Category: SEC News

SEC’s Home Court or Federal District Court?

Dodd-Frank gave the Securities and Exchange Commission broader powers to bring its enforcement actions in its own administrative court, instead of federal district court. Dodd-Frank changed that with its Section 929P. The SEC may now impose a civil penalty in an administrative proceeding against any person or company.

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The SEC recently released its “Division of Enforcement Approach to Forum Selection in Contested Actions” (.pdf) in what I think was an attempt to create greater transparency in the decision-making process.

There is no rigid formula dictating the choice of forum. The Division considers a number of factors when evaluating the choice of forum and its recommendation depends on the specific facts and circumstances of the case. Not all factors will apply in every case and, in any particular case, some factors may deserve more weight than others, or more weight than they might in another case. Indeed, in some circumstances, a single factor may be sufficiently important to lead to a decision to recommend a particular forum.

At just over three pages, you couldn’t expect much and it met that low bar.

At least one SEC Commissioner thought the SEC should have written guidelines. I assume that was part of the reason for releasing these guidelines.

The guidelines start off solid with the acknowledgment that certain claims and relief require a particular forum. If the SEC is looking for a temporary restraining order or asset freeze, it needs the powers of federal district court and has to bring the case in that forum. For registered entities or individuals, the SEC needs its administrative courts to impose a bar or suspension.

Then the guidelines wander into the messy and ill-defined areas of the efficient use of the SEC resources.

Towards the end, I found one section troubling.

If a contested matter is likely to raise unsettled and complex legal issues under the federal securities laws, or interpretation of the Commission’s rules, consideration should be given to whether … obtaining a Commission decision on such issues, subject to appellate review in the federal courts, may facilitate development of the law.

I don’t like the idea of the SEC developing law in its home court. Based on this statement, the SEC may be deciding to use its administrative courts as an incubator to create novel cases and areas of enforcement.

SEC developed the law of insider trading. There is no act of Congress that makes it specifically illegal. The SEC deemed it a fraud and developed the legal theory. The federal district court has recently handed the SEC a big set-back with the Newman insider trading case.

In federal district court, the judge will decide the law and the jury will determine if there is a violation. Obviously, a jury will be less sophisticated than an SEC administrative law judge in understanding the facts and the implications. The concept is to add a reasonable person standard to the process.

The guidelines seem to give the SEC the ability to take the ball back into its own court if it does not like what the federal district courts are doing. Of course that is subject to appellate review, after appealing to the Commission. That may cause the defendant in the SEC’s cross-hairs to spend more time and money appealling the decision.

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SEC Brings a Valuation Case Against an Investment Adviser

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Lynn Tilton and her firm, Patriarch Partners, are known for their high-risk, high-return investments in distressed companies. The Securities and Exchange Commission brought a case against her and the firm claiming that they were using improper valuations, failing to mark down assets when the investment became more distressed.

At this point we only have the SEC’s charges. According to a quote in the Wall Street Journal: “I’m choosing to fight,” Ms. Tilton said. “My reputation is very important to me and my companies. When my integrity or my intent are questioned, I fight back and let truth prevail.”

She will have to fight the SEC on its home turf. The SEC chose to bring the case as an action in its administrative court,s instead of federal district court. According to the Wall Street Journal the SEC brought the case through its in-house court in part to try to move the case quickly, since one of the funds at issue has a maturity date in November 2015.

Debt tends to be trickier to value than equity. There is the judgment call about how likely you are to have the debt repaid. This is even trickier with Patriarch where the debt is being used to fund the company’s turnaround being managed by Tilton and her companies. She would have the direct power or influence to determine when debt was repaid.

Patriarch’s valuation policy calls for current loans to be valued at the principal amount of the outstanding loan. A defaulted loan is supposed to be written down under the policy. The SEC viewed a default under the documents to be when the debtor fails to make an interest payment. According to the SEC, Tilton determined a loan in default when she will no longer provide financial and management support to the company.

In addition, the funds were supposed to have GAAP-compliant financial statements. Under GAAP, a loan is impaired, and must be measured for impairment when, based on all available information, it is probable that the creditor will be unable to collect all amounts due for interest and principal based on the contract with the debtor.

The difference in characterizing a default resulted in more than $200 million in fees earned on the higher valuations. It sounds like many of the problems could have been fixed with a stronger compliance program. Disclosure would have solved many of the issues in the SEC Order.

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Drew Bowden Thinks Private Equity is a Great Business

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“I tell my son, I have a teenaged son, I tell him, ‘Cole, you want to be in private equity. That’s where to go, that’s a great business, that’s a really good business. That’ll be good for you.'” – Andrew Bowden

Mr. Bowden, Director of the Securities and Exchange Commission’s Office of Compliance Inspections and Examinations, was speaking at Emerging Regulatory Issues in Private Equity, Venture Capital, & Capital Formation in Silicon Valley, hosted by Stanford Law School.

His quote was in the context of the financial services industry complaining about too much regulation. His comment led some to question the SEC’s coziness with the industry.

I still remember Bowden’s speech delivered at the 2014 PEI Private Fund Compliance Forum. He figuratively threw a grenade in the room by saying his team found violations of law or material weaknesses in over 50% of the exams of private equity firms when it came to fees and expenses.

I don’t see his speech as industry capture. I see it as telling private equity to quit complaining and get your house in order. Private equity is good for investors and good for managers. Don’t screw up.

It’s the job of compliance to keep the good thing going and not let the firm screw up.

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Image of Andrew Bowden is by the Securities and Exchange Commission (on Flickr!?!)

Getting Caught With IPO Fever

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A decade ago shares in an initial public offering were handed out as gifts to curry favor with business executives. The shares were all but guaranteed to pop on the opening day for an easy gain. The recent Twitter IPO had that similar feeling of a guaranteed pop. Gregory Gray thought he could make some money on this and brought investors along for the rollercoaster ride. Instead, the Securities and Exchange Commission allege that he took the investors along on a broken down merry-go-round.

Gray raise $5.2 million from investors to invest in pre-IPO shares with a targeted price of $20 according to the fund documents. It was a good bet. Twitter priced at $26, rose as high as $50 and closed on the opening day at $45.

The key was getting his hands on the shares and doing so at that price. The majority of investing world also believed that the pre-IPO shares were a good bet. So the shares would be hard to get.

According to the SEC, Gray missed his target. He only managed to purchase $1.8 million worth of shares at an average price of $23.44.

Gray also apparently missed the reason that anyone would sell the shares at a discount. Insiders’ shares are typically subject to a lock-up. Gray’s shares were subject to a restriction that they could not be sold for six months. That first day pop was meaningless for Gray and his investors.

Those facts alone are merely a missed investment opportunity. But… according to the SEC, Gray lied to his investors about how many shares he acquired and the lock-up. The SEC also alleges that moved cash among his funds to cover-up the lies.

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Fighting Against the SEC’s Administrative Hearings

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Prior to the Dodd-Frank Wall Street Reform and Consumer Protection Act, the Securities and Exchange Commission’s authority to impose penalties in a case brought as an administrative proceeding was restricted to regulated entities. The SEC could not impose a significant civil penalty in an administrative proceeding. That limited administrative proceedings to cease-and-desist proceedings against broker-dealers, investment advisers, and mutual funds. The alternative to the administrative brought before an SEC administrative law judge was a lawsuit brought in federal court.

Dodd-Frank changed that with its Section 929P. The SEC may now impose a civil penalty in an administrative proceeding against any person or company.

Administrative proceedings have many built-in advantages for the SEC: limited discovery, no right to a jury trial, an inherently biased administrative law judge, and a biased appeal to the SEC commissioners. The SEC has the “home court” advantage. According to a Wall Street Journal story, in the 12 months through September, the SEC won all six contested administrative hearings where verdicts were issued, but only 11 out of 18 federal-court trials.

There is an upside to the administrative proceeding. Some defendants will see it as a quicker or less costly proceeding.

One defendant thinks otherwise and has filed suit against the SEC in defense of an upcoming administrative proceeding. Joseph Stillwell runs an investment fund that is under investigation by the SEC. He received a Wells Notice and is expecting his case to end up as administrative proceeding after settlement talks have stalled.

A second defendant in a separate case also challenged an administrative proceeding. Jordan Peixoto was accused by the SEC of insider trading, but the SEC decided to use its new administrative proceeding alternative to federal court. Unlike Stillwell, Peixoto was not subject to SEC registration. The only other time the SEC has acted in this manner was with Rajat Gupta.

There is a constitutional question raised by each case. Each raises concerns about due process and presidential appointment powers. Since the SEC is an independent agency, the SEC commissioners can only be removed for good cause. The administrative judges also have tenure and can only be removed for cause. Prior federal cases have only permitted one level of tenure, not the two levels for the SEC administrative judges.

There is an ethical question. The administrative judges are appointed by the SEC and any appeal of the judges decision is appealed to the SEC commissioners. Since it takes a vote of the SEC commissioners to proceed with an enforcement action, those commissioners are hearing the appeal of the case they authorized to proceed in the first place. The judges are not held to any code of conduct or code of ethics. In the Peixoto complaint, the proceeding is called a “star chamber” where the accused is defenseless.

He also pulled up a statement by the SEC’s general counsel that called into question the adequacy of the administrative process for insider trading cases.

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Failing to Disclose Fees

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The Securities and Exchange Commission has been focused on fees charged by investment advisers and fund managers. The latest target is Robare Group Ltd. based in Houston. The SEC alleges that the firm was receiving a fee from certain investments made for its clients but failed to properly disclose that it was receiving the fee.

According to the SEC order, an unnamed broker agreed to pay the Robare Group a fee for client funds invested in funds sold by the broker. There is nothing inherently wrong with that arrangement. However, it should be disclosed to clients. The concern is that the adviser would direct clients to invest in those funds because it is good for the adviser, not necessarily because it is good for the client.

One interesting thing about the alleged violation is that the SEC is not stating any harm to Robare Group’s clients or even that the clients were invested in the fund for a disproportionate amount. The SEC is focused solely on a violation for failure to disclose. The disclosures were not adequate because they said the Robare Group “may” receive compensation from the broker for selling the mutual funds, when it was definitely receiving payments, the SEC said. In my opinion, that’s a very thin distinction to make.

The interesting thing about the press release for the alleged violation is the statement that the SEC’s asset management unit has enforcement initiative focused on undisclosed compensation arrangements between investment advisers and brokers. This is sounds like a similar effort focused on undisclosed compensation to private equity fund managers from portfolio companies.

 

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SEC’s Municipal Advisor Exam Initiative

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The Securities and Exchange Commission announced a new examination initiative directed at newly regulated municipal advisors. The examinations are designed to establish a “presence” with the newly regulated municipal advisors.

We’ve seen this blueprint before. It looks a lot like the presence exam initiative for newly registered private fund managers and the never before examined initiative for unexamined advisers. The SEC is trying to knock on as many doors as they can.

The SEC is working with the Municipal Securities Rulemaking Board (MSRB) and the Financial Industry Regulatory Authority (FINRA) to facilitate a coordinated approach to oversight of municipal advisors. SEC’s OCIE will examine municipal advisors for compliance with applicable SEC rules and applicable final MSRB rules once the MSRB rules are approved by the SEC and become effective.

Section 975 of Dodd-Frank added a new requirement that “municipal advisers” register with the SEC. Municipal Advisor is defined in 15 U.S.C. 78o-4(e)(4)(E)(4) as:

(A) means a person (who is not a municipal entity or an employee of a municipal entity) that—

(i) provides advice to or on behalf of a municipal entity or obligated person with respect to municipal financial products or the issuance of municipal securities, including advice with respect to the structure, timing, terms, and other similar matters concerning such financial products or issues; or

(ii) undertakes a solicitation of a municipal entity;

(B) includes financial advisors, guaranteed investment contract brokers, third-party marketers, placement agents, solicitors, finders, and swap advisors, if such persons are described in any of clauses (i) through (iii) 5 of subparagraph (A); and

(C) does not include a broker, dealer, or municipal securities dealer serving as an underwriter (as defined in section 77b(a)(11) of this title), any investment adviser registered under the Investment Advisers Act of 1940 [15 U.S.C. 80b–1 et seq.], or persons associated with such investment advisers who are providing investment advice, any commodity trading advisor registered under the Commodity Exchange Act [7 U.S.C. 1 et seq.] or persons associated with a commodity trading advisor who are providing advice related to swaps, attorneys offering legal advice or providing services that are of a traditional legal nature, or engineers providing engineering advice;

Starting later this year, OCIE in coordination with FINRA and the MSRB will hold a Compliance Outreach Program for newly regulated municipal advisors where they will learn more about the examination process and their obligations under the Dodd-Frank Wall Street Reform and Consumer Protection Act and related rules.

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The SEC Shows Some Respect for the Working Woman

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The Securities and Exchange Commission decided to emphasize that working wives can be a source of material non-public information. The SEC press release highlighted insider trading cases brought against husbands who engaged in insider trading after learning confidential information from their wives.

The first case was against Tyrone Hawk. His wife worked at Oracle. Mr. Hawk overheard Mrs. Hawk talking about Oracle’s acquisition of Acme Packet. He decided to make a quick buck and bought shares in Acme Packet. His trade netted him $150,000 after the stock went up 23% on the takeover news.

The second case was against Ching Hwa Chen. His wife worked at Informatica. He overheard news from Mrs. Chen that the company was not going to make its quarterly earnings target. He decided to profit on the bad news by taking a short position on the stock. He made a quick $140,000 in profit.

To emphasize the point, the press release highlighted three older cases of husbands engaging in insider trading after misappropriating information from their spouses: James Balchan, M. Jason Hanold, and William A. Marovitz.

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Do U.S. Regulators Listen to the Public?

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Regulators get piles of comment letters on proposed rules. But do the comments have an affect? Three math and finance professors tried analyzed the text of comments and regulations to find and answer.

Andrei A. Kirilenko, Shawn Mankad, and George Michailidis created a regulatory analytical tool called RegRank. The three researchers pointed RegRank at the CFTC and the 104 proposed rules the commission issued between January 2010 and September 2013. Those proposed rules resulted in 60,000 comment letters and 67 final rules.

The researchers used RegRank to rate a particular proposed rule, final rule and comments as pro-regulation or anti-regulation.  Then they use the tool to characterize how the CFTC rules evolved.

The data indicates that the regulators adjust the rules based on comments.

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There is a general pattern of a proposed rule becoming more in line with the calculated sentiment of the comment letters when it becomes a final rule.

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Are SEC Employees Profiting from Enforcement Actions?

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Emory University accounting professor Shivaram Rajgopal points an accusatory finger at Securities and Exchange Commission employees and proclaims a pattern of selling stocks of companies subject to enforcement actions. His study finds “significant abnormal returns of (i) about 4% per year for all securities in general; and (ii) about 8.5% in U.S. common stocks in particular. The abnormal returns stem not from the buys but from the sale of stock ahead of a decline in stock prices.”

Rajgopal throws the big rock:

Most of these returns stem from the timely sale of these stocks, suggesting that a regulator’s employees are most likely to know about sanctions against companies before the market as a whole.

The study is based on reported securities trades by 3,500 SEC employees during late 2009, and for all of 2010 and 2011. However, the data is severely constrained. Rajgopal merely had a list of transactions and no ability to compute the profits or losses. There is also no data on holdings. The study only looks at what was bought and sold. Rajgopal constructs a synthetic hedge model in an attempt to model the trading.

I’m going to assume his analysis is correct and that SEC employees were more likely to sell in companies that become subject to SEC enforcement actions. Rajgopal claims this is illegal trading before public announcements. I think it’s just SEC employees over-emphasizing SEC actions as a reason to sell the stock.

One fault in Rajgopal’s accusation is how limited the news about an enforcement action may be. The SEC is a huge organization. But even if the news of an enforcement action is leaky, only a small percentage of the 3,500 employees would have that information and be able to make the illegal trade. That small number would not be as statistically significant as Rajgopal finds in his study.

The only meaningful part of the report is its focus in Table 3 of 87 trades of the 7,200 employee trades studied. Those 87 trades are in Bank of America, General Electric, Citi, Johnson & Johnson, JP Morgan, and General Electric in the period prior to the announcement of enforcement actions.

The trades highlight the need for preclearance. An organization may have material non-public information. But the information is only seen by a subset of employees. Clearly, you can track document and email traffic to prove that someone knew that information. That’s what the SEC does in its insider trading investigations. The tough part is defending from an accusation of having the knowledge.

It’s hard to prove that you didn’t know something.

The SEC is stuck with an accusation and little way of proving that those 87 trades were not made on material non-public information. Clearly, the information existed within the SEC. Perhaps the SEC can find a smoking gun that proves that some of those 87 were made by employees who knew about the enforcement action. I would guess that majority were made without that knowledge and no way to prove that they lacked the knowledge.

The SEC should have a pre-clearance requirement or a planned sell window so that the SEC and its employees can avoid the taint of accusations like Rajgopal’s accusation. That’s why public companies have 10b-5 plans and registered investment advisers have pre-clearance requirements.

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