In order to provide an overview for busy in-house counsel and compliance professionals, we summarize below some of the most important SEC enforcement developments from the past month, with links to primary resources. This month we examine:

  • Whether the SEC is broadening the scope of what constitutes violations of whistleblower protections under Rule 21F-17;
  • The latest on the Division of Enforcement’s EPS Initiative and earnings management;
  • How advisers should be dealing with alternative data providers and expert networks;
  • The SEC’s landmark Archegos action; and
  • A recent action from the Enforcement Division’s Climate and ESG Task Force.

1. SEC Expands Its Interpretation of Tipster Protection Rules

On April 12, 2022, the SEC issued an order and fined David Hansen, the ex-Chief Information Officer and co-founder of a non-public technology company (NS8, Inc.), nearly $100,000 for violating Rule 21F-17 of the Securities Exchange Act of 1934. The Rule prohibits “any action to impede an individual from communicating directly with the Commission staff about a possible securities law violation.” This order suggests the SEC’s interpretation of “action to impede” may be expanding from prior Rule 21F-17 enforcement proceedings.

According to the Hansen order, an NS8 employee submitted a tip to the SEC and raised concerns one month later to Hansen that the company was overstating its number of paying customers in external materials. During their conversation, the employee threatened to reveal “his allegations” to NS8’s customers, investors, and other interested parties unless the company addressed the inflated customer data. Subsequently, both the CEO and Hansen “took steps to remove the [employee’s] access” to the company’s IT systems, and used administrative accounts to access and monitor the employee’s company computer. The order listed these as among “Hansen’s Action’s to Impede” under Rule 21F-17.

Commissioner Hester M. Peirce released a statement, also on April 12, 2022, dissenting from the agency’s decision. Commissioner Peirce stated that the agency failed to explain precisely what Hansen did that impeded the employee’s ability to communicate with the SEC, particularly since the employee had already submitted his tip to the agency. Instead, Commissioner Peirce asserted that, “At most, [Hansen’s] actions affected the content of what the NS8 Employee could communicate, not whether he could communicate.” (Emphasis added.)

Prior Rule 21F-17 enforcement actions largely focused on document provisions, such as confidentiality, non-disparagement, or separation agreements that could potentially impede employees from reporting securities laws violations to the SEC. Typically, these provisions required employees to receive authorization from the company’s legal or compliance departments before an employee could disclose information to regulators. However, the Hansen order reflects a broader and arguably more aggressive application of Rule 21F-17, as it appears to scrutinize a company’s decision to restrict an employee’s access to proprietary data after the employee had raised concerns regarding a possible securities law violation. In situations where there is a legitimate concern about an employee disclosing confidential information to non-government sources, companies (and individuals) should proceed with caution, ensure employees have appropriate channels to report concerns, and document all business decisions taken after an employee raises such concerns. #21F-17 #actiontoimpedecommunicationstoSEC #documentyourreasons

2. SEC Imposes the Highest Penalty to Date for Improper Earnings Management Under Earnings per Share (EPS) Initiative

On April 18, 2022, the SEC settled with Rollins, Inc., a pest control service company based in Atlanta, for $8 million to resolve charges of improper earnings management practices. The SEC also fined the company’s then-CFO, Paul Edward Northen, $100,000 for his alleged role in the practice as well as for causing the company to violate the financial reporting, books and records, and internal controls provisions of the Exchange Act.

In its order, the SEC found that in the first quarter of 2016 and the second quarter of 2017, Northen reduced accounting reserves without following generally accepted accounting principles, which raised Rollins’ reported EPS up to the next penny, allowing the company to meet analyst estimates. The SEC further claimed that Rollins’ improper reduction to accounting reserves took place in “an environment of inadequate internal accounting controls” that gave significant discretion to individuals in the finance department, including the CFO, to adjust the amount of reserves during the quarterly process. While Rollins had policies and procedures that required supporting documentation of any accounting entries, the SEC alleged that, over a period of almost three years, Rollins’ finance personnel entered manual journal entries without adequate documentation. The Order cited instances of Northen receiving guidance from another Rollins executive, who advised that a particular reserve account could “offset negative surprises,” and referred to “the art of the close” at quarter-end. Northen also received communications from the executive that referred to the “need to keep something in that cookie jar for quarters like this.”

The Rollins order is the fourth enforcement action brought against an issuer for improper earnings management under the SEC’s EPS initiative, which uses data analytics to uncover potential accounting and disclosure violations caused by earnings management practices. In instituting the Rollins order, Enforcement Director Gurbir Grewal stated that the SEC “will continue to pursue public companies that lack adequate accounting controls and engage in improper earnings management practices.” Thus, as the SEC continues to monitor and enforce proper financial reporting, issuers should document their accounting judgments and ensure compliance with their disclosure controls and procedures as set forth in this MoFo Client Alert. #EPSinitiative #Can’tkeepacookiejar #documentyourreasons

3. SEC Highlights Deficiencies in Investment Adviser MNPI Compliance Practices

On April 26, 2022, the SEC’s Division of Examinations issued a risk alert flagging certain notable deficiencies that it has observed related to advisers’ potential misuse of material non-public information (“MNPI”) and flagged an area of a recent novel enforcement action: alternative data.

The risk alert set forth that, if an adviser uses alternative data (e.g., information gleaned from satellite and drone imagery of crop fields and retailers’ parking lots, analyses of aggregate credit card transactions, social media and internet search data, email data obtained from apps, geolocation data from consumers’ cell phones), the exam staff will expect to see written policies and procedures to address the potential risk of receiving MNPI through the providers of such alternative data. Although the SEC did not charge any fund managers with violations of the securities laws in its enforcement action against AppAnnie and its former CEO—in fact, the fund managers appear to be the victims of AppAnnie and its former CEO’s fraud—the exam staff asserted that it expects advisers to memorialize due diligence on their alt data vendors and consistently apply onboarding procedures.

The risk alert also noted how exam staff observed that advisers either did not appear to have or did not implement adequate policies and procedures related to calls with expert networks consultants, including:

  • Tracking and logging calls with expert network consultants;
  • Reviewing detailed notes from expert network calls; and
  • Reviewing relevant trading activity of supervised persons in the securities of publicly traded companies that are in similar industries as those discussed during calls.

The observation referring to trading in companies in similar industries seems is evocative of charges made in the recent SEC v. Panuwat case, sometimes referred to as the “shadow insider trading” case. In that case, Panuwat, an employee of biopharmaceutical company Medivation, traded in the securities of another biopharmaceutical company, Incyte, allegedly based on merger information Panuwat received from Medivation. Significantly, Medivation’s insider-trading policy, which Panuwat signed, specifically prohibited its employees from using confidential information acquired at Medivation to trade in the securities of another public company, including suppliers and competitors. See our client alert on the district court’s decision to deny Panuwat’s motion to dismiss and takeaways for in-house counsel, including the significance of the company’s insider-trading policy in defining the breach of a duty, which is one of the elements of insider trading. #MNPI #AltData #ExpertNetworks

4. SEC Charges Archegos Executives with Market Manipulation

On April 27, 2022, the SEC filed a complaint in the Southern District of New York against Archegos Capital Management, LP, as well as individuals Sung Kook (Bill) Hwang, Patrick Halligan, William Tomita, and Scott Becker, alleging fraud and manipulation of stock prices using total return swaps. Additionally, the U.S. Attorney’s Office for the SDNY announced criminal charges against the four individuals, two of whom (Tomita and Becker) have pled guilty and are cooperating with the government. In a separate action, the CFTC also filed similar charges.

According to the SEC’s complaint, from March 2020 until March 2021, Hwang purchased on margin billions of dollars of total return swaps, which allowed him to take on large equity positions in companies by posting limited funds up front. The SEC alleged that Hwang frequently entered into certain of these swaps without any economic purpose other than to artificially and dramatically raise the prices of various companies’ securities, which induced investors to purchase these securities at inflated prices.

The complaint further alleges that Archegos purposely misled many counterparties about its exposure, liquidity, and concentration so that it could increase its trading capacity and continue to purchase swaps for its most concentrated positions, thereby driving up the price of those stocks. When these concentrated positions experienced price declines in March 2021, the SEC alleged that Archegos could not meet its significant margin calls, and its subsequent default and collapse resulted in billions in credit losses for Archegos’ counterparties. The SEC is seeking to obtain injunctive relief, disgorgement, and civil penalties, as well as to bar the individual defendants from serving as officers or directors of a public company.

In its press release, Chairman Gensler encouraged prime brokers and other investors to pay close attention to the risks associated with counterparty relationships and highlighted the SEC’s ongoing work to update the security-based swaps market. #$36Bhouseofcards #marketmanipulation #TotalReturnSwaps

5. SEC Files First ESG Enforcement Action After Formation of Climate and ESG Task Force

On April 28, 2022, the SEC filed a complaint in the Eastern District of New York against Vale S.A., a Brazilian mining company whose American Depositary Shares trade on the NYSE, alleging the company made false and misleading claims about the safety of its dams prior to the collapse of its Brumadinho dam, which caused 270 deaths and allegedly led to a loss of more than $4 billion in Vale’s market cap.

Specifically, the SEC alleged that Vale manipulated multiple dam safety audits, obtained fraudulent stability certificates, and regularly misled local governments, communities, and investors about the dam’s stability through its ESG disclosures, despite knowing the dam did not meet internationally recognized safety standards. For example, Vale claimed on its 2017 Sustainability Report that “100% of the audited structures were certified to be in stable condition…by the responsible auditors,” but the SEC alleged that Vale concealed reports made by the company’s safety auditors and engineers, who determined that the dam was at risk of rupturing due to internal strains from excessive rainfall.

The complaint against Vale charges scienter-based violations of the federal securities laws and is being litigated by the company. The complaint does not charge individuals. In announcing the charges, the SEC’s press release highlighted the mandate of the SEC’s Climate and ESG Task Force to identify material gaps or misstatements in issuers’ ESG disclosures, “like the false and misleading claims made by Vale.” #StatementsInSustainabilityReports #ESGdisclosureenforcement #ENFandESG