With Settlements, Will the SEC Make Defendants Admit Guilt?

Reporting on Mary Jo White’s speech at a Wall Street CFO Network function, the Washington Post notes her comments about the long-simmering topic of failure of securities law violators to admit guilt when they settle with the SEC.  As a matter of practice, the SEC has routinely allowed defendants to settle cases “without admitting or denying wrongdoing.”  In light of public criticism and some pointed criticisms by judges handling these type settlements(See my December 15, 2011 blog post ), White wants to draw a sharper distinction between those cases where clear-cut misconduct is shown and those cases where wrongdoing or guilt is less clear.

The Washington Post article notes that “[i] an e-mail sent to the SEC staff earlier this week, the co-directors of the enforcement division said that cases in which the defendant engaged in “egregious intentional misconduct” may justify requiring an admission, as would the obstruction of an SEC investigation or “misconduct that harmed large numbers of investors.”

Despite public protestations, and some courts’ misgivings about allowing defendants to pay large fines to settle cases without admitting wrongdoing, wholesale changes in the settlement policy are unlikely.  Further, district courts have limited authority to change an executive branch agency’s decision to settle a claim, including the SEC’s “neither admit nor deny” policy.

Whether a sharper line is drawn or not, such settlements still serve an important public policy.  Similar to the rationale for plea bargaining in criminal cases, without being able to settle without admitting guilt, many defendants would not settle.   Some defendants would rather risk going to trial than admit guilt that might leave them open to other lawsuits, denial of insurance coverage, or higher insurance premiums.  Still other defendants,  lacking resources, might simply consider walking away from these cases.  The result — long investigations and trials with even harsher fines and sanctions that may go uncollected and waste limited resources.

 

Public Arbitrator Definition Excludes Mutual Funds and Hedge Funds

Effective July 1, 2013, add to the types of  individuals who are no longer eligible to serve as public arbitrators in FINRA arbitrations persons associated with, or registered through, a mutual fund or hedge fund.

The list has been growing and already includes  (i) attorneys and accountants who derive a certain percentage or a certain amount of their income from the securities industry, (ii) investment advisers, (iii) persons or spouses employed by entities involved in the securities industry, and (iii) directors or officers or spouses or an immediate family member of a person who is a director or officer of, an entity that directly or indirectly controls, is controlled by, or is under common control with, any partnership, corporation or other organization that is engaged in the securities business.

Despite complaints from some in the securities industry that the change means more arbitrators with less experience and education about how the securitie industry works, the rationale approved by the SEC and adopted under Codes of Arbitration Rules (Customer and Industry Codes) 12100(u)(3) and 13100(u)(3) for including these categories is just the opposite.  The change arises from complaints that certain arbitrators on FINRA’s public arbitrator roster are not perceived as public and may be biased because of their industry background and experience.  The exclusion is not permanent.   If the individual ends the affiliation that was the basis for the exclusion, they are eligible to serve as a public arbitrator  two calendar years after ending the affiliation.

The Consequences For Untimely Producing Records to Regulators

A recent SEC enforcement case illustrates again how an investment adviser’s  failure to  timely respond to SEC requests for books and records during an inspections and examinations can turn into an enforcement action.  The outcome should not surprise.  With the limited facts available, one wonders why the SEC’s restraint in bringing an action lasted as long as it did.  There are, however, a few important takeaways for advisers and their compliance professionals.

The case, In the Matter of  EM Capital Management, LLC and Seth Richard Freeman,  involves the SEC issuing an order instituting administrative and cease-and-desist proceedings against an adviser and its principal for failing, over a year and a half period, to furnish books and records to the Commission’s Investment Adviser/Investment Company examination staff.  The requested records included financial statements, e-mails, and documents relating to the adviser and a mutual fund it managed.

After repeatedly promising to produce the documents following repeated requests from the examination staff, the adviser ultimately did comply.  However,  by then, presumably, the Commision’s patience had finally worn thin, and the staff notified the adviser and its principal that the SEC was considering enforcement action against him and the firm.

The Commission alleged that the adviser violated, and the principal aided and abetted violations of Section 204 of the Advisers Act and Rule 204-2, thereunder.  These  regulations and rules require SEC-registered investment advisers to produce required books and records to the Commission’s staff. The adviser and principal were censured and jointly ordered to pay a civil penalty of $20,000.

The lessons imparted from this and similar cases brought by the Commission are at least three-fold:

  1. Never refuse to produce documents that are subject to the SEC’s inspection powers. i.e. generally, with a few exceptions, Rule 204-2(e) of the Investment Advisers Act of 1940 (“Advisers Act”) requires advisers to maintain their books and records for at least five years, and maintained in an appropriate office of the adviser for the first two years.
  2. Delaying tactics is not a good idea since it probably raise more red flags for the examination staff that’s some rule violation may have occured.  If  additional time is needed to comply bring requests to the staff’s attention and make sure it and any extensions granted are documented.
  3. Despite the lesser sanctions in this case, advisers and their compliance personnel should never forget that, under Section 217 of the Advisers Act, willful failure to permit the SEC to inspect books and records is a felony, punishable by a fine of not more than $10,000 and imprisonment up to five years or both.
  4. Nothing stated above should suggest that advisers may not seek to limit the scope of books and records sought.  This includes, where appropriate, asserting relevant privileges against producing certain documents, seeking clarifications about unclear or open-ended requests, and objecting to burdensome and unreasonable production.

 

SEC 2012 Enforcement Actions Against Investment Professionals

In a press release yesterday, the Securities and Exchange Commission  announced enforcement results for its fiscal year ending September 30, 2012.

The results include the SEC having filed 734 enforcement actions, just one case shy of last year’s record of 735.  According to the Division of Enforcement, the cases,  involved everything from highly complex products, transactions, and practices, including those related to the financial crisis, trading platforms and market structure, to insider trading by market professionals.  In addition, orders were entered in some of these cases requiring the payment of more than $3 billion in penalties and disgorgement for the benefit of investors who were harmed.

Investment Advisers

As for investment advisers, the SEC filed 147 enforcement actions in 2012 against investment advisers and investment companies.  Several cases  resulted from the Division of Investment Management’s investment adviser compliance initiative involving advisers who failed to maintain effective compliance programs designed to prevent securities laws violations.

Other actions involving advisers included the SEC

Broker-Dealers

The Commission filed 134 enforcement actions related to broker-dealers — a 19 percent increase over 2011.  Enforcement actions included an action against a Latvian trader and electronic trading firm for their involvement in an online account intrusion scheme that manipulated the prices of more than 100 NYSE and Nasdaq securities; and an action against New York-based brokerage firm Hold Brothers On-Line Investment Services and three of its executives for allowing overseas traders to access the markets and conduct manipulative trading through accounts the firm controlled.

Municipal Securities

The number of enforcement actions related to municipal securities more than doubled since 2011. The SEC filed 17 actions related to municipal securities, including charging Detroit’s former mayor and treasurer in a pay-to-play scheme involving Detroit’s pension funds.  In another action, the SEC charged Goldman Sachs for violating municipal securities rules resulting from undisclosed “in-kind” non-cash contributions that one of its investment bankers made to a Massachusetts gubernatorial candidate.

 

Compliance Officers and In-house Attorneys Remembering Rule Number One

Back on July 25, 2011, we blogged about the importance attached to chief compliance officers’ understanding the regulatory framework and guiding principles for what it is they do.  As we said then,

“Rule Number One

: Your Job is to “Administer” the Compliance Program: The CCO’s job function as mandated by Rule 206(4)-7 (the “rule”) is limited to “administering” the investment adviser’s compliance policies and procedures. While the rule contains no explicit definition for what the term administering means, the rule makes one thing clear, it is the adviser who is legally required to “adopt and implement written policies and procedures reasonably designed to prevent violation” of the Investment Advisers Act of 1940. What this means is that you are not the guarantor that your adviser will not experience a compliance failure. Nor is it necessarily true, from a supervisory perspective, that you are responsible for the compliance failures of others in the firm. To the contrary, the failure of a compliance program to find and remedy compliance problems can just as easily be viewed as evidence that the adviser’s compliance program, including its policies and procedures, are not effective.

This doesn’t mean that compliance personnel of an adviser can’t be sanctioned for not properly supervising employees. Of course, they can be and are sanctioned. However, the fact that you are a CCO does 

 

not, in and of itself, give you supervisory responsibility over your adviser’s personnel. In short, if you’re not supervising other advisory personnel, and you limit supervisory responsibility to persons who are part of the compliance staff, the Adopting Release to the rule makes clear that you aren’t necessarily liable for the supervisory lapses of your adviser. ……..”

The signficance of this rule is born out in an article appearing in AdviserOne entitled “” makes reference to a report prepared by the law firm of Sutherland Asbill tracking recent regulatory actions involving CCOs and in-house attorneys facing disciplinary actions covering everything from lapses involving  inadequate supervisory systems, anti-money-laundering (AML) compliance program, inadequate due diligence in private offerings, books and records violations to lying to regulators.

Understanding and remembering first what your role is as CCO or in-house counsel may prove to be the only thing separating you and a regulatory sanction.

Hedge Funds Should Heed SEC’s Latest Investor Bulletin

Add a few recent SEC actions against hedge funds that include a hedge fund manager running a $37 million Ponzi scheme; a former director in a compensation scheme that netted hundreds of thousands of dollars in undisclosed income; co-founders of a Chicago-area investment firm misleading investors and supervisory failures resulting in penalties of more than $1 million; a private fund manager and his investment advisory firm taking more than $17 million in losses in a Ponzi-like scheme.

And now add to that two even more recent cases: a hedge fund manager over the course of several years invest the majority of a fund’s assets in a private business owned by the manager’s affiliated company; and a manager who used his hedge fund as a ruse to misappropriate over $550,000 from a retired schoolteacher, and you get the math of why SEC hedge fund oversight will continue to intensify.  Given many of the enforcement actions in the past two years are the result of  fairly egregous conduct, the SEC Office of Investor Education and Advocacy’s most recent  Investor Bulletin is still  instructive, not simply for investors, but also, for the hedge funds who serve them.

The bulletin warns investors about continued hedge fund-related misconduct in the markets while mentioning these cases as examples of why investors need to take precaution before making hedge fund investments.  While there’s nothing surprising about precautions and recommendations that include

  •  a need for investors to understand a hedge fund’s investment strategy and its use of leverage and speculative techniques before making the investment;
  • a need for investors to evaluate a hedge fund manager’s potential conflicts of interest and take other steps to research those managing the fund;

the bulletin highlights the need for registered advisers to hedge funds to pay particular attention to conflicts of interest when making investment decisions, particularly when determining how investment opportunities are allocated.  Advisers also have to be wary about engaging in principal transactions when managing hedge funds — for example, engaging in rebalancing or other types of cross trades.  Among others, they should concern themselves with the valuations assigned to particular securities, and calculations of  all fees and other income sources. 

For hedge fund advisers, these bulletins, whose primary aim is educating the investing public, are another way to take a deeper look for potential conflicts that may lead to violations and to understand the emphasis SEC examiners and regulators will place on such conflicts.

Revenue Sharing Arrangements to Get Heightened SEC Scrutiny

Investment advisers and broker-dealer should be aware that SEC through its Asset Management Unit has commenced an initiative aimed at shedding more light on revenue-sharing arrangements between investment advisers and brokers.

The SEC has announced that it will continue to focus enforcement and examination efforts on uncovering arrangements between advisers and broker-dealers where advisers receive undisclosed compensation and conceal such conflicts of interest from clients.

The Commission recently instituted a settled administrative proceeding against  Focus Point Solutions and The H Group, two Portland, Oregon-based investment advisory firms, and their owner over their failure to disclose to clients a revenue-sharing agreement and other potential conflicts of interest.

The SEC’s investigation found that the two firms and their owner failed to disclose to customers that they were receiving revenue-sharing payments from a brokerage firm that managed a particular category of mutual funds being recommended to Focus Point’s clients.  Since Focus Point received a percentage of every dollar that its clients invested in the mutual funds, there was an incentive to recommend these funds over other investment  opportunities in order to generate additional revenue for the firm.

 As part of the arrangement , the broker agreed to pay Focus Point for all client assets that Focus Point invested in certain mutual funds.  In exchange, Focus Point agreed to provide certain custodial support services to the broker.  The SEC found that the agreement created incentives for Focus Point to favor a particular category of mutual funds over other investments.

 Focus Point also provided misleading information about its fee structure to  trustees of a mutual fund Focus Point for whom was seeking approval to become the sub-adviser.  During the sub-adviser to the fund hiring process,  Focus Point told the trustees that Focus Point would not receive any compensation beyond its sub-advisory fee.  This was not true.  Unbeknownst to the trustees, Focus Point had an arrangement with the fund’s primary adviser whereby the primary adviser would compensate Focus Point.

As part of the SEC’s Order entered in the case, Focus Point, The H Group and its owner were censured and agreed to pay a combined $1.1 million to settle the case.

FINRA’s Broker-Dealer Conflicts of Interest Sweep

Seeking to ensure that broker-dealers identify conflicts and place their customers’ interests above there own, FINRA sent to its member firms, in July, another “Targeted Examination Letter”  announcing that it would be conducting targeted examinations (or sweeps) of  member practices to review how they identified and managed conflicts of interest.  The letter sent to  a number of firms seeks a response by September 14, 2012, followed by a potential three hour meeting to discuss information reported. 

What this exercise means for member firms in the near term and in the future is that any new rules FINRA enacts are likely to have a significant effect on broker-dealers with retail clients, particularly in the areas of best execution and customer order handling.  Firms will need to address whether conflicts exist for topics related to best execution as “internalization” (i.e. agency cross trades orders), “preferencing (directing to one market maker over another), affiliated brokerage (i.e. directing  fund brokerage commissions to brokers that sold large number of fund shares), and the priority of trade execution (i.e. trading ahead of customers, block trading, front running and proprietary trading issues) to name a few.     

FINRA makes explicit that it will not be using information gathered from the sweeps as a tool for potential enforcement actions, but instead is using  responses to better understand whether firms are taking reasonable steps to properly identify, manage and mitigate conflicts that may impact clients and the industry.  The letter also states that FINRA intends to develop potential guidance for the industry from the information it learns.  From a fiduciary perspective, and if  broker-dealers haven’t been doing so, they need to start thinking about creating formal risk assessment programs that address conflicts concerns.

CFP Board Announces New Sanction Guidelines

The Board of Directors of Certified Financial Planner Board of Standards, Inc. (CFP Board)  has announced, effective August 27, 2012,  the adoption and  implementation of  new Sanction Guidelines.

Typically, the CFP Board’s enforcement process involves them investigating incidents of alleged unethical behavior using  procedures established by the CFP Board’s Disciplinary Rules and ProceduresWhen violations are found, the CFP Board can impose discipline ranging from a private letter of censure or public admonition to suspension or revocation of the right to use the CFP®  mark. 

In the past, the differences in punishment meted out for those violating CFP’s rules haven’t always represented a model of consistency.  Presumably, the new guidelines will  assist the Disciplinary and Ethics Commission (DEC), the group that conducts disciplinary hearings under the  CFP Board’s rules,  in doing just that.  Similar to FINRA’s approach, the CFP Board’s sanction guidelines includes a chart featuring recommended sanctions for violations that cover everything from bankruptcy, to borrowing money from a client to unauthorized use of  the CFP®  mark.  The chart also includes a column or category entitled “Policy Notes” or factors that the DEC, and if appealed, may also be used by the Appeals Committee of the Board of Directors which considers appeals of DEC decisions.

 

 

Big Firms Fare Better in SEC Enforcement Actions

So says a study conducted by Berkeley Law School professor, Stavros Gadinis.  The article appears in The Business Lawyer, published in the May 2012 issue  (Volume 67, Number 3)  by the American Bar Association. The study covers SEC enforcement actions against investment banks and brokerage houses during a period just before the 2007-2008 economic crisis (the dataset covers 2005, 2006, and the first four months of 2007); and the data suggests that defendants in smaller firms fared far worse in SEC enforcement actions.  According to Professor Gadinis, there are three dimensions to the data.

The first is that when the SEC action involved big firm misconduct, the preferred choice was corporate responsibility as opposed to individual liability.  In short, this sounds,  in part, like some of the criticism heaped on the Bush and Obama Justice Department for failing to bring criminal cases against some individual senior officers in the banking industry responsible for the financial debacle.  Often in these SEC actions, neither the individual who actually participated in the violative conduct nor high-level supervisors were subject to additional sanctions.

Even though both legal venues are open to them, a second factor involves the SEC’s more likely decision to bring adminstrative proceedings against big firms instead of court proceedings.  Hence, the study found that financial professionals subjected to court proceedings resulted in stiffer sanctions, including higher penalties and even bans from the securities industry.

Concomitantly, with administrative proceedings, a third factor arises.  For the same violation and comparable levels of harm to investors, the study found that big firms and their employees were less likely to be banned from the securities industry, even after controlling for violation type and harm to investors.

Skepticism over the legal and public policy implications of not holding individuals liable for violations noted in the Gadinis article (and as we discussed in our January 2, 2012 post) has been raised some courts like Judge Jed Rakoff’s criticism and rejection of the SEC’s settlements with Citi Bank and Bank of America.

To be fair, the article makes clear that “[w]hile… [these theories] seek to explain the SEC’s enforcement strategy… they do not purport to represent an exhaustive list of potential explanations of the [SEC’s] motives.”  Instead, the data raises and addresses major issues about the future implications of the SEC’s activities in recent years.