought to enhance the transparency and fairness of trading systems. In January 2015, the SEC secured its largest penalty to date against an alternative trading system when UBS Securities LLC paid $14 million, including a $12 million penalty, in connection with its inadequate disclosures and other violations related to the marketing of its dark pool. A few months later, the SEC broke its own record, settling similar charges against Investment Technology Group, Inc., (“ITG”) and AlterNet Securities for approximately $20 million, including an even larger $18 million penalty, in connection with ITG’s operation of an undisclosed trading desk and misuse of confidential trading information belonging to dark pool subscribers.
In addition to the SEC’s spotlight on alternative trading systems, the SEC pressed ahead with its enforcement of the market access rule, which requires broker-dealers to maintain adequate risk-management systems that address risks associated with their market access. In June 2015, the SEC imposed a $7 million penalty on Goldman, Sachs & Co. for violating the market access rule by sending thousands of mispriced options orders, due to a software error. The next quarter, the SEC imposed a $5 million penalty on high-frequency trading firm Latour Trading LLC for violating the market access rule by sending millions of improper orders over nearly four years and without the required direct control over its risk-management system. The SEC has explained that the market access rule is an important roadblock to fraudulent and manipulative trading practices, particularly those instigated by overseas traders. In the coming year, the SEC likely will continue ramping up its enforcement of the market access rule.
The SEC also maintained its bread-and-butter enforcement cases against broker-dealers as well—namely fraud and registration-related offenses. In one of many fraud actions, the SEC reached a $180 million settlement with two Citigroup affiliates for several misrepresentations relating to two hedge funds that ultimately collapsed. Also, the SEC settled a “first-of-its-kind” case against UBS AG for $19.5 million in connection with various misstatements and omissions made in offering materials related to structured notes. Finally, the SEC cracked down on unregistered broker-dealers, running the gamut from large entities to small firms and individuals, including, for example: (1) International Capital Group and its executives, that agreed to pay over $4 million to settle charges that they sold billions of shares of penny stocks without proper broker-dealer registration; and (2) an individual and two of his affiliated companies that neglected to register as broker-dealers before offering to help small businesses in Los Angeles raise money and identify potential investors. While similar fraud and registration-related actions will no doubt emerge in 2016, the SEC’s market structure enforcement actions are the cases to closely watch in 2016.
Investment Adviser Cases
The SEC’s enforcement actions brought against investment advisers in 2015 largely mirrored those brought in recent years, with the exception of two trending areas related to the compliance procedures and cybersecurity policies of investment advisers.
Consistent with the SEC’s enforcement priorities in prior years, undisclosed conflicts of interest by investment advisers remained a priority in 2015. As the SEC’s Asset Management Unit noted in early 2015, possible conflicts of interest were being investigated in nearly every ongoing matter. As just one example of its investigative success, two J.P. Morgan subsidiaries agreed to pay $267 million and admitted wrongdoing in connection with their failure to disclose multiple conflicts of interest. In another matter, an investment adviser firm agreed to pay $20 million and engage an independent compliance consultant after it failed to disclose a conflict of interest created by its senior executive’s loan from an advisory client. And in yet another matter, the SEC charged a Wisconsin-based advisory firm and its owner for improperly “cherry-picking” its trades—a fraudulent practice—and another form of an undisclosed conflict of interest whereby the investment adviser allocates profitable trades to preferred accounts. Notably, in its press release announcing the case, the SEC noted that the case was in part the result of data mining by the SEC’s Division of Economic and Risk Analysis.
The SEC also continued to actively enforce violations stemming from improper fees, expenses, and other misrepresentations. In March, the SEC brought charges against an investment adviser and her firms for breaching their fiduciary duties by failing to follow the disclosed valuation policies and thus improperly valuing assets in three collateralized loan obligation funds. As a result, the SEC alleged, the firms subsequently collected almost $200 million in management and other fees to which they were not entitled. The SEC also settled charges against private equity firm Kohlberg Kravis Roberts and Company for $30 million after it misallocated “broken deal” expenses. The SEC imposed its first penalty on an investment adviser and affiliated distributor pursuant to the SEC’s recent Distribution-in-Guise Initiative, which is designed to protect mutual fund shareholders from investment firms that improperly use fund assets to pay for distribution. See our November 2015 Newsletter (“And the Winner Is…The SEC Touts Record Number of Cases for Its FY2015, and Highlights Innovative Firsts”) for other “first-of-its-kind” cases brought in 2015.
Finally, as highlighted in our November 2015 Newsletter (“Return of the Cyborg Part II: First-Ever SEC Cybersecurity Enforcement Action Filed Against Investment Advisory Firm”), the SEC brought its first-ever cybersecurity enforcement action against investment adviser R.T. Jones Capital Equities Management after signaling its growing interest in cybersecurity issues. According to the SEC, R.T. Jones failed to implement adequate cybersecurity policies and procedures as required by Rule 30(a) of Regulation S-P under the Securities Act. Without admitting or denying these findings, R.T. Jones agreed to be censured and pay $75,000. In the wake of this case, the SEC made clear that it will closely examine regulated entities’ cybersecurity policies and procedures, making this largely unchartered territory of SEC enforcement another hot issue in 2016.
Notably, the SEC Enforcement Division received criticism for its aggressive pursuit of compliance officers at investment advisory firms. But not everyone at the SEC agreed with the SEC’s actions. Reacting to charges against BlackRock Advisors LLC and its chief compliance officer in connection with their failure to disclose a conflict of interest created by a portfolio manager’s joint venture, and separate charges against SFX Financial Advisory Management Enterprises and its chief compliance officer in connection with its former president stealing client funds, Daniel M. Gallagher, an SEC Commissioner at the time, released a biting commentary calling for a “hard look” at the SEC rules governing compliance officers’ responsibilities, as well as the SEC’s enforcement approach to their violations. In response, Andrew Ceresney, Director of the SEC’s Division of Enforcement, confirmed that enforcement actions against compliance officers are pursued only in “rare” instances, and that these two actions did not deviate from the SEC’s judicious enforcement approach. While Gallagher’s dissent was met with Ceresney’s assurances, the SEC’s attitude toward investment adviser compliance issues, and its enforcement actions against compliance officers, remains to be seen in the coming year.
Insider Trading and Disclosure
Newman, Left Untouched by the Supreme Court, Reverberates Throughout Lower Courts
The Second Circuit’s decision in United States v. Newman is undoubtedly one of the biggest developments in insider trading law as demonstrated by the impact it continues to have on rulings in the nation’s lower courts. That case, decided by the Second Circuit in December 2014 and cemented by the Supreme Court’s denial of certiorari this year, has generated reverberations for insider trading cases throughout the country.
In Newman, the Second Circuit reversed the convictions of two hedge fund managers, finding that there was insufficient evidence to prove that the corporate insider “tippers” had obtained any personal benefit in exchange for the tips conveyed. In so doing, the court ruled that such remote tippees cannot be held liable for insider trading unless they knew the tipper was disclosing confidential information in exchange for a personal benefit. Friendship alone does not satisfy the “personal benefit.” Instead, under Newman, the government must provide “proof of a meaningful close personal relationship [between tipper and tippee] that generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature.” This represents a sea change from past practice, in which it was deemed sufficient for prosecutors to allege only friendship as a personal benefit.
The impact of this decision, and of the denial of the U.S. Attorney’s petition for review, has been significant, with defendants withdrawing guilty pleas and the government seeking to dismiss actions where it lacked the requisite proof of a personal benefit or knowledge under the Newman standard. In one such case, the district court vacated guilty pleas for defendants alleged to have traded on inside information regarding IBM Corp’s $1.2 billion purchase of SPSS Inc. Shortly thereafter, the government sought to drop the charges against all five defendants in that case, and requested dismissal of the case without prejudice. United States v. Conradt, No. 12-887, 2015 U.S. Dist. LEXIS 16263 (S.D.N.Y. Jan. 22, 2015). And, this fall, the government dropped charges against a former portfolio manager of SAC Capital Advisors LP, who, along with cooperating witnesses, was convicted in 2013 of a scheme involving tech stocks that yielded over $1.8 million in profits. United States v. Steinberg, No. 14-2141 (S.D.N.Y.).
Notably, however, some courts have applied the standard articulated in Newman fairly flexibly in civil enforcement actions brought by the SEC. On December 28, 2015, a New York federal judge ruled that a jury should decide whether two individuals accused of insider trading knew that the individual who tipped them off about a pending deal received a personal benefit under Newman. SEC v. Payton, et al., Case No. 1:14-cv-4644 (S.D.N.Y). The two defendants allegedly received $290,000 in unlawful profits after learning about a deal between IBM and software firm SPSS Inc. prior to its public announcement. According to the government’s case, the tip originated from a law firm associate who set off a string of tippers that culminated in Daryl Payton and Benjamin Durant learning about the deal. Even though the tippees denied knowing whether their tipper received any benefit in exchange for the information, Judge Jed S. Rakoff denied their motion for summary judgment, holding that the “credibility of these statements remains a matter for the jury to assess,” as a jury could reasonably find that “it was more likely than not that the defendants made deliberate choices not to inquire further into the circumstances.” In a major win for the SEC, a jury found both Payton and Durant liable for insider trading in February 2016.
In July 2015, the Ninth Circuit entered the mix with its insider trading decision in United States v. Salman, which threw what the Wall Street Journal called a splash of “cold water” on the trend of post-Newman reversals and dismissals. In that case, the defendant sought to overturn his insider trading conviction on the grounds that he did not know of any tangible benefit received by the insider, his future brother-in-law, in exchange for the tip conveyed. The Ninth Circuit rejected that request, holding that, although it could not “lightly ignore the most recent ruling” of the Second Circuit in Newman, the gift of confidential information from an insider to a trading relative or friend meets the element of breach of fiduciary duty in an insider trading claim. Although the Supreme Court refused to hear a petition for certiorari of Newman, it recently agreed to hear an appeal of Salman’s case out of the Ninth Circuit. The case, which will be heard by the high court this year, turns on whether prosecutors are still required to show the exchange of a significant personal benefit where the tipper and tippee are close family or friends. Salmanv. U.S., Case No. 15-628 (U.S. Supreme Ct.).
Importantly, recent rulings have also extended Newman’s personal benefit requirement to apply to both classic and misappropriation theories of insider trading. In September, an SEC administrative law judge dismissed insider trading charges brought against a former Wells Fargo trader on a misappropriation theory. Although the SEC had argued that it did not need to prove personal benefit at all in misappropriation cases, the judge ruled “[t]he personal benefit element applies in both classical and misappropriation cases,” and found that the government “did not satisfy its burden to establish that [the tipper] tipped Ruggieri for a personal benefit within the meaning of Dirks v. SEC... and United States v. Newman.”
As insider trading continues to be a high priority and a high-profile area for prosecutors and the SEC nationwide, 2016 will likely see a number of additional rulings in the lower courts as they continue to interpret and apply Newman to pending cases on their dockets. Additional trends in this area include the use of advanced technology and undercover techniques by the government to unearth complex insider trading schemes, including wiretapping, search warrants, efforts to turn witnesses, and coordination with international regulatory enforcement counterparts to advance investigations.
Other Notable Insider Trading Cases
In 2015, the SEC has continued to show a strong interest in focusing on cases arising from tips of confidential information by professionals, in industries ranging from investment banking to medicine to law. According to one statement by an SEC official, “[w]e will continue to proactively identify and combat serial insider trading schemes, particularly when it involves industry professionals.”
In one such example, the SEC charged a law firm partner with insider trading in the stock of Harleysville Group., Inc., ahead of its announcement of a $760 million merger with Nationwide Mutual Insurance Company. The partner purportedly learned about the deal at his now-former firm, which was advising on the merger. He purchased Harleysville stock the day before the merger was announced, and, hours after the announcement, sold it for roughly $79,000 in illegal profits. The SEC charges were accompanied by criminal charges filed this summer by the DOJ. In February, the former law firm partner was convicted of insider trading.
Further, in July 2015, the SEC accused a former executive of Spanish bank Banco Santander, S.A., of trading on information about a proposed acquisition he learned of in connection with Banco Santander’s role as adviser and underwriter for the transaction. Interestingly, the executive purchased not stock, but contracts-for-difference (“CFDs”), which are highly leveraged securities that, while not traded in the U.S., mirrored the stock’s pricing. According to statements released by the SEC, the case demonstrates its resolve to hold accountable those who “think they can mask their insider trading by trading CFDs rather than the underlying equity security.” Less than a month later, the same executive was also charged with coordinating with a friend to purchase call options involving the same transaction, the day before the public announcement of the acquisition bid. See SEC v. Maillard, No. 15-cv-6380 (S.D.N.Y. 2015).
Pivoting to the healthcare industry, the SEC also brought charges in connection with information learned in advance of the merger of Clarient Inc. and GE Healthcare. In that case, a father, son, and family friend allegedly purchased substantial amounts of Clarient stock after a Clarient employee tipped the father off about the deal before its public announcement. After allegedly reaping more than $50,000 in illegal profits from the scheme, the three men paid approximately $170,000 this summer to settle the action.
And, on an even larger scale, in August, the SEC announced charges against a 27-year-old investment bank analyst for tipping confidential information he learned while working at J.P. Morgan’s San Francisco office. The analyst allegedly passed tips to friends about impending mergers between tech companies, including an old college friend—and, by using an account set up by his college friend, the analyst was able to circumvent J.P. Morgan’s pre-clearance rules. After trading on the information, the analyst and his friends allegedly earned over $672,000 in illegal profits. The case includes parallel criminal charges by the DOJ, and is currently pending in Los Angeles.
The New Convergence of Insider Trading and Cyber Theft
This year also saw classic insider trading schemes played out with the benefit of modern technology. In August, the SEC brought insider trading charges against an international hacking ring that constituted “one of the most intricate and sophisticated trading rings” to date. According to the SEC, two Ukrainian men spent approximately five years hacking into newswire services and stealing corporate earnings announcements prior to the newswires releasing that information publically. The men are alleged to have then transmitted the stolen data across the globe to traders, who then used it to make repeated illicit trades, funneling a portion of profits back to the hackers. The case evinces the government’s commitment to the intersection between cyber theft and traditional insider trading laws, and involves the use of unique analytical tools to both detect and prosecute suspicious trading.
What’s Ahead for SEC Enforcement in 2016?
We expect the SEC to continue filing a steady stream of enforcement cases in 2016, and predict the following trends or areas of emphasis:
- Pre-IPO Securities: Pre-IPO securities have been receiving a lot of attention in the media and in the SEC Enforcement Division. The SEC Enforcement Division is scrutinizing the pre-IPO securities market with a focus on not only secondary trading in private company shares, but also on how pre-IPO companies raise capital. Among other issues, the SEC appears to be focused on valuation issues for private company shares, whether investment advisers who purport to have shares are making misrepresentations to potential investors; whether intermediaries who broker shares are properly registered; and whether sales of derivative interests tied to private shares run afoul of new Dodd-Frank rules that strictly regulate securities-based swaps. We expect that the SEC will open multiple investigations and file a number of enforcement actions in 2016 in this space.
- Executive Compensation and Perk Disclosure: The Enforcement Division is closely examining proxy disclosures of executive perks, looking for signs that a company may not be fully disclosing perks; or that perks have not been approved through the appropriate corporate governance channels; or there have been significant changes in the year-over-year disclosures.
- Deeper Dives on Insider Trading: With the Newman decision’s emphasis on the need for the government to show a close relationship between the purported tipper and tippee and an exchange of value, SEC investigators have sharpened their investigative tools and are combing financial records of targets, and even reaching out to speak with work colleagues and friends in search of such evidence.
- Fewer Administrative Filings: In 2015, we saw significant pushback from defense counsel, some federal court judges, and even Congress over the Enforcement Division’s choice to file an increasing number of cases in SEC administrative courts. In addition, constitutional challenges to the way the agency appoints its administrative law judges are currently under appeals court review, with decisions expected this year. As a result of these factors, we are beginning to see fewer contested cases being filed in those courts—a trend that may continue, depending on how the appeals courts rule.
- What is Cooperation?: In November, Enforcement Director Andrew Ceresney announced that, for FCPA violations, companies that do not self-report the misconduct are no longer eligible for a non-prosecution or deferred prosecution agreement. This announcement highlights the SEC’s increasing scrutiny regarding corporate “cooperation.” In addition to the formal cooperation analysis, SEC attorneys often keep an informal “cooperation score card” during an investigation. Corporations that are viewed as assisting the government in completing the investigation may be rewarded, while those who are viewed as intransigent may be penalized. In 2016, corporations should expect the SEC to continue to emphasize self-reporting and to apply enhanced scrutiny to the level of cooperation.
1 In 2013, the SEC brought 68 financial reporting and audit cases; in 2014, the SEC filed 135 such cases.