Broker-Dealer Cases

In 2015, the SEC continued to bring large numbers of broker-dealer enforcement actions, with a focus on market structure enforcement cases and fraud and registration-related cases. The escalating number of market structure enforcement actions reflected the SEC’s concern that evolving markets pose new and complex concerns, including a surge in trading venues, automated trading, and the development of high-frequency trading. As Andrew Ceresney, director of the SEC’s Division of Enforcement, explained, today’s markets present issues which “simply did not exist and would have been difficult to conceptualize just ten years ago.” Within this ever-complex market, broker-dealers are often seen as the gatekeepers.

In an effort to tackle some of these issues, the SEC sought to enhance the transparency and fairness of trading systems. In January 2015, the SEC secured its largest penalty to date against an alternative trading system when UBS Securities LLC paid $14 million, including a $12 million penalty, in connection with its inadequate disclosures and other violations related to the marketing of its dark pool. A few months later, the SEC broke its own record, settling similar charges against Investment Technology Group, Inc., (“ITG”) and AlterNet Securities for approximately $20 million, including an even larger $18 million penalty, in connection with ITG’s operation of an undisclosed trading desk and misuse of confidential trading information belonging to dark pool subscribers.

In addition to the SEC’s spotlight on alternative trading systems, the SEC pressed ahead with its enforcement of the market access rule, which requires broker-dealers to maintain adequate risk-management systems that address risks associated with their market access. In June 2015, the SEC imposed a $7 million penalty on Goldman, Sachs & Co. for violating the market access rule by sending thousands of mispriced options orders, due to a software error. The next quarter, the SEC imposed a $5 million penalty on high-frequency trading firm Latour Trading LLC for violating the market access rule by sending millions of improper orders over nearly four years and without the required direct control over its risk-management system. The SEC has explained that the market access rule is an important roadblock to fraudulent and manipulative trading practices, particularly those instigated by overseas traders. In the coming year, the SEC likely will continue ramping up its enforcement of the market access rule.

The SEC also maintained its bread-and-butter enforcement cases against broker-dealers as well—namely fraud and registration-related offenses. In one of many fraud actions, the SEC reached a $180 million settlement with two Citigroup affiliates for several misrepresentations relating to two hedge funds that ultimately collapsed. Also, the SEC settled a “first-of-its-kind” case against UBS AG for $19.5 million in connection with various misstatements and omissions made in offering materials related to structured notes. Finally, the SEC cracked down on unregistered broker-dealers, running the gamut from large entities to small firms and individuals, including, for example: (1) International Capital Group and its executives, that agreed to pay over $4 million to settle charges that they sold billions of shares of penny stocks without proper broker-dealer registration; and (2) an individual and two of his affiliated companies that neglected to register as broker-dealers before offering to help small businesses in Los Angeles raise money and identify potential investors. While similar fraud and registration-related actions will no doubt emerge in 2016, the SEC’s market structure enforcement actions are the cases to closely watch in 2016.

Investment Adviser Cases

The SEC’s enforcement actions brought against investment advisers in 2015 largely mirrored those brought in recent years, with the exception of two trending areas related to the compliance procedures and cybersecurity policies of investment advisers.

Consistent with the SEC’s enforcement priorities in prior years, undisclosed conflicts of interest by investment advisers remained a priority in 2015. As the SEC’s Asset Management Unit noted in early 2015, possible conflicts of interest were being investigated in nearly every ongoing matter. As just one example of its investigative success, two J.P. Morgan subsidiaries agreed to pay $267 million and admitted wrongdoing in connection with their failure to disclose multiple conflicts of interest. In another matter, an investment adviser firm agreed to pay $20 million and engage an independent compliance consultant after it failed to disclose a conflict of interest created by its senior executive’s loan from an advisory client. And in yet another matter, the SEC charged a Wisconsin-based advisory firm and its owner for improperly “cherry-picking” its trades—a fraudulent practice—and another form of an undisclosed conflict of interest whereby the investment adviser allocates profitable trades to preferred accounts. Notably, in its press release announcing the case, the SEC noted that the case was in part the result of data mining by the SEC’s Division of Economic and Risk Analysis.

The SEC also continued to actively enforce violations stemming from improper fees, expenses, and other misrepresentations. In March, the SEC brought charges against an investment adviser and her firms for breaching their fiduciary duties by failing to follow the disclosed valuation policies and thus improperly valuing assets in three collateralized loan obligation funds. As a result, the SEC alleged, the firms subsequently collected almost $200 million in management and other fees to which they were not entitled. The SEC also settled charges against private equity firm Kohlberg Kravis Roberts and Company for $30 million after it misallocated “broken deal” expenses. The SEC imposed its first penalty on an investment adviser and affiliated distributor pursuant to the SEC’s recent Distribution-in-Guise Initiative, which is designed to protect mutual fund shareholders from investment firms that improperly use fund assets to pay for distribution. See our November 2015 Newsletter (“And the Winner Is…The SEC Touts Record Number of Cases for Its FY2015, and Highlights Innovative Firsts”) for other “first-of-its-kind” cases brought in 2015.

Finally, as highlighted in our November 2015 Newsletter (“Return of the Cyborg Part II: First-Ever SEC Cybersecurity Enforcement Action Filed Against Investment Advisory Firm”), the SEC brought its first-ever cybersecurity enforcement action against investment adviser R.T. Jones Capital Equities Management after signaling its growing interest in cybersecurity issues. According to the SEC, R.T. Jones failed to implement adequate cybersecurity policies and procedures as required by Rule 30(a) of Regulation S-P under the Securities Act. Without admitting or denying these findings, R.T. Jones agreed to be censured and pay $75,000. In the wake of this case, the SEC made clear that it will closely examine regulated entities’ cybersecurity policies and procedures, making this largely unchartered territory of SEC enforcement another hot issue in 2016.

Notably, the SEC Enforcement Division received criticism for its aggressive pursuit of compliance officers at investment advisory firms. But not everyone at the SEC agreed with the SEC’s actions. Reacting to charges against BlackRock Advisors LLC and its chief compliance officer in connection with their failure to disclose a conflict of interest created by a portfolio manager’s joint venture, and separate charges against SFX Financial Advisory Management Enterprises and its chief compliance officer in connection with its former president stealing client funds, Daniel M. Gallagher, an SEC Commissioner at the time, released a biting commentary calling for a “hard look” at the SEC rules governing compliance officers’ responsibilities, as well as the SEC’s enforcement approach to their violations. In response, Andrew Ceresney, Director of the SEC’s Division of Enforcement, confirmed that enforcement actions against compliance officers are pursued only in “rare” instances, and that these two actions did not deviate from the SEC’s judicious enforcement approach. While Gallagher’s dissent was met with Ceresney’s assurances, the SEC’s attitude toward investment adviser compliance issues, and its enforcement actions against compliance officers, remains to be seen in the coming year.