At a recent Practicing Law Institute panel, several of the regulators, including the Director of the Division of Enforcement at the Securities and Exchange Commission (SEC), spoke about the general priorities and trends in the enforcement area.
One trend, while not a type of misconduct, but rather a method of detecting it, is the SEC’s focus on ‘big data’. The SEC and other regulators are making a practice of analysing data, including trade reporting and compliance engine (TRACE) data, which includes transactions in complex financial instruments, to identify patterns that would suggest potential misconduct.
The process involves a request by the SEC for the full trade blotters or, in the case of a clearing firm, several years of trading data. From there, the data is reviewed and analysed for patterns that may indicate activities such as insider trading, cherry picking, unsuitable mark-ups and unsuitable sales. In the first instance, if the SEC detects a potential issue, it will likely approach the firm and open a dialogue to determine whether there is an acceptable explanation for the pattern identified.
The SEC has found this approach to be very helpful. During 2016, it was used to bring enforcement actions against two dealers in respect of their retail structured notes activity. The SEC brought a successful ‘failure to supervise’ case against one bank based on a review of such data. The action was based on the bank’s failure to train its employees to determine the suitability of certain investment products. It was determined that sales of such products were made to thousands of unsophisticated clients.
In the context of data analysis, the SEC has made a point of emphasising the importance of self-reporting and cooperation by entities and individuals.
Investment advisor enforcement
Over the past several years, the SEC has increasingly focused on the regulation of private equity firms. In 2016, there were approximately a dozen actions against such firms for activities such as undisclosed accelerated monitoring fees, failure to register as a broker dealer and commission fees charged to accounts in the absence of a policy governing such fees.
In respect of the SEC’s dealings with these firms, there is a strong emphasis on transparency by limited partners, as well as disclosure, particularly in respect of changes to fees and expenses policies. The SEC is also focused on valuations, which the industry generally acknowledges can be difficult. However, advisors must have policies and procedures in place to avoid providing false valuations. In addition, it is vital that auditors and fund administrators investigate circumstances that raise red flags, in order to provide a valid defence against any potential issues with the regulators.
Not surprisingly, the SEC is continuing its focus on insider trading activities. However, at this moment, the SEC, along with the rest of the industry, is awaiting a key decision in the Salman case, which is currently pending before the Supreme Court. The Court heard oral arguments in early October 2016 and a decision has not yet been issued.
Under current law, there is currently a split between the 2nd Circuit Court of Appeals (New York) and the 9th Circuit (California) with respect to the type of benefit that a tipper must receive in exchange for the material, non-public information in order to establish liability. In the 2nd Circuit case (Newman), the Court held that in order for liability to attach, a tipper must receive a benefit in the form of “an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature.” In Salman ( the 9th Circuit case) the court held that the benefit could be a shared family relationship. In Salman, the original tipper passed the inside information to his brother, Mr Kara, who in turn passed it to his future brother-in-law, Mr Salman. Mr Kara did not receive any tangible benefit for leaking this information. However, the government’s argument is that leaking the information as a gift to a family member is akin to receiving a personal benefit; the defence’s position is that a more tangible benefit (that is, something that can be monetised) is required.
As a result of this pending case, at least until the Supreme Court decides one way or the other, the SEC’s current (and possibly future) investigations will be more focused on the personal benefit issue in insider trading cases than previously.