Morgan Lewis’s 15th annual 2020 Year in Review and a Look Forward provides a comprehensive overview and analysis of key 2020 US Securities and Exchange Commission (SEC) enforcement and examination developments, notable broker-dealer cases, and anticipated enforcement priorities for 2021, including under the potential leadership of SEC chair nominee Gary Gensler. Below we offer a preview of the report’s insights into what can be expected from the SEC as the year continues, from Regulation Best Interest to ESG funds to disgorgement.
SEC Chair Nominee Gary Gensler’s Leadership
- Streamlining the SEC Enforcement Process: Mr. Gensler set effective investigation performance measures while at the Commodity Futures Trading Commission (CFTC). If confirmed as SEC chair, we expect him to evaluate internal processes to decrease the length of investigations, which on average lasted 24 months as of 2020.
- Voluntary Reporting Initiatives: Voluntary initiatives have added significantly to the Division of Enforcement’s (Enforcement’s) bottom-line number of filed actions and disgorgement. With an increased focus on aggressive enforcement, Enforcement may turn again to a voluntary reporting initiative.
- Significant Increase in Financial Remedies Sought in Settlement: While the SEC had a record year for money ordered in fiscal year (FY) 2020, now more than any time in the last several years, those numbers are driven by a relatively small number of large cases. We expect Enforcement to seek larger penalties across the board regardless of the size of the case.
Lasting COVID-19 Practices
- Continued Use of Informal Interviews: We have witnessed a higher incidence of requests for informal interviews at the outset of investigations during the pandemic. However, the tactic of speaking to those under investigation at the outset of a matter, in part to speed the staff’s understanding of the basic facts, likely is a method that will continue beyond the pandemic.
- More Comfort with Remote Testimony: As the staff has become more adept and comfortable with remote testimony, we anticipate they will use remote testimony to conserve resources and avoid scheduling conflicts caused by travel that in the past might have delayed investigations.
- Steering Committee Success in Marshaling Resources: One of the apparent successes of the Coronavirus Steering Committee is an ability to marshal resources in multiple regions to move matters forward. Look for this type of coordination across regional offices and tasks to continue after the pandemic.
Legislation and Rulemaking
- Revisiting Regulation Best Interest (BI): Given the significant cost and expense incurred by registrants to implement Regulation BI, wholesale changes appear unlikely. However, there certainly will be debate.
- Reevaluation of Waivers in the Enforcement Settlement Process: On February 11, 2021, Acting Chair Allison Herren Lee reversed former Chair Jay Clayton’s “Statement Regarding Offers of Settlement.” The question that remains unanswered is whether this move will lead to more denials of waivers and more resulting litigation of enforcement matters due to a lack of certainty. As former staffers in Commissioner Kara Stein’s office, both Commissioner Caroline Crenshaw and Acting Chair Lee are well versed in these issues.
- Buybacks and Reformation of Rule 10b5-1: Company stock buybacks and executive Rule 10b5-1 plans have drawn considerable recent focus from Congress. While Rule 10b5-1 plans are designed to provide protections for prearranged trades, questions have arisen concerning the need to further clarify the requirement that an executive entering into the plan does not possess material nonpublic information at the time that he or she enters into the plan.
- SEC Elects Not to Pursue Disgorgement in Insider Trading Cases: At the time of Liu’s issuance in June 2020, we anticipated that the mandate that disgorgement must be for the benefit of investors could affect claims for disgorgement in insider trading cases where it is typically paid to the Treasury. Recent cases suggest that the SEC has conceded this point.
- Continued Litigation Exploring Liu’s Limitations: Defendants in pending SEC actions have been relying on Liu to attack Commission requests for disgorgement with mixed success so far. One district court denied without prejudice an SEC request for disgorgement that did not affirmatively “identify whether the disgorgement award would be for ‘the benefit of investors.’” However, other district courts have left the fundamental burdens of quantifying disgorgement unchanged, with the Commission needing only to present a reasonable approximation and the defendant then required to provide evidence supporting any deductions from that calculation.
- More Discovery and Litigation Regarding Use of Proceeds: Both the SEC and defendants are more focused on use of proceeds to determine if payments benefited the defendants. However, in some instances this has led to an increased burden on defendants to demonstrate that the money was used for the business in question, rather than expenses that ultimately benefited the defendants and not the business.
- Civil Penalties in Lieu of Disgorgement: In the wake of Liu, there was speculation that the SEC might seek greater civil penalties rather than become embroiled in litigation over disgorgement. Former Director Stephanie Avakian confirmed this approach in remarks made last fall. In a brief filed recently in a microcap fraud case, the SEC opted to forgo disgorgement in its entirety and seek only civil penalty, stating that “disgorgement in this particular case would present significant practical obstacles, and the SEC therefore urges the Court to adopt the solution that the Court itself envisioned—i.e., to eliminate disgorgement and to increase the penalty amounts against each Defendant.”
- More Press Releases: In FY 2020 not only did the number of awards increase dramatically, so did the number of press releases by Enforcement announcing the awards. This is by design and is an attempt to advertise the prospect of awards for providing tips.
- A Growing Exception for Compliance and Audit Employees: When the SEC whistleblower rules were promulgated, the Commission recognized that “there are good policy reasons to exclude information from consideration as ‘independent knowledge’ or ‘independent analysis’ in the hands of certain persons, and in certain circumstances, where its use in a whistleblower submission might undermine the proper operation of internal compliance systems.” The recent $300,000 award to an employee with audit-related responsibilities where the individual had a reasonable basis to believe that the entity “would impede” the SEC investigation seems at the edge of the contemplated exemption.
Investigations and Case Categories
- Increase in Investigations and Cases Filed: Given the 40% increase in tips, complaints, and referrals (TCRs) year over year, we expect an increase in the number of investigations and ultimately the number of cases filed, particularly given the more aggressive enforcement stance of the Biden administration. The first indication of increased activity will be seen in subpoenas and other investigative steps, not necessarily filed actions, which typically follow years later.
- Review of Aged Matters: If Mr. Gensler is confirmed by the Senate, we expect a full review of aged investigations with possible closings of many. Given the limited Enforcement resources, aged investigations will otherwise create a significant drag on going-forward initiatives.
Division of Examinations
- Investor Protection and Retail Focus: In October 2020 Deputy Director of the Division of Examinations (Examinations) Kristin Snyder noted that Examinations would continue to focus on its investor protection mission and matters of importance to retail investors. Registrants should expect this to be manifested in an ongoing focus on senior investors and individual saving for members of the military and educators.
- Regulation BI: Ms. Snyder also noted that Examinations would be “taking a careful look at advisors’ Form CRS filings to ensure that the appropriate information is included and that forms are actually being created, delivered, and updated with respect to the information that's required.”
- Conflicts: Conflicts of interest will remain an area of emphasis, and particularly conflicts of interest and related disclosure issues as they relate to fee and expense issues.
- ESG Funds: Due to increased proliferation and popularity with investors, Examinations will remain concentrated on environmental, social, and governance funds (ESG funds). Examinations’ attention will be on ensuring that advisors are managing ESG funds in a manner consistent with the disclosures provided to investors and that the practices, policies, and procedures are in place to ensure that the strategies are consistent with the disclosures.
- COVID-19-Related Risks: Examinations will also look at matters that are perennial risks such as liquidity, and likely will focus on “funds that are concentrated in sectors that were more impacted by the market disruption—energy, real estate and then certain asset-backed investments.”
- Private Fund Advisors: Expect examinations of private fund advisers to also seek information about allocation of fees and expenses among funds to determine whether such activities are consistent with disclosures to investors.
Read the full 2020 Year in Review and a Look Forward >>