In a program held on September 15, 2014 sponsored by the Securities and Exchange Commission Historical Society on Current Issues in Broker-Dealer Enforcement, Andrew Ceresney, the Director of the SEC’s Division of Enforcement responded to questions concerning whether the Division was implementing a ‘broken window’ philosophy of enforcement.
This phrase refers to a practice of pursuing numerous violations of rules perceived by some to have less investor protection significance and to settle them in accordance with a streamlined settlement process with the goal of deterring more serious violations. See The SEC Historical Society.
Mr. Ceresney emphasized that this mischaracterized their overall strategy since the emphasis in the cases attracting this criticism is on important issues where the SEC has observed a lack of compliance focus.
These cases have been easier to bring because of the “big data” analytical capabilities that the SEC staff now possesses. Based on these analytics, questionnaires or letters are sent to numerous potential targets where there are apparent violations as a prelude to relatively swift settlements where violations are confirmed.
The two areas Mr. Ceresney highlighted are:
- Violations of Section 105 of the SEC’s Regulation M under the Securities Exchange Act of 1934 (the “Exchange Act”), which generally prohibits firms or individuals from short selling a stock within five business days of acquiring the same stock from an underwriter or broker-dealer participating in an SEC registered offering;
- Failure to make timely ownership reports, either insider reports under Section 16(a) of the Exchange Act involving officers and directors or beneficial owners of 10% or more of a class of equity securities of US reporting companies, or Schedules 13D and 13G required under the Exchange Act for reporting 5% or more beneficial ownership of a class of equity securities of US reporting companies.
Section 105 is designed to prevent short sales that could artificially depress the price at which a stock is being offered in a registered offering, enabling the short sellers to cover at an artificially lower price.
Insider reports filed pursuant to Section 16(a), including initial reports on Form 4, provide important information to the market regarding insider holdings. Schedule 13D provides information about the intentions of persons who may have an influence on corporate control. Schedule 13G provides information concerning large holders who are either passive investors or regulated financial institutions which are not seeking to influence corporate control, but whose holdings are large enough that they could influence corporate control if their intentions changed.
Mr. Ceresney indicated that this trend of enforcement actions would continue with new areas of enforcement likely to emerge in the coming year as well. He indicated that these cases do not take away resources from major fraud cases involving investor protection issues, such as Ponzi schemes or major manipulation claims in which intentional conduct must be proven.
Consistent with Mr. Ceresney’s remarks, on September 16, 2014, the SEC announced settlements of administrative proceedings with 19 firms and one individual involving Rule 105 violations, resulting in a combined total of $9 million in disgorgement, interest and penalties. All of the firms involved were asset management firms, including one foreign-based firm. See SEC Sanctions 19 Firms and Individual Trader for Short Selling Violations in Advance of Stock Offerings.
This action follows the same pattern as the enforcement actions announced on September 17, 2013, involving 23 firms accused of Rule 105 violations, and the settlement with 22 out of 23 of them, resulting in over $14.4 million in monetary sanctions. These actions included proceedings against several foreign-based firms, including a foreign public pension fund. See SEC Charges 23 Firms With Short Selling Violations in Crackdown on Potential Manipulation in Advance of Stock Offerings.
On September 10, 2014, the SEC also announced charges against 28 officers, directors or major shareholders for violations involving their beneficial ownership of securities. Six public companies were charged with contributing to these reporting failures. 33 out of 34 individuals and companies settled, resulting in financial penalties of $2.6 million. Ten of the proceedings involved asset management and banking firms, including a large foreign banking group. See SEC Announces Charges Against Corporate Insiders for Violating Laws Requiring Prompt Reporting of Transactions and Holdings.
It should be noted that Section 105 has potentially worldwide application to persons acquiring stock from an underwriter or broker or dealer participating in an SEC registered offering. The reporting violations also fully apply to persons investing from outside the United States, even if they are acquiring the stock of a US reporting company in trading on a non-US marketplace. However, Section 16 (a) insider reporting does not apply if the issuer meets the definition of a foreign private issuer, as defined in Rule 3b-4 under the Exchange Act. See §240.3b-4 Definition of “foreign government,” “foreign issuer” and “foreign private issuer”.
Schedule 13D and Schedule 13G reporting, on the other hand, applies to all beneficial owners of equity securities of foreign private issuers, even if the stock is acquired in foreign trading. All of these reporting regimes have complex aggregation rules affecting affiliated groups and persons acting together, for which compliance systems need to be designed and implemented.
Both domestic and non-US market participants can expect the SEC staff to pursue monetary sanctions in cases involving these rule violations, and likely other trading and reporting violations that will emerge in the coming year, even if the market impact is limited. In the past, especially with foreign market participants, warnings and education were often used for relatively minor infractions.
The SEC staff is now signaling an increasing trend to zero tolerance for these types of violations.