On November 2, 2018, the SEC Enforcement Division (“Division”) released its Annual Report summarizing the past year’s enforcement activity. In the 2018 fiscal year, the first full fiscal year that Stephanie Avakian and Steven Peikin served as Co-Directors of the Division, the SEC brought 821 enforcement actions, up from 754 in fiscal year 2017 and obtained US$3.945 billion in disgorgement and penalties, a slight increase compared to fiscal year 2017’s US$3.789 billion in recovery. While setting forth the relevant enforcement statistics, the Co-Directors of the Division emphasize the importance of evaluating the Division’s efforts through qualitative assessments rather than solely through quantitative measures, a theme that Ms. Avakian had previewed in a September 20, 2018 speech.
The Annual Report notes that recommending actions against important market participants, protecting retail investors, creating effective remedies, and addressing emerging risks highlight the success of the Division in ways that quantitative assessments may not. The Co-Directors also highlight that in fiscal 2018, the Division was dealing with budgetary and personnel cutbacks, as well as the Supreme Court’s decision in Kokesh v. SEC,1 which confirmed a five year time limit on the SEC’s ability to seek disgorgement. The Co-Directors estimate that the Kokesh decision caused the Division to forego approximately US$900 million in such remedies in fiscal 2018.
The remainder of the Annual Report reiterates the five core principles the Co-Directors announced in the 2017 Annual Report, describes the Division’s key initiatives and summarizes key enforcement data over the 2018 fiscal year.
Five Core Principles
The Annual Report begins by setting forth the specific actions that the Division has taken over the past year to further the five core principles the Co-Directors introduced last year: (1) focusing on the Main Street investor, (2) focusing on individual accountability, (3) keeping pace with technological change; (4) imposing remedies that most effectively further enforcement goals; and (5) constantly assessing the allocation of the Division’s resources. With regard to the focus on the Main Street investor, the Annual Report notes the “hundreds” of cases of misconduct targeting retail investors that the Division has investigated and recommended to the Commission, as well as hundreds of additional investigations that were in process at the end of the fiscal year. The Annual Report also highlights the US$794 million returned to harmed investors.
The Division’s second core principle is a focus on individual accountability, which includes pursuing actions against employees for wrongdoing. In fiscal year 2018, the SEC charged individuals in more than 70% of stand-alone enforcement actions. This number was slightly down from fiscal year 2017, where individuals were charged in over 80% of such actions.
The Division is pursuing its third core principle, keeping pace with technological change, mainly through a Cyber Unit, which became fully operational in fiscal year 2018. In conjunction with the Department of Justice, the Cyber Unit investigates and prosecutes cyber-related misconduct. The Division has pursued registration violations, false regulatory filings used for price manipulation, misuse of the dark web, and misconduct surrounding initial coin offerings (“ICOs”), which have boomed over the past year, among other violations.
As for the fourth core principal, the Annual Report describes the use of remedies beyond disgorgement, penalties, bars, and suspensions (though these remain the remedies used in most cases), to address misconduct. For example, the Annual Report specifically mentions the recent SEC actions against the CEOs of Theranos and Tesla. The SEC’s action against the Theranos CEO resulted in stripping her of super-majority voting control and limiting her ability to benefit from a potential sale or liquidation. The SEC’s action against the Tesla CEO resulted in significant changes to the corporation’s governance, including the composition of the board, the inclusion of independent directors, and oversight over the CEO’s communication practices.
With regard to the Division’s final core principle, the Annual Report points to the shift in resources to address emerging risks including cyber threats and ICOs, as an example of the Co-Directors’ commitment to ensuring that the SEC’s resources are allocated efficiently.
With the Division’s core principles in mind, the Co-Directors describe their key initiatives over the past year: the Retail Strategy Task Force (“RSTF”), the Cyber Unit, and the Share Class Selection Disclosure Initiative.
The RSTF, formed in fiscal year 2018, works with data analytics groups within the SEC on a number of issues to pursue misconduct affecting retail investors, including fee disclosures, market manipulation, and fraud. The RSTF also works on technology-related initiatives involving fraud in the cryptocurrency and distributed ledger technology areas.
The Cyber Unit has assisted the Division in pursuing cyber-related misconduct since it was created in fiscal year 2018. The Annual Report notes that in the past year, the SEC brought 20 stand alone cases related to cyber activity and had over 225 cyber-related investigations ongoing at the end of the year. The Annual Report also highlights the SEC’s first action against an entity for violating the Identity Theft Red Flags Rule, following a cyber intrusion into a broker-dealer’s systems that caused the release of customers’ personal information.
The Annual Report also emphasizes the Division’s concerns with ICOs and digital assets that lack significant track records, viable products or the ability to safeguard assets from theft by hackers. To address threats in this area, the Division has not only used public statements to warn against unlawful promotion of these products, but also recommended enforcement actions in some instances and recommended trading suspension of certain securities. In fiscal year 2018, the Division opened dozens of investigations involving fraud and registration deficiencies among ICOs and digital assets. The Division also pursued actions related to public company disclosures of cybersecurity risks and intrusions. Most notably, Yahoo! settled an action related to the then-largest cyber intrusion in history by paying a US$35 million penalty.
The last key initiative addressed in the Annual Report is the Share Class Selection Disclosure Initiative, which pursues misconduct related to marketing and distribution (or 12b-1) fees charged to investors in certain mutual fund share classes. This initiative is a voluntary program allowing investment advisors to self-report failures to disclose conflicts of interest related to their compensation from 12b-1 fees. Under this initiative, the Division recommends a settlement with standardized terms that will include a cease-and-desist proceeding for violations of Sections 206(2) and 207 of the Advisers Act, the payment of disgorgement and prejudgment interest, and an acknowledgment that the adviser has or will provide specified undertakings related to the misconduct. In exchange for self-disclosure, the Division will recommend that the Commission not impose any civil penalties. The Annual Report discusses the alleged persistence of share class selection misconduct and its desire to identify and remediate as many violations as quickly as possible.
2018 Enforcement Results
In the 2018 fiscal year, the SEC brought 821 enforcement actions, up from 754 in fiscal year 2017. Of these, 490 were stand-alone actions brought in federal court or administratively (up from 446 in fiscal year 2017), while 210 were follow-on proceedings based on prior administrative or criminal actions. The remaining 121 actions were proceedings to deregister public companies that were delinquent in their SEC filings. The Annual Report also notes that the most common types of stand-alone actions were those related to securities offerings and investment advisory issues, constituting 25% and 22% of actions, respectively. Both of those categories saw marked increases, with approximately 30% more actions compared to the prior fiscal year. Conversely, stand-alone actions concerning issuer reporting and disclosure and market manipulation actions saw modest reductions in enforcement activity.
The SEC obtained US$3.945 billion in disgorgement and penalties, a slight increase compared to fiscal year 2017’s $3.789 billion in recovery. While the overall amount of money recovered was similar to last year, disgorgement and penalties moved in opposite directions. Disgorgement dropped from US$2.957 billion to US$2.506 billion. The Annual Report refers to the Kokesh decision repeatedly in explaining new challenges to seeking disgorgement. Unlike the disgorgement numbers, SEC penalties rose significantly in 2018, from US$832 million to US$1.439 billion. However, the Annual Report discloses in a footnote that a large majority of penalties (over US$853 million) were assessed in one case, which the SEC announced three days prior to the end of the 2018 fiscal year.2 Absent this case, penalties would have dropped 30% from fiscal year 2017 to approximately US$586 million. Similarly, 60% of the $794 million that the SEC returned to investors in fiscal year 2018 came from one Fair Fund.3
Expectations for 2019
Fiscal year 2018 was the first full year of Ms. Avakian’s and Mr. Peikin’s leadership at the Division. As such, its current priorities are clearer today than they were at this time last year. We expect the Division to continue focusing on misconduct that impacts retail investors, including a push for more self-reporting through disclosure initiatives, as well as increased capability and pursuit of wrongdoing related to digital assets and cybersecurity. As ICOs continue to proliferate and digital assets become more sophisticated, we believe that the Cyber Unit will become a larger part of the Division’s enforcement program, at least in the short to medium-term. Companies should consider systematic and nimble approaches to confronting constantly changing threats posed by cyber intrusions. The Division and the SEC more broadly will continue to upgrade their data analytics capabilities, and companies may want to consider how to integrate data analytics into their own compliance programs.
We also believe that the Division’s efforts and initiatives using traditional investigatory and enforcement tools will continue apace over the next fiscal year.