2013 proved to be a year of major change for SEC enforcement.  As detailed in our July mid-year update,[1] Chair Mary Jo White came on board in April 2013, and shortly thereafter named Andrew Ceresney and George Canellos as Co-Directors of the Division of Enforcement.  All three are former criminal prosecutors — Chair White served as United States Attorney in Manhattan under President Clinton, and both Ceresney and Canellos were Assistant U.S. Attorneys in her office — and all immediately took steps to embrace an aggressive enforcement program, both in terms of policy and public pronouncements.  (Canellos announced his departure from the agency at the beginning of 2014, leaving Ceresney as sole Director.)

Since that publication, there have been a significant number of new appointments at senior levels of the agency.  The Chicago, San Francisco, Boston, Denver and Salt Lake City Regional Offices all have new regional directors, over half of whom similarly have experience as federal criminal prosecutors.  New leaders were also appointed to several of the Enforcement Division’s specialized units.

With so many senior-level changes, it is little surprise that we have seen shifts not just in enforcement policy and priorities, but in the handling of ongoing investigations.  Anecdotally, there is talk in the securities enforcement bar about long-running investigations that were heading for settlement or termination being revisited by the staff; a tentative settlement with the staff appeared to have been scuttled and new, harsher settlement terms proposed (including an admission of liability under the SEC’s new policy of demanding admissions in certain cases).

Recognizing that demanding admissions (and tougher sanctions generally) may lead more defendants to take cases to trial, Chair White and others at the agency have embraced a larger litigation docket.  In a November 2013 speech, Chair White emphasized the SEC’s willingness to try more cases, hailing the importance of trials in fostering legal developments and creating public accountability. That said, the agency’s trial record over the past six months has been a mixed bag.

In terms of which cases will draw the attention of an energized Enforcement Division, it is still too soon to tell.  2013 enforcement actions remained consistent with recent years, with a significant number of cases involving investment advisers, fund managers and brokers, and a seemingly endless flow of insider trading cases.  The SEC filed a number of cases arising out of the financial crisis, perhaps signaling that the end of the pipeline is approaching.  And the Division appears poised to refocus its attention on financial reporting by public companies, an area that continued to see a marked decline in enforcement actions, with few meaningful new cases filed in recent months (and almost all of those involving Chinese issuers).

A.   2013 Enforcement Trends: Statistical Overview

While the SEC is taking (and certainly talking) a tougher enforcement approach, the actual number of new cases filed this year showed a noticeable decline.  The SEC brought 686 new cases in the fiscal year ended September 30, 2013, down seven percent from last year.[2] After excluding the 132 delinquent filing cases (which actually constituted the highest proportion of the overall enforcement docket since the agency began tracking them), FY2013 turned out to be the slowest year for new cases since 2006.

In addition, according to data released by the SEC to the Wall Street Journal, the number of new inquiries opened by the Enforcement Division is also in decline, though the Division attributed some of this to improved triage of incoming tips and complaints.[3]  One growth area for the Division was the number of formal orders, which rose 20 percent over 2012.[4]  This suggests a continuing trend towards investigations becoming formal (and thus allowing the staff to issue subpoenas compelling witnesses to testify and produce records) on a more routine basis, instigated by the SEC’s policy change several years ago delegating formal order authority to senior Enforcement officials.  While the increase in formal orders may lead to enhanced discovery burdens for companies and individuals, on the plus side the issuance of a formal order is arguably no longer symptomatic of an investigation becoming somehow more serious in the eyes of the SEC (and shareholders), but rather just a routine part of any investigative inquiry by the staff.

Figure 1: Enforcement Actions Filed by Fiscal Year, 2006-2013[5]

More telling than the overall number of new cases, however, is how those actions were allocated across subject matter areas.  In this regard, the Enforcement program was relatively unchanged from the past few years, with the bulk of cases coming in the investment adviser/investment company and broker-dealer space, while the number of financial fraud/issuer disclosure cases (as well as FCPA matters) continued to decline.  Indeed, the SEC filed a strikingly low 68 public company reporting cases, and a mere 5 new FCPA cases.  Combined, these cases represented only 13 percent of the enforcement caseload (excluding delinquent filings matters), as compared to the high of 36 percent in 2007.  (Before taking too much comfort from these figures, however, issuers should note that in the three and a half months since the end of fiscal 2013, the SEC has already filed 5 more FCPA actions.)  At the same time, cases involving brokers or advisers represented over 47 percent of the docket (versus 28 percent in 2007).  Meanwhile, insider trading remains relatively consistent, comprising about eight percent of new enforcement filings in 2013.

Figure 2: Breakdown of Enforcement Cases Filed in FY 2013

B.    The Return of Financial Fraud (Investigations)

As referenced in our mid-year update, the SEC announced the formation of a Financial Reporting and Audit Task Force in July 2013.[6]  The Task Force intends to use qualitative and quantitative analyses of public filings to identify indicia of potential accounting irregularities and other signifiers of fraud.  For example, the SEC may compare discretionary accruals reported by peer companies and target outliers to determine whether improper earnings management is occurring.   Obviously, given the typical length of a public company reporting investigation, it will be some time before we see whether this initiative is successful in proactively ferreting out financial fraud cases.

In light of the continued decline in the number of SEC financial fraud cases illustrated above, it is an open question whether this trend reflects an absence of improprieties in the industry, or simply the agency’s lack of focus on the area.  While the Division has reallocated significant investigative resources to financial crisis-related investigations, and to its enhanced focus on investment adviser cases, it does not necessarily mean that the agency is “missing” a groundswell of fraudulent reporting — the decline in these cases may very well be the result of improved internal controls and reporting quality post-Sarbanes-Oxley, or market trends diminishing the incentives or opportunities to commit financial fraud (such as a smaller IPO pipeline).  Nonetheless, we anticipate that the SEC’s public proclamations about enhancing its public company presence, and the freeing up of resources as financial crisis investigations wind down, will lead to the opening of significant financial reporting investigations this year based simply on anomalous metrics in corporate financial statements.  A rising number of investigations in this realm is likely to be further exacerbated by the growing visibility of the SEC’s whistleblower program, as discussed below.

C.   The SEC Begins Requiring Party Admissions

We discussed in our mid-year update the SEC’s new policy, announced in June 2013, of requiring party admissions as a condition of settlement in certain cases.  While the agency emphasized that most cases would continue to be settled with parties neither admitting nor denying the SEC’s allegations, the SEC would break from this long-standing practice in cases which involved “egregious intentional misconduct,” where the misconduct “harmed large numbers of investors,” or where the defendant obstructed the investigation.[7]  Chair White reaffirmed the policy in her first public statement of 2014, explaining, “What we are focused on is the enhanced public accountability and the admission of the conduct, the wrongdoing… An apology is easy.  We want you to admit what you did.”[8]

In the intervening months since announcing the policy, the SEC has only reached two settlements that required admissions.  First, in August, the SEC announced a settlement with hedge fund adviser Harbinger Capital Partners and its principal Philip Falcone, in which the defendants admitted to a statement of facts concluding that they acted “recklessly,” that Falcone “improperly borrowed” funds from a fund to pay personal tax obligations, and that they selectively agreed to redemption requests by favored customers.[9]  The settlement further provided for the payment of $18 million in penalties and disgorgement, as well as a five-year industry bar for Falcone.  Notably, despite early assurances that the SEC would not be applying the new policy to cases already in settlement talks,[10] news reports suggest that a tentative agreement (without admissions) had already been in the works, but was viewed by the Commission as too lax.[11]

The second settlement under the new policy came a month later, when the SEC settled with JPMorgan Chase over the bank’s multi-billion dollar “London Whale” trading loss.[12]  As part of the settlement, JPMorgan admitted that the bank misstated financial results, lacked effective internal controls, and misled senior management.[13]  A month later, the Commodity Futures Trading Commission announced a settlement with JPMorgan Chase Bank in which the regulator appeared to follow the SEC’s lead and required admissions that JPMorgan traders acted recklessly.  However, JPMorgan “neither admitted nor denied the CFTC’s legal conclusion that there was a violation” of the law.[14]  It is unclear to date whether the CFTC will adopt the SEC’s admissions policy more broadly or how often the regulator will require admissions as part of a settlement.

Given the paucity of SEC settlements so far including party admissions, it is still too soon to tell how often the agency will invoke the policy, or what fact scenarios are likely to trigger an admissions requirement.  Most practitioners agree that admissions are most likely to be found in high-impact, publicly-scrutinized matters, but the SEC brought a number of high profile cases in recent months (including several stemming from the financial crisis) which continued to be settled on a neither-admit-nor-deny basis.  This will be a closely-watched area in the months ahead.

D.   The SEC’s Mixed Record at Trial

One clear implication of the SEC’s move towards requiring some settling parties to admit misconduct, as well as the general trend towards tougher settlements, is that more parties will be incentivized to take their chances at trial.  Indeed, the SEC has recognized this likelihood and publicly embraced it.  In a November 2013 speech entitled “The Importance of Trials to the Law and Public Accountability,” Chair White stated:  “[I]n this age of diminishing trials, we at the SEC may be about to reverse the trend a bit… If, in fact, a result of our change in settlement policy results in more trials, one clear winner will be the administration of justice, which will always fare best in the open for the public to see and to take stock of what a defendant did and what its government is doing.”[15]  She called the SEC’s 80 percent success rate in trials over the past three years “impressive,” especially given the limited trial tools available to the SEC relative to the criminal authorities.

Notwithstanding this show of confidence, the latter half of 2013 saw a number of significant trial setbacks for the SEC.  The agency got off to a solid start in August, when a federal jury found former Goldman Sachs trader Fabrice Tourre liable on six of seven counts in the closely-watched case involving the sale of a collateralized debt obligation.[16]  But any celebrating at the SEC was presumably cut short two months later, when, on October 16, a jury found against the agency on all counts in the highly publicized insider trading trial of Mark Cuban.[17]  The case may not offer any broader lessons on the SEC’s insider trading strategy — the SEC tried the case without its key witness appearing to testify, against a celebrity before a home-town jury, on a legal theory shaky enough that the trial judge had initially dismissed it on the pleadings.[18]  But a clear-cut loss in such a high-profile matter may embolden more defendants to roll the dice and litigate against the SEC.

The Cuban trial was followed by back-to-back defeats in financial fraud cases.  In early December, in a case alleging that website design company NIC, Inc. had failed to disclose $1.18 million in perquisites paid to its CEO, a Kansas jury found CFO Stephen Kovzan not liable on all counts.[19]  And two weeks later, in a case alleging that water purification company Basin Water Inc. had engaged in sham transactions to boost reported revenue, the court dismissed all claims against the CEO and CFO following an eight-day bench trial.  The court held that the SEC had failed to present evidence that the defendants had misled anybody, or that they had acted with scienter.[20]

It seems unlikely that these recent losses will lead the SEC to soften its settlement posture or refrain from bringing difficult cases.  However, the recent trial record may result in the SEC filing more cases as administrative proceedings before an administrative law judge, where the Enforcement Division is perceived to face an easier battle.  Dodd-Frank includes provisions allowing the SEC to secure essentially the same relief in an administrative proceeding that it can obtain in a civil court case.[21]  The implications of more administrative proceedings — which permit limited (if any) discovery, no jury, a much shorter path to trial, and a more challenging appeal path for respondents — may be significant for parties in the SEC’s sights.

E.    The Continuing Ascendance of Whistleblowers

The SEC’s whistleblower program, created pursuant to Dodd-Frank and in effect for just over two years, continued to make headlines.  After a seemingly slow start, with just two relatively small awards handed out to whistleblowers, the Commission announced on October 1, 2013, that a confidential whistleblower was designated to receive over $14 million after providing tips that helped the SEC quickly investigate and file an enforcement action.[22]  Because of the requirement that the SEC maintain the confidentiality of the whistleblower’s identity, the agency’s announcement provided minimal insight into the underlying case, though it appears likely to have been (like the two earlier cases) a fraud in connection with a securities offering.  As whistleblowers are eligible to receive between 10 to 30 percent of the money collected from a successful case, this particular case may involve over $140 million.

Less than a month later, the SEC announced a fourth case in which a whistleblower award had been authorized, this time for $150,000.[23]  Once again, the facts were scant, but it appeared to be yet another offering fraud.

In November, the SEC released its second annual report on the Dodd-Frank Whistleblower Program.[24]  The report showed a slight increase in the overall number of whistleblower tips, from 3,001 in the 2012 fiscal year to 3,238 in 2013.  For the second straight year, “Corporate Disclosures and Financials” was the single largest category of complaints (followed closely by offering fraud and market manipulation claims).  Nonetheless, we have yet to see whether the program will lead to enforcement actions involving public companies, or regulated entities such as hedge funds, mutual funds or brokers.  Of course, such cases typically take longer than offering frauds to investigate, so there could be cases on the way.  And a $14 million payout will undoubtedly generate attention among potential whistleblowers (including corporate insiders who might otherwise be reluctant to come forward), not to mention the plaintiffs’ bar.

F.    First Deferred Prosecution Agreement with an Individual

The Enforcement Division has been gradually rolling out its cooperation tools since then-Director Robert Khuzami first began adapting criminal tools for the SEC’s civil program several years ago.  The program took another step forward in November 2013, when the SEC entered into its first deferred prosecution agreement (“DPA”) with an individual.  (The SEC has previously reported several DPAs with companies.)  The SEC announced it had entered an agreement with Scott Herckis, a former hedge fund administrator whose “voluntary and significant cooperation” enabled the SEC to file an emergency enforcement action alleging that the Heppelwhite Fund’s founder and manager had misappropriated more than $1.5 million from the hedge fund and overstated its performance to investors.[25]  As a part of the DPA, Herckis admitted that he aided and abetted violations of the securities laws and, as a result, he cannot serve as a fund administrator or associate with any broker, dealer, investment adviser, or registered investment company for a period of five years, and must disgorge approximately $50,000 in fees that he received for serving as the fund administrator.

Given that Director Ceresney, like Khuzami, has background as a criminal prosecutor (as does Chair White), we anticipate that the SEC’s use of various quasi-criminal cooperation agreements will continue to expand under the new administration.

G.   JOBS Act Rulemaking

Finally, one additional area to watch in the months ahead will be investigations arising out of securities offerings taking advantage of the 2012 Jumpstart Our Business Startups Act (“JOBS Act”).  In September 2013, certain key provisions of the JOBS Act went into effect, including broadened availability of general solicitations for companies seeking access to the capital markets.  The SEC finalized rules addressing reasonable steps issuers must take to ensure that all investors qualify as accredited investors, as well as governing the involvement of certain “bad actors” associated with issuers whose regulatory or criminal history either precludes the company from using general solicitations or requires disclosure to investors.[26]  The SEC also proposed rules calling for additional disclosure requirements for companies utilizing general solicitations, as well as initial rule proposals for companies seeking to raise up to $1 million using crowdfunding platforms.[27]

While the JOBS Act provisions are too new to gauge how widely they will be utilized, the SEC wasted no time in signaling that they will be vigilant in policing potential abuses.  In September, shortly before the general solicitation rules became effective, Director Ceresney stated, “We’re focused on making sure that we’re poised to address any fraud that may occur” under the Act.[28]  And in an October speech, Chair White emphasized:

Contemporaneously with lifting the ban on general solicitation, the SEC staff has undertaken an interdivisional effort designed to monitor how the ability to advertise and “generally solicit” is actually occurring — how companies and hedge funds are taking advantage of the new rule. It includes assessing the impact of general solicitation on the market for private securities and — importantly — on identifying fraud if it is occurring. If it is, we can seek to stop those in their tracks, who would inappropriately take advantage of this new more open environment.[29]

As issuers and funds begin testing the waters of the JOBS Act, we expect the Enforcement Division to be proactive in opening investigations and, down the road, bringing enforcement actions designed to deter abuse of the new rules.

II.   Insider Trading Developments

The SEC continued to bring a steady stream of insider trading enforcement actions in 2013.  As in recent years, the agency, often alongside the United States Attorney’s Office for the Southern District of New York, trained their sights in particular on the private investment fund industry and large-scale trading schemes.

A.   SAC Capital Advisors

The government’s long-running investigation into SAC Capital Advisors (SAC) reached several watershed points in 2013.  In July, the Southern District of New York unsealed a criminal indictment against SAC, perhaps the most noteworthy criminal securities fraud action against an entity since the Arthur Andersen case over a decade ago.  In November, SAC agreed to plead guilty, paying $1.8 billion in penalties and ceasing its investment advisory business in return for the government’s agreement to recommend a five-year statutory maximum term of probation.[30]

Shortly thereafter, in a related case stemming from the same investigation, the Southern District prevailed in their five-week jury trial against Michael Steinberg, the former portfolio manager of related entity Sigma Capital Management.[31]  Steinberg was found guilty of trading in the securities of two publicly traded technology companies, based on inside information allegedly obtained by a Sigma research analyst.  A second criminal insider trading trial, against Matthew Martoma, portfolio manager of SAC affiliate CR Intrinsic Investors, is slated to begin in January 2014.

Meanwhile, the SEC, which had previously filed civil actions against Martoma and Steinberg, and which in March settled with CR Intrinsic Investors for more than $600 million (the largest insider trading settlement in SEC history),[32]  filed a litigated case against SAC founder Steven Cohen in July 2013.  Most notably, the SEC did not sue Cohen (who was not charged criminally) for insider trading, but rather for allegedly failing to supervise Martoma and Steinberg.[33]  The SEC alleged that Cohen received suspicious information that should have caused a reasonable hedge fund manager to investigate their activities, yet he failed to do so.  A week later, the SEC filed an enforcement action against yet another former SAC portfolio manager for allegedly trading on information he had received from sources at several technology companies.[34]

B.    Galleon Group

The long-running investigation of hedge fund Galleon Group continued to bear fruit for the SEC in the latter half of 2013.  The SEC added to the running tally of actions brought by the SEC and the U.S. Attorney’s Office stemming from the ongoing investigation, bringing its total to 35 individuals and entities charged by the SEC.  In September, the SEC brought a settled action against Kieran Taylor, marketing director of a public technology company, alleging he had tipped confidential information to an associate of Galleon founder Raj Rajaratnam.[35]  And in November, the SEC brought a settled action against Sam Miri, a former employee of Marvell Technology Group, alleging he had tipped information to a Galleon portfolio manager.[36]

Prior civil and criminal actions arising out of the investigation continue to work their way through the system.  For example, in May the Second Circuit Court of Appeals heard arguments in the appeal of the criminal conviction former Goldman Sachs director Rajat Gupta, who argued, among other things, that the trial court had improperly admitted wiretap evidence, phone logs, and trading data that linked Gupta to illegal trades allegedly made by Rajaratnam.[37]  No decision has yet been issued.  In the related SEC action, Gupta was fined $13.9 million, and barred from acting as an officer or director of a public company or associating with any broker, dealer, or investment adviser.[38]  Gupta has also appealed that ruling to the Second Circuit.

C.   Asset Freeze Cases

In a growing trend, the SEC continues to file emergency actions seeking to freeze assets in foreign and domestic accounts to prevent the movement of alleged profits from insider trading — often long before the SEC has identified the source of the alleged inside information or even the identity of the account holder.  The latter half of 2013 saw this strategy meeting with mixed success.

In September, Bangkok-based trader Badin Rungruangnavarat agreed to a $5.2 million settlement after the SEC froze his U.S. brokerage account.[39] In the week before a proposed sale of Smithfield Foods to China’s Shuanghui International Holdings became public, Rungruangnavarat bought large quantities of Smithfield out-of-the-money call options and single-stock futures contracts.  The SEC’s press release is noticeably vague on the underlying allegations, stating only that “among his possible sources of material, non-public information about the impending deal was a Facebook friend who was an associate director at the investment bank for a different company that was considering a Smithfield acquisition.”

The SEC agreed to a similar settlement with brothers Rodrigo and Michel Terpins, suspected of improperly trading ahead of the acquisition of H.J. Heinz Company by Berkshire Hathaway and 3G Capital.[40] In February the Commission froze $1.7 million in a Swiss bank account after the brothers–their identities then unknown–purchased call options in Heinz the day before it was announced that the company would be acquired. The brothers agreed to disgorge $1.8 million of illegal profits and pay $3 million in penalties.

A third action was less successful for the agency.  In July, the SEC froze assets totaling nearly $4.6 million in response to suspected insider trading surrounding Amgen, Inc.’s offer to acquire Onyx Pharmaceuticals.[41] Then-unknown traders purchased call options for shares of Onyx just days before the company’s shares jumped over 50 percent following the public announcement of Amgen’s purchase offer.  Dubai residents Dhia Jafar and Omar Nabulsi took responsibility for making trades that produced $2.5 million of the frozen assets, but denied any wrongdoing. In November, the court dismissed the SEC’s complaint, explaining that the SEC failed to “make particular factual allegations supporting a reasonable inference that the defendants violated Section 10(b) and Rule 10b-5.”[42]  Acknowledging that the SEC need not identify a tipper in every claim, the court nevertheless found that the failure to do so here meant that the allegations failed as a whole.  The court left a modified asset freeze in place for 30 days, giving the SEC an opportunity to file an amended complaint with more specific factual allegations.  On December 23rd, the SEC filed a revised complaint, adding further details about the trading.[43]

D.   Traditional Insider Trading

Amidst higher-profile cases, the SEC continues to pursue more traditional insider trading cases alleging trading or tipping ahead of major corporate announcements.  The month of September 2013 alone saw a steady flow of insider trading cases.  On September 3, the SEC filed settled charges against the former CEO of CECO Environmental Corp. and API Technologies Corp, alleging that he had repeatedly traded ahead of public announcements by the two companies.  The settlement includes a $1.5 million payment and a five-year bar from serving as an officer or director of a public company.[44]  On September 20, the SEC charged the owner of a New York-based financial advisory firm with insider trading regarding Pfizer, Inc.’s planned acquisition of King Pharmaceutical, allegedly netting $300,000, and tipping a friend who profited by more than $100,000.[45]  And on September 23, the SEC charged a former officer of Qualcomm, Inc. and his broker with insider trading ahead of three major announcements regarding Qualcomm’s financial results and acquisition plans, which allegedly resulted in over $250,000 in illicit profits.[46]  The U.S. Attorney’s Office for the Southern District of California also filed criminal charges against the former officer, his brother, and his broker on September 20, 2013.

The SEC also expanded the growing trend in applying traditional insider trading theories beyond stock and option trading, such as the trading of foreign derivative instruments linked to US markets.  In July, the SEC filed charges against two Spanish nationals — the CEO of a Madrid investment bank and a former judge — who allegedly traded based on inside information about an acquisition being handled by the investment bank.[47]  The SEC alleged that the pair profited over $1 million trading foreign derivatives whose price was based on U.S. exchange-listed stock.

III.   Investment Adviser Developments

Enforcement actions involving investment advisers and investment companies represented the largest single category of SEC cases in fiscal 2013, comprising a quarter of the overall caseload (excluding delinquent filings cases).

A.   Actions Involving Chief Compliance Officers

The SEC continued to walk a tight wire between trying to incentivize and empower chief compliance officers to maintain effective oversight of advisers, while bringing enforcement actions against CCOs who, in the view of the Commission, failed to do so.

In July, the SEC instituted settled administrative proceedings against Comprehensive Capital Management, Inc. (CCM) and its Chief Compliance Officer Ronald S. Rollins, alleging that Rollins failed to supervise an employee who misappropriated over $16 million from investment advisory accounts managed by CCM.[48]   Rollins agreed to an industry bar for twelve months, but the SEC did not impose a civil penalty.  CCM agreed to a censure, cease-and-desist order, and a $120,000 penalty.

In October, the SEC instituted a settled enforcement proceeding against Equitas Capital Advisors, Equitas Partners, owner David S. Thomas, Jr., Chief Compliance Officer Susan Christina, and former owner and Chief Compliance Officer Stephen Derby Gisclair, alleging,  among other things, that the firms failed to adopt and implement written compliance policies and procedures and to conduct annual compliance reviews.[49]  The SEC emphasized that these alleged violations occurred despite warnings by SEC examiners in 2005, 2008, and 2011.  The firms reimbursed all overcharged clients, and Equitas Capital Advisers, Thomas, and Gisclair agreed to pay a total of $225,000 in additional penalties.

And in November, the SEC announced a pair of actions against advisory firms Parallax Investments LLC and Tri-Star Advisors and several of their respective officers for executing thousands of principal transactions through their affiliated brokerage firm without informing their clients.[50]   The SEC also charged Parallax CCO F. Robert Falkenberg for failing to ensure the firm complied with the custody rule, alleging that he failed to take steps to retain a PCAOB-registered auditor and deliver financial statements to investors on a timely basis.

On the flip side of the coin, the Commission also filed its first action under Rule 38a-1(c) of the Investment Company Act for misleading and obstructing a chief compliance officer.  The SEC instituted settled administrative proceedings against Carl Johns, a former portfolio manager at Boulder Investment Advisors (BIA).[51]   Johns allegedly failed to pre-clear or report several hundred securities trades in his personal accounts and, to conceal this misconduct, created false documents that purported to be pre-trade approvals.  The settled order included a five-year industry bar, approximately $230,000 in disgorgement, nearly $24,000 in prejudgment interest, and a $100,000 penalty.

B.   Assorted Violations

The SEC’s broad docket of investment adviser and fund-related enforcement actions continued to cover the waterfront, ranging from recurring priority issues such as valuation and undisclosed conflicts, to more serious fraud violations, as well as lesser or more technical violations by recidivists.

1.   Valuation

In November, the SEC instituted settled administrative proceedings against hedge fund adviser Agamas Capital Management, alleging, among other things, that Agamas did not fully document its use of discretion in valuing certain securities, which in turn prevented the firm from ensuring the accuracy of disclosures to investors regarding valuation practices.   Agamas agreed to an order that it cease and desist from causing violations of Section 206(4) of the Advisers Act and Rule 206(4)-7 in addition to paying a $250,000 penalty.[52]

In December, the SEC also instituted settled administrative proceedings against London-based hedge fund adviser GLG Partners L.P. and its former U.S. holding company for allegedly overvalued the fund’s private equity stake in an emerging market coal mining company, even though several employees received information calling the valuation into question.  As part of the settlement, the firms agreed to hire an independent consultant to recommend new valuation policies and procedures, in addition to paying nearly $9 million in disgorgement, prejudgment interest, and civil penalties.[53]

2.   Conflicts of Interest

In September, the SEC charged a partner at hedge fund adviser Vicis Capital LLC with entering into an undisclosed principal transaction by authorizing the fund to buy $7.5 million from associated persons and personally receiving a portion of the transaction proceeds.  The respondent paid a $2.9 million penalty and was barred from associating with any investment company for at least 18 months.[54]

3.   Best Execution

In August, the SEC announced a pair of settled proceedings against dually-registered advisers and brokers for best execution failures.  The SEC alleged that A.R. Schmeidler & Co. failed to reevaluate whether it was providing best execution for its clients when it negotiated terms with its clearing firm that provided the it with a larger commission share.   ARS agreed to pay more than $1 million in disgorgement, interest, and penalties to settle the charges.[55]  Separately, Goezler Investment Management was alleged to have recommended its brokerage services to advisory clients without conducting the comparative analysis of other brokerage options as described in its Form ADV.  The adviser and its CEO, Gregory Goezler, paid almost $500,000 in disgorgement, interest and penalties.

In October, the SEC also sanctioned investment adviser Manarin Investment Counsel LTD. and its principal Roland R. Manarin for causing clients to invest in mutual funds for which they incurred ongoing 12b-1 distribution fees, rather than lower-cost institutional shares available to the clients, with the excess fees being passed through to the brokerage firm owned by Manarin.[56]  The parties paid around $1 million to settle the claims.  The SEC pursued a similar case advisory firm Sarkauskas and Associates, Inc., and its principal, who were alleged to have invested their clients in pooled investment vehicles charging transactional sales charges when comparable no-load funds were available.  The parties settled for nearly $500,000 in disgorgement and penalties.[57]

4.   Cherry-Picking

In August, the SEC announced a litigated administrative action against California firm J.S. Oliver Capital Management and its CEO Ian Mausner for allegedly engaging in a year-long scheme to delay the allocation of trades so as to award more profitable trades to hedge funds in which Mausner and his family had invested.[58]  Less profitable trades would be directed to other clients, who ultimately suffered over $10 million in losses.

5.   Other Misrepresentations

In August, the SEC announced litigated charges against Chariot Advisors LLC and its owner for falsely claiming to an investment fund’s board that Chariot used an algorithmic model for its currency trading, when in fact the firm had no algorithms capable of engaging in the promised currency trading.[59]  The SEC press release noted that the action arose out of the Enforcement Division’s Asset Management Unit’s focus on the evaluation of fund advisory agreements by fund boards under Section 15(c) of the Investment Company Act.

In November, the SEC brought a litigated action against advisory firm Ambassador Capital Management and its portfolio manager for allegedly misleading fund trustees about the credit risk in the securities that they purchased, exposing the fund to undue risk in the Eurozone credit crisis of 2011.[60]

6.   Compliance Program Initiative

Finally, the SEC continued to bring enforcement actions under the umbrella of the agency’s ongoing Compliance Program Initiative, which targets firms that have been previously warned by SEC examiners about compliance deficiencies.  For example, in October, the SEC instituted a settled enforcement proceeding against Modern Portfolio Management (MPM) and its owners G. Thomas Damasco II and Bryan Ohm for failing to correct ongoing compliance violations at the firm, including failing to complete annual compliance reviews and overstating the firm’s assets under management, despite prior warnings from SEC examiners.[61]  MPM, Damasco, and Ohm agreed to be censured and pay a total of $175,000 in penalties. Damasco and Ohm also agreed to complete 30 hours of compliance training and MPM must retain a compliance consultant for three years.

IV.   Broker-Dealer and Bank-Related Developments

A.   Financial Crisis Cases

In the second half of 2013, the SEC continued to pursue enforcement actions against financial institutions for conduct stemming from the financial crisis, particularly in regards to allegedly insufficient disclosures to investors involving offerings of collateralized debt obligations (CDOs) and residential mortgage-backed securities (RMBS).  The SEC announced settlements in three such investigations over the past six months.  In August, UBS Securities paid a settlement of $50 million for allegedly insufficient disclosures surrounding their derivative offerings.[62]  In November, RBS Securities settled allegations by the SEC as to similar allegedly insufficient disclosures for $150 million.[63]  And in December, the SEC announced settlements with Merrill Lynch and NIR Capital Management LLC, a small North Carolina-based investment advisory firm for $131 million and $472,000, respectively.[64]  The SEC alleged that Merrill Lynch failed to disclose the involvement of a third-party hedge fund in the selection of funds used in a CDO offering; the investment advisory firm agreed to exit the securities industry as a result of its involvement in the alleged wrongdoing.  All three banks settled without admitting or denying the allegations.

The SEC also filed a litigated action against Bank of America in the Western District of North Carolina in which the SEC alleged that Bank of America misrepresented the origin of at least 70 percent of the mortgages re-packaged as part of an RMBS offering.[65]

Finally, the SEC announced a pair of cases against banks for allegedly improper accounting practices during the financial crisis.  In September, the SEC brought a settled action against Mercantile Bancorp and its former CEO and CFO for their alleged failure to timely recognize significant loan losses.[66]  Each executive paid a $100,000 penalty and agreed to an officer and director bar.  And in December, the SEC brought a settled case against Fifth Third Bank and its former CFO for failing to reclassify troubled real estate loans, resulting in understated losses.  The bank paid a $6.5 million penalty, and the CFO paid a $100,000 penalty and was suspended from appearing before the SEC as an accountant for one year.[67]

B.    Fraud and Unregistered Securities

In the second half of 2013, the Commission continued its aggressive enforcement efforts against broker-dealers and their employees alleged to have participated in the defrauding of investors.  In September, the Commission announced charges against 10 former brokers at Albany, N.Y.-based McGinn Smith & Co., in connection with an alleged $125 million Ponzi scheme for which the co-owners of the firm had already received jail sentences.[68]  The Commission also obtained an initial decision from an administrative law judge in August, concluding that three senior employees of a broker-dealer owned by R. Allen Stanford had violated antifraud provisions of the securities laws based on alleged material misrepresentations and omissions relating to the sale of so-called certificates of deposit that were in reality investments in Mr. Stanford’s purported Ponzi scheme.[69]  The decision barred the three individuals from the securities industry, required disgorgement of ill-gotten gains, and assessed monetary penalties.

However, in September, the Commission suffered defeat when the Ninth Circuit reversed summary judgment against a transfer agent and its owner, holding that material issues of fact existed regarding the extent of their participation in an alleged scheme to sell unregistered securities of CMKM Diamonds, Inc., a purported mining company that allegedly did not have any legitimate operations.[70]

C.   Short Selling

In August, the SEC issued a Risk Alert intended to help market participants detect and prevent short selling in violation of Regulation SHO.[71]  Among other things, Regulation SHO, enacted in 2005, requires short sellers who fail to deliver securities after the settlement date to close out their position immediately.  The Risk Alert describes certain trading strategies indicative of an attempt to bypass Regulation SHO’s “close-out requirement” for short sales, such as the continuous failure to deliver positions and excessive trading in hard-to-borrow or threshold list securities.

The Enforcement Division also brought a series of short selling cases in the second half of 2013 under Rule 105 of Regulation M, which prohibits the short sale of an equity security during a restricted period prior to the pricing of an offering and the subsequent purchase of that same security through the offering.  Most notably, in September, the Commission announced enforcement actions against 23 firms (of which 22 have already settled) for purchasing shares of securities in public offerings after short sales of those securities during the restricted period.[72]  In all, the settlements from the sweep have netted a total of over $9.6 million in disgorgement and over $4.2 million in monetary penalties.  Two months later, the SEC filed yet another settled Rule 105 case.[73]

D.   Other Broker-Dealer Enforcement Developments

Supervisory failures were another area of focus for the SEC in the broker-dealer context in 2013.  In October, the SEC agreed to a settlement with Knight Capital in connection with the firm’s August 2012 systems failure that resulted in the acquisition of “several billion dollars in unwanted positions.”[74]  In the first ever enforcement action under Rule 15c3-5, the market access rule, the SEC faulted Knight Capital for inadequate safeguards that allowed the entry of millions of erroneous orders.  Specifically, in the first 45 minutes of trading on August 1, 2012, Knight Capital’s router sent over four million orders into the market in response to only 212 actual customer orders.  These erroneous orders ultimately resulted in the trading of nearly 400 million shares and several billion dollars in unwanted positions, leading to a loss for Knight Capital of more than $460 million.  The Commission charged the firm with violating the market access rule by, inter alia, lacking adequate controls to ensure the comparison of orders leaving the router with those entered and relying on financial risk controls that could not prevent the entry of orders that exceeded Knight Capital’s pre-set capital thresholds.  The SEC’s order required Knight Capital to pay a $12 million penalty and retain an independent consultant to examine the firm’s controls and compliance programs as they relate to the market access rule.

In August, the SEC settled with the Chicago Stock Exchange, Inc. (“CHX”), which agreed to pay a $300,000 penalty in connection with its alleged failures to implement procedures for the detection and prevention of violations of Rule 611 of Regulation NMS, the Order Protection Rule.[75]  The Order Protection Rule requires that trading centers establish and enforce procedures to prevent investors from receiving an execution price that is inferior to the best-priced quotes of automated trading centers.  The Commission had charged that, from December 2006 to December 2010, CHX’s system for institutional brokers to execute proprietary cross trades outside of CHX’s automated limit-order matching system had flaws that resulted in certain brokers abusing the system through the execution of trades at non-market prices in violation of Rule 611.

V.   Public Company Reporting & Accounting Developments

As discussed earlier, notwithstanding the SEC’s recently-announced initiative to refocus Enforcement resources on public company accounting fraud, 2013 saw a significant decline in new reporting and disclosure cases.  The latter half of the year in particular was limited primarily to cases against China-based companies and small domestic entities, as well as a number of cases against outside auditors.

A.   Focus on China

The SEC has maintained its heightened scrutiny of alleged accounting irregularities at Chinese companies listed in the United States.  In July, the SEC filed a complaint against a pair of related companies and their respective (sibling) CEOs, alleging they raised and diverted millions in US offerings, and then attempted to hide the diversions by lying to auditors and making false and materially misleading filings with the Commission.[76]

The SEC then brought a series of enforcement actions in September alleging various financial shenanigans by China-based issuers trading in US markets.  First, the SEC filed a complaint alleging that former executives of ChinaCast Education Corporation secretly transferred and pledged millions of ChinaCast’s funds to entities outside of ChinaCast’s control, without filing proper disclosures with the SEC.[77]  Similarly, the SEC filed a settled fraud action against Universal Travel Group and its CEO and CFO, alleging that defendants failed to properly disclose $41 million in cash transfers to entities outside the company, thus rendering false and misleading the risk factor and liquidity discussions in the company’s public disclosures.[78]  The settlement includes monetary penalties and five-year officer and director bars for the executives.  Finally, the SEC initiated litigated cease and desist proceedings against China Ruitai and various senior executives, alleging that they orchestrated a scheme to fraudulently obtain up to $40 million in bank financing using falsified documents and failed to make the necessary disclosures in SEC filings.[79]

B.    Misrepresentations and Omissions

The latter half of 2013 saw multiple actions against public companies and their executives for misrepresenting the company’s financial position.  For example, in September the SEC filed charges against Imperial Petroleum and several executives and suppliers for posing as a legitimate biofuel producer while concealing illegal activity that accounted for 99 percent of its revenues.[80]  When the scheme fell apart, Imperial’s stock price plummeted, resulting in a market loss of approximately $60 million.  The U.S. Attorney’s Office announced separate criminal charges.   A week later, the SEC charged Troy Lyndon, the founder of Left Behind Games Inc., a religious-themed video game manufacturer, and a friend with creating phony revenue streams through sham circular transfers to falsely inflate the company’s revenue by nearly 1,300 percent.[81]

Also in September, the SEC charged Imaging Diagnostics Systems, a medical technology company, and two top executives for multiple disclosure issues, including misrepresentations involving its Food and Drug Administration application, failure to remit payroll taxes to the IRS, and failure to file beneficial ownership reports.[82]

C.   Auditors

Notwithstanding the relative dearth of cases involving domestic issuers, the Enforcement Division targeted a number of auditors for scrutiny.  Several of these matters arose out of an ongoing sweep entitled “Operation Broken Gate.”  In late September, the SEC filed complaints against three auditors, alleging audit deficiencies including failure to obtain sufficient evidential material, failure to prepare adequate work papers, failure to properly consider audit risk, and lacking the requisite qualification to serve as an engagement partner.[83]  Also in September, the SEC initiated settled 102(e) proceedings against accountant Marc Nochimson, in connection with his audit of weight loss company Medifast, for his alleged failure to comply with PCAOB audit standards relating to various tax accounting issues.  Nochimson agreed to be barred from practice before the Commission as an accountant for a period of at least one year.[84]

The theme of China-related accounting fraud carried over into several auditor cases as well.  In September, the SEC filed a settled action against the New Jersey-based audit firm Patrizio & Zhao LLC along with the head of the firm’s China practice, Xinggeng Zhao, for non-compliance with US auditing standards in their audit of China-based Keyuan Petrochemicals.[85]  Zhao and the firm allegedly failed to subject Keyuan’s disclosure to appropriate scrutiny, improperly neglecting to disclose various related-party transactions.  As part of the settlement, both the firm and Zhao are barred from practicing as accountants before the Commission for at least three years, and the firm must pay a $30,000 fine.  Similarly, in November, the SEC brought a settled action against New York-based Sherb & Co. LLP as well as its founder, two partners, and an audit manager alleging improper professional conduct in connection with their audits of multiple China-based companies.[86]  The settlement agreement bars the individual accountants from appearing before the SEC for periods ranging from 3-5 years, and imposes a $75,000 penalty on the firm.

Finally, the SEC took the relatively unusual step of enforcing several pre-existing bar orders against accountants.  In November, the SEC filed a civil complaint against R. Gordon Jones, alleging that he and his firm J&J Consultants provided financial statement preparation work for public companies in violation of a 2001 order barring him from appearing before the Commission under Rule 102(e).[87]  Similarly, in August, the SEC filed a civil action against accountant Michael H. Taber, barred in 2004 under Rule 102(e), for continuing to provide accounting services to public companies through a professional outsourcing firm.[88]  Both actions seek injunctive relief as well as disgorgement of compensation received while engaging in the prohibited work.  Notably, in a comparable case, an administrative law judge found against the Enforcement Division where they had sued a CPA for issuing audit reports after his license had lapsed, holding that such conduct did not violate the antifraud provisions of the Exchange Act.[89]

D.   Regulation FD

Other than the Report of Investigation regarding the applicability of Regulation FD to social media, arising out of the Enforcement Division’s Netflix investigation (discussed in our mid-year update), the SEC brought only a single enforcement action under the fair disclosure rule this year.  In September, the SEC charged the former head of investor relations at First Solar Inc., for violating Regulation FD when he made around twenty one-on-one analyst calls, allegedly to caution them about a negative business development at the company.[90]  The defendant agreed to pay a $50,000 penalty.  Notably, the Commission decided against bringing an enforcement action against First Solar based on the company’s cooperation, explaining in its press release that the company had a culture of compliance prior to the improper disclosure, promptly disclosed the violation through a press release the next morning, self-reported the misconduct to the SEC, and undertook remedial measures to address the conduct.

E.    Stop Order

Finally, in August, the SEC took the rare step of issuing a stop order to halt the initial public offering of Counseling International after it determined that the company’s registration statement contained false and misleading information.[91]  Among other deficiencies, the registration statement allegedly failed to identify the company’s control persons and promoters and falsely described the circumstances surrounding the departure of the former CEO.  Counseling International consent to the issuance of the stop order and agreed not to engage or participate in any unregistered offering of securities conduced in reliance on Rule 506 of Regulation D for the next five years.

VI.   Municipal Securities Developments

Although the Enforcement Division’s Municipal Securities and Public Pensions specialized unit appeared to get off to a slow start, the unit gathered steam throughout 2013, bringing several additional cases against cities and municipalities in the latter half of the year.

In July, the Commission brought a litigated action against the City of Miami and its former budget director, alleging that, they made materially false and misleading statements and omissions relating to certain intrafund transfers in three bond offerings in order to mask the increasing deficits in the City’s primary operating fund.[92]   The Commission also charged the City with violating a 2003 SEC Cease-and-Desist Order, which was entered against the City based on similar misconduct.  The Commission is seeking injunctive relief and financial penalties against both the City and the former budget director.  The case is the first ever injunctive action against a municipality already under an existing SEC cease-and-desist order.

Also in July, the Commission charged the Indiana West Clark Community Schools school district and its Indianapolis based municipal bond underwriter, City Securities Corporation, with falsely stating to bond investors that the school district had been properly providing annual financial information and notices required as part of its prior bond offerings, and faulted the underwriter for not conducting adequate due diligence to detect that the statements were false.[93]  In addition to settling with the district and the underwriter, the SEC brought a settled action against the head of City Securities’ public finance and municipal bond department .  The school district agreed to remedial actions including designating an individual responsible for compliance and implementing training, and the underwriter agreed to disgorge its profits, pay a $300,000 penalty and undergo an internal review of its policies.

In September, the SEC charged Public Health Trust, the operator of the largest hospital in Miami-Dade County, with misleading investors about the extent of its deteriorating financial condition, specifically its non-operating loss projections, prior to an $83 million bond offering.[94]   The Commission determined to settle the matter without imposing a monetary penalty due to the Trust’s financial condition, cooperation and remedial steps taken to date.

Finally, in November, the SEC charged Washington state’s Greater Wenatchee Regional Events Center Public Facilities District, as well as other individuals and entities, with misleading investors in an events center bond offering about, among other things, the financial projections for the events center and whether there was an independent review of those projections.[95]  The District agreed to settle the charges by paying a $20,000 penalty and undertaking remedial actions.  This marked the first time that the Commission assessed a financial penalty against a municipal issuer, which the SEC said it would consider doing when the penalty “can be paid from operating funds without directly impacting taxpayers.”

VII.   Miscellaneous Cases

Finally, we note a few themes outside the mainstream of corporate America which are likely to capture a fair amount of the Enforcement Division’s attention going forward.  First, with market manipulation cases continuing to constitute just under 10 percent of the SEC’s enforcement caseload, the Enforcement Division, simultaneous with its announcement of the financial fraud task force in July, also announced the creation of the “Microcap Fraud Task Force,” which will target abusive trading and fraudulent conduct in securities issued by microcap companies.[96]  The principal goal of the Task Force will be to target the “gatekeepers,” such as attorneys, auditors, broker-dealers, transfer agents, stock promoters, and the purveyors of shell companies.

Second, the SEC has begun calling attention to abuses under the nation’s EB-5 Immigrant Investor Pilot Program, under which foreign investors can earn conditional visas and eventually green cards by making investments in U.S. economic development projects that will create or preserve a minimum number of jobs for U.S. companies.   The SEC and the U.S. Citizenship and Immigration Services (“USCIS”) jointly issued an investor alert cautioning investors about abusive scams taking advantage of the program.[97]  The SEC also brought the second case of the year against individuals in the US who had misappropriated funds from foreign investors under the guise of an EB-5 visa program.[98]

Third, the SEC made its first foray into the high profile emerging market surrounding Bitcoins, a form of virtual currency whose supply is controlled through a series of complex computer algorithms.  Bitcoins exist through an open-source software program, and are not managed by any one company, nor are they regulated by a central bank.  Users can buy Bitcoins through exchanges that convert conventional currencies, such as the U.S. dollar, into the virtual currency.  In July, the SEC filed charges against a Texas man, Trendon Shavers, and his company for defrauding investors in a Ponzi scheme involving Bitcoins.[99]  According to the SEC, Shavers’s scheme raised at least 700,000 Bitcoin, amounting to approximately $4.5 million when the transactions occurred (but due to the volatility of the currency, would amount to nearly $60 million at the time of the filing).  Shavers challenged the SEC’s case, arguing that the SEC had no jurisdiction to sue him because Bitcoin investments are not securities or subject to any U.S. regulation.  But a federal judge in the Eastern District of Texas ruled that Bitcoin investments “meet the definition of investment contract, and as such, are securities.”[100]  It remains to be seen whether the SEC’s ventures into the world of Bitcoins will extend beyond Ponzi schemes into otherwise legitimate businesses accepting Bitcoins as payment.