SEC Enforcement Actions: A Look at 2011 and What to Expect in the Next YearMatthew Nielsen and Crystal Jamison
In 2011, the U.S. Securities and Exchange Commission ushered in a new era of securities regulation, marked by a record-setting number of enforcement actions and a significant expansion of enforcement techniques and tools. This E-Alert focuses on key developments during 2011 and trends that will likely shape the SEC’s enforcement program in the next 12 to 18 months.
Key Developments in SEC Enforcement During 2011
Over the last two years, the SEC has significantly reorganized its Division of Enforcement, most notably through the creation of special investigative units and multi-agency working groups dedicated to high-priority areas of enforcement. Also in this period, the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act gave the SEC new enforcement tools, including expanded enforcement authority, wider use of administrative proceedings, and broader scope of and expanded penalties for violations of securities laws. 2011 was the first full year of the SEC’s enforcement program under these new changes.
The organizational reforms and new tools culminated in the SEC filing a record 735 enforcement actions in 2011, an 8% increase from 2010.1 In 2011, the SEC filed 266 civil actions against 803 defendants, a slight increase from 2010, but substantially down from 2009. The SEC, however, continued the upswing in administrative proceedings, filing 469 cases against 1,058 individuals and companies in 2011, representing a 33% increase as compared to administrative cases brought in 2009. While the SEC sought about the same number of temporary restraining orders in 2011 versus 2010 (39 and 37, respectively), the agency requested much fewer asset freezes as compared to 2010, declining 26% from 57 to 42.
During 2011, the SEC obtained judgments and settlements for $2.806 billion in penalties and disgorgement, only slightly down from the 2010 record of $2.85 billion.2 But, the median settlement value with companies nearly doubled from $800,000 in 2010 to $1.47 million in 2011, near the post-Sarbanes-Oxley high of $1.5 million in 2006.3 And, the median settlement value for individuals was $275,000, a 35% increase from the previous post-SOX high of $130,000 in 2008.
Not all numbers were up, however. In 2011 the SEC both opened and closed fewer investigations. While the number of investigations opened was only slightly down from 2010, the number of investigations closed decreased by 36%.4 The SEC, however, saw an increase in formal investigations opened during 2011, rising nearly 9% from those opened in 2010 and 16.5% from 2009.
Major Enforcement Areas in 2011
Financial Crisis Cases —Enforcement actions against firms and individuals linked to the 2008 financial crisis remained a high priority for the SEC in 2011, continuing a three-year rise in the percentage of SEC settlements involving alleged misrepresentations or misappropriation by financial services firms. These types of settlements accounted for 41.6% of all SEC settlements in 2011, as compared to the average of 23.7% seen from 2003 to 2008.5 Since 2008, the SEC has filed 36 separate actions arising from the financial crisis against 81 defendants, nearly half of whom were individuals, meaning CEOs, CFOs and other senior corporate executives. Fifteen of these actions were filed in 2011, up from twelve filed in 2010. The majority of cases related to collateral debt obligations (“CDOs”) and mortgage-backed securities.
Notable 2011 financial-crisis cases include an SEC action brought against six executives at Brooke Corporation and three executives at mortgage lender IndyMac Bancorp for allegedly misleading investors about the deteriorating financial condition at their respective companies. The SEC also filed several actions alleging that firms concealed from investors the risks, terms, and improper pricing of CDOs. But, the most notable case of 2011 came in December, when the SEC filed suit against six former top executives at Fannie Mae and Freddie Mac for allegedly causing the companies to underreport the number of subprime mortgages they purchased during 2006 to 2008.6
Investment Advisers and Broker-Dealers —In 2011, there was a substantial increase in the number of actions against SEC registrants, with 146 actions against investment advisers and investment companies, a 30% increase from 2010, and 112 broker-dealers actions, up 60% from 2010. Indeed, investment adviser, investment company, and broker-dealer actions constituted over 35% of the SEC’s total enforcement actions in 2011. The SEC focused on traditional areas of concern including inaccurate or inadequate disclosure, conflicts of interest, misappropriation of client assets and fraudulent trading schemes, misallocation of investment opportunities, false or misleading performance claims, and market manipulation. Another top priority that is likely to gain even more attention in the year to come is compliance programs, including the adoption and implementation of written compliance policies and procedures, as well as annual review of such programs.
Investment adviser and broker-dealer actions brought by the SEC in 2011 included charges against Charles Schwab entities and executives for allegedly making misleading statements to investors regarding a mutual fund heavily invested in mortgage-backed and other risky securities and AXA Rosenberg Group LLC and its founder for allegedly concealing a significant error in the computer code of the quantitative investment model that they used to manage client assets. The Schwab entities paid more than $118 million to settle the SEC’s charges, while AXA Rosenberg agreed to pay $217 million to cover investor losses and a $25 million penalty.
Insider Trading Cases —Protecting the integrity of the financial markets continued to be a major area of focus in the SEC’s enforcement program. In 2011, the SEC filed 57 insider trading cases (nearly an 8% increase over 2010’s total) against 126 defendants.7 Many insider trading cases also included parallel criminal charges by the Department of Justice ("DOJ"), including the highly-publicized Galleon hedge fund case discussed below. Among those charged in SEC insider trading cases in 2011 were various hedge funds managers and traders involved in an alleged $30 million expert network trading scheme, a former NASDAQ Managing Director, a former Major League Baseball player, and an FDA chemist. The SEC also brought insider trading charges against a Goldman Sachs employee and his father who allegedly traded on confidential information learned at work on the firm’s ETF desk, and a corporate board member of a major energy company and his son for allegedly trading on confidential information about the impending takeover of the company.
Executive Clawbacks —In 2011, the SEC became more aggressive in seeking executive compensation clawbacks. Section 304 of the Sarbanes-Oxley Act provides that if an issuer restates its financials because of misconduct, then the CEO and CFO “shall” reimburse any bonuses or other incentive-based compensation, or equity-based compensation, received during the year following the issuance of the incorrect financials. During 2011, the SEC sought clawbacks from executives even in instances where they were not personally involved in or aware of the alleged misconduct at the company, including a settlement to recover bonuses totaling more than $450,000 in cash and 160,000 options from the CEO of Koss Corp. for the CFO’s alleged wrongdoing. The SEC’s trend towards forcing innocent executives to pay the price for wrongdoing that happens under their watch will likely continue following the implementation of section 954 of Dodd-Frank early this year, which expands clawbacks to all executives, rather than just CEOs and CFOs, and is triggered even if the restatement did not occur because of “misconduct” by the issuer.
Chinese Reverse Mergers — Chinese companies who gain listing on a U.S. exchange through a reverse merger with a listed company have become a heavy focus of the SEC and other federal agencies. In 2011, the SEC unveiled new rules approved and adopted by each of the three major U.S. stock exchanges which impose more stringent listing requirements for foreign reverse merger companies. During the last 18 months, the SEC halted securities trading in several Chinese reverse merger companies, revoked the securities registration of several companies, and brought enforcement actions against executives and auditors of these types of companies.8 Moreover, the SEC is aggressively pushing to gain access to financial records for companies based in China. This led to the SEC’s suit against the Shanghai office of Deloitte Touche Tohmatsu CPA Ltd. to enforce an investigation subpoena compelling production of documents located in China.9 The Commission pursued this rarely used remedy when Deloitte refused to produce any documents, contesting the SEC’s ability to compel an audit firm to produce documents predating the Dodd-Frank Act and asserting that the production was prohibited under Chinese law. In resolving the tension between an entity’s competing obligations under U.S. and foreign law, the court recently granted the SEC’s show cause motion, thereby forcing Deloitte either to concede jurisdiction by appearing at the hearing, or to risk default judgment.
Breakdown of Major Categories of SEC Actions10
Changing the Structure of Enforcement Actions
New Cooperation Initiatives —In May 2011, the SEC entered into its first Deferred Prosecution Agreement (“DPA”), in which it agreed not to bring an enforcement action against Tenaris S.A. based on alleged violations of the FCPA, in exchange for Tenaris’ agreement to perform certain undertakings, to abide by a cooperation clause, and to pay about $5.4 million in disgorgement.11 The SEC introduced the DPA in 2010, along with the Cooperation Agreement and Non-Prosecution Agreement (“NPA”), as tools to encourage greater cooperation from individuals and companies. The SEC executed one NPA in 2010 and two more in 2012, one with Fannie Mae and one with Freddie Mac, in which the entities stipulated to certain facts and agreed to extensive cooperation clauses that make it clear the companies will be on the SEC’s side in the related litigation against individual targets.
Whistleblower Initiative —An additional initiative focused on rewarding cooperation is the SEC’s whistleblower program, another product of Dodd-Frank, that officially went into effect on August 12, 2011.12 The program is intended to incentivize whistleblowers to report potential securities violations to the SEC, with tipsters standing to earn bounty of 10 to 30% of any SEC recovery over $1 million. To qualify for the reward, the whistleblower must “voluntarily” provide “original information” that leads to successful enforcement proceedings. Within seven weeks of the SEC’s Office of the Whistleblower opening for business, it received 334 tips. So far, the most common complaint categories included market manipulation (16.2%), corporate disclosures and financial statements (15.3%), and offering fraud (15.6%).13
The SEC has yet to file a case based on a tip from the whistleblower programs, potentially because it is looking for the “perfect case” as the first few cases to come before the courts will likely be highly scrutinized given the huge potential bounties available to whistleblowers. Despite the apparent initial success of the program, the SEC’s limited resources and ability to follow up on tips may neutralize the impact of the initiative, giving companies a chance to investigate some of these complaints. Still, companies should refine compliance programs and training/awareness to encourage whistleblowers to approach internal investigators before going to the SEC directly.
Expanded Enforcement Tools —Through the Dodd-Frank Act, Congress increased the SEC’s enforcement power. The SEC is now allowed to seek civil monetary penalties and other relief in administrative proceedings, even those against entities that are not registered with the SEC, which were previously available only in federal court actions. The SEC flexed its new authority for the first time in March 2011 through a well-publicized administrative action in an insider trading case against Raj Rajaratnam, head of the Galleon Management hedge fund. Despite already receiving an 11-year prison sentence and being ordered to pay an $11 million fine and $53.8 million in restitution in the related DOJ action, the SEC imposed an additional $92.8 million civil penalty.14
Galleon highlights the convergence of SEC civil and DOJ criminal enforcement, and raises questions about double and excessive penalties in government enforcement actions. Other aspects of Galleon are also worth noting, including its potential to expand the SEC’s powers in conducting investigations. In Galleon, not only did the SEC use wiretaps in its investigation, the district court admitted the wiretaps into evidence – a decision that shocked many, especially Rajaratnam. This will play an important role in the upcoming year as wiretaps may become more routine in insider trading and other complex securities fraud cases.
Dodd-Frank also expanded SEC’s authority to bring aiding and abetting claims under the Securities Act of 1933 and to obtain civil penalties for aiding and abetting violations of the Investment Advisers Act of 1940. Congress also reduced the SEC’s burden to prove aiding and abetting liability to a “recklessness” standard. The SEC further obtained “collateral bar” authority — the ability to bar or suspend a registrant from the securities industry completely, although the registrant only committed a violation with regard to a particular segment. The effect of these new powers is not yet certain, but clearly give the SEC more tools in its enforcement program.
Key Securities Cases to Watch in 2012: Judiciary Pressuring the SEC to Re-Think Strategy
Janus and the Future of “Scheme Liability”
A Supreme Court opinion issued in June 2011 had an immediate impact on how the SEC pleads and attempts to prove its cases. In Janus, the Court considered whether separate legal entities within the Janus corporate group (adviser and parent) had exposure to primary liability for the statements of the entity issuing the securities and related disclosures.15 The Court ultimately interpreted the person who makes a statement very narrowly, finding that a defendant may be liable for making an alleged misstatement under section 10(b) of the Exchange Act only if he had “ultimate authority” or “control” over both the content and dissemination of the statement.
In the immediate wake of Janus, the SEC shifted the focus of its cases against non-speakers and non-signers from the “misstatements” prong of Rule 10b-(b) to the “scheme liability” provisions of Rules 10b-5(a) and (c) under the Exchange Act and to section 17 of the Securities Act. According to the SEC, Janus addressed only liability under Rule 10b-5(b), but “scheme liability” claims under subsections (a) and (c) of Rule 10b-5, as well as claims under section 17(a), survived Janus, because unlike Rule 10b-5(b) claims, these claims were not dependent on the word “make.”16 The lower courts are already grappling with how to apply Janus, with one court (and the SEC’s own Chief Administrative Law Judge) rejecting the SEC’s scheme liability and section 17(a) theories,17 while two others found Janus did not apply to claims brought under section 17(a).18
SEC’s Pursuit of Negligence-Based Claims
In 2011, the SEC showed an increased willingness to proceed against alleged negligent or nonscienter-based conduct as opposed to scienter-based fraud, especially in the context of CDO-related cases. For example, the SEC charged Citigroup Global Markets, Inc. with misrepresenting to investors the quality of fund assets and with failing to disclose its short position against the assets.19 Although the allegations appeared to be based on knowing and fraudulent intent, the SEC charged Citigroup only with negligence-based fraud under section l7(a)(2) and (3) of the Securities Act.
The negligence-based claims are easier to prove, thus the new focus should encourage companies to tighten their controls, deterring fraud before it happens, and leading to more stringent enforcement tactics. But, the penalties available for negligence-based misconduct are much lower than with scienter-based claims. Also, by focusing on negligent conduct, the SEC must divert its already scarce resources away from more flagrant, intentional conduct, running the risk of another “Madoff miss.”
Judicial Scrutiny of SEC’s “Neither Admit Nor Deny” Settlements
The use of negligence- and non-fraud-based settlements has already led to closer judicial scrutiny of the SEC’s standard settlement practices and language. In October 2011, the SEC reached a $285 million settlement with Citigroup relating to a mortgage-backed securities claim.20 In an unprecedented move, U.S. District Judge Jed S. Rakoff rejected the settlement as against the public interest because the SEC did not provide adequate factual support for the court's approval and because Citigroup did not admit to any misconduct.21 Judge Rakoff sharply criticized the SEC’s longstanding practice of entering into settlements in which the defendant neither admits nor denies wrongdoing, finding that approving such settlements is “worse than mindless, it is inherently dangerous.” The SEC appealed the decision in December 2011.22
A second judge has followed suit, challenging similar language the SEC used in a settlement with Koss Corp. and its CEO.23 Both the defense bar and the SEC have expressed concerns about what will happen if this aggressive judicial scrutiny of settlements continues. If companies have to admit to violations to settle with the SEC, it will undoubtedly make it more difficult for the SEC and the defendants to reach settlements, meaning the number of settlements will go down and the amount of costly litigation will rise. Admitting guilt opens companies up to shareholder and other private litigation, and potentially even criminal liability. The SEC can only bring so many cases with its limited resources, as its Enforcement Director has repeatedly noted.
It is difficult to predict the result here. But, in the wake of Rakoff's decision and the related media attention, the SEC announced on January 6, 2012, that parties will no longer be permitted to settle SEC charges on the basis of “neither admitting nor denying” wrongdoing when they admit to related criminal charges.This policy would also apply in situations in which a corporate defendant has entered into a DPA or NPA in the criminal matter.
Judicial Guidance on Key Issues Relating to the FCPA
In 2011, the courts also had the opportunity to weigh in on key issues relating to the FCPA, including the definition of “foreign official,” the knowledge requirement under the FCPA, and the jurisdictional scope of the Travel Act, which is often also charged in FCPA cases. An increased focus on pursuing individuals, who are generally more likely to litigate than companies, led to an unprecedented number of trials and related litigation that did not always bring favorable results for the government. Indeed, the government suffered a mistrial in the trial of the first group of SHOT Show Sting defendants and the convictions returned by the jury in the Lindsey Manufacturing case were vacated and the indictments dismissed.
Previously, judicial interpretations of the FCPA were limited and positions asserted by enforcement authorities often went unchallenged, especially in the context of settlements. Expect this year to bring even more opportunities for the judiciary to give guidance, as many of the 2011 decisions are the subject of appeals and more significant trial activity is poised to continue. The DOJ also announced that it will publish its own guidance on the FCPA in 2012.
Securities Enforcement in the Next Year
In 2011, the SEC soundly demonstrated its commitment to a vigorous securities enforcement program to address old and new priorities. All signs point to the SEC continuing to aggressively detect, prevent, and combat securities violations, especially in high-priority areas. Along with the progression of the key cases and areas identified above, here is what to expect in the next twelve to eighteen months:
- More Dodd-Frank Initiatives: In addition to the continued development of the whistleblower program and other initiatives implemented this year, the SEC plans to conclude the voluminous rulemaking required by the Dodd-Frank Act, including finalizing rules on executive compensation.
- More Financial Crisis Cases: While the SEC ramped up the number of cases stemming from the financial crisis, it will likely bring more such cases and name more individuals. Both Congress and the media have criticized the SEC for not holding more individuals accountable for wrongdoing that fueled the crisis.
Tougher Sentencing Guidelines: On January 19, 2012, in response to a Dodd-Frank directive to re-evaluate the sentencing guidelines for fraud offenses, the U.S. Sentencing Commission proposed amending the federal sentencing guidelines to include harsher penalties for senior leaders implicated in insider trading and increase the “offense level” and penalties for instances of “sophisticated insider trading.”24 These amendments, which could be approved later this year, would impact not only public companies, but also brokerage firms and investment advisers.
Shift to SEC Administrative Proceedings: The SEC will likely continue the trend of more enforcement actions through administrative proceedings, especially due to the SEC’s expanded remedies and claims in such proceedings coupled with the increased federal court scrutiny of settlements.
Continued Focus on High-Priority Areas: The SEC will continue to be active in its designated and traditional high-priority areas. Mostly notably, the SEC will likely focus on Asset Management (hedge funds, investment advisers, and private equity), Market Abuse (large-scale insider trading and other market manipulation schemes), FCPA, and insider trading cases. Also, with the SEC’s Whistleblower program underway, the SEC will likely institute more investigations and enforcement actions based on fraudulent financial reporting, which has waned over the last few years.
Increased Focus on Compliance Programs: The SEC will more heavily focus on the operations of compliance programs, both in examinations of registered advisers and broker-dealers and when making enforcement decisions as to SEC registrants where fraud has occurred. In addition to the right "tone at the top," companies need to ensure that they have good policies covering key-risk areas (such as financial reporting, anti-corruption, business conduct and ethics, insider trading, and internal reporting channels for employees who suspect wrongdoing), appropriate training, and adequate oversight and testing.
1. SEC Press Release No. 2011-234 (Nov. 9, 2011), available at http://www.sec.gov/news/press/2011/2011-234.htm. Note, the information provided by year in this E-Alert refers to the SEC’s fiscal-year data.
3. Year-by-Year SEC Enforcement Actions, available at http://www.sec.gov/news/newsroom/images/enfstats.pdf.
8. See April 27, 2011 letter from Mary Shapiro to Hon. Patrick McHenry, available at http://s.wsj.net/public/resources/documents/BARRONS-SEC-050411.pdf.
9. SEC v. Deloitte Touche Tohmatsu CPA Ltd., No. 11-00512 (D.D.C.).
12. SEC Annual Report on the Dodd-Frank Whistleblower Program - Fiscal Year 2011 (Nov. 2011), available at http://www.sec.gov/about/offices/owb/whistleblower-annual-report-2011.pdf.
14. U.S. v. Rajaratnam, et al., No. 09-01184 (S.D.N.Y.); SEC v. Galleon Mmgt, et al., No. 09-08811 (S.D.N.Y.).
15. Janus Capital Group, Inc. v. First Derivative Trader, 131 S. Ct. 2296 (2011).
16. SEC v. Kelly, 2011 WL 4431161 (S.D.N.Y. Sept. 22, 2011).
18. SEC v. Daifotis, 2011 WL 3295139 (N.D. Cal. Aug. 1, 2011); SEC v. Landberg, 2011 WL 5116512 (S.D.N.Y. Oct. 26, 2011).
19. SEC v. Citigroup Global Mkts., Inc., No. 11-07387 (S.D.N.Y.).
21. 2011 WL 5903733 (S.D.N.Y. Nov. 28, 2011).
23. SEC v. Koss Corp., et al., No. 11-CV-00991 (E.D. Wis.). On February 2, 2012, Wisconsin federal Judge Rudolph Randa issued an order directing the SEC to “provide a written factual predicate for why it believes the Court should find the proposed final judgments are fair, reasonable, adequate, and in the public interest.” Judge Randa cited Rakoff’s objections to the Citigroup settlement in his order.
24. See Carolina Bolado, US Proposes Tougher Sentences for Securities Fraud, Jan. 19, 2012, available at http://www.law360.com/topnews/articles/301721/us-proposes-tougher-sentences-for-securities-fraud.