The Securities and Exchange Commission (SEC) continues to devote resources to examining private fund managers. SEC officials have described the agency’s plans for private fund managers at several industry events held in 2014. In particular, private fund managers should be aware of:
- the SEC’s continued focus on insider trading;
- the possibility that more enforcement actions will be brought in SEC administrative proceedings (rather than in federal courts); and
- the SEC’s new technological capabilities.
Background: SEC’s Enforcement Jurisdiction
A firm, such as a private fund manager, that falls within the definition of “investment adviser” (and is not eligible for an exclusion or otherwise prohibited from registering) gener- ally must register with the SEC pursuant to the Investment Advisers Act of 1940, as amended (Advisers Act). Registered investment advisers are subject to the requirements of the Advisers Act, which include:
- fiduciary duties to clients;
- substantive prohibitions and requirements;
- contractual requirements with clients;
- recordkeeping requirements; and
- administrative oversight by the SEC.
Although many individuals who are employed by firms that are registered investment advisers, including private fund managers, may also fall within the definition of “investment adviser,” the SEC generally does not require those individu- als to register. Instead, the firm must register; its registration covers its employees and other persons under its control (so long as the individuals’ advisory activities are undertaken on behalf of the firm).1
The Advisers Act contains several provisions granting the SEC the power to impose disciplinary sanctions and other penal- ties on registered investment advisers and their affiliated persons.2 These include the power to restrict the investment adviser’s activities and impose monetary sanctions.
In addition to the Advisers Act, the SEC may also bring en- forcement actions against private fund managers and their employees for violations of other U.S. federal securities laws including, among others, the Securities Act of 1933, as amended (Securities Act) and the Securities Exchange Act of 1934, as amended (Exchange Act).
“SEC Speaks in 2014” Focus on Enforcement
The SEC held its annual “SEC Speaks” conference in Washington, DC, from February 21-22, 2014, at which senior staff reviewed significant developments from the prior year and discussed current and upcoming enforcement priorities. SEC Chair Mary Jo White made clear that the agency is eager to complete and move beyond its extensive rule-making re- sponsibilities mandated by the Dodd-Frank Act and JOBS Act to focus on and understand the ever-changing financial markets. Chair White noted that she set three priorities when she arrived at the SEC in April, 2013:
- rule making;
- ensuring that the equity markets are structured and operate efficiently; and
- increasing the robustness of the enforcement program.3
With respect to the enforcement program, Chair White noted that enforcement will continue to be one of the SEC’s top pri- orities and cited 169 charges, brought under her watch, tied to the financial crisis (including 70 brought against high-rank- ing executives) that resulted in $3.4 billion in disgorgement and other civil penalties. She remarked that, during that time, the SEC “brought landmark insider trading cases and created specialized units that pursued complex cases against invest- ment advisers, broker dealers and exchanges…. But there is always more to do.”
The SEC pursued a number of insider trading actions against private fund managers and their employees in 2013 and has continued that trend in 2014.4 In particular, Matthew Solomon, the SEC’s Chief Litigation Counsel for Enforcement, discussed changes to the SEC’s approach to insider trading cases. He noted that the recent SEC v. Contorinis decision provides the SEC with a powerful tool for settlement nego- tiations. In SEC v. Contorinis5 the U.S. Court of Appeals for the Second Circuit affirmed an order requiring Contorinis, for- merly a managing director at Jeffries & Company, Inc. who co-managed the Jeffries Paragon Fund, to personally disgorge more than $7 million in insider trading profits realized by the fund even though he did not personally realize those gains.
SEC Administrative Actions Versus Suits Brought in Federal Court
Private fund managers should expect the SEC to bring more actions through administrative proceedings than in the past. Given the differences between a court action and an admin- istrative proceeding before the SEC, private fund managers should take note of the manner in which the SEC is currently utilizing the administrative process.
Andrew Ceresney, then the Co-Director of Enforcement, told a Practicing Law Institute6 audience that he expected the SEC to bring more administrative proceedings (relative to court actions) given the recent statutory changes conferring addi- tional powers on the SEC. Those changes granted the agency broad authority to impose civil monetary penalties in ad- ministrative proceedings in addition to the cease-and-desist orders previously available.7
In an administrative proceeding the SEC can seek many of the remedies also available to it in a federal court action, includ- ing civil monetary penalties and disgorgement, censures, bars from association with the securities industry, cease and desist orders and suspension or revocation of investment adviser (or broker-dealer) registrations. Administrative proceedings differ from civil court actions in that they are conducted by an SEC administrative law judge (ALJ), an independent judi- cial officer conducting public hearings in a manner similar to non-jury trails in federal district court. Following the hearing the ALJ issues an initial decision that includes findings of fact, legal conclusions and the suggested remedy, if any. Both the SEC staff and the respondent may appeal all or any portion of the initial decision to the SEC’s commissioners (the Commission). The Commission may affirm the decision of the ALJ, reverse the decision, or remand it for additional hearings. The Commission’s decision can be appealed in federal court.
There are a number of important procedural differences between an SEC administrative hearing and a proceeding in federal court. SEC administrative proceedings, among other differences, (1) offer only limited discovery to a respondent (the inability to depose witnesses can put a respondent at a disadvantage because the SEC has the ability to take the testimony of a witness outside the presence of any defense counsel other than counsel to that particular witness during the investigation leading up to an administrative proceed- ing), (2) are expedited (this expedited process can put a re- spondent at a disadvantage because the SEC, unlike the re- spondent’s lawyers, has full access to the investigative record before the administrative proceeding begins) and (3) offer no right to a jury trial.8
Example of the SEC’s Use of its Administrative Forum: Failure to Supervise Action
During his keynote address at a recent seminar,9 Andrew Calamari, Director, New York Regional Office of the SEC, suggested that the private funds industry can expect the SEC to bring administrative actions against individuals and entities for failure to supervise employees using the blue- print developed in its well-publicized 2013 action against Steven A. Cohen.10
The SEC’s decision to bring an administrative action against Cohen, alleging failure to supervise,11 instead of a charge of insider trading in federal court, may signal an important shift in its enforcement strategy. In the past the SEC has generally brought failure to supervise actions against broker-dealers or chief compliance officers for systematic failures to main- tain, for instance, adequate regulatory procedures and com- pliance tools and typically involve the failure of a supervisor to perform specified tasks. Charging Cohen with failure to supervise marked a departure from the SEC’s traditional use of that action.
When the SEC brings an insider trading case against a private fund manager and/or its employees under the Exchange Act, it must prove that the respondent knowingly engaged in insider trading (or recklessly disregarded the fact that it was taking place). In an administrative action brought under the Advisers Act alleging failure to supervise a person acting on his or her behalf, the SEC need only prove that the respondent was negligent with respect to that failure. Notwithstanding the SEC’s decreased burden of persuasion in a failure to supervise action, a private fund manager and/or its employ- ees may face severe penalties, including fines, censures and bars from association with the securities industry.
If the SEC continues to make greater use of its administrative forum, private fund managers and their employees may find themselves charged with an action for failure to supervise that, in the past, might not have been pursued by the SEC in federal court.
New Technologies and Industry Knowledge
Private fund managers should be aware of certain new tech- nological tools that the SEC has developed that will, among others, be employed during examinations and on which the SEC will likely rely for routine market regulation and monitor- ing and general enforcement activities.
In her speech to the 41st Annual Securities Regulation Institute, Chair White noted that the securities markets have been revolutionized by advances in computing power and other technology and that it is the SEC’s job to not only “keep pace with this rapidly changing environment, but, where pos- sible, also to harness and leverage advances in technology to better carry out our mission.”12 She briefly described a new SEC computer program, developed by the Quantitative Analytics Unit of the National Exam Program, called the National Exam Analytics Tool (NEAT) and a trade data analysis program called the Market Information Data Analytics System (MIDAS), each of which is discussed below.
NEAT is an analytical tool that can be applied to sift through trading data to detect trading patterns. It is expected to be used during examinations and will permit the SEC’s examin- ers to access and systematically analyze massive amounts of a private fund’s trading data. Chair White noted that NEAT will allow SEC examiners to compare a “database of signifi- cant corporate activity like mergers against the companies in which a registrant is trading and analyze how the registrant traded at the time of those significant events.” 13 For instance, NEAT may be used during an SEC examination of a hedge fund manager to search for evidence of insider trading by reviewing every trade that a private fund manager executed around the time of a merger or earnings announcement to detect suspi- cious trading patterns.
Andrew Calamari, speaking both at a recent seminar14 and at an industry event held on April 8, 2014, noted that he expects NEAT to revolutionize the SEC’s ability to detect patterns of insider trading, front running and violations of Regulation M, among others. He described an example of an examina- tion of a registered investment adviser in which NEAT was able to download three years’ worth of the manager’s trade blotter and, within 36 hours, analyze nearly seventeen million transactions.
Unlike NEAT, which is designed to be used in examinations of investment advisers, MIDAS collects vast amounts of in- formation about the broad activities of the markets. It col- lects more than one billion records per day from each of the 13 national equity exchanges, each time-stamped to the mi- crosecond. MIDAS allows the SEC to access data about every displayed order posted in the national exchanges in near real- time. MIDAS is designed to give the SEC the horsepower to monitor market activities as they happen, and can be used in forensic analysis to spot abnormal trading patterns.
The SEC expects that this type and amount of trading data may help reduce speculation about the behavior of the current market structure by, for instance, monitoring and helping to understand mini-flash crashes, reconstructing market events and developing a better understanding of long-term market trends. Certain parts of the MIDAS system are accessible on the SEC’s website and the SEC has and plans to continue making available market studies based on trading pattern analyses performed by MIDAS.