Insider trading has been a focus of Securities and Exchange Commission (SEC) enforcement actions and we anticipate that this trend will continue in 2014. Private fund managers should take note of the SEC’s current approach to enforcement actions, particularly its relatively new admissions policy.

The SEC was busy pursuing enforcement actions in 2013 and shows no signs of slowing its pace in 2014. 2013 was a record year for SEC enforcement actions and, on December 17, 2013, the agency announced that enforcement actions for the year resulted in $3.4 billion in monetary sanctions ordered against “wrongdoers.”1 The SEC filed 686 enforcement actions in the fiscal year ended in September, 2013. That number represents a 22% increase from 2011, when the SEC filed the most actions in agency history. The SEC pursued insider trading actions against employees of, among others, affiliates of S.A.C. Capital Advisors, Whittier Trust Company, Level global Investors, galleon Management, Whitman Capital and Tiger Asia Management.2

“Broken Windows” Strategy

As SEC Chair Mary jo White stated in her so-called “broken windows” speech, “investors in our markets want to know that there is a strong cop on the beat – not just someone sitting in the station house waiting for a call, but patrolling the streets and checking on things…. I believe the SEC should strive to be that kind of cop – to be the agency that covers the entire neighborhood and pursues every level of violation.”3 She likened this enforcement approach to that of former New york City Mayor Rudy giuliani and Police Commissioner William Bratten, who sought to project an air of law and order by essentially declaring that no infraction was too small to punish. Chair White observed that, “[t]he theory is that when a window is broken and someone fixes it, it is a sign that disorder will not be tolerated. But, when a broken window is not fixed, it ‘is a signal that no one cares, and so breaking more windows costs nothing.’ ”

The SEC arguably demonstrated this enforcement approach in 2013. For instance, it announced actions against 23 firms, including a number of hedge fund managers, alleging violations of Rule 105 of Regulation M under the Securities Exchange Act of 1934, which generally prohibits purchasing securities in follow-on and secondary offerings when the purchaser has effected short sales in the securities within a specified amount of time, generally five days, prior to the pricing of an offering.4 The charges resulted in more than $14.4 million in monetary sanctions notwithstanding the fact that the SEC did not allege wrongful intent on the part of any of the firms charged.

Admissions Policy

In june, 2013 SEC Chair White announced that the agency would change its longstanding practice of allowing defendants to settle cases without admitting liability. While it is expected that “neither-admit-nor-deny” settlement statements will remain common, the SEC may require, in the public interest, certain defendants to admit misconduct. While the SEC has not specified under what circumstances it will require admissions as a settlement condition, Chair White did highlight four likely scenarios:

  • A large number of investors have been harmed or the conduct was otherwise egregious;
  • The conduct posed a significant risk to the market or investors;
  • Admissions would aid investors deciding whether to deal with a particular party in the future; and
  • Reciting unambiguous facts would send an important message to the market about a particular case.5

The SEC quickly demonstrated this new policy. It announced in August, 2013 that Philip A. Falcone and his advisory firm, Harbinger Capital Partners, agreed to a settlement in which they would pay more than $18 million and admit wrongdoing (Falcone also agreed to be temporarily barred from the securities industry).6 Falcone admitted to, among other things, improperly borrowing $113.2 million from the Harbinger Capital Partners Special Situations Fund to pay his personal tax obligation. Falcone borrowed the money from the fund at an interest rate less than the fund was then paying to borrow money, at a time when the fund had barred other investors from making redemptions and did not disclose the loan to investors for approximately five months. The SEC announced in September, 2013 that jPMorgan, in connection with the socalled London Whale activities, agreed to settle SEC charges by paying a $200 million penalty, admitting the facts underlying those charges and publicly acknowledging that it violated U.S. securities laws.7,8

Implications of the Admissions Policy

Faced with the prospect of admissions that can be used against them in other proceedings and expose them to collateral damages, many firms and their officers may be incentivized to take more actions to trial.

Admitting liability may subject firms to greater exposure in private litigation. A firm or officer settling with the SEC, in addition to whatever penalties and other sanctions are contained in that settlement, runs a greater risk of liability, and potentially increased damage calculations, in related private actions. There is also the possibility that other state or federal regulators could leverage an admission of liability in a future regulatory or criminal proceeding against the firm or its officers.

Although the precise impact of the SEC’s enforcement priorities is evolving, private fund managers should take notice of the shift in the SEC’s enforcement approach. Particular attention should be paid to the effectiveness of existing compliance and training programs to prevent and detect violations of the securities laws and whether upgrades should be made. In addition, firms that are facing the possibility of an SEC investigation should consider whether and how they will cooperate, including whether to self-report violations and how to address allegations of wrongdoing by individual officers or employees. Individuals similarly will need to weigh how to best respond to SEC inquiries. These decisions are likely to be increasingly important in determining how a matter will be resolved in this new era of aggressive SEC enforcement.