12 January 2018 - Post by:
Last year was something of a transitional year at the U.S. Securities and Exchange Commission (“SEC” or the “Commission”) and changes are now taking shape that will figure prominently on the SEC enforcement landscape in the coming year. Among them are the influence of new leadership, new enforcement priorities and programs, and new case law. Below, we consider several securities enforcement developments that are likely to have transformative effects in 2018.
New leadership, new direction
There has been a great deal of speculation about how aggressively new SEC leadership will investigate and punish securities laws violations. And the defense bar has been eagerly watching the direction of the SEC enforcement program since the new Chairman, Jay Clayton, and his Co-Directors of Enforcement, Stephanie Avakian and Steven Peikin, assumed their positions in 2017. 
Many have speculated that Mr. Clayton will usher in an “enforcement light” era at the Commission. Preliminary numbers reflect a modest decline in enforcement actions under the leadership of Mr. Clayton and his Co-Directors of Enforcement, but the dip may be fairly attributed to the winding up of several large-scale industry sweeps. Moreover, it is far too early to tell whether a moderate dip in the number of enforcement actions during this transitional period portends a broader directional change at the Commission.
It is not too early, however, to identify a few themes that have emerged in the months since Mr. Clayton was sworn in as Chairman. Below, we identify three such themes that are likely to be significant.
First, Mr. Clayton and the Co-Directors of Enforcement are outwardly committed to maintaining a robust enforcement program. On several occasions, Mr. Clayton has spoken about the need to “aggressively police our capital markets and enforce our nation’s securities laws.” Likewise, Co-Directors Avakian and Peikin insist that “[v]igorous enforcement of the federal securities laws is critical to combat wrongdoing, compensate harmed investors, and maintain confidence in the integrity and fairness of our markets.” Indeed, Ms. Avakian has made clear that, “[w]hile new leadership certainly brings about all sorts of change, one thing that will not change is the mission of the Enforcement Division—to protect investors.” From these statements, it would appear that neither Mr. Clayton nor the Co-Directors of Enforcement plan to foster an “enforcement light” culture at the Commission.
Second, the “broken windows” era is over.  Ms. Avakian and Mr. Peikin have given indications that they will pull away from former Chair Mary Jo White’s “broken windows” enforcement agenda and its attendant “industry sweeps.” Ms. Avakian and Mr. Peikin have shown less fervor about policing technical rules violations—they would prefer to dedicate their limited resources to rooting out misconduct that has a practical impact on the investing public.
Third, the Co-Directors of Enforcement are less concerned about enforcement statistics than their predecessors. While the number of enforcement actions and the amount of penalties has increased every year for the past several years, Ms. Avakian and Mr. Peikin have suggested that those who follow SEC enforcement matters should consider more than the raw number of enforcement actions when assessing the Division’s accomplishments. Mr. Peikin has suggested, for example, that the amount of money returned to harmed investors might be a suitable proxy for the program’s success. (In FY2017, the SEC returned a record $1.07 billion to harmed investors.)
Together, these themes would seem to suggest that the number of enforcement actions and the amount of penalties will decline, but the overall trajectory of the enforcement program will remain largely on course.
It is likely that the Enforcement Division will reallocate available resources to focus on new priorities and programs. Indeed, Mr. Clayton has “asked the Division of Enforcement to evaluate regularly whether we are focusing appropriately on retail investor fraud and investment professional misconduct, insider trading, market manipulation, accounting fraud and cyber matters.”
New priorities and new programs
The Enforcement Division’s FY2017 Annual Report identified five “core principles” that will shape the enforcement program: (1) focusing on Main Street investors, (2) focusing on individual accountability, (3) keeping pace with technological change, (4) imposing sanctions that most effectively further enforcement goals, and (5) constantly assessing the allocation of resources.
In keeping with these principles, Co-Directors Avakian and Peikin have consistently identified protecting retail investors and policing cyber-related misconduct as their top enforcement priorities. In support of those priorities, the Enforcement Division has reallocated resources to create a Retail Strategy Task Force and a dedicated Cyber Unit, both of which will play important roles in the Enforcement Division in 2018.
Retail Strategy Task Force
Mr. Clayton and the Co-Directors of Enforcement have spoken repeatedly about the programmatic importance of protecting retail investors. To that end, the Enforcement Division will be particularly keen on rooting out Ponzi schemes and microcap or offering frauds, as well as misconduct “that occurs at the intersection of investment professionals and retail investors”—in other words, misconduct involving investment advisers or broker-dealers who recommend unsuitable products or strategies, engage in abusive practices like churning, or charge outsized or undisclosed fees.
To bolster its efforts to protect retail investors, in September 2017 the Enforcement Division created a Retail Strategy Task Force that will develop proactive, targeted initiatives to identify misconduct impacting retail investors. The dedicated Task Force staff is not responsible for conducting investigations, but for developing and communicating ideas and strategies, in cooperation with offices and divisions across the SEC—including the Office of Compliance, Inspections and Examinations (“OCIE”).
The Retail Strategy Task Force has also been charged with developing data analytics tools and technologies that the Enforcement Division will use to identify potential threats to, or ongoing misconduct impacting, retail investors. In particular, Ms. Avakian has explained that the Task Force “will work with others in Enforcement…to consider ways to apply new tools and technologies, like text analytics and machine learning, to the vast amounts of trade and other data that we have, including the more than 16,000 tips, complaints and referrals that the Commission receives every year—to cover the broad landscape of conduct that directly affects the retail investor, in the most strategic and efficient way possible.”
In September 2017, the SEC Division of Enforcement announced the creation of a dedicated “Cyber Unit” that will focus on detecting and prosecuting cyber-related misconduct. The new Cyber Unit became the sixth so-called “specialized unit” within the Enforcement Division.
The Cyber Unit will target cyber-related misconduct in several areas, including market manipulation schemes involving electronic and social media; hacking-and-trading schemes; violations involving distributed ledger or “blockchain” technology and initial coin offerings (“ICOs”); intrusions into retail brokerage accounts; and threats to trading platforms and other critical market infrastructure.
The Cyber Unit filed its first charges in December 2017 in connection with a $15 million ICO fraud. According to Robert Cohen, Chief of the Cyber Unit, the case “hits all of the characteristics of a full-fledged cyber scam and is exactly the kind of misconduct the unit will be pursuing.” Indeed, given the SEC’s particular focus on ICOs and ICO fraud—and the frequency with which new issuances are coming to the market—it is likely that 2018 will see a raft of enforcement actions relating to token or coin offerings. 
In addition to the Cyber Unit’s stated priority areas, the Co-Directors are also considering the circumstances in which it would be appropriate to bring actions against regulated entities that fail to adequately safeguard information or ensure system integrity (e.g., charges under Regulations S-P, S-ID, or SCI). At present, they are disinclined to bring actions against an entity whose systems are breached or compromised—i.e., the “victim” of a breach—unless the entity knew about and ignored cybersecurity vulnerabilities.
New cases changing the enforcement landscape
In addition to changes within the Commission and the Enforcement Division, a number of recent and pending cases will impact the securities enforcement landscape in 2018.
The U.S. Supreme Court ruled in Kokesh v. SEC that disgorgement ordered in connection with SEC enforcement proceedings constitutes a “penalty” that is subject to a five-year statute of limitations. This limitation places an onerous burden on the enforcement staff to timely detect misconduct and institute investigations or enforcement actions. The limitations period may be particularly burdensome in FCPA cases, where disgorgement is a typical remedy and the alleged misconduct is often more than five years old.
The case will likely result in changes to the way the SEC approaches investigations and enforcement actions. For example, the SEC is likely to request tolling agreements with greater frequency, and also that they are agreed earlier in investigations; investigations will operate on tighter timetables; and the staff will try to find ways around Kokesh limitations (such as bringing AML or conspiracy charges with longer statutes of limitation or referring matters to foreign law enforcement agencies that operate under less restrictive time constraints).
In addition to these direct effects, there are likely to be collateral consequences to the Kokesh ruling. Among them, courts are beginning to apply Kokesh in different contexts. For example, the U.S. Court of Appeals for the D.C. Circuit ruled in October 2017 that, under Kokesh, expulsion or suspension of a securities broker is a “penalty.” The court instructed that, going forward, “FINRA and the SEC will have to reasonably explain in each individual case why an expulsion or suspension serves the purposes of punishment and is not excessive or oppressive.”
More importantly, perhaps, a footnote in Kokesh calls into question courts’ authority to order disgorgement in SEC enforcement proceedings. The footnote seems to invite a challenge and is likely to spawn litigation in 2018 regarding the scope of remedies available to the SEC. The consequences of such litigation remain unclear, but it could result in a finding that the disgorgement remedy is no longer available to the SEC in matters it brings in federal district courts. (Disgorgement is, however, a statutorily provided remedy in SEC administrative proceedings.)
Lucia v. SEC
The U.S. Supreme Court is poised to take a case that could resolve a split between the Tenth Circuit and the D.C. Circuit over whether Administrative Law Judges (“ALJs”) are “inferior officers” that must be appointed by the president or the “head” of a department under the Appointments Clause of the Constitution.
In November 2017, the SEC asked the Court to take the case and, in its brief, the SEC abandoned its long-standing position that its ALJs are not “inferior officers,” but “mere employees” whose hiring need not pass constitutional muster. Following its change in position, the Commission formally ratified its prior appointments of five ALJs, in an effort to remedy the potentially unconstitutional hiring process. The SEC also ordered its ALJs to reconsider the record in all pending cases.
Should the U.S. Supreme Court take the case, its decision could have a transformative effect on administrative proceedings at the SEC and other regulatory agencies that rely on ALJs to resolve enforcement or disciplinary actions. Importantly, if the Court were to decide that ALJs are, in fact, “inferior officers”, the validity of all prior ALJ decisions may be in question.
Since its inception in 2011, the SEC’s whistleblower program has been extraordinarily successful. Indeed, the SEC has awarded more than $175 million to whistleblowers, and enforcement actions involving whistleblower tips have resulted in more than $1 billion in financial remedies. The whistleblower program, which enjoys largely bipartisan support, will continue to be an important source of information relating to potential violations of the securities laws.
A potential wrinkle, however, arises in Digital Realty Trust Inc. v. Paul Somers, a case in which the U.S. Supreme Court will decide whether a whistleblower must report to the SEC in order to qualify for certain whistleblower protections provided in the Dodd-Frank Wall Street Reform and Consumer Protection Act (e.g., protection against employer retaliation). The SEC insists that all whistleblowers—including those that report internally, but not to the SEC—qualify for Dodd-Frank whistleblower protections. The Court, however, seems inclined to strictly interpret language in the Dodd-Frank Act to find that whistleblower protections apply only to SEC whistleblowers. Such a ruling could result in more reports to the SEC by whistleblowers who want to preserve all possible protections.
It is worth noting, too, that the Court has demonstrated an inclination to use Digital Realty as an opportunity to clarify—or limit—the scope of so-called “Chevron Deference”, a doctrine that gives broad deference to federal agencies’ interpretations of rules or laws that they are charged with administering. A ruling that touches Chevron could result in a rebalancing that would almost certainly limit the power of federal agencies.
US v. Martoma
Over the past several years, a number of landmark cases have changed the insider trading landscape. Generally, those cases have considered the circumstances in which it may be said that a “personal benefit” flowed to an insider/tipper from an outsider/tippee in exchange for material nonpublic information.
First, in U.S. v. Newman, the Second Circuit held that a “personal benefit” exists where a “meaningfully close personal relationship … generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature.” Later, in Salman v. U.S., the U.S. Supreme Court held that the “personal benefit” test is satisfied when an insider/tipper provides information to a relative or friend who then trades, irrespective of any actual or potential pecuniary gain.
In August 2017, in U.S. v. Martoma, the Second Circuit abandoned the “close personal relationship” requirement, holding that the “personal benefit” test is satisfied where material nonpublic information “was disclosed with the expectation that the recipient would trade on it, and the disclosure resembles trading by the insider followed by a gift of the profits to the recipient.” The defendant has requested a rehearing before the Second Circuit, though the case could end up before the U.S. Supreme Court.
Insider trading law was once well-settled terrain, but the sands have shifted over the past several years. It will be interesting to see how the landscape continues to evolve through case law in 2018. And, perhaps, given the continuing degree of uncertainty, Congress and/or the Commission will consider creating an insider trading statute. Several foreign jurisdictions have clarified their insider trading restrictions through legislation, and U.S. District Judge Jed Rakoff has recommended on several occasions that the U.S. follow suit.
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The coming year will continue to be a transitional period for the Enforcement Division. While it appears the new era will be marked mostly by consistency with past enforcement programs, we should expect to see a moderate decline in the number of enforcement actions, as well as changes in enforcement priorities. We should also expect changes to the overarching legal framework and be prepared to adjust its new contours. Tracking the developments identified above will help you spot directional changes in 2018.
 Hester Peirce and Robert Jackson were sworn in as SEC Commissioners on January 11, 2018, filling out the five-member commission for the first time since 2015. While Ms. Peirce and Mr. Jackson spoke to the importance of a robust enforcement program during their confirmation hearing, it remains to be seen what impact they will have on the SEC’s enforcement agenda.
 Former SEC Chair Mary Jo White described the “broken windows” theory in a 2013 speech: “[W]hen a window is broken and someone fixes it—it is a sign that disorder will not be tolerated. But, when a broken window is not fixed, it ‘is a signal that no one cares, and so breaking more windows costs nothing.’ The same theory can be applied to our securities markets—minor violations that are overlooked or ignored can feed bigger ones, and, perhaps more importantly, can foster a culture where laws are increasingly treated as toothless guidelines. And so, I believe it is important to pursue even the smallest infractions.”
 For example, Chairman Jay Clayton has “asked the SEC’s Division of Enforcement to continue to police this area vigorously and recommend enforcement actions against those that conduct initial coin offerings in violation of the federal securities laws.”