The Securities Enforcement Forum West 2018 brought together current and former senior U.S. Securities and Exchange Commission and U.S. Department of Justice officials, securities enforcement and white-collar attorneys, in-house counsel and other professionals to discuss current enforcement trends. This year’s conference featured a keynote speech by Robert Cohen, chief of the newly-established Cyber Unit of the SEC’s Division of Enforcement, as well as commentary by two regional directors: Jina Choi, director of the SEC’s San Francisco Regional Office, and Michele Wein Layne, director of the SEC’s Los Angeles Regional Office.
As discussed below, the May 10 event included panels covering enforcement related to private companies, cyber security and cryptocurrency—the latter two having only recently come to the forefront of discussions among the regulators and practitioners. The cryptocurrency panel included Michael Dicke, co-chair of the securities enforcement group at Fenwick.
Although IPO activity has increased this year compared to last year, many late-stage companies remain private. Responding to criticism that the SEC should focus only on public companies and allow institutional investors in private companies to make their own investment decisions, Choi observed: “If no one is policing private markets, that’s a problem.”
In addition to Choi’s comments, Erin Schneider, associate regional director for enforcement in the SEC’s San Francisco Regional Office, emphasized three recent enforcement actions that illustrate the SEC’s concerns with the private market:
- Credit Karma: In March 2018, the SEC announced a settled proceeding against San Francisco-based Credit Karma for issuing almost $14 million in stock options to employees over a one-year period without a valid registration exemption. The SEC concluded that the company did not qualify for an exemption under Securities Act Rule 701 because it did not provide required financial information and disclosures to its employees. Significantly, Credit Karma provided financial statements and risk disclosures to potential institutional investors but failed to provide the same information to its own employees due to confidentiality concerns. According to Schneider, the case illustrates the SEC’s concern that some private companies are issuing large amounts of securities to employees but failing to recognize that their employees are also investors who are entitled to essential information about their investment. She further noted that there may be additional cases against other companies for failing to comply with pre-IPO disclosure requirements. Our commentary on the case can be found in our earlier analysis: “SEC Fines Private Company in First Enforcement Action Resulting from Rule 701 Option Grants Investigation.”
- Theranos: In March 2018, the SEC announced an enforcement action against Silicon Valley-based Theranos, as well as its CEO and its former president. At issue were numerous allegedly false and misleading statements regarding the company’s blood testing technology, which would purportedly revolutionize the industry by allowing comprehensive blood tests from finger drops of blood. Schneider’s comments emphasized the SEC’s concerns that private companies may commit intentional fraud by overstating the efficacy of their technology. She also noted that as part of the settlement, the CEO (and founder) undertook to give up a supermajority of voting shares, enhancing the board’s ability to exercise oversight. It is unclear whether the SEC will enter into other settlements containing similar provisions, but it is apparently something the SEC may consider.
- Zenefits: In October 2017, the SEC announced a settled proceeding against San Francisco-based Zenefits and its founder, Parker Conrad, for making material misstatements and omissions in connection with the company’s Series B and Series C financings. The company provides a cloud-based platform for managing human resources functions, including the purchase of employee health insurance policies. Although the company operated in a highly-regulated industry, according to the SEC, it made material misrepresentations and omissions about its compliance with state insurance licensing laws and failed to disclose that its controls were insufficient to ensure compliance. Schneider noted that the SEC is likely to level greater scrutiny on private companies as they expand their reach and begin to receive financing from mutual funds and other investment vehicles for retail investors and retirement funds.
Public Companies Must Establish Thoughtful Controls around Cybersecurity Disclosures
Over the past year, the SEC has clearly signaled its interest in ensuring that public companies adequately disclose material cybersecurity risks and incidents. On February 21, 2018, the SEC issued guidance on cybersecurity disclosures, and on April 24, 2018, the commission announced its first enforcement action for failure to disclose a material data breach. (See Fenwick articles “SEC Releases Updated Cybersecurity Guidance” and “Yahoo’s $35M SEC Settlement: Takeaways from the First Enforcement Action for Failure to Disclose a Data Breach.”) The SEC has previously emphasized that disclosure of cybersecurity incidents can involve complex technical issues and difficult judgment calls, particularly where public disclosure may lead to further harms, and enforcement staff have repeatedly emphasized that the SEC does not intend to “second-guess good faith exercises of judgment about cyber-incident disclosure.”
Cohen and other SEC officials clarified that a good faith judgment to not disclose a cyber incident must be grounded in a thoughtful and robust process for analyzing cybersecurity disclosure obligations. For example, public companies should make sure to address each of the following issues before a cyber incident occurs:
- What is the company’s most important data (i.e., its “crown jewels”), and where does it reside in the company’s infrastructure?
- What is the company’s incident response plan for investigating and analyzing potential cyber incidents? Do employees have a sufficient understanding of the incident response plan to implement it in the event of a cyber incident?
- How does information get escalated within the company to determine the business impact, reputational harm, and other factors in determining the materiality of the cyber incident?
- What is the company’s process for assessing its disclosure obligations, and did it seek advice from external experts (e.g., outside counsel, outside auditors or other external consultants)?
SEC officials also noted that they would consider whether there were any indicia of bad faith or misconduct, such as an attempt to cover up a material disclosure. This exception further emphasizes the need to establish robust controls in advance so that nondisclosure of a cyber incident can be explained with respect to existing processes rather than as the result of a post hocrationalization based on the desired outcome.
It remains to be seen how actively the SEC intends to police nondisclosures of cyber incidents. A number of SEC officials emphasized the fact that the February 2018 guidance was issued by the commission, not by staff, and as such was a reflection of the SEC’s priorities. However, Cohen emphasized that this is not an area where the SEC expects to bring dozens of cases each year. Taken as a whole, the comments suggest that the SEC will bring a limited number of targeted enforcement actions where companies have departed significantly from the baseline best practices outlined by the SEC.
The SEC is Focusing Increasing Attention on Cryptocurrencies and Initial Coin Offerings
Perhaps no issue attracted greater attention at this year’s enforcement forum than discussions on several panels of the SEC’s increasing enforcement role in the exploding cryptocurrency and ICO markets. Cryptocurrencies have experienced exponential growth over the past few years, and the cryptocurrency market is now valued at almost $400 billion. And the number of companies interested in offering crypto assets to raise capital grew in kind, with more than 400 ICOs that raised over $6.5 billion, by some counts, in 2017 alone.
In July 2017, the SEC issued an investigative report analyzing virtual tokens offered and sold by a Decentralized Autonomous Organization, or DAO. The DAO was a virtual organization embodied in computer code and executed on a distributed ledger or blockchain. The SEC analyzed The DAO tokens using the test articulated in SEC v. W.J. Howey Co., 328 U.S. 293 (1946) and concluded that the tokens were securities subject to the federal securities laws because (1) investors in The DAO invested money in a common enterprise (2) with a reasonable expectation of profits (3) derived from the managerial efforts of others. Since The DAO Report was issued, the SEC has announced a number of enforcement actions against ICOs based on allegations of fraud. Significantly, in December 2017, the SEC also brought an enforcement action against Munchee based not on any perceived fraud, but solely on its failure to register its tokens as required under the securities laws because the company had advertised the tokens as an investment that would increase in value. Our commentary on those developments can be found in: “The SEC and Plaintiffs’ Class Action Attorneys Are Targeting Initial Coin Offerings.”
Cohen and other SEC officials emphasized that the purpose for The DAO Report was to provide notice that virtual tokens can be, and often are, securities. While the SEC encourages innovation in capital formation, it will also enforce the federal securities laws where appropriate. Companies and individuals seeking to issue virtual tokens through ICOs must either register the offering, qualify for an exemption from registration, or be prepared to demonstrate that the token does not qualify as a security under the Howey test. Cohen noted that there are a number of ongoing investigations into registration issues, and that there are likely to be additional enforcement actions with increasing penalties for noncompliance if ICOs do not start complying with registration requirements.
During the cryptocurrency and ICO-specific panel, SEC Enforcement Assistant Director Steven Buchholz emphasized that any decisions as to what is and is not a security will take place on a case-by-case basis, and that we are unlikely to see an instance where the commission declines an investigation because it does not believe it has jurisdiction.
Another topic of interest were the inconsistent enforcement postures of the various administrative agencies like FinCen, CFTC, DOJ and the SEC, which is causing uncertainty in the blockchain industry, and could lead to due process concerns for enforcers if entrepreneurs are unable to know in advance what conduct violates the law. Taking a different tack, the panel also discussed the difficulty in applying traditional GAAP principles to determine the value of these crypto assets that are not connected to equity or revenue.
Finally, Dicke pointed out that we were already seeing an uptick in private litigation in the crypto space, including everything from investor class actions to founders’ disputes to litigation over intellectual property rights. In a recent example, Ripple, a top-five digital currency by market cap, is facing an investor class action suit for a loss the named plaintiff took on his resale of Ripple’s XRP coin. The panel agreed that as long as the SEC and other regulators continue to treat token issuances as securities offerings, the number of investor class actions inevitably will increase.