Doubling Down on Disgorgement

Back in 2017, the Supreme Court in Kokesh v. Securities and Exchange Commission pointed out that the disgorgement claims made by the Securities and Exchange Commission are penalties and therefore subject to the five-year statute of limitations. The Kokesh decision left some question about whether the SEC could pursue disgorgement at all. The Supreme Court did not mean to kill it and earlier this year upheld the SEC’s disgorgement power in Liu v. Securities and Exchange Commission.

Congress managed to tuck some some goodies in the National Defense Authorization Act. Sure, that went through gyrations after President Trump vetoed it because it didn’t have some things he wanted in it. On Jan. 1, Congress overrode President Trump’s veto of the defense spending bill.

Section 6501 of the NDAA specifically authorizes disgorgement and allows for a 10 year period in some instances.

SEC. 6501. INVESTIGATIONS AND PROSECUTION OF OFFENSES FOR VIOLATIONS OF THE SECURITIES LAWS.
(a) In General.–Section 21(d) of the Securities Exchange Act of 1934 (15 U.S.C. 78u(d)) is amended–

(3) by adding at the end the following:

(7) Disgorgement.–In any action or proceeding brought by the Commission under any provision of the securities laws, the Commission may seek, and any Federal court may order, disgorgement.

(8) Limitations periods.–
(A) Disgorgement.–The Commission may bring a claim for disgorgement under paragraph (7)–
(i) not later than 5 years after the latest date of the violation that gives rise to the action or proceeding in which the Commission seeks the claim occurs; or
(ii) not later than 10 years after the latest date of the violation that gives rise to the action or proceeding in which the Commission seeks the claim if the violation involves conduct that violates–
(I) section 10(b);
(II) section 17(a)(1) of the Securities Act of 1933 (15 U.S.C. 77q(a)(1));
(III) section 206(1) of the Investment Advisers Act of 1940 (15 U.S.C. 80b-6(1)); or
(IV) any other provision of the securities laws for which scienter must be established.

The 10-year period is only for scienter-based claims. The SEC will have to allege intentional fraud.

What’s not clear in the statutory change is whether the Liu limiting principles will still apply to disgorgement claims. The Supreme Court laid out three limitation on disgorgement claims:

  • Disgorged funds should be returned to the victims.
  • Joint and several liability theory may not apply;
  • Should be limited to “net” profits, allowing deduction of legitimate business expenses

I’ll leave figuring out whether they still apply to the legal scholars and, inevitably, future court cases.

In addition to the disgorgement extension, there is a new anti-money laundering scheme as part of the NDAA. More to come on that.

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SEC Reaction to Form CRS

Registered Investment Advisers had a June 30th deadline for delivery of the new Form CRS to their clients. The forms also need to be filed with the SEC. If you thought the SEC would not look at them, you were wrong.

The SEC’s new Standards of Conduct Implementation Committee has been reviewing the Form CRS submissions to assess compliance with the format and standard requirements of the Form CRS regulations.

It sounds like the Committee is not happy with what it’s seen so far.

The relationship summaries reviewed to date generally reflect effort by firms to meet the content and format requirements of Form CRS….

That sounds like they’re giving out a participation trophy to a lot of firms. A comforting coach thanking players for coming out even though they lost.

Not all are mediocre or bad. The Committee found some good examples with simple, clear disclosure. It intends to find ways to share best practices and feedback. There should be a roundtable in the fall for the Committee’s staff to share ideas.

As for private fund managers, funds are not considered natural persons who would be retail investors under the Form CRS regulation.

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New SEC Commissioner to be Nominated

Commissioner Robert J. Jackson Jr. stepped down from the SEC when his term expired in February, 2020. President Trump had identified his replacement to serve on the Securities and Exchange Commission: Caroline Crenshaw.

Ms. Crenshaw currently serves in the Army JAG Corps and as senior counsel to the SEC. When she first joined the SEC in 2013, she served in the Office of Compliance and Examinations in the Division of Investment Management.

Is she the first SEC examiner to become SEC Commissioner?

From the New York Times

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More Filing Relief from the SEC

The SEC must have realized that its relief from Form ADV filing and Form PF filing deadlines was not providing much relief. The SEC issued a new order for the deadlines.

You still have to send the SEC a notice that your firm is relying on the Order, but you no longer have to say why you can’t file the forms on a timely basis and don’t have to provide an estimated date for delivery.

The SEC has not extended the deadline. It’s still only 45 days.

If you are relying on the Order, you still need to post a notice on your firm’s website.

I think most firm’s are not going to take advantage of the order. Nobody wants to tell the SEC that can’t meet a deadline, even in the case of a pandemic.

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Some Additional Relief From the SEC

The timing of the Coronavirus is coming at the time most private funds are working on audited financial statements.

Form ADV and Form PF

The first move was giving some extra time to file your Form ADV. It requires notifying the SEC and posting information on your website. Similar extensions are available for filing Form PF.

Custody

The SEC updated Question II.1 of the Custody Rule FAQ about inadvertently receiving client funds or securities. Given that many firms are unable to access mail and deliveries at their offices, The SEC has revised the guidance to set the date when the firm is considered to have received such securities on the date that they actually are able to access mail or deliveries at their office locations. The guidance requires investment advisers to return inadvertently received client funds and securities. Now the FAQ modifies that the “three business day” clock begins to run when you have access to office mail and deliveries. This relief is only available when the investment adviser’s personnel are unable to access mail or deliveries as a result of the investment adviser’s business continuity plan relating to COVID-19.

Form ADV – Office Locations

With many firms operating under business continuity and working from home, I’ve heard some concerns about office locations. If people are working from home on a longer basis does that become an office location that needs to be reported on Form ADV?

The SEC stepped up and answered the question. ” As long as the employees are temporarily teleworking as part of the firm’s business continuity plan due to such circumstances, staff would not recommend enforcement action if the firm does not update either Item 1.F of Part 1A or Section 1.F of Schedule D in order to list the temporary teleworking addresses.”

Audited Financial Statements

There is an older FAQ on delivery of audited financial statements under the custody rule for pooled investment vehicles. What happens if you’re not able to get your audited financial statements out within the 120 days mandated by the custody rule?

A: The Division would not recommend enforcement action for a violation of rule 206(4)-2 against an adviser that is relying on rule 206(4)-2(b)(4) and that reasonably believed that the pool’s audited financial statements would be distributed within the 120-day deadline, but failed to have them distributed in time under certain unforeseeable circumstances. (Question VI.g Modified March 5, 2010.)

I would put the Covid-19 into the category of unforeseeable circumstances. On the other hand, private fund documents typically contain a contractual obligation to deliver financial statements in a stated period of time.

Stay Healthy

I hope all the readers of Compliance Building are staying healthy. These are extraordinary times. Use common sense.

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SEC’s Rulemaking Agenda

The Securities and Exchange Commission released its Fall Regulatory Flexibility Agenda, showing its expected rulemaking activity over the next year and updating the Spring edition of its agenda.

I highlighted three items from the Spring Agenda:

  1. Amendments to the Marketing Rules
  2. Amendments to the Custody Rules for Investment Companies and Investment Advisers
  3. Harmonization of Exempt Offerings

The proposed amendments to the marketing rules came out two weeks ago. This puts is solidly in the proposed rule stage. The proposed new regulation is in the release.

Amendments to the Custody Rule is still on the Agenda. It seems to be generously designated as being in the “proposed rule stage.” Maybe I missed it, but I don’t remember seeing any proposed changes.

The Harmonization of Exempt offerings had a concept release this summer. It too is generously designated as being in the “proposed rule stage.”

What’s new that caught my eye?

Accredited Investor Definition. This gets a designation of “proposed rule stage.” I assume this will end up being a part of the harmonization of exempt offerings. But the SEC may end up treating this separately if the Commissioners have trouble coming to agreement on the larger harmonization. The agenda also lists Regulation Crowdfunding Amendments and Regulation A Amendments separately.

Amendments to the Whistleblower Program Rules are listed as being in the final rule stage. The proposed changes to the whistlebower program were published over a year ago in July 2018.

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SEC 2019 Enforcement Report

The Securities and Enforcement Commission’s Division of Enforcement release its 2019 Annual Report highlighting the 862 actions and $4.3 billion in disgorgement and penalties.

The report emphasized actions against individuals. Excluding the Share Class Initiative cases, 69% of the standalone cases were against individuals. This is in line with cases filed during the past few years. Included in this individual accountability is the suspension or barring of nearly 600 people from the securities industry.

Actions against investment advisers and investment companies in FY 2019 nearly doubled from the year before. That sounds ominous. But this increase includes 95 settlements that resulted from self-reports in the SEC’s Share Class Selection Disclosure initiative. Removing those cases, removes the over-allocation of cases to advisers.

For FY2019, the Division had __ ares of focus:

  1. Retail investor protection, the most vulnerable to bad actors in the industry.
  2. Cyber-related misconduct – hacking and ICO failures
  3. Unlawful trading – new SEC tech to spot problems.

The Report highlights some of the Division’s difficulties.

The Kokesh case made it clear that the SEC’s power to impose penalties and disgorgement is subject to a five-year statute of limitations. The Report estimates that this has resulted in the SEC foregoing over $1 billion in disgorgement.

The SEC had been subject to a two-year hiring freeze, which was lifted in the Spring of 2019. The freeze is effectively a reduction in size because personnel leaving for retirements and departures can not be filed.

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“May” May Not Be Adequate Disclosure

I’m sure you heard that Facebook is paying a $5 billion fine for privacy violations to the Federal Trade Commission. You may not have heard that the Securities and Exchange Commission decided to pile on and fine Facebook another $100 million for disclosure failures.

As Matt Levine of Bloomberg says “Everything is securities fraud.”

[T]he Risk Factor disclosures in its Form 10-Q filed on October 30, 2014, Facebook cautioned that “Improper access to or disclosure of user information, or violation of our terms of service or policies, could harm our reputation and adversely affect our business.” In the same Form 10-Q, the company advised that if developers “fail to comply with our terms and policies . . . our users’ data may be improperly accessed or disclosed.” This, the company acknowledged, “could have a material and adverse effect on our business, reputation, or financial results.”

My emphasis and the emphasis of the SEC in its press release

The problem was that Facebook knew that the users’ data had in fact been improperly accessed and disclosed. The SEC is taking the position that this phrasing of a risk creates a false impression that it is merely hypothetical and not actually happening.

The SEC had this fight over “may” in the Robare case. That ended up being a bad strategy for that case. If you remember, Robare’s disclosure was that it may be earning other fees, when it was always earning those fees. One court overturned the SEC. But it had a long history after the case and the SEC ended up winning anyhow.

In the Facebook case, the company made press releases that were incorrect or misleading because they failed to disclose the Cambridge Analytica problem.

The SEC tops this off by pointing out that the Facebook stock price fell from $185 to $159 after the Cambridge Analytica problem was disclosed to the public. That reinforces that the problem was material and should have been disclosed.

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The Pre-Holiday Regulatory Axe

While I was preparing for Thanksgiving on Wednesday, the Securities and Exchange Commission put 43 of its rules on the chopping block.

As you know, it’s not so simple to just eliminate a rule. Eliminating a rule is itself a rulemaking, requiring notice and comment periods. Of course, the SEC would also need to justify why the rule which was at one time deemed to work, no longer works.

The Regulatory Flexibility Act requires requires federal agencies to review regulations for their impact on small businesses and consider less burdensome alternatives. Sec did its part and provided 43 rules. The list is not binding. It’s just notice that the SEC is thinking about making changes to these rules and invite comment. The rules may be continued without change, or could be
“amended or rescinded to minimize any significant economic impact of the rules upon a substantial number of such small entities.”

I’m not sure where private funds and real estate fund managers might fit into the size and scope of a “small entity.”

I found two rules to be the most applicable to private fund managers on the list:

  1. 206(4)-8 Prohibition of fraud by advisers to certain pooled investment vehicles.
  2. 206(4)-2 Custody Rule 

The applicability of fraud to investors rule is a bit a remnant from the SEC trying to breach the old small adviser exception to registration. There is always an inherent conflict between a fund manager looking out for the best interest of the fund and looking out for the best interest of a certain investor. Fund investors are going to have different tax, liquidity and diversity requirements. I’m not sure what is wrong with the rule that has caused the SEC to put it on this list.

The Custody Rule is full of land mines and foot faults for fund managers. I’m sure many fund managers and investment advisers would like clarification on many aspects of the rule and to clean up the messy guidance that has followed since the rule was last amended in 2009.

In a recent conversation with some SEC folks, we discussed the Chairman’s reminder that guidance is not binding. Word is that the SEC would like to roll up guidance into officially approved rules. It seems like the Custody Rule and its followup guidance fit into that category.

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SEC’s Enforcement Division’s Annual Report

The Securities and Exchange Commission has the same problem as any compliance professional: “How do you prove you’re being effective?”  The Enforcement Division issued its annual report of its ongoing efforts to protect investors and market integrity.

On one hand, remedying the identified harms committed by bad actors on investors is easy to measure. The missing piece is how effective the SEC was at identifying the bad actors. The second prong is a deterrence to the harmful conduct. What bad acts didn’t happen because the potential bad actor changed his mind?

Rightly, the report shows the quantitative and qualitative activities of enforcement.

The quantitative part is easy to lay out: 821 enforcement actions with $3.945 billion in disgorgement and penalties. That’s up from last year which had 754 actions yielding $3.7 billion.

Those are big numbers that should create some amount of deterrence. How much?

Co-Directors of Enforcement Stephanie Avakian and Steve Peiken de-emphasized the importance of those numbers and chose to focus on qualitative metrics such as “the nature, quality, and effects” of the Division’s enforcement program as a better measure of success. The report lays out five principles that guide the Enforcement Division’s assessment of its performance:

  1. focus on the Main Street investor;
  2. focus on individual accountability;
  3. keep pace with technological change;
  4. impose remedies that most effectively further enforcement goals; and
  5. constantly assess the allocation of our resources.

As for the first item, the Annual Report highlights the Retail Strategy Task Force that was formed the past year.  The second is the Share Class Selection Disclosure Initiative. “We do not believe the Commission faces a binary choice between protecting Main Street and policing Wall Street. It must do both.”

For individual accountability, the Annual Report notes that firm does not act autonomously. People do the bad things. The enforcement actions were 70% charges against individuals.

We all are challenged with keeping pace with technological change. The Enforcement Division’s Cyber Unit became fully operational during the past year. The Annual Report has a focus on actions against cryptocurrency and ICOs.

The Enforcement Division wants to have a package of remedies to address misconduct. Besides the penalties and disgorgement, the SEC wants to tailor specific relief to address the misconduct. The report notes that the Kokesh decision limiting the periods eligible for disgorgement reduced the dollar amounts.

The SEC is still under an agency-wide hiring freeze that has been in place since late 2016. The Annual Report notes that the number of positions at the Enforcement Division, including the number of contractors supporting the it’s investigations, has decreased by 10% from FY 2016 to FY 2018.

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