Securities Compliance Sentinel - Analysis of Cutting Edge Securities Industry Issues

One of the more anticipated and debated outgrowths of the Dodd-Frank Act was the designation of a self-regulatory organization responsible for investment advisers.  Yet, it has recently been reported that this issue is dead for the current Congressional session, although likely to come back again.

The only consensus thus far is that the SEC is ill-equipped to be the SRO.  The primary disagreement has focused on who should be the SRO for investment advisers: a new entity, FINRA or an enhanced SEC funded by user fees.

Regardless of the outcome of the Presidential election, this issue is likely to percolate once again in the next Congressional session.  The SEC is clearly not currently constituted to serve in the capacity as the SRO and, at the same time, there is a push for investment advisers to be subject to better oversight.

In the short-run, this means that investment advisers will still be subject to SEC examinations, which historically have resulted in very few examinations on a yearly basis relative to the number of investment advisers.  In the long-run, the debate will continue and it is likely that, at some point, there will be an SRO for investment advisers.  The most like SRO would, in my view, be an enhanced SEC as it already serves in an oversight role over investment advisers.  The question becomes whether any of us will be alive to see this happen.

Apparently, despite the Inspector General change, the SEC continues to be beset by problems with its internal operations that its Inspector General has recently pointed out.  The OIG has detailed in several reports problems relating to privacy violations as well as building security issues, among other areas.  Additionally, the OIG has indicated that it will be releasing several other reports in the near future.  What other tales will be told???!!!! 

Essentially, it is probably a safe assumption that the SEC will never be “perfect.”

Apparently, despite requiring public companies and regulated entities to prepare for business disruptions, the SEC's house does not seem to be in order.

In a recent report, the SEC was criticized for not having a comprehensive business disruption program, and allowing certain important activities to be at risk if there was a business disruption.  For example, the SEC had not yet updated its supplemental plans or provided that the certain network data was protected.  The critical report announced 38 recommendations that SEC should consider implementing.  To its credit, the SEC has agreed to implement them.   

Obviously, the SEC should clean its own house and ensure that it will continue to monitor the markets in case of a major business disruption. 

Yogi Berra's famous quote seems like it was written for SEC Enforcement Division Director Robert Khuzami, and what has become his all too frequent outcry regarding lawyers who practice before the SEC.  He claims that attorney misconduct is occurring frequently enough that he has to raise these issues once again.  Khuzami claims that problematic attorney misconduct includes: multiple representation in a single case; delayed document production until the eleventh hour of a case; internal investigations that are more advocacy than investigation; and witness coaching. 

Khuzami noted that the SEC can address this perceived misconduct three ways: (1) the attorneys can be charged under the federal securities laws; (2) the lawyers can be referred to administrative proceedings and lose their ability to practice before the SEC; and (3) referral to the DOJ of attorneys who engage in perjury or obstruction. 

Whether the problems with lawyers are real or perceived, something has to give.  First and foremost, lawyers have rules of ethics by which they must conduct themselves.  Failure to do so could result in censure or worse from their licensing bar.  At the same time, however, those rules require lawyers to be zealous aadvocates.  The SEC has to respect zealous advocacy, and not expect that a lawyer is simply going to lead a flock of sheep to slaughter.  It is this balance between advocacy and ethics for which lawyers who practice before the SEC, not the SEC itself have to be gatekeepers.  If not, than do not be surprised if you are subject to the one of three options laid out above.

Recently, SEC Chairman, Mary Shapiro, was called to task for the high number of reported administrative proceedings by Congress.  In particular, the SEC was accused of reporting follow on administrative proceedings as if they were new actions when it announced the yearly enforcement statistics. 

Such reporting gives the indication that the SEC is bringing more cases than  theoretically possible.  Essentially, the SEC is being accused of "double-counting," bringing an injunction action and an administrative proceeding arising from the same facts.  Certain reports indicate that the SEC reported 30% of its 735 enforcement actions were merely follow on administrative proceedings to previously filed injunctive actions.  (By the way, the number of enforcement actions in 2011 was the highest ever filed by the SEC.)  Various members of Congress have questioned this practice and believe it provides a false impression.

In sum, although technically accurate, the SEC effectively is providing incomparable information.  There is little extra work necessary to bring a follow on administrative proceeding to a previously filed injunctive action, without much additional regulatory benefit.  In any event, I suppose Disraeli was correct, “there are lies, damn lies and then there are statistics.”

According to an internal SEC guidance report, the SEC is taking to heart the criticism that it does not employ enough of an economic analysis in its rule-making process.  The guidance directed the SEC to take a cost-benefit approach to all rule-making, regardless if the rules are discretionary or mandated by Congress.

This guidance report is in direct response to an earlier report that sharply criticized the SEC for not conducting the cost-benefit analysis for rules mandated by Dodd-Frank.  As part of its response, Chairman Schapiro has noted that the SEC has hired 20 economists and is asking Congress form the funding to hire an additional 20 economists.

Although the SEC should be praised for taking criticism to heart, it also reflects a bit of self-preservation.  If the SEC did not take this action, then it faced the risk of legislation that would require the cost-benefit analysis in rule-making.  Some in Congress still want to press for such a statutory mandate.  That way, there would be no room for confusion as to what is expected from the SEC. 

Regardless of why the SEC is employing a cost-benefit analysis in its rule-making, it should only be seen as a positive development.  In the absence of such an analysis, we could be faced with, for example, a uniform fiduciary duty for anyone providing investment advice regardless of its costs.  Such a result would be problematic to say the least.

Chairman Schapiro recently announced several technology enhancement initiatives that are designed to improve the SEC's enforcement efforts and business practices.  These initiatives were certainly designed to enhance the SEC's ability to monitor activity to bolster its quiver of ammunition against improper activity.

Among other things, the SEC implemented new search capabilities that permit SEC staff to conduct more intuitive and and focused searches.  This new system will also assist the SEC with identifying links between documents and disparate data.  The SEC plans to ultimately link this system with other tools, such as audio-searching technology.  This technology will allow the SEC to find relevant communications between brokers and customers without forcing the SEC to review hours and hours of audio files.  The SEC is also testing technology that allows it to graph phone lines or lines of trading data into a visual schematic, which allows the SEC to find hidden relationships. 

In other words, this developing technology will make the SEC more efficient in its surveillance capabilities.  This is born out by the fact that the SEC is already using some of this technology in its current enforcement cases.  In this day and age of tight budgets, the SEC has been forced to become leaner and meaner through the use of new and improved technologies.  We should expect that the SEC will continue to roll out enforcement cases based upon information learned through this new technology.  Just remember, the SEC is watching and listening.

The SEC's delay in adopting an uniform fiduciary duty will only be prolonged but yet another analysis that the SEC will commission.  Chairman Schapiro recently announced plans to issue a public request for information regarding "retail financial advice and the regulatory alternatives".  With respect to the adoption of the uniform fiduciary duty standard, the SEC suggested that it was still in the information gathering stage of rule-making.  Interpretation; the SEC is no closer to adopting a uniform fiduciary duty standard.  Although the SEC has not ruled rule-making for 2012, it is not likely.

The SEC has advised the House Financial Services CapitalMarkets subcommittee that it has three economists working on the initiative.  Among other things, the economists have reviewed available market information for the retail financial advice market, including the differences between broker-dealers and registered investments advisers.  Notwithstanding the work of the economists to date, the SEC noted that the rule-making associated with the uniform fiduciary duty will require an analysis of information that may not be publicly available such that it will be particularly important for the SEC to solicit the public to provide information and/or empirical data.

Of the information that the SEC will seek in its public request for information, broker-dealers should expect that some of the data sought will cover a cost-benefit analysis of whether the adoption of a uniform standard will outweigh the cost of doing so.  Although delayed, the SEC is, it appears, trying to have a full and complete analysis to ultimately justify a uniform fiduciary duty.  In light of the manner in which many courts and arbitration panels treat broker-dealers, this whole exercise could be seen as making something "official" that has already been in place for many years.  The question that remains is whether the cost to make the standard an "official" one is worth it considering the prevailing view of many that it may already exist.

In a letter to certain senators, SEC Chairman Mary Schapiro has requested new statutory power to enhance the SEC’s Enforcement program’s effectiveness. In particular, the SEC is seeking statutory upgrades in five areas.

The first new power would be to increase the SEC's ability to impose fines on individuals and entities up to $1 million per violation for individuals and $10 million per violation for entities.  Similarly, the SEC also seeks to increase the maximum Tier 3 penalty, authorizing penalties equal to three times the gross amount of pecuniary gain from a charged individual or entity.  The SEC believes this new enhancement would eliminate the current disparity between the penalty relief available in federal district court actions and SEC administrative proceedings. The third proposed change would authorize a Tier 3 penalty based upon the amount of investor losses in both civil and administrative actions, allowing the SEC to consider more directly investor harm.  Seemingly, such a change may result in uncertainty as to actual investor losses, and bring the SEC squarely down as the investors’ recovery mechanism as opposed to a regulator interested in fair, transparent and orderly markets.

The SEC also seeks a penalty enhancement whereby the penalty would be increased threefold if the defendant were to have been criminally convicted or had an order imposed against it in any SEC action alleging fraud.  Finally, the SEC requested a legislative change to authorize a civil penalty for violations of a federal injunction obtained by the SEC, in place of the SEC filing a civil contempt proceeding.

In short, the SEC believes that, by increasing penalties, it will prevent future securities violations.  However, there does not appear to be any evidence that increasing said penalties  would provide the deterrent effect the SEC seeks.

As some may have heard, on last Friday afternoon, the SEC decided to inform the world of its intention to change the settlement language in its cases.  The SEC has now determined that, if a person or entity has plead to or been found guilty of a crime, the SEC will no longer allow the party to "neither admit nor deny" the underlying factual allegations contained in a parallel SEC action as part of a settlement of that SEC action.  Of course, where there is no such criminal action, the old language will remain.

Obviously, this policy change resulted from Judge Rakoff's decision in the Citi case where he rejected the SEC proposed settlement.  Interestingly, despite Judge Rakoff's criticism and the SEC's subsequent appeal of his decision, this new policy STILL DOES NOT address Judge Rakoff's concerns because, in that case, there was no underlying criminal action against Citi!!!  In typical SEC fashion, the solution simply does not fit the problem.

The SEC's approach to this problem does not correct the serious deficiencies contained in its settlement process.  For example, despite the fact the SEC is a government agency, it is only a civil agency and has no criminal authority.  As such, the allure of an admission of "guilt" in SEC settlements truly misses the point.  It is true that federal judges almost always will not accept a guilty plea in a criminal case where the defendant refuses to acknowledge their guilt-- sometimes referred to as an Alford plea.  However, the SEC is not seeking a criminal plea in its cases.  This new policy clearly is seeking to blur the lines between the SEC's civil jurisdiction and the implications derived from criminal prosecutions.  The SEC, thus, has an obligation to not confuse its role in this process by attempting to undertake a "criminal" resolution of its civil settlements.

Additionally, the SEC'ssettlement language change does not address the significant problems with its "Obey-the-Law" injunctions.  That is, the SEC's "Obey-the-Law" injunctions do nothing more than require the person or entity subject to said injunction to follow the statute or regulation cited in the settlement.  Query:  doesn't everyone have to follow the law anyway?  The language change does not correct the overbroad character of the SEC's injunctions, or the fact the SEC, rarely-- if ever-- obtains a contempt sanction against a person or entity that may violate a previously issued SEC injunction.  Instead, the SEC, generally, obtains another injunction against that person or entity.  One wonders how changing the settlement language to obtain an admission addresses these significant structural problems with the SEC's "Obey-the-Law" injunctions or deters potential recidivists.

Further, there was nothing in the SEC's pronouncement that would indicate the SEC would be willing to compromise on other aspects of relief the SEC ordinarily seeks in these cases.  There was no mention if the SEC would forego an officer or director bar, disgorgement or civil penalties, among other relief, from a defendant in exchange for agreeing to this new language.  Does the SEC really think a person or entity is going to agree to this language change without receiving something in exchange?  We really hope the SEC is not under that belief. 

However, assuming the SEC has nothing but the purest intent and its shifting position is because it believes it may do some good in subsequent private civil lawsuits, that belief, unfortunately, is sorely misplaced.  From an evidentiary standpoint, the SEC's settlement language change will have minimal to no bearing on subsquent private civil lawsuits.  The SEC's insistence on an admission provides no added benefit for a subsequent civil plaintiff since any subsequent civil plaintiff could easily rely upon the criminal conviction without any reference to SEC activity in such a private lawsuit.

Finally, the SEC's insistence on this language change will, most likely, make SEC civil settlements less likely.  There would be no point or advantage gained by a potential defendant settling with the SEC under these terms.  The person or entity could simply ignore the SEC action, and allow the SEC to obtain a default judgment against the the person or entity.  The defendant would, therefore, have avoided admitting to any factual allegation proposed by the SEC, and, as discussed above, there would be no appreciable change in the relief granted to the SEC.

Accordingly, the SEC's change in its settlement language may result in the reverse effect for SEC settlements.  That is, instead of the SEC settlement adding to deterrence, the agency's work would be less relevant since defendants would simply bypass the agency, and ignore any efforts by the SEC to obtain a judgment.  Consequently, we are still waiting for the SEC to seriously address the systemic problems in its settlement process.  Our guess is we will be waiting for sometime.

Recently, Judge Pauley of the United States District Court for the Southern District of New York harshly criticized the SEC’s management of a private claims administrator, who was hired to distribute funds from a settlement received from the Zurich Financial Services Group.

The fund administrator requested $1 million dollars in fees and expenses for a $25,000,000 settlement fund.  Judge Pauley criticized the SEC’s management as to how such expenses could even be incurred.  The record indicated that the SEC had conducted no meaningful oversight over the fund’s administrator, and that it had acted “in ostrich like fashion.”  Judge Pauley indicated that, for similar securities class action matters, fees were literally half those in this particular case.  The SEC was ordered to respond to the court’s criticisms by October 28, 2011, in a decision that denied without prejudice the request for fees and expenses. 

Interestingly, the Court allowed the SEC an opportunity to respond to this “calling out” of its administration.  We are certain that there will be more to tell of this story when the SEC responds.

Approximately 2 years ago, the SEC implemented a new e-mail security protocol for its communications regarding non-public investigations, among other things.

This system required defense counsel to fill out a webpage form, enter e-mails and passwords to meet the SEC security requirements.  Ultimately, the recipient would only be able to read and reply to the e-mail over this secure network.

Of course, the thought that the SEC wishes to encrypt e-mails and protect such information is laudatory, but it has created a problem for users, who do not have easy access to Internet Explorer and Outlook.  Further, many of the e-mails are time sensitive, and, as such, do not allow for instantaneous communication.  Additionally, the system only retains e-mails for approximately 90 days, and it is not clear if the SEC is taking precautions to keep the e-mails for longer periods of time.

Like much of the SEC's attempts to modernize its systems, this e-mail system has a number of "bugs."  The SEC may have to consider another system or changes to the current one if it continues down this path.  If it does not, the SEC may lose important information, and continue its run of bad press over  document retention and preservation policies.

Recently, the historians at the National Archives have weighed in on the SEC’s disclosure that it had destroyed possibly over 9,000 documents, and they are not happy.  As a result, the SEC suspended its document destruction policies for several high profile cases. 

This indicates a strong suspicion that the SEC had been destroying documents that were required to be maintained.  Apparently, the SEC destroyed records relating to some of the most controversial cases that its handled over the last several years, including, but not limited to, cases involving Bernie Madoff, Goldman Sachs, Lehman Brothers and Bank of America..  It appears that the SEC may have become somewhat lax in its internal protocols.  Senator Chuck Grassley and the SEC’s own Inspector General have, in fact, launched investigations into the document destruction, and devoted serious investigative resources to understanding what occurred.

In sum, the SEC will undergo a strict review, and will be forced to adopt changes to its procedures to address these significant shortfalls.  Nonetheless, this is another example of the SEC being tone deaf to the public’s concern as to its operations and mission.  Time will tell if the SEC learns any lessons from these missteps.