Division of Enforcement 2019 Annual Report
As my firm does not practice in the enforcement arena, it is not an area I always write about, but this year I found a few trends that are interesting. In particular, just by following published enforcement matters on the SEC’s website, I’ve noticed a large uptick in actions to suspend the trading in, or otherwise take action against, micro- and small-cap companies, especially delinquent filers. I’ve also noticed a large uptick of actions against smaller public and private companies that use misleading means to raise capital from retail investors, and the concurrent use of unlicensed broker-dealers. Of course, there have always been a significant number of actions involving cryptocurrencies. In light of my own observations, I decided to review and report on the SEC’s view of its actions.
As an aside, before discussing the report, I note that the Government Accountability Office (GAO) has raised concerns about the quality of record keeping and documentation maintained by the SEC and used to generate the enforcement report. The GAO report states, “[E]nforcement has written procedures for recording and verifying enforcement-related data (including on investigations and enforcement actions) in its central database. However, Enforcement does not have written procedures for generating its public reports (currently, the annual report), including for compiling and verifying the enforcement statistics used in the report. To produce the report, Enforcement staff told GAO that staff and officials hold meetings in which they determine which areas and accomplishments to highlight. Enforcement was not able to provide documentation demonstrating that the process it currently uses to prepare and review the report was implemented as intended.”
Keeping in mind that the report may not be completely accurate, in fiscal year 2019, the SEC brought 862 enforcement actions, including 526 stand-alone actions. These actions addressed a broad range of significant issues, including issuer disclosure/accounting violations; auditor misconduct; investment advisory issues; securities offerings; market manipulation; insider trading; and broker-dealer misconduct. Through these actions, the SEC obtained judgments and orders totaling more than $4.3 billion in disgorgement and penalties and returned approximately $1.2 billion to investors. The number of enforcement actions rose by more than 30% over the prior fiscal year with more than half of the new actions targeting investment advisers, investment companies or broker-dealers. In 2019, the two-year hiring freeze was lifted and enforcement added 22 new positions.
The Enforcement Report highlights new initiatives by the SEC, including (i) the Retail Strategy Task Force; (ii) the Cyber Unit; and (iii) the Share Class Selection Disclosure Initiative. The Retail Strategy Task Force has two primary objectives: (i) developing data-driven, analytical strategies for identifying practices in the securities markets that harm retail investors and generating enforcement matters in these areas; and (ii) collaborating with internal and external partners, such as OIEA and the Department of Justice, on retail investor advocacy and outreach. The focus on retail investors has resulted in a significant uptick in actions against investment advisors, investment companies and broker-dealers. The Share Class Selection Disclosure Initiative was directed at investment advisory firms that purchased mutual fund shares from a fee paying mutual fund when a lower- or no-cost share class of the same mutual fund was available.
Gatekeepers continued to be an enforcement focus including broker-dealers, the Options Clearing Corporation, auditors and audit firms and attorneys. The SEC also used its power under the Sarbanes-Oxley Act of 2002 to pursue actions against individuals including CEOs and CFOs, usually related to activities to manipulate reported financial results including revenue. In fiscal 2019, 69% of enforcement proceedings included actions against individuals. The SEC always seeks both monetary and non-monetary relief, especially against individuals. Settled proceedings almost always include injunctive relief prohibiting not only future violations but also officer, director bars, penny stock bars, investment restrictions and the like.
Like last year, the SEC prosecuted several cryptocurrency, digital asset and distributed ledger technology cases. The cases involved the usual unregistered sale of securities but also actions were brought related to the promotion of an ICO, touting by celebrities and operating unlicensed trading platforms. In 2019 the SEC reached settlements with three digital asset issuers that resulted in guidance for compliance and registration. The SEC report touts that these actions send the clear message that, if a product is a security, regardless of the label attached to it, those who issue, promote, or provide a platform for buying and selling that security must comply with the investor protection requirements of the federal securities laws.
Cybersecurity continues to be the target of many investigations and enforcement proceedings. In addition to actions against cyber-criminals, the SEC has turned to a review of industry participants and compliance with Regulation Systems, Compliance and Integrity (see HERE), resulting in an enforcement proceeding against the Options Clearing Corporation.
The SEC has encouraged defendant cooperation and as a result, in fiscal 2019, 76% of defendants cooperated, a record high. Law enforcement and interagency coordination also plays a big role in SEC enforcement matters. The SEC regularly works with the Department of Justice, FBI and state attorney general offices where a matter goes beyond civil enforcement. In 2019, more than 400 investigations included a parallel criminal proceeding.
The whistleblower program continues to result in a significant number of enforcement proceedings. However, the SEC receives thousands of tips per year, which is much more than it can efficiently review and process. As a result, it is working on streamlining the process and accelerating the evaluation of claims to determine viable information.
In June 2017, the Supreme Court case of Kokesh v. SEC limited the SEC’s claims for disgorgement to a five-year statute of limitations. The Kokesh case had a significant impact on SEC enforcement proceedings, which often involve many years of complex fraudulent activity. The SEC estimates that Kokesh reduced disgorgement judgments by as much as $1.1 billion in filed cases.
Commissioner Hester M. Peirce’s Statement on Enforcement Report
One of the reasons I was interested in the 2019 Enforcement Report is that SEC Commissioner Hester Peirce took the time to speak about it and, as usual, her thoughts are similar to mine. Commissioner Peirce analogizes the current SEC environment with “broken windows,” reminding me of the strategy heralded in by former SEC Chair Mary Jo White back in 2013 (see HERE). However, Commissioner Peirce was not referring to the former policy, but rather her point that if the SEC had three broken windows, it “would count them and then issue press releases and reports, and journalists and academics would write all sorts of catchy articles based on those delicious statistics. But just as one cannot derive much of a pattern from the three broken windows in my lobby in 2019, one ought to be wary of drawing conclusions from our enforcement statistics.”
Commissioner Peirce’s point is that enforcement proceedings are fluid, with some taking longer than others. Publishing reports and statistics based on the ones that happen to finish during a particular period of months ends up providing arbitrary and not particularly useful information. Moreover, even breaking up cases by type is arbitrary as the factual differences in each case provide the important precedence.
Likewise, penalty amounts are not that important. She points out that low-dollar cases can provide important meaning, such as the case with the Options Clearing Corporation, which was a relatively low dollar amount but included important ongoing undertakings to address several issues. Ms. Peirce states, “[O]ur enforcement program is not a set of data points. Instead, our program consists of the judgments made by a group of hard-working, experienced, bright attorneys, accountants, economists, paralegals, data analysts, computer experts, and support staff dedicated to safeguarding the integrity of our markets.”
In that regard, Commissioner Peirce repeats a mantra she has said before, and that is that the SEC should be selective in its enforcement efforts. SEC resources are limited and not every matter opened should lead to a settlement or ligation action. The SEC should also be looking within to improve the enforcement program. Part of that process is looking for rules that need to be written, eliminated or rewritten. As an example, she points to the advertising rule banning testimonials about investment advisors. Reviews and testimonials are a basic part of consumer decision making in today’s world, and she doesn’t understand why investment advisors should be different. Commissioner Peirce succinctly states, “[R]ather than enforcing anachronistic rules, we should rewrite them and instead devote enforcement resources to the problems of today, of which, I can assure you, there are many.”
Commissioner Peirce also spends time talking about the much-needed overhaul to Rule 15c2-11 (see HERE). Micro-cap fraud is a systemic problem that results in an environment of distrust negatively impacting the legitimate capital-raising efforts by small and development-stage companies. A redo of 15c2-11 will definitely have an impact on the micro-cap space in general and certainly fraud in particular. Commissioner Peirce points out what I have been hearing from my colleagues, and that is that the comments and responses to the proposed rules have been voluminous and largely negative (I haven’t had time to read them yet). The early sentiment is that the proposed rules would shut down an important trading market for day traders and sophisticated investors that trade in the non-reporting or minimal information space on a regular basis, or even for a living. Commissioner Peirce recognizes that a balance must be had that “hinders fraudsters without killing the market for micro-cap stocks.”
Another area of needed regulatory modernization deals with the regulation of transfer agents, which has remained virtually unchanged since 1977. Commissioner Peirce points to the four-year-old concept release (see HERE) and seems to be hopeful that actual proposed rule changes will be forthcoming.
Commissioner Peirce points out that the lack of regulation can be as problematic is improper regulation. An area that is badly in need of attention relates to the regulation of finders. Commissioner Peirce points out, “[I]n the absence of rulemaking, these would-be good actors are forced to discern the path from a murky mishmash of staff no-action letters and enforcement actions.” Commissioner Peirce recognizes that the current broker-dealer framework is inappropriate for finder’s working to make a few connections between investors and companies in need of capital. I’ve been very vocal about the need for a finder’s regulatory framework – see HERE.
Commissioner Peirce also thinks that the current regulatory framework for digital assets hinders innovation and growth: “The only guidance out of the SEC is a parade of enforcement actions and a set of staff guidance documents and staff no-action letters.” She supports creating a non-exclusive safe harbor period within which a token network could blossom without the full weight of the securities laws crushing it before it becomes functional.
In addition to rules, the SEC can improve enforcement by focusing more on compliance. The Office of Compliance, Inspections and Examinations can work with broker-dealers, investment advisors and market participants to improve their systems and remediate issues found during a review rather than making an enforcement referral.
Another recommendation to improve the enforcement program involves further utilizing technology. Although technology and data processing has been effective in uncovering insider trading and cherry-picking schemes, it comes at the expense of privacy. The Consolidated Audit Trail project, for example, tracks all trading activity in the equity and options markets and as such could be abused by overzealous regulators and cybercriminals. Once again, Ms. Peirce hits the nail on the head, stating, “[I] would rather have an enforcement program that respects the liberty and privacy of American investors, even if it comes at the cost of lost enforcement opportunities, than an enforcement program that has a hundred-percent success rate at catching wrongdoers.”