Category: SEC News

Supreme Court Limits SEC Internal Tribunals

“When the SEC seeks civil penalties against a defendant for securities fraud, the Seventh Amendment entitles the defendant to a jury trial.”

SEC v. Jarkesy

The case presented three issues:

(1) Whether statutory provisions that empower the Securities and Exchange Commission to initiate and adjudicate administrative enforcement proceedings seeking civil penalties violate the Seventh Amendment.
(2) Whether statutory provisions that authorize the SEC to choose to enforce the securities laws through an agency adjudication instead of filing a district court action violate the nondelegation doctrine.
(3) Whether Congress violated Article II by granting for-cause removal protection to administrative law judges in agencies whose heads enjoy for-cause removal protection.

The Supreme Court ruled on the first item and didn’t address the other two. Fights for another day.

Dodd-Frank granted the Securities and Exchange Commission broader rights to use its internal administrative law tribunals for non-registered parties. [Section 929P(a)]. Of course with the addition of private fund managers by Dodd-Frank, the world of non-registered parties got smaller.

Mr. Jarkesy and his Patriot28 fund were investigated by the SEC for inflating the fund values and lying about its service providers prior to Dodd-Frank. It decided to charge them using the in-house tribunal by using its new authority under Dodd-Frank. Mr. Jarksey lost the decision in 2014 and has been fighting ever since.

The Supreme Court decision looks at the Public Rights Exception to Article III jurisdiction. This exception allows some matters to go through administrative law proceedings and don’t require Article III proceedings. The Supreme Court essentially determines that civil penalties are designed to punish and deter and not compensate. Therefore, a case seeking civil penalties can’t go through the in-house tribunal.

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Private Funds Rule is Vacated

We consider a challenge to the Final Rule by petitioners National Association of Private Fund Managers, Alternative Investment Management Association, Ltd., American Investment Council, Loan Syndications and Trading Association, Managed Funds Association, and the National Venture Capital Association collectively “Private Fund Managers”). For the following reasons, we VACATE the Final Rule.

The central focus is thus on whether the Dodd-Frank Act expanded the Commission’s rulemaking authority to cover private fund advisers and investors under section 211(h) of the Advisers Act, see Part III.B.1., and whether section 206(4) authorizes the Commission to adopt the Final Rule, see Part III.B.2. We hold neither section grants the Commission such authority

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The Court found that the language in Section 211(h) applies to retail customers and therefore the SEC exceeded its authority. It looks at Section 913 of Dodd-Frank and points out that it applies to the defined term “retail customers.” Section 211(h) was enacted under Section 913. Therefore, rules under 211(h) should only be for the protection of retail investors. Private fund investors are not “retail customers.”

As for enacting the Private Fund Rules under the anti-fraud provisions of Section 206, the Fifth Circuit found the SEC conflated “lack of disclosure” with fraud or deception.

The Fifth Circuit found the remedy to be vacating the entire Private Funds Rule.

I assume the SEC will appeal the decision to the Supreme Court. The reasoning of the Fifth Circuit is strong enough that it risks invalidated other SEC rules if left standing. I’m hoping that the SEC will formally announce the delay of the compliance deadlines under the Private Fund Rules. It looks like it is pencils down on these new requirements.

23-60471_Documents-SEC-Private-FUnds-CaseDownload

Goodbye Salt Lake City


“The Securities and Exchange Commission today announced that it will close its Salt Lake Regional Office (SLRO) later this year, reducing its regional footprint from 11 regional offices to 10.”

The SEC’s Salt Lake City office has always stood out for covering such a small area. According to the press release, it has been the SEC’s smallest regional office. It has not housed examination teams for many years.

The One with the Bad Films

Film production is risky. There is need for capital to make the films and there are investors who want to say they helped fund a film. Christopher Conover had clients and investors who wanted to make those investments.

Mr. Conover disclosed that he “receives fees related to Mr. Conover’s role as an Executive Producer for film and television productions” and “a conflict of interest exists to the extent Hudson has an incentive to recommend investments in films and television productions for which Mr. Conover serves as Executive Producer.”

For two years, Hudson failed to disclose the producer compensation in its Form ADV. When it did update the disclosure is failed to disclose that the compensation was based solely on the amounts of money loaned to the Production Company for these films. The SEC felt the disclosure was inadequate.

The real problem is that the investments went bad. Mr. Conover made the mistake of allowing one investor to redeem and take money out while preventing other investors from doing so. According to the fund documents, partners who wanted to redeem their interest had to give at least 90 days’ notice and were capped at a withdrawal of 50% on a quarterly basis. Hudson and Mr. Conover deviated from their practice of satisfying limited partner redemptions on a pro rata basis when it lacked liquidity and redeemed a single investor in full ahead of other simultaneously submitted redemption requests from other investors. That special treatment was a violation of Mr. Conover’s fiduciary duty in the eyes of the SEC.

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Investment Adviser Statistics

The Securities and Exchange Commission published its 2024 report on Form ADV data for investment advisers.

The number of advisers and total assets have increased dramatically.

From 2012 when Dodd-Frank implemented a change requiring fund managers to register the number of registered investment advisers and Exempt Reporting advisers has increased by 60% from 13,222 to 21,203. The Regulatory assets under management has increased 138% from $55 trillion to $128.8 trillion.

The number of private funds has tripled from 33 thousand to over 100 thousand, with gross assets also tripling from $9 trillion to $27 trillion.

For real estate funds, there 658 registered advisers with over $1.1 trillion in gross assets for the 5,215 real estate funds. Those are increases from 371 advisers, $0.3 trillion in gross assets in 1,827 funds in 2012.

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Another Fund Manager Falls Victim to a Political Contribution

Another fund manager was heavily fined for an employee making a political contribution. Wayzata Investment Partners had to pay a $60,000 fine.

The Minnesota State Board of Investments made $300 million in commitments to Wayzata funds from 2007 to 2013. In 2022 a Wayzata employee made a $4000 campaign contribution to a Minnesota elected official who was up for re-election. The board of the Minnesota State Board of Investments consists of the Governor, State Auditor, Secretary of State, and Attorney General. All are elected offices. Neither the name of the employee or the politician are named in the SEC action.

Under SEC Rule 206(4)-5 a covered associate of a registered investment adviser can not make a contribution of more than $150 to a elected official who can directly or indirectly influence investment decisions. The Minnesota State Board of Investments falls under the coverage of the Rule.

The $60,000 fine was levied even though the funds were closed-end funds with no opportunity for withdrawal. The contribution was years after the commitments were made. There was no finding that there was a connection between the government investment and the political contribution. Under the Rule, the SEC does not have to prove any connection.

The fine is much less than the full penalty under the SEC rule which would be forfeiture of 2 years of management fees and carried interest. 

As with some other political contribution fines, Commissioner Peirce dissented from the decision in this case. She points out the stifling of political participation.

I’ll point out the magnitude of the fine. In most SEC cases the subject ends up paying a fine that matches the damage. In these political contribution cases, the subject is paying over a 10x penalty.

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SEC’s “Gag Rule” Survives Another Challenge

As part of the Wells Report in 1972, the Securities and Exchange Commission adopted its no-admit/no-deny policy. The SEC, in agreeing to settle a case, relinquishes the opportunity to present the case in court. The defendant relinquishes the right to defend the case in court, in the press, and in the eyes of the public.

The New Civil Liberties Alliance as part of its many attacks against administrative law has challenged the policy. It started in 2018 with a petition to amend the rule. Six years later, the SEC denied the petition on January 30, 2024.

The NCLA also took its legal attack to court, supporting an appeal by Christopher Novinger to get out from under this part of his settlement with the SEC. The Fifth Circuit denied his appeal this week on procedural ground. The decision is based deep on federal civil procedure and does not really get to the substance of the appeal. But the procedural hurdles may not allow an appeal.

The SEC complaint charged that Mr. Novinger fraudulently offered and sold life settlement interests by knowingly (or with severe recklessness):

  1. misrepresenting the purported safety and security of the investment;
  2. making false and misleading representations to prospective investors about his business experience ;
  3. failing to disclose to investors the sanctions imposed, and adverse actions taken, against them by multiple regulatory agencies;
  4. creating and using phony, meaningless titles for himself that were not actual, recognized designations in the financial industry – such as “licensed financial consultant,” “licensed financial strategist,” and “licensed consultant” – to create a false air of legitimacy; and
  5. providing investors with a net worth calculator that improperly inflated investors’ assets.

Mr. Novinger settled the case in 2016 and as part of the settlement was barred from association with an broker, dealer, investment adviser and was barred from participating in any penny stock offering. Of course, he agreed to not deny the charges against him.

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Private Funds Are Bigger Than Commercial Banks

The annual Securities and Exchange Commission request for funding from Congress is not generally very interesting. For fiscal year 2025 its seeking $2.6 billion to support over 5,000 full-time equivalents. Some of the stats are interesting. This one caught my eye:

Looking at the private funds area, in the last five years, the number of funds has increased 54 percent to approximately 56,000. The assets managed by private fund managers, now at $26 trillion in gross assets, surpasses the size of the entire U.S. commercial banking sector of approximately $23 trillion.

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Those 5,000 FTE cover a lot of firms:

We oversee approximately 40,000 entities—including more than 13,000 registered funds, more than 15,400 investment advisers, more than 3,400 broker-dealers, 24 national securities exchanges, 103 alternative trading systems, 10 credit rating agencies, 33 self-regulatory organizations, and six active registered clearing agencies, among other external entities. In addition, the SEC oversees the Public Company Accounting Oversight Board (PCAOB), the Financial Industry Regulatory Authority (FINRA), the Municipal Securities Rulemaking Board (MSRB), the Securities Investor Protection Corporation (SIPC), and the Financial Accounting Standards Board (FASB).

As for examinations of registered investment advisers, the SEC reached 2,362 this past year, expect to reach 2,282 this year and hopes to reach 2,324 in the following year. (See page 22) That’s assuming it gets the budget requested.

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SEC Proposes Updated Definition to Help Three Funds

The press release for changes to “qualifying venture capital fund” caught my attention. I didn’t recall that definition, so I took a closer look. It’s in Section 3(c)(1) of the Investment Company Act, which makes it part of the “private fund” definition.

Section 504 of the Economic Growth, Regulatory Relief, and Consumer Protection Act of 2018 (“EGRRCPA”) amended section 3(c)(1) of the Investment Company Act by adding “qualifying venture capital funds” into the exemptions from the investment company definition. Other companies can only have 100 people. Qualifying venture capital funds can have up to 250 people. EGRRCPA created the new definition of “qualifying venture capital fund” as:

“a venture capital fund that has not more than $10,000,000 in aggregate capital contributions and uncalled committed capital.”

That seems like an really small fund and I would think that a change to the definition if it added an extra zero would be very meaningful. Then I read that the SEC was only proposing to increase the amount from $10 million to $12 million.

Why bother? The statutory definition in EGRRCPA requires this $10,000,000 threshold “be indexed for inflation once every 5 years by the SEC. Here it is five years later.

I rarely read the economic analysis of a proposed rule, but I was really interested in the impact.

Based on the Form ADV filings there are at least 23,759 venture capital funds. Of those, there are 14,822 qualifying venture capital funds. Of those, 653 have more than 100 beneficial owners.

Ultimately, the SEC estimates that there are three (3!) venture capital funds that are not currently excluded from registration under section 3(c)(1) but that could be defined as a qualifying venture capital fund if the threshold were adjusted for inflation to $12,000,000 as proposed.

I was floored to read how many small venture capital fund are out there. I was not surprised that the rule only helped a handful of funds.

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