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April 14, 2021 |
Understanding the SEC’s Focus on Environmental, Social, and Governance Investing and Investment Advisers

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SEC Division of Examinations Risk Alert Provides a Useful Roadmap on Compliance Issues for Fund Managers

On Friday, April 9, 2021, the Securities and Exchange Commission (“SEC”) Division of Examinations (the “Division”), issued a Risk Alert detailing its observations of deficiencies and internal control weaknesses from examinations of investment advisers and funds regarding investing that incorporates environmental, social, and governance factors (“ESG investing”).[1]  This alert follows another recent announcement of the creation of a Climate and ESG Task Force within the Division of Enforcement to focus on ESG-related disclosures by public companies and ESG investment practices by investment funds.[2]

Key Takeaways

The Risk Alert provides useful guidance regarding the types of compliance issues the Staff is reviewing in its examinations of investment advisers, examples of deficiencies the Staff is finding, as well as instances in which the Staff has observed effective compliance practices.  Accordingly, the Risk Alert provides a useful roadmap to assist investment advisers in developing, testing and enhancing their compliance policies, procedures and practices.

On the heels of the Risk Alert, Commissioner Peirce issued a cautionary statement to express her view that the alert, “should not be interpreted as a sign that ESG investment strategies are unique in the eyes of examiners,” but simply that, as with any other investment strategy, “[f]irms claiming to be conducting ESG investing need to explain to investors what they mean by ESG and they need to do what they say they are doing.”[3]

In sum, the SEC’s focus on ESG investment strategies heightens the need for investment advisers to make sure their disclosures align with investment practices and that there is sufficient and knowledgeable oversight and review by compliance personnel to avoid a divergence between the two over time.

Concerns Identified by the Division

In the Division’s examination of investment advisers, registered investment companies, and private funds engaged in ESG investing, the Staff observed the following weaknesses:

  • Lack of adherence to global ESG frameworks where firms claimed such adherence.
  • Weakness in policies and procedures governing implementation and monitoring of ESG-related directives. For example, the Staff observed that advisers did not have adequate controls around implementation and monitoring of clients’ negative screens.
  • Inconsistency between public ESG-related proxy voting claims and internal voting policies and practices, including the dissemination of public statements that ESG-related proxy proposals would be independently evaluated on a case-by-case basis, while internal deadlines generally did not provide such case-by-case analysis.
  • Unsubstantiated or otherwise potentially misleading claims regarding ESG investing in marketing materials that touted favorable risk, return, and correlation metrics related to ESG investing, without disclosing material facts regarding the significant expense reimbursement received from the fund-sponsor, which inflated returns for those ESG-oriented funds.
  • Inadequate controls to ensure that ESG-related disclosures and marketing are consistent with the firm’s practices, including lack of documentation of ESG investing decisions and issuer engagement efforts, as well as a failure to update marketing materials timely.
  • Limited knowledge by compliance personnel of relevant ESG-investment analyses or oversight over ESG-related disclosures and marketing decisions.

Guidance for ESG Investing Disclosures and Procedures

The Staff also observed policies, procedures, and practices which were reasonably designed to convey approaches to ESG investing.  The Division noted that the following practices may be helpful to address the compliance issues identified above:

  • Simple and clear disclosures regarding the firm’s approach to ESG investments in client-facing materials.
  • Explanations regarding how ESG investments are evaluated using goals established under global ESG frameworks on the firm’s website, client presentations, and annual reports.
  • Detailed, comprehensive investment policies and procedures regarding ESG investments and factors considered in specific investment decisions; when multiple ESG investing approaches are considered, specific written procedures, due diligence documentation, and separate specialized personnel who provide additional rigor to the portfolio management process.
  • Compliance personnel who are knowledgeable about the firm’s ESG approaches and practices. Firms with dedicated ESG compliance personnel were more likely to avoid materially misleading claims in their ESG-related marketing materials and other client/investor-facing documents.

Conclusion

In conclusion, the SEC’s Risk Alert reaffirms the need for firms involved in ESG investing to ensure that their disclosures accurately describe their ESG-related investment practices.  Periodic reviews of marketing materials and other investor disclosures against current investment strategy and adherence to stated ESG metrics will avoid the types of deficiencies the Staff has observed in recent inspections, and, in the worst cases, avoid even greater scrutiny from the Division of Enforcement.

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   [1]   Division of Examinations, Risk Alert, Securities and Exchange Commission (Apr. 9, 2021), https://www.sec.gov/files/esg-risk-alert.pdf.

   [2]   Press Release, U.S. Securities and Exchange Commission, SEC Announces Enforcement Task Force Focused on Climate and ESG Issues (Mar. 4, 2021), https://www.sec.gov/news/press-release/2021-42?_sm_au_=iHVN4cW7DnktSD5NFcVTvKQkcK8MG.

   [3]   Public Statement, Statement on the Staff ESG Risk Alert (Apr. 12, 2021), https://www.sec.gov/news/public-statement/peirce-statement-staff-esg-risk-alert.


Gibson, Dunn and Crutcher’s lawyers are available to assist in addressing any questions you may have regarding these developments. Please contact the Gibson Dunn lawyer with whom you usually work, any member of the firm's Securities Enforcement practice group, or the following authors:

Mark K. Schonfeld – New York (+1 212-351-2433, mschonfeld@gibsondunn.com) Tina Samanta – New York (+1 212-351-2469, tsamanta@gibsondunn.com) Lauren Myers – New York (+1 212-351-3946, lmyers@gibsondunn.com)

© 2021 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

February 1, 2021 |
The GameStop Short Squeeze – Potential Regulatory and Litigation Fall Out and Considerations

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Over this past week, the stock market has experienced a turbulent and acutely volatile series of events related to the trading of a small group of public companies’ shares. With echoes of the 2010 “Flash Crash” and a mid-2020 surge in the share price of Hertz while Hertz remained mired in ongoing bankruptcy proceedings,[1] numerous companies’ stock prices have become unglued from their financials, valuations, and other fundamental analyses. Perhaps most (in)famously, the stock price of GameStop surged from a low of less than $20 in early January to a high of nearly $500 on January 28th —an increase of well over 1,000%—for no discernible reason beyond the efforts of thousands, or perhaps even millions, of internet message board users[2] to force a “short squeeze” targeting asset managers who shorted the stock in anticipation of GameStop’s declining stock price based on their analysis of the company’s fundamentals.[3] The ramifications have been widespread, ranging from the temporary crash of Reddit, the very website on which these efforts originated,[4] to popular trading platforms restricting customers’ ability to trade in particularly volatile securities,[5] and prominent financial institutions changing their investment approaches and abandoning certain short-sale trading positions.[6] Reactions have equally run the gamut, ranging from pundits who find these events “hilarious” or view this as a story of “an underdog against a mighty foe,” on the one hand, to those, on the other, who view the volatility as “a story of utter nihilism” and a “terrifying proof of concept” as to what can happen in financial markets when there is seemingly no connection between price and financial fundamentals.[7] For better or worse, many have analogized the increasingly powerful role of non-institutional investors to a “democratization of the markets.”[8]

While these events continue to unfold in real time, all three branches of the federal government have indicated an intent to address them. On January 28th, the Chairwoman of the House of Representatives’ Committee on Financial Services announced that it would hold hearings “with a focus on short selling, online trading platforms, gamification and their systemic impact on our capital markets and retail investors,”[9] while the incoming Chairman of the Senate Committee on Banking, Housing, and Urban Affairs similarly announced plans for forthcoming hearings “on the current state of the stock market.”[10] That very same day, the first litigation relating to these events was filed in the Southern District of New York, as an investor brought a putative class action lawsuit against the electronic trading platform Robinhood, alleging that limitations on trading implemented amidst this volatility had “deprived retail investors of the ability to invest in the open market” with intent “to manipulate the market for the benefit of . . . financial institutions.”[11] A dozen other lawsuits against Robinhood and others quickly followed in courts across the country.[12] In addition, the SEC announced that it was “actively monitoring the on-going market volatility in the options and equities markets” and working to “assess the situation and review the activities of regulated entities, financial intermediaries, and other market participants,”[13] with news media reporting that the SEC is “eyeing a possible market manipulation case” analogizing traders’ online efforts to hype shares of particular companies to “a classic pump and dump” scheme.[14] At least two state attorneys general announced that they had initiated their own probes.[15]

I. Litigation Considerations

In light of the significant sums of money being made and lost, and the media blitz about the new reality and impact of retail investors taking collective action, it was almost inevitable that disputes would arise. Accordingly, it is no surprise that a wave of litigation is already finding its way to the courthouse.

What form is such litigation taking? Generally, the suits filed against Robinhood to date have been brought by certain of the company’s customers and have focused on Robinhood’s trading restrictions, sounding in alleged breaches of contract, breaches of the implied duty of good faith and fair dealing, negligence, and breaches of fiduciary duty. Other suits against Robinhood and various other parties have alleged antitrust claims under state law and both Sections 1 and 2 of the Sherman Act, and have asserted (without citing any evidence or making particularized allegations) improper coordination in prohibiting the purchase of certain securities to unreasonably restrain trade in the stock market, as well as exclusionary and anticompetitive conduct in prohibiting plaintiffs from effectuating trades.[16] In addition, claims have now also been brought under Rule 10b-5.[17]

Market manipulation can be prosecuted criminally by the United States Department of Justice, or pursued through civil litigation brought by agencies such as the SEC and/or private parties who have personally been harmed, including the aforementioned asset managers who have been subjected to a “short squeeze.” Many such claims may rely on Rule 10b-5, adopted by the SEC pursuant to the Securities Exchange Act of 1934, which broadly prohibits all schemes and artifices, including deception, in the trading of securities.[18] Rule 10b-5 is likely to be the most common basis of securities fraud causes of action when market participants are alleged to have perpetrated a fraud, deception, or other willful wrongdoing that results in the manipulation of a stock price—including in classic, or novel, “pump and dump” schemes—although there may be other potential causes of action available as well. For instance, Section 9(a)(2) of the Securities Exchange Act of 1934 has been litigated far less than Rule 10b-5, but it might also apply given its prohibition on “effect[ing] . . . a series of transaction in any security . . . creating actual or apparent active trading in such security, or raising or depressing the price of such security, for the purpose of inducing the purchase or sale of such security by others.”[19]

Of course, the application of Rule 10b-5, Section 9(a)(2), or any other cause of action to a particular set of transactions, and whether such claims can be economically litigated against those engaging in relatively small transactions, including through the novel use of a defendant class action,[20] are questions that are necessarily fact-specific and cannot be addressed in the abstract. Whether an asset manager would file suit against a group of traders circulating materially, false and misleading information, for example, for purposes of artificially inflating the stock price is uncertain given the commercial reality that many of the traders do not have sufficient assets to cover the losses, that litigation is a two-way street and would require a plaintiff asset manager to open up their internal analyses and communications to discovery, and it might create optics issues for a resourceful asset manager bringing action against a group of retail investors. Accordingly, the more likely prosecutor of such market manipulation is the government.

Another type of claim regulators may investigate in these circumstances is open-market manipulation. Open-market manipulation is a more ambiguous and amorphous violation of the securities laws that is effectuated solely through facially legitimate trading.[21] A typical example of prosecutable open market manipulation is known as “marking” or “banging the close,” which occurs when a trader with the intent to defraud purchases a large quantity of shares at or near the close of the trading day. This can boost the trader’s portfolio value, or allow the trader to avoid losing out on an option position. A related form of manipulation called “painting the tape” occurs when a trader with the intent to defraud purchases or sells shares throughout the day to increase the trading volume in an effort to attract more investment in the stock. Such transactions may appear legitimate on their face because they are simply open market trades, but if their intent and effect is to artificially drive up a stock’s closing price for the purposes of defrauding others, they may be actionable under Rule 10b-5.[22] While difficult to prove and heavily dependent on the facts and circumstances, claiming open market manipulation is not without precedent. Two examples are illustrative.

First, Markowski v. SEC involved executives of Global America, Inc., an underwriter, who challenged an SEC order sustaining disciplinary action taken against them by the National Association of Securities Dealers. Global America had underwritten an IPO of a security, after which it accounted for nearly all of the open market purchases and sales in the first six months of that security’s trading. The SEC alleged that Global America’s trading activity kept the stock price artificially inflated, until Global America stopped trading in the stock and its price cratered. Although all of Global America’s transactions were real trades at the market price and did not involve any misrepresentations, the SEC alleged that the effect and intent of Global America’s trading was nevertheless to boost the share price of the security in question. In December 2001, the D.C. Circuit affirmed Rule 10b-5 liability for the Global America executives involved in this stock market manipulation.[23]

United States v. Mulhern provides another example of a claim of open market manipulation that satisfied the elements (though in this instance the government failed to meet its burden of proof). Mulhern involved famed financier Ivan Boesky, who acquired 4.9% of Gulf & Western Industries’ common stock. The government’s unproven allegations were as follows: Boesky first made a failed attempt at a leveraged buyout, after which he subsequently offered to sell his stake back to Gulf & Western at an above-market price. When Gulf & Western rejected that proposal, Boesky next allegedly caused his associate John Mulhern, the chief trader and general partner of a broker-dealer, to make a series of purchases of additional Gulf & Western stock that soon pushed its share price up to Boesky’s desired level. With the stock price rising, Gulf & Western eventually agreed to the earlier proposal and purchased from Boesky his entire 4.9% stake. In addition to losing Mulhern approximately $65,000 on his Gulf & Western investment when the price subsequently went back down, the U.S. Attorney for the Southern District of New York criminally charged Mulhern with multiple counts of market manipulation under Rule 10b-5. The Second Circuit subsequently overturned Mulhern’s conviction on four counts of market manipulation. Crucially, however, the Second Circuit did not reject the legal theories at the heart of the prosecution, but rather determined that the government had failed to satisfy its burden of proof.[24]

II. Other Options to Maintain Market Integrity

Aside from litigation, both the private sector and regulators have a number of options to preserve the integrity of financial markets.

a. Regulatory Intervention

The SEC and other regulators have a wide variety of tools at their disposal to “protect[ ] investors, maintain[ ] fair, orderly and efficient markets, and facilitat[e] capital formation.”[25] Although it has yet to invoke this power, for example, the SEC may suspend trading in a security for up to ten days, either outright or with respect to particular types of trading.[26] Notably, during the 2008 financial crisis the SEC suspended short selling to protect the integrity of the market.[27] Self-regulatory organizations (“SRO”), such as stock exchanges, can also halt trading in circumstances where there is a significant imbalance in the volume of buy and sell orders in a security.[28]

Neither the SEC nor the various SROs handling GameStop and the other securities with similar patterns of extremely volatile trading divorced from their financial fundamentals have chosen to exercise this authority during the current short squeeze event to-date. Robinhood, a trading platform used by retail investors, did choose to temporarily limit certain types of trading in approximately 50 different securities—including GameStop—as a risk management decision that Robinhood asserted was necessary to protect the platform and its clearinghouses, and to ensure its compliance with various regulatory requirements.[29]

b. Practical Considerations for Hedge Funds and Other Financial Institutions

Short of litigating claims based on market manipulation, market participants might also consider other approaches to these tumultuous times.

As an initial matter, recent market events have underscored the importance of securities law compliance and monitoring. Hedge funds and other financial institutions could consider expanding their current compliance programs, if needed, to include monitoring of message boards and social media postings to determine whether other market participants are complying with the securities laws. Such monitoring could allow hedge funds and others to more proactively anticipate and respond to market disrupting events. To the extent that they have not already done so, for instance, hedge funds and other financial institutions could create a process for swiftly compiling and analyzing online chatter in order to remain alert as to emerging efforts to coordinate investment activities.

When it comes to information circulated online, hedge funds and others might also consider proactively engaging with retail investors and the media by correcting any misinformation being disseminated online. Specifically, institutional investors might consider identifying and correcting false information discovered in the marketplace through counsel and external investigators. Financial institutions could also collaborate with public relations consultants to engage online and traditional media platforms to assist in correcting emerging inaccuracies before they attain undue momentum.

Hedge funds and others should also consider proactively engaging with online platforms to request that false, misleading and/or reckless allegations concerning a company or its personnel be taken down pursuant to the hosting companies’ policies and processes. “Take Down” requests might not be feasible on the grand scale currently seen on Reddit message boards, however, and targeting particularly problematic posts may be more effective. For social media platforms hosting stock trading discussions, such as Reddit and Yahoo!, it is important to note that Section 230 of the Communications Decency Act of 1996 provides them with broad protection in connection with content posted by third-parties on their platforms. Accordingly, the hosting entities themselves generally cannot be held liable for what others say on their platform.[30] Market participants can nevertheless work with counsel to familiarize themselves with the user policies of social media companies and online message boards in order to flag instances of misconduct that may violate the hosting platform’s policies. On the evening of January 27th, for example, online platform Discord briefly removed a “WallStreetBets” thread for violating its guidelines on hate speech and spreading misinformation.[31] Notably, the “WallStreetBets” forum on Reddit has rules that prohibit posts that “contain[ ] false or misleading information . . . made for the purpose of manipulating the market for a security” and provide that “[a]ny activity of this sort is against the securities laws and will not be tolerated on this forum.”[32] Efforts to pinpoint specific violations can thus aid online platforms in the expedient removal of false and misleading posts.

c. Practical Considerations for Issuers of Securities

As markets are liberalized and retail investors can more readily access equities markets and coordinate efforts therein to create massive volatility, issuers should be aware of their strategic options if they become a target of a similar GameStop-style campaign. As with all aspects of a business, the first step in addressing any potential harm is monitoring and becoming aware of the situation before it gets out of control.

Rising share prices seemingly present opportunities for issuers that should be carefully considered with legal counsel and other advisors. For instance, those with shelf offerings or at-the-market equity programs in place may attempt to capitalize on their good fortune. To provide an example, AMC Entertainment, another issuer recently impacted by significant retail investor activity, completed a pre-planned at-the-market equity program by selling 63.3 million shares after seeing its stock price increase significantly in the first weeks of January, allowing it to raise $304.8 million.[33] An issuer finding itself in the strange situation of not believing in the value of its own share price nevertheless must be careful to avoid making any material misstatements or omissions supporting such unjustified enthusiasm, especially when considering making any form of stock issuance. For example, an issuer might consider if it is appropriate under the circumstances to make a public statement explaining that there is no material information to account for the rising share price. Companies issuing securities based on a price they believe to be inflated may well run the risk of regulatory inquiries, and/or securities litigation if and when the share price eventually declines. And, as always, issuers and employees of issuers must be cautious to avoid even the appearance of trading on inside information when dealing in the company’s securities.

Of course, instead of the next volatility event of this nature driving stock prices up, it is just as likely an issuer could be targeted with a run of short-selling that drives the stock price down. In this case, issuers should be ready to engage in the “take down” efforts, discussed above. Issuers might also consider engaging, as appropriate under the circumstances, legal counsel, crisis management experts, accountants, and a public relations team to ensure they are correcting any false information and assuring the public of the issuers fundamental health. Issuers in such a situation might also avail themselves of one of the author’s prior writings on this very topic.[34]

* * * * * * *

By developing sound crisis management plans and executing them with the right mix of offensive and defensive strategies, hedge funds, financial institutions and issuers can weather these turbulent times. And as always, Gibson Dunn remains available to help its clients in doing so.

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   [1]   See, e.g., Theron Mohamed, Day Traders Are Piling into Hertz, JCPenney, and Other Bankruptcy Stocks Despite Massive Risks, Business Insider (Jun 11, 2020), https://www.businessinsider.com/robinhood-traders-bet-hertz-bankruptcy-stocks-despite-huge-risks-2020-6.

   [2]   Some have analogized the current activity of message board users to “idea dinners” or gatherings of hedge fund managers to discuss stocks, markets, and trends. Such dinners and other idea exchanges were previously investigated by the United States Securities and Exchange Commission (“SEC”) and the United States Department of Justice. In 2010, for example, the Department of Justice investigated a number of hedge funds for allegedly colluding in betting against the Euro after one such idea dinner. No charges were ever brought.

   [3]   See, e.g., Ian Sherr, Reddit’s GameStop Stock Battles with Wall Street are Turning Into a War, CNET (Jan. 28, 2021), https://www.cnet.com/personal-finance/reddits-gamestop-stock-battles-with-wall-street-are-turning-into-a-war; Yun Li, GameStop Mania Explained: How the Reddit Retail Trading Crowd Ran Over Wall Street Pros, CNBC (Jan. 27, 2021), https://www.cnbc.com/2021/01/27/gamestop-mania-explained-how-the-reddit-retail-trading-crowd-ran-over-wall-street-pros.html.

   [4]   Katie Canales, Reddit Says It’s Down Amid a Stock-Market Frenzy Caused by Subredditors and Skyrocketing GameStop Shares, Business Insider (Jan. 27, 2021), https://www.businessinsider.com/reddit-is-down-outage-amid-gamestop-stock-market-interest-2021-1.

   [5]   Elana Dure, Robinhood, Interactive Brokers Latest to Restrict Trading of GameStop and Others, Investopedia (Jan. 28, 2021), https://www.investopedia.com/robinhood-latest-broker-to-restrict-trading-of-gamestop-and-others-5100879.

   [6]   See, e.g., Yun Li, Melvin Capital, Hedge Fund Targeted by Reddit Board, Closes out of GameStop Short Position (Jan. 27, 2021), https://www.cnbc.com/2021/01/27/hedge-fund-targeted-by-reddit-board-melvin-capital-closed-out-of-gamestop-short-position-tuesday.html; Maggie Fitzgerald, Citron Research, Short Seller Caught Up in GameStop Squeeze, Pivoting to Finding Long Opportunities (Jan. 29, 2021), https://www.cnbc.com/2021/01/29/citron-research-short-seller-caught-up-in-gamestop-squeeze-pivoting-to-finding-long-opportunities.html.

   [7]   Compare David Dayen, The GameStop Craziness Pulls Back the Curtain on the Stock Market, The American Prospect (Jan. 28, 2021), https://prospect.org/power/gamestop-craziness-pulls-back-curtain-on-stock-market/, and Sarah Jones, The Final Boss is Capitalism, New York Magazine (Jan. 29, 2021), https://nymag.com/intelligencer/2021/01/gamestop-saga-shows-the-final-boss-is-capitalism.html; with Matt Levine, The GameStop Game Never Stops, Bloomberg (Jan. 25, 2021), https://www.bloomberg.com/opinion/articles/2021-01-25/the-game-never-stops.

   [8]   Zachary Karabell, How the GameStop Trading Surge Will Transform Wall Street, Time (Jan. 28, 2021), https://time.com/5934285/gamestop-trading-wall-street/; see also, e.g., John Detrixhe, The Dark Side of the Democratization of Trading, Quartz (Jan. 29, 2021), https://news.yahoo.com/dark-side-democratization-trading-161358522.html.

   [9]   Following Recent Market Instability, Waters Announces Hearing on Short Selling, Online Trading Platforms (Jan. 28, 2021), here.

[10]   Brown: Wall Street Only Cares About Rules When Hedge Funds Get Hurt (Jan. 28, 2021), https://www.brown.senate.gov/newsroom/press/release/brown-wall-street-hedge-funds.

[11]   Nelson v. Robinhood Financial LLC, No. 21 Civ. 777, Dkt. 1 (S.D.N.Y. Jan. 28, 2021).

[12]   See, e.g., Courtney v. Robinhood Financial LLC et al., 21 Civ. 60220 (S.D. Fla.); Daniels v. Robinhood Financial, LLC et al., No. 21 Civ. 290 (D. Colo.); Gatz v. Robinhood Financial, LLC, No. 12 Civ. 490 (N.D. Ill.); Kayali v. Robinhood Financial, LLC et al., No. 21 Civ. 510 (E.D. Ill.); Lavin v. Robinhood Financial, LLC et al., No. 21 Civ. 115 (E.D. Va.); Ross v. Robinhood Financial LLC et al., No. 21 Civ. 292 (S.D. Tex.); Schaff v. Robinhood Markets, Inc. et al., No. 21 Civ. 216 (M.D. Fla.); Simpson v. Robinhood Financial, LLC, No. 21 Civ. 207 (N.D. Tex.); Weig v. Robinhood Financial, LLC et al., No. 21 Civ. 693 (N.D. Cal.); Ziegler v. Robinhood Financial LLC et al., No. 21 Civ. 123 (D. Conn.); Zybura v. Robinhood Financial, LLC et al., No. 21 Civ. 1348 (D.N.J.).

[13]   Dean Seal, White House, SEC ‘Monitoring’ Volatile GameStop Stock, Law360 (Jan. 27, 2021), https://www.law360.com/media/articles/1349195/white-house-sec-monitoring-volatile-gamestop-stock?nl_pk=ef15795b-2462-46f9-bdad-117fcfcc6a0f&utm_source=newsletter&utm_medium=email&utm_campaign=media.

[14]   Charles Gasparino, Sic the SEC? Not so Fast – Case Near Impossible to Prove, N.Y. Post (Jan. 28, 2021), https://nypost.com/2021/01/28/will-the-sec-probe-the-gamestop-stock-mania-not-so-fast/. In a “pump and dump” scheme an investor spreads false or misleading information about a company in an attempt to induce other market participants to buy stock in that company. Once the stock price has been “pumped” up by the increased, but unwarranted, market enthusiasm, the investor will then “dump” their shares at a profit before the market accounts for the false information and returns the stock to a more appropriate baseline price.

[15]   The Texas Attorney General issued civil investigative demands. See Diane Bartz, Texas Attorney General Probes GameStop Trade Curbs from Robinhood, Others (Jan. 29, 2021), https://www.reuters.com/article/us-retail-trading-robinhood-texas/texas-attorney-general-probes-gamestop-trade-curbs-from-robinhood-others-idUSKBN29Y2US. The New York Attorney announced an inquiry. See Ben Feuerherd, NY AG Letitia James ‘Reviewing’ Robinhood Over GameStop Trade Restrictions (Jan. 28, 2021), https://nypost.com/2021/01/28/ny-ag-letitia-james-reviewing-robinhood-over-gamestop-trading/.

[16]   See Kayali v. Robinhood Financial, LLC et al., No. 21 Civ. 510 (N.D. Ill.); Lavin v. Robinhood Financial, LLC et al., No. 21 Civ. 115 (E.D. Va.); Ross v. Robinhood Financial LLC et al., No. 21 Civ. 292 (S.D. Tex.).

[17]   See Daniels v. Robinhood Financial, LLC et al., No. 21 Civ. 290 (D. Colo.); Gatz v. Robinhood Financial, LLC, No. 12 Civ. 490 (N.D. Ill.).

[18]   17 C.F.R. § 240.10b-5(a)-(c).

[19]   15 U.S.C. § 78i(a)(2).

[20]   See Fed. R. Civ. P. 23(a) (“One or more members of a class may sue or be sued as representative parties on behalf of all members . . . .”) (emphasis added).

[21]   For an in-depth analysis of open market manipulation see Gina-Gail S. Fletcher, Legitimate Yet Manipulative: The Conundrum of Open-Market Manipulation, 68 DUKE L.J. 479 (2018).

[22]   See e.g., SEC v. Masri, 523 F. Supp. 2d 361 (S.D.N.Y. Nov. 20, 2007); CFTC v. Amaranth Advisors , L.L.C., 554 F. Supp. 2d 523 (S.D.N.Y. May 21, 2008).

[23]   Markowski v. SEC, 274 F.3d 525 (D.C. Cir. 2001).

[24]   United States v. Mulheren, 938 F.2d 364 (2d Cir. 1991).

[25]   What We Do, SEC, https://www.sec.gov/about/what-we-do.

[26]   Investor Bulletin: Trading Suspensions, U.S. Securities and Exchange Commission (Dec. 3, 2018), https://www.investor.gov/introduction-investing/general-resources/news-alerts/alerts-bulletins/investor-bulletins/investor-5.

[27]   SEC Halts Short Selling of Financial Stocks to Protect Investors and Markets, U.S. Securities and Exchange Commission (Sept. 19, 2008), https://www.sec.gov/news/press/2008/2008-211.htm.

[28]   Trading Halts and Delays, U.S. Securities and Exchange Commission (July 3, 2010), https://www.sec.gov/fast-answers/answerstradinghalthtm.html.

[29]   See, e.g., Kate Kelly, Matt Phillips, and Gillian Friedman, Trading Curbs Reverse GameStop Rally, Angering Upstart Traders, NYTimes (Jan. 28, 2021), here; Catherine Ross, Robinhood CEO on Trading Halts: ‘We Made the Correct Decision,’ Yahoo! Finance (Jan. 28, 2021), https://finance.yahoo.com/news/robinhood-ceo-trading-halts-made-001505664.html; Maggie Fitzgerald, Robinhood is Still Severely Limiting Trading, Customers Can Only Buy One Share of GameStop, CNBC (Jan. 29, 2021), https://www.cnbc.com/2021/01/29/robinhood-is-still-severely-limiting-trading-gamestop-holders-can-only-buy-one-additional-share.html; Nicholas Jasinski, Why Did Robinhood Stop GameStop Trading? Everything to Know., Barron’s (Jan. 29, 2021), https://www.barrons.com/articles/why-did-robinhood-stop-gamestop-trading-51611967696.

[30]   See 47 U.S.C. § 230 (“No provider or user of an interactive computer service shall be treated as the publisher or speaker of any information provided by another information content provider.”).

[31]   Connor Smith, Reddit’s WallStreetBets Briefly Goes Private After Discord Shuts Down Server, Barron’s (Jan. 27, 2021), https://www.barrons.com/articles/reddits-wallstbets-goes-private-shortly-after-discord-shuts-down-server-51611792059.

[32]   r/wallstreetsbets/rules, Reddit (last accessed January 31, 2021), https://www.reddit.com/r/wallstreetbets/about/rules.

[33]   See AMC Completes At the Market Equity Program, Yahoo! Finance (Jan. 27, 2021), https://finance.yahoo.com/news/amc-completes-market-equity-program-170800262.html.

[34]   See Avi Weitzman, Barry Goldsmith & Jonathan Seibald, What to Know About Short-Seller Risks During Pandemic, Law360 (June 3, 2020), https://www.law360.com/articles/1278319.


The following Gibson Dunn attorneys assisted in preparing this client update: Alexander H. Southwell, Reed Brodsky, Jennifer L. Conn, Avi Weitzman, Michael Nadler, Liesel N. Schapira and Trevor Gopnik.

Gibson Dunn’s lawyers are available to assist with any questions you may have regarding these developments. For additional information, please feel free to contact the Gibson Dunn lawyer with whom you usually work, any member of the firm’s Securities Enforcement Group, or the following authors in New York:

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January 20, 2021 |
What the CFTC’s Settlement with Vitol Inc. Portends about Enforcement Trends

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On December 3, 2020, the Commodity Futures Trading Commission (“CFTC” or the “Commission”) Division of Enforcement (the “Division”) announced a settlement with Vitol Inc. (“Vitol”), an energy and commodities trading firm in Houston, Texas. This is the first public action coming out of the CFTC’s initiative to pursue violations of the Commodity Exchange Act (“CEA”) involving foreign corruption. The CFTC’s action rests on an aggressive theory that seeks to approach allegations of corruption through its historic ability to pursue fraud and manipulation, which has not yet faced a serious legal challenge. It is an enforcement area we expect will continue to be a priority for the CFTC. This settlement involved cooperation between U.S. and Brazilian regulators in what appears to be another significant corporate resolution associated with the Operation Car Wash corruption investigations in Brazil. We expect to see the continued convergence of enforcement by a variety of U.S. enforcement authorities and regulators approaching aspects of alleged foreign corruption from a range of angles corresponding to their primary focus of interest. Depending on the facts, the same conduct that the Department of Justice (“DOJ”) and the Securities and Exchange Commission (“SEC”)—the principal FCPA investigation authorities—investigate for violations of the Foreign Corrupt Practices Act (“FCPA”) already may face scrutiny by DOJ’s Money Laundering and Asset Recovery Section (“MLARS”) on a money laundering basis (including its Kleptocracy Asset Recovery initiative where foreign plutocracy is involved and its Bank Integrity Unit where banks are involved), by the CFTC for violations of the CEA where commodities trading is involved, and by the Federal Reserve for violations of banking regulations. And in the Biden Administration, this convergence may accelerate as the Administration aligns with more vigorous corporate enforcement anticipated in the new era. Navigating the expanding investigations field will become more complex, even more so to the extent that agencies flexing their muscles do not coordinate their efforts.

Given the CFTC’s aggressive approach to bringing enforcement actions involving foreign corruption, and its stated intention to continue to do so, it is particularly important that companies regulated by the CFTC assess and update their compliance programs to meet the standards set forth in the guidance on evaluating compliance programs that the CFTC issued in September 2020.[1] Moreover, in light of the multi-agency targeting of conduct involving foreign corruption, such companies should also make sure that their compliance programs meet the standards of other agencies, such as DOJ.[2]

The Vitol Settlement

The CFTC asserted that from 2005 to early 2020, Vitol engaged in manipulative and deceptive conduct involving foreign corruption and physical and derivatives trading in the U.S. and global oil markets.[3] Specifically, the CFTC’s order found that Vitol violated the CEA [4] in a few different ways, using for the first time the alleged foreign corrupt conduct as a basis for a finding of manipulative or fraudulent acts cognizable under the statute.[5] First, it allegedly made corrupt payments, such as bribes and kickbacks, to employees and agents of certain state-owned entities (“SOEs”) in Brazil, Ecuador, and Mexico to obtain preferential treatment and access to trades with the SOEs to the detriment of the SOEs and other market participants.[6] Vitol, according to the CFTC, concealed this conduct by funneling the payments through offshore bank accounts or to shell entities, and by issuing deceptive invoices.[7] Second, it allegedly made corrupt payments to employees and agents of the Brazilian SOE in exchange for confidential information about trading in physical oil and derivatives, such as the specific price at which Vitol would win a supposedly competitive bidding or tender process.[8] Additionally, Vitol attempted to manipulate two Platts fuel oil benchmarks in order to benefit Vitol’s physical and derivatives positions.[9] If Vitol’s attempts to manipulate the benchmarks had been successful, charged the CFTC, it would have harmed those market participants who held opposing positions and those who rely on the benchmarks as an untainted price reference for U.S. physical or derivative trades.[10]

The same day, the Fraud Section of the DOJ and the United States Attorney’s Office for the Eastern District of New York announced a parallel action in which they entered a Deferred Prosecution Agreement (“DPA”) with Vitol on charges of conspiracy to violate the FCPA.[11] Vitol agreed to pay a criminal penalty of $135 million under the DPA, and the DOJ noted that it would credit $45 million against the amount Vitol agreed to pay to resolve an investigation by the Brazilian Ministério Público Federal (“MPF”) for conduct related to the company’s bribery scheme in Brazil.[12] Specifically, on December 3, 2020, the MPF entered into a leniency agreement with Vitol Inc. and Vitol do Brasil Ltda. in connection with Operation Car Wash. In a December 29, 2020 securities filing, Brazilian state-run oil company Petrobras announced that it received 232.6 million reais (or $44.65 million) as a result of this leniency agreement.[13]

The CFTC ordered Vitol to pay more than $95 million in civil monetary penalties and disgorgement.[14] Notably, it recognized Vitol’s cooperation during the investigation in the form of a reduced civil monetary penalty.[15] It also recognized and offset a portion of the criminal penalty that Vitol agreed to pay to the DOJ in the parallel criminal action.[16]

CFTC’s Foreign Corrupt Practices Initiative

The CFTC launched its foreign corrupt practices initiative on March 6, 2019, when the Division issued an advisory on self-reporting and cooperation for CEA violations involving foreign corrupt practices (the “Enforcement Advisory”).[17] It announced that it would apply a presumption, absent aggravating circumstances, that it would not recommend imposing a civil monetary penalty in a CFTC action involving foreign corrupt practices where a company or individual not registered or required to be registered with the CFTC (i) voluntarily discloses violations of the CEA involving foreign corrupt practices, (ii) provides full cooperation, and (iii) appropriately remediates.[18] The CFTC bolstered its initiative in May 2019 by issuing a whistleblower alert targeting foreign corrupt practices in the commodities and derivatives markets.[19] To date, this is only the fourth area of potential misconduct regarding which the CFTC has proactively sought tips from would-be whistleblowers.

Implications of Settlement

First, we expect the CFTC to continue pursuing more cases involving foreign corruption in the future. This is the first case brought by the CFTC involving foreign corruption, but it is unlikely to be the last. There are public reports of at least two additional foreign corruption investigations undertaken by the CFTC involving commodities traders. The Enforcement Advisory was issued on the heels of a voluntary disclosure by Switzerland-based mining company Glencore, in April 2019, that it was the subject of an investigation by the CFTC involving foreign corruption claims. Glencore also has announced anti-corruption investigations by the DOJ for potential violations of the FCPA and U.S. money laundering statutes, Brazilian authorities, and Swiss prosecutors,[20] and it disclosed that the CFTC’s investigation had a similar scope as the ongoing DOJ investigation.[21] No settlement or charges have been announced with respect to the Glencore investigations. News sources also report that Trafigura Group Pte. Ltd., a Singapore-based commodity trading company, is under investigation by the CFTC and Brazilian authorities for similar allegations.[22]

The CFTC’s 2019 issuance of a whistleblower alert soliciting tips about foreign corrupt practices further shows that it is serious about bringing enforcement actions in this area. The CFTC’s whistleblower program pays a qualified tipster 10 to 30 percent of any fine over $1 million levied against a firm for violations of CFTC regulations, and it has significantly enhanced the CFTC’s enforcement program. Whistleblowing is likely to increase, not just because there may be conduct to report, but because those aware of it and lawyers working to facilitate reporting will see the benefit of doing so through the CFTC’s initiative. Just as the Dodd-Frank whistleblowing award program has significantly increased FCPA tips to the SEC (and DOJ), we expect the CFTC’s whistleblowing push could significantly increase the amount of information the CFTC receives and, in turn, the CFTC’s ability to bring enforcement actions relating to foreign corruption.

With the announcement of the Vitol settlement, the CFTC has reaffirmed its interest in pursuing CEA violations involving foreign corruption. The CFTC has identified the following examples of foreign corrupt practices that could constitute violations of the CEA and thus be the focus of a CFTC enforcement action:

  • The use of bribes to secure business in connection with regulated activities like trading, advising, or dealing in swaps or derivatives;
  • Manipulation of benchmarks that serve as the basis for related derivatives contracts;
  • Reporting prices that are the product of corruption to benchmarks; and
  • Corrupt practices that might alter the prices in commodity markets that drive U.S. derivatives prices.[23]

Second, the CFTC will continue to coordinate closely with other regulators in its pursuit of foreign corruption. The CFTC frequently coordinates with the DOJ, SEC, and other law enforcement partners, often bringing parallel enforcement actions in areas such as spoofing, misappropriating funds, violations of registration provisions of the federal securities laws, and the manipulation of benchmark interest rates (e.g., the LIBOR cases).[24] The Vitol settlement underscores that this cooperation will continue in its foreign corruption initiative. We expect the CFTC to continue to utilize its partnerships with other regulators to pursue foreign corruption, with commodities trading serving as the CFTC’s entry point to police foreign corruption under the CEA. That Gary Gensler, formerly the CFTC Chair from 2009 to 2014, is expected to be nominated to serve as the next SEC Chair may smooth the way for the two regulators to collaborate more in foreign corruption (and other) investigations and bringing parallel enforcement actions.[25]

While the CFTC has stated publicly that it is not trying to enforce the FCPA or “pile on” when it comes to penalties,[26] if there is a commodities trading component to a foreign corruption scheme, the CFTC has made clear it has a role to play in investigating and charging such conduct. In announcing the CFTC’s foray into foreign bribery, the former Director of Enforcement emphasized the agency’s intention to coordinate closely with DOJ, SEC, and other regulators, including foreign authorities, so that it is “investigat[ing] in parallel with other enforcement authorities” to “avoid duplicative investigative steps,” account for penalties imposed by other authorities, and give “credit for disgorgement or restitution payments in connection with other related actions.”[27] But the CFTC’s involvement creates an added layer of liability and a potentially expanded universe of relevant conduct that companies with international operations must be mindful of going forward. As we have seen with navigating other multi-agency investigations where conflicting investigative approaches and duplicative penalty demands occur too frequently, early and careful coordination between investigations is critical to ensuring outcomes are proportionate.

Third, going forward, we expect that foreign corruption allegations involving commodities-related business will continue to be investigated and pursued by multiple agencies, domestic and foreign, approaching the issue from different angles. In other words, as the growing number of multi-jurisdictional and agency anti-corruption resolutions suggest, the FCPA units of the DOJ and SEC are not the only cops on the beat, and they have not been for quite some time. As a growing number of regulators in the U.S. and abroad get involved in anti-corruption enforcement, the enforcement landscape only becomes more complex. By way of domestic examples, DOJ’s Money Laundering and Asset Recovery Section (“MLARS”) has repeatedly teamed up with its FCPA colleagues to pursue foreign corruption through the lens of the anti-money laundering statutes, both to recover huge sums through its Kleptocracy Program and in prosecuting companies and individuals involved in moving tainted bribery proceeds. In the financial sector, the Federal Reserve has demonstrated its resolve to pursue banks for similar conduct under its authority to supervise banks’ financial controls and oversight functions.[28] Not to be outdone, the CFTC has joined the fray, making clear it will aggressively pursue foreign corruption under the CEA where commodities or related derivatives are involved.[29]

Finally, energy firms in particular should be aware of this development. Although they will not be the CFTC’s only focus, energy trading firms are squarely in the CFTC’s sights. They have historically engaged in transactions that fall under the CEA and often involve contact with risky counterparties. The Vitol settlement makes clear that energy is one industry the CFTC is monitoring with respect to foreign corruption. We expect to see the CFTC under the Biden Administration focus on energy trading cases involving foreign corrupt practices, including assertions that such conduct in energy pricing has disadvantaged the consumer.

In sum, the CFTC will likely become increasingly active in using the CEA as a tool to go after perceived foreign corruption in the commodities markets, claiming such conduct constitutes manipulation or even fraud, while working in parallel with the DOJ and possibly other domestic and foreign regulators intent on vindicating their particular enforcement mandate. Businesses that are involved in cross-border derivatives work should be prepared for potential scrutiny of their transactions, particularly those involving contact with foreign officials or sovereign wealth funds. The CFTC previously has launched broad industry initiatives (for example, with regard to LIBOR interest rate benchmarks), and it remains to be seen whether the CFTC will take such an approach, or pursue foreign corruption on a company-by-company basis as evidence surfaces. Either way, as the CFTC made clear in its 2020 compliance guidance, the CFTC expects companies to address potential corrupt behavior that may harm commodities markets through compliance program enhancements.

______________________

   [1]   CFTC, Guidance on Evaluating Compliance Programs in Connection with Enforcement Matters (Sept. 10, 2020), https://www.cftc.gov/media/4626/EnfGuidanceEvaluatingCompliancePrograms091020/download.

   [2]   Dep’t of Justice, Evaluation of Corporate Compliance Programs (June 3, 2020), https://www.justice.gov/criminal-fraud/page/file/937501/download.

   [3]   CFTC Press Release Number 8326-20, CFTC Orders Vitol Inc. to Pay $95.7 Million for Corruption-Based Fraud and Attempted Manipulation (Dec. 3, 2020), https://www.cftc.gov/PressRoom/PressReleases/8326-20.

   [4]   The CFTC relied on allegations involving corruption to establish fraud under the CEA, even though corruption and fraud are distinct acts with different harms. The CFTC appears to believe that the corruption in this case was a form of deceptive practice and that it need only prove that such corruption infected the market. This is an aggressive theory to which there may be defenses.

   [5]   Order Instituting Proceedings, In re Vitol Inc., CFTC Docket No. 21-01 (Dec. 3, 2020), https://www.cftc.gov/media/5346/enfvitolorder120320/download.

   [6]   Id. at 4.

   [7]   Id.

   [8]   Id. at 5.

   [9]   Id. at 6-7.

[10]   Id.

[11]   Dep’t of Justice, Press Release, Vitol Inc. Agrees to Pay over $135 Million to Resolve Foreign Bribery Case (Dec. 3, 2020), https://www.justice.gov/opa/pr/vitol-inc-agrees-pay-over-135-million-resolve-foreign-bribery-case.

[12]   Id.

[13]   Petróleo Brasileiro S.A. – Petrobras Form 6-K (Dec. 29, 2020), here; see Petrobras receives $45 million in Vitol corruption settlement, Reuters (Dec. 29, 2020), https://www.reuters.com/article/us-petrobras-vitol-settlement/petrobras-receives-45-million-in-vitol-corruption-settlement-idUSKBN294043.

[14]   Id. at 11-12.

[15]   Id. at 3, 8.

[16]   Id. at 11, 12, 14.

[17]   See CFTC Enforcement Advisory: Advisory on Self-Reporting and Cooperation for CEA Violations Involving Foreign Corrupt Practices (Mar. 6, 2019) (“Enforcement Advisory”); CFTC Press Release Number 7884-19, CFTC Division of Enforcement Issues Advisory on Violations of the Commodity Exchange Act Involving Foreign Corrupt Practices (Mar. 6, 2019), https://www.cftc.gov/PressRoom/PressReleases/7884-19; Remarks of CFTC Director of Enforcement James M. McDonald at the American Bar Association’s National Institute on White Collar Crime (Mar. 6, 2019), https://www.cftc.gov/PressRoom/SpeechesTestimony/opamcdonald2 (“McDonald Remarks”).

[18]   Registrants are not eligible for the presumptive recommendation of no penalty. However, registrants who self-report, cooperate, and remediate will continue to be eligible for a “substantial reduction in penalty” under the existing Enforcement Advisories. See McDonald Remarks.

[19]   CFTC Whistleblower Alert: Blow the Whistle on Foreign Corrupt Practices in the Commodities and Derivatives Markets (May 2019), https://www.whistleblower.gov/whistleblower-alerts/FCP_WBO_Alert.htm.

[20]   Glencore, Update on subpoena from United States Department of Justice (July 11, 2018), https://www.glencore.com/media-and-insights/news/Update-on-subpoena-from-United-States-Department-of-Justice; Jeffrey T. Lewis et al., Brazil’s Car Wash Probe Eyes Glencore, Vitol, Trafigura for Paying Millions in Bribes, The Wall Street Journal (Dec. 5, 2018), https://www.wsj.com/articles/brazils-car-wash-probe-eyes-glencore-vitol-trafigura-for-paying-millions-in-bribes-1544021378; Glencore, Investigation by the Office of the Attorney General of Switzerland (June 19, 2020), https://www.glencore.com/media-and-insights/news/investigation-by-the-office-of-the-attorney-general-of-switzerland.

[21]   Glencore, Announcement re the Commodity Futures Trading Commission (Apr. 25, 2019), https://www.glencore.com/media-and-insights/news/announcement-re-the-commodity-futures-trading-commission.

[22]   Rob Davies, Trafigura investigated for alleged corruption, market manipulation, The Guardian (May 31, 2020), https://www.theguardian.com/world/2020/may/31/trafigura-investigated-for-alleged-corruption-market-manipulation; Dave Michaels and Dylan Tokar, Energy Trader Vitol Paying $163 Million to Settle Corruption, Manipulation Charges, The Wall Street Journal (Dec. 3, 2020), https://www.wsj.com/articles/energy-trader-vitol-to-pay-90-million-to-settle-u-s-corruption-charges-11607023519.

[23]   McDonald Remarks.

[24]   See, e.g., CFTC Press Release Number 7884-19; CFTC Press Release Number 8074-19, CFTC Orders Proprietary Trading Firm to Pay Record $67.4 Million for Engaging in a Manipulative and Deceptive Scheme and Spoofing (Nov. 7, 2019), https://www.cftc.gov/PressRoom/PressReleases/8074-19; CFTC Press Release Number 8120-20, CFTC Charges Investment Firm and VP with Commodity Pool Fraud (Feb. 20, 2020), https://www.cftc.gov/PressRoom/PressReleases/8120-20; Press Release, Securities and Exchange Comm’n, SEC Charges Bitcoin-Funded Securities Dealer and CEO (Nov. 1, 2018), https://www.sec.gov/litigation/litreleases/2018/lr24330.htm; CFTC Press Release Number 7159-15, Deutsche Bank to Pay $800 Million Penalty to Settle CFTC Charges of Manipulation, Attempted Manipulation, and False Reporting of LIBOR and Euribor (Apr. 23, 2015), here.

[25]   See Andrew Ackerman and Dave Michaels, Biden Is Expected to Name Gary Gensler for SEC Chairman, Wall Street Journal, https://www.wsj.com/articles/biden-is-expected-to-name-gary-gensler-for-sec-chairman-11610487023.

[26]   McDonald Remarks.

[27]   Id.

[28]   See Board of Governors of the Federal Reserve System, Press Release, Federal Reserve Board orders JPMorgan Chase & Co. to pay $61.9 million civil money penalty (Nov. 17, 2016), https://www.federalreserve.gov/newsevents/pressreleases/enforcement20161117a.htm; Board of Governors of the Federal Reserve System, Press Release, Federal Reserve Board fines the Goldman Sachs Group, Inc. $154 million for failure to maintain appropriate oversight, internal controls, and risk management with respect to 1Malaysia Development Berhad (1MDB) (Oct. 22, 2020), https://www.federalreserve.gov/newsevents/pressreleases/enforcement20201022a.htm.

[29]   While it is difficult to predict whether other U.S. regulators will prioritize focusing on foreign bribery conduct, the statutory support may already be there for other banking regulators, as well as even FinCEN. For example, FinCEN has authority under the Bank Secrecy Act (“BSA”) and AML laws to hold U.S. financial institutions accountable for weak controls. And, notably, on January 1, 2020, the Senate passed the Anti-Money Laundering Act of 2020 (“AMLA”), which is the most comprehensive set of reforms to the AML laws in the United States since the USA PATRIOT Act in 2001. See William M. (Mac) Thornberry National Defense Authorization Act for Fiscal Year 2021, H.R. 6395. The AMLA has a number of provisions that could result in significantly increased civil and criminal enforcement of AML violations, including, among others, a significantly expanded whistleblower award program that parallels that of the CFTC. See AMLA, § 6314 (adding 31 U.S.C. § 5323(b)(1)). The AMLA is discussed in detail in a separate Gibson Dunn client alert: Gibson Dunn, The Top 10 Takeaways for Financial Institutions from the Anti-Money Laundering Act of 2020 (Jan. 1, 2021), https://www.gibsondunn.com/the-top-10-takeaways-for-financial-institutions-from-the-anti-money-laundering-act-of-2020/.


Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments.  Please contact the Gibson Dunn lawyer with whom you usually work, any member of the firm's Derivatives, Securities Enforcement or White Collar Defense and Investigations practice groups, or the following authors:

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January 19, 2021 |
2020 Year-End Securities Enforcement Update

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I.   Introduction: Themes and Notable Developments

This year’s update marks the end of the Trump administration and the beginning of the Biden administration. The change in leadership of the Securities and Exchange Commission has already begun. In December, Jay Clayton stepped down as Chairman, and this week the Biden administration nominated Gary Gensler to be the new Chairman. Mr. Gensler was Chairman of the Commodity Futures Trading Commission in the Obama administration and presided over a period of heightened financial regulation and aggressive enforcement against major financial institutions. The Wall Street Journal predicts that Mr. Gensler could give Wall Street its “most aggressive regulator in two decades.”[1] In addition to a new Chairman, 2021 will also bring new senior leadership to the Division of Enforcement, as the Division’s Co-Directors have also left the agency. In this update, we look back at the significant enforcement actions and developments from the last six months of 2020, and consider what to expect from new leadership at the Commission and the Enforcement Division. In sum, it is safe to say that the next four years will see a return to increasing regulatory oversight and escalated enforcement of market participants.

A.   Back to the Future: A Look Back and the View Ahead

During the last six months of 2020, the SEC’s enforcement program continued to follow the priorities emphasized by Chairman Clayton over the last four years, while also navigating the challenges presented by the pandemic. In the last few months, there has also been a nearly complete departure of the senior-most leadership of the Division of Enforcement. In August and December, respectively, Division Co-Directors Steven Peikin and Stephanie Avakian, departed the agency. And in January, Marc Berger, who had been appointed Deputy Director and then Acting Director also announced that he will be leaving at the end of January. In one of his last speeches, Chairman Clayton reflected on his tenure and echoed the theme that has defined enforcement during the last administration, namely a focus on “Main Street” investors.[2] In practice, and as the Chairman noted, this has translated into a significant number of enforcement actions against fraudulent securities offerings – Ponzi schemes, affinity frauds and other offering frauds – that targeted individual investors. Of course, one of the notable challenges for the Enforcement Division this year was created by the COVID-19 pandemic. After overcoming the initial hurdles of conducting investigations remotely, the Enforcement staff continued to pursue investigations and bring enforcement actions. Nevertheless, from a numerical standpoint, the number of enforcement actions was off from the prior year. For fiscal 2020, the SEC brought a total of 715 enforcement actions (of which 405 were stand-alone enforcement actions), a significant decline from 862 actions in fiscal 2019 (of which 526 were stand-alone enforcement actions) – a decline of 23% in stand-alone enforcement actions.[3] There was also a change from last year in the types of cases the SEC brought. For fiscal 2020, the largest single category of cases involved securities offerings, typically offering frauds or unregistered securities offerings. This category accounted for nearly one-third, or 32%, of the stand-alone enforcement actions, compared to 21% of the actions brought in 2019 (and compared to only 16% of the cases in the last year of the Obama administration). Other major categories of cases in fiscal 2020 included cases against investment advisers, which comprised 21% of the total (compared to 36% of the total in fiscal 2019) and cases involving public company financial reporting and disclosure, which comprised 15% of the total in fiscal 2020 (compared to 17% of the total in fiscal 2019). Despite the decline in the number of cases, there was an increase in the amount of financial remedies (disgorgement and penalties) ordered in enforcement actions. For fiscal 2020, financial remedies totaled $4.68 billion, representing an increase of approximately 8% over the amount ordered in 2019. However, it should be noted that a substantial portion of the 2020 financial remedies was attributable to one case – a settlement with Telegram Group Inc. – in which the company was ordered to pay $1.2 billion in disgorgement, but was credited in full for returning the same amount to investors that had purchased the company’s unregistered digital tokens. Removing this settlement from the financial remedies for fiscal 2020 would reduce the total amount recover to an amount well below the amount ordered in 2019. Notwithstanding the challenges of the pandemic, the SEC brought a number of significant enforcement actions in the last half of 2020 that we discuss in greater detail in other sections of this update. In particular, the SEC brought a number of cases against public companies for financial reporting and disclosure issues. Three of these cases were the result of the Enforcement Division’s “EPS Initiative,” in which the staff used risk-based data analytics to identify potential earnings management practices. Other significant cases were the result of the Enforcement Division’s focus on cases related to the pandemic. In particular, the SEC brought the first enforcement action based on disclosures concerning a company’s ability to operate sustainably despite the pandemic. This year also saw a number of enforcement actions in the area of crypto-currency and other digital assets. In particular, shortly before the end of the year, the SEC filed a complaint against Ripple Labs for alleged violation of the securities registration provisions. The outcome of this litigation will have a significant impact on enforcement and regulation of the digital asset market in the future. Another highlight of the last year has been the continued growth of the SEC’s whistleblower program. This year is the tenth anniversary of the program and was also a year of record awards both in number and size. Increased efficiency in the award process is also ensuring that the program has become, and will continue to be, an important source of investigations for the future. Looking ahead, there is little doubt that the new administration will bring a heightened level of enforcement activity. But more important, we can expect a shift in focus and priorities away from retail investors and securities offering frauds and an increased emphasis on the conduct of institutional market participants – investment advisers and broker-dealers, as well as public company accounting, financial reporting and disclosure. Assuming Mr. Gensler is confirmed by the Senate to be the next SEC Chairman, his experience, both at the helm of the CFTC and since, confirm expectations for increased regulation and enforcement. Mr. Gensler oversaw the implementation of an entirely new regime for the regulation of the markets for derivatives as well as the adoption of numerous regulations pursuant to the Dodd-Frank Act. The CFTC under his leadership also took aggressive enforcement actions against financial institutions in connection with the alleged manipulation of LIBOR. Mr. Gensler will also bring a strong interest in, and familiarity with, the market for crypto-currency and other digital tokens. This will ensure that the market for digital assets will receive particular attention in the coming years. The last time there was a transition to a Democratic administration in 2008, the SEC confronted the financial crisis and the collapse of the mortgage-backed securities market. In the wake of the financial crisis, the SEC had a defined focus for investigation in distressed financial institutions and participants in the market for mortgage-backed securities. The SEC also adopted a number of initiatives to empower the enforcement program – some based in statute, such as the whistleblower program; others based in policy and practice, such as the encouragement of witness cooperation and the imposition of admissions on certain settling defendants. The current transition in administrations follows a year of extreme market volatility caused by the pandemic, but also ending with the markets continuing to set records, benefiting from government stimulus and continued low interest rates. There is anticipation that as the COVID-19 crisis abates, the economy and markets will experience significant growth in the coming year. New Enforcement Division leadership will endeavor to identify areas of risk that they deem worthy of heightened scrutiny. In addition, oversight by a Democratic controlled House and Senate may further escalate pressure on the SEC to demonstrate its aggressiveness. The takeaway from all of this is that the next four years will put a premium on legal and compliance departments and financial reporting functions of financial institutions, investment advisers, broker-dealers and public companies.

B.   Commissioner and Senior Staffing Update

As the Trump administration wound down, there were a number of significant changes in the leadership of the Commission and the Enforcement Division. Looking ahead to the coming months, there will be further developments as a new Chairman is confirmed and new leadership of the Enforcement Division is appointed. Simultaneous with Chairman Clayton’s departure, the White House appointed Republican Commissioner Elad Roisman as Acting Chairman of the Commission. During the interim period following the inauguration of President-elect Biden, but before a new Chairman is nominated and confirmed, the White House could substitute the senior Democratic Commissioner, Allison Herren Lee, as Acting Chairman. Also during the second half of 2020, the other two Commissioners were sworn in: Democrat Commissioner Caroline Crenshaw filled the vacancy left by former Commissioner Robert Jackson, and Republican Commissioner Hester Peirce was sworn in for a second term, after her original term (for which she filled a vacancy in 2018) ended. There were also significant changes in the leadership of the Enforcement Division. With the departure of the Co-Directors Peikin and Avakian, Marc Berger was appointed Acting Director of the Enforcement Division in December. This month, Mr. Berger also announced his departure. No Acting Director has been appointed as of this writing. Other changes in the senior staffing of the Commission include:
  • In August, Scott Thompson was appointed Associate Regional Director of Enforcement in the SEC’s Philadelphia Regional Office. Mr. Thompson succeeds Kelly Gibson, who was appointed Director of the Philadelphia office in February 2020. Mr. Thompson has worked at the SEC since 2007, first as a trial attorney in the Enforcement Division and most recently as Assistant Regional Director from 2013 until his promotion in August 2020.
  • Also in August, Richard Best was appointed Director of the SEC’s New York Regional Office, succeeding Mr. Berger in the role. Mr. Best has worked at the SEC since 2015, serving in two other Regional Director roles—Salt Lake and Atlanta—before becoming the Director of the New York office. He also previously worked in FINRA’s Department of Enforcement and as a prosecutor in the Bronx District Attorney’s Office.
  • In early December, Nekia Hackworth Jones was appointed Director of the SEC’s Atlanta Regional Office. She joins the SEC from private practice where she specialized in government investigations and white collar criminal defense. Ms. Jones also previously served as an Assistant U.S. Attorney in the Northern District of Georgia and in DOJ’s Office of the Deputy Attorney General.

C.   Legislative Developments: Disgorgement

With little fanfare, the SEC achieved a significant legislative success at the end of 2020, cementing its ability to obtain disgorgement in civil enforcement actions. On January 1, 2021, Congress voted to override the President’s veto of the National Defense Authorization Act (“NDAA”), a military spending bill passed each year since 1961.[4] Buried in the $740.5 billion bill was an amendment to the Securities Exchange Act of 1934, which gives the SEC explicit statutory authority to seek disgorgement in federal court.[5] Under Section 6501 of the NDAA, the SEC is authorized to seek “disgorgement . . . of any unjust enrichment by the person who received such unjust enrichment.”[6] Perhaps more significant, the amendment establishes a ten-year statute of limitations for obtaining disgorgement for scienter-based violations of federal securities laws, doubling the 5-year standard previously established by the Supreme Court. The amendment applies to any action or proceeding that is pending on, or commenced after its enactment (i.e., January 1, 2020). As discussed in a previous alert, the amendment is a response to two recent Supreme Court decisions which limited the SEC’s authority to seek disgorgement, although the agency has a long history of seeking and receiving disgorgement: Kokesh v. SEC, 137 S. Ct. 1635 (2017) (imposing a five-year statute of limitations on disgorgement), and Liu v. SEC, 140 S. Ct. 1936 (2020) (which imposed equitable limitations on disgorgement, such as the limitation to net profits). The extension of the statute of limitations to ten years is a significant enhancement to the SEC’s remedies since many cases involve conduct that extends more than five years before an action is filed. However, notably, the amendment does not expressly reverse the equitable limitations that the Supreme Court imposed on the disgorgement remedy in Liu. Accordingly, the SEC will continue to confront defenses grounded in equitable principles, such as deduction for legitimate expenses and the elimination of joint and several liability for disgorgement.

D.   Whistleblower Awards

2020 marked the 10-year anniversary of the SEC’s whistleblower program. It also marked a record year for the number of whistleblower awards, the total amount of money awarded and the largest single whistleblower award.[7] During fiscal 2020, the Commission issued awards totaling approximately $175 million to 39 individual whistleblowers. As of the end of 2020, the SEC has awarded a total of approximately $736 million to 128 individual whistleblowers in the program’s 10-year history.[8] Perhaps equally notable, enforcement actions attributed to whistleblower tips have resulted in more than $2.5 billion in ordered financial remedies. The increase in the number of awards is the result of the SEC’s efforts to increase the efficiency of the claim review and award process. In September, the SEC also adopted amendments to the Whistleblower Rule to promote efficiencies in the review and processing of whistleblower award claims. The amendments aim to provide the Commission with tools to appropriately reward individuals, and include a presumption of the statutory maximum award for certain whistleblowers with potential awards of less than $5 million.[9] For further discussion of the amendments to the Whistleblower Rule, see our prior alert on the subject. The amendments also made one modification to the Whistleblower Rule that has proven to be controversial. As originally proposed in 2018, the amendment would have given the Commission authority to reduce the dollar amount of awards in cases with large monetary sanctions (in excess of $100 million). In the face of opposition from whistleblower advocates, the final rule dropped that amendment, and instead clarified that in determining the appropriate award, the Commission has discretion to consider both the percentage and the dollar amount of the award a discretion the Commission. In the adopting release, the Commission explained the modification as merely clarifying the discretion that the Commission always had in determining the appropriate award. One whistleblower advocate has already filed a suit against the SEC challenging the validity of the amendment under the Administrative Procedure Act.[10] In October, the SEC also announced the largest award in the program’s history—a payment of over $114 million to a whistleblower who provided information and assistance leading to successful enforcement actions.[11] The award, which consists of a $52 million award in connection with the SEC matter and a $62 million award arising out related actions by another agency, comes on the heels of the SEC’s previous record-breaking $50 million whistleblower award in June.[12] This year also saw a record level of tips received by the Office of the Whistleblower, as well as other complaints and referrals received by the Enforcement Division as a whole. The Office of the Whistleblower received over 6,900 tips in fiscal year 2020, a 31% increase over the second-highest tip year in fiscal year 2018.[13] More broadly, the Enforcement Division received over 23,650 tips, complaints and referrals in fiscal 2020, a more than 40% increase over the prior year. Inevitably, the increase in tips this past year is likely to lead to an increase in the number of investigations in the years to come. The SEC’s whistleblower awards also emphasize the assistance whistleblowers contribute to investigations through industry expertise or simply expediting an investigation. For example, in November, the SEC made a payment of over $28 million to an individual who provided information that prompted a company’s internal investigation, and who provided testimony and identified a key witness.[14] Likewise, the SEC announced an award of over $10 million in October to a whistleblower, emphasizing the individual’s substantial ongoing assistance, including help deciphering communications and distilling complex issues.[15] Also of importance to the Commission is a whistleblower’s efforts to reduce ongoing harm to investors. In December, the SEC announced an award of over $1.8 million to a whistleblower who took immediate steps to mitigate harm to investors.[16] Additionally, the announcement noted the whistleblower’s ongoing assistance, which saved time and resources of SEC staff.[17] Other significant whistleblower awards granted during the second half of this year include:
  • An award in July of $3.8 million to a whistleblower for information that allowed the SEC to disrupt an ongoing fraud scheme and led to a successful enforcement action.[18]
  • An award in August of over $1.25 million for information leading to a successful enforcement action, resulting in the return of millions of dollars to investors.[19]
  • Eleven awards in September, including a notable award of $22 million to an insider whistleblower whose tip led the SEC to open an investigation, and who provided ongoing assistance; and a $7 million award to another whistleblower who provided what the SEC deemed “valuable” information regarding the investigation.[20] Additional awards in September included an award of over $2.5 million to joint whistleblowers for a tip based on an independent analysis of a public company’s filings, and for the whistleblowers’ ongoing assistance in the SEC’s investigation;[21] a $10 million payment to an individual who provided information and assistance that were described as of “crucial importance” to the SEC’s successful enforcement action;[22] a $250,000 award to joint whistleblowers who raised concerns internally and whose tip to the SEC spurred the opening of an investigation and a successful enforcement action;[23] payment of $2.4 million to a whistleblower who provided information and assistance that ultimately stopped ongoing misconduct;[24] awards to totaling over $2.5 million to two whistleblowers who reported misconduct overseas;[25] an award of $1.8 million for information regarding ongoing securities law violations;[26] and four awards totaling almost $5 million for “critical information” resulting in a successful enforcement action.[27]
  • An award in October of $800,000 for information that caused the SEC to open an investigation leading to two successful enforcement actions.[28]
  • Four awards in November, including a payment of $3.6 million to a whistleblower who provided information and ongoing assistance to enforcement staff regarding misconduct abroad;[29] a $750,000 payment to an individual who met with enforcement staff and provided information regarding an ongoing fraud;[30] an award of over $1.1 million to a whistleblower who provided what the SEC described a “exemplary assistance,” and led the staff to look at new conduct during an ongoing investigation;[31] and a payment of over $900,000 to an individual who provided importantly information regarding securities law violations occurring overseas.[32]
  • Six awards in December, including payments totaling of over $6 million to joint whistleblowers who provided information, submitted documents, participated in interviews, and identified key witnesses leading to a successful enforcement action;[33] a payment of nearly $1.8 million to a company insider who provided information that would have otherwise been difficult to detect;[34] an award of approximately $750,000 to two whistleblowers who provided tips and substantial assistance to the staff, including participating in interviews and providing subject matter expertise;[35] a payment of almost $400,000 to two individuals who provided information that prompted the opening of an investigation and ongoing assistance to SEC staff;[36] an award of more than $300,000 to a whistleblower with audit-related responsibilities who provided “high-quality” information after becoming aware of potential securities law violations;[37] a payment of more than $1.2 million for a whistleblower who provided information leading to a successful enforcement action, but whose “culpability and unreasonable delay” impacted the award amount; and a $500,000 payment to a whistleblower who provided significant information and ongoing assistance, which led to a successful enforcement action.[38]

II.   Public Company Accounting, Financial Reporting and Disclosure Cases

Public company accounting and disclosure cases comprised a significant portion of the SEC’s cases in the latter half of 2020, and included a range of actions concerning earnings management, revenue recognition, impairments, internal controls, and disclosures concerning financial performance.

A.   Financial Reporting Cases

EPS Initiative In September, the SEC announced the Enforcement Division’s “Earnings Per Share (EPS) Initiative” and the settlement of its first two investigations arising from the Initiative. According to the press release announcing the settled actions, the SEC described the EPS Initiative as using “risk-based data analytics to uncover potential accounting and disclosure violations.”[39] Based on the facts described in the two settled actions, the EPS Initiative is focused at least in part on detecting a practice known as “EPS smoothing,” i.e., questionable accounting to achieve EPS results consistent with consensus analyst estimates. According to the SEC, the first company, a carpet manufacturer, made unsupported and non-GAAP-compliant manual accounting adjustments to multiple quarters in order to avoid EPS results falling below consensus estimates. The second company, a financial services company, used a valuation method that was inconsistent with the valuation methodology described in its filings, in order to appear to have consistent earnings over time. Without admitting or denying wrongdoing, the carpet manufacturer agreed to pay a $5 million penalty to settle the charges; the financial services company agreed to pay a $1.5 million penalty. Based on our experience representing clients in such matters, the SEC’s attention can be drawn simply by consistent EPS performance, even in the absence of any basis to suspect misconduct. In such circumstances, it is important to demonstrate to the Staff the integrity of accounting and financial reporting controls that negate the potential for improper accounting. Other Financial Reporting Actions In August, the SEC instituted a settled action against a motor vehicle parts manufacturer for failing to estimate and report over $700 million in future asbestos liabilities.[40] The SEC alleged that, from 2012 to 2016, the company failed to perform quantitative analyses to estimate its future asbestos claim liabilities, despite having decades of raw historical claims data. Instead, the company incorrectly concluded that it could not estimate these liabilities and therefore did not properly account for them in its financial statements. The company agreed to pay a penalty of $950,000 to settle the action, without admitting or denying the SEC’s allegations. Also in August, the SEC announced a settled action against a computer server producer and its former CFO related to alleged violations of the antifraud, reporting, books and records, and internal accounting controls provisions of the federal securities laws.[41] According to the SEC’s order, among other violations, the company incentivized employees to maximize revenue at the end of each quarter without implementing and maintaining sufficient internal accounting controls, resulting in a variety of accounting violations related to prematurely recognized revenue. Without admitting or denying wrongdoing, the company agreed to pay a $17.5 million penalty; the CFO agreed to pay more than $300,000 as disgorgement and prejudgment interest and $50,000 as a penalty. Additionally, the company’s CEO, who was not charged with misconduct, consented to reimburse the company $2.1 million in stock profits he received during the period when the accounting errors occurred under the Sarbanes-Oxley Act’s clawback provision. In September, the SEC instituted a settled action against an engine manufacturer that allegedly inflated its revenue by nearly $25 million by recording its revenues in a manner inconsistent with GAAP.[42] The SEC alleged that the company overstated its revenue by improperly recognizing revenue from incomplete sales, from products that customers had not agreed to accept, and from products with falsely inflated prices, among other violations of GAAP. Without admitting or denying the allegations, the company agreed to pay a $1.7 million penalty, and to undertake measures aimed at remediating alleged deficiencies in its financial reporting internal controls. Also in September, the SEC announced a settled action against a lighting manufacturer and four of its current and former executives for allegedly inflating the company’s revenue from late 2014 to mid-2018, by prematurely recognizing revenue.[43] According to the complaint, using a variety of improper practices, the company recognized sales revenue earlier than allowed by GAAP and by the company’s own internal accounting policies. The company also allegedly provided backdated sales documents to the company’s auditor in order to cover up the improper practices related to premature revenue recognition. Without admitting or denying wrongdoing, the company agreed to pay a $1.25 million penalty, and the executives agreed to pay penalties as well. The same month, the SEC also instituted a settled action against an automaker and two of its subsidiaries related to charges that the automaker disclosed false and misleading information related to overstated retail sales reports.[44] According to the SEC, the automaker inflated its reported retail sales using a reserve of previously unreported retail sales to meet internal monthly sales targets, regardless of the date of the actual sales. The company also allegedly paid dealers to falsely designate unsold vehicles as demonstrators or loaners so that the vehicles could be counted as having been sold, even though they had not been sold. The company and its subsidiaries agreed to pay a joint penalty of $18 million without admitting or denying the SEC’s allegations. Also in September, the SEC instituted settled actions against a heavy equipment manufacturer and three of its former executives for allegedly misleading the company’s outside auditor about nonexistent inventory in order to overstate its income.[45] According to the SEC, the company improperly accounted for nonexistent inventory and created false inventory documents, which it later provided to its outside auditor. The company also allegedly deceived its outside auditor about approximately $12 million in revenue that it improperly recognized. Without admitting or denying the SEC’s allegations, the company and its executives agreed to pay a total of $485,000 in penalties. In October, the SEC filed a complaint against a seismic data company and four of its former executives for accounting fraud for concealing theft by the executives, and for falsely inflating the company’s revenue.[46] According to the complaint, the company improperly recorded revenue from sales to a purportedly unrelated client (that was actually controlled by the executives), with the company recording roughly $100 million in revenue from sales that it knew the client would be unable to actually pay. The U.S. Attorney’s Office for the Southern District of New York also brought a criminal action against the company’s CEO. In November, in a case related to previously settled charges against a large bank, the SEC filed a complaint against the bank’s former Senior Executive Vice President of Community Banking alleging that disclosures concerning the bank’s “cross-sell” metric were misleading and that the defendant knew or should have known was improperly inflated.[47] The SEC also instituted a settled action against the bank’s former chairman and CEO for certifying statements that he should have known were misleading arising from the bank’s inflated cross-sell metric. The SEC alleged that the executives knew or should have known that the cross-sell metric was “inflated by accounts and services that were unused, unneeded, or unauthorized.” The litigation against the vice president remains pending; the CEO agreed to pay a $2.5 million penalty to settle the charges, without admitting or denying the SEC’s allegations. In December, the SEC instituted a settled action against a China-based coffee company, alleging that the company defrauded investors by misstating its revenue, expenses, and net operating losses.[48] According to the complaint, among other things, the company recorded approximately $311 million in false retail sales transactions, as well as roughly $196 million in inflated expenses to conceal the fraudulent sales. The company agreed to pay a $180 million penalty to settle the action, without admitting or denying the SEC’s allegations.

B.   Disclosure Cases

Disclosures Related to the COVID-19 Pandemic In March 2020, the SEC’s Division of Enforcement formed a Coronavirus Steering Committee to oversee the Division’s efforts to actively look for COVID-19 related misconduct. Since the Steering Committee’s formation, there have been at least five enforcement actions for alleged disclosure violations related to COVID-19. As discussed in our mid-year 2020 alert, there was an initial flurry of disclosure-related enforcement actions at the onset of the pandemic. These actions tended to involve microcap companies whose stock was suspended from trading after sky rocketing on the back of allegedly false statements about these companies’ ability to distribute or access highly coveted protective equipment or technology that could detect or prevent the coronavirus.[49] In the second half of 2020, the SEC has continued to bring enforcement actions against companies for allegedly making false statements about their ability to detect COVID-19. For example, in September, the SEC filed an action against a President and Chief Science Officer (“CSO”) alleging he issued false and misleading statements about the company’s development of a COVID-19 blood test.[50] According to the complaint, the President and CSO incorrectly stated that (i) the company had purchased materials to make a test, (ii) the company had submitted the test for emergency approval, and (iii) there was a high demand for the test. The SEC’s complaint also alleged that the defendant failed to provide necessary documents and financial information to the company’s independent auditor to update the company’s delinquent financial statements for 2014 and 2015. More recently, the SEC announced charges against a biotech company and its CEO for making false and misleading claims in press releases that the company had developed a technology that could accurately detect COVID-19 through a blood test.[51] According to the complaint, the company and CEO made false and misleading statements about the existence of the physical testing device and the status of FDA emergency use authorization while advisors warned that the testing kit would not work as the company publicly described. The SEC is also starting to bring enforcement actions against companies for alleged misstatements concerning how their financials were affected by the coronavirus. For example, in December, the SEC announced a settled order against a publicly traded restaurant company for allegedly incomplete disclosures in a Form 8-K about the financial effects of the pandemic on the company’s business operations and financial condition.[52] In brief, according to the SEC’s settled order, the company disclosed that it expected to be able to operate “sustainably, ” but did not disclose that it was losing $6 million in cash per week, it only had 16 weeks of cash remaining, it was excluding expenses attributable to corporate operations from its claim of sustainability, and it was not going to pay rent in April 2020. Without admitting or denying the SEC’s findings, the company agreed to pay a $125,000 penalty and to cease-and-desist from further violations of the reporting provisions in Section 13(a) of the Exchange Act and Rules 13a-11 and 12b-20. See our prior alert on this case for additional analysis and commentary on this case. Other Disclosure Cases In December, the SEC instituted a settled action against a U.S. based multinational company for allegedly failing to disclose material information about the company’s power and insurance businesses in three separate situations.[53] First, according to the SEC, the company misled investors by disclosing its power business’s increased profits without also disclosing that between one-quarter and one-half of those profits were a result of reductions in the company’s prior cost estimates. Second, the company failed to disclose that its reported increase in cash collections came at the expense of future years’ cash and was derived principally from internal sales between the company’s own business units. Third, the company lowered projected costs for its future insurance liabilities without disclosing uncertainties about those projected costs due to a general trend of rising long-term health insurance claim costs. Without admitting or denying wrongdoing, the company agreed to settle the allegations and pay a $200 million penalty. The settlement also contained a relatively unique undertaking by which the company agreed to self-report to the SEC regarding certain accounting and disclosure controls for one year. In September, the SEC announced a settled action against an automaker for allegedly misleading disclosures about its vehicles’ emissions control systems.[54] According to the SEC, the automaker stated in a February press release and annual report that an internal audit had confirmed its vehicles complied with emissions regulations, without disclosing that the internal audit had a narrow scope and was not a comprehensive review, and also without disclosing that the Environmental Protection Agency and California Air Resource Board had expressed concerns to the automaker about some of its vehicles’ emissions. The automaker agreed to pay a $9.5 million penalty without admitting or denying the SEC’s allegations. In September, the SEC instituted a settled action against a hospitality company for failing to fully disclose executive perks by omitting disclosure of approximately $1.7 million in executive travel benefits.[55] The benefits at issue related to company executives’ stays at the company’s hotels, and to the CEO’s personal use of corporate aircraft from the period 2015 to 2018. The company agreed to pay a $600,000 penalty to settle the action, without admitting or denying the SEC’s allegations.

C.   Cases Involving Both Misleading Disclosures and Financial Reporting

In July, the SEC announced a settled action against a pharmaceutical company and three of its former executives for misleading disclosures and accounting violations.[56] According to the SEC, the company made misleading disclosures related to its sales to a pharmacy that the company helped establish and subsidize. For example, the company announced it was experiencing double-digit same store organic growth (a non-GAAP financial measure) without disclosing that much of that growth came from sales to the subsidized pharmacy and without disclosing risks related to that pharmacy. The SEC also alleged that the company improperly recognized revenue by incorrectly allocating $110 million in revenue attributable solely to one product to over 100 unrelated products. Without admitting or denying the allegations, the company agreed to pay a $45 million penalty; the former executives agreed to pay penalties ranging from $75,000 to $250,000 and to reimburse the company for previously paid incentive compensation in amounts ranging from $110,000 to $450,000. Additionally, the Controller agreed to a one-year accounting practice bar before the SEC. In August, the SEC settled instituted a settled action against the former CEO and Chairman of a car rental company alleging that he aided and abetted the company in filing misleading disclosures and inaccurate financial reporting.[57] According to the SEC, the former CEO lowered the company’s depreciation expenses by lengthening the period for which the company planned to hold rental cars in its fleet, from holding periods of twenty months to holding periods of twenty-four and thirty months; the CEO did not fully disclose the new, lengthened holding periods, and did not disclose the risks associated with an older fleet. The complaint also alleged that, when the company fell short of forecasts, the former CEO pressured employees to “find money,” mainly by reanalyzing reserve accounts, resulting in his subordinates making accounting changes that left the company’s financial reports inaccurate. Without admitting or denying the SEC’s allegations, the former CEO agreed to pay a $200,000 penalty and reimburse the company $1.9 million. The car rental company had already agreed to pay a $16 million penalty to settle related charges, in December 2018. In September, the SEC announced a settled action against a charter school operator engaged in a $7.6 million municipal bond offering, and its former president alleging that the defendants provided inaccurate financial projections and failed to disclose the school’s financial troubles.[58] According to the complaint, the school’s offering document included inaccurate profit and expense projections that indicated the school would become profitable in the next year when, according to the SEC, the school knew or should have known that these projections were inaccurate. The complaint also alleged that the school failed to disclose that it was operating at a sizable loss and had made repeated unauthorized withdrawals from its reserve accounts to pay its debts and routine expenses. Without admitting or denying wrongdoing, the school and its former president agreed to a settlement enjoining them from future violations; the former president also agreed to be enjoined from participating in future municipal securities offerings and to pay a $30,000 penalty. Also in September, the SEC instituted a settled action against a technology company for inflating reported sales by prematurely recognizing sales expected to occur later and for failing to disclose these practices.[59] According to the SEC’s order, the company allegedly failed to disclose a practice used to increase monthly sales in which some regional managers would accelerate, or “pull-in,” to an earlier quarter’s sales that they expected to occur in later quarters. The company also allegedly failed to disclose that some regional managers sold to resellers known to violate company policy by selling product outside their designated territories in order to increase monthly sales. Finally, the SEC’s order alleged that the company made misleading disclosures by disclosing information related to its channel health that only included channel partners to which the company sold directly, without disclosing that this information did not include channel partners to which the company sold indirectly. The company agreed to pay a $6 million penalty, without admitting or denying wrongdoing. In December, the SEC announced the settlement of an action filed in February against an energy company and its subsidiary for making misleading statements by claiming that the company would qualify for large tax credits for which the company knew it likely would not be eligible.[60] According to the SEC, the company represented that its project to build two new nuclear power units was on schedule, and therefore, would likely qualify for more than $1 billion in tax credits, when the company knew its project was substantially delayed and, resultingly, would likely fail to qualify for these tax credits. Without admitting or denying the allegations, the company agreed to pay a $25 million penalty; the company and its subsidiary also agreed to pay $112.5 million in disgorgement and prejudgment interest. The settlement remains subject to court approval. The litigation against two of the company’s senior executives remains ongoing. Also in December, the SEC filed a complaint against a brand-management company with violations of the federal securities laws’ related to the company’s alleged failure to account for and disclose evidence of goodwill impairment.[61] The complaint alleged that the company unreasonably concluded that its goodwill was not impaired based on a qualitative impairment analysis, without taking into account and also without disclosing two internal quantitative analyses showing that goodwill was likely impaired. The litigation against the company remains ongoing.

D.   Internal Controls

Increasingly, the SEC has demonstrated a willingness to resolve investigations of public companies on the basis of violations of the internal controls provisions of the Exchange Act. One recent example of an internal controls settlement provided a rare window into a significant divergence of opinion among the Commissioners concerning the appropriateness of such settlements based on a broad application of the internal controls provision. In October, the SEC instituted a settled action against an energy company related to charges that the company failed to maintain internal controls that would have provided reasonable assurance that the company’s stock buyback plan would have complied with its own buyback policies.[62] According to the SEC’s order, the company implemented a $250 million stock buyback while in possession of material nonpublic information (MNPI) about a potential acquisition, in spite of the company’s policy prohibiting repurchasing stock while in possession of MNPI. In addition to detailing the litany of factors illustrating that the probability of the acquisition was sufficiently high as to have constituted MNPI, the SEC’s order focused on the company’s insufficient process for evaluating whether the acquisition discussions were material at the time it adopted a 10b5-1 plan for the buyback. Specifically, the process did not include speaking with the individuals at the company reasonably likely to have material information about significant corporate developments. As a result, the SEC’s order alleged that the company’s legal department did not consult with the CEO about the prospects of the company being acquired, even though the CEO was the primary negotiator. The company’s legal department thus “failed to appreciate” that the transaction’s probability was high enough to constitute MNPI. Despite these findings, the SEC did not bring insider trading charges, but instead alleged that the company’s internal controls were insufficient to provide reasonable assurance that the company’s buyback transactions would comply with its buyback policy. Without admitting or denying the allegations, the company agreed to pay a $20 million penalty. Notably, Republican Commissioners Roisman and Peirce dissented from the Commission’s decision to institute the enforcement action. In a public statement explaining their dissent, the Commissioners argued that the internal controls provision, Section 13(b)(2)(B) of the Exchange Act, applies to “internal accounting controls,” and thus does not apply to internal controls to ensure a company does not repurchase stock in compliance with company policies.

III.   Investment Advisers

In the second half of 2020, the SEC instituted a number of actions against investment advisers. We discuss notable cases below.

A.   Payment for Order Flow

In August, the SEC instituted a settled action against two affiliated investment advisers in connection with their alleged misrepresentations to certain mutual fund and exchange-traded fund clients regarding “payment for order flow” arrangements, i.e., payments the investment adviser received for sending client orders to other brokerage firms for execution.[63] According to the SEC, on multiple occasions, the investment advisers made misleading statements that the payment for order flow arrangements did not adversely affect the prices at which the clients’ orders were executed, when in fact the executing brokers adjusted the execution prices to recoup those payments. Without admitting or denying the findings in the SEC’s order, the firms agreed to a cease-and-desist order, and to pay a combined total of $1 million in penalties.

B.   Mutual Fund Share Classes

In August, the SEC instituted a settled action against a California-based investment advisory firm based on allegations that it engaged in practices that violated its fiduciary duties to clients.[64] According to the SEC, the firm failed to disclose a conflict of interest in selecting mutual fund share classes that charged certain fees instead of available lower-cost share classes of the same funds. The firm’s affiliated broker received the associated fees in connection with these investments. Additionally, the SEC alleged that the firm failed to disclose its receipt of revenue sharing payments from its clearing broker in exchange for purchasing or recommending certain money market funds to clients. The SEC further alleged that these practices resulted in a violation of the firm’s duty to seek best execution for those transactions. Without admitting or denying the findings in the SEC’s order, the firm agreed to a cease-and-desist order and to pay disgorgement of $544,446, plus prejudgment interest of $22,746, and a penalty of $200,000, all for distribution to investors.

C.   Exchange-Traded Products

In November, the SEC announced the first enforcement actions resulting from the Division of Enforcement’s “Exchange-Traded Products Initiative.” The SEC instituted settled actions against five firms registered as investment advisers and/or broker dealers in connection with their alleged unsuitable sales of complex, volatility-linked exchange-traded products to retail investors.[65] According to the SEC, representatives of the firms recommended that their clients buy and hold exchange-traded products for long periods of time, contrary to the warnings in the products’ offering documents, which made clear that they were intended to be short-term investments. The SEC further alleged that the firms failed to adopt or implement policies and procedures to address whether their registered representatives sufficiently understood the products to be able to form a reasonable basis to assess suitability or to recommend that their clients buy and hold the products. The firms agreed to pay a total of $3,000,000 in civil penalties among the five firms.

D.   Puerto Rico Bonds

In December, the SEC filed a complaint in federal court in Puerto Rico against a Florida-based individual operating as an unregistered investment adviser.[66] According to the SEC’s complaint, the individual promised municipal officials in Puerto Rico an annual return of 8-10% on their approximately $9 million investment in the municipality’s funds, with no risk to principal. To convince officials to invest in the municipality’s funds, the individual allegedly falsified bank correspondence and brokerage opening documents. The SEC further alleged that the individual failed to execute the promised investment strategy, instead misappropriating $7.1 million of taxpayer funds by transferring the funds to himself, entities he controlled, and his associates. The SEC’s complaint seeks permanent injunctive relief, disgorgement of alleged ill-gotten gains plus prejudgment interest, and a civil penalty.

E.   Disclosure Violations

In December, the SEC instituted a settled action against a UK-based investment adviser based on allegations that the company failed to make complete and accurate disclosures relating to the transfer of its highest-performing traders from its flagship client fund to a proprietary fund, and the replacement of those traders with a semi-systematic, algorithmic trading program.[67] The SEC alleged that the algorithmic trading program underperformed compared to the firm’s live traders, generating less profit with greater volatility. Additionally, the investment adviser allegedly failed to adequately implement policies and procedures reasonably designed to prevent the violations of the Investment Advisers Act under the particular circumstances described above. Without admitting or denying the findings in the SEC’s order, the firm agreed to a cease-and-desist order and to pay disgorgement and penalties totaling $170 million, all to be distributed to investors.

F.   Single Broker Quotes

In December, the SEC instituted a settled action against a New York-based investment adviser and global securities pricing service based on allegations that the firm failed to adopt and implement policies and procedures reasonably designed to address the risk that the single broker quotes it delivered to clients did not reasonably reflect the value of the underlying securities.[68] The SEC further alleged that the firm failed to effectively or consistently implement quality controls for prices delivered to clients based on the single broker quotes. Without admitting or denying the findings in the SEC’s order, the firm agreed to cease and desist from future violations, to a censure, and to pay an $8 million penalty.

G.   Cherry Picking

In December, the SEC filed a complaint in federal court in Texas against a Dallas-based investment adviser and its principal, charging the defendants with violations of the antifraud provisions of the federal securities laws.[69] The SEC’s complaint alleges that the principal placed options trades in the investment adviser’s omnibus account early in the trading day, but waited until near or after market close to allocate the trades to either his personal account or to specific client accounts. As alleged in the complaint, the principal disproportionately allocated profitable trades to his personal accounts and unprofitable trades to advisory clients, while representing to clients that all trades would be equitably allocated. The SEC’s complaint seeks permanent injunctions, disgorgement with prejudgment interest, and civil penalties.

IV.   Broker-Dealers and Financial Institutions

Although not as numerous as prior years, there were nevertheless notable cases involving the conduct of broker-dealers in the latter half of 2020.

A.   Financial Reporting and Recordkeeping

In August, the SEC instituted a settled action against a broker-dealer for neglecting to file over 150 suspicious activity reports (SARs) relating to microcap securities that the firm traded on behalf of its customers.[70] The purpose of SARs is to identify and investigate potentially suspicious activity, and the SEC’s order alleged that the broker-dealer failed to do so, even when suspicious transactions were identified by compliance personnel. The allegedly suspicious activity included numerous instances where customers either deposited and sold large blocks of microcap securities before quickly withdrawing the resulting proceeds from the respective accounts, sold enough of a particular microcap security on given days to account for over 70% of the daily trading volume for that security, or deposited microcap securities that were subject to SEC trading suspensions. The broker-dealer agreed to pay an $11.5 million penalty to the SEC, without admitting or denying the findings, and additionally agreed to pay penalties of $15 million and $11.5 million to FINRA and the CFTC respectively. In September, the SEC instituted a settled action against a broker-dealer subsidiary of a global financial services firm for alleged violations of Regulation SHO.[71] Regulation SHO governs short sales and, among other things, generally prohibits broker-dealers from separately marking their long and short positions in a given security, instead requiring order aggregation to determine and mark one net position for each security. The SEC’s order alleged that the broker-dealer had a “Long Unit” that purchased equity securities to hedge short synthetic exposure, which should have been aggregated with a separate “Short Unit” that sold equity securities to similarly hedge long synthetic exposure for the purposes of order marking. The broker-dealer agreed to pay a $5 million penalty without admitting or denying the SEC’s findings.

B.   Trade Manipulation

In September, the SEC instituted a settled action against a broker-dealer subsidiary of a global financial services firm for allegedly using trading techniques that artificially depressed or boosted the price of securities that it intended to buy or sell.[72] Specifically, the SEC’s order alleged that traders at the broker-dealer entered bona-fide buy-or-sell orders for particular securities, while simultaneously entering non bona-fide orders on the opposite side of the market to create a false appearance of buy or sell interest. In a settlement, the broker-dealer admitted to the SEC’s findings and agreed to pay a $25 million penalty and $10 million in disgorgement.

C.   Best Execution and Payment for Order Flow

In December, the SEC instituted a settled action against a retail broker-dealer for alleged misstatements concerning revenue streams and execution quality, and for alleged best execution violations.[73] Specifically, the SEC’s order alleged that the broker-dealer did not disclose that it received revenue from order flow, i.e. routing its customers’ orders to principal trading firms, and further alleged that its statements concerning execution quality were inaccurate, even after accounting for customer savings from not having to pay a commission. Without admitting or denying the Commission’s findings, the broker-dealer agreed to pay a $65 million penalty and to obtain an independent consultant to review its relevant policies.

V.   Cryptocurrency and Digital Assets

The Commission continued to bring enforcement actions in the area of digital assets during the second half of 2020. As in the first half of the year, these actions primarily were based on alleged failures to comply with the requirement to register an offering of assets deemed to be securities or allegations of fraud in the offer and sale of digital assets.

A.   Significant Developments

Significantly, the SEC closed the year by bringing two enforcement actions involving digital assets. On December 22, the SEC charged Ripple Labs Inc. (“Ripple”) and two of its executives—its co-founder and board chairman and its CEO—with raising $1.3 billion through the sale of unregistered digital asset securities.[74] In particular, the SEC alleged that the native digital currency of Ripple, XRP, which has been sold by Ripple and others and trading in secondary markets, including on cryptocurrency exchanges for seven years, is a security (not merely a currency) under the Howey test, which defines a security as an investment of money in a shared enterprise with an expectation of profits from others’ work.[75] Additionally, the SEC alleged that the two executives personally made $600 million worth of unregistered sales of the digital asset. In the press release announcing the action, the SEC stressed that all public issuers “must comply with federal securities laws that require registration of offerings unless an exemption from registration applies.” Six days later, on December 28, the SEC obtained an emergency asset freeze against Virgil Capital LLC and its affiliates due to an alleged fraud perpetrated by the company’s owner.[76] The complaint alleged that the owner and his companies had been fraudulently misrepresenting to investors that their funds were to be used only for digital currency trading, when in reality those funds were used for personal expenses or other high-risk investments. Another notable development demonstrates the increasing emphasis the SEC is placing on the protection of investors in the context of FinTech innovation. On December 3, 2020, the Commission announced that it was elevating the Strategic Hub for Innovation and Financial Technology (“FinHub”), to a stand-alone office. Previously, the FinHub, which was initially established in 2018, had been a unit within the Division of Corporation Finance.[77] Since its inception, FinHub has “spearheaded agency efforts to encourage responsible innovation in the financial sector, including in evolving areas such as distributed ledger technology and digital assets, automated investment advice, digital marketplace financing, and artificial intelligence and machine learning,” and provided industry players and regulators with a forum to engage with SEC Staff. The establishment of FinHub as a stand-alone office—which will continue to be led by current director Valerie A. Szczepanik—signals that the Commission will continue to focus on digital assets in the years to come. Although the end of the year arguably was a high-water mark concerning the SEC’s enforcement of actions involving digital assets, the Commission consistently brought similar actions throughout the second half of the year, as discussed below.

B.   Registration Cases

In July, the SEC instituted a settled action against a privately-owned California-based company and a related Philippine company for offering and selling U.S.-based securities without registration via an app and for trading in the related swap transactions outside of a registered national exchange.[78] The app allowed individuals to enter into a contract in which they would choose specific securities to “mirror,” and the value of their contracts would fluctuate according to the price of the underlying security. The Commission determined that the contracts constituted security-based swaps, and therefore were subject to U.S. securities laws. Without admitting or denying to the findings in the order, the two companies agreed to pay a penalty of $150,000. Additionally, the companies entered into a separate settlement with the CFTC arising from similar conduct. In September, the SEC instituted a settled action against an operator of an online gaming and gambling platform for conducting an unregistered initial coin offering (“ICO”) of digital assets.[79] The order found that the company raised approximately $31 million through the offering of its digital token, and promised investors that it would develop a secondary market for trading in its tokens. The SEC determined that the tokens were sold as investment contracts, thereby constituting securities, the offering of which should have been registered. The company agreed to pay a $6.1 million penalty, without admitting or denying the Commission’s findings, and further agreed to disable the token and remove it from all digital asset-trading platforms. The Washington State Department of Financial Institution separately entered into a settlement agreement in connection with this offering.

C.   Fraud Cases

In August, the SEC instituted a settled action against a Virginia-based company and its CEO, in connection with the company’s $5 million ICO to raise funding to develop an internet-based job-posting platform.[80] The SEC found that the offering of sale of the coin constituted the sale of unregistered securities, and that the company and its CEO made false and misleading statements to investors relating to the stability of its digital asset and its scalability compared to its competitors. Without admitting or denying the findings in the order, the company agreed to disgorge the $5 million raised and pay over $600,000 in prejudgment interest; the CEO was barred from serving as an officer or director of a public company and agreed to pay a $150,000 penalty; and the company and CEO both agreed to cease trading in (and destroy existing) coins and refrain from participating in any offerings of any digital asset securities. In September, the SEC instituted a settled action against four individuals, and brought non-settled charges against another individual—an Atlanta-based film producer—and their two companies in connection with the misappropriation and theft of funds that were raised via ICOs.[81] The producer allegedly used the misappropriated funds and proceeds of manipulative trading to buy a Ferrari, a home, jewelry, and other luxury items. Three of the settling defendants agreed to pay a penalty of $25,000 and are prohibited from participating in the issuance of or otherwise transact in digital assets for five years. The fourth settling defendant agreed to pay a $75,000 penalty and is subject to a similar injunction. The U.S. Attorney’s Office for the Northern District of Georgia has also brought a criminal action against the non-settling defendant. In October, the SEC filed an action against a software magnate and computer programmer for fraudulently promoting investments in ICOs to his thousands of Twitter followers.[82] The Complaint alleges that the programmer failed to disclose that he was paid more than $23 million to promote the investments and made other false and misleading statements, such as that he was advising some of the issuers and personally invested in some of the ICOs. The SEC also brought charges against the programmer’s bodyguard, alleging that he received over $300,000 to help with the scheme. The SEC also alleged that the programmer secretly amassed a large holding in another digital asset while promoting it on Twitter, with the intention of selling his holding at an inflated price. The DOJ’s Tax Division has separately brought criminal charges against the computer programmer.

VI.   Insider Trading

Insider trading is another area in which the number and size of cases was diminished from prior years. Nevertheless, insider trading enforcement remains a significant focus for the SEC. Below we note some of the more significant actions. The SEC announced two insider trading cases in September, and brought a third in December. In the first case, the SEC filed charges against a senior manager at an index provider and his friend, for allegedly obtaining more than $900,000 by trading on inside information.[83] According to the SEC, the manager used information regarding which companies were to be added or removed from the market index to place call and put options using the friend’s brokerage account. The SEC’s complaint seeks injunctive relief and civil penalties; the U.S. Attorney’s Office for the Eastern District of New York filed parallel criminal charges against the manager. In the second case, the SEC settled insider trading charges against a former finance manager at an online retailer and two family members.[84] According to the SEC’s complaint, the employee allegedly tipped her husband about the company’s financial performance in advance of earnings announcements; the employee’s husband and his father used the information to trade in the company’s shares. The three individuals consented to the entry of a judgment enjoining future violation ordering payment of approximately $2.65 million in disgorgement and penalties. The U.S. Attorney’s Office for the Western District of Washington filed parallel criminal charges against the employee’s husband. Most recently, the SEC filed insider trading charges against an individual in the Eastern District of New York.[85] According to the SEC’s complaint, the individual obtained information regarding a private equity firm’s interest in a publicly traded chemical manufacturing company in advance of a press release announcing the news. The individual traded on the information and additionally tipped others to trade for a collective profit of $1 million once the news broke. The SEC’s complaint seeks injunctive relief and civil penalties.

VII.   Actions Against Attorneys

It is rare for the SEC to bring enforcement actions against attorneys for conduct in their capacity as lawyers. Thus, when the SEC does bring such cases, it is notable. In December, the SEC filed a partially settled action against two attorneys: one licensed attorney and one disbarred attorney with fraud related to the licensed attorney’s reliance on the disbarred attorney for the preparation of attorney opinion letters for the sale of shares in microcap securities to retail investors.[86] The SEC alleged that the licensed attorney knew the disbarred attorney was disbarred during all relevant times. According to the complaint, the disbarred attorney prepared for the licensed attorney’s signature at least thirty attorney opinion letters, on which the licensed attorney falsely stated that he had personal knowledge of the bases for the opinions in the letters. The complaint also alleged that the disbarred attorney submitted over 100 attorney opinion letters in which he falsely claimed to be an attorney. Without admitting or denying the allegations, the licensed attorney agreed to a partial settlement to an injunction and penny-stock bar, with the potential for other remedies, including penalties, reserved. The SEC’s litigation against the disbarred attorney remains ongoing, as does a criminal action against both attorneys.

VIII.   Offering Frauds

The SEC continued to bring offering fraud cases, which often contain charges against individuals and companies that target particular groups of investors.

A.   Frauds Targeting Senior Citizens and Retirees

In July, the SEC filed a complaint against an aviation company and its owner, alleging that the company raised $14 million, largely from retired first responders, by representing that it would use the funds to purchase engines and other aircraft parts for leasing to major airlines.[87] The SEC’s complaint alleges that, instead, the company and its owner diverted most of the money for unauthorized purposes, including Ponzi-scheme like payments to other investors. In September, the SEC charged the former president of a real estate company with violating antifraud provisions of the securities laws in connection with a $330 million alleged Ponzi-like scheme that impacted seniors.[88] In a second September case, the SEC announced settled charges against two individuals charged in connection with the sale of unregistered stock, following up on a 2019 action by the SEC against the company’s former CEO and two previously barred brokers.[89] According to the SEC, the three recently-charged individuals received undisclosed commissions totaling nearly $500,000 in connection with the sale of nearly $1.4 million in stocks to retail investors, most of whom were seniors. In a recent case, the SEC filed civil charges against an individual in the Eastern District of New York for operating a Ponzi-like scheme that raised over $69 million from current and retired police officers and firefighters, among other investors.[90] The SEC’s complaint alleges that the individual represented that the investments would be used to acquire jewelry for a business that he operated, but instead were diverted to perpetuate and conceal the fraudulent scheme. The individual has pleaded guilty to related criminal charges.

B.   Frauds Targeting Affinity Groups

In August, the SEC charged three principals and their companies in connection with a Ponzi-like scheme targeting African immigrants.[91] According to the SEC, the investors believed that the funds would be used for foreign exchange and cryptocurrency trading. The CFTC also filed civil charges, and the DOJ filed criminal charges. In September, the SEC filed a complaint in the Eastern District of New York against a Swedish national in connection with a purportedly “pre-funded reversed pension plan” that was largely marketed online and attracted over 800 investors from the Deaf, Hard of Hearing and Hearing Loss communities.[92] Finally, in December, the SEC brought an emergency action against a real estate development company and its owner in connection with a $119 million round of fundraising that predominantly targeting South Asian investors.[93]

C.   Fraud Related to Online Retailers and Technology Providers

The SEC has also focused on companies engaged in or making representations about emerging technologies and e-commerce. For example, the SEC charged an e-commerce startup and its CEO in Northern California with misrepresenting the extent of the company’s contracts with more well-known retailers and brands in order to attract investment.[94] The SEC filed another complaint against the founder and CEO of a machine-learning analytics company in California, alleging that the founder misrepresented the company’s prior financial performance and its client list.[95] In the Eastern District of Virginia, the SEC filed charges alleging that the founder and CEO of an online marketplace in connection with the offering and selling of over $18.5 million in securities, some of which were sold to corporate investors.[96] Both the U.S. Attorney’s Office and the Fraud Section of the Department of Justice have also announced criminal charges based on similar allegations. Finally, a court in the Southern District of New York froze over $35 million in assets[97] in connection with allegations by the SEC that the former CEO of a fraud detection and prevention software company misled investors by providing investors with erroneous financial statements.[98] According to the SEC, the former CEO altered bank statements supplied to the company’s finance department and incorporated into investor materials over the course of two years, during which the company raised approximately $123 million. ________________________     [1]     Paul Kiernan and Scott Patterson, “An Old Foe of Banks Could Be Wall Street’s New Top Cop,” Wall Street Journal, Jan. 16, 2021, available at https://www.wsj.com/articles/an-old-foe-of-banks-could-be-wall-streets-new-top-cop-11610773211.    [2]     Speech by Chairman Jay Clayton, “Putting Principles into Practice, the SEC from 2017-2020,” Remarks to the Economic Club of New York, Nov. 12, 2020, available at https://www.sec.gov/news/speech/clayton-economic-club-ny-2020-11-19.    [3]     See 2020 Annual Report of U.S. SEC Division of Enforcement, available at https://www.sec.gov/files/enforcement-annual-report-2020.pdf.    [4]     National Defense Authorization Act for Fiscal Year 2021, H.R. 6395, 116th Cong. (2020).    [5]     Id.    [6]     Id.    [7]     Whistleblower Program, 2020 Annual Report to Congress, available at https://www.sec.gov/files/2020%20Annual%20Report_0.pdf.    [8]     SEC Press Release, SEC Awards Over $1.6 Million to Whistleblower (Dec. 22, 2020), available at https://www.sec.gov/news/press-release/2020-333.    [9]     SEC Press Release, SEC Adds Clarity, Efficiency, and Transparency to Its Successful Whistleblower Award Program (Sept. 23, 2020), available at https://www.sec.gov/news/press-release/2020-219.    [10]    Lydia DePhillis, “The SEC Undermined a Powerful Weapon Against White-Collar Crime,” ProPublica (Jan. 13, 2021), available at https://www.propublica.org/article/the-sec-undermined-a-powerful-weapon-against-white-collar-crime.    [11]    SEC Press Release, SEC Issues Record $114 Million Whistleblower Award (Oct. 22, 2020), available at https://www.sec.gov/news/press-release/2020-266.    [12]    SEC Press Release, SEC Issues Record $114 Million Whistleblower Award (Oct. 22, 2020), available at https://www.sec.gov/news/press-release/2020-266.    [13]    Whistleblower Program, 2020 Annual Report to Congress, available at https://www.sec.gov/files/2020%20Annual%20Report_0.pdf.    [14]    SEC Press Release, SEC Awards Over $28 Million to Whistleblower (Nov. 3, 2020), available at https://www.sec.gov/news/press-release/2020-275.    [15]    SEC Press Release, SEC Awards Over $10 Million to Whistleblower (Oct. 29, 2020), available at https://www.sec.gov/news/press-release/2020-270.    [16]    SEC Press Release, SEC Issues Multiple Whistleblower Awards Totaling Over $3.6 Million (Dec. 18, 2020), available at https://www.sec.gov/news/press-release/2020-325.    [17]    SEC Press Release, SEC Issues Multiple Whistleblower Awards Totaling Over $3.6 Million (Dec. 18, 2020), available at https://www.sec.gov/news/press-release/2020-325.    [18]    SEC Press Release, SEC Issues $3.8 Million Whistleblower Award (July 14, 2020), available at https://www.sec.gov/news/press-release/2020-155.    [19]    SEC Press Release, SEC Awards Over $1.25 Million to Whistleblower (Aug. 31, 2020), available at https://www.sec.gov/news/press-release/2020-199.    [20]    SEC Press Release, SEC Awards Almost $30 Million to Two Insider Whistleblowers (Sept. 30, 2020), available at https://www.sec.gov/news/press-release/2020-239.    [21]    SEC Press Release, SEC Awards Over $2.5 Million to Joint Whistleblowers for Detailed Analysis That Led to Multiple Successful Actions (Sept. 1, 2020), available at https://www.sec.gov/news/press-release/2020-201.    [22]    SEC Press Release, SEC Awards More Than $10 Million to Whistleblowers (Sept. 14, 2020), available at https://www.sec.gov/news/press-release/2020-209.    [23]    SEC Press Release, SEC Awards Almost $250,000 to Joint Whistleblowers (Sept. 17, 2020), available at https://www.sec.gov/news/press-release/2020-214.    [24]    SEC Press Release, SEC Issues $2.4 Million Whistleblower Award (Sept. 21, 2020), available at https://www.sec.gov/news/press-release/2020-215.    [25]    SEC Press Release, SEC Issues Two Whistleblower Awards for High-Quality Information Regarding Overseas Conduct (Sept. 25, 2020), available at https://www.sec.gov/news/press-release/2020-225.    [26]    SEC Press Release, SEC Issues $1.8 Million Whistleblower Award to Company Outsider (Sept. 28, 2020), available at https://www.sec.gov/news/press-release/2020-231.    [27]    SEC Press Release, SEC Whistleblower Program Ends Record-Setting Fiscal Year With Four Additional Awards (Sept. 30, 2020), available at https://www.sec.gov/news/press-release/2020-240.    [28]    SEC Press Release, SEC Awards $800,000 to Whistleblower (Oct. 15, 2020), available at https://www.sec.gov/news/press-release/2020-255.    [29]    SEC Press Release, SEC Awards More Than $3.6 Million and $750,000 in Separate Whistleblower Awards (Nov. 5, 2020), available at https://www.sec.gov/news/press-release/2020-278.    [30]    SEC Press Release, SEC Awards More Than $3.6 Million and $750,000 in Separate Whistleblower Awards (Nov. 5, 2020), available at https://www.sec.gov/news/press-release/2020-278.    [31]    SEC Press Release, SEC Awards Over $1.1 Million to Whistleblower for Independent Analysis (Nov. 13, 2020), available at https://www.sec.gov/news/press-release/2020-283.    [32]    SEC Press Release, SEC Awards Whistleblower Over $900,000 (Nov. 19, 2020), available at https://www.sec.gov/news/press-release/2020-288.    [33]    SEC Press Release, SEC Awards Over $6 Million to Joint Whistleblowers (Dec. 1, 2020), available at https://www.sec.gov/news/press-release/2020-297.    [34]    SEC Press Release, SEC Issues Multiple Whistleblower Awards Totaling Nearly $3 Million (Dec. 7, 2020), available at https://www.sec.gov/news/press-release/2020-307.    [35]    SEC Press Release, SEC Issues Multiple Whistleblower Awards Totaling Nearly $3 Million (Dec. 7, 2020), available at https://www.sec.gov/news/press-release/2020-307.    [36]    SEC Press Release, SEC Issues Multiple Whistleblower Awards Totaling Nearly $3 Million (Dec. 7, 2020), available at https://www.sec.gov/news/press-release/2020-307.    [37]    SEC Press Release, SEC Awards More Than $300,000 to Whistleblower with Audit Responsibilities (Dec. 14, 2020), available at https://www.sec.gov/news/press-release/2020-316.    [38]    SEC Press Release, SEC Issues Multiple Whistleblower Awards Totaling Over $3.6 Million (Dec. 18, 2020), available at https://www.sec.gov/news/press-release/2020-325.    [39]         SEC Press Release, SEC Charges Companies, Former Executives as Part of Risk-Based Initiative (Sept. 28, 2020), available at https://www.sec.gov/news/press-release/2020-226.    [40]    SEC Press Release, SEC Charges BorgWarner for Materially Misstating its Financial Statements (Aug. 26, 2020), available at https://www.sec.gov/news/press-release/2020-195.    [41]    SEC Press Release, SEC Charges Super Micro and Former CFO in Connection with Widespread Accounting Violations (Aug. 25, 2020), available at https://www.sec.gov/news/press-release/2020-190.    [42]    SEC Press Release, Engine Manufacturing Company to Pay Penalty, Take Remedial Measures to Settle Charges of Accounting Fraud (Sept. 24, 2020), available at https://www.sec.gov/news/press-release/2020-222.    [43]    SEC Press Release, SEC Charges Lighting Products Company and Four Executives with Accounting Violations (Sept. 24, 2020), available at https://www.sec.gov/news/press-release/2020-221.    [44]    SEC Press Release, SEC Charges BMW for Disclosing Inaccurate and Misleading Retail Sales Information to Bond Investors (Sept. 24, 2020), available at https://www.sec.gov/news/press-release/2020-223.    [45]    SEC Press Release, SEC Charges Manitex International and Three Former Senior Executives with Accounting Fraud (Sept. 29, 2020), available at https://www.sec.gov/news/press-release/2020-237.    [46]    SEC Press Release, SEC Charges Seismic Data Company, Former Executives with $100 Million Accounting Fraud (Oct. 8, 2020), available at https://www.sec.gov/news/press-release/2020-251.    [47]    SEC Press Release, SEC Charges Former Wells Fargo Executives for Misleading Investors About Key Performance Metric (Nov. 13, 2020), available at https://www.sec.gov/news/press-release/2020-281.    [48]    SEC Press Release, Luckin Coffee Agrees to Pay $180 Million Penalty to Settle Accounting Fraud Charges (Dec. 16, 2020), available at https://www.sec.gov/news/press-release/2020-319.    [49]    See, e.g., Praxsyn Corp., Applied Biosciences Corp., and Turbo Global partners Inc.    [50]     SEC Press Release, SEC Orders Top Executive of California Microcap Company for Misleading Claims Concerning COVID-19 Test and Financial Statements (Sept. 25, 2020), available at https://www.sec.gov/news/press-release/2020-224.    [51]     SEC Press Release, SEC Charges Biotech Company and CEO with Fraud Concerning COVID-19 Blood Testing Device (Dec. 18, 2020), available at https://www.sec.gov/news/press-release/2020-327.    [52]     SEC Press Release, SEC Charges the Cheesecake Factory for Misleading COVID-19 Disclosures (Dec. 4, 2020), available at https://www.sec.gov/news/press-release/2020-306.    [53]    SEC Press Release, General Electric Agrees to Pay $200 Million Penalty for Disclosure Violations (Dec. 9, 2020), available at https://www.sec.gov/news/press-release/2020-312.    [54]    SEC Press Release, Fiat Chrysler Agrees to Pay $9.5 Million Penalty for Disclosure Violations (Sept. 28, 2020), available at https://www.sec.gov/news/press-release/2020-230.    [55]    SEC Press Release, SEC Charges Hospitality Company for Failing to Disclose Executive Perks (Sept. 30, 2020), available at https://www.sec.gov/news/press-release/2020-242.    [56]    SEC Press Release, Pharmaceutical Company and Former Executives Charged with Misleading Financial Disclosures (July 31, 2020), available at https://www.sec.gov/news/press-release/2020-169.    [57]    SEC Press Release, SEC Charges Hertz’s Former CEO with Aiding and Abetting Company’s Financial Reporting and Disclosure Violations (Aug. 13, 2020), available at https://www.sec.gov/news/press-release/2020-183.    [58]    SEC Press Release, SEC Charges Charter School Operator and its Former President with Fraudulent Municipal Bond Offering (Sept. 14, 2020), available at https://www.sec.gov/news/press-release/2020-208.    [59]    SEC Press Release, SEC Charges HP Inc. with Disclosure Violations and Control Failures (Sept. 30, 2020), available at https://www.sec.gov/news/press-release/2020-241.    [60]    SEC Press Release, Energy Companies Agree to Settle Fraud Charges Stemming from Failed Nuclear Power Plant Expansion (Dec. 2, 2020), available at https://www.sec.gov/news/press-release/2020-301.    [61]    SEC Press Release, SEC Charges Sequential Brands Group Inc. with Deceiving Investors by Failing to Timely Impair Goodwill (Dec. 11, 2020), available at https://www.sec.gov/news/press-release/2020-315.    [62]    SEC Press Release, SEC Charges Andeavor for Inadequate Controls Around Authorization of Stock Buyback Plan (Oct. 15, 2020), available at https://www.sec.gov/news/press-release/2020-258.    [63]     SEC Press Release, SEC Charges Affiliated Advisers for Misrepresentations About Payment for Order Flow Arrangements (Aug. 5, 2020), available at https://www.sec.gov/news/press-release/2020-175.    [64]     SEC Press Release, Advisory Firm Settles Charges of Defrauding Investors, Agrees to Refund Allegedly Ill-Gotten Gains to Harmed Clients (Aug. 13, 2020), available at https://www.sec.gov/news/press-release/2020-182.    [65]     SEC Press Release, SEC Charges Investment Advisory Firms and Broker-Dealers in Connection with Sales of Complex Exchange-Traded Products (Nov. 13, 2020), available at https://www.sec.gov/news/press-release/2020-282.    [66]     SEC Press Release, SEC Charges Unregistered Investment Adviser with Defrauding Puerto Rico Municipality (Dec. 1, 2020), available at https://www.sec.gov/news/press-release/2020-299.    [67]     SEC Press Release, SEC Orders BlueCrest to Pay $170 Million to Harmed Fund Investors (Dec. 8, 2020), available at https://www.sec.gov/news/press-release/2020-308.    [68]     SEC Press Release, Global Securities Pricing Service to Pay $8 Million for Compliance Failures (Dec. 9, 2020), available at https://www.sec.gov/news/press-release/2020-310.    [69]     SEC Litig. Rel. No. 24990, SEC Charges Texas-Based Investment Adviser and Its President for Conducting Fraudulent “Cherry-Picking” Scheme (Dec. 21, 2020), available at https://www.sec.gov/litigation/litreleases/2020/lr24990.htm.    [70]     SEC Press Release, SEC Charges Interactive Brokers with Repeatedly Failing to File Suspicious Activity Reports (Aug. 10, 2020), available at https://www.sec.gov/news/press-release/2020-178.    [71]     SEC Press Release, Morgan Stanley Agrees to Pay $5 Million for Reg SHO Violations in Prime Brokerage Swaps Business (Sept. 30, 2020), available at https://www.sec.gov/news/press-release/2020-238.    [72]     SEC Press Release, J.P. Morgan Securities Admits to Manipulative Trading in U.S. Treasuries (Sept. 29, 2020), available at https://www.sec.gov/news/press-release/2020-233.    [73]     SEC Press Release, SEC Charges Robinhood Financial with Misleading Customers About Revenue Sources and Failing to Satisfy Duty of Best Execution (Dec. 17, 2020), available at https://www.sec.gov/news/press-release/2020-321.    [74]    SEC Press Release, SEC Charges Ripple and Two Executives with Conducting $1.3 Billion Unregistered Securities Offering (Dec. 22, 2020), available at https://www.sec.gov/news/press-release/2020-338.    [75]     SEC v. W.J. Howey Co., 328 U.S. 293 (1946).    [76]    SEC Press Release, SEC Obtains Emergency Asset Freeze, Charges Crypto Fund Manager with Fraud (Dec. 28, 2020), available at https://www.sec.gov/news/press-release/2020-341.    [77]    SEC Press Release, SEC Announces Office Focused on Innovation and Financial Technology (Dec. 3, 2020), available at https://www.sec.gov/news/press-release/2020-303.    [78]    SEC Press Release, SEC Charges App Developer for Unregistered Security-Based Swap Transactions (July 13, 2020), available at https://www.sec.gov/news/press-release/2020-153.    [79]    SEC Press Release, Unregistered ICO Issuer Agrees to Disable Tokens and Pay Penalty for Distribution to Harmed Investors (Sept. 15, 2020), available at https://www.sec.gov/news/press-release/2020-211.    [80]    SEC Press Release, SEC Charges Issuer and CEO With Misrepresenting Platform Technology in Fraudulent ICO (Aug. 13, 2020), available at https://www.sec.gov/news/press-release/2020-181.    [81]    SEC Press Release, SEC Charges Film Producer, Rapper, and Others for Participation in Two Fraudulent ICOs (Sept. 11, 2020), available at https://www.sec.gov/news/press-release/2020-207.    [82]    SEC Press Release, SEC Charges John McAfee With Fraudulently Touting ICOs (Oct. 5, 2020), available at https://www.sec.gov/news/press-release/2020-246.    [83]     SEC Press Release, SEC Charges Index Manager and Friend With Insider Trading (Sept. 21, 2020), available at https://www.sec.gov/news/press-release/2020-217.    [84]     SEC Press Release, SEC Charges Amazon Finance Manager and Family With Insider Trading (Sept. 28, 2020), available at https://www.sec.gov/news/press-release/2020-228.    [85]     SEC v. Peltz, 20-cv-6199 (E.D.N.Y. Dec. 22, 2020), ECF 1.    [86]    SEC Press Release, SEC Charges Disbarred New York Attorney and Florida Attorney with Scheme to Create False Opinion Letters (Dec. 2, 2020), available at https://www.sec.gov/news/press-release/2020-300.    [87]     SEC Press Release, SEC Charges CEO and Company With Defrauding First Responders and Others Out of Millions (July 30, 2020), available at https://www.sec.gov/news/press-release/2020-167.    [88]     SEC Press Release, SEC Charges Former Real Estate Executive With Misappropriating $26 Million in Ponzi Scheme (Sept. 29, 2020), available at https://www.sec.gov/news/press-release/2020-236.    [89]     SEC Press Release, SEC Charges Unregistered Brokers in Penny Stock Scheme Targeting Seniors (Sept. 29, 2020), available at https://www.sec.gov/news/press-release/2020-234; see also SEC Press Release, SEC Halts Penny Stock Scheme Targeting Seniors (Nov. 27, 2019), available at https://www.sec.gov/news/press-release/2019-245.    [90]     SEC Press Release, SEC Charges Jewelry Wholesaler with Fraudulent Securities Offering Targeting Current and Retired Police Officers and Firefighters (Dec 30, 2020), available at https://www.sec.gov/news/press-release/2020-343.    [91]     SEC Press Release, SEC Charges Ponzi Scheme Targeting African Immigrants (Aug. 18, 2020), available at https://www.sec.gov/news/press-release/2020-198.    [92]     SEC Press Release, SEC Charges Swedish National with Global Scheme Defrauding Retail Investors, Including Deaf Community Members (Sept. 21, 2020), available at https://www.sec.gov/news/press-release/2020-232.    [93]     SEC Press Release, SEC Charges Company and CEO for $119 Million Securities Fraud Targeting Members of the South Asian American Community (Dec. 21, 2020), available at https://www.sec.gov/news/press-release/2020-329.    [94]     SEC Press Release, SEC Charges E-Commerce Startup and CEO With Defrauding Investors (Nov. 23, 2020), available at https://www.sec.gov/news/press-release/2020-291.    [95]     SEC Press Release, SEC Charges Silicon Valley Start-Up and CEO With Defrauding Investors (July 20, 2020), available at https://www.sec.gov/news/press-release/2020-160.    [96]     SEC Press Release, SEC Charges Trustify Inc. and Founder in $18.5 Million Offering Fraud (July 24, 2020), available at https://www.sec.gov/news/press-release/2020-162.    [97]     SEC v. Rogas, No. 20-cv-7628 (S.D. Cal. Sept. 24, 2020), ECF No. 21.    [98]     SEC Press Release, SEC Charges Former CEO of Technology Company With Raising $123 Million in Fraudulent Offerings (Sept. 17, 2020), available at https://www.sec.gov/news/press-release/2020-213.
The following Gibson Dunn lawyers assisted in the preparation of this client update:  Mark Schonfeld, Barry Goldsmith, Richard Grime, Jeff Steiner, Tina Samanta, Brittany Garmyn, Zoey Goldnick, Rachel Jackson, Jesse Melman, Lauren Myers, Jaclyn Neely, Jason Smith, Mike Ulmer, Timothy Zimmerman, and Marie Zoglo. Gibson Dunn is one of the nation’s leading law firms in representing companies and individuals who face enforcement investigations by the Securities and Exchange Commission, the Department of Justice, the Commodities Futures Trading Commission, the New York and other state attorneys general and regulators, the Public Company Accounting Oversight Board (PCAOB), the Financial Industry Regulatory Authority (FINRA), the New York Stock Exchange, and federal and state banking regulators. Our Securities Enforcement Group offers broad and deep experience.  Our partners include the former Director of the SEC’s New York Regional Office, the former head of FINRA’s Department of Enforcement, the former United States Attorneys for the Central and Eastern Districts of California, and former Assistant United States Attorneys from federal prosecutors’ offices in New York, Los Angeles, San Francisco and Washington, D.C., including the Securities and Commodities Fraud Task Force. Securities enforcement investigations are often one aspect of a problem facing our clients. Our securities enforcement lawyers work closely with lawyers from our Securities Regulation and Corporate Governance Group to provide expertise regarding parallel corporate governance, securities regulation, and securities trading issues, our Securities Litigation Group, and our White Collar Defense Group. Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments. Please contact the Gibson Dunn lawyer with whom you usually work or any of the following: Securities Enforcement Practice Group Leaders: Barry R. Goldsmith – New York (+1 212-351-2440, bgoldsmith@gibsondunn.com) Richard W. Grime – Washington, D.C. (+1 202-955-8219, rgrime@gibsondunn.com) Mark K. Schonfeld – New York (+1 212-351-2433, mschonfeld@gibsondunn.com) Please also feel free to contact any of the following practice group members: New York Zainab N. Ahmad (+1 212-351-2609, zahmad@gibsondunn.com) Matthew L. Biben (+1 212-351-6300, mbiben@gibsondunn.com) Reed Brodsky (+1 212-351-5334, rbrodsky@gibsondunn.com) Joel M. Cohen (+1 212-351-2664, jcohen@gibsondunn.com) Lee G. Dunst (+1 212-351-3824, ldunst@gibsondunn.com) Mary Beth Maloney (+1 212-351-2315, mmaloney@gibsondunn.com) Alexander H. Southwell (+1 212-351-3981, asouthwell@gibsondunn.com) Avi Weitzman (+1 212-351-2465, aweitzman@gibsondunn.com) Lawrence J. Zweifach (+1 212-351-2625, lzweifach@gibsondunn.com) Tina Samanta (+1 212-351-2469, tsamanta@gibsondunn.com) Washington, D.C. Stephanie L. Brooker (+1 202-887-3502, sbrooker@gibsondunn.com) Daniel P. Chung (+1 202-887-3729, dchung@gibsondunn.com) M. Kendall Day (+1 202-955-8220, kday@gibsondunn.com) Jeffrey L. Steiner (+1 202-887-3632, jsteiner@gibsondunn.com) Patrick F. Stokes (+1 202-955-8504, pstokes@gibsondunn.com) F. Joseph Warin (+1 202-887-3609, fwarin@gibsondunn.com) San Francisco Winston Y. Chan (+1 415-393-8362, wchan@gibsondunn.com) Thad A. Davis (+1 415-393-8251, tadavis@gibsondunn.com) Charles J. Stevens (+1 415-393-8391, cstevens@gibsondunn.com) Michael Li-Ming Wong (+1 415-393-8234, mwong@gibsondunn.com) Palo Alto Michael D. Celio (+1 650-849-5326, mcelio@gibsondunn.com) Paul J. Collins (+1 650-849-5309, pcollins@gibsondunn.com) Benjamin B. Wagner (+1 650-849-5395, bwagner@gibsondunn.com) Denver Robert C. Blume (+1 303-298-5758, rblume@gibsondunn.com) Monica K. Loseman (+1 303-298-5784, mloseman@gibsondunn.com) Los Angeles Michael M. Farhang (+1 213-229-7005, mfarhang@gibsondunn.com) Douglas M. Fuchs (+1 213-229-7605, dfuchs@gibsondunn.com) Nicola T. Hanna (+1 213-229-7269, nhanna@gibsondunn.com) Debra Wong Yang (+1 213-229-7472, dwongyang@gibsondunn.com) © 2021 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

January 13, 2021 |
Supreme Court Vacates Second Circuit Ruling Expanding Insider Trading Liability

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On January 11, 2021, the Supreme Court in a summary disposition vacated the U.S. Court of Appeals for the Second Circuit’s major insider trading decision in United States v. Blaszczak, 947 F.3d 19 (2d Cir. 2019), remanding the case to the Second Circuit for further consideration in light of the Supreme Court’s recent decision in Kelly v. United States, 140 S.Ct. 1565 (2020). See Blaszczak v. United States, 2021 WL 78043 (Jan. 11, 2021); Olan v. United States, 2021 WL 78042 (Jan. 11, 2021). The Supreme Court’s decision raises important questions regarding whether, and to what extent, the Second Circuit will retreat from the significant expansion of insider trading liability it enunciated in Blaszczak barely more than one year ago.

United States v. Blaszczak

As we described in greater detail in a prior client alert, in Blaszczak, the U.S. Department of Justice (“DOJ”) alleged that, between 2009 and 2014, certain Centers for Medicare & Medicaid Services (“CMS”) employees disclosed confidential information relating to planned changes to medical treatment reimbursement rates to David Blaszczak, a former CMS employee who became a “political intelligence” consultant for hedge funds. Blaszczak allegedly provided this “predecisional” confidential information to employees of the hedge fund Deerfield Management Company, L.P., which then shorted stocks of healthcare companies that would be hurt by the planned reimbursement rate changes.

The DOJ indicted Blaszczak, one CMS employee, and two Deerfield employees for the alleged insider trading scheme. After an April 2018 trial, the jury returned a split verdict, acquitting all the defendants on certain counts, but finding the defendants guilty on other counts, including conversion, wire fraud, and (except for the CMS employee) Title 18 securities fraud. The defendants appealed.

In December 2019, the Second Circuit upheld the convictions and, in doing so, heightened the risk of investigation and prosecution in certain types of insider trading cases in two significant respects. First, in traditional civil and criminal insider trading cases against both tippers and tippees for Title 15 securities fraud under the Securities Exchange Act, the government must prove, among other things, that the tipper breached a duty in exchange for a direct or indirect personal benefit, and that the downstream tippee knew that the tipper had done so. The Second Circuit held that, by contrast, there is no “personal benefit” requirement in criminal insider trading cases charging Title 18 offenses like wire fraud and the criminal securities fraud provisions added in 2002 in the Sarbanes-Oxley Act.

Second, the court held that the “predecisional” confidential information relating to planned medical treatment reimbursement rate changes constituted government “property” necessary to bring insider trader cases under an embezzlement or misappropriation theory. In so holding, the Second Circuit found that this confidential government information was more akin to The Wall Street Journal’s confidential business information that the Supreme Court held constituted property for insider trading purposes in Carpenter v. United States, 484 U.S. 19 (1987), than to the fraudulently-obtained Louisiana state video poker licenses that the Supreme Court found did not constitute property in Cleveland v. United States, 531 U.S. 12 (2000), because “the State’s core concern” in granting video poker licenses was “regulatory.”

The Second Circuit’s decision thus expanded potential criminal insider trading liability in cases where there was limited-to-no evidence of a personal benefit to the tipper or that the downstream tippee knew of such a benefit, as well as in cases involving disclosure of nonpublic government information.

Kelly v. United States

In May 2020, five months after the Second Circuit’s decision in Blaszczak, the Supreme Court in Kelly addressed the scope of government “property” under federal fraud statutes. Specifically, the Supreme Court reviewed the criminal convictions of two “Bridgegate” defendants on federal-program and wire fraud charges arising out of their alleged involvement in a scheme to limit the number of lanes in Fort Lee, New Jersey accessing the George Washington Bridge as political retribution against the city’s mayor. To convict under both fraud provisions, the government was required to show “that an object of their fraud was money or property.”

The Supreme Court reversed the convictions, holding that “[t]he realignment of the toll lanes was an exercise of regulatory power—something this Court has already held fails to meet the statutes’ property requirement. And the [traffic engineers and toll collectors’] labor was just the incidental cost of that regulation, rather than itself an object of the officials’ scheme.” In reaching this conclusion, the Supreme Court relied heavily on Cleveland, noting that the defendants “exercised the regulatory rights of ‘allocation, exclusion, and control,’” and “under Cleveland, that run-of-the-mine exercise of regulatory power cannot count as the taking of property.”

Blaszczak Appeal to Supreme Court

In September 2020, three of the Blaszczak defendants petitioned the Supreme Court for a writ of certiorari, arguing that the Second Circuit had improperly expanded criminal insider trading liability by holding that there was no “personal benefit” requirement in Title 18 insider trading cases and that, contrary to the Supreme Court’s rulings in Cleveland and Kelly, predecisional confidential information constituted government property. See Petition for a Writ of Certiorari, Blaszczak v. United States (Sept. 4, 2020) (No. 20-5649); Petition for a Writ of Certiorari, Olan v. United States, 2020 WL 5439755 (Sept. 4, 2020).

Rather than address the propriety of the Second Circuit’s decision head-on, the government in its response brief instead argued that “the appropriate course is to grant the petitions for writs of certiorari, vacate the decision below, and remand the case for further consideration in light of Kelly.” Mem. for the United States, Blaszczak v. United States (Nov. 24 2020) (Nos. 20-306 & 20-5649).

On reply, the petitioners argued that the Supreme Court should squarely rule on their petition, rather than vacate and remand, noting that the Second Circuit may only “reverse[] itself on the ‘property’ issue,” without needing to again address its prior holding that there was no personal benefit requirement in Title 18 insider trading cases. Reply Brief for Petitioners, Olan v. United States, 2020 WL 7345516 (Dec. 8, 2020). As a result, “unless the [Second Circuit’s] existing erasure of the personal-benefit requirement…is repudiated, prosecutors in the Second Circuit will continue to feel free to charge insider-trading crimes even where there is no proof of personal benefit. And district courts in the Circuit (where most insider-trading prosecutions are brought) would likely follow the Second Circuit’s lead even if it were not technically binding….”

Despite the concerns that petitioners raised, on January 11, 2021, the Supreme Court agreed to the course that the government proposed, granting certiorari and directing that “[t]he judgment is vacated, and the case is remanded to the…Second Circuit for further consideration in light of Kelly….” Blaszczak v. United States, 2021 WL 78043 (Jan. 11, 2021); Olan v. United States, 2021 WL 78042 (Jan. 11, 2021).

Implications of Supreme Court’s Blaszczak Decision

It is unclear at this juncture what effect, if any, the Supreme Court’s decisions in Kelly and Blaszczak will have on the Second Circuit’s expansion of insider trading liability. In an expansive reading, for example, the Second Circuit could distinguish the “exercise of regulatory power” in Kelly from the “predecisional” government information in Blaszczak and continue to analogize confidential government information to the confidential business information that the Supreme Court ruled in Carpenter constitutes property for insider trading purposes. In a narrower reading, the Second Circuit could find that the principle of Kelly should apply to predecisional government information and thus that it does not constitute property under Title 18 securities fraud.

If the Second Circuit concludes that, after Kelly, confidential government information does not constitute property, the Court could reverse the convictions on this ground while leaving unaddressed its prior holding that there is no personal benefit requirement in Title 18 insider trader cases. As the petitioners warned the Supreme Court, prosecutors in this scenario would likely treat this silence as a green light to continue to charge insider-trading crimes where there is little to no evidence of a personal benefit to the tipper, or tippee knowledge of that benefit. Of course, under such circumstances, prosecutors would not have the benefit of Blaszczak to rely on, and thus there could be litigation risk to the government depending on the facts of the particular case.

Clouding the picture even further is that the Second Circuit ruling in Blaszczak was a 2-1 decision. And one of the two judges who joined in the majority ruling has since retired. As a result, the outcome of Blaszczak could be impacted significantly by the views of the third judge assigned to the panel. Should that new judge join with the original dissenting judge, the Blaszczak holding will change substantially. In addition, regardless of how the Second Circuit rules on remand, the losing side may seek the Supreme Court’s review of that decision. Blaszczak will therefore continue to be an important case to monitor in the ongoing court battles to define the scope of insider trading liability.


Gibson Dunn’s lawyers are available to assist with any questions you may have regarding these developments. For additional information, please feel free to contact the Gibson Dunn lawyer with whom you usually work, any member of the firm’s Securities Enforcement or White Collar Defense and Investigations practice groups, or the following authors:

Reed Brodsky – New York (+1 212-351-5334, rbrodsky@gibsondunn.com) Barry R. Goldsmith – New York (+1 212-351-2440, bgoldsmith@gibsondunn.com) M. Jonathan Seibald – New York (+1 212-351-3916, mseibald@gibsondunn.com)

Please also feel free to contact any of the following practice leaders:

Securities Enforcement Group: Barry R. Goldsmith – New York (+1 212-351-2440, bgoldsmith@gibsondunn.com) Richard W. Grime – Washington, D.C. (+1 202-955-8219, rgrime@gibsondunn.com) Mark K. Schonfeld – New York (+1 212-351-2433, mschonfeld@gibsondunn.com)

White Collar Defense and Investigations Group: Joel M. Cohen – New York (+1 212-351-2664, jcohen@gibsondunn.com) Nicola T. Hanna – Los Angeles (+1 213-229-7269, nhanna@gibsondunn.com) Charles J. Stevens – San Francisco (+1 415-393-8391, cstevens@gibsondunn.com) F. Joseph Warin – Washington, D.C. (+1 202-887-3609, fwarin@gibsondunn.com)

© 2021 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

December 18, 2020 |
Congress Buries Expansion of SEC Disgorgement Authority in Annual Defense Budget

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On December 11, 2020, Congress fulfilled its constitutional obligation “to provide for the common defense,”[1] passing for the 60th consecutive year the National Defense Authorization Act (“NDAA”), H.R. 6395. Buried on page 1,238 of this $740.5 billion military spending bill is an amendment to the Securities Exchange Act of 1934. That amendment gives the Securities and Exchange Commission, for the first time in its history, explicit statutory authority to seek disgorgement in federal district court. It also doubles the current statute of limitations for disgorgement claims in certain classes of cases. The amendment appears to be a direct response to recent Supreme Court decisions limiting the SEC’s authority.

Although the Exchange Act does not by its terms authorize the SEC to seek “disgorgement” for Federal Court actions, the agency has long requested this remedy, and courts have long awarded it under their power to grant “equitable relief.”[2] In Liu v. SEC, 140 S. Ct. 1936 (2020), however, the Supreme Court made clear that while disgorgement could qualify as “equitable relief” in certain circumstances, to do so, it must be bound by “longstanding equitable principles.”[3] Generally, under Liu, disgorgement cannot be awarded against multiple wrongdoers under a joint-and-several liability theory, and any amount disgorged must be limited to the wrongdoer’s net profits and be awarded only to victims, not to the U.S. Treasury. And just three years earlier, in Kokesh v. SEC, 137 S. Ct. 1635 (2017), the Court added other limitations on the SEC’s ability to seek disgorgement, holding that disgorgement as applied by the SEC and courts is a “penalty” and therefore subject to the same five-year statute of limitations as the civil money penalties the SEC routinely seeks.[4]

The SEC has not responded positively to either decision, particularly Kokesh. Chairman Clayton stated that he is “troubled by the substantial amount of losses” he anticipated the SEC would suffer as a result of the five-year statute of limitations applied in Kokesh.[5] And for that reason, he has urged Congress to “work with” him to extend the statute of limitations period for disgorgement.[6]

Section 6501 of the NDAA appears to grant the SEC its wish, at least in part. The bill authorizes the SEC to seek “disgorgement . . . of any unjust enrichment by the person who received such unjust enrichment,” establishing that the SEC has statutory power to seek disgorgement in federal court. And it provides that “a claim for disgorgement” may be brought within ten years of a scienter-based violation—twice as long as the statute of limitations after Kokesh. As one Congressman put it in reference to a similar provision in an earlier bill, this “legislation would reverse the Kokesh decision” by allowing the SEC to seek disgorgement for certain conduct further back in time.[7] The proposed amendment would apply to any action or proceeding that is pending on, or commenced after, the enactment of the NDAA.

If enacted, the NDAA will likely embolden the SEC on numerous levels. It will, for instance, likely encourage the agency to charge scienter-based violations to obtain disgorgement over a longer period. It also will likely incentivize the SEC to use this authority to eschew the equitable limitations placed on disgorgement in Liu and even to apply that expanded conception of disgorgement retroactively to pending cases. It is not clear, however, whether courts would go along. If Congress, for example, had wanted to free the SEC from all equitable limitations identified in Liu, it could have said so explicitly. Courts may be especially reluctant if, as the SEC may claim, the disgorgement provision of the NDAA can be applied retroactively. Because the “[r]etroactive imposition” of a penalty “would raise a serious constitutional question,”[8] the courts would not lightly find that disgorgement had slipped Liu’s equitable limitations, the one thing potentially keeping disgorgement from “transforming . . . into a penalty” after Liu.[9]

We will continue to monitor the NDAA, which is currently awaiting the President’s signature or veto. Although the President has threatened to veto the bill over unrelated provisions, Congress likely has enough votes to override that veto.[10]

____________________

[1] U.S. Const. pmbl.; see also U.S. Const. art. I, § 8, cls.12–14.

[2] 15 U.S.C. § 78u(d)(5); see Liu v. SEC, 140 S. Ct. 1936, 1940–41 (2020).

[3] Liu, 140 S. Ct. at 1946.

[4] The Supreme Court’s cabining of the SEC’s disgorgement authority to “longstanding equitable principles” in Liu raised at least some doubt whether SEC disgorgement continued to be a “penalty” for statute of limitations purposes under Kokesh.

[5] Jay Clayton, Chairman, SEC, Keynote Remarks at the Mid-Atlantic Regional Conference (June 4, 2019), https://www.sec.gov/news/speech/clayton-keynote-mid-atlantic-regional-conference-2019.

[6] Id.

[7] 165 Cong. Rec. H8931 (daily ed. Nov. 18, 2019) (statement of Rep. McAdams), https://www.congress.gov/116/crec/2019/11/18/CREC-2019-11-18-pt1-PgH8929.pdf.

[8] Landgraf v. United States, 511 U.S. 244, 281 (1994).

[9] Liu, 140 S. Ct. at 1944.

[10] Lindsay Wise, Senate Approves Defense-Policy Bill Despite Veto Threat, Wall St. J. (Dec. 11, 2020), https://www.wsj.com/articles/senate-advances-defense-policy-bill-despite-trump-veto-threat-11607703243.


Gibson Dunn’s lawyers are available to assist with any questions you may have regarding these issues. To learn more about these issues, please contact the Gibson Dunn lawyer with whom you usually work in the firm’s Securities Enforcement, Administrative Law and Regulatory or White Collar Defense and Investigations practice groups, or the following authors:

Barry R. Goldsmith – New York (+1 212-351-2440, bgoldsmith@gibsondunn.com) Helgi C. Walker – Washington, D.C. (+1 202-887-3599, hwalker@gibsondunn.com) M. Jonathan Seibald – New York (+1 212-351-3916, mseibald@gibsondunn.com) Brian A. Richman – Washington, D.C. (+1 202-887-3505, brichman@gibsondunn.com)

Please also feel free to contact any of the following practice leaders:

Securities Enforcement Group: Barry R. Goldsmith – New York (+1 212-351-2440, bgoldsmith@gibsondunn.com) Richard W. Grime – Washington, D.C. (+1 202-955-8219, rgrime@gibsondunn.com) Mark K. Schonfeld – New York (+1 212-351-2433, mschonfeld@gibsondunn.com)

Administrative Law and Regulatory Group: Helgi C. Walker – Washington, D.C. (+1 202-887-3599, hwalker@gibsondunn.com)

White Collar Defense and Investigations Group: Joel M. Cohen – New York (+1 212-351-2664, jcohen@gibsondunn.com) Charles J. Stevens – San Francisco (+1 415-393-8391, cstevens@gibsondunn.com) F. Joseph Warin – Washington, D.C. (+1 202-887-3609, fwarin@gibsondunn.com)

© 2020 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

December 7, 2020 |
SEC Brings First Enforcement Action Against a Public Company for Misleading Disclosures About the Financial Impacts of the Pandemic

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On December 4, 2020, the Securities and Exchange Commission (“SEC”) announced its first enforcement action against a public company for misleading disclosures about the financial effects of the pandemic on the company’s business operations and financial condition. In a settled administrative order, the Commission found that disclosures in two press releases by The Cheesecake Factory Incorporated violated Section 13(a) of the Exchange Act and Rules 13a-11 and 12b-20 thereunder. Without admitting the findings in the order, the company agreed to pay a $125,000 penalty and to cease-and-desist from further violations.[1] In March 2020, the SEC’s Division of Enforcement formed a Coronavirus Steering Committee to oversee the Division’s efforts to actively look for Covid-related misconduct.

The Company’s Form 8-Ks

On March 23, 2020, the company furnished a Form 8-K to the Commission, disclosing, among other things, that it was withdrawing previously-issued financial guidance due to economic conditions caused by Covid-19. As an exhibit to the Form-8-K, the company included a copy of its press release providing a business update regarding the impact of Covid-19. The press release announced that the company was transitioning to an “off-premise” model (i.e., to-go and delivery) that would enable the company to continue to “operate sustainably.” This press release did not elaborate on what “sustainably” meant. The release also disclosed a $90 million draw down on the company’s revolving credit facility, and stated that the company was “evaluating additional measures to further preserve financial flexibility.”

On March 27, 2020, in response to media reports, the company filed another Form 8-K, disclosing that it was not planning to pay rent in April and that it was in discussion with landlords regarding its rent obligations, including abatement and potential deferral. The company also disclosed that as of April 1, it had reduced compensation for executive officers, its Board of Directors, and certain employees, and that it furloughed approximately 41,000 employees.

On April 3, 2020, the company furnished another Form 8-K to the Commission that attached a copy of an April 2, 2020 press release. This press release provided a preliminary Q1 2020 sales update, which reflected the impact of Covid-19. The release stated that “the restaurants are operating sustainably at present under this [off-premise] model.”

The SEC found that the March 23 and April 3 Form 8-Ks – but not the March 27 Form 8-K – were materially misleading.

What the Company Did Not Disclose

The company’s disclosures on March 23 and April 3 did not disclose:

  1. a March 18, 2020 letter from the company to its restaurants’ landlords stating that it was not going to pay its rent for April 2020;
  2. that the company was losing $6 million in cash per week;
  3. that it had only approximately 16 weeks of cash remaining even after the $90 million revolving credit facility borrowing; and
  4. that it was excluding expenses attributable to corporate operations from its claim of sustainability.

The SEC’s Findings

The SEC found that the company’s March 23 and April 3, 2020 Forms 8-K were materially false and misleading in violation of Section 13(a) of the Exchange Act and Rules 13a-11 and 12b-20 thereunder. These sections require that every issuer of a security registered pursuant to Section 12 of the Exchange Act file with the Commission accurate and current information on its Form 8-K, including material information necessary to make the required statements made in the reports not misleading.

Observations and Takeaways

Although this is the first enforcement action against a public company based on disclosures about the financial effects of the pandemic, the findings against the company are fairly unusual.

Two observations:

  • First, the SEC’s order focuses on two press releases included as exhibits in Form 8-Ks that are deemed to be “furnished,” and not “filed,” under the Exchange Act. Specifically, one was filed under Item 7.01 and the other under Item 2.02. Because these Form 8-Ks are not deemed to be “filed” for purposes of Section 18 of the Exchange Act, there is no private right of action under Section 18 that can arise in connection with these Form 8-Ks. So, although “furnishing” reports results in lower liability exposure, it does not mean that the SEC cannot take enforcement action if it believes the disclosure is misleading.
  • Second, the language at issue in the two Form 8-Ks is the word of the moment, “sustainably,” as in “operating sustainably.” It should be noted that, nine months after the disclosures were made, the company remains in business (and did not file for bankruptcy) and, in fact, as of the close of trading on December 4, 2020, its stock price closed near the high of the 52-week range. The concept of sustainability is generally thought to encompass the concept of over the long- or longer term, so it is not self-evident that these disclosures were materially misleading.

Some takeaways:

  • In using the word “sustainably” without further qualification or explanation, issuers run the risk of being misunderstood. Sustainably in what sense (as a synonym for liquidity?) or to which degree? Over what period of time? It is not self-evident what sustainability entails.
  • Where the subject matter involves the impact of Covid, the Commission’s order certainly demonstrates its willingness to take action even if, at worst, the disclosure at issue is vague or unclear. This was not a case in which the company claimed it had no liquidity issues when, in fact, it was experiencing significant liquidity issues. Put another way, this case raises the question as to whether Covid disclosures are attracting greater scrutiny than other corporate disclosures in the current climate.
  • To state the obvious, the Commission brought this action for a reason: to underscore the importance of carefully drafted disclosures with respect to the impact of Covid on issuers’ results of operations, financial condition and liquidity; and to signal its willingness to take action if issuers’ Covid-related disclosures are not carefully drafted. A quote from the SEC Chair in the press release announcing this action is a further indication of the importance the SEC is placing on this area of enforcement.[2]

_______________________

  [1]   Order Instituting Cease-and-Desist Proceedings, Securities Exchange Act of 1934 Release No. 90565 at 4 (Dec. 4, 2020).

  [2]   Press Release, Securities and Exchange Commission, SEC Charges The Cheesecake Factory For Misleading COVID-19 Disclosures (Dec. 4, 2020), available at https://www.sec.gov/news/press-release/2020-306.


Gibson Dunn’s lawyers are available to assist with any questions you may have regarding these issues. To learn more about these issues, please contact the Gibson Dunn lawyer with whom you usually work in the firm's Securities Enforcement or Securities Regulation and Corporate Governance practice groups, or the following authors:

Thomas J. Kim – Washington, D.C. (+1 202-887-3550, tkim@gibsondunn.com) Mark K. Schonfeld – New York (+1 212-351-2433, mschonfeld@gibsondunn.com) Barry R. Goldsmith – New York (+1 212-351-2440, bgoldsmith@gibsondunn.com) Richard W. Grime – Washington, D.C. (+1 202-955-8219, rgrime@gibsondunn.com) Elizabeth Ising – Washington, D.C. (+1 202-955-8287, eising@gibsondunn.com) James J. Moloney – Orange County, CA (+ 949-451-4343, jmoloney@gibsondunn.com) Ronald O. Mueller – Washington, D.C. (+1 202-955-8671, rmueller@gibsondunn.com) Lauren Myers – New York (+1 212-351-3946, lmyers@gibsondunn.com)

Please also feel free to contact the practice group leaders:

Securities Enforcement Practice Group Leaders: Barry R. Goldsmith – New York (+1 212-351-2440, bgoldsmith@gibsondunn.com) Richard W. Grime – Washington, D.C. (+1 202-955-8219, rgrime@gibsondunn.com) Mark K. Schonfeld – New York (+1 212-351-2433, mschonfeld@gibsondunn.com)

Securities Regulation and Corporate Governance Group: Elizabeth Ising – Washington, D.C. (+1 202-955-8287, eising@gibsondunn.com) James J. Moloney – Orange County, CA (+ 949-451-4343, jmoloney@gibsondunn.com) Lori Zyskowski – New York, NY (+1 212-351-2309, lzyskowski@gibsondunn.com)

© 2020 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

November 30, 2020 |
CFTC Division of Enforcement Issues New Guidance Regarding the Recognition of Cooperation, Self-Reporting, and Remediation in Enforcement Orders

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The Commodity Futures Trading Commission (“CFTC” or the “Commission”) recently announced that its Division of Enforcement (the “Division”) issued new guidance to its staff when considering a recommendation that the Commission recognize a respondent’s cooperation, self-reporting, or remediation in an enforcement order (the “Guidance”).[1] The Guidance represents the latest step in the Commission’s ongoing efforts to provide clarity and transparency regarding the Division’s practices and procedures.

Prior Advisories on Cooperation, Self-Reporting and Remediation Remain in Effect

The Guidance explicitly states that it does not change how the Division evaluates self-reporting, cooperation, or remediation, nor how the Division considers reductions in penalties in connection with self-reporting, cooperation, or remediation.[2] Rather, these evaluations are guided by factors described in prior advisories published by the Division (the “Advisories”)[3] and set forth in the agency’s Enforcement Manual,[4] which continue to remain in effect.

While the Advisories remain in effect, they are not binding on Division staff. Instead, they emphasize the discretionary nature of both the Division’s evaluation of cooperation and its resulting recommendations.[5] Moreover, the Advisories caution that they “should not be read as requiring the Division staff to recommend, or the Commission to impose or authorize, a reduction of sanctions based on the presence or absence of particular cooperation factors.”[6] Thus, in certain circumstances, and at the discretion of the Division staff, cooperation, self-reporting, and/or remediation may result in a recommendation of recognition and of reduced sanctions in a Commission enforcement order.[7] The Advisories do note, however, that—at the far end of the self-reporting/cooperation/remediation spectrum—“if a company or individual self-reports, fully cooperates, and remediates, the Division will recommend that the Commission consider a substantial reduction from the otherwise applicable civil monetary penalty.”[8] However, where an individual or company did not self-report but otherwise fully cooperated and remediated deficiencies, the Advisories provide that the Division may recommend a reduced civil monetary penalty.[9]

The New Guidance: Clarity on When and How

The Guidance builds upon the Advisories by providing transparency and clarity regarding “when and how” the Division will recommend that assessments relating to self-reporting, cooperation, or remediation be reflected and recognized by the CFTC in its enforcement orders.[10] To achieve this objective, the Guidance sets forth the following four scenarios and the corresponding level of recognition and penalty reduction (if any) to be recommended by the Division.

Scenario

Degree of Self-Reporting, Cooperation and Remediation

Recognition/ Penalty

Enforcement Order Language

1

None

No Recognition in Enforcement Order

N/A

2

No Self-Reporting, But Cognizable Cooperation and/or Remediation

Recognition, But No Reduction in Penalty

“In accepting Respondent’s offer, the Commission recognizes the cooperation of [name of Respondent] with the Division of Enforcement’s investigation of this matter.   The Commission also acknowledges Respondent’s representations concerning its remediation in connection with this matter.”

3

No Self-Reporting, But Substantial Cooperation and/or Remediation

Recognition and Reduced Penalty

“In accepting Respondent’s Offer, the Commission recognizes the substantial cooperation of [name of respondent] with the Division of Enforcement’s investigation of this matter. The Commission also acknowledges Respondent’s representations concerning its remediation in connection with this matter. The Commission’s recognition of Respondent’s substantial cooperation and appropriate remediation is further reflected in the form of a reduced penalty.”

4

Self-Reporting, Substantial Cooperation and Remediation

Recognition and Substantially Reduced Penalty

“In accepting Respondent’s Offer, the Commission recognizes the self-reporting and substantial cooperation of [name of Respondent] in connection with the Division’s investigation of this matter. The Commission also acknowledges Respondent’s representations concerning its remediation in connection with this matter. The Commission’s recognition of Respondent’s self-reporting, substantial cooperation, and appropriate remediation is further reflected in the form of a substantially reduced penalty.”

By arranging the list of factors set forth in the Advisories into four typical combinations (scenarios), and noting when each particular combination should result in a specific recommendation to the Commission, the Guidance provides the Division’s staff with a clear roadmap for exercising its discretion under the Advisories. The Guidance also provides the staff with the exact language it should recommend be included by the Commission in an enforcement order to describe the nature and extent of a respondent’s self-reporting, cooperation, or remediation for each scenario. In addition, the Division’s recommendation to the Commission should include a description of the particular acts of cooperation, self-reporting, or remediation that should be included in the enforcement order. Significantly, the Guidance—unlike the Advisories—is binding on the Staff.[11]

Implications of the Guidance

The new Guidance has several important implications. First, the Guidance is an important contribution to the Commission’s initiative to provide consistency, transparency, and clarity to market participants regarding its enforcement actions. The CFTC published its first Enforcement Manual in May 2019, noting its core value of clarity.[12] On the heels of that publication, the Division issued new civil monetary penalty guidance and compliance program evaluation guidance in, respectively, May 2020 and September 2020.[13] In connection with these publications, the Commission has noted that clarity serves multiple purposes, including deterring misconduct and assisting respondents by enhancing predictability.[14] As explained by Chairman Tarbert, the new Guidance furthers these objectives “by ensuring the public understands the levels of recognition the CFTC may provide in its enforcement orders.”[15]

Second, the Guidance will facilitate consistent practices by the enforcement staff with regard to their recommendations for the recognition of cooperation, self-reporting, or remediation. The binding nature of the Guidance will help promote consistency in that the various geographic offices of the Division will now be required to interpret and apply the Advisories in accordance with the Guidance. Consistent practices by the enforcement staff will, in turn, enhance predictability. While the Commission will continue to exercise its independent judgment in determining when and how self-reporting, cooperation, or remediation should be recognized in its orders, market participants who are considering whether to negotiate a resolution of an enforcement investigation will benefit significantly from increased predictability by the staff.[16] Moreover, increased predictability will further incentivize self-reporting, cooperation, and remediation, which will advance some of the key goals of the Division’s enforcement program.

Finally, the Guidance—as well as enforcement orders issued by the Commission as a result of the Guidance—will be valuable reference points for market participants who are negotiating settlements with the Division. The Guidance, coupled with the Advisories, can be used by parties to frame arguments regarding the nature and extent of the credit they should receive for their self-reporting, cooperation, or remediation. Similarly, enforcement orders issued under the Guidance can be used as benchmarks when parties negotiate settlements. The Guidance’s requirements that staff recommendations include a description of the particular acts of self-reporting, cooperation, or remediation by the respondent and that proposed enforcement orders use uniform language for the recognition of such acts should foster benchmarking. Although parties can still use enforcement orders issued before the Guidance as reference points, such orders sometimes include disparate language to describe what are essentially the same levels of self-reporting, cooperation, or remediation. Going forward, it will be easier for parties to compare “apples to apples.”

In sum, although the Guidance has been issued by the Division for its staff, it will be beneficial both to market participants who are considering whether to self-report, cooperate, or remediate, and to parties who are considering whether to attempt to resolve an investigation being conducted by the Division.

 _____________________

[1]  CFTC Press Release No. 8296-20.

[2]  Memorandum from Vincent A. McGonagle, Acting Director, Division of Enforcement, to Division of Enforcement Staff, Recognizing Cooperation, Self-Reporting, and Remediation in Commission Enforcement Orders (Oct. 29, 2020) (the “Guidance”), at 1.

[3]  Enforcement Advisory: Cooperation Factors in Enforcement Division Sanction Recommendations for Individuals (Jan. 19, 2017) (the “Individual Cooperation Guidance”); Enforcement Advisory: Cooperation Factors in Enforcement Division Sanction Recommendations for Companies (Jan. 19, 2017) (the “Company Cooperation Guidance”); Enforcement Advisory: Updated Advisory on Self-Reporting and Full Cooperation (Sept. 25, 2017) (the “Updated Self-Reporting and Cooperation Guidance”).

[4]  See Commodity Futures Trading Commission, Enforcement Manual (2020).

[5]  See Individual Cooperation Guidance at 5; Company Cooperation Guidance at 5.

[6]  Updated Self-Reporting and Cooperation Guidance at 2.

[7]  Id. at 1, 5.

[8]  Updated Self-Reporting and Cooperation Guidance at 2.

[9]  Id.

[10]  Guidance at 1.

[11]  Guidance at 2.

[12]  CFTC Press Release No. 7925-19.

[13]  CFTC Press Release Nos. 8165-20 and 8235-20.

[14]  See CFTC Press Release No. 7925-19 (“Clarity and transparency in our policies should promote fairness, increase predictability, and enhance respect for the rule of law.”); CFTC Press Release No. 8165-20 (“Clarity about how our statutes and rules are applied is essential to deterring misconduct and maintaining market integrity.”); CFTC Press Release No. 8235-20 (“It’s in both the agency’s interest and the interest of compliance personnel that the Commission is clear about how and what we’ll evaluate.”).

[15]  CFTC Press Release No. 8296-20 (quoting Chairman Heath Tarbert); see also CFTC Press Release No. 8296-20 (“Providing clarity to market participants and the public is one of the CFTC’s core values. . . . Through this and the other public guidance, the division seeks consistency and transparency across CFTC enforcement actions.” (quoting Acting Director Vincent McGonagle)).

[16]  See Cooperation Recognition Guidance at 2, n.4.


Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments.  Please contact the Gibson Dunn lawyer with whom you usually work in the firm’s Derivatives practice group, or the following authors:

Lawrence J. Zweifach – New York (+1 212-351-2625, lzweifach@gibsondunn.com) Jeffrey L. Steiner – Washington, D.C. (+1 202-887-3632, jsteiner@gibsondunn.com) Lauren M.L. Nagin – New York (+1 212-351-2365, lnagin@gibsondunn.com) Darcy C. Harris – New York (+1 212-351-3894, dharris@gibsondunn.com)

Derivatives Practice Group: Michael D. Bopp – Washington, D.C. (+1 202-955-8256, mbopp@gibsondunn.com) Jeffrey L. Steiner – Washington, D.C. (+1 202-887-3632, jsteiner@gibsondunn.com) Arthur S. Long – New York (+1 212-351-2426, along@gibsondunn.com).com) Stephanie Brooker – Washington, D.C. (+1 202-887-3502, sbrooker@gibsondunn.com) Lawrence J. Zweifach – New York (+1 212-351-2625, lzweifach@gibsondunn.com)

© 2020 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

November 18, 2020 |
Webcast: SEC Enforcement Focus on COVID-19 Issues and Key Areas of Risk

Please join us to discuss the SEC’s enforcement priorities and key areas of risk in light of COVID-19.  In this webcast, we will discuss:

  • The SEC’s latest accounting and pandemic-related enforcement trends and initiatives;
  • Impact of the SEC Division of Enforcement’s EPS Initiative;
  • Key areas of accounting risk amplified by COVID-19, including revenue recognition, asset impairment, and going concern risks; and
  • Disclosure issues pertaining to COVID-19’s impact on business and forward-looking guidance.
View Slides (PDF)

PANELISTS: Richard W. Grime is co-chair of Gibson Dunn’s Securities Enforcement Practice Group. Mr. Grime’s practice focuses on representing companies and individuals in corruption, accounting fraud, and securities enforcement matters before the SEC and the DOJ. Prior to joining the firm, Mr. Grime was Assistant Director in the Division of Enforcement at the SEC, where he supervised the filing of over 70 enforcement actions covering a wide range of the Commission’s activities, including the first FCPA case involving SEC penalties for violations of a prior Commission order, numerous financial fraud cases, and multiple insider trading and Ponzi-scheme enforcement actions. Monica K. Loseman is co-chair of Gibson, Dunn’s Securities Litigation Practice Group and is a partner in the Denver office. Ms. Loseman has substantial experience in complex corporate and securities enforcement matters and civil litigation. Her practice includes a focus on financial reporting, accounting and related investigations and accountant defense. Ms. Loseman’s trial experience largely focused on accounting and financial reporting and corporate governance matters, including three trials before SEC administrative law judges, several bench and jury trials, and private arbitrations. Ms. Loseman also conducts independent investigations involving allegations of corporate fraud and issues relating to financial reporting, accounting, internal controls, and other issues, and is skilled at interacting with Board committees and other stakeholders in presenting results and remedial recommendations. Michael J. Scanlon is a partner in the Washington, D.C. office, where he is a member of the Firm’s Securities Regulation and Corporate Governance, and Securities Enforcement Practice Groups. Mr. Scanlon has an extensive practice representing U.S. and foreign public company and audit firm clients on regulatory, corporate governance, and enforcement matters. He advises corporate clients on SEC compliance and disclosure issues, the Sarbanes-Oxley Act, and corporate governance best practices, with a particular focus on financial reporting matters. Jason H. Smith is a senior associate in the Washington, D.C office where, he is a member of the White Collar Defense and Investigations Practice Group and focuses primarily on white collar defense, corporate compliance, and securities enforcement.  Mr. Smith has particular experience representing multinational corporate clients in government investigations, including before the Department of Justice, Securities and Exchange Commission, and other regulatory and enforcement agencies.
MCLE CREDIT INFORMATION: This program has been approved for credit in accordance with the requirements of the New York State Continuing Legal Education Board for a maximum of 1.25 credit hour, of which 1.25 credit hour may be applied toward the areas of professional practice requirement. This course is approved for transitional/non-transitional credit. Attorneys seeking New York credit must obtain an Affirmation Form prior to watching the archived version of this webcast. Please contact CLE@gibsondunn.com to request the MCLE form. Gibson, Dunn & Crutcher LLP certifies that this activity has been approved for MCLE credit by the State Bar of California in the amount of 1.25 hours. California attorneys may claim “self-study” credit for viewing the archived version of this webcast. No certificate of attendance is required for California “self-study” credit.

September 30, 2020 |
SEC Amends Whistleblower Rules

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On Wednesday, September 23, 2020, the Securities and Exchange Commission approved—on a 3-2 vote—amendments to its whistleblower program. Democratic members Allison Herren Lee and Caroline Crenshaw voted in opposition. These amendments, in particular those pertaining to the determination of whistleblower award amounts, have attracted considerable public attention. Although the award amount provisions have been the most eye-catching, there are other critical changes contained in the amendments that warrant mention. Below, we survey and summarize the most significant new provisions and offer some key takeaways for consideration.

  • Revised whistleblower definition: In accordance with the Supreme Court’s holding in Digital Realty Trust, Inc. v. Somers, the amendments provide whistleblower protections against retaliation only for individuals who make reports, in writing, to the SEC.
  • Measures to address frivolous claims: The amendments include provisions designed to facilitate faster resolution of plainly non-meritorious whistleblower claims.
  • Clarification on the types of resolutions that can be predicates for awards: The amendments clarify that various types of resolutions, including deferred prosecution agreements (“DPAs”) or non-prosecution agreements (“NPAs”), can serve as the basis for a whistleblower award.
  • Interpretive guidance on independent analysis: The SEC is publishing interpretive guidance clarifying that “independent analysis” means “evaluation, assessment, or insight beyond what would be reasonably apparent to the Commission from publicly available information.”
  • Amendments/guidance on award determinations: The amendments grant the Commission authority to adjust small awards upward and also clarify the Commission’s discretion in determining awards.

The cumulative effect of these amendments—and whether they meet their stated goals—remains to be seen. But several outcomes appear likely. On the one hand, truly frivolous whistleblower claims may decrease in light of the Commission’s new procedure for summarily disposing of meritless tips. Nevertheless, total whistleblower activity—including for lower-stakes cases—may increase. That is because the amendments (consistent with the 2018 decision in Digital Realty) reinforce the incentive to prioritize reporting directly to the SEC over reporting internally to receive whistleblower protections under the rules. This in turn could discourage internal reporting and complicate companies’ internal efforts to prevent and detect misconduct. Moreover, the Commission’s revised rules on award determinations suggest a willingness to issue a greater volume of smaller awards, which could incentivize increased reporting. Thus, companies should be vigilant and continuously evaluate and improve their internal compliance reporting and investigations protocols, as well as auditing and monitoring controls to prevent and detect potential misconduct.

Whistleblower Program Background

The SEC’s whistleblower program was established in 2010 to incentivize individuals to report high-quality tips and to help the Commission detect wrongdoing. Since the program’s inception, “[o]riginal information provided by whistleblowers has led to enforcement actions in which the Commission has obtained over $2.5 billion in financial remedies, most of which has been, or is scheduled to be, returned to harmed investors.”[1] Along the way, the SEC has awarded more than $500 million to whistleblowers.[2] Seven of the ten largest whistleblower awards were made in the last three years, with the largest individual award on record—$50 million—made in June 2020.[3]

Critical Changes Under The Final Rule

1. Revised Definition of “Whistleblower” For Anti-Retaliation Provisions

The amendments to the rule limit the SEC’s whistleblower protections to individuals who report information in writing directly to the SEC. The previous rule applied anti-retaliation protections both to internal reports and to reports to the SEC, and the SEC did not define the manner of providing information to qualify for retaliation protection.

This amendment brings Rule 21F-2 in line with the Supreme Court’s 2018 ruling in Digital Realty Trust, Inc. v. Somers, where the Court found that under the plain language of the statute, an individual is a Dodd-Frank Act “whistleblower” for purposes of the Act’s anti-retaliation provision only if she reports information directly to the SEC.[4] Therefore, under Digital Realty and the amended Rule 21F-2(d)(4), an individual who only reported alleged misconduct internally is not protected from retaliation under these regulations. (The existing rule already limits the availability of whistleblower awards to such individuals.)

Critics of the amendment argue that it will negatively impact the integrity of internal compliance programs and will further chill internal reporting. Moreover, Commissioner Crenshaw criticized the Commission's decision to limit the "anti-retaliation protections to whistleblowers who submit information in writing," thus failing "to protect those who cooperate with [its] exams and investigations,” for example, “through interviews or testimony.”[5]

The SEC will issue interpretive guidance defining the scope of retaliatory conduct prohibited by Section 21(h)(1)(A), which may provide much needed clarity for companies as they navigate complex employment and disciplinary determinations when addressing potential whistleblower issues. In the meantime, companies should bear in mind that internal reporting (made prior to written reporting to the SEC) may still be protected under the Sarbanes-Oxley Act and other federal and state laws with whistleblower provisions. And companies should also brace themselves for the possibility that the requirement that whistleblowers report to the SEC to avail themselves of Dodd-Frank’s anti-retaliation provision, though already announced in Digital Realty, could incentivize complainants to make written reports to the SEC sooner, more frequently, and at the same time as internal reports.

2. Measures to Increase Efficiency of Claims Review Process

Two changes were made to increase efficiency in processing whistleblower award applications. First, new rule 21F-8(e) allows the SEC to bar individuals from submitting whistleblower award applications where they have been found to have submitted false information to the SEC, and allows the SEC to bar individuals who have made three frivolous claims in SEC actions. The latter provision is particularly important because frivolous claims lead to significant expenditures of time and resources both for the Commission and corporate compliance departments.

Second, new rule 21F-18 creates a summary disposition procedure for certain types of award applications, including untimely applications, applications that involve a tip that was provided in the incorrect form, and applications where the claimant’s information was never provided to or used for the investigation. As Jane Norberg, chief of the SEC’s Office of the Whistleblower, explained, “some individuals [] submit claims that have absolutely no connection to the enforcement action. Under our current rules, we’re unable to quickly address clearly nonmeritorious claims and known serial frivolous submitters.”[6]

These changes could enable the SEC to more expeditiously dispense with nonmeritorious claims, including any uptick in such claims due to the potential increase in lower-dollar-value awards.

3. Broadening Array of Resolutions That Can Serve as Predicates for Awards

The amendments also resolve an open question as to the types of resolutions that qualify for awards. The Commission can issue awards to whistleblowers who contribute to the successful enforcement of “covered judicial or administrative actions” brought by the Commission and certain “related actions.”[7] However, prior to the amendments, the Commission’s rules were silent as to whether certain resolutions, such as DPAs or NPAs entered into by the Department of Justice (“DOJ”) or state attorneys general in criminal cases, qualified for awards. NPAs presented a particular dilemma, because—unlike DPAs—NPAs are not filed in court and thus did not squarely fit within the concept of a “judicial or administrative action[].” The rules were also silent as to whether the Commission’s own NPAs and DPAs were outside of a judicial or administrative action.[8]

In closing this gap, the Commission took the view that “Congress did not intend for meritorious whistleblowers to be denied awards simply because of the procedural vehicle that the Commission (or the other authority) has selected.”[9] As a result, the Commission’s revised definitions make clear that a broad array of resolutions can serve as predicates for whistleblower awards.

Specifically, the Commission’s amendments change the definition of “action” in Rule 21F-4(d) to include (i) DPAs/NPAs brought by DOJ or state attorneys general in a criminal case, and (ii) a settlement with the Commission, even if brought outside of a judicial or administrative proceeding. The amendments also clarify that a “required payment” made under a DPA, an NPA, or an SEC settlement outside of a judicial or administrative proceeding, is a “monetary sanction[]” under Rule 21F-4(e), on the basis of which the amount of a resulting whistleblower award can be determined. And “required payments” now include funds “designated as disgorgement, a penalty, or interest,” or funds “otherwise required as relief” in resolving a covered action.

These additions may prove significant because DOJ and some regulators rely heavily on DPAs and NPAs in reaching resolutions with corporate defendants, and because DOJ and the SEC continue to conduct parallel investigations in key areas.[10]

4. Interpretive Guidance on Independent Analysis

In addition to the proposed amendments to the rules, the SEC included proposed interpretive guidance to help clarify the meaning of “independent analysis” as defined in Exchange Act Rule 21F-4. Under the whistleblower program, (1) the whistleblower must have provided “original information” to the Commission; and (2) such information must have “led to” the successful enforcement of an action. Congress defined “original information” as information that is derived from either a whistleblower’s “independent knowledge” or the whistleblower’s “independent analysis.” The SEC’s guidance clarifies that “independent analysis” means “evaluation, assessment, or insight beyond what would be reasonably apparent to the Commission from publicly available information.”[11]

In the final rule, the Commission added that, subject to Section 21F(a)(3)(C) of the Exchange Act, the Commission may determine that a whistleblower’s examination and evaluation of publicly available information reveals information that is “not generally known or available to the public”—and therefore is “analysis” within the meaning of Rule 21F-4(b)(3)—where: (1) the whistleblower’s conclusion of possible securities violations derives from multiple sources, including sources that, although publicly available, are not readily identified and accessed by a member of the public without specialized knowledge, unusual effort, or substantial cost; and (2) these sources collectively raise a strong inference of a potential securities law violation that is not reasonably inferable by the Commission from any of the sources individually.[12]

The Commission noted that they expect to treat as “independent analysis” highly probative submissions in which the whistleblower’s insights and evaluation provide significant independent information that “bridges the gap” between the publicly available information itself and the possibility of securities violations.[13] This amendment raises the bar for whether an individual’s provision of information to the SEC will qualify them for a whistleblower award.

5. Provisions Regarding Award Amounts

a. Upward Adjustments for Smaller Awards

Under the current whistleblower program, a whistleblower who provides information that leads to a successful enforcement action against a company can be eligible for an award of between 10% and 30% of an overall monetary sanction over $1 million. Within that range, Rule 21F-6(a) and (b) identifies four criteria that may increase an award percentage, and three that may decrease it.[14]

The amendments add a new paragraph (c) to the 21F-6 framework, giving the SEC the discretion to apply upward adjustments to awards of $5 million or less. In addition to other limitations, such as the negative award factors described above, the Commission would not be permitted to use any upward adjustment to raise the award payout above $5 million, or to raise the total amount awarded to all whistleblowers in the aggregate above 30%.

In the June 2018 proposed amendments, the SEC had suggested allowing upward adjustments only to awards to a single whistleblower under $2 million. In the final rule, the SEC made a number of modifications to the proposed rule, including, but not limited to, the following:

  • The SEC selected $5 million, rather than $2 million, as the ceiling for upward adjustments. From August 2012 to July 2020, 74% of awards were less than $5 million, of which 56% were less than $2 million.[15]
  • In the final rule, the SEC noted that unreasonable delay under Rule 21F-6(b)(2) will not automatically disqualify individuals from receiving enhancements.
  • Subject to exceptions, the new rule embodies a presumption that, where the statutory maximum is $5 million or less in the aggregate, the Commission will pay a meritorious claimant the statutory maximum amount where none of the negative award criteria specified in Rule 21F-6(b) are implicated and the award claim does not trigger Rule 21F-16. The Commission may determine that an otherwise eligible claimant will not receive the statutory maximum if it determines that the claimant’s assistance was limited or providing the statutory maximum to the claimant would be inconsistent with the public interest, investor protection or the objectives of the program.

Although the amendments to the rules have yet to officially go into effect, the implications are already being felt. On Friday, September 25, 2020, the Commission awarded over $1.8 million to a whistleblower for providing a tip about overseas conduct that formed the basis for an SEC action against the company involved.[16] The Commission wrote that after considering the administrative record and applying the award criteria in Rule 21F-6 to the facts and circumstances, it chose to increase the award amount to the whistleblower above the preliminary determination by the Claims Review Staff.

These amendments reflect the Commission’s belief that bringing meritorious whistleblowers forward is critical to the program’s success. Although the effects remain to be seen, the prospect of upward increases in smaller awards is likely to lead to an increase of whistleblower claims.

b. Clarifying SEC Discretion Regarding Awards

In the commentary to the final rule, the SEC noted that the comments in response to proposed rules Rule 21F-6(c) and (d) illuminated a disconnect between the SEC’s and the public’s understanding of the SEC’s discretion to consider the dollar amount of monetary sanctions collected, as opposed to focusing exclusively on a percentage amount (i.e., between 10% and 30%) in the statutory range, when applying the award factors and setting the award amount. To clarify the Commission’s discretionary authority, the final rules modify Rule 21F-6 to state that the Commission may consider only the factors set forth in Rule 21F-6 in relation to the facts and circumstances of each case.

The original 2018 proposal reflected a belief that the Commission would be unable to consider the application of the award criteria in dollar terms and adjust the “award amount downward if it found that amount unnecessarily large for purposes” of achieving the program’s goals.[17] Commissioner Lee objected to the final rule because she believed that instead of providing the Commission with a limited ability to adjust the award amounts downward based on their size, with which she also disagreed, with the new clarification to Rule 21F-6 the SEC now “claim[s] that we do not need a new rule at all, that we’ve had this discretion all along.”[18] Commissioner Lee added “the new rule is even more problematic than the proposal because we are no longer even restricted to the largest awards.”[19] It remains to be seen how the Commission will exercise this discretion in future awards.

Conclusion

The new rules will become effective 30 days after their publication. As described above, the amendments aim to resolve open interpretive questions, to streamline the award process, and to provide improved incentives for future whistleblowers. Whether these goals are achieved remains an open question, but both proponents and skeptics of the amendments will be eager to see whether future developments bear out their predictions.

________________________

   [1]   Press Release, Sec. & Exch. Comm’n, SEC Adds Clarity, Efficiency and Transparency to Its Successful Whistleblower Award Program (Sept. 23, 2020), https://www.sec.gov/news/press-release/2020-219.

   [2]   Sec. & Exch. Comm’n, Whistleblower Awards Over $500 Million for Tips Resulting in Enforcement Actions, https://www.sec.gov/page/whistleblower-100million (June 4, 2020).

   [3]   Press Release, Sec. & Exch. Comm’n, SEC Awards Record Payout of Nearly $50 Million to Whistleblower (June 4, 2020), https://www.sec.gov/news/press-release/2020-126.

   [4]   Digital Realty Trust Inc. v. Somers, 583 U.S. __ (2018).

   [5]   Public Statement, Caroline Crenshaw, Comm’r, Sec. & Exch. Comm’n, Statement of Comm’r Caroline Crenshaw on Whistleblower Program Rule Amendments (Sept. 23, 2020), https://www.sec.gov/news/public-statement/crenshaw-whistleblower-2020-09-23.

   [6]   Al Barbarino, SEC’s Whistleblower Chief Reflects After $500M Milestone, Law360 (July 28, 2020), https://www.law360.com/articles/1294863/sec-s-whistleblower-chief-reflects-after-500m-milestone.

   [7]   15 U.S.C. 78u-6(b)(1).

   [8]   Press Release, Sec. & Exch. Comm’n, SEC Announces Initiative to Encourage Individuals and Companies to Cooperate and Assist in Investigations (Jan. 13, 2010), https://www.sec.gov/news/press/2010/2010-6.htm.

   [9]   Whistleblower Program Rules, Rel. No.34-89963, at 14.

[10]   See Gibson Dunn, 2020 Mid-Year Update On Corporate Non-Prosecution Agreements And Deferred Prosecution Agreements (July 15, 2020), https://www.gibsondunn.com/wp-content/uploads/2020/07/2020-mid-year-npa-dpa-update.pdf

[11]   Whistleblower Program Rules, Rel. No.34-89963, at 115.

[12]   Whistleblower Program Rules, Rel. No.34-89963, at 121-122.

[13]   Whistleblower Program Rules, Rel. No.34-89963, at 122.

[14]   The criteria that may increase an award percentage are: (1) significance of the information provided by the whistleblower; (2) assistance provided by the whistleblower; (3) law enforcement interest in making a whistleblower award; and (4) participation by the whistleblower in internal compliance systems. Rule 21F-6(a). The criteria that may decrease the percentage are: (1) culpability of the whistleblower; (2) unreasonable reporting delay by the whistleblower; and (3) interference with internal compliance and reporting systems by the whistleblower. Rule 21F-6(b).

[15]   Whistleblower Program Rules, Rel. No.34-89963, at 139.

[16]  SEC Whistleblower Award Proceeding, Release No. 34-89996, https://www.sec.gov/rules/other/2020/34-89996.pdf.

[17]   Whistleblower Program Rules, Rel. No. 34-83557, at 45.

[18]   Public Statement, Allison Herren Lee, Comm’r, Sec. & Exch. Comm’n, June Bug vs. Hurricane: Whistleblowers Fight Tremendous Odds and Deserve Better (Sept. 23, 2020), https://www.sec.gov/news/public-statement/lee-whistleblower-2020-09-23.

[19]   Id.


The following Gibson Dunn lawyers assisted in preparing this client update:  Michael Diamant, Richard Grime, Michael Scanlon, Jason Schwartz, Patrick Stokes, Oleh Vretsona, Molly Senger, Elizabeth Niles, Michael Jaskiw, Michael Dziuban, and Allison Lewis.

Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these issues.  Please contact the Gibson Dunn attorney with whom you usually work, or the following authors in Washington, D.C.:

Michael S. Diamant (+1 202-887-3604, mdiamant@gibsondunn.com) Richard W. Grime (+1 202-955-8219, rgrime@gibsondunn.com) Michael J. Scanlon (+1 202-887-3668, mscanlon@gibsondunn.com) Patrick F. Stokes (+1 202-955-8504, pstokes@gibsondunn.com) Oleh Vretsona (+1 202-887-3779, ovretsona@gibsondunn.com)

Please also feel free to contact any of the following practice group leaders:

Securities Enforcement Group: Barry R. Goldsmith – New York (+1 212-351-2440, bgoldsmith@gibsondunn.com) Richard W. Grime – Washington, D.C. (+1 202-955-8219, rgrime@gibsondunn.com) Mark K. Schonfeld – New York (+1 212-351-2433, mschonfeld@gibsondunn.com)

White Collar Defense and Investigations Group: Joel M. Cohen – New York (+1 212-351-2664, jcohen@gibsondunn.com) Charles J. Stevens – San Francisco (+1 415-393-8391, cstevens@gibsondunn.com) F. Joseph Warin – Washington, D.C. (+1 202-887-3609, fwarin@gibsondunn.com)

Labor and Employment Group: Catherine A. Conway – Los Angeles (+1 213-229-7822, cconway@gibsondunn.com) Jason C. Schwartz – Washington, D.C. (+1 202-955-8242, jschwartz@gibsondunn.com)

Securities Regulation and Corporate Governance Group: Elizabeth Ising – Washington, D.C. (+1 202-955-8287, eising@gibsondunn.com) James J. Moloney – Orange County (+1 949-451-4343, jmoloney@gibsondunn.com) Lori Zyskowski – New York (+1 212-351-2309, lzyskowski@gibsondunn.com)

© 2020 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

August 17, 2020 |
CFTC Settles Its Fourth Insider Trading Action

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On August 4, 2020, the Commodity Futures Trading Commission (“CFTC”) announced that the U.S. District Court for the Southern District of New York entered a consent order resolving the CFTC’s seven-year old charges against the New York Mercantile Exchange (“NYMEX”) and its two former employees for the two employees’ repeated disclosure of material non-public information in violation of the Commodity Exchange Act (“CEA”) and CFTC regulations.[1] Neither NYMEX nor its former employees admitted or denied the CFTC’s allegations. The CFTC’s enforcement action against NYMEX and its former employees is the first time the CFTC has charged an exchange with violations of the CEA and CFTC regulations’ proscriptions against disclosures of material non-public information by exchange employees.[2] It also represents one of the few actions that the CFTC has taken against a party for violating its insider trading rules in the commodity futures, options, and swap markets. And it provides guidance as to what the CFTC considers to be material, nonpublic information relating to order flow.

CFTC’s Expanded Scope of Enforcement

The Dodd-Frank Wall Street Reform and Consumer Protection Act[3], signed into law in 2010, amended the Commodity Exchange Act and granted the CFTC authority to devise enforcement to promulgate such “rules and regulations… are reasonably necessary to prohibit … trading practice that is disruptive of fair and equitable trading[.]”[4] On July 7, 2011, the CFTC adopted new antifraud regulation – Rule 180.1 which is expressly modeled on Section 10b-5 of the Securities Exchange Act of 1934. The new Rule prohibits “trading on the basis of material nonpublic information in breach of a pre-existing duty (established by another law or rule, agreement, understanding or some other source) and trading on the basis of material nonpublic information that was obtained through fraud or deception.”[5]

On December 2, 2015, the CFTC settled on consent with Arya Motazedi, for various violations of CFTC Rules[6]. This was the CFTC’s first enforcement of its anti-manipulation rules in an insider trading case. Motazedi was a gasoline and energy trader at a large, unmade, public traded company. The CFTC alleged that Motazedi committed fraud by (a) trading in his personal account against the company without the company’s knowledge, and (b) trading ahead of company orders in his personal account, taking advantage of the material, nonpublic information of his employer. Specifically, the CFTC alleged that Motazedi stole material, nonpublic information concerning the times, volumes, and prices at which his company intended to trade energy commodities futures. Instead of solely basing Motazedi’s liabilities on general antifraud provisions of the CEA, the CFTC focused on Section 6(c)(1) of the CEA and Rule 180.1 and Motazedi entered into a settlement, neither admitting nor denying that he breached his duty to his employer in violation of both Section 6(c)(1) and Rule 180.1.[7]

Similar to the Motazedi enforcement action, in September 2016, the CFTC filed a case against and reached a settlement with Jon P. Ruggles to pay a $1.75 million penalty and to forego more than $3.5 million in gains and banned him from trading and registration. Neither admitting nor denying liability, Ruggles allegedly traded in the same NYMEX products in personal accounts in his wife’s name with material nonpublic information of his employer.[8]

On September 28, 2018, the CFTC filed a civil complaint in the Southern District of Texas against EOX Holdings and Andrew Gizienski alleging violations of the CEA and CFTC insider trading regulations.[9] In this case, which remains ongoing, the CFTC alleges that Gizienski disclosed material, nonpublic information about EOX Holdings’ customer identities, block trades, and security positions, in breach of Gizienski’s duties to those customers, to profit in a friend’s trading account. The CFTC further alleges that EOX approved Gizienski’s trading in a friend’s account, but failed to implement reasonable procedures to monitor trading in that account. On the date that the CFTC charged EOX and Gizienski, the CFTC announced the formation of an Insider Trading and Information Protection Task Force.

Enforcement Against NYMEX and Its Former Employees

Over seven years ago, on or about February 21, 2013, the CFTC charged NYMEX, which is owned and operated by the CME Group, and the two former employees (William Byrnes and Christopher Curtin) with repeatedly disclosing customer trading information transmitted through the CME ClearPort Facilitation Desk to a commodity broker on at least in total approximately seventy-six occasions. The ClearPort Facilitation Desk provided clearing and settlement services for exchange-traded contracts and over-the-counter derivatives transactions. ClearPort customers were allegedly told that the trades they submitted would not be made public and would be deemed to be confidential; the customer user agreements, for example, allegedly stated that all “Exchange Data shall be deemed to be confidential” which the CFTC alleged included all price and other trade-related data, and such information could not be disclosed to third parties for any purpose other than to facilitate the transactions. At the time of the disclosures, Byrnes was a supervisor on the ClearPort Facilitation Desk and Curtin was the Associate Director of the Globex Control Center. The CFTC alleged that the disclosures were often captured on tape, and that NYMEX had failed to investigate an anonymous complaint about improper disclosures for over a year before terminating Byrnes.[10]

In the consent order against NYMEX and its two former employees, the CFTC alleged that, on numerous occasions between 2008 and 2010, the two former employees (William Byrnes and Christopher Curtin) disclosed material, nonpublic information about derivatives trading activity that they obtained through their employment at the NYMEX.[11] The material and nonpublic information Byrnes and Curtin allegedly disclosed includes “the identifies of counterparties, whether a particular counterparty purchased or sold the option, whether it was a call or a put, the volume of contracts traded, the expiry, the strike price and the trade price.”[12] The disclosures were allegedly made to a commodities broker who was apparently not authorized to receive the information.

The CFTC alleged that Byrnes and Curtin were directly liable for the alleged disclosures of material, nonpublic information of trading activity, and that NYMEX was vicariously liable for the conduct of its former employees.[13] Both employees are permanently banned from trading commodity interests and registering with the CFTC. The order also enjoins NYMEX to the extent the CEA and CFTC regulations apply under the vicarious liability provision of the CEA.[14] The order imposes a $4 million joint and several monetary penalty on NYMEX, Byrnes and Curtin, capping the liability of Byrnes and Curtin at $300,000 and $200,000 respectively.[15]

In 2016, NYMEX submitted a motion for summary judgement arguing that it was not vicariously liable for the violations of Byrnes and Curtin. On September 19, 2019, Judge Broderick denied NYMEX’s motion stating that “Plaintiff [CFTC] identifies several facts that could permit a jury to find that Byrnes and Curtin intended to serve some purpose of NYMEX and were acting within the scope of their employment.”[16] Judge Broderick quoted several allegations in the CFTC’s complaint that precluded the Court from granting the defense motion including: (1) Curtin’s 2007 NYMEX self-evaluation where he wrote one of his goals was to “continue to grow facilitation desk knowledge base and increase the business”; (2) Byrnes and Curtin allegedly knew that the broker whom they allegedly tipped was on NYMEX’s list of ‘Top 50’ Brokers for ClearPort; and (3) NYMEX earned fees as a result of the broker’s trades.[17]

Takeaways

There are multiple, important takeaways from this civil action that the CFTC took against NYMEX and its two former employees for violating the CFTC’s insider trading rules.

First, the CFTC set forth again its position that certain customer trading information which is supposed to be kept confidential pursuant to user agreements is material, nonpublic information. The CFTC’s position will not be tested in this case, because NYMEX and its two former employees reached a settlement resolving the matter, without admitting or denying the allegations.

Second, for purposes of alleging that the former NYMEX employees had a duty not to disclose the customer trading information, the CFTC relied on the employer’s code of conduct, the employee handbook, the employment agreements, and the customer user agreements. Often such codes of conduct, handbooks, and agreements are highly general and fail to provide clear notice as to what can and cannot be disclosed. It is important for all market participants to be aware of the non-disclosure provisions in the agreements available to them, and certainly the ones which each individual signs and agrees to follow.

Third, the CFTC partially built its case against the former NYMEX employees through recorded lines during which there was disclosure of customer information to a commodities broker and the employees were captured trying to avoid the recorded line by agreeing on the recorded line to call each other on their mobile devices. Regulators will often look for evidence that market participants are trying to avoid discussions over recorded lines such as the commodities broker’s statements “Do you want me to call you on your cell” and “Bring your cell phone tomorrow” so we can discuss customer trading.

Fourth, upon receipt of an anonymous complaint of improper activity, it is incumbent on the firm to investigate expeditiously and to be prepared to defend that investigation to regulators later. In this case, upon receipt of confidential information regarding trades cleared through CME ClearPort had been disclosed to a brokerage firm improperly, NYMEX’s manager of the ClearPort Facilitation Desk allegedly conducted a belated and cursory investigation by reviewing phone calls and emails from one day, and did not question the employees allegedly involved in the disclosures. Moreover, although the manager directed all employees on the CME ClearPort Facilitation Desk not to use mobile devices for business, the employees allegedly used their personal cell phones in the open at their desks.

Fifth, the CFTC’s theory of vicarious liability against NYMEX will unfortunately not be tested at trial. It was an aggressive theory given that Curtin and Byrnes appeared to have acted contrary to NYMEX’s policies and agreements, and against their employer’s interests. In demonstrating that the conduct of rogue employees should not be vicariously liable to their employer, it is critical to develop facts to demonstrate that the employees acted outside the scope of their employment, contrary to training and instructions, and for the purpose of benefitting themselves at the expense of the employer.

Sixth, the CFTC charged the recipient of the allegedly material, nonpublic information with aiding and abetting the primary violations of the former NYMEX employees. The CFTC alleged that the broker “repeatedly solicited Byrnes and Curtin for the specific material nonpublic information they disclosed to him and providing Byrnes and Curtin with information they needed to identify and locate information about the specific trades in which Eibschutz was interested.”[18] Whether the CFTC will be able to prove aiding and abetting liability against the broker will test the regulator’s ability to go after the recipients of material, nonpublic information.

Finally, the CFTC’s civil action took approximately seven years and six months since filing of the complaint, and over ten years since the alleged underlying misconduct took place, to resolve the matter against NYMEX and its former employees. There are many reasons for this long delay including the time taken to submit and resolve a motion to dismiss, discovery disputes, and the submission and resolution for summary judgment. That extensive stretch of time presents serious challenges to regulators and market participants in terms of the burden on regulators to prove their actions, the costs of litigating, and the distraction and other collateral consequences of a never-ending civil action to market participants. Of course the civil action against the recipient broker remains ongoing, and it’s unclear whether that will also result in a settlement or go to trial.

_________________

   [1]   NYMEX and Two Former Employees to Pay $4 Million for Disclosing Material Non-Public Information, Release Number 8216-20 (Aug 4, 2020). Please see here.

   [2]   Id.

   [3]   Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), Pub. L No. 111-2031, § 753, 124 Stat. 1376 (2010).

   [4]   7 U.S.C § 6c(a)(6) (2018).

   [5]   Commodity Futures Trading Commission Q&A – Anti-Manipulation and Anti-Fraud Final Rules (2011), please see here.

   [6]   In re Arya Motazedi, CFTC Docket No. 16-02 (Dec 2, 2015).

   [7]   Id.

   [8]   In re Jon P. Ruggles, CFTC Docket No. 16-34 (Sept. 29, 2016).

   [9]   Complaint, U.S. Commodity Futures Trading Commission v. EOX Holdings LLC et al., Case No.: 1:18-cv-08890 (S.D.N.Y. filed Sept. 28, 2018).

[10]   Complaint, U.S. Commodity Futures Trading Commission v. William Byrnes et al., Case No.: 1:13-cv-01174 (S.D.N.Y. filed Feb. 21, 2013).

[11]   U.S. Commodity Futures Trading Commission v. William Byrnes, Christopher Curtin, The New York Mercantile Exchange, Inc., and Ron Eibschutz, No. 13 Civ. 1174 (Aug 4, 2020).

[12]   Id.

[13]   Id.

[14]   Id.

[15]   Id.

[16]   U.S. Commodity Futures Trading Commission v. William Byrnes, Christopher Curtin, The New York Mercantile Exchange, Inc., and Ron Eibschutz, No. 13 Civ. 1174 (S.D.N.Y., Sep. 19, 2019).

[17]   Id.

[18]   CFTC Charges Ron Eibschutz with Aiding and Abetting Disclosures of Material Nonpublic Information about Customer Trades in its Case Against the CME Group’s New York Mercantile Exchange and Two Former Employees, Release Number 6584-13 (May 8, 2013). Please see: https://www.cftc.gov/PressRoom/PressReleases/6584-13.


Gibson Dunn’s lawyers are available to assist with any questions you may have regarding these developments. For additional information, please feel free to contact the Gibson Dunn lawyer with whom you usually work, any member of the firm’s Securities Enforcement Group, or the following authors:

Reed Brodsky - New York (+1 212-351-5334, rbrodsky@gibsondunn.com) Dan Li - New York (+1 212-351-6310, dli@gibsondunn.com)

Securities Enforcement Group:

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© 2020 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

July 20, 2020 |
2020 Mid-Year Securities Enforcement Update

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I.  Introduction: Themes and Notable Developments

A.  Impact of the Pandemic on Securities Enforcement

The first half of 2020 will undoubtedly be most remembered for the impact of the pandemic on every aspect of our lives, both personal and professional. To be sure, the pandemic has had a profound effect on the economy and financial markets. As we know from prior crises, financial shocks give rise to a host of regulatory risks for public companies and market participants and lead the SEC to shift its attention to identifying and investigating indicators of potential securities law violations. History teaches us that unprecedented market volatility, fast moving economic events, and dislocations create substantial challenges for compliance, and that there is a significant increase in the risk of an investigation. As the impact of the pandemic continues today, this heightened investigative risk is compounded by unique challenges of remote work arrangements and the diminished ability for direct oversight and interaction.

Similarly, the pandemic had a significant impact on the SEC’s enforcement program. Among other things, the pandemic caused the Enforcement Division to recalibrate priorities to address emerging risks, resulted in a number of enforcement actions against parties seeking to take advantage of the crisis, and required an adaptation of the investigative process to a remote work environment. Despite the pandemic, the Commission also continued to institute enforcement actions in its traditional areas of focus that had been in the pipeline since before the quarantine.

1.  Enforcement Priorities and Regulatory Risks Arising from the Pandemic

Shortly after the nation implemented quarantine protocols in March, the co-directors of the SEC Enforcement Division took the unusual step of issuing a cautionary statement emphasizing “the importance of maintaining market integrity and following corporate controls and procedures” during this crisis. The SEC cited as examples the heightened risk of insider trading (“in these dynamic circumstances, corporate insiders are regularly learning new material nonpublic information that may hold an even greater value than under normal circumstances”) and the need to be mindful of disclosure controls (“protect against the improper dissemination and use of material nonpublic information”).[1]

Six weeks later, in a speech in May, Enforcement Co-Director Steven Peikin provided insights on the Division’s enforcement priorities in light of the pandemic.[2] In response to the pandemic, the Enforcement Division formed a Coronavirus Steering Committee, comprised of leadership from the Home and Regional Offices, the specialized units, and the Office of Market Intelligence, to identify areas of potential misconduct and coordinate the Division’s response to pandemic-related issues.  Among the issues receiving heightened regulatory scrutiny are:

  • Insider Trading and Market Manipulation: The rapid and dramatic impact of the pandemic on the financial performance of companies increases the potential for trading that could be perceived as attributable to material nonpublic information.  The Steering Committee is working with the Division’s Market Abuse Unit to monitor announcements in industries particularly impacted by the pandemic and to identify potentially suspicious market movements.
  • Accounting Fraud: As with other financial crises, the pandemic is likely to expose previously undisclosed financial reporting issues, as well as give rise to rapidly evolving financial reporting and disclosure challenges.  The Steering Committee is on the lookout for indications of potential disclosure and reporting misconduct.  In particular, the Steering Committee is reviewing public filings with an eye toward disclosures that appear out of step with companies in similar industries.  The Committee is also looking for accounting that attempts to inaccurately characterize preexisting financial statement issues as coronavirus related.
  • Asset Management: Asset managers confront unique challenges created by the pandemic, including with respect to valuations, liquidity, disclosures, and the management of potential conflicts among clients and between clients and the manager.  The Steering Committee is working with the Division’s Asset Management Unit to monitor these issues, including failures to honor redemption requests, which could reveal other underlying asset management issues.
  • Complex Financial Instruments: As with prior financial crises, the pandemic may reveal risks inherent in various structured investment products.  The Steering Committee is working with the Division’s Complex Financial Instruments Unit to monitor complex structured products and the marketing of those products to investors.
  • Microcap Fraud: The Steering Committee is working with the Division’s Microcap Fraud Task Force and Office of Market Intelligence, and has suspended trading in the securities of over 30 issuers relating to allegedly false or misleading claims related to the coronavirus.

As we discussed in our prior alerts in March and May on these issues, by understanding the issues that can give rise to regulatory scrutiny, and consulting with counsel on how to navigate unique challenges, issuers and financial institutions can both lower the risk of being in a regulatory spotlight and resolve regulatory inquiries more efficiently.

2.  Enforcement Actions Related to the Pandemic

The SEC has brought several enforcement actions against parties allegedly seeking to take advantage of the pandemic. These cases have typically involved allegations that a company, or those trading in a company’s securities, have made false or misleading statements about the company’s ability to supply scarce protective or testing products in response to the pandemic. It will take much longer to assess whether the crisis leads to enforcement actions based on more nuanced financial reporting, disclosure, or trading conduct.

In late April, the SEC filed an action against a company and its CEO alleging the defendants issued false and misleading press releases about the company’s ability to supply large quantities of N95 masks.[3] According to the SEC’s complaint, the company issued a press release in February stating that it was in the process of solidifying its mask supply chain, and another press release in March stating that it had a large number of masks on hand. In a subsequent March press release, the company admitted it never had any masks available to sell. The SEC’s complaint alleged that the company never had the masks, any orders for them, or any contracts with companies that could supply them.

In May, the SEC filed actions against two different companies for allegedly misleading investors in their press releases concerning COVID-19 product offerings.[4] According to the first complaint, a bioscience company’s press release incorrectly stated that the company had begun shipping home finger-prick COVID-19 tests when the tests neither shipped nor were intended for home use. In a second action, the SEC alleged that a company and its CEO issued a misleading press release announcing a multinational public-private partnership to sell thermal scanning equipment to detect individuals with fevers when, in fact, the company had neither an agreement to sell the product nor a government partnership.

In June, the SEC also filed actions alleging market manipulations by parties allegedly using the pandemic as a means to inflate the price of companies’ securities. In one action, the SEC alleged that a trader manipulated the stock of a biotechnology company through misleading statements in an online investment forum, including assertions that the company had developed an approved COVID-19 blood test.[5] The complaint also alleged that the defendant spoofed orders on the company’s stock to create the appearance of high demand. In a second action against five Canadian citizens, the SEC alleged that the defendants fraudulently inflated microcap companies’ stock through misleading statements such as a claim that one of the companies could make medical facemasks and that another had automated kiosks for retail use. The complaint also alleged that the defendants enabled the companies’ control persons to anonymously sell company stock and evade registration requirements.[6]

3.  Investigative Process in a Remote Work Environment

Despite the pandemic, the Commission’s Enforcement program has continued to conduct investigations, albeit with accommodations for the realities of remote work situations.

In his speech in May, Co-Director Peikin noted that the Division staff continued to remain engaged despite the new challenges of a remote work environment.  The Division staff was directed to work with defense counsel and others to reach reasonable accommodations concerning document production, testimony, interviews, and counsel meetings, given the challenges of the pandemic, but Mr. Peikin also cautioned that the staff will need to protect potential claims and won’t agree to an indefinite hiatus in investigations or litigations.  In particular, Mr. Peikin noted that in instances where defense counsel does not agree to tolling agreements, the Division will consider recommending that the Commission commence an enforcement action, despite an incomplete investigative record, and will rely on civil discovery to further support its claims.

B.  Supreme Court Ruling on Disgorgement

In June 2020, the Supreme Court in Liu v. S.E.C. issued a major decision regarding the scope of the SEC’s power to obtain disgorgement of ill-gotten gains in litigated cases.[7] Liu did not, as some had hoped, do away with disgorgement in litigated actions entirely. Instead, while leaving lower courts to fill in the precise contours, the Supreme Court articulated three guiding principles for determining the availability and scope of SEC disgorgement: first, disgorgement should benefit “wronged investors” rather than “the public at large”; second, courts may hold parties liable only for their own profits, not others’ profits; and third, disgorgement cannot exceed actual gains and must instead be limited to “net profits” after deducting “legitimate expenses.”[8]

Liu arose from a 2016 enforcement action alleging misappropriation of millions of dollars of investors’ funds under the guise of constructing a cancer-treatment center that would have qualified the investors for EB-5 immigration status. In assessing the district court’s award of disgorgement to the SEC, the Supreme Court held that “a disgorgement award that does not exceed a wrongdoer’s net profits and is awarded for victims is … permissible under [15 U.S.C.] § 78u(d)(5),” the statute authorizing the SEC to seek equitable relief.[9] The Court provided general guidelines for lower courts to consult in crafting disgorgement awards consistent with this holding.

First, the Court emphasized that disgorgement must be for the benefit of investors, noting that it “must do more than simply benefit the public at large by virtue of depriving a wrongdoer of ill-gotten gains.”[10] In many cases—for example, where there are no apparent investor victims or it is infeasible to distribute the funds to harmed individuals—the SEC deposits disgorged funds with the Treasury. The Court raised doubts about this practice, opining, “It is an open question whether, and to what extent, that practice … satisfies the SEC’s obligation to award relief ‘for the benefit of investors’….”[11]

Second, the Court emphasized “the common-law rule requiring individual liability for wrongful profits,” while noting that “[t]he historic profits remedy … allows some flexibility to impose collective liability.”[12] Thus, while there could potentially be “liability for partners engaged in concerted wrongdoing,” like the married petitioners in Liu, joint-and-several liability was “seemingly at odds with the common-law rule.”[13]

Third, the Court explained that disgorgement must not exceed a party’s ill-gotten gains, and, therefore, “courts must deduct legitimate expenses before ordering disgorgement.”[14] In assessing whether expenses were legitimate (and hence deductible), even if incurred in connection with a fraudulent scheme, the Court distinguished legitimate expenses that “have value independent of fueling a fraudulent scheme”—for example, possibly the lease payments and cancer-treatment equipment in Liu—from “‘inequitable deductions’ such as for [the alleged fraudsters’] personal services.”[15]

It is unclear how significantly Liu’s guidelines will impact SEC enforcement actions going forward. In particular, the Supreme Court left open the question of whether, and under what circumstances, the SEC is permitted to deposit disgorged funds into the Treasury where, as is often the case, it is infeasible to distribute funds to injured investors (if any exist). The SEC may try to sidestep this issue by finding new ways to benefit investors—for example, by depositing disgorgement proceeds into investor protection funds rather than the Treasury. Meanwhile, the Court’s guidance regarding the deductibility of legitimate expenses that “have value independent of fueling a fraudulent scheme” will, in at least some cases, likely result in a broader set of deductible expenses, thereby shrinking the “net profits” eligible for disgorgement.

Even if Liu significantly constrains the SEC’s disgorgement authority, the Commission could pivot to minimize its impact. First, it is unclear the extent to which Liu’s guiding principles apply to disgorgement in administrative proceedings, where there is express statutory authority for the remedy. The SEC may therefore decide to bring more administrative cases and avoid the judicial forum. Additionally, the SEC may increasingly rely on its statutory authority to pursue civil penalties to make up for any shortfall in disgorgement. As a result, Liu may have the effect of altering the mix (but not the amount) of monetary remedies the SEC seeks.

C.  Commissioner and Senior Staffing Update

During the first half of 2020, there were a number of leadership changes, several of which reflect the advancement of lawyers with many years of experience in the Division of Enforcement to positions of senior leadership.

As we previewed in our Year-End Enforcement Alert, Commissioner Robert Jackson stepped down in February 2020 to return to teaching at NYU Law School. In June, President Trump nominated Caroline Crenshaw to fill the vacancy. Ms. Crenshaw has worked at the Commission since 2013, most recently as counsel to Commissioner Jackson. Previously, Ms. Crenshaw worked as counsel to former Democratic Commissioner Kara Stein, a position also once held by current Democratic Commissioner Allison Herren Lee. Before joining the Commission, Ms. Crenshaw worked in private practice on investigations defense. Ms. Crenshaw is also a judge advocate in the U.S. Army Judge Advocate General’s Corps. Until Ms. Crenshaw is confirmed, the Commission will operate with four Commissioners: Chairman Jay Clayton, along with Commissioners Hester Peirce, Elad Roisman, and Lee (currently the only Democrat).

Other changes in the senior staffing of the Commission include:

  • In February, Paul Montoya was appointed Associate Regional Director in the SEC’s Chicago Office. As Associate Regional Director, Mr. Montaya co-heads the Enforcement program for the Office, along with Associate Regional Director Kathryn Pyszka. Mr. Montoya has worked at the SEC since 1997, including most recently as an Assistant Regional Director in the Chicago office, where he supervised staff in the Asset Management Unit.
  • Also in February, Kelly Gibson was appointed Director of the SEC’s Philadelphia Office. She was most recently Associate Regional Director in the Philadelphia office, and has worked at the SEC since 2008, including working in the Market Abuse Unit.
  • In June, Jennifer Leete was named Associate Director in the SEC’s Division of Enforcement. Ms. Leete has worked at the SEC since 1999, most recently as an Assistant Director. She succeeds Antonia Chion who retired in February 2020.

With the election approaching in November, one should expect a number of additional changes over the remainder of the year at senior levels of the Commission. In June, President Trump proposed Chairman Clayton as the U.S. Attorney for the Southern District of New York. However, in view of the events surrounding the nomination, it appears unlikely that the appointment will receive Senate consideration before the election.

D.  Whistleblower Awards

The last six months have reflected two distinct trends in the Commission’s whistleblower program—an increase in the number of whistleblower complaints, as well as an increase in the number and size of whistleblower awards.

First, as a result of the pandemic, the Commission has noted a marked increase in the number of whistleblower tips.  In the two months of quarantine, from mid-March to mid-May, the Enforcement Division triaged more than 4,000 whistleblower tips, a 35% increase over the same period in 2019. As the pandemic continues to impact businesses through the remainder of this year, including by affecting financial reporting, disclosure, and trading, one should expect the increased pace of whistleblower complaints to continue. This puts a premium on companies’ ability to demonstrate their response to internal complaints that could presage a whistleblower report to the government.

The second notable trend has been the increased number and size of whistleblower awards in the first half of this year. During the first half of 2020, the SEC awarded a total of nearly $115 million to 15 separate whistleblowers.

Most notably, in June, the SEC announced the single largest whistleblower payment in the program’s history—$50 million to an individual who reported what the SEC described as “detailed, firsthand observations” of company misconduct which resulted in an enforcement action that returned funds to harmed investors.[16] In April, the SEC awarded over $27 million, the seventh-largest award in the program’s history, to a whistleblower for information that uncovered violations occurring domestically and abroad.[17] Also in April, the SEC awarded over $18 million to a whistleblower who provided information that helped initiate an enforcement action which allowed investors to recover “millions of dollars in losses.”[18]

Other significant whistleblower awards granted during the first half of this year include:

  • Two awards in January of $277,000 and $45,000 respectively to two whistleblowers in connection with separate fraudulent retail investment schemes.[19]
  • An award in February of over $7 million for sustained cooperation that led to a successful enforcement action.[20]
  • Four awards in March—a $1.6 million payment for information that revealed securities law violations;[21] $570,000 and $94,000 payments for assistance that resulted in several enforcement actions;[22] and a $450,000 payment for assistance from a compliance professional who first reported internally and waited the required 120 days before reporting to the SEC.[23]
  • Two awards in April: one for $2 million for information the SEC deemed “vital” and difficult to uncover without the individual’s cooperation;[24] and a second for nearly $2 million for what the SEC described as “critical evidence of wrongdoing” provided by a whistleblower who suffered hardship as a result of first raising concerns within their organization.[25]
  • An award in May of nearly $2 million for information that led to a successful enforcement action and allowed for an asset freeze that prevented disgorgement of ill-gotten investor funds.[26]
  • Two awards in June, including a $700,000 payment for information that resulted in asset recovery for investors[27] and a $125,000 payment for information and assistance which helped the SEC and another agency bring enforcement actions against the perpetrator of a fraudulent securities offering.[28]

In total, as of the end of June 2020, the Commission has paid out approximately $501 million to 85 individuals since the whistleblower program began.[29] Because whistleblower awards relate to prior enforcement actions, the recent awards are unrelated to the pandemic. However, the number and size of the recent awards reflect the strong incentives such awards provide to would-be whistleblowers.

II.  Public Company Cases

A.  Accounting Fraud and Internal Controls

1.  Disclosures Cases

In February, the SEC announced a settled order against a global alcohol producer for failing to disclose trends affecting its key performance indicators.[30] The SEC alleged that the producer reported high organic net sales growth and organic operating profit growth without mentioning its pattern of shipping products in excess of distributor demand. According to the settled order, the company allegedly pressured distributors to buy products in excess of demand in order to meet internal sales targets despite declining market conditions, and the resulting increase in shipments enabled the company to meet performance targets and to report higher growth in certain performance indicators. The order also alleged that the company failed to disclose the trends that resulted from shipping products in excess of demand, the positive impact the over-shipping had on sales and profits, and the negative impact that the increase in inventory would have on future growth. The SEC’s order notes that the producer did not report these trends because it did not have adequate procedures in place to consider whether the company needed to disclose them.[31] Without admitting or denying the findings in the SEC’s order, the producer agreed to pay a $5 million civil penalty to settle the action.

In June, the SEC announced a settled action against an insurance company for failing to fully disclose benefits provided to its former CEO.[32] The company allegedly did not report over $5.3 million worth of personal expenses over five years even after the company had been made aware of the inaccuracies. Without admitting or denying the findings, the company consented to the SEC’s cease-and-desist order and to a $900,000 civil penalty.

2.  Financial Reporting

In February, the SEC instituted a settled action against a financial institution for allegedly misleading representations concerning the success of its cross-selling business strategy.[33] According to the settled order, the cross-sell metric reflected accounts and services that were unused and unauthorized by customers, and that had been opened through sales practices inconsistent with the company’s disclosure of a needs-based selling model. Without admitting or denying the allegations, the firm agreed to cease and desist from future violations and to pay a civil penalty of $500 million for distribution to investors. The settlement was part of a broader resolution with the Department of Justice.

Also in February, the SEC filed an action against a parent company, two of its former executives, and its energy subsidiary for allegedly making misleading statements about the subsidiary’s nuclear power plant expansion.[34] According to the complaint, which was filed in federal court in South Carolina, the defendants represented that the company was on track in its plan to build two plants and receive nearly $1 billion in tax credits, even though they knew the company was behind schedule and the plan was eventually abandoned.

3.  Cases against Independent Auditors

In May, the SEC instituted settled administrative actions against three former audit partners at an international accounting firm based on allegations that they improperly shared answers to internal training exams and attempted to cover up the misconduct during an internal investigation.[35] The settled order alleged that one former partner requested a second former partner to text him images of exam questions, and during the firm’s internal investigation, the first former partner deleted the texts and encouraged the other former partner to follow suit. The third former partner also allegedly shared exams and answers within his team. Without admitting or denying the findings, the former partners agreed to suspensions on appearing or practicing before the SEC as accountants with the right to apply for reinstatement after durations of three years for the first former partner, two for the second, and one for the third.

III.  Broker-Dealers

A.  Suitability

In February, the SEC instituted a settled action against two subsidiaries of a broker-dealer relating to supervision of investment advisers and registered representatives who recommended certain investments—single-inverse ETFs—to retail investors.[36] The SEC’s administrative order alleged that the broker-dealer’s policies and training were not reasonably designed to prevent and detect potentially unsuitable recommendations of single-inverse ETFs. Consequently, certain employees allegedly recommended clients buy and hold those securities, despite the risk associated with holding such investments for longer than one day. Without admitting or denying the SEC’s findings, the firm agreed to pay a $35 million penalty to be distributed to clients.

B.  Trade Execution

In May, the SEC instituted a settled administrative action against an agency broker-dealer for routing certain customer orders in a manner inconsistent with representations in marketing materials as to how customer orders would be routed to market centers for execution.[37] According to the SEC’s order, the firm represented that customer orders would be routed to market centers through the firm’s smart order router based on execution price and liquidity factors. However, during the relevant period, the firm had entered into arrangements to route orders to unaffiliated broker-dealers (who had more favorable, high-volume pricing arrangements with market centers) to determine routing of the orders to market centers. Without admitting or denying the SEC’s allegations, the firm agreed to pay a $5 million penalty. The SEC’s order also recognized the firm’s cooperation, including retaining an outside expert to analyze the large volume of data related to customer orders and executions.

C.  Fees

In May, the SEC instituted a settled action against a broker-dealer based on allegations that the firm provided allegedly misleading information about its “wrap fee” program to customers.[38] “Wrap fee” programs offer accounts in which clients pay an asset-based fee for a bundle of investment advisory and brokerage services, including trade execution services. According to the SEC’s order, the firm marketed the program as providing investment advice, trade execution, and other services for a single fee, but it allegedly directed certain wrap fee clients’ trades to third-party broker-dealers for execution, which in some instances resulted in clients incurring additional trade execution fees. Without admitting or denying the allegations, the firm agreed to pay a $5 million penalty for distribution to affected clients.

D.  Record-Keeping

In the first half of this year, the SEC instituted settled enforcement actions against two separate broker-dealers for deficiencies in trading information—known as “blue sheet” data—that the firms provided to the SEC in response to requests.[39] SEC staff routinely requests blue sheet data from broker-dealers in a variety of investigations or regulatory inquiries. In both of the enforcement actions, the errors in the data that the broker-dealers provided were the result of undetected coding errors in the process for identifying data for production to the SEC. In both actions, the broker-dealer firms consented to violations of the record-keeping provisions of the Securities Exchange Act, Section 17(a)(1) and Rules 17a-4(j) and 17a-25. The firms agreed to pay penalties to the SEC of $3.2 million and $1.55 million, respectively.

Notably, in both settlements, the SEC required the respondent broker-dealer firms to admit to the findings in the settled order, even as both orders acknowledged the firms’ remedial actions and cooperation in the investigations; admissions have become a standard practice in blue sheet cases brought by the SEC.

IV.  Investment Advisers

A.  Risk Management

In January, the SEC instituted partially settled enforcement actions against a New York-based investment advisory firm, the firm’s president, and a senior portfolio manager for allegedly misleading representations concerning the management of risk in a mutual fund managed by the advisory firm.[40] The advisory firm and president settled the action; the portfolio manager is contesting the allegations. According to the SEC’s order and complaint, during a three-month period, from December 2016 to February 2017, the fund managed by the advisory firm lost approximately 20% of its value when markets moved against the fund’s positions. The SEC’s settled order against the firm and the president alleged that the advisory firm represented that it maintained risk parameters, but that the firm breached those parameters and did not take corrective action to avoid losses. The SEC’s pending complaint against the portfolio manager alleges that he represented to investors that he employed a risk management strategy involving safeguards to prevent losses of more than 8%, but that in fact such safeguards did not limit losses. Without admitting or denying the SEC’s findings, the advisory firm and president agreed to implement remedial compliance measures and to pay disgorgement and interest of approximately $9 million and penalties of $1.3 million by the advisory firm and $300,000 by the president.

B.   Pre-Release ADRs

In 2020, the SEC has continued its initiative, commenced in 2018, focused on practices related to American Depositary Receipts (“ADRs”). ADRs are U.S. securities that represent foreign shares of a foreign company, and they typically require foreign shares in the same quantity to be held in custody at a depositary bank.[41] “Pre-released” ADRs are a variation that are issued without the deposit of foreign shares. Instead, they require that a customer either already owns the number of shares in equal amounts to the number of shares represented by the ADR or that the broker receiving the shares has an agreement with a depository bank.

In February, the SEC instituted its fifteenth action involving pre-released ADRs. In that settled action, the SEC’s order alleged that the broker-dealer improperly borrowed pre-released ADRs from other brokers when it should have known that the brokers did not own the corresponding foreign shares.[42] The order also alleged that the broker-dealer failed to reasonably supervise its securities lending desk personnel concerning the borrowing of pre-released ADRs from these brokers. Without admitting to or denying the allegations, the firm agreed to pay disgorgement and interest of approximately $400,000 and a penalty of approximately $180,000.

C.  Share Class Disclosure

In April, the SEC instituted the final three actions the Enforcement Division intends to recommend under the Division’s Share Class Selection Disclosure Initiative, a program which provided advisers an opportunity to self-report failures to fully disclose conflicts of interest in selecting mutual fund share classes. Under the program, self-reporting advisers were eligible for standardized settlement terms that included disgorgement of fees, but did not include a penalty.[43] These latest settled orders related to two advisers who self-reported by the deadline and consented to violations of Section 206(2) of the Advisers Act and one who reported shortly after the deadline and consented to violations of Sections 206(2) and 206(4) of the Advisers Act and agreed to pay a $10,000 penalty.

D.  Policies and Procedures to Prevent Misuse of MNPI

In May, the SEC instituted a settled administrative action against a Los Angeles-based private equity investment adviser firm based on allegations that the firm failed to implement and enforce policies and procedures reasonably designed to prevent the misuse of material nonpublic information under the particular circumstances in which the firm had a senior employee on the board of a portfolio company while also trading in the public securities of the portfolio company.[44] Notably, the settled order did not allege that the firm engaged in any trading while in possession of material nonpublic information. Even though the firm conducted its trading during the portfolio company’s open trading windows, and the firm’s compliance department had approved the firm’s trades, the SEC’s order alleged that the firm did not require its compliance staff to inquire or document sufficiently whether the board representative or other members of the investment team were in possession of material nonpublic information relating to the portfolio company. Without admitting or denying the allegations, the firm agreed to pay a $1 million penalty.

E.  Misrepresentation

In May, the SEC filed a complaint and a request for appointment of a receiver against a Florida-based investment advisory firm alleging that the firm improperly inflated revenue data in order to increase asset values and performance metrics.[45] The complaint also alleged that the firm misrepresented monthly returns and investment balances, which, in turn, resulted in the payment of inflated management fees to the firm. The court granted the SEC’s request for appointment of a receiver, and the litigation is ongoing.

V.  Ratings Agencies

In May, the SEC instituted a settled action against a credit rating agency for allegedly violating two conflict of interest rules—Rule 17g-5(c)(8)(i) and Section 15E(h)(1) of the Securities Exchange Act of 1934—designed to separate credit ratings and analysis from sales and marketing efforts.[46] According to the SEC’s settled order, analysts responsible for analyzing and rating the credit of companies also participated in sales and marketing efforts targeted at the same companies the analysts were responsible for rating, creating an impermissible conflict of interest. Additionally, the SEC alleged that the credit rating agency failed to maintain sufficient written policies and procedures to separate the firm’s analytical and business development functions. Without admitting or denying the findings, the credit rating agency agreed to pay a $3.5 million penalty and agreed to conduct training and implement changes to its internal controls, policies, and procedures related to the charged provisions.

VI.  Cryptocurrency

In the first half of 2020, the Commission continued to bring enforcement actions in the area of cryptocurrency and other digital assets. Some of the enforcement actions were based on alleged failures to comply with the requirement to register an offering of assets deemed to be securities; other actions included allegations of fraud in the offer and sale of digital assets; and one case concerned a celebrity endorsement of an initial coin offering (ICO) without disclosure of compensation received by the celebrity.

A.  Registration Cases

In February, the SEC instituted a settled action against a blockchain technology company for conducting an unregistered offering of digital tokens, which the SEC determined to be investment contracts, i.e., securities.[47] Citing to the Supreme Court’s decision in SEC v. W.J. Howey Co.,[48] as well as the SEC’s Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO,[49] the SEC’s order alleged that a purchaser of the digital tokens would have had a reasonable expectation of obtaining a future profit based on the company’s representations and efforts to build its business, including through its use of the ICO fund proceeds to develop a data marketplace for data sets relating to digital assets. In total, the offering raised approximately $45 million. Without admitting or denying the SEC’s findings, the company has agreed to return the funds raised to investors via a claims process, register the tokens as securities, file periodic reports with the SEC, and pay a $500,000 penalty.

In May, the SEC instituted a settled action against a blockchain technology company for conducting an unregistered ICO which raised over $25 million by selling Consumer Activity Tokens to approximately 9,500 investors.[50] During the offering, the company emphasized its expectation that the tokens would increase in value and took steps to make the tokens available for trading on third-party digital asset trading platforms after the ICO. The company planned on using the ICO funds to develop a blockchain-based search platform for targeted consumer advertising. Without admitting or denying the SEC’s findings, the company agreed to pay disgorgement and interest of approximately $29 million and a penalty of $400,000. Additionally, the company removed the Consumer Activity Tokens from all digital asset trading platforms and does not plan to continue development of the search platform.

B.  Fraud Cases

In January, the SEC commenced an action against two individuals and two businesses, alleging violations of the antifraud and securities registration provisions of the federal securities laws in connection with the sale of digital assets.[51] The complaint alleged that in marketing and selling digital asset securities to raise funds for a blockchain technology they were developing, the defendants misrepresented that the technology was being tested by 20 hedge funds, when in reality they had sent a prototype to 12 hedge funds, none of which used the prototype. Additionally, the complaint alleged that one of the individual defendants used a fake identity when marketing the digital securities to conceal his criminal record. In a parallel action, the U.S. Attorney’s Office for the District of New Jersey announced criminal charges against the individual who misrepresented his identity to investors.

In February, the SEC filed an action against an individual alleging violations of the antifraud provisions of the federal securities laws based on misrepresentations about the profits purportedly earned from trading digital assets.[52] The complaint alleged that the defendant misrepresented to investors, comprised mainly of physicians, that he had developed a proprietary algorithm that enabled him to generate extraordinary profits trading cryptocurrencies. Additionally, the complaint alleged that the defendant misrepresented the amount of assets he had under management and used investor funds to pay for personal expenses. In parallel actions, the U.S. Attorney’s Office for the Southern District of New York and the Commodity Futures Trading Commission brought criminal and civil actions against the defendant.

In March, the SEC filed an action against three individuals alleging violations of the antifraud and securities registration provisions of the federal securities laws in connection with an ICO. The complaint alleged that the individuals conducted an unregistered ICO—raising more than $4.3 million from more than 150 investors—and made fraudulent representations to investors regarding the risk and value of the digital assets being offered.[53] The complaint also alleged that the individuals never distributed the digital assets to the investors and instead used investor funds to pay personal expenses and funnel proceeds to two other parties.

C.  Failure to Disclose Compensation for Endorsement

In February, the SEC instituted a settled action against a celebrity for allegedly violating the anti-touting provisions of the federal securities laws.[54] The celebrity promoted an investment in an ICO but failed to disclose payments he received from the issuer for the endorsements. The endorsements included posts on the celebrity’s public social media accounts and a press release. Without admitting or denying the SEC’s findings, the celebrity agreed to pay disgorgement of the promotional payments of $157,000 he had received, as well as a $157,000 penalty and agreed not to promote any securities, digital or otherwise, for three years.

VII.  Offering Frauds

In the first half of 2020, the SEC continued to bring a substantial number of enforcement actions to enjoin offering frauds, particularly those that targeted retail investors, including seniors.

A.  Ponzi-Like Schemes

In January, the SEC filed three cases alleging fraudulent securities offerings that amounted to Ponzi-like schemes. In the first, the SEC alleged that an individual fraudulently raised at least $75 million from more than 500 investors through unregistered securities offerings, promising investors a perpetual guaranteed rate of return on their investments, which he claimed to be channeling into the purchase or creation, marketing, and maintenance of revenue-generating websites.[55] The complaint, which the SEC filed in federal court in Chicago, alleges that, in reality, the defendant used investors’ funds to pay investor returns and his own personal expenses, including mortgage payments and private school tuition for his family. The Court granted a temporary restraining order and preliminary injunction, ordered an asset freeze and other emergency relief against the defendant, and appointed a receiver for the defendant’s company.[56]

In the second case, the SEC filed an action against two individuals and their companies, alleging that they conducted a fraudulent securities offering that raised almost $5 million from retail investors.[57] The complaint, which the SEC filed in federal court in California, alleges that the defendants solicited investments in a holding company they controlled, purporting that the funds would be used to operate a Washington-licensed recreational marijuana company. Instead, the complaint alleges, the defendants used the investors’ funds to support their own lavish lifestyles.

In the third case, the SEC filed an action against a California couple alleging a fraudulent securities offering that raised almost $1 billion from seventeen investors, including major institutional investors, between 2011 and 2018.[58] According to the complaint, which the SEC filed in federal court in Sacramento, the defendants solicited investments from wealthy investors by offering securities in the form of investment contracts through their two solar generator companies. The complaint alleged that the defendants promised investors tax credits, lease payments, and profits from the operation of mobile solar generators but never manufactured the majority of the promised generators and instead used investor funds to pay other investors and for personal expenses. The defendants consented to permanent injunctions, with monetary relief to be determined by the court.

In the first half of 2020, the SEC filed two actions alleging investment frauds that targeted retail investors, including senior citizens. In February, the SEC filed an action against a Florida-based private real estate firm and its CEO and Managing Director, alleging the defendants fraudulently raised more than $170 million from at least 1,100 investors.[59] According to the complaint, the defendants represented to investors that they would receive between 8% and 10% annual interest on their investments, and that their investment would be used to purchase undervalued real estate. The SEC alleges that, in reality, the defendants invested less than half of the funds in properties and used the remainder on personal expenses and to repay investors in another fund. The court granted the SEC’s request for emergency relief, including an accounting and the appointment of a receiver over the primary and relief defendants.

In a second case, in May, the SEC filed an action against a California investment adviser alleging he conducted a Ponzi scheme targeting senior citizens in Southern California.[60] The complaint alleges that the defendant raised more than $5.6 million from at least 35 investors by marketing securities in another of his companies and by promising investors between 3% and 10.5% returns on so-called “private annuity contracts.” According to the complaint, the defendant did not invest the funds in any securities but rather used the funds to pay promised returns to other investors and to settle investor fraud lawsuits. The court ordered an asset freeze, an accounting, and appointment of a temporary receiver.[61] The U.S. Attorney’s Office for the Central District of California also filed a criminal complaint against the defendant.

B.  Microcap Stock Fraud

In January, the SEC filed a pair of complaints against six individuals in the U.S., Canada, and Europe alleging fraudulent and unregistered stock offerings in at least 45 microcap companies that raised over $35 million.[62] The complaints allege that the defendants conducted two schemes: one to secretly dump large quantities of microcap stock while fraudulently transferring and hiding the source of funds used to promote the stocks, and another to sell and then manipulatively trade millions of unregistered shares of a microcap stock while artificially inflating its price and dumping the shares into the market. The U.S. Attorney’s Office for the Southern District of New York announced parallel criminal charges.

C.  Affinity-Based Offering Frauds

In January, the SEC filed a settled action against a Pennsylvania man for allegedly conducting a decade-long fraud, which raised approximately $60 million in investments from Amish and Mennonite community members.[63] According to the SEC’s complaint, the defendant, who provided accounting and investment services to fellow Amish and Mennonite community members, solicited investments from his clients and promised to invest the funds in business and real estate loans to other members of the religious community but instead funneled a large percentage of the investments into his personal investment projects, which failed and left him unable to repay investors. The settlement provided for injunctive relief and the return of ill-gotten gains plus prejudgment interest. In February, the defendant also pleaded guilty to criminal charges of conspiracy and fraud brought by the U.S. Attorney’s Office for the Eastern District of Pennsylvania.

Also in the first half of 2020, the SEC filed two actions against individuals alleging investment frauds that targeted senior retail investors’ retirement funds. In the first action, in March, the SEC filed a complaint alleging that a Russian national, through a number of companies he owned, raised over $26 million from retail investors, many of them older investors looking to invest their retirement savings. According to the complaint, the defendant used internet ads linked to spoofed websites of 24 actual legitimate financial firms to lure investors to invest in fictitious Certificates of Deposit.[64] The U.S. Attorney’s Office for the District of New Jersey announced parallel criminal charges.

In the second action, in June, the SEC filed a complaint alleging that a securities broker based in Nashville, Tennessee, defrauded two seniors of nearly $1 million over the course of four years.[65] According to the complaint, after acting as the senior investor’s registered representative for more than three decades, the defendant made unauthorized sales of securities from the investor’s account and transferred the proceeds of those sales into his own bank account using falsified wire transfer forms. The complaint further alleged that, after the first investor’s death in March 2019, the defendant stole funds from another senior’s brokerage account in similar fashion. The U.S. Attorney’s Office for the Middle District of Tennessee also filed parallel criminal charges.

D.  Misuse of Client Funds

In March, the SEC filed charges, and obtained an asset freeze and other emergency relief, against a Florida-based investment adviser and its managing member in connection with an alleged fraudulent unregistered securities offering.[66] The SEC’s complaint alleged that the investment adviser made misrepresentations to investors about a purported hedge fund including assurances that investor funds were deposited into a sub-fund, which was purportedly invested in U.S.-listed products and 90% hedged using listed options. According to the complaint, the investment adviser instead directed a significant part of investor funds to a private start-up company owned by a managing member.

In May, the SEC filed an action against the owner of a film distribution company for allegedly violating the antifraud provisions of the federal securities laws.[67] The SEC’s complaint alleged that the individual diverted funds he received from an investment management company, which were meant to support his film distribution business, to a sham company and then used the investor funds to pay personal expenses. The SEC is seeking disgorgement, civil penalties, and permanent injunctive relief. In a parallel action, the U.S. Attorney’s Office for the Southern District of New York filed criminal charges against the individual.

______________________

[1]              Public Statement, “Statement from Stephanie Avakian and Steven Peikin, Co-Directors of the SEC’s Division of Enforcement, Regarding Market Integrity” (Mar. 23, 2020), available at https://www.sec.gov/news/public-statement/statement-enforcement-co-directors-market-integrity.

[2]              See May 12, 2020 Keynote Address: Securities Forum West 2020, available at https://www.sec.gov/news/speech/keynote-securities-enforcement-forum-west-2020.

[3]              SEC Press Release, SEC Charges Company and CEO for COVID-19 Scam (Apr. 28, 2020), available at https://www.sec.gov/news/press-release/2020-97.

[4]              SEC Press Release, SEC Charges Companies and CEO for Misleading COVID-19 Claims (May 14, 2020), available at https://www.sec.gov/news/press-release/2020-111.

[5]              SEC Press Release, SEC Charges California Trader Engaged in Manipulative Trading Scheme Involving COVID-19 Claims (June 9, 2020), available at https://www.sec.gov/news/press-release/2020-128.

[6]              SEC Press Release, SEC Charges Microcap Fraud Scheme Participants Attempting to Capitalize on the COVID-19 Pandemic (June 11, 2020), available at https://www.sec.gov/news/press-release/2020-131.

[7]              140 S. Ct. 1936 (2020).

[8]              See also Barry Goldsmith et al., Supreme Court Reins In, But Does Not Overturn, SEC’s Disgorgement Authority, New York Law Journal (June 25, 2020), available at https://www.law.com/newyorklawjournal/2020/06/25/supreme-court-reins-in-but-does-not-overturn-secs-disgorgement-authority/, for a discussion of the implications of Liu.

[9]              140 S. Ct. at 1940.

[10]             Id. at 1948.

[11]             Id.

[12]             Id. at 1949.

[13]             Id.

[14]             Id. at 1950.

[15]             Id.

[16]             SEC Press Release, SEC Awards Record Payout of Nearly $50 Million to Whistleblower (June 4, 2020), available at https://www.sec.gov/news/press-release/2020-126.

[17]             SEC Press Release, SEC Awards Over $27 Million to Whistleblower (Apr. 16, 2020), available at https://www.sec.gov/news/press-release/2020-89.

[18]             SEC Press Release, SEC Awards Over $18 Million to Whistleblower (Apr. 28, 2020), available at https://www.sec.gov/news/press-release/2020-98.

[19]             SEC Press Release, SEC Awards Whistleblowers Whose Information Helped Stop Fraud (Jan. 22, 2020), available at https://www.sec.gov/news/press-release/2020-15.

[20]             SEC Press Release, SEC Awards More Than $7 Million to Whistleblower (Feb. 28, 2020), available at https://www.sec.gov/news/press-release/2020-46.

[21]             SEC Press Release, SEC Awards Over $1.6 Million to Whistleblower (Mar. 23, 2020), available at https://www.sec.gov/news/press-release/2020-69.

[22]             SEC Press Release, SEC Awards Over $570,000 to Two Whistleblowers (Mar. 24, 2020), available at https://www.sec.gov/news/press-release/2020-71.

[23]             SEC Press Release, SEC Awards $450,000 to Whistleblower (Mar. 30, 2020), available at https://www.sec.gov/news/press-release/2020-75.

[24]             SEC Press Release, SEC Awards Approximately $2 Million to Whistleblower (Apr. 3 2020), available at https://www.sec.gov/news/press-release/2020-80.

[25]             SEC Press Release, SEC Issues $5 Million Whistleblower Award (Apr. 20, 2020), available at https://www.sec.gov/news/press-release/2020-91.

[26]             SEC Press Release, SEC Awards Almost $2 Million to Whistleblower (May 4, 2020), available at https://www.sec.gov/news/press-release/2020-100.

[27]             SEC Press Release, SEC Awards Almost $700,000 to Whistleblower (June 19, 2020), available at https://www.sec.gov/news/press-release/2020-138.

[28]             SEC Press Release, SEC Awards $125,000 to Whistleblower (June 23, 2020), available at https://www.sec.gov/news/press-release/2020-141.

[29]             Id.

[30]             SEC Press Release, SEC Charges Global Alcohol Producer with Disclosure Failures (Feb. 19, 2020), available at https://www.sec.gov/news/press-release/2020-36.

[31]             Administrative Proceeding File No. 3-19701, In the Matter of Diageo plc (Feb. 19, 2020), available at https://www.sec.gov/litigation/admin/2020/33-10756.pdf.

[32]           SEC Press Release, Insurance Company Settles SEC Charges for Failing to Disclose Executive Perks (June 4, 2020), available at https://www.sec.gov/news/press-release/2020-127.

[33]             SEC Press Release, Wells Fargo to Pay $500 Million for Misleading Investors About the Success of Its Largest Business Unit (Feb. 21, 2020), available at https://www.sec.gov/news/press-release/2020-38.

[34]             SEC Press Release, SEC Charges South Carolina Energy Companies Former Executives With Defrauding Investors (Feb. 27, 2020), available at https://www.sec.gov/news/press-release/2020-44.

[35]             SEC Press Release, SEC Charges Three Former KPMG Audit Partners for Exam Sharing Misconduct (May 18, 2020), available at https://www.sec.gov/news/press-release/2020-115.

[36]             SEC Press Release, SEC Charges Wells Fargo in Connection with Investment Recommendation Practices (Feb. 27, 2020), available at https://www.sec.gov/news/press-release/2020-43.

[37]             SEC Press Release, SEC Charges Bloomberg Tradebook for Order Routing Misrepresentations (May 6, 2020), available at https://www.sec.gov/news/press-release/2020-104.

[38]             SEC Press Release, SEC Charges Morgan Stanley Smith Barney with Providing Misleading Information to Retail Clients (May 12, 2020), available at https://www.sec.gov/news/press-release/2020-109.

[39]             SEC Press Release, Cantor Fitzgerald Agrees to Pay $3.2 Million to Settle Charges for Providing Deficient Blue Sheet Data (Apr. 6, 2020), available at https://www.sec.gov/news/press-release/2020-81; SEC Press Release, SG Americas to Pay $3.1 Million to Settle Charges of Providing Deficient Blue Sheet Data (June 24, 2020), available at https://www.sec.gov/news/press-release/2020-142.

[40]             SEC Press Release, SEC Charges Portfolio Manager and Advisory Firm with Misrepresenting Risk in Mutual Fund (Jan. 27, 2020), available at https://www.sec.gov/news/press-release/2020-21.

[41]             SEC Press Release, ABN AMRO Clearing Chicago Charged with Improper Handling of ADRs (Feb. 6, 2020), available at https://www.sec.gov/news/press-release/2020-29.

[42]             Admin. Proc. File No. 3-19693, In the Matter of ABN AMRO Clearing Chicago LLC (Feb. 6, 2020), available at https://www.sec.gov/litigation/admin/2020/34-88139.pdf.

[43]             SEC Press Release, SEC Orders Three Self-Reporting Advisory Firms to Reimburse Investors (Apr. 17, 2020), available at https://www.sec.gov/news/press-release/2020-90.

[44]             SEC Press Release, Private Equity Firm Ares Management LLC Charged with Compliance Failures (May 26, 2020), available at https://www.sec.gov/news/press-release/2020-123.

[45]             SEC Press Release, SEC Obtains Receiver Over Florida Investment Adviser Charged with Fraud (May 12, 2020), available at https://www.sec.gov/news/press-release/2020-110.

[46]             SEC Press Release, SEC Orders Credit Rating Agency to Pay $3.5 Million for Conflicts of Interest Violations (May 15, 2020), available at https://www.sec.gov/news/press-release/2020-112.

[47]             SEC Press Release, ICO Issuer Settles SEC Registration Charges, Agrees to Return Funds and Register Tokens As Securities (Feb. 19, 2020), available at https://www.sec.gov/news/press-release/2020-37.

[48]             328 U.S. 293 (1946).

[49]             Exchange Act Rel. No. 81207 (July 25, 2017).

[50]             SEC Press Release, Unregistered $25.5 Million ICO Issuer to Return Money for Distribution to Investors (May 28, 2020), available at https://www.sec.gov/news/press-release/2020-124.

[51]             SEC Press Release, SEC Charges Convicted Criminal Who Conducted Fraudulent ICO Using a Fake Identity (Jan. 17, 2020), available at https://www.sec.gov/news/press-release/2020-12.

[52]             SEC Press Release, SEC Charges Orchestrator of Cryptocurrency Scheme Ensnaring Physicians (Feb. 11, 2020), available at https://www.sec.gov/news/press-release/2020-32.

[53]             SEC Press Release, SEC Emergency Action Stops Digital Asset Scam (Mar. 20, 2020), available at https://www.sec.gov/news/press-release/2020-66.

[54]             SEC Press Release, Actor Steven Seagal Charged With Unlawfully Touting Digital Asset Offering (Feb. 27, 2020), available at https://www.sec.gov/news/press-release/2020-42.

[55]             SEC Press Release, SEC Obtains Emergency Asset Freeze, Charges Businessman With Operating a Ponzi-Like Scheme (Jan. 14, 2020), available at https://www.sec.gov/news/press-release/2020-10.

[56]             SEC Litigation Release, SEC Obtains Preliminary Injunction Against Businessman for Operating a Ponzi-Like Scheme (Mar. 6, 2020), Litigation Release No. 24760, available at https://www.sec.gov/litigation/litreleases/2020/lr24760.htm.

[57]             SEC Press Release, SEC Files Charges Against Scheme to Sell Fictitious Interests in Marijuana Company (Jan. 21, 2020), available at https://www.sec.gov/news/press-release/2020-14.

[58]             SEC Press Release, SEC Charges Husband and Wife with Nearly $1 Billion Ponzi Scheme (Jan. 24, 2020), available at https://www.sec.gov/news/press-release/2020-18.

[59]             SEC Press Release, SEC Charges Real Estate Company and Executives With Defrauding Retail Investors, Obtains Emergency Relief (Feb. 18, 2020), available at https://www.sec.gov/news/press-release/2020-35.

[60]             SEC Press Release, SEC Shuts Down Fraudulent Investment Adviser Targeting Senior Citizens (May 22, 2020), available at https://www.sec.gov/news/press-release/2020-120.

[61]             SEC Litigation Release, SEC Obtains Preliminary Injunction Against Fraudulent Investment Adviser Targeting Senior Citizens, Litigation Release No. 24831 (June 9, 2020), available at https://www.sec.gov/litigation/litreleases/2020/lr24831.htm.

[62]             SEC Press Release, SEC Charges Six Individuals in International Microcap Fraud Schemes (Jan. 2, 2020), available at https://www.sec.gov/news/press-release/2020-1.

[63]             SEC Press Release, SEC Brings Charges Against Fraud Targeting Amish and Mennonite Investors (Jan. 31, 2020), available at https://www.sec.gov/news/press-release/2020-26.

[64]             SEC Press Release, SEC Charges Russian National for Defrauding Older Investors of Over $26 Million in Phony Certificates of Deposit Scam (Mar. 13, 2020), available at https://www.sec.gov/news/press-release/2020-61.

[65]             SEC Press Release, SEC Charges Broker Who Defrauded Seniors Out of Almost $1 Million (June 12, 2020), available at https://www.sec.gov/news/press-release/2020-132.

[66]             SEC Press Release, SEC Halts Fraudulent Offering by Florida Investment Adviser (Mar. 10, 2020), available at https://www.sec.gov/news/press-release/2020-56.

[67]             SEC Press Release, SEC Charges Owner of Film Distribution Company with Defrauding Publicly Traded Fund (May 22, 2020), available at https://www.sec.gov/news/press-release/2020-122.


The following Gibson Dunn lawyers assisted in the preparation of this client update:  Mark Schonfeld and Tina Samanta.

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June 30, 2020 |
Supreme Court Reins In, But Does Not Overturn, SEC’s Disgorgement Authority

New York partner Barry Goldsmith, Denver partner Frederick Yarger, and New York associate Jonathan Seibald are the authors of  "Supreme Court Reins In, But Does Not Overturn, SEC's Disgorgement Authority," [PDF] published by the New York Law Journal on June 25, 2020.

June 22, 2020 |
Supreme Court Limits Disgorgement Remedy In SEC Civil Enforcement Actions

Click for PDF Decided June 22, 2020 Liu v. Securities and Exchange Commission, No. 18-1501

Today, the Supreme Court held 8-1 that although the SEC may seek disgorgement in civil enforcement actions, the remedy must be limited to the wrongdoer’s net profits and be awarded for the benefit of victims. 

Background: When alleging securities fraud in a civil action, the SEC is authorized to seek civil penalties and any “equitable relief” that “may be appropriate or necessary for the benefit of investors.” 15 U.S.C. § 78u(d)(5). Here, the SEC alleged that Petitioners misappropriated millions of dollars of investor money after soliciting funds for the construction of a cancer-treatment center. Finding for the SEC, the district court imposed a civil penalty and ordered disgorgement equal to the full amount Petitioners raised from investors less the amount that remained in the corporate accounts for the project.

Petitioners objected that the disgorgement award failed to account for their business expenses. Petitioners relied on Kokesh v. SEC, 137 S. Ct. 1635 (2017), which held that a disgorgement order in an SEC enforcement action imposes a “penalty” for purposes of the applicable statute of limitations. Because courts of equity historically could not impose punitive sanctions, Petitioners reasoned, the court lacked statutory authority to impose the disgorgement remedy. But the Ninth Circuit disagreed, concluding that the proper amount of disgorgement was the entire amount raised minus the money paid back to investors.

Issue: Whether, and to what extent, disgorgement is statutorily authorized “equitable relief” in an SEC civil enforcement action.

Court's Holding: A disgorgement award in an SEC civil enforcement action is “equitable relief” so long as it does not exceed a wrongdoer’s net profits and is awarded for victims.

“[A] disgorgement award that does not exceed a wrongdoer’s net profits and is awarded for victims is equitable relief permissible under § 78u(d)(5).

Justice Sotomayor, writing for the Court

What It Means:
  • The Supreme Court held that a disgorgement remedy may constitute “equitable relief” under 15 U.S.C. § 78u(d)(5), but only if limited to the wrongdoer’s net profits and awarded for victims. This holding, the Court noted, was consistent with the “circumscribed” power of courts of equity to strip wrongdoers of ill-gotten gains. The Court therefore vacated the Ninth Circuit’s judgment and remanded with instructions to ensure that any legitimate business expenses are deducted from the disgorgement award.
  • The opinion casts doubt on several SEC disgorgement practices that have appeared in recent decades. The Court observed that disgorgement awards are “in considerable tension” with equity practice when they (1) order the funds deposited in the U.S. Treasury instead of disbursing them to victims; (2) impose joint-and-several liability; or (3) decline to deduct business expenses that are legitimate or that have value independent of fueling a fraudulent scheme. The Court left those questions to the Ninth Circuit to address on remand.
  • The Court’s decision reinforces the need, in a variety of contexts, to examine and apply traditional limits on awarding “equitable relief.” The Court examined traditional equitable practice in concluding that courts of equity would not award more than the wrongdoer’s net profits to the victims of the offense.

The Court's opinion is available here.

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May 29, 2020 |
Second Circuit Cases Clarify Scope of Investors’ “Insider” Status for Short-Swing Profit Statutes

Click for PDF

On May 20, 2020, in Rubenstein v. International Value Advisers, LLC[1] and Rubenstein v. Rofam Inv. LLC,[2] Judges Kearse, Parker and Sullivan of the Second Circuit issued a pair of opinions clarifying when a group of investors may be considered insiders for purposes of securities laws requiring the disgorgement of profits earned through short-term investments by dint of relationships with their investment advisors.  While the issue has arisen elsewhere in lower courts,[3] International Value and Rofam are the first appellate decisions in this novel area of securities litigation.  Accordingly, their determination that group liability for short-swing profits does not arise where investors grant their advisors discretionary authority over their accounts provides important and persuasive authority in support of investment managers facing related claims.

The Short-Swing Profit Rule In order to curb the risk that corporate insiders might trade based on material non-public information, the Securities Exchange Act of 1934 applies strict liability in requiring insiders to disgorge to the issuer any profits from certain “short-swing” trades in which an issuer’s equity is purchased and then sold, or sold and then purchased, within a period of six months or less.[4]  This rule applies to issuers’ directors, officers, and any “person who is directly or indirectly the beneficial owner of more than 10 percent of any class of any equity security of the issuer.”[5] In this context, however, the term “person” refers not only to individuals but rather to groups as well.  Specifically, the Exchange Act and rules under it provide that whenever multiple people “act as a . . . group for the purpose of acquiring, holding, or disposing of securities of an issuer,” they are considered a single “person” for purposes of the short-swing profit rule.[6]  SEC rules further clarify that when individuals “agree to act together for the purpose of acquiring, holding, voting or disposing of equity securities of an issuer,” they are considered a single person for purposes of short-swing profits liability and each such individual is “deemed” to be the beneficial owner of equity securities owned by any other group member.[7]  Stated otherwise, if members of such a group collectively own more than 10% of a company’s equity, each member of that group becomes subject to strict liability disgorgement of their short-swing profits from investments in that issuer’s equity securities.[8] An investor, Aaron Rubenstein, claimed to rely on these rules in bringing two similar suits.  He first sued clients of investment advisor Fairholme Investment Management based upon the ownership of more than 10% of Sears common stock by Fairholme and its clients and, subsequently, he sued both investment advisor International Value Advisers and a “John Doe” client in light of the advisory firm’s holding more than 10% of the common stock of Adtalem Global Education Services (formerly and better-known as the DeVry Education Group).  Rubenstein advanced the same theory in each case:  the investment advisors’ clients were part of a “group” for purposes of the short-swing profit rule in light of the investment advisors’ undisputed insider status.  Accordingly, Rubenstein argued that the clients of each investment advisor were liable for short-swing profits earned through investments in Sears and DeVry, respectively. Investment Advisors’ Insider Status  Is Not Imputed To Their Clients In a matter of first impression, the Second Circuit rejected Rubenstein’s theory, explaining that an investor does not automatically “become a member of a group solely because his or her advisor caused other (or all) of its clients to invest in securities of the same issuer,” and an “investment advisory client does not form a group with its investment advisor by merely entering into an investment advisory relationship.”[9]  Rather, in light of the short-swing profit rule’s use of the singular phrase “an issuer,” the Second Circuit held that the short-swing profit rule imposes liability only when individuals agree to act as a group for purposes of investing in “the securities of a particular issuer.”[10]  Because Rubenstein alleged that the clients had entered agreements delegating discretionary investment authority to their investment advisors without reference to any specific securities, he failed to state a claim in either case.  Since the investment management agreements were not “issuer-specific,”[11] they did not “constitute[] an ‘agreement’ to trade in DeVry [and Sears] securities”[12] giving rise to group liability. The Second Circuit also rejected Rubenstein’s implied agreement theory in which he argued that the client-defendants had agreed to invest in DeVry and Sears in light of the investment advisors’ public disclosures concerning their beneficial ownership of significant holdings in those companies.  That theory was based entirely on “unconstrained speculation about the knowledge and intent of [the] clients,” however, and risked imposing liability on clients who were unaware of the advisors’ disclosure statements or what securities were held in other clients’ accounts.[13]  As Judge Parker memorably wrote, the Second Circuit would not “hold a retiree on the beach in Florida liable when he fails to conduct an ongoing analysis of his IRA manager’s trading in other clients’ accounts.”[14]  Nor would it impose liability on the theory that the clients became members of an insider group by dint of the investment advisors’ appointing directors to the boards of Sears and DeVry because most clients were likely also unaware of that fact and, “even if some clients were so aware, there is no indication that they agreed” to such appointments.[15] In addition to its textual analysis, the Second Circuit analyzed the purpose of the group designation, which was “designed to ‘prevent a group of persons who seek to pool their . . . interests in the securities of an issuer from evading the provisions of the [short-swing profit rule] because no one individual owns more than 10 percent of the securities.”[16]  In rejecting several policy arguments advanced by Rubenstein, the Second Circuit held that the short-swing profit rule’s strict liability provisions required the exercise of “caution[] against exceeding [its] ‘narrowly drawn limits’” while noting it was not offering “a safe harbor to investment managers engaged in insider trading” that would otherwise give rise to liability under the Exchange Act’s general anti-fraud provisions.[17]  Nor was the Second Circuit concerned that its holding would undermine the requirement that the beneficial owners of more than 5% of a company’s shares file disclosure statements with the SEC[18] because investment advisors can still qualify as the beneficial owner of shares in their clients’ accounts regardless of whether or not their clients have formed a group for purposes of the short-swing profit rule.  Accordingly, firms that “purchase a sufficient quantity of a security in their clients’ managed accounts will become subject to [the] disclosure requirement even if they do not form an insider group with their clients.”[19] Conclusion It is fitting that the novel group theory of liability advanced in Rofam and International Advisers would first be addressed by the Second Circuit.  In light of its jurisdiction over Wall Street and its long-recognized role as the “‘Mother Court’ of securities law,”[20] the Second Circuit’s determination that clients of an investment advisor are not necessarily a “group” for purposes of the short-swing profit rule will likely be given significant weight by other courts who will inevitably face similar arguments in the future.  We will continue to monitor this developing area of the law, however, as only time will tell whether other jurisdictions will find the Second Circuit’s reasoning persuasive. _____________________    [1]   No. 19-560, --- F.3d --- (2d Cir. May 20, 2020) (hereinafter “Int’l Value”).    [2]   No. 19-796, --- F. App’x --- (2d Cir. May 20, 2020) (hereinafter “Rofam”).    [3]   See, e.g., Greenfield v. Criterion Capital Mgmt. LLC, No. 15 Civ. 3583, 2017 WL 2720208 (N.D. Cal. June 23, 2017); Brian B. Sand & Zachary B. Sand Joint Trust v. Biotechnology Value Fund, L.P., No. 16 Civ. 1313, 2017 WL 3142110 (N.D. Cal. July 25, 2017).    [4]   15 U.S.C. § 78p(b).    [5]   Int’l Value, 2020 WL 2549507 at *1; see also id. at *1 n.1 (explaining the “somewhat involved” statutory definition of beneficial ownership).    [6]   15 U.S.C. § 78m(d)(3).    [7]   17 C.F.R. § 240.13d-5(b)(1).    [8]   See 17 C.F.R. § 240.16a-1(a)(3).    [9]   Int’l Value, 2020 WL 2549507 at *4. [10]   Id. at *3 (emphasis added). [11]   Rofam, 2020 WL 2551039 at *1. [12]   Int’l Value, 2020 WL 2549507 at *4 [13]   Rofam, 2020 WL 2551039 at *2. [14]   Int’l Value, 2020 WL 2549507 at *7 [15]   Id. [16]   Id.  at *4 (quoting H.R. Rep. No. 90-1711 (1968)). [17]   Id. (quoting Gollust v. Mendell, 501 U.S. 115, 122 (1991)). [18]   See 15 U.S.C. § 78m(d). [19]   Id. at *5. [20]   Morrison v. Nat’l Australia Bank Ltd., 561 U.S. 247, 276 (2010) (Stevens, J., concurring) (quoting Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723, 762 (1975)).
Gibson Dunn’s lawyers are available to assist with any questions you may have regarding these developments. For additional information, please feel free to contact the Gibson Dunn lawyer with whom you usually work, any member of the firm’s Securities Enforcement Group, or the following authors: Reed Brodsky - New York (+1 212-351-5334, rbrodsky@gibsondunn.com) Akiva Shapiro - New York (+1 212-351-3830, ashapiro@gibsondunn.com) Michael Nadler - New York (+1 212-351-2306, mnadler@gibsondunn.com) © 2020 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

May 13, 2020 |
A Glimpse Behind the Curtain: Insights to SEC Enforcement During the Pandemic and Tips for Mitigating Investigative Risk

Click for PDF In a speech on May 12, 2020, Steven Peikin, Co-Director of the U.S. Securities and Exchange Commission’s Division of Enforcement, provided insights on the Division’s enforcement priorities in light of the pandemic, as well as how the Division is managing the investigative process under remote work conditions.[1]  The remarks provide helpful guidance on how companies and financial institutions can mitigate risk of investigative scrutiny for financial shocks resulting from the pandemic. In response to the pandemic, the Enforcement Division has formed a Coronavirus Steering Committee, comprised of leadership from the Home and Regional Offices, the specialized units and the Office of Market Intelligence, to identify areas of potential misconduct and coordinate the Division’s response to COVID-19 related issues.  The below areas of regulatory focus provide a helpful roadmap for companies and financial institutions, and reinforce the guidance we provided in our prior alert, to reduce the risk of drawing scrutiny.

  • Insider Trading and Market Manipulation: The rapid and dramatic impact of the pandemic on the financial performance of companies increases the potential for trading that could be perceived as attributable to material non-public information.  The Steering Committee is working with the Division’s Market Abuse Unit to monitor announcements in industries particularly impacted by COVID-19 and to identify potentially suspicious market movements.
  • Accounting Fraud: As with other financial crises, the pandemic is likely to expose previously undisclosed financial reporting issues, as well as give rise to rapidly evolving financial reporting and disclosure challenges.  The Steering Committee is on the lookout for indications of potential disclosure and reporting misconduct.  In particular, the Steering Committee is reviewing public filings with an eye toward disclosures that appear out of step to companies in similar industries.  The Committee is also looking for  accounting that attempts to inaccurately characterize preexisting financial statement issues as coronavirus related.
  • Asset Management: Asset managers confront unique challenges created by the pandemic, including with respect to valuations, liquidity, disclosures, and the management of potential conflicts among clients and between clients and the manager.  The Steering Committee is working with the Division’s Asset Management Unit to monitor these issues, including failures to honor redemption requests, which could reveal other underlying asset management issues.
  • Complex Financial Instruments: As with prior financial crises, the pandemic may reveal risks inherent in various structured investment products.  The Steering Committee is working with the Division’s Complex Financial Instruments Unit to monitor complex structured products and the marketing of those products to investors.
  • Microcap Fraud: The Steering Committee is working with the Division’s Microcap Fraud Task Force and Office of Market Intelligence, and has suspended trading in the securities of over 30 issuers relating to allegedly false or misleading claims related to the coronavirus.
As we discussed in our prior alert, by understanding the issues that can give rise to regulatory scrutiny, and consulting with counsel on how to navigate the unique challenges, issuers and financial institutions can both lower the risk of being in a regulatory spotlight, as well as resolve regulatory inquiries more efficiently. Speaking more broadly on the Enforcement Division’s process during the pandemic, Peikin noted that the Division staff continues to remain engaged despite the new challenges of a remote work environment.  The Division staff has been directed to work with defense counsel and others to reach reasonable accommodations concerning document production, testimony, interviews and counsel meetings, given the challenges of the pandemic, but also cautioned that the staff will need to protect potential claims and won’t agree to an indefinite hiatus in investigations or litigations.  In particular, Peikin noted that in instances where defense counsel would not agree to tolling agreements, the Division will consider recommending that the Commission commence an enforcement action, despite an incomplete investigative record, and will rely on civil discovery to further support its claims. Predictably, the pandemic has already led to a marked increase in Enforcement investigations and whistleblower tips.  Since mid-March, the Division has opened hundreds of new investigations concerning issues related both to COVID-19 as well as traditional areas of investigation.  In addition, the Division has triaged more than 4,000 whistleblower tips since mid-March, a 35% increase over the same period last year.  Since March 23, the Commission has granted nine whistleblower awards, including one for over $27 million (though these awards were clearly in the pipeline long before the pandemic).  Nevertheless, the notable increase in whistleblower complaints further reinforces the guidance in our prior alert on how companies can manage the heightened risks of whistleblowers resulting from the pandemic. In sum, Peikin noted that while there is uncertainty ahead, the Enforcement Division expects the pandemic will result in increased enforcement activity as the market decline and volatility will lead to investigations of potential past misconduct as well as potential new misconduct. ____________________ [1]   See May 12, 2020 Keynote Address: Securities Forum West 2020, available at https://www.sec.gov/news/speech/keynote-securities-enforcement-forum-west-2020.
Gibson Dunn lawyers regularly counsel clients on the issues raised by this pandemic.  For additional information, please contact any member of the firm’s Coronavirus (COVID-19) Response Team, the Gibson Dunn lawyer with whom you usually work in the firm’s Securities Enforcement Practice Group, or the following authors: Mark K. Schonfeld – New York (+1 212-351-2433, mschonfeld@gibsondunn.com) Tina Samanta – New York (+1 212-351-2469, tsamanta@gibsondunn.com)   © 2020 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

May 12, 2020 |
How Biz Development Cos. Can Mitigate Regulatory Risks

New York partner Mark Schonfeld, of counsel Gregory Merz and associate Chris Hamilton are the authors of "How Biz Development Cos. Can Mitigate Regulatory Risks," [PDF] published by Law360 on May 11, 2020.

April 30, 2020 |
Operating Partners and/or Captive Consultants: Recent SEC Action and Six Takeaways

Click for PDF On April 22, 2020, the U.S. Securities and Exchange Commission (the “Commission”) issued a settled order finding that a middle-market private equity fund adviser failed to adequately disclose that costs relating to an internal “Operations Group” would be charged to the portfolio companies of the adviser’s fund.  In addition to finding a violation of Section 206(2) of the Investment Advisers Act of 1940, as amended (the “Advisers Act”), the negligence-based anti-fraud provision, the adviser agreed to pay disgorgement of $1.7 million and a civil penalty of $200,000.[1] The order states that, although the applicable fund documents described certain fees that would be charged to portfolio companies, including “monitoring fees” and “consulting fees,” the documents failed to discuss any operations group costs or describe with any specificity any other relevant fees that would be charged by the adviser to the portfolio companies of the fund and not be subject to management fee offset.  Furthermore, the Commission found to be inadequate language that was subsequently added to the adviser’s Form ADV disclosure brochure describing potential costs relating to adviser personnel that “may”[2] be charged to portfolio companies of the fund.  The order is consistent with prior settlement orders where the Commission found disclosures inadequate for costs relating to in-house services[3] and captive consulting groups.[4] Operating partner arrangements come in a variety of forms, and it is important to distinguish captive consulting groups from other arrangements.  The recent order describes the operating partners as an “in-house ‘Operations Group’” and provides other facts that distinguish it from many third-party consultant arrangements, including that it was held out to investors as being in-house, that it serviced the adviser’s entire portfolio and that it charged fees designed to cover costs.[5]  While the order does not address third-party consultant arrangements, by including such distinguishing facts in its order the Commission suggests that those facts are relevant to its evaluation of the adequacy of disclosure.  While third-party consultant arrangements may receive somewhat less scrutiny, even those types of arrangements  can present meaningful conflicts or other issues that merit specific disclosure.[6] Given the Commission’s focus on operating partners and the variety of conflicts presented by operating partners, we encourage clients to discuss with counsel and consider the following general takeaways.

  1. Determine if the operating partners will be viewed as third-party consultants or as an in-house, captive consulting group. Ensuring independence and limiting the use of operating partners may be appropriate depending on disclosure and other factors and may reduce regulatory risk.
  2. Ensure that disclosure is adequate in view of the arrangement (specifically evaluating what costs are disclosed and can be fairly charged to funds and portfolio companies) and consider if periodic reporting of costs to investors is sufficiently comprehensive. Broad disclosures such as references to “monitoring fees” or “consulting fees” may be viewed as inadequate by the Commission.  In particular, the more “captive” the operating partners arrangement is, the more extensive and specific the disclosure regarding the arrangement should be.
  3. Consider what compliance controls are appropriate given the arrangement. Even if the operating partners are not “supervised persons” of the adviser under the Advisers Act, it may be appropriate to subject them to certain compliance controls consistent with an adviser’s responsibility to prevent the misuse of material, nonpublic information.
  4. Evaluate broker-dealer registration issues, if the arrangement includes the potential for transaction-based compensation.
  5. Generally consider other conflicts and issues presented by the arrangement and how they should be addressed (disclosure, consent, additional controls).
  6. Where costs of internal operating partners are allocated among portfolio companies or between portfolio companies and the adviser, it is important to maintain contemporaneous documentation to support the allocations.
_____________________ [1]  Monomoy Capital Management, L.P., Administrative Order No. 3-19764, the U.S. Securities and Exchange Commission (April 22, 2020) available at https://www.sec.gov/litigation/admin/2020/ia-5485.pdf. [2]  Notably, the Commission has expressed its dislike of the use of “may” in certain disclosures relating to conflicts of interest.  See Commission Interpretation Regarding Standard of Conduct for Investment Advisers, the U.S. Securities and Exchange Commission (July 12, 2019), available at https://www.sec.gov/rules/interp/2019/ia-5248.pdf (“Similarly, disclosure that an adviser ‘may’ have a particular conflict, without more, is not adequate when the conflict actually exists.”). [3]  In 2015, the Commission found that an adviser violated Section 206(2) of the Advisers Act for failing to adequately disclose costs relating to legal and compliance services provided by in-house personnel charged by the adviser.  See Cherokee Investment Partners, LLC and Cherokee Advisers, LLC, Administrative Order No. 3-16945, the U.S. Securities and Exchange Commission (November 5 2015) available at  https://www.sec.gov/litigation/admin/2015/ia-4258.pdf. [4]  In 2018, the Commission announced settlement with an adviser concerning the way in which it allocated compensation-related expenses for employees of an internal operating partner group.  See NB Alternatives Advisers LLC, Administrative Order No. 3-18935, the U.S. Securities and Exchange Commission (December 17, 2018) available at https://www.sec.gov/litigation/admin/2018/ia-5079.pdf. [5]  The order cites the following statements from the adviser’s advertising materials: “an extensive in-house operational and financial restructuring team that drives business improvement throughout the [adviser’s] portfolio.” “The operations team is led by two operating partners…. The operating partners currently supervise a team of five portfolio company employees and 12 contractors who lead business improvement and lean manufacturing programs throughout the [adviser’s] portfolio.” [6]  On December 13, 2018, the Commissioner announced a settlement with an adviser for its failure to disclose certain in-house employee costs and arrangements with third-party consultants that gave rise to actual or potential conflicts of interest.  Notably, the arrangement with the third-party consultant included a personal loan between the consultant and a senior person at the adviser.  See Yucaipa Master Manager, LLC, Administrative Order No. 3-18930, the U.S. Securities and Exchange Commission (December 113, 2018) available at https://www.sec.gov/litigation/admin/2018/ia-5074.pdf.
Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments.  Please contact the Gibson Dunn lawyer with whom you usually work, any member of the firm’s Investment Funds or Securities Enforcement practice groups, or the following authors: Mark K. Schonfeld - New York (+1 212-351-2433, mschonfeld@gibsondunn.com) Y. Shukie Grossman - New York (+1 212-351-2369, sgrossman@gibsondunn.com) C. William Thomas, Jr. - Washington, D.C. (+1 202-887-3735, wthomas@gibsondunn.com) Gregory Merz - Washington, D.C. (+1 202-887-3637, gmerz@gibsondunn.com) Chris Hamilton - New York (+1 212-351-2495, chamilton@gibsondunn.com) Dan Li - New York (+1 212-351-6310, dli@gibsondunn.com) © 2020 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

March 26, 2020 |
SEC Enforcement Focus on Fallout from COVID-19: Insights for Public Companies and Investment Advisers During a Crisis

Click for PDF In a warning of things to come, the co-directors of the SEC Enforcement Division took the unusual step of issuing a cautionary statement on March 24, 2020, emphasizing “the importance of maintaining market integrity and following corporate controls and procedures” during this crisis. The SEC cited as examples the heightened risk of insider trading (“in these dynamic circumstances, corporate insiders are regularly learning new material nonpublic information that may hold an even greater value than under normal circumstances”) and the need to be mindful of disclosure controls (“protect against the improper dissemination and use of material nonpublic information”).[1] History teaches us that unprecedented market volatility, fast moving economic events, and dislocations create substantial challenges for compliance, and that there is a significant increase in the risk of an investigation. Today, this heightened investigative risk is compounded by unique challenges of remote work arrangements and the diminished ability for direct oversight and interaction. In an effort to help our clients navigate the latest enforcement challenges, we have compiled below a list of potential issues to be considered in the coming weeks in light of the SEC Enforcement Division’s notice and past experience on how the SEC has investigated matters in the midst of and following a crisis.

General Guidance

  1. Businesses should be prepared to operate under these conditions for at least the next three-to-six months.
  2. Businesses should maintain centralized communications with employees, clients, and investors, ensuring that even in the face of rapidly moving events that such communications are accurate and complete. Once statements are made, updates and modifications may become appropriate.
  3. Given the compliance and operational challenges of supervising employees and service providers remotely, it is helpful to have a plan in place for such supervision.
Business Continuity and Disaster Recovery Plans Firms should follow, and modify as necessary, their business continuity and disaster recovery plans. During and after past crises, the SEC’s Office of Compliance Inspections and Examinations, FINRA, and the CFTC have jointly and separately reviewed the business continuity and disaster recovery planning of firms, especially in the event of a problem experienced during the crisis. Material Contracts It is important to review material contracts to understand what would happen if your business or a counterparty cannot perform due to the current crisis. In particular, we recommend focusing on the (i) default, (ii) force majeure, (iii) termination and (iv) indemnification provisions in material contracts. For more information, see our alerts: Force Majeure Clauses: A 4-Step Checklist and Flowchart[2] and Coronavirus and Force Majeure: Addressing Epidemics in LNG and Other Commodities Contracts.[3] Regulatory Disclosures As always, consider if the current crisis has materially affected your business and if, when and how those events may need to be disclosed and if any recent statements need to be updated. There is an enhanced investigative risk that regulators will in hindsight review a business’ public statements and disclosures to determine whether a firm intentionally and materially overstated, understated, failed to correct prior statements, and/or made misleading or incomplete statements, in light of crisis-related events

Public Company Considerations

Fair Disclosure, Regulation FD Pursuant to Regulation Fair Disclosure (“Regulation FD”), in general, issuers cannot selectively disclose material, nonpublic information to stock analysts, investment advisors, security holders, or other market participants, and must disclose such information to that audience by means of simultaneous broad public dissemination.[4] Given that this crisis may have a short-term, material impact on an issuer’s finances and business operations, among other things, it is important to make sure that the process of communicating these developments with shareholders, analysts, media and other stakeholders is consistent with public disclosures and monitored with Regulation FD in mind. Sensitivity to the requirements of Regulation FD is critical in light of the extreme market volatility and the desire of market participants for information during the current COVID-19 crisis. Insider Trading and Trading Windows Public issuers should evaluate and potentially modify established trading windows during this crisis as rapidly evolving materials events may render historical trading windows inadequate. For example, during the exigency of evolving events, material nonpublic information may quickly arise outside of the traditional blackout periods, requiring the imposition of immediate restrictions on trading for certain groups of employees, executives and directors. Moreover, media reporting on notable stock sales by corporate executives heightens the exposure to regulatory inquiry. In limited instances, blackout periods might be shortened if it is in the best interests of the company and its shareholders to enable trading, and there is no material, nonpublic information due to uncertainty around how the situation is affecting the company; however, during a crisis such as this, care should be taken not to improperly restrict the communication of material information, particularly to directors and others that may need to know such information in order to perform their duties. Any changes to blackout periods must be based on the specific facts and circumstances, and should be communicated in writing with appropriate guidelines. As a general matter, public companies should exercise care in allowing corporate insiders to trade in its securities (both buying and selling) during the current crisis. 10b5-1 Plans Pursuant to Rule 10b5-1, corporate insiders frequently set up passive investment plans at a time when they do not have material, nonpublic information, in order to provide a mechanism to purchase and sell securities of their company when they have material, nonpublic information.[5] In a time of crisis, there is risk that any changes to such plans which continue to involve trading in the issuer’s securities will be scrutinized carefully by regulators, the media, and others as to whether they were made while in possession of material, nonpublic information about the effect of the crisis on the relevant issuer and to take advantage of such knowledge. Terminating a Rule 10b5-1 plan so as to cease any trading of securities in this time of crisis does not in and of itself violate the insider trading laws, and there may be very good reasons to do so. While the extraordinary changes in the markets and economy resulting from the COVID-19 situation may provide a basis for defending past transactions under a Rule 10b5-1 plan as having been made in good faith, terminating a Rule 10b5-1 plan may bear on the timing of any future decision to set up a new plan. Before making any changes to and/or stopping such a plan, corporate insiders and companies should consult their general counsel’s office and consider the best practices under the circumstances. Investment Adviser Considerations Insider Trading During a crisis, reminding investment professionals about the policies and procedures to prevent insider trading is critically important. There is a heightened investigative risk that communications with management and investor relations, which are a standard and proper part of an investment professional’s analyses of companies, regarding COVID-19 will be reviewed, in hindsight, for any disclosures of material, nonpublic information. There is also a heightened investigative risk that communications with political experts, members of federal and state executive branches and their agencies, and the staff of public representatives regarding ongoing executive and legislative actions, and the application of new laws and regulations, will be reviewed, in hindsight, for any disclosures of material, nonpublic information in violation of a fiduciary and/or other duty of confidentiality. Finally, there is a heightened investigative risk that communications with other asset managers regarding their analyses of the impact of COVID-19, which include communications, directly or indirectly, with management, investor relations, political experts, members of the executive branch, and staffs of public representatives, will be evaluated, in hindsight for any disclosures of material, nonpublic information. Investment Strategy Changes Certain investment strategies may be materially impaired by this current crisis or advisers may find unique opportunities outside of their traditional strategies. Under such circumstances, it is important to, among other things, review the documents governing the strategies to identify what changes fall within and outside such strategies, and what steps, if any, should be taken to make modifications to those strategies. Unique Opportunity Allocations Given market volatility during a crisis, unique investment opportunities may arise. Investment advisers may have to consider how to allocate unique opportunities amongst their funds, accounts and potential co-investors. As always, an adviser’s personnel will need to follow the adviser’s policies and procedures designed to ensure that they do not personally take investment opportunities away from funds and accounts managed by the adviser. Form ADV/Form PF Limited Relief For investment advisers, limited SEC relief for Form ADV/Form PF filing deadlines is available for those advisers experiencing crisis-related issues. Updated SEC guidance issued on March 25, 2020, provided that advisers “must notify the [SEC] staff and/or investors, as applicable, of the intent to rely on [such] relief, but generally no longer need to describe why they are relying on the order or estimate a date by which the required action will occur.” We nonetheless encourage advisers to file timely unless they are experiencing serious crisis-related issues, and to the extent an adviser must seek deadline relief, internally document reasons for failing to timely file.[6] Custody Rule Relief The SEC has not yet granted specific relief to the audited financial statement delivery requirement under the Rule 206(4)-2,[7] and advisers should try to meet their delivery requirements. Notably, in March 2010, an SEC Division of Investment Management FAQ stated that it would not recommend enforcement if an adviser “reasonably believed that the pool's audited financial statements would be distributed within the 120-day deadline, but failed to have them distributed in time under certain unforeseeable circumstances.”[8] It is not clear whether the Staff would consider this interpretive guidance to apply to a failure to deliver financial statements on time due to disruptions relating to COVID-19. Nevertheless, in the absence of relief related to the specific crisis, the Staff might be less inclined to bring an action against advisers making reasonable efforts to comply with the delivery requirement. Investor Communications Approaches will vary, but consider proactively advising investors of the steps you are taking to maintain operations and whom to contact with questions or concerns. Performance and investment risk discussions should include discussions of the impact this current crisis may have on investments. Under any approach, advisers should continue to maintain records of communications with investors and other stakeholders, together with any secondary support for information distributed. For funds raising capital or that permit redemptions, updates to offering materials may be appropriate. Selective disclosure to investors should be avoided. Valuation Throughout this crisis, advisers should continue to follow their valuation policies, and this could be a good time to remind relevant personnel of the details of such policies. While following existing policies is important, personnel should consider reassessing valuation assumptions and methodologies in consideration of the current environment. Decisions about changes to valuations relating to distressed asset sales should be made in consultation with experts and compliance.[9] Finally, we recommend taking additional time for the valuation process (i.e., starting earlier) and potentially conducting valuations more frequently. Liquidity Management Certain open-ended funds may experience a high volume of requests for redemptions, and advisers may have challenges in satisfying all requests in a timely fashion. An adviser facing this type of risk should carefully assess options under the applicable fund or account documents, including the possibility of imposing redemption gates, side pockets or suspensions. Implementing these types of measures may draw regulatory scrutiny in retrospect, and should be handled with care. If an adviser intends to seek liquidity through a related party transaction or a forced sale, the adviser should carefully consider the legal and regulatory issues that can be raised by these actions. Side Letter and Strategic Partnership Obligations Side letters or strategic partnership agreements may have notice or redemption rights that are implicated by the current crisis, and should be reviewed carefully. Crisis-Related Fund Expenses As with other expense allocation decisions, prior to allocating crisis-related expenses between funds or between a fund and an adviser, carefully consider the language in the operative fund documents. Record-Keeping After major market events in the past, the SEC has conducted sweep examinations seeking to understand how investment advisers respond to financial and operational challenges. Each adviser should maintain appropriate contemporaneous records that document how it assessed and responded to the financial and operational challenges posed by the current crisis for business continuity and to assist with responding to potential regulatory scrutiny. __________________
  1. Public Statement, “Statement from Stephanie Avakian and Steven Peikin, Co-Directors of the SEC’s Division of Enforcement, Regarding Market Integrity” (March 23, 2020), available at, https://www.sec.gov/news/public-statement/statement-enforcement-co-directors-market-integrity
  2. Force Majeure Clauses: A 4-Step Checklist & Flowchart, Gibson, Dunn & Crutcher LLP (March 24, 2020) https://www.gibsondunn.com/wp-content/uploads/2020/03/force-majeure-clauses-a-4-step-checklist-and-flowchart.pdf.
  3. Coronavirus and Force Majeure: Addressing Epidemics in LNG and Other Commodities Contracts, Dunn & Crutcher LLP (February 14, 2020), available at, https://www.gibsondunn.com/coronavirus-and-force-majeure-addressing-epidemics-in-lng-and-other-commodities-contracts/.
  4. 17 CFR § Part 243 - Regulation FD, available at, https://www.govinfo.gov/content/pkg/CFR-2012-title17-vol3/pdf/CFR-2012-title17-vol3-part243.pdf.
  5. 17 CFR § 240.10b5-1 Trading “on the basis of” material nonpublic information in insider trading cases, available at, https://www.govinfo.gov/content/pkg/CFR-2013-title17-vol3/pdf/CFR-2013-title17-vol3-sec240-10b-3.pdf.
  6. Press Release, U.S. Securities and Exchange Commission, Division of Investment Management, “SEC Takes Targeted Action to Assist Funds and Advisers, Permits Virtual Board Meetings and Provides Conditional Relief from Certain Filing Procedures” (March 13, 2020), available at, https://www.sec.gov/news/press-release/2020-63; Press Release, U.S. Securities and Exchange Commission, Division of Investment Management, “SEC Extends Conditional Exemptions From Reporting and Proxy Delivery Requirements for Public Companies, Funds, and Investment Advisers Affected By Coronavirus Disease 2019 (COVID-19)” (March 25, 2020), available at, https://www.sec.gov/news/press-release/2020-73.
  7. 17 CFR § 275.206(4)-2 - Custody of funds or securities of clients by investment advisers, available at, https://www.govinfo.gov/content/pkg/CFR-2011-title17-vol3/pdf/CFR-2011-title17-vol3-sec275-2064-2.pdf.
  8. Staff Responses to Questions About the Custody Rule, U.S. Securities and Exchange Commission, Division of Investment Management (March 2010), available at, https://www.sec.gov/divisions/investment/custody_faq_030510.htm.
  9. See Accounting Standards Update No. 2011-04 (May 2011), available at, https://asc.fasb.org/imageRoot/00/7534500.pdf.

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March 20, 2020 |
Delaware Supreme Court Unanimously Upholds Federal-Forum Provisions

Click for PDF In Salzberg, et al. v. Sciabacucchi (“Blue Apron II”),[1] a unanimous Delaware Supreme Court, with Justice Valihura writing, confirmed the facial validity of federal-forum provisions (“FFPs”)—provisions Delaware corporations adopt in their certificates of incorporation requiring actions arising under the Securities Act of 1933 (the “1933 Act”) to be filed exclusively in federal court. The Court’s decision emphasizes the “broadly enabling” scope of both the Delaware General Corporation Law (“DGCL”) as a whole, and of Section 102(b)(1),[2] which governs the contents of a corporation’s certificate of incorporation, in particular. Rejecting facial challenges to FFPs adopted by Delaware corporations in connection with several recent IPOs, the Court held that Section 102(b)(1) authorizes corporations to adopt provisions regulating matters within an “outer band” of “intra-corporate affairs” extending beyond the “universe of internal affairs” of a Delaware corporation. In this regard, Blue Apron II may offer Delaware corporations, their boards and advisors a valuable new tool for managing complex, multidistrict litigation related to their corporate governance. Blue Apron I and the Established Scope of “Internal Corporate Claims” Blue Apron II reversed, on de novo review, the December 2018 decision of the Delaware Court of Chancery in Sciabacucchi v. Salzberg, et al. (“Blue Apron I”).[3] In Blue Apron I, a stockholder in each of Blue Apron, Inc., Roku Inc., and Stitch Fix, Inc. sought a declaratory judgment that FFPs adopted in each corporation’s certificate of incorporation in connection with their 2017 IPOs were facially invalid as a matter of Delaware law. As detailed by Vice Chancellor Laster, the basic principles underlying the holding in Blue Apron I were developed in Boilermakers,[4] ATP Tour,[5] and DGCL § 115,[6] each of which addressed bylaws for disputes involving Delaware corporations. Relying upon these authorities, the Blue Apron I court held that, despite the broad scope of DGCL § 102(b)(1), the FFPs could not validly restrict a stockholder plaintiff’s choice of forum for actions arising under the 1933 Act because such claims were “external” to the corporations at issue based upon their similarity to “a tort or contract claim brought by a third-party plaintiff who was not a stockholder at the time the claim arose.” The Court of Chancery also concluded that Section 115 implicitly narrowed Section 102(b)(1) to restrict the authority of Delaware corporations to regulating only “internal corporate claims.” Additionally, the trial court also noted, but did not reach, an argument that FFPs are invalid as a matter of public policy, because they “take Delaware out of its traditional lane of corporate governance and into the federal lane of securities regulation” and could even be preempted by federal law providing forum alternatives. The New Frontier: Intra-Corporate Affairs and the “Outer Band” of Section 102(b)(1) In Blue Apron II, the Delaware Supreme Court reversed the Court of Chancery, holding that FFPs are facially valid because such provisions “could easily fall within either of the[] broad categories [of Section 102(b)(1)],” and “do not violate the laws or policies of this State” or “federal law or policy.” In doing so, the Supreme Court rejected the Court of Chancery’s conclusions that Section 115 implicitly narrowed Section 102(b)(1) and that, under Boilermakers and ATP Tour, “everything other than an ‘internal affairs’ claim was ‘external’ and, therefore, not the proper subject of a bylaw.” Instead of such a “binary world,” the Supreme Court held that claims involving “intra-corporate affairs” under Section 102(b)(1), such as the federal antitrust claims underlying the fee-shifting bylaws in ATP Tour and certain 1933 Act claims considered hypothetically by the Court in Blue Apron II, sit on a “continuum” of corporate affairs. At one end of the spectrum is “the more traditional realm of ‘internal affairs,’” including “matters peculiar to the relationships among or between the corporation and its current officers, directors, and shareholders.” At the other end are “purely ‘external’ claims,” such as tort claims and commercial contract claims.  According to the Supreme Court, the scope of matters that certificates of incorporation may properly regulate under Section 102(b)(1) falls between those poles, as it set forth in Figure 1, below. The “outer band” of Section 102(b)(1), the Court explained, extends to all “[i]ntra-corporate affairs,” which is a “universe of matters” that “is greater than the universe of internal affairs matters.” This includes FFPs “regulating the fora for Section 11 claims involving at least existing stockholders [because such claims] are neither ‘external’ nor ‘internal affairs’ claims.” Figure 1: Textual Analysis of Corporate Affairs Notwithstanding the Supreme Court’s holding that federal-forum provisions are facially valid, the Court acknowledged that the extent to which such provisions will be respected and enforced going forward by Delaware courts, and, even more critically, by other state and federal courts, will depend in large part on the unique facts and circumstances of each case. Key Takeaways Blue Apron II provides valuable guidance to Delaware litigators and board advisors on best practices for adopting FFPs and other provisions governing the procedural aspects of intra-corporate litigation pursuant to Section 102(b)(1) of the DGCL:

  • In the wake of this development, Delaware corporations that have not done so already may amend their charters to require claims under the 1933 Act to be filed in federal court.[7] After Cyan was decided in 2018, the filing of 1933 Act claims in state courts increased significantly.[8] Given that such claims cannot be removed to federal court under Cyan, corporations have increasingly been mired in unnecessarily costly, and sometimes duplicative, state and federal court litigation throughout the country.
  • The Supreme Court in Blue Apron II quells “concern that if [FFPs were] upheld, the ‘next move’ might be forum provisions that require arbitration of internal corporate claims,” explicitly reasoning that “[s]uch provisions, at least from [Delaware] state law perspective, would violate Section 115 . . . .” But it is not yet clear whether practitioners will continue to push to include arbitration as an exclusive means to resolve certain intra-corporate disputes lying within the “outer bound” of Section 102(b)(1).
  • Although Delaware law prohibits Delaware corporations from adopting mandatory arbitration provisions in their certificates of incorporation or bylaws, it remains to be seen whether other states will follow suit. States competing for Delaware’s franchise might attempt to attract corporations by authorizing such arbitration provisions to minimize the burden and cost of litigation.
  • FFPs clearly benefit stockholders by minimizing wasteful multi-jurisdictional litigation over many disputes involving the corporations they own. Nonetheless, corporate directors and officers should anticipate that some stockholders may be wary of the provisions, including broader FFPs adopted or approved under Blue Apron II. This decision should serve as a reminder that corporations may be well advised to engage with key stockholders to discuss the benefits these provisions provide before their adoption.
____________________       [1]     Salzberg, et al. v. Sciabacucchi, No. 346, 2019 (Del. Mar. 18, 2020) [hereinafter “Blue Apron II”)].       [2]    8 Del. C. § 102(b)(1) (“[T]he certificate of incorporation may also contain . . . [a]ny provision for the management of the business and for the conduct of the affairs of the corporation , and any provision creating, defining, limiting and regulating the powers of the corporation, the directors, and the stockholders . . . .”).       [3]   Sciabacucchi v. Salzberg, et al., 2018 WL 6719718 (Del. Ch. Dec. 19, 2018) [hereinafter “Blue Apron I”].       [4]   Boilermakers Local 154 Retirement Fund v. Chevron, 73 A.3d 934, 942, 952 (Del. Ch. 2013).       [5]    ATP Tour, Inc. v. Deutscher Tennis Bund, 91 A.3d 554 (Del. 2014).       [6]   8 Del. C. § 115 (“‘Internal corporate claims’ means claims, including claims in the right of the corporation, (i) that are based upon a violation of a duty by a current or former director or officer or stockholder in such capacity, or (ii) as to which this title confers jurisdiction upon the Court of Chancery.”).       [7]   Blue Apron II does not address the applicability of an FFP to claims arising under the Securities Exchange Act of 1934 (the “1934 Act”), which unlike the 1933 Act vests exclusive jurisdiction with federal courts and does not include a bar to removing claims improperly filed in state court.  Compare 15 U.S.C. 78aa(a) (1934 Act), with 15 U.S.C. 77v (1933 Act).       [8]   Stanford L. Sch. Sec. Class Action Clearinghouse & Cornerstone Research, Sec. Class Action Filings 2019 Year in Review 4 (2020).
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