Data collection and analysis continue to impact SEC’s approach to enforcement.
The increasing use of data analytics to jump-start investigations and enforcement efforts dominated the panel discussion at this year’s “SEC Speaks” conference, at which senior officials from the US Securities and Exchange Commission (SEC or Commission) gathered to highlight the Commission’s accomplishments in fiscal year 2015 and announce their priorities for 2016. Officials from the SEC’s Division of Enforcement (Enforcement Division or Division) repeatedly emphasized the use of data analytics and collaborative intra-agency efforts to monitor market activity and identify and pursue potential misconduct. The use of data analytics was trumpeted as a powerful tool to inform priorities and policy and to flag potential areas of risk to the markets and investors. Enforcement officials also discussed the increasing use of innovative investigative techniques to streamline investigations and, increasingly, to present investigative findings and legal analyses to registrants at early stages of those investigations.
The Enforcement panel highlighted many “first-of-their-kind” cases that occurred in 2015. These included cases brought by the Division in the following areas:
- Cybersecurity (inadequate policies and procedures related to protecting client data)
- Municipal Securities (consolidated actions against underwriters related to inadequate due diligence regarding issuer reporting obligations)
- Foreign Corrupt Practices Act (first-ever FCPA case against a financial institution, related to improper hiring practices)
- Whistleblower Program (improperly restrictive language in corporate confidentiality agreements)
- Broken-Deal Expenses (firm accused of allocating expenses from unsuccessful buyout opportunities to its private equity funds instead of its co-investors)
- High-Frequency Trading Market Manipulation (firm accused of using an algorithm to place aggressive, rapid-fire trades right before market close to artificially inflate market price)
- Alternative Trading Systems (dark pool operator accused of running a secret trading desk and using information about customer trades to develop trading strategy)
- Conflicts of Interest (asset manager’s failure to disclose conflicts of interest to registered fund boards and advisory clients)
- Distribution-in-Guise (improperly using fund assets to cover costs of marketing and distribution of shares)
Looking ahead, SEC Chair Mary Jo White emphasized three primary areas of focus for the Division in 2016:
- Financial reporting
- Market structure, including actions involving market manipulation (e.g., “spoofing” and “layering”) and continued use of data analysis to detect insider trading
- Structure, disclosure, and sales of complex financial instruments, with an emphasis on protecting vulnerable investors in the retail market
Key Enforcement Issues for 2016
Enforcement Officials Make Clear That Use of Data Analytics Will Continue to Drive Investigations and Enforcement Actions
Enforcement officials repeatedly emphasized their continued collaboration with the Division of Economic and Risk Analysis (DERA) to leverage complex data analytics to develop innovative methods of identifying and responding to potential areas of violative conduct and market risk.
For example, Michael J. Osnato, Jr., Chief of the Complex Financial Instruments Unit, discussed his staff’s collaborative work with DERA to implement smart and agile coding to identify abuses in the complex over-the-counter debt market, with a particular focus on the secondary market. Mr. Osnato reported on a new initiative called “ABS TRACER” where his group, with the help of DERA, is using algorithms to analyze large quantities of trading data from the Trade Reporting and Compliance Engine (TRACE) to pull out trades and identify trading patterns that may indicate misconduct. Mr. Osnato also said that his staff is combining this smart “data crunching” with innovative investigative techniques such as “reverse proffers” to streamline the investigative process and pursue cases with maximum efficiency. In 2016, Mr. Osnato’s unit will be focusing on ratings issues, dealer disclosure practices with respect to the sale of complex debt instruments, and working with the Financial Industry Regulatory Authority (FINRA) to protect retail investors.
The Division’s Financial Reporting and Audit Group and DERA are also working hand-in-hand to detect and prevent potential financial reporting misconduct by corporate issuers. For example, DERA’s Corporate Issuer Risk Assessment (CIRA) dashboard provides the staff with custom metrics that can be used to compare specific companies with their peers in order to help detect relative abnormalities in financial reporting. Margaret S. McGuire, Chief, stated that the Financial Reporting and Audit Group uses CIRA in real time to monitor and compare issuer reporting data. As a result, the Group has identified 270 issuers for further surveillance. Ms. McGuire stated that in 2016, the Group will focus on the adequacy of company internal controls and expects to bring cases against issuers for violations of the internal control provisions of the federal securities laws—even where no fraudulent misconduct exists. Ms. McGuire also indicated that the Group will examine the conduct of auditors and auditing firms for audit failures.
Marshall S. Sprung, Co-Chief of the Asset Management Unit (AMU), reported on how data analytics are driving the enforcement efforts of the AMU. For example, the AMU’s Aberrational Performance Inquiry Initiative continues to review the investment returns of hedge funds in order to identify funds whose returns are outliers when compared to the market, signaling potential misconduct. Mr. Sprung also highlighted the Division’s first-ever action against an asset manager for failing to disclose conflicts of interest to fund boards. In that case, the SEC additionally charged the asset manager’s then-chief compliance officer with causing the violations. Mr. Sprung stated that 2016 priorities will continue to include conflicts of interest, allocation of fees and expenses, best execution, and actions against fund auditors and board members.
Not surprisingly, the Broker-Dealer Task Force is also using data and technology to enhance its enforcement efforts in 2016. Andrew M. Calamari (Regional Director, New York Regional Office) discussed the task force’s use of clearing firm data to investigate excessive trading/”churning.” The task force began using the clearing firm data based on advice from the Office of Compliance Inspections and Examinations (OCIE), which has prioritized churning for years. The Broker-Dealer Task Force also uses data to drive its Alternative Products Due Diligence initiative, which identifies firms that derive a significant portion of their revenue from selling alternative products to retail investors. Mr. Calamari stated that protecting retail investors in the market for alternative products will be a priority in 2016. Associate Director Antonia Chion described the task force’s efforts to combat money laundering by analyzing suspicious activity reports (SARs) filed under the Bank Secrecy Act. In collaboration with the Bank Secrecy Act Review Group, Ms. Chion’s staff uses risk metrics to identify registrants whose SAR filings are deficient, and stated that investigations related to SAR filings are ongoing.
Cybersecurity Remains a Top Focus
Cybersecurity remains a top priority. Enforcement Deputy Director Stephanie Avakian reported that the Division is focused on how firms are meeting their obligations to safeguard customer data under Regulation S-P, starting with the adequacy of their written policies and procedures, and how firms react in the wake of a data breach. Ms. Avakian highlighted three areas of concern for Enforcement: (1) regulated firms’ failure to safeguard information, noting that some have a strong sense of cyber awareness whereas others, in Enforcement’s view, have no sense at all; (2) pursuing hackers where information is stolen and used to gain a market advantage; and (3) examining corporate failures to disclose cyber-related incidents to law enforcement. With respect to disclosure, Ms. Avakian stressed that the Division understands that cyberattacks are fluid situations. She stated that she wants firms to involve law enforcement rather than not disclose data breaches for fear of an investigation, but also said that the Enforcement Division would act where it believed the company violated its obligations to come forward to the agency after becoming aware of a data breach. Ms. Avakian made clear that the agency has yet to bring a case against a company for failing to disclose a data breach, and that a disclosure failure would have to be significant to warrant such a case. She also stressed the importance of implementing appropriate safeguards, including strong written policies and procedures, and cited a recent enforcement action against an investment adviser for failing to adopt written policies and procedures designed to protect customer records and information.
Gatekeepers Remain in Enforcement Spotlight
Enforcement Division Chief Counsel Joseph K. Brenner said that the Division will continue to pursue “gatekeepers” (e.g. auditors, directors, underwriters, rating agencies). Mr. Brenner highlighted three major cases:
- A case against a mutual fund adviser accused of providing mutual fund boards with incomplete or inaccurate information regarding advisory fees and the nature and quality of its services
- An action against a brokerage firm for failing to file SARs to report potential misconduct by a client brokerage firm
- Actions against a transfer agent that ignored red flags when it authorized requests by a company’s CEO to have billions of unregistered shares of his company’s stock issued to himself
Mr. Brenner noted that it is not the aim of the Division to second-guess good faith judgment calls by gatekeepers; rather, enforcement cases against gatekeepers will focus on affirmative misconduct by gatekeepers, conduct inconsistent with regulatory or professional standards of conduct, and conduct inconsistent with affirmative representations made to the public by gatekeepers. Mr. Brenner noted that most cases against gatekeepers involve individual conduct and emphasized that the Division is increasingly seeking remedies tailored to address specific areas of misconduct that form the basis of such enforcement actions. For example, recent settled cases have including case-specific remedies such as prohibiting a lawyer from providing advice on a particular topic, preventing auditors from taking on new clients for a period of time, and requiring companies to implement stringent training requirements.
Heightened Focus on Fraud and Corruption in Municipal Securities Industry
Lee Ann Gaunt, Chief of the Municipal Securities and Public Pensions Unit, described a new initiative that was touted as a mechanism to increase the unit’s ongoing collaboration with criminal law enforcement in the area of public corruption, with particular focus on investment of public pension funds and on government contracts (e.g., the hiring of underwriters). Ms. Gaunt also reported on 2015 results of the Municipalities Continuing Disclosure Cooperation (MCDC) initiative and confirmed that in 2016, the industry can expect to see settlements with issuers who self-reported under the MCDC initiative. Other areas of focus in the coming year according to Ms. Gaunt will include broker-dealer conduct in connection with sales of municipal securities, including suitability, valuation, and underwriter due diligence.
Insider Trading Developments: US Supreme Court to Clarify What Evidence is Necessary to Prove “Personal Benefit” in Insider Trading Cases
Insider trading remains a priority, as reflected in numbers provided by Deputy Director Stephanie Avakian that in the last six years, the Division has brought actions against more than 650 defendants in insider trading cases. Ms. Avakian stated that her staff will continue to bring strong cases this year.
Ms. Avakian also discussed the US Supreme Court’s January 19, 2016, decision to grant certiorari in Salman v. United States, an insider trading case with significant implications for insider trading law. In Salman, the Court will decide what the government must prove in order to show that a tipper in an insider trading case received a “personal benefit” in exchange for a tip. The case came on the heels of the Second Circuit’s decision in United States v. Newman, which held that for purposes of establishing a personal benefit to the tipper, the government must demonstrate “proof of a meaningfully close relationship that generates an exchange that is objective, consequential, and that represents at least a potential gain of a pecuniary or similarly valuable nature.” In contrast, the Ninth Circuit’s decision in Salman caused a circuit split when it held that the “personal benefit” element could be satisfied by showing merely that the insider intended to benefit a trading relative or friend. The Supreme Court’s decision will resolve this circuit split.
Ms. Avakian stated that the Newman decision, to date, has not had a major impact on the Division’s enforcement efforts in bringing insider trading cases, explaining that courts have declined to extend Newman’s holding beyond the facts of Newman. For example, Ms. Avakian observed that in United States v. Riley—decided after Newman—the court held that career advice and investment advice could qualify as a “personal benefit.” She also pointed to the decision in SEC v. Payton, in which the court allowed the Commission’s insider trading case involving two roommates with a history of mutual favors to survive the defendants’ motion to dismiss. Notably, Payton and Salman were both written by the same judge—Judge Jed Rakoff of the Southern District of New York—who was sitting by designation in the Ninth Circuit at the time Salman was decided.
The Supreme Court’s decision will therefore clarify whether the lesser burden articulated in Salman and Payton is all that is required of the government, or whether the more stringent standard articulated in Newman will be the rule going forward.
2015 Enforcement Program Highlights
A Year in FCPA “Firsts”
FCPA Unit Chief Kara A. Brockmeyer highlighted several “firsts” for the Foreign Corrupt Practices Act (FCPA) Unit in 2015. In its first-ever FCPA case against a financial institution, the Commission settled with a financial firm where the Division alleged that the firm improperly provided student internships to (unqualified) family members of foreign officials. Ms. Brockmeyer forecasted that the industry can expect to see similar cases in 2016. She also highlighted that the Commission had entered into its first-ever deferred prosecution agreement with an individual in an FCPA case, deferring charges against a Chinese national in exchange for significant cooperation with the Commission’s investigation of a technology company and its Chinese subsidiaries. Ms. Brockmeyer said that the FCPA Unit will ramp up its focus on pharmaceutical companies, and also pledged that the Division will bring more stand-alone cases, including cases involving no bribery charges.
Whistleblowers, Deferred Prosecution, and Limited Penalties as Incentives for Self-Reporting
Sharon B. Binger, Regional Director for the Philadelphia Regional Office, reported on the Division’s whistleblower and cooperation programs. With respect to the whistleblower program, Ms. Binger reported that in 2015 the Division brought its first-ever case against a public company for requiring employees to sign confidentiality agreements that prohibited them from discussing possible violations of the securities laws with the SEC, which is in violation of Securities Exchange Act Rule 21F-17. Ms. Binger signaled that the Division would continue to look for covenants restrictive in either word or effect that could interfere with the right to bring information to the Commission. In 2015, the Commission made its largest award to date, authorizing a $30 million award to a whistleblower on September 22. The Commission also authorized its first-ever award to a company outsider who provided a detailed analysis of trading information that led to a successful enforcement action that granted an award of $700,000. With respect to the Enforcement Cooperation Program, Ms. Binger reported that since the program’s inception, the Division has offered 103 cooperation agreements, six non-prosecution agreements, and nine deferred-prosecution agreements—as well as reductions in monetary relief, suspensions, and bars—to firms and individuals that cooperate with investigations and enforcement actions. However, she noted that cooperation credit is only available to companies who share results of internal investigations with the government, and cautioned that companies who don’t self-report possible misconduct or otherwise cooperate are taking a gamble.
What Does All of This Mean?
As the Division makes use of data analytics to investigate financial reporting and insider trading, monitor market structure and stability, and police the structure and sale of complex financial instruments, industry participants can expect to be under a near-constant state of investigation, examination, and/or surveillance in 2016. Moreover, using the tools discussed above, the Division can now review and analyze more data more quickly than ever before, meaning that firms can expect more investigations and enforcement actions. Additionally, registrants can also expect to be confronted with such data and asked to explain what it means at earlier stages in an investigation.