Category: SEC News

What Do You Get For Cooperation with the SEC?

Rebecca Files

  • More likely to get sanctioned.
  • Reduction of $30.3 million in penalties when you initiate your own investigation.
  • Reduction of $609,000 in company penalties for each week earlier the statement is announced the public.
  • Reduction of $112,000 in personal penalties for each week earlier the statement is announced the public.

We in the compliance field have often heard from federal regulators that cooperation will get you benefits. Although when asked how much, it’s merely a “trust us” reply. Back in the beginning of 2010, the SEC launched a new enforcement cooperation initiative. The SEC’s 2001 Seaboard Report lists several criteria that SEC staff evaluate before making enforcement decisions, including whether ―the company cooperated completely with the appropriate regulatory and law enforcement bodies‖ and whether ―the company promptly, completely, and effectively disclosed the existence of the misconduct to the public [and] to regulators

I figured some academic would spend the time to sit down and see how much benefit really accrues when you cooperate. Rebecca Files of the University of Texas at Dallas did just that.

Dr. Files dove into a set of the 2443 press releases announcing an earnings restatements compiled by the General Accounting Office (GAO 2003, 2006a,b) during the 1997-2005 time period. She ended up culling the list down to 1,249 for a variety of reasons. Of those, 127 received a formal sanction by the SEC.

Individuals were sanctioned in 115 of the 127 cases, paying an average of $3.9 million in fines. Companies were sanctioned in 109 of the cases with an average fine of $35.5 million.

When the company had independently investigated their restatements, they paid an average of $30.3 million less in penalties than those that did not.

Dr. Files concludes that the end result is mixed. “[C]ompany-initiated investigations significantly increase the likelihood of an SEC enforcement action, but decrease firm-level penalties associated with a sanction. … Regarding forthright disclosures, I find somewhat mixed results. Headline disclosure of a restatement increases the likelihood of an SEC sanction, suggesting that SEC staff is influenced by the visibility of press release disclosures when choosing its enforcement targets. However, individuals pay significantly smaller fines when the restatement is disclosed prominently in a press release or on a Form 8-K or amended filing. Placing restatement information in a Form 8-K or amended filing also significantly reduces the likelihood of an SEC sanction, but only in the post-2001 period. Consistent with the Seaboard Report, timely disclosure of a restatement reduces the likelihood of being sanctioned and results in lower individual and firm penalties.”

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SEC is Changing Form ADV

The SEC is trying to improve Form ADV. I wonder if it takes into account the new registration standards under the Dodd-Frank Act or whether they will need to make another to recognize the new law.

From the SEC press Release SEC Approves Disclosure Form Changes to Provide Investors Greater Information About Their Investment Advisers:

Under the new rules, advisers will have to provide new and prospective clients with narrative brochures that are organized in a consistent, uniform manner and that include plain English disclosures of the adviser’s business practices, fees, conflicts of interest, and disciplinary information. Advisory firms also must provide “brochure supplements” to clients containing information about the employees who will provide the advisory services to that client.

The Amendments

  • Improved Format and Updating Requirements. Advisers are required to prepare a narrative, plain English, brochure, presented in a consistent, uniform manner that will make it easier for clients to compare different advisers’ disclosures. The clear and concise narrative descriptions provided in the brochure will improve the ability of clients and prospective clients to evaluate advisers and to understand conflicts of interest that the firms and their personnel face, the effects of those conflicts on the firms’ services, and the steps the adviser takes to address the conflicts.

    Advisers must deliver the brochure to a client before or at the time the adviser enters into an advisory contract with the client. In addition, advisers must provide each client an annual summary of material changes to the brochure and either deliver a complete updated brochure or offer to provide the client with the updated brochure.

  • Expanded Content. The new brochure addresses those topics the Commission believes are most relevant to clients, including:
    • Advisory business — An investment adviser must describe its advisory business, including the types of advisory services offered, state whether it holds itself out as specializing in a particular type of advisory service, and disclose the amount of client assets that it manages.
    • Fees and compensation — An investment adviser must describe how it is compensated for its advisory services, provide a fee schedule, and disclose whether fees are negotiable. The investment adviser must also describe the types of other fees or expenses, such as brokerage fees, custody fees, and fund expenses that clients may pay in connection with the services provided.
    • Performance-based fees and side-by-side management — An investment adviser that accepts performance-based fees, or that supervises an individual who accepts such fees, is required to disclose this fact. If the investment adviser also manages accounts that are not charged a performance fee, the adviser must explain the conflicts of interest that arise from the simultaneous management of these accounts and must describe how it addresses those conflicts.
    • Methods of analysis, investment strategies, and risk of loss — An investment adviser must describe its methods of analysis and investment strategies and explain that investing in securities involves risk of loss which clients should be prepared to bear. Investment advisers who use a particular method of analysis or strategy or who recommend a particular type of security are required to explain the material risks involved and discuss the risks in detail if those risks are unusual.
    • Disciplinary information — An investment adviser is required to disclose in its brochure material facts about any legal or disciplinary event that is material to a client’s evaluation of the advisory business or to the integrity of its management personnel. An investment adviser must deliver promptly to clients updated information when there is new disclosure of a disciplinary event or a material change to an existing disciplinary event.
    • Code of ethics, participation or interest in client transactions, and personal trading — An investment adviser is required to describe briefly its code of ethics and state that a copy is available upon request. The adviser must also disclose whether it or an affiliate recommends to clients, or buys or sells for client accounts, securities in which the adviser or an affiliate has a material financial interest and, if so, the conflicts of interest associated with that practice. The adviser also must disclose whether it or an affiliate invests (or is allowed to invest) in the same securities that it recommends to clients or in related securities, such as options or other derivatives, and must explain the conflicts involved and how it addresses those conflicts. In addition, an investment adviser that trades in the recommended securities at or around the same time as the client has to explain the specific conflicts inherent in that practice and how it addresses them.
    • Brokerage practices — An investment adviser is required to describe the factors considered in selecting or recommending broker-dealers for client transactions and determining the reasonableness of brokers’ compensation. Investment advisers also must disclose soft dollar practices (research or other products or services, other than execution, provided by brokers or a third party to the investment adviser in connection with client transactions); client referrals (using client brokerage to compensate brokers for client referrals); directed brokerage (asking or permitting clients to send trades to a specific broker for execution); and trade aggregation (bundling trades to obtain volume discounts on execution costs). Investment advisers must explain how they address the various conflicts of interest associated with these practices.
  • Supplements. An adviser is required to deliver “brochure supplements” to new and prospective clients providing them with information about the specific individuals who will provide services to the clients. The supplement will contain brief résumé-like disclosure about the educational background, business experience, other business activities, and disciplinary history of the individual, so that the client can assess the person’s background and qualifications. It will also include contact information for the person’s supervisor in case the client has a concern about the person.
  • Internet Availability. Advisers are required to electronically file brochures, which will be publicly available on the SEC’s website.

The SEC expects that most investment advisers will begin distributing and publicly posting new brochures in the first quarter of 2011.

Goldman Settles; Fabulous Fab is Left on His Own

Goldman Sachs settled with the Securities and Exchange Commission. That’s not a surprise. Goldman did not want to litigate this action. It wanted it to go away.

As a shareholder in Goldman, I wanted it to go away. It seems others did also. GS stock price opened at $138.50 on Thursday morning. It opened at $151.47 this morning. That’s a 10% increase based on the settlement. The stock has been down 21% since the SEC filed its complaint.

Goldman is going pay $550 million, with $250 million going to investors and $300 million going to the SEC. The dollar amount is not a surprise. I assumed the top dollar amount was the $1 billion lost by investors. I think the time it took between the filing of the action and the settlement was largely focused on how much Goldman was going to pay to make this ugly incident go away.

That is a big dollar amount. As SEC enforcement director Robert Khuzami points out, it’s the biggest SEC fine against a Wall Street firm. There have been bigger fines in other industries.

According to Footnoted, Goldman has $27 billion is cash and short term securities. It’s big dollar number, but Goldman can find that much the cash by looking under the cushions on its couch.

Unfortunately for Goldman VP Fabrice Tourre, he is not included in the settlement. The SEC is continuing its litigation against him. Fabulous Fab has a Monday deadline to respond to the SEC complaint. Fab still works at Goldman but is on paid leave.

He is trying to clear his name. Goldman just paid to get theirs back.

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SEC Votes on Pay to Play

At Wednesday’s Open Meeting the Securities and Exchange Commission took up the discussion of their proposed rules on pay-to-play for investment advisers. The proposal is a new Rule 206 (4)-5 under the Investment Advisers Act. The Commission voted unanimously to adopt the rule.

The rule will have three main prongs:

Two Year Time-Out

An investment adviser who makes a political contribution to an elected official in a position to influence the selection of the adviser would be barred for two years from providing advisory services for compensation, either directly or through a fund.

There will be two de minimis exceptions. For an official the person can vote for, you can contribute up to $300 350. That exception is lowered to $150 if you are not entitled to vote for the official.

There is a limited ability to get a return of a political contribution for inadvertent violations. It sounds like this will be difficult.

There was a mention that the political contributions limitation may not affect all employees of an investment adviser.

Coordination

The proposed rule also would prohibit an adviser from coordinating, or asking another person or political action committee to:

  1. Make a contribution to an elected official (or candidate) who can influence the selection of the adviser.
  2. Make a payment to a political party of the state or locality where the adviser is seeking to provide advisory services to the government.

The SEC does not want investment advisers to be gatekeepers or aggregaters for political contributions to elected officials who select investment advisers for government funds.

Placement Agents and Solicitors

The third prong would prohibit advisers from hiring third party persons to act as agents or solicitors for an investment adviser unless the third party is a regulated person subject to pay-to-play regulation similar to this rule. The placement agents will need to a registered investment adviser or broker-dealer.

The comments to the flat ban resulted in the most comments to the rule. This is the biggest change to the final rule will vary from proposed rule.

They are going to keep a close eye on placement agents. If there continues to be a problem, the SEC is prepared to put a complete ban in place.

Catch-All

There is a catch-all provision is the rule that prohibits indirect violation of the rules.

Applicability

Rule 206 (4)-5 will apply to registered investment advisers and unregistered investment advisers who are relying on the small adviser exception to registration. (Of course, that exception is likely to be eliminated shortly as part of the financial reform legislation.) Private equity fund managers and their employees will be subject to this rule.

There will be a one year period before the placement agent limitations are effective. This is designed to give FINRA time to enact its new regulations on pay-to-play.  It’s not clear if the one-year period is applicable for the other parts of Rule 206 (4)-5.

First Amendment

Commissioner Casey raised a concern that the rule not violate the first amendment rights to engage in the political process. She thought the rule struck a good balance. Commissioner Parades was concerned about rogue employees making contributions in violation of the policy.

Full Text

As is typical with the SEC rules, the final text of Rule 206 (4)-5 was not released at the time of the vote. Keep an eye out for the final release and its detailed requirements.

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SEC’s Rule on Pay to Play is Coming

It’s been almost a year, but it looks like the SEC is ready to issue its rule on political contributions by investment advisers. They announced the subject matter for the Wednesday June 30 10:00 am open meeting:

The Commission will consider whether to adopt a new rule and related rule amendments under the Investment Advisers Act of 1940 to address “pay to play” practices by investment advisers. The new rule is designed to prohibit advisers from seeking to influence the award of advisory contracts by public entities by making or soliciting political contributions to or for those officials who are in a position to influence the awards.

Since private equity funds will have to register as investment advisers, the rule will be applicable.  Actually, the proposed rule was drafted to be applicable to registered investment advisers or those unregistered in reliance on the exemption under Section 203(b)(3), so it would have been applicable to most private equity funds anyhow.

Back in April, the SEC engaged FINRA to craft rules for registered broker-dealers when acting as a placement agent soliciting investments from government investors. That would make it likely that placement agents will not be banned, but merely subject to some additional regulatory requirements.

The proposed rule limited political contributions to $250 per election per candidate if the contributor is entitled to vote for the candidate. Otherwise, the investment adviser would be subject to a two-year ban on providing advisory services for compensation to that government investor.

Private equity firms gearing up for registration will need to include a policy on political contributions. Next week we will not what need to be in that policy.

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Why Is It Called a “Wells Notice”?

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In 1972, SEC Chairman William J. Casey appointed a committee to review and evaluate the Commission’s enforcement policies and practices. Chairman Casey appointed John A. Wells, a lawyer at Royall, Koegel & Wells in New York, to the committee. He also added and former SEC Chairmen Manny Cohen and Ralph Demmler.  Chairman Casey asked Jack Wells to be the Chairman of the Committee specifically because he was not a securities lawyer,

Thus began what is now knows as the Wells Committee.

The Committee started its work in January 1972, and published a report with forty-three recommendations for the Commission in June of 1972. Of the 43 recommendation in the report, recommendation 7:

“The conduct of an investigation should remain with in the control of the Commission; where circumstances permit, however, the Commission should as a general practice give a party against whom the staff proposes to recommend proceedings an opportunity to present his own version of the facts by affidavit or testimony under oath.”

They further elaborated in the report:

“We recommend that, except where the nature of the case precludes, a prospective defendant or respondent should be notified of the substance of the staff’s charges and probable recommendation in advance of the submission of the staff memorandum to the Commission and be accorded an opportunity to submit a written statement to the staff which would be forwarded to the Commission together with the staff memorandum.”

The “Wells submissions” operate as a last chance for respondents to persuade the SEC staff that an enforcement recommendation is not warranted. If that fails, the Wells submissions are submitted to the Commission, along with a staff recommendation memorandum, so the Commission will have both sides of the story when it considers a recommendation for enforcement.

Who Came up With the Idea?

Former SEC Commissioner Paul S. Atkins gives credit for the concept to former Chairman Hamer Budge:

“In 1970, just months before Chairman Budge left the SEC, the Commission issued a memo to the all division directors and office heads regarding procedures to be followed in enforcement proceedings. The memo had two significant components: (1) it required the staff to get Commission approval before engaging in settlement discussions, and (2) it required the staff to provide a summary of the defendant’s arguments in a recommendation memo sent to the Commission. The latter requirement became a subject of study by the Wells Committee….”

The Wells Committee observed that “[a]s a practical matter, only experienced practitioners who are aware of the opportunity to present their client’s side of the case have made use of [such] procedures.”

Is a Wells Notice Required?

The recommendations of the Wells Committee were met with mixed responses. The Commission apparently felt hamstrung by the mandatory-sounding nature of the phrase “except where the nature of the case precludes.” They did not formally adopt the proposal. In SEC Release No. 5310 the Commission found that it would not be “in the public interest” to adopt a formal rule and instead should give notice on a strictly informal basis. The Commission “cannot place itself in a position where, as a result of the establishment of formal procedural requirements, it would lose its ability to respond to violative activities in a timely fashion.”

What’s in a Wells Notice?

From the SEC Division of Enforcement Enforcement Manual:

  • identify the specific charges the staff is considering recommending to the Commission
  • accord the recipient of the Wells notice the opportunity to provide a voluntary statement, in writing or on videotape, arguing why the Commission should not bring an action against them or bringing any facts to the Commission’s attention in connection with its consideration of this matter
  • set reasonable limitations on the length of any submission made by the recipient (typically, written submissions should be limited to 40 pages, not including exhibits, and video submissions should not exceed 12 minutes), as well as the time period allowed for the recipients to submit a voluntary statement in response to the Wells notice
  • advise the recipient that any submission should be addressed to the appropriate Assistant Director
  • inform the recipient that any Wells submission may be used by the Commission in any action or proceeding that it brings and may be discoverable by third parties in accordance with applicable law
  • attach a copy of the Wells Release, Securities Act Release No. 5310
  • attach a copy of the SEC’s Form 1662 (“Supplemental Information for Persons Requested to Supply Information Voluntarily or Directed to Supply Information Pursuant to a Commission Subpoena”)

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SEC’s Mickey Mouse Sting Operation

Maybe this would have worked last year. But traders are probably a little nervous when it comes to buying inside information since the Galleon insider trading case. Hedge funds are now well aware that the SEC and FBI are willing to use a broader range of investigation techniques including wire taps and undercover agents.

That’s probably exactly what they were thinking when they got this mysterious email in March 2010:

“Hi, I have access to Disney’s (DIS) quarterly earnings report before its release on 05/03/10 [sic]. I am willing to share this information for a fee that we can determine later. I am sorry but I can’t disclose my identity for confidentiality reasons but we can correspond by email if you would like to discuss it. My email is [email protected]. I count on your discretion as you can count on mine. Thank you and I look forward to talking to you.”

According to the criminal complaint, at least 33 investment firms received the email. It’s not clear which firms alerted the SEC or the FBI.

The FBI sent in “Al Tyson”, a hedge fund trader to discuss the purchase of the inside information. Al was was an undercover FBI agent. The FBI also used undercover agents “Kurt” and “Bill Evers” in separate discussions. There was even a confidential informant for the FBI: “Oscar.”

Bonnie Hoxie worked for Disney as an executive assistant and thought she could get pre-release earnings information. Her boyfriend, Yonni Sebbag sent the emails.

Bonnie and Yonni must not have heard of the Galleon insider trading case. I’m sure the investment firms they contacted have heard of Galleon and I’m sure are extra cautious of insider trading cases. Especially anonymous emails offering to sell inside information.

I guess they smelled a rat instead of a mouse.

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The SEC’s Agenda: Enforcement and Regulatory Priorities

Compliance week starts off with a Keynote speech from U.S. SEC Commissioner Luis A. Aguilar, dubbed “The Enforcement Commissioner” by Compliance Week in March 2009, will provide an update on SEC’s enforcement developments and priorities, including topics such as penalty guidelines and the SEC’s streamlining of the formal order process. Commissioner Aguilar will also explore broader regulatory priorities and the SEC.

I’m sure the full text of the speech will be published soon after this speech. (UPDATE- Text of the speech: Market Upheaval and Investor Harm Should Not be the New Normal.) These are my notes, live from the presentation:

(Of course, the statements are his and not necessarily the view of the SEC.)

Its been an interesting year since he gave last year’s keynote at Compliance Week 2009. We have seen breakdowns in the markets and failures that could have been prevented by better and more extensive regulation. Re-regulation was part of the problem and the public expects reform. Wall Street and Main Street are in a struggle over regulation, with Wall Street making the loudest statements and are better connected.

He does not lay the blame solely on Wall Street. The legislature and regulators have to accept some of the blame for not reigning in the exotic financial transaction. He put forth four themes:

  1. Regulatory oversight is piecemeal.
  2. The SEC needs a real-time transparent view into the markets.
  3. The regulations  need to revisit the concept of the “sophisticated investor.”
  4. We must remember the crucial role that the SEC plays in rigorous oversight.

He spent some time using the Flash-Crash on May 6 as an example of the problems. There was a significant failure and still, weeks later, we don’t understand what happened or how to prevent it.

He is looking forward to the self-funding mechanism in the Dodd bill to escape the perennial funding shortfall at the SEC.

by Francine McKenna

He thinks the approach to the “sophisticated investor” is short-sighted. Even these investors need transparency and full disclosure. Since these institutional investors are often just an aggregation of small investors, therefore having a huge impact on small investors. A pension fund may have billions in assets, but those assets reflect the retirement savings of its workers.

He wants to focus on effective deterrence, by scaring people with the possibility of sanctions. “I do not want that to happen to me.” That means harsher sanctions, more individual sanctions, and more money penalties (not merely disgorgement). Crime should not pay.

“Corporate penalties come out of the shareholders pocket.” He dismisses that concept. Management controls how money is spent. He thinks lots of that penalty would go to bonuses. He threw out the idea of SEC penalties coming out of the bonus pool for the company.

He thinks insider trading penalties should not be merely disgorgement plus a penalty equal to a disgorgement. He thinks the SEC should set penalties at the maximum under the statute: 3X.

He is also looking for stronger de-debarment powers to kick bad actors out of the securities industry and out of the management of public companies.

Unfortunately, the Commissioner need to run out to the joint SEC-CFTC meeting on Emerging Regulatory Issues.

One question was about the PCAOB case in the Supreme Court. He said the SEC has some contingency plans (he chose not to disclose), but recognizes that it will be up to Congress to change the law.

Other coverage:

SEC Censure for Failing to Conduct Due Diligence

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The SEC censured and fined an investment adviser for due diligence lapses. Yosemite Capital Management, LLC and its managing director, Paul H. Heckler, got a wrist slap for failing to disclose to clients that they had encountered substantial problems when attempting to perform the due diligence.

The big problem is that Yosemite had made a promise to at least two clients prior to placing his clients into the investment. They had promised to conduct due diligence. We saw a similar action by the SEC against the Hennessee Group for their failure to conduct their promised due diligence.

Yosemite ended up putting their clients’ money into a Ponzi scheme. Yosemite placed $3.25 million of four clients’ funds through a feeder fund, Ashton Investments LLC which was supposed to make bridge loans arranged by Norman Hsu and Next Components, Ltd. Heckler’s clients’ funds became part of a Hsu’s $60 million Ponzi scheme.

Yosemite missed some bright red flags:

  • The business cards from Ashton’s representatives that listed their position as “Represenative” [sic].
  • Ashton gave Yosemite a brochure riddled with spelling errors and mostly general, unverified information.
  • In addition to the business cards and the brochure, the only other written information concerning Ashton and Hsu that Yosemite received were emails, without any identifying information, that summarized a few of the loans.
  • Heckler was told that he could not contact Hsu’s lawyers or accountants because Hsu was a  private person.
  • Heckler was told that the bridge loans were safer than stocks or bonds.
  • When Heckler requested a disclaimer in the loan agreement, he was told that it was unnecessary because the investment was not risky.
  • Because Ashton had no offices, Heckler met the Ashton representatives at local restaurants to discuss the investment.

Heckler and Yosemite willfully violated Section 206(2) of the Advisers Act, which prohibits any investment adviser from engaging in any transaction, practice, or course of business, which operates as a fraud or deceit on any client or prospective client, and Heckler caused Yosemite’s violations of Section 206(2) of the Advisers Act.

The “wrist slap” was a disgorgement of the fee earned ($26,000), prejudgment interest and a $50,000 fine. Heckler invested $275,000 of his own money in the scheme and lost $150,000 of it.

Of the $3.25 million of the clients’ money invested, they lost $1.95 million when Hsu’s Ponzi scheme collapsed.

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SEC Attacks the Rating Agencies

The SEC took its first swing at the failure of credit rating agencies by serving a Wells Notice on Moody’s Investor Service.

At issue, according to the Moody’s filing, is the determination in 2007 that members of one of its European rating committees “engaged in conduct contrary to Moody’s Code of Professional Conduct.”  Members of a credit committee knew that some of the products had been given inflated ratings because of a problem in the company’s risk modeling software.

Moody’s is one of only 10 Nationally Recognized Statistical Rating Organizations under the Credit Rating Agency Reform Act of 2006.

The disclosure in Moody’s 10-Q states that the SEC “is considering recommending that the SEC institute administrative and cease-and-desist proceedings against MIS in connection with MIS’s initial June 2007 application on SEC Form NRSRO to register as a nationally recognized statistical rating organization under the Credit Rating Agency Reform Act of 2006.” The theory is that Moody’s description of its procedures and principles were “rendered false and misleading” as of the time the application because of the Company’s finding that a rating committee policy had been violated.

The case reminds me of the Hennessee Group action where the SEC brought an action against a hedge fund for failing to conduct adequate diligence. The reason was that the hedge fund claimed that they had a particular due diligence program, but failed to follow the program. The diligence failure by itself was not actionable, but failing to live up to your self-professed standards made it actionable.

It sounds the SEC is making a similar case against Moody’s. In their application, they claimed to have a certain procedure but failed to follow it. We all know that credit agencies did a poor job of rating CDOs. That by itself caused damages but may not be actionable. So the SEC is going after them for failing to follow their own self-professed standards and policies.

It’s too early to tell what may happen. A worst case scenario would be removing Moody’s status as a NRSRO.  Obviously that would be a nuclear option that would destroy the company. The SEC action sounds like it is related to Moody’s ratings of just one type credit product, so the effects might be minimal.

Will the SEC go after the other rating agencies? or will Moody’s be the sacrificial lamb to warn the others?

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