Category: SEC News

New SEC Rulemaking Database

Strong rulemaking is central to the mission of the Securities and Exchange Commission. Transparency to the process is important so the affected parties can provide input and see changes coming. To help with mission and to improve transparency, the SEC launched a new database intended to provide better transparency.

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I applaud any effort the SEC takes to make it easier for compliance professionals to find, understand and implement its regulatory scheme.

I decided to try out the index/database and share my initial thoughts.

The new database does provide a better single source for lots of the SEC rules. It’s better than the current chronological listing of rules. But not not that much better.

The rules have three sortable fields:

  • Last action
  • File number
  • Title of rulemaking

The first two are not useful. Anyone remember the date the rule was proposed or the file no.? No I didn’t think so. The title is useful if you know the name and the name is descriptive.

I decided to look for two rulemaking that interest me: Crowdfunding implementation under the JOBS Act and General solicitation amendments to Form D and the private placement regime.

I had trouble. I didn’t know the date or the file number or the name. I have the choice to limit the rules displayed by Status: “All”, “complete” or “Proposed”. I also had the choice to limit the display by SEC division. None of these choice are particularly useful for the layperson. I’m not sure any of the database choices are even useful for compliance professionals.

The database lacks a separate search.

Fortunately, I have this website so I could search for the post about the changes, find the relevant SEC document and locate the file number on the document so I could use the database.

I found my post on the proposed amendments to Rule 506 and Form D that were released at the time the SEC issued the new Rule 506(c) allowing general solicitation. In the SEC’s database I see that the database shows the proposed rule and second rule re-opening the comment period.  I’m not sure I could have found that entry if it were not for this website.

Fortunately, the crowdfunding regulation was actually called “Crowdfunding” so it was easier to spot by sorting the “rulemaking” column.

I did notice that the Naked Short Selling Anti-Fraud rule is out of order because it is titled “Naked” Short Selling Anti-Fraud, with the punctuation disrupting the alphabetical sort.

 

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The SEC Tries to Change Its Home-Court Advantage

There has been much written about the problems with the Securities and Exchange Commission adjudicating cases in its own administrative law courts.  The SEC launched a proposal to change the rules for the SEC’s administrative proceedings to adjust the tilt of the home-court advantage.

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It’s clearly a move to limit the problems with the use of administrative judges. That is running into its own Constitutional challenge. It would seem that the SEC should change the appointment mechanism for its administrative judges. Of course that risks having past decisions overturned.

There is a clear home-court advantage for the SEC. The SEC won against 90% of defendants before its own judges in contested cases from October 2010 through March of this year, a Wall Street Journal analysis found. That’s higher than the 69% success rate in federal court.

The SEC’s proposals include many changes to the SEC’s Rules of Practice:

  • Permit parties to take depositions of witnesses as part of discovery
  • Require parties in administrative proceedings to submit filings and serve each other electronically, and to redact certain sensitive personal information from those filings
  • Hold hearings within four to eight months of an order.
  • Allow depositions but the requesting party would be responsible for all fees and expenses for the witness.
  • Permit subpoenas to compel a witness to attend a deposition, including one who “testified during an investigation.”
  • Reveal details of an expert witness’ upcoming testimony, exhibits to be shown and how much compensation the witness received.
  • Permit the division to withhold information on persons who are in settlement negotiations but “who are not respondents in the proceeding at issue.”

I think this a good step in the right direction for the SEC. There is an advantage to using the expertise of the SEC’s administrative judges who focus on the substantive area than a federal judge who handles a broad range of actions. The focus should be on the substance and not the procedural restrictions in the proceedings. The SEC should not have a home court advantage on the procedural side if it thinks it has better substantive decision-making.

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ReTIRE Initiative

The SEC said it would focus on matters relating to retail investors saving for retirement and the SEC followed through with the new exam focus: the ReTIRE Initiative.

risk alert

We’ve seen this coming. The National Exam 2015 priorities list stated that OCIE will focus on how retail investors at or nearing retirement are being served by investment advisers and broker-dealers.

Unlike some of the past initiatives, this one seems to look in a different direction than private funds. Unless of course the private fund is being marketed to retirement accounts.

(On a side note, I have mixed feelings about the forced acronym for the initiative. I admit that I said the “Never-Before Examined Initiative” lacked pizazz and a snappy title like “presence exam.”)

SEC examiners will be looking for signs of harm to these investors, in particular with retirement accounts, on four areas:

  1. Reasonable basis for recommendations
  2. Conflicts of interest
  3. Supervision of compliance controls
  4. Marketing and disclosure

These areas are not different or new compared to past initiatives. It just seems the focus is on advice around retired investors and retirement accounts.  That may be an interesting challenge if a firm is not tracking the types of accounts.

For private funds, the Form PF asks a breakdown of fund investors in 14 different categories. Retirement accounts is not one of those categories in Question 16. I’m not sure this is a category that many private funds actually track.

Perhaps the focus may be for self-directed IRAs and the risk of fraud seen in other cases for alternative investments.

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The SEC Goes After the Gate Keeper

When a fraud is uncovered, the Securities and Exchange Commission no only wants to get the fraudsters, it also wants to get those who should have stopped the fraud. The SEC just brought an action against an IRA Custodian for ignoring red flags for its accounts that invested in Ponzi schemes.

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The underlying fraud was conducted by Ephren Taylor with his City Capital Corporation investment fraud, and Randy Poulson with his Equity Capital Investments fraud. Taylor was convicted and was sentenced to 235 months in prison. Poulson has been indicted but is still fighting his case.

Equity Trust is a leading provider of self-directed IRAs. The firm pushes the laudable goal of seeking diversity outside of the stock market. It’s successful, with over 30,000 clients and approximately $12 billion of assets in custody.

According to the SEC complaint, the problem is that the firm’s salespeople have goals of opening accounts. That lead at least one unnamed salesperson to enter into a cozy relationship with Taylor and City Capital. Equity Trust’s accounts were a source of new capital for its Ponzi scheme and City Capital was a source of new accounts for Equity Trust.

The relationship was too cozy for the custodian from the view of the SEC. The salesperson was pushing its client accounts at Taylor and City Capital.

For example, in an email dated January 14, 2009, Salesperson A wrote to Taylor that he learned that the broker of an Equity Trust customer recommended to the customer that she not invest in Taylor Notes. Salesperson A then told the customer, “‘how can you comment on something you know nothing about….how can this broker comment on real estate when he has never done it.’” The customer responded, “‘great point’ let’s do it.” Salesperson A concluded his email to Taylor stating: “I am on it…I will close it.” The customer then invested more than $500,000 in Taylor Notes.

The salesperson trained City Capital on the use of self-directed IRAs. The firm even hosted a webpage for potential investors. The City Capital notes came in poorly documented and started having repayment issues. The firm began escalating holds and added City Capital to the “do not process” list. The firm continued to process existing accounts and collect fees. But did not inform the account holders of the problems with City Capital.

A similar story occurred with the Poulson’s investment fraud. Accounts were open and investments made, but the documentation was poor or missing. During one review, 25 out of 25 accounts were missing proper documentation. But Equity Trust continued to process to new accounts. It was only a year later that the firm put a stop on new investments.

The description above comes from the SEC charges which Equity Trust is contesting. The SEC also re-issued an investor alert on self-directed IRAs and the risk of fraud.

In my reading of the complaint, Equity Trust is charged with not acting quickly enough to stop investments in these two fraudulent schemes. At least one of the salespeople went too far and encouraged investment in the Ponzi scheme.

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Château de Crécy-la-Chapelle: Gate is by Baishiya 白石崖
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The SEC Suffers a Setback In Its Use of In-House Judges

Prior to the Dodd-Frank Wall Street Reform and Consumer Protection Act, the Securities and Exchange Commission’s authority to impose penalties in a case brought as an administrative proceeding was restricted to regulated entities. Dodd-Frank changed that with its Section 929P. The SEC may now impose a civil penalty in an administrative proceeding against any person or company. That means the SEC could use its in-house courts for insider trading cases. The SEC suffered its first major setback in that strategy.

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The SEC charged Charles L. Hill with the illegal use of material non-public information in the purchase of Radiant stock. The SEC alleged that Hill was tipped off by Radiant’s COO that the company was about to be acquired by NCR Corporation. Hill bought over 100,000 shares of Radiant and turned a profit of $744,000 in a month.

Hill is a real estate developer and is not a registered with SEC. The SEC chose to use an administrative proceeding instead of federal district court to bring the charges.

Hill fought back.

Hill filed for Temporary Restraining Order against the SEC, seeking to declare the administrative proceeding unconstitutional and to stop the SEC proceedings.

The judge found that the administrative proceeding does not provide meaningful judicial review. The SEC tried to deal with this challenge in the proceeding, but even the administrative judge admitted that the constitutional challenge was outside the SEC’s expertise.

The judge did not agree with Mr. Hill’s non-delegation claim. The SEC was free to chose the forum because Congress properly delegated that choice.

The judge also did not agree with Mr. Hill’s claim that the administrative proceeding wrongfully took away his Seventh Amendment right to a jury trial. Past interpretations of the Seventh Amendment have carved out the position that the jury is not the exclusive fact-finding mechanism for civil cases.

Mr. Hill did succeed in arguing that the administrative proceeding was a violation of the Appointments Clause of Article II of the Constitution.

Under that Clause, the President has principal officers who he or she selects, and are then confirmed by the Senate. There are inferior officers who may be appointed by the President, the heads of departments or the judiciary. The judge agreed that the SEC’s administrative judges are inferior officers.

As inferior officers, the administrative judges must be appointed by the five commissioners of the SEC. The SEC hired the judge in Mr. Hill’s case through its office of in-house judges.

The ruling is a setback for the SEC, but it seems it could be easily fixed. The SEC commissioners could directly make the appointments. That would likely cure the Appointment Clause violation.

The judge did not get to the two levels of tenure argument that might violate the Removals Clause of Article II. That issue is still out there and may be another roadblock to the SEC’s use of administrative judges for contested insider trading cases.

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SEC Loses Case Over the Word “May”

Few things make a compliance officer’s eyes roll more than the case the SEC was fighting against an adviser who used the word “may” in its Form ADV when the SEC thought it should say “will.” One of the SEC’s own administrative judges slapped down the SEC and dismissed the case.

Cash in the grass with room for your type.

According to the SEC charging order, an unnamed broker agreed to pay The Robare Group a fee for client funds invested in funds sold by that broker. Of course, there is nothing inherently wrong with that arrangement as long as it is disclosed to clients. Obviously, the concern is that the adviser would direct clients to invest in those funds because it is good for the adviser, not necessarily because it is good for the client.

The SEC is focused solely on a violation for failure to disclose. The SEC claimed the disclosures were not adequate because they said the Robare Group “may” receive compensation from the broker for selling the mutual funds, when it was definitely receiving payments. That’s a very thin distinction to make. Especially when the SEC stated in the complaint that it did not identify any harm to Robare Group’s clients or even that the clients were invested in those funds in a disproportionate amount.

The Robare Group used Fidelity mutual funds and much later found out that Fidelity offered a “revenue sharing arrangement” in which it would pay the firm between two and twelve basis points based on the assets under management. According to the final decision, Robare confirmed that the arrangement would not result in additional costs to its clients and would not alter the construction of its clients’ portfolios.

In the order, the judge highlights the testimony of Melissa Harke, a branch chief in the Commission’s Division of Investment Management, who testified that advisers are expected to disclose material conflicts in the Form ADV and should conversely not throw in everything just to “cover” themselves “for legal purposes.”

The judge also highlighted that the firm used an outside compliance consultant, Renaissance Regulatory Services to help with drafting the Form ADV.

No doubt, Mr. Robare and Mr. Jones paid Renaissance in hopes of avoiding the very proceeding of which they are now the subject.

There is no doubt that the revenue sharing arrangement gave rise to a potential conflict of interest. If the conflict is “material” it has to be disclosed in the Form ADV. The judge found that the conflict was material. The judge went on to find that the SEC failed to prove that Robare acted with any intent to deceive, manipulate or defraud its clients.

The SEC tried to argue that even if Robare did not have the intent to deceive, it was reckless in its failure to “fully and accurately disclose.” The judge found that

“with respect to Form ADV disclosures, advisers operate in a difficult environment that presents challenges for even experienced compliance professionals….I find that the relevant standard of care entails employing a compliance professional and following his or her advice.”

That similarly doomed the SEC’s argument that Robare was negligent. The firm and its principals did not have the expertise to properly disclose the information on Form ADV.

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Senator Warren Versus SEC Chair White

Senator Elizabeth Warren sent a sharp letter to Mary Jo White, Chair of the Securities and Exchange Commission.

“You have now been SEC Chair for over two years, and to date, your leadership of the Commission has been extremely disappointing.”

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Senator Warren raises four major issues:

  1. The SEC’s failure to finalize the rules for disclosure of the ratio of CEO pay to the median worker.
  2. The SEC’s failure to curb the use of waivers for companies found to be in violation of securities law.
  3. The SEC has settled the vast majority of cases without requiring the companies to admit guilt.
  4. Chair White’s inability to participate in numerous cases because of her prior employment and her husband’s ongoing employment.

Personally, I believe that Senator Warren and Chair White are both well-meaning individuals who are both trying to protect the American consumer and the American financial markets. Senator Warren is one of my Senators and I voted for her.

I think the CEO pay rule is a useless exercise that will take a great deal of resources at public companies. The actual calculations will be full of assumptions and inconsistencies. The end result will do nothing to curb CEO pay inflation, protect consumers, or bolster the capital markets.

According to competing stories, in a private meeting between White and Warren, White promised the final CEO Pay Ratio Rule would be enacted in 2015. However, the SEC released a rulemaking schedule to the Office of Management and Budget that stated the CEO Pay Ratio rule would not be done until April 2016. I’m not sure the statements are inconsistent. There may be a misunderstanding between when the rule is “finalized” and when it becomes “effective.” I suspect the goal is to get the rule enacted in 2015 but not have it be effective for annual filings until the 10Ks for 2016.

The waiver granting has gotten out of hand. I know many feel that it merely reinforces “too big to fail.” The SEC is liberally granting the waivers to the big firms that allows them to continue operating. However, the true test will be when a smaller firm gets into the same trouble. Will the SEC kill the smaller firm by not granting the same waiver?

Senator Warren cites the statistic that between June 2013 and September 2014, the SEC made 520 settlements but only required admission of guilt in 19 cases. But before White’s tenure, the SEC had never required a guilty admission, according to an SEC official. It’s still a strange legal limbo to settle, but not admit guilt.  The problem, of course, is the impact on private litigation such as shareholder lawsuits.

According to Warren’s letter, Chair White had to recuse herself at least four dozen times. Her personal restrictions have expired now that it has been two years since she left her law firm and her clients. Senator Warren raises an interesting point about Chair White’s husband. She sets up a theory that defendants may try to hire his firm to force her to recuse herself from the case.

These are all valid concerns. The letter is clearly setting the stage for the upcoming nominations for the two open slots on the SEC.

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SEC’s Home Court or Federal District Court?

Dodd-Frank gave the Securities and Exchange Commission broader powers to bring its enforcement actions in its own administrative court, instead of federal district court. Dodd-Frank changed that with its Section 929P. The SEC may now impose a civil penalty in an administrative proceeding against any person or company.

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The SEC recently released its “Division of Enforcement Approach to Forum Selection in Contested Actions” (.pdf) in what I think was an attempt to create greater transparency in the decision-making process.

There is no rigid formula dictating the choice of forum. The Division considers a number of factors when evaluating the choice of forum and its recommendation depends on the specific facts and circumstances of the case. Not all factors will apply in every case and, in any particular case, some factors may deserve more weight than others, or more weight than they might in another case. Indeed, in some circumstances, a single factor may be sufficiently important to lead to a decision to recommend a particular forum.

At just over three pages, you couldn’t expect much and it met that low bar.

At least one SEC Commissioner thought the SEC should have written guidelines. I assume that was part of the reason for releasing these guidelines.

The guidelines start off solid with the acknowledgment that certain claims and relief require a particular forum. If the SEC is looking for a temporary restraining order or asset freeze, it needs the powers of federal district court and has to bring the case in that forum. For registered entities or individuals, the SEC needs its administrative courts to impose a bar or suspension.

Then the guidelines wander into the messy and ill-defined areas of the efficient use of the SEC resources.

Towards the end, I found one section troubling.

If a contested matter is likely to raise unsettled and complex legal issues under the federal securities laws, or interpretation of the Commission’s rules, consideration should be given to whether … obtaining a Commission decision on such issues, subject to appellate review in the federal courts, may facilitate development of the law.

I don’t like the idea of the SEC developing law in its home court. Based on this statement, the SEC may be deciding to use its administrative courts as an incubator to create novel cases and areas of enforcement.

SEC developed the law of insider trading. There is no act of Congress that makes it specifically illegal. The SEC deemed it a fraud and developed the legal theory. The federal district court has recently handed the SEC a big set-back with the Newman insider trading case.

In federal district court, the judge will decide the law and the jury will determine if there is a violation. Obviously, a jury will be less sophisticated than an SEC administrative law judge in understanding the facts and the implications. The concept is to add a reasonable person standard to the process.

The guidelines seem to give the SEC the ability to take the ball back into its own court if it does not like what the federal district courts are doing. Of course that is subject to appellate review, after appealing to the Commission. That may cause the defendant in the SEC’s cross-hairs to spend more time and money appealling the decision.

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SEC Brings a Valuation Case Against an Investment Adviser

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Lynn Tilton and her firm, Patriarch Partners, are known for their high-risk, high-return investments in distressed companies. The Securities and Exchange Commission brought a case against her and the firm claiming that they were using improper valuations, failing to mark down assets when the investment became more distressed.

At this point we only have the SEC’s charges. According to a quote in the Wall Street Journal: “I’m choosing to fight,” Ms. Tilton said. “My reputation is very important to me and my companies. When my integrity or my intent are questioned, I fight back and let truth prevail.”

She will have to fight the SEC on its home turf. The SEC chose to bring the case as an action in its administrative court,s instead of federal district court. According to the Wall Street Journal the SEC brought the case through its in-house court in part to try to move the case quickly, since one of the funds at issue has a maturity date in November 2015.

Debt tends to be trickier to value than equity. There is the judgment call about how likely you are to have the debt repaid. This is even trickier with Patriarch where the debt is being used to fund the company’s turnaround being managed by Tilton and her companies. She would have the direct power or influence to determine when debt was repaid.

Patriarch’s valuation policy calls for current loans to be valued at the principal amount of the outstanding loan. A defaulted loan is supposed to be written down under the policy. The SEC viewed a default under the documents to be when the debtor fails to make an interest payment. According to the SEC, Tilton determined a loan in default when she will no longer provide financial and management support to the company.

In addition, the funds were supposed to have GAAP-compliant financial statements. Under GAAP, a loan is impaired, and must be measured for impairment when, based on all available information, it is probable that the creditor will be unable to collect all amounts due for interest and principal based on the contract with the debtor.

The difference in characterizing a default resulted in more than $200 million in fees earned on the higher valuations. It sounds like many of the problems could have been fixed with a stronger compliance program. Disclosure would have solved many of the issues in the SEC Order.

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Drew Bowden Thinks Private Equity is a Great Business

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“I tell my son, I have a teenaged son, I tell him, ‘Cole, you want to be in private equity. That’s where to go, that’s a great business, that’s a really good business. That’ll be good for you.'” – Andrew Bowden

Mr. Bowden, Director of the Securities and Exchange Commission’s Office of Compliance Inspections and Examinations, was speaking at Emerging Regulatory Issues in Private Equity, Venture Capital, & Capital Formation in Silicon Valley, hosted by Stanford Law School.

His quote was in the context of the financial services industry complaining about too much regulation. His comment led some to question the SEC’s coziness with the industry.

I still remember Bowden’s speech delivered at the 2014 PEI Private Fund Compliance Forum. He figuratively threw a grenade in the room by saying his team found violations of law or material weaknesses in over 50% of the exams of private equity firms when it came to fees and expenses.

I don’t see his speech as industry capture. I see it as telling private equity to quit complaining and get your house in order. Private equity is good for investors and good for managers. Don’t screw up.

It’s the job of compliance to keep the good thing going and not let the firm screw up.

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Image of Andrew Bowden is by the Securities and Exchange Commission (on Flickr!?!)