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SEC Releases Fiscal Year 2018 Division of Enforcement Report That Highlights Increase of Enforcement Actions, Protection of The Retail Investor and Focus on Cyber-Security Fraud

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  • Posted on: Nov 21 2018

On November 2, 2018, the U.S. Securities and Exchange Commission (the “SEC” or “Commission”), Division of Enforcement (the “Division”), released its annual report for the fiscal year ended September 30, 2018 (“FY 2018”) (the “Report”) (here). The Report highlights the Division’s enforcement-related actions and key initiatives for the fiscal year and reveals an agency focused on pursuing cases affecting retail investors, such as investment adviser fraud, as well as actions directed at the impact of emerging technological on the securities market, such as cryptocurrencies and cybersecurity.

“As this report demonstrates, the Division’s approach to enforcement is multifaceted and outcomes-oriented with the interests of our Main Street investors front of mind,” said SEC Chairman Jay Clayton.  “The Enforcement Division has been and continues to be extremely successful in its efforts to deter bad conduct and effectively remedy harms to investors.”

A copy of the November 2, 2018 press release announcing the issuance of the Report can be found here.

Below are some of the Report’s highlights.

FY 2018 Enforcement Proceedings.  In FY 2018, the Commission brought 821 enforcement actions, of which 490 were “stand alone” actions brought in federal court or as administrative proceedings, 210 were “follow-on” proceedings seeking bars based on the outcome of Commission actions or actions by criminal authorities or other regulators, and 121 were proceedings to deregister public companies – typically microcap issuers – that were delinquent in their Commission filings.

A significant number of the stand-alone cases concerned securities offerings (approximately 25%), investment advisory issues (approximately 22%), and issuer reporting/accounting and auditing (approximately 16%). In addition to the foregoing, the Commission continued to bring actions involving broker-dealer misconduct (13%), insider trading (10%), and market manipulation (7%).

From a year-over-year perspective, the number of Foreign Corrupt Practices Act (“FCPA”) cases brought by the Commission remained flat compared to FY 2017. In both years, the Commission brought 13 FCPA cases. The most significant year-over-year increases came from enforcement proceedings involving investment advisers/investment companies (108 in FY 2018 compared to 82 in FY 2017) and securities offerings (121 in FY 2018 compared to 94 in FY 2017).

Focus on Retail Investors. The report shows that the SEC continues to focus its attention on the protection of retail investors. Of the 490 stand-alone enforcement proceedings, one half of the actions brought in FY 2018 involved allegations or findings of wrongdoing that harmed Main Street investors. Consistent with the Commission’s focus on Main Street, the SEC returned a substantial amount of money to these investors in FY 2018.

In FY 2018, the Commission continued to obtain significant monetary relief in the form of disgorgement and civil penalties. In this regard, the Commission obtained $2.506 billion in the disgorgement of ill-gotten gains, a decrease over the prior year. The Commission imposed a total of $1.439 billion in civil penalties, an increase from the prior year. A significant amount of the money ordered in FY 2018, however, came from In the Matter of Petroleo Brasileiro S.A. – Petrobras, AP File No. 3-18843, Securities Exchange Act Release No. 34-84295 (Sept. 27, 2018) (disgorgement and prejudgment interest totaling $933,473,797 and a penalty of $853,200,000). Total monetary relief increased in FY 2018 by approximately 4% from the prior year.

The Report noted that the Supreme Court’s 2017 decision in Kokesh v. SEC (discussed by this Blog here), in which the Court held that Commission claims for disgorgement are subject to a five-year statute of limitations, continues to have a significant effect on the Commission’s efforts to obtain disgorgement. With respect to matters that have already been filed, the Division estimated that the Court’s ruling in Kokesh may cause the Commission “to forego up to approximately $900 million in disgorgement, of which a substantial amount likely could have been returned to retail investors.”

Holding Individuals Accountable: According to the Commission, individual accountability was critical to its enforcement program and was one of the Division’s core principles during the fiscal year. In FY 2018, of the 490 stand-alone actions, 72% involved charges against one or more individuals, approximately the same percentage as in FY 2017 (73%). Many of the individuals charged in FY 2018 include senior officers at prominent companies and other public figures, including the CEOs of Tesla Inc. (“Tesla”) (discussed by this Blog here) and Theranos Inc. (“Theranos”), the former CEO of SeaWorld Entertainment Inc., a U.S. Congressman, the former CEOs and CFOs of Walgreens Boots Alliance Inc. and Rio Tinto p.l.c., and a professional football player (discussed by this Blog here).

The Division also sought to penalize individuals and require them to pay back ill-gotten gains. In FY 2018, the Commission obtained judgments or orders for disgorgement and/or penalties from over 500 individuals, representing an increase of 9% over FY 2017.

“In FY 2018, the Commission obtained favorable verdicts in three trials against four defendants and an unfavorable verdict in one trial against one defendant. As of the close of the fiscal year, the Commission was awaiting a verdict in one completed bench trial. The number of district court trials conducted in FY 2018 (5) is similar to the number of such trials in FY 2017 (4).”

In FY 2017, there were various pending constitutional challenges to the Commission’s administrative proceedings and the appointment of its administrative law judges (“ALJ”). In June 2018, the Supreme Court held in Lucia v. SEC (discussed by this Blog here) that the appointment of the SEC’s ALJs violated the U.S. Constitution’s Appointments Clause, requiring a new hearing in front of a different fact finder. After Lucia, the Commission stayed all pending administrative proceedings. The Commission lifted the stay on August 22, 2018, and approximately 200 administrative proceedings were reassigned at that time. The SEC noted that addressing these administrative proceedings would require the expenditure of substantial litigation resources during FY 2019.

Cyber-Related Misconduct: According to the Report, cyber-related misconduct continues to be a key focus area for the Commission. In FY 2018, the Division commenced 20 stand-alone actions involving Initial Coin Offerings (“ICOs”) and digital assets. According to the Report, the Division’s Cyber Unit, which was formed at the end of FY 2017, and became fully operational in FY 2018, has been instrumental in identifying and bringing an array of cases from registration violations, to unregistered broker-dealer activity, to instances in which the purported use of blockchain-related technology was a thinly veiled cover for fraudulent misconduct.

The Report also stated that the Division has 225 on-going cyber-related investigations. As such, the Commission expects FY 2019 to see even more significant developments in this area.

Relief Obtained. In every enforcement action, the Division seeks “appropriately tailored remedies” that further its enforcement goals. In addition to disgorgement and penalties, there is a wide range of potential remedies available. Consequently, the agency seeks remedies that are appropriate and meaningful to the case and the alleged wrongdoing.

In FY 2018, the Division employed undertakings (e.g., actions that require a defendant/respondent to take affirmative steps, either in conjunction with entry of the order or in the future) as a tool in its enforcement actions and settlement recommendations to the Commission. The Theranos and Tesla matters are examples of the Commission’s use of this remedial tool.

Enforcement actions resulted in nearly 550 bars and suspensions of wrongdoers in FY 2018. According to the Report, one of the most important actions that the Commission can take to protect investors is to remove individuals from positions where they can engage in future wrongdoing. The Commission assesses bars and suspensions to prevent wrongdoers from serving as officers or directors of public companies, dealing in penny stocks, associating with registered entities such as broker-dealers and investment advisers, or appearing or practicing before the Commission as accountants or attorneys.

As noted in the Report, “[u]nder the federal securities laws, the Commission may suspend trading in a stock for 10 days and generally prohibit a broker-dealer from soliciting investors to buy or sell the stock again until certain reporting requirements are met.” In FY 2018, the Commission suspended trading in the securities of 280 issuers in order to combat potential market manipulation and microcap fraud threats to investors.

“In FY 2018, the Commission obtained 26 court-ordered asset freezes.” Court-ordered prejudgment relief in the form of asset freezes, said the Commission, is important to its ability to protect investors. As noted in the Report, asset freezes prevent alleged wrongdoers from dissipating assets that could otherwise be marshaled for distribution to investors harmed by the alleged misconduct.

Impact of Resource Constraints: The Commission continues to be impacted by the constraints imposed by an agency-wide hiring freeze that has been in place since late 2016. The Report notes that the number of positions at the Division, including the number of contractors supporting the Division’s investigations, declined 10% from FY 2016 to FY 2018. As a result, the Division “paid careful attention to case selection” in FY 2018, “attempting to open and pursue investigations that [were] likely to have the most meaningful impact for investors and the markets.”

In discussing the financial constraints on the agency, the Report provides insight into the Division’s priorities going into the new fiscal year. In this regard, the Commission observed that “additional resources would support two key priorities of the Division: protecting retail investors and combating cyber-related threats.”  The Commission also said that “with more resources” it “could focus more on individual accountability,” especially since “individuals are more likely to litigate” and, therefore, exhaust the Division’s litigation resources.

Takeaway

The Report reflects an emphasis on protecting the Main Street investor. This emphasis is most likely the result of a change in philosophy within the Division away from the Wall-Street centric approach championed by Chairman Clayton’s predecessors.  The Division’s rollout in FY 2018 of the Retail Strategy Task Force and the Share Class Selection Disclosure Initiative (discussed by this Blog here) further underscores the Commission’s shift to policing conduct that targets retail investors, including “disclosures concerning fees and expenses” and “misconduct that occurs in the interactions between investment professionals and retail investors.”  Likewise, FCPA-related enforcement actions – which received significant attention during the prior Chair’s tenure – is given little attention in the Report.  The numbers support this de-emphasis. FCPA-related enforcement actions declined nearly 40 percent from FY 2016, when enforcement actions reached an all-time high. Although Avakian and Peiken believe that the Division does not “face a binary choice between protecting Main Street and policing Wall Street,” the numbers cited in the Report tell a different story.

The Report also reveals the Commission’s shift from deterrence through substantial monetary penalties to a “wide range” of “investor-oriented” individualized remedies “tailored” to “the underlying charged conduct.”  The Commission’s use of undertakings in its cases against Theranos and Tesla and their CEOs demonstrate this new approach. In both cases, the Commission required the CEOs of each company to relinquish control of the companies (temporarily and permanently) and the companies to implement internal controls to monitor the social media communications of their executives.  Consistent with the Division’s stated focus on protecting Main Street investors, the Report described these undertakings, along with the monetary penalties and governance reforms, as “remediat[ing] the harm visited on shareholders by the misconduct at issue and provid[ing] shareholders with greater protection in the future.”

The Report further reveals an emphasis on combating cyber-related misconduct. In FY 2018, the Commission brought a dozen “cryptocurrency”-related cases. Four of those cases were brought by the SEC’s new Cyber Unit. At the time of the unit’s launch, Avakian identified cyber-related threats as “among the greatest risks facing investors and the securities industry.” In FY 2018, the Commission brought 20 stand-alone cases related to cyber fraud and had more than 225 ongoing cyber-related investigations. Although the numbers are not yet reflective of the Commission’s emphasis on all things cyber-related, the Report makes a point of discussing the need for additional funding to “combat[ ] cyber-related threats” – one of the “two key priorities of the Division” in the upcoming fiscal year.

Finally, in the Commission’s FY 2017 report, the agency articulated five core principles that would guide the Division for the upcoming fiscal year: (1) focus on the Main Street investor; (2) focus on individual accountability; (3) keep pace with technological change; (4) impose remedies that most effectively further enforcement goals; and (5) constantly assess the allocation of our resources. Those principles are reiterated in the FY 2018 Report. The numbers and initiatives discussed in this year’s Report, concluded the Division, demonstrate “a faithful adherence to these principles.”

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