Mary Jo White was confirmed in April 2013 as Chair of the Securities and Exchange Commission (the “SEC”), becoming the first former United States Attorney to serve in that role. Given her background, and despite criticism from some quarters for overarching tactics best left for criminal authorities, not civil administrative regulatory agencies, Chair White has worked to reshape the SEC’s Enforcement Division into something akin to a criminal prosecutor‘s office. Under her direction, the Staff in 2014 continued to deploy prosecutorial tools such as deferred prosecution agreements, non-prosecution agreements, and cooperation agreements. Concepts such as public accountability, which prior to her arrival were foreign to a civil regulatory body, continued as an SEC focus in 2014, through settlements requiring admissions by defendants.
On October 16, 2014, the SEC issued a press release touting “a very strong year for enforcement” in the past fiscal year (ended September 30), including a record 755 enforcement actions and orders totaling $4.16 billion in disgorgement and penalties. The release quoted Chair White as praising the SEC’s “aggressive” enforcement efforts, and quoted Andrew Ceresney, Director of the SEC’s Division of Enforcement (and another former DOJ prosecutor), as stating, “I am proud of our excellent record of success and look forward to another year filled with high-impact enforcement actions.” On November 17, 2014, the SEC issued its Agency Financial Report for fiscal 2014, in which it identified five notable jury trials over the past year that resulted in verdicts in favor of the SEC.
These results followed Chair White’s speech, delivered in September 2013 and titled “Deploying the Full Enforcement Arsenal,” in which she espoused “public accountability” as a goal of SEC enforcement actions, acknowledged that much of her thinking on that issue was shaped by the time she had spent as a criminal prosecutor, and set out the hope that the SEC would become – and be perceived as – “the tough cop.”
Not mentioned in either the SEC’s press release or its Agency Financial Report was the large number of insider trading cases it had brought that resulted in pre-verdict dismissals of the SEC’s charges or verdicts in favor of the defendants. The SEC lost at least nine federal court cases in its fiscal 2014 in the insider trading sphere alone. Moreover, as seen in the first highlight we discuss – one of the more significant Circuit Court decisions in the past generation on the boundaries of insider trading violations – the prospects for aggressive SEC enforcement in this area appear to have taken another hit.
1. The Reversal of the Insider Trading Conviction in U.S. v. Newman
Though the SEC continued to aggressively pursue insider trader charges in 2014, bringing at least 30 new cases last year, its ability to achieve successful insider trading convictions was severely curbed by the Second Circuit’s decision in United States v. Newman, issued by the United States Court of Appeals for the Second Circuit on December 10, 2014. In that case, the Second Circuit vacated insider trading convictions of two former hedge fund portfolio managers, Todd Newman and Anthony Chiasson, directing that charges against them be dismissed with prejudice. Though Newman and Chiasson were remote downstream tippees (neither received information directly from a tipper-insider), both were initially convicted for trading on material, nonpublic information relating to shares of public companies in advance of earnings reports.
The Second Circuit reversed the convictions and held that, to establish that a tippee engaged in insider trading, the government must prove – in a criminal case, beyond a reasonable doubt – that the tippee had knowledge of the personal benefit to the tipper. The Court further held that a personal benefit in the context of insider trading requires a quid pro quo relationship. The Court based its analysis on the early 1980s Supreme Court’s insider trading decisions of Dirks v. SEC  and Chiarella v. United States, which established that “insider trading liability is based on breaches of fiduciary duty.”
Though Newman was a criminal, not civil, case, the Second Circuit delivered a significant blow to the SEC’s ever-expanding insider trading enforcement efforts. Indeed, the holding in Newman appears to have had an immediate impact on the SEC’s Enforcement Division. Just a few days after the Court's decision, the SEC dropped a high profile insider trading case, In re Peixoto, against an alleged tippee in connection with Herbalife Ltd. shares.The SEC claimed that it sought to drop charges because two key witnesses were in Poland and could not be compelled to testify, yet this seems unlikely, as the SEC had been aware of this fact for weeks. Instead, the SEC seemed unsure that it could meet the new burden of proof articulated by the Second Circuit, since the agency never claimed that the alleged tippee shared any of his earnings with the alleged tippers, or that a tipper knew of the trading or received any benefit.
The Newman decision may also affect the SEC’s pending case against Michael Steinberg, whose criminal conviction may be overturned in light of the Newman holding.
2. New High Frequency Trading Cases
High frequency trading (HFT) firms came under much scrutiny last year after the publication of Michael Lewis’s book, “Flash Boys: A Wall Street Revolt,” in which Lewis argued that HFT firms exploit ultrafast technology to gain an unfair advantage in trading. Following publication of the book, scores of investors filed a plethora of federal lawsuits seeking class action certification in HFT matters. The SEC was quiet on this front for the first half of the year but ramped up its efforts in the fall of 2014, settling two cases against HFT firms and adopting new rules which require additional safeguards by exchanges and “dark pools.”
In September 2014, the SEC settled a case against Latour Trading LLC, a New York-based HFT firm for an alleged violation of the net capital rule, which requires all broker-dealers to maintain minimum levels of net liquid assets or net capital. Latour paid a $16 million penalty to settle the charges, making it by far the largest-ever net capital violation fine (the previous high was a $400,000 penalty in 2004). The SEC also charged the firm’s CEO with causing the violations; that case was settled for $150,000.
In October 2014, the SEC settled its first HFT manipulation case, against Athena Capital Research, imposing a fine of $1 million. The SEC claimed that Athena used a sophisticated algorithm to manipulate closing prices of thousands of NASDAQ stocks by entering large volumes of orders in the final two seconds of trading to ensure a profitable result for other trades by the firm. According to the SEC, Athena’s last-second trades flooded the market’s available liquidity and artificially altered market prices to Athena’s benefit. In an internal e-mail, an Athena officer referred to this scheme as the firm’s “golden goose.”
3. Enforcement Cases Against Bitcoin Industry Operators
Bitcoin – a virtual, private cryptocurrency – also received ample SEC attention last year. In May 2014, the SEC issued an investor alert focusing on Bitcoins and other virtual currency-related investments, highlighting various risks that investors may encounter when dealing with Bitcoins.
In June 2014, the SEC charged the co-owner of two Bitcoin-related websites, Erik Voorhees. The SEC action focused on unregistered shares offered by the two entities. One of the entities raised 2,600 Bitcoins (approximately $15,000) and another raised 50,600 Bitcoins (approximately $722,659) in connection with an unregistered offering of their respective shares. The SEC investigation uncovered that Voorhees published prospectuses online and actively solicited investors to buy shares in his entities. The SEC alleged that such actions violated Sections 5(a) and 5(c) of the Securities Act of 1933 (the Securities Act), which prohibit sales, offers to sell, and offers to buy securities unless they have been registered. Voorhees agreed to pay $50,000, including disgorged profits, to settle the charges. Notably, the SEC did not address the issue of whether Bitcoins or other virtual currencies are securities, focusing instead on unregistered offerings of shares priced in Bitcoins.
Continuing on this path, in December 2014, the SEC charged Ethan Burnside, a computer programmer, for operating two unlicensed digital currency venues that traded securities using the virtual currencies Bitcoin or Litecoin without registering the venues as broker-dealers or stock exchanges. To settle the charges, Burnside agreed to pay $58,387.07 in disgorgement and prejudgment interest plus a penalty of $10,000.
4. Two Social Media Fraud Cases Highlight Investor Risks
In November 2014, the SEC issued an investor alert, publishing tips for avoiding fraud on social media sites such as Facebook, YouTube, and Twitter. The alert also shone light on common investment scams in social media, such as “pump-and-dump” schemes, fraudulent research opinions or investment newsletters, high-yield investment programs, and offerings that are noncompliant with federal securities laws.
Shortly after the investor alert was issued, the SEC brought charges against two India-based operators of an alleged high-yield investment scheme seeking to exploit investors through pervasive social media pitches on Facebook, YouTube, and Twitter. India’s Pankaj Srivastava and Nataraj Kavuri, operating under the pseudonyms “Paul Allen” and “Nathan Jones,” offered “guaranteed” daily profits as they anonymously solicited investments for their purported investment management company Profits Paradise. The operators created a Profits Paradise website and related social media sites and described the profits as “huge,” “lucrative,” and “handsome,” and the risk as “minimal.” The SEC’s Enforcement Division alleged that Srivastava and Kavuri violated Section 17(a) of the Securities Act and will litigate this matter before an administrative law judge.
Additionally, last year, the SEC announced antifraud charges of social media fraud against Keiko Kawamura. The SEC charged that Kawamura, posing as an investment and hedge fund expert, sought investors for her purported hedge fund, using Twitter to perpetuate false information about ostensible returns. The SEC charged that, instead of investing the money she received from would-be investors, Kawamura spent the funds on personal expenses.
5. SEC Maintains Focus on Investment Advisers’ Compliance With Custody Rule
In 2014, the SEC continued its emphasis on compliance by registered investment advisers (RIAs) with the SEC’s “Custody Rule,” Rule 206(4)-2 under Section 206(4) of the Investment Advisers Act of 1940 (the “Advisers Act”).
In October 2013, the SEC prominently charged three RIAs with various violations of the Custody Rule. In January 2014, in its annual “examination priorities” letter, the SEC staff highlighted the Custody Rule as a core concern, stating that “the staff will continue to test compliance with the Custody Rule and confirm the existence of assets through a risk-based asset verification process.”
In October 2014, the SEC instituted proceedings against Sands Brothers Asset Management, LLC (Sands), an RIA with offices in New York, Connecticut, and California, and three of its senior officers, based entirely on violations of the Custody Rule. In the press release announcing these charges, Andrew Calamari, director of the SEC’s New York Regional Office, stated, “The custody rule is not a technicality. It is a critical investor protection provision designed to help ensure that investor assets are safe.”
The SEC in 2010 had charged Sands and two of the same officers with violating and aiding and abetting violations of the Advisers Act, including the Custody Rule, and they had consented to a cease-and-desist order covering future violations of the Custody Rule. In 2014, the SEC found that Sands had taken no remedial action in response to the 2010 order and never submitted to a surprise examination by an independent public accountant. The SEC also found that Sands failed to comply with the “audit exception” set forth in Rule 206(4)-2(b)(4) – under which an RIA can be deemed to comply with the independent verification requirement by distributing audited financial statements – because it repeatedly failed to distribute audited financial statements to all limited partners within 120 days of the end of its fiscal year. One wonders how foolish an organization can be to not follow up with appropriate remedies after charges.
The SEC enforcement action against Sands followed at least one federal injunctive action and four other administrative cease-and-desist actions against RIAs in 2014 that cited alleged violations of the Custody Rule, among other violations.
6. SEC Highlights Whistleblower Protections With First-Ever Anti-Retaliation Enforcement Action
Section 21F of the Securities Exchange Act of 1934 (the Exchange Act), which was added in 2010 by the Dodd-Frank Act, most notably required the SEC to establish a program for granting awards to individuals who provide the SEC with “original information” that leads to successful enforcement relating to securities law violations. The SEC in 2014 announced several awards to whistleblowers under this program, including, in August 2014, its first award to an individual with an audit or compliance function at a company, and, in September 2014, its largest-ever award, expected to exceed $30 million.
Less publicized, but perhaps equally important for firms to be aware of, are the protections for whistleblowers established by the Dodd-Frank Act. In particular, subsection (h) of Section 21F prohibits employers from discharging, demoting, suspending, threatening, harassing, or in any other manner discriminating against whistleblowers based on their activities as whistleblowers. Subsection (h) provides whistleblowers a federal cause of action for discharge or other such discrimination.
The SEC highlighted these protections in June 2014, when it brought its first proceeding asserting whistleblower retaliation in violation of Section 21F. In March 2012, the then-head trader of Paradigm Capital Management, Inc., a registered investment adviser, voluntarily made a whistleblower submission to the SEC, revealing that Paradigm had engaged in principal transactions with an affiliated broker-dealer without providing effective disclosure to, or obtaining effective consent from, a hedge fund client advised by Paradigm. Paradigm subsequently removed the whistleblower from his head trader position, stripped him of his supervisory responsibilities, directed him to work offsite, and instructed him to spend his time preparing a report detailing the facts that supported his report to the SEC. The whistleblower ultimately resigned. Paradigm and its founder/president settled SEC charges involving the prohibited principal transactions, a related material omission in its Form ADV, and the firm’s retaliatory measures against the whistleblower, agreeing to pay disgorgement and prejudgment interest totaling over $1.8 million, and a civil penalty of $300,000. The SEC did not allocate publicly the monetary sanctions among the various types of violations. In the press release announcing the settled charges, Sean McKessy, chief of the SEC’s Office of the Whistleblower, stated, “We will continue to exercise our anti-retaliation authority in these and other types of situations where a whistleblower is wrongfully targeted for doing the right thing …. ”
7. SEC’s Aggressive Enforcement Posture Leads to More Enforcement Actions but a Series of Judicial Losses
In 2014, the SEC continued to aggressively bring insider trading cases, though the agency’s efforts were met by a series of judicial losses, even before the holding in United States v. Newman (discussed above). Andrew Ceresney, chief of the SEC's Division of Enforcement, previously stated that: “[i]f we’re not losing trials, we’re not being aggressive enough.” But such rhetoric is dangerous, as it seems to ignore the significant financial and reputational damage suffered by defendants from simply the leveling of insider trading charges against an individual in the financial services industry.
The SEC’s insider trading losses in 2014 included SEC v. Jilaine Bauer, where, on appeal to the Seventh Circuit, the SEC abandoned its reliance on the classical theory of insider trading and for the first time sought to rely on the misappropriation theory. On remand, the District Court vindicated Bauer’s costly 11-year defense, noting that “no precedent supports the extension of [the misappropriation] theory” to a mutual fund investment adviser such as Bauer. In SEC v. Samuel Wyly, et al., the District Court dismissed with prejudice insider trading charges, finding that the SEC’s theory of materiality would “impermissibly broaden civil and criminal insider trading liability.” In SEC v. Nelson J. Obus, et al., a jury returned a verdict in favor of defendants accused of insider trading in 2001. After the verdict, Obus noted that the SEC’s “12-year campaign” had cost him and his codefendants “more than $12 million in legal and trial expenses”; and that, since “not many small firms” could bear such costs, the “potential harm to small businesses – the engine of economic growth and job creation in this country – is enormous” from “a system that provides regulators with every incentive to overreach without repercussions.” In SEC v. Larry Schvacho, following a bench trial, the District Court dismissed the SEC’s insider trading claims, and criticized the SEC’s “overreaching, self-serving interpretation” of circumstantial evidence. And in SEC v. Mark Cuban, N. D. Tex., Oct. 16, 2013, a jury returned a verdict in defendant Cuban’s favor.After the verdict, Cuban noted that not every person can afford to battle SEC charges: “I’m glad I can be the person who can afford to stand up to them.”
As indicated in these examples, an overaggressive SEC enforcement program that pushes the boundaries of both the law beyond clear precedent and facts beyond reason can impose real costs and can result in substantial injustice. In a perfect world, the outcomes in these and other cases would lead the SEC to reexamine its enforcement policies and exercise more discretion in bringing and resolving cases. However, as yet there are no signs that the SEC’s losses in these and other cases are bringing about any reconsideration by the SEC of its approach to enforcement. Rather, the SEC appears to maintain Director Ceresney’s implicit view that there is no significant harm caused when the SEC pursues enforcement actions that are proved deficient under the law, the facts, or both. Respectfully, to these authors, this directive appears flawed. Instead, the SEC’s goal should be, as the court articulated in Schvacho, ‘‘for a just result and not just for a result.’’
8. A Series of Actions to Enforce Auditor Independence Rules, Including the SEC’s First Such Action Arising from Lobbying Activities
The SEC’s auditor independence rules, set forth in Rule 2-01 of Regulation S-X of the Exchange Act, are intended to ensure that auditors remain independent from their audit clients. Rule 2-01 sets forth a nonexhaustive list of nonaudit services which an auditor cannot provide to its audit clients and be considered independent. The SEC brought a series of actions in 2014 charging accounting firms, large and small, with violating the auditor independence rules, highlighting various ways that audit firms can run afoul of their independence obligations.
In May 2014, the SEC instituted a settled administrative proceeding against James Adams, a former chief risk officer at Deloitte LLP and a partner of Deloitte & Touche LLP (D&T). The SEC found that Adams had repeatedly accepted tens of thousands of dollars in casino markers – instruments used by a casino customer to draw on a line of credit at the casino – from a casino gaming corporation, while he was the advisory partner on a D&T audit of the corporation. In settling the charges, Adams agreed to a suspension of at least two years from practicing as an accountant on behalf of any publicly traded company or other entity regulated by the SEC.
In July 2014, the SEC instituted a settled administrative proceeding against Ernst & Young LLP (E&Y), in the SEC’s first action involving violations of the auditor independence rules in connection with lobbying activity. The SEC found that an E&Y subsidiary, Washington Council E&Y, had impaired the firm’s independence by, among other actions, communicating with congressional staff and urging passage or defeat of proposed legislation favorable or detrimental to E&Y audit clients, asking third parties to approach a U. S. senator to seek support for a legislative amendment sought by an E&Y audit client, and marking up a draft bill by inserting an E&Y audit client’s language and sending the markup to congressional staff. In settling the charges, E&Y agreed to pay disgorgement and prejudgment interest totaling over $1.6 million, and a civil money penalty of $2,480,000.
In December 2014, the SEC instituted settled administrative proceedings against eight audit firms located nationwide for violating auditor independence rules by preparing the financial statements of brokerage firms that were their audit clients. In settling the charges, the firms agreed to pay collectively $140,000 in penalties and comply with various remedial undertakings (the largest penalty was $55,000). In the press release announcing these settlements, Stephen Cohen, associate director of the SEC’s Division of Enforcement, stated, “To ensure the integrity of our financial reporting system, firms cannot play the roles of auditor and preparer at the same time.”
9. SEC Targets Investment Advisory Firm for Failure to Supervise Hedge Fund Manager
In September 2014, the SEC settled charges against San Francisco-based investment advisory firm WestEnd Capital Management LLC (WestEnd) for failing to effectively supervise one of its hedge fund managers, who allegedly took excess management fees from client accounts and used the money for personal expenses. WestEnd clients were advised of an annual management fee of 1.5 percent, but the fund manager withdrew amounts that greatly exceeded that number. WestEnd agreed to pay a $150,000 penalty to settle the SEC’s charges.
According to the SEC, the manager operated the hedge fund with little to no supervision from WestEnd, and he had sole discretion to calculate and withdraw funds that clients purportedly owed to WestEnd. The SEC alleged that WestEnd failed to adopt policies or procedures instituting internal controls, and also failed to maintain the required books and records, including documents relating to the management fees it obtained from the hedge fund. WestEnd agreed to cease and desist from committing or causing future violations, without admitting or denying the findings. The settlement also required WestEnd to retain a compliance consultant.
10. SEC Brings False Performance Claims Against Investment Adviser F-Squared
In December 2014, investment management firm F-Squared Investments, Inc., (F-Squared) settled SEC charges that it defrauded investors through false performance advertising about its flagship product, admitting wrongdoing and agreeing to pay a total of $35 million. The SEC also charged the firm’s co-founder and former CEO Howard Present with making false and misleading statements to investors as the public face of F-Squared.
F-Squared is the largest marketer of index products using exchange-traded funds (ETFs). In 2008, F-Squared and Present created, and began marketing, an algorithm to create a model portfolio of sector ETFs that could be rebalanced periodically as the signals changed. The SEC alleged that, while marketing the algorithm, F-Squared falsely advertised a successful seven-year track record for the investment strategy based on purported actual performance, specifically stating that the mechanism was not “backtested.” In fact, the performance recorded was obtained through backtesting, and the model applied historical market data to generate a purported performance during a past period. Additionally, the purported data had a significant performance calculation error which inflated the results more than threefold.
F-Squared admitted to the violations and agreed to cease and desist from committing or causing further violations. F-Squared will retain an independent compliance consultant and pay disgorgement of $30 million and a penalty of $5 million. The case against Present is ongoing.