Within several months of Securities and Exchange Commission Chair Mary Jo White’s announcement in late 2013 of a commitment to improving the SEC’s trial readiness,1the Commission suffered a number of losses in federal district court.2 Perhaps not coincidentally, the SEC recently announced that it will be adding two new Administrative Law Judges (ALJs) to its staff—bringing the Commission’s total complement of ALJs to five3—and the Commission’s Director of Enforcement, Andrew Ceresney, has since stated that the Commission will likely begin bringing more enforcement actions before the SEC’s own ALJs, rather than in district court.4
The difference in forum can be significant. The SEC’s ALJs, who are employed by the Commission, are sometimes thought to give the SEC a “home-court edge” that the Commission typically lacks in federal district court before a neutral judge and a jury who are not experts in securities law.5 Thus, the Commission has traditionally reserved its ALJs—whom the Commission touts as having “a sophisticated understanding of the securities laws and markets”—for “cases involving complicated securities issues and technical violations” of the securities laws.6
Although the Commission has increased the number of its ALJs and indicated that administrative proceedings will be used in a wider variety of upcoming enforcement actions,7 the Commission has not signaled the specific types of cases it is likely to pursue. However, given the securities markets expertise8 of the Commission’s ALJs, it would not be surprising to see the Commission bring more cases likely to implicate hot-button technical issues, including valuation and cybersecurity cases.
The SEC has trained its sights on valuation methodologies and practices used by private funds,9 and perhaps for good reason, as investments in private funds, including hedge funds and private equity funds, present a host of valuation-related issues.
Valuation matters, particularly in hedge funds.10 Too high a valuation overcompensates the manager and transfers wealth from new investors to redeeming investors; too low a valuation, on the other hand, transfers wealth from redeeming investors to new investors. Secondly, some hedge funds may employ the use of side pockets, which allow fund managers to exclude certain investments from the calculation of the fund’s net asset value (NAV). The inclusion of unprofitable investments in a side pocket without recognizing the embedded losses would not only present investor liquidity concerns, but also artificially inflate the fund’s NAV.
Given the technical nature of valuation-related issues, administrative proceedings involving valuation may occur with increasing frequency.11
The Commission has also recently shown an interest in cybersecurity, issuing an alert announcing that the SEC’s Office of Compliance Inspections and Examinations would be conducting cybersecurity exams of fifty broker-dealers and investment advisers.12SEC cybersecurity-related enforcement actions are typically based on Regulation S-P (i.e., the “Safeguards Rule”), which, in general terms, requires broker-dealers, investment advisers, and investment companies to take steps to ensure the safety and confidentiality of customer information by having policies and procedures “that address administrative, technical, and physical safeguards for the protection of customer records and information.”13 Thus, because they are often based on the somewhat technical issue of whether a firm’s policies and procedures were adequate, cybersecurity enforcement actions are likely to be brought as administrative enforcement actions. Indeed, although the SEC has not brought any enforcement actions arising out of its recent cybersecurity sweep, it has brought several cybersecurity-related enforcement actions in recent years, each of which has been handled administratively.14
The Commission’s decision to bring an enforcement action as an administrative proceeding rather than as a civil action in federal district court is not guided by hard-and-fast rules. As the Commission’s Director of Enforcement, Andrew Ceresney, has noted, the Division “evaluate[s] the appropriate forum in each case and make[s] the decision based on the particular facts and circumstances.”15 While the constitutionality of the SEC’s administrative proceedings has given some commentators pause,16 the Commission’s decision to add two more ALJs suggests that it intends to increasingly use administrative proceedings, or the threat of administrative proceedings, to resolve issues that, in the Commission’s view, are too “technical” for federal district court.