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Quarterly Securities Enforcement Briefing

January 2015
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SEC Identifies 2015 Enforcement Priorities in its Agency Financial Report for Fiscal Year 2014
By Jeffrey B. Coopersmith

In November 2014, the SEC released its Agency Financial Report for Fiscal Year 2014. The full report is available here. The SEC reported that it ended its Oct. 1, 2013, through Sept. 30, 2014, fiscal year by bringing 755 enforcement actions and obtaining orders for $4.16 billion in penalties and disgorgement. The SEC credited its success in part to its use of data mining techniques to detect fraud and other securities law violations.

For 2015, the SEC announced its enforcement priorities for 2015. Among other things, the SEC reported that it intends to focus on the following areas:

  • Financial reporting and accounting fraud. The SEC stated that its Financial Reporting and Audit Task Force will continue to identify violations relating to the preparation of financial statements, issuer reporting and disclosure, and audit failures.
  • Broker-Dealers. The SEC’s Broker-Dealer Task Force will focus on developing and rolling out nationwide initiatives to combat problematic practices such as churning and the failure to comply with anti-money laundering requirements.
  • Microcap Fraud. The Microcap Fraud Task Force plans to be proactive by using strategies including trading suspensions and efforts to target repeat players and gatekeepers (i.e., lawyers, accountants, and other professionals).
  • Data Mining. The SEC plans to continue to use technology to better process and understand large volumes of data. This includes employing technology to identify and investigate potential violations, including high-risk areas that could harm investors, markets, or regulated entities.

2nd Circuit Deals Significant Blow to Government in Insider Trading Cases
By Conner G. Peretti

The 2nd Circuit’s Dec. 20, 2014, opinion in United States. v. Newman and Chiasson has significantly raised the bar for federal prosecutors in insider trading cases. The 2nd Circuit dismissed the indictments against two defendants who had been convicted of insider trading at trial because the government failed to prove that they knew that the insiders who tipped them the information received a “personal benefit” in exchange for the tips. In dismissing the indictments, the 2nd Circuit raised the bar on the definition of “personal benefit,” holding that a “personal benefit” to the tipper is sufficient to sustain a conviction of the tipper or tippee only if it “generates an exchange that is objective, consequential and represents at least a potential gain of a pecuniary or similarly valuable nature.”

The decision deals a significant blow to the government’s prosecution of insider traders. Before this ruling, the U.S. Department of Justice and the Securities and Exchange Commission often relied on proof of “reputational benefit” to the tipper, such as friendship, advice or mentoring. As of the result of Newman, the government now must prove (at least in the 2nd Circuit but perhaps beyond as the case law develops) an objective, consequential exchange with at least a potential for pecuniary or similar gain, as well as the tippee’s knowledge of that benefit to the insider. As the court noted, if proof of friendship, career advice or other “reputational benefit” were a “benefit” under the law, “practically anything would qualify.” Id. at 21.

Some legal commentators have described the decision as a “roadmap” for insider traders because it may authorize casual sharing of inside information among friends, as long as there is no potential for pecuniary gain.  Other commentators have noted that the prohibition on insider trading comes only from the general securities fraud statute, not from any specific statute, so it is fitting that the courts are more restrictive as to criminal liability. Preet Bharara, the U.S. Attorney for the Southern District of New York, responded in a statement that the decision “will limit the ability to prosecute people who trade on leaked information, [though it] affects only a subset of our recent cases.” On Jan. 23, Mr. Bharara’s office sought rehearing and a rehearing en banc of the decision, describing the new standard in the filing as “deeply confounding.”

The Question of Whether Internal Reporting Triggers Whistleblower Protection Under Dodd-Frank Remains Unsettled
By John A. Goldmark

The 5th Circuit’s 2013 decision in Asadi v. GE Energy (USA) LLC, which limited Dodd-Frank’s whistleblower protections to those who reported to the SEC in advance of the alleged retaliation, has sharply divided the district courts, setting up the issue for a circuit split and likely eventual Supreme Court review.

In Asadi, the 5th Circuit ruled that a former GE executive, who claimed he was fired for reporting a possible securities law violation, did not qualify as a whistleblower under Dodd-Frank because he reported internally rather than to the SEC.  The court found the plain language of Dodd-Frank extends whistleblower protection only to those individuals who report securities violations “to the Commission,” and refused to give deference to a recent SEC regulation stating that internal reporting satisfies Dodd-Frank. This ruling makes Dodd-Frank stand in contrast to the Sarbanes-Oxley Act, 18 U.S.C. § 1514A, which extends whistleblower protection to individuals who claim retaliation after reporting violations internally.

Before Asadi, most district courts had found ambiguity in Dodd-Frank and relied on the SEC’s interpretation in extending protection to internal reporting (like the Sarbanes-Oxley Act does). But Asadi changed the legal landscape. District courts outside the 5th Circuit are now split, with some courts following Asadi and the plain statutory language and others finding statutory ambiguity and relying on the SEC’s expansive interpretation.

Until other circuit courts address the issue, or it is resolved by the Supreme Court, there will continue to be uncertainty about whether an employee who claims to have been fired for reporting securities violations internally can claim whistleblower protection under Dodd-Frank.

FINRA Announces 2015 Regulatory Priorities
By Candice M. Tewell

On Jan. 6, 2015, the Financial Industry Regulatory Authority (“FINRA”) released its 2015 Regulatory and Examination Priorities letter highlighting risks and issues FINRA believes could adversely affect investors and market integrity. The 15-page letter to broker-dealers outlines a number of areas FINRA examiners will focus on as part of their inspections this year, from sales practices around complex securities to firms’ approaches to cybersecurity risk management to the use of abusive trading algorithms.

This year’s letter opens by highlighting five areas in which it has seen recurring challenges or shortcomings in broker-dealer activity:

  • Alignment of firms’ interests with those of their customers;
  • Standards of ethical behavior;
  • Development of strong supervisory and risk management systems;
  • Development, marketing, and sale of novel products and services; and
  • Management of conflicts of interest.

These challenges cut across and can affect many of the areas of focus described in the letter.

FINRA’s areas of focus for 2015 cover a broad spectrum. Some are product-focused concerns, for example the sale of interest rate-sensitive fixed income securities and floating-rate bank loan funds. Another area of focus will be high-risk and recidivist brokers, who can cause outsized risk to investors. FINRA is also seeking to protect the growing population of senior investors, noting that “[t]he consequences of unsuitable investment advice can be particularly severe for this investor group since they rarely can replenish investment portfolios with fresh funds and lack time to make up losses.”

Cybersecurity is becoming an area of focus for FINRA as it has for public and private companies across the globe. FINRA examiners will now “review firms’ approaches to cybersecurity risk management, including their governance structures and processes for conducting risk assessments and addressing the output of those assessments.” In early 2015, FINRA expects to publish the results of a 2014 sweep investigating the types of threats to which member firms are subject.

Another specific problem area already subject to FINRA sweeps launched in July 2014 are brokerages’ order-routing practices. Early reviews of routing decisions “show that some firms do not have active best execution committees or other supervisory structures in place to meet their obligation to regularly and rigorously evaluate the quality of customer order executions.”

For more information, you can find FINRA’s 2015 Regulatory and Examination Priorities letter here. 
 

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