November 27, 2017: The U.S. Securities and Exchange Commission (“SEC”) was established by an Act of Congress to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation. Compliance with the Investment Advisers Act, the Investment Company Act, and other federal securities statutes is highly dependent upon the adviser’s capacity to fully appreciate where the SEC is headed when they contemplate a deficiency letter, enforcement action, or referral to the Department of Justice. For investment advisers, all aspects of the SEC mission statement have a direct correlation to the adviser’s business model, i.e., the non-compliant registered investment adviser presents an ongoing threat to undermine the Commission’s execution of its mission statement and therefore attracts significant resources and scrutiny from the regulator.
Fiscal year 2017 was by all accounts a successful year for the SEC’s Division of Enforcement. The Commission brought 754 actions and obtained judgments and orders totaling more than $3.7 billion in disgorgement and penalties. Significantly, it also returned a record $1.07 billion to harmed investors, suspended trading in the securities of 309 companies, and barred or suspended more than 625 individuals.
The Commission recently announced that in its fiscal year 2018, it will deliver a 20 per cent increase in the number of examinations of US investment advisers year-over-year. In June of 2017, the SEC announced the reassignment of 100 staff to adviser exams from the broker-dealer regime. In testimony before Congress, Chairman Jay Clayton noted that “for at least the next several years we will need to do more each year to increase the agency’s examination coverage of investment advisers in light of continuing changes in the markets…”
Beyond the OCIE Deficiency Letter, there are three manifestations of an SEC enforcement action to be imposed upon a non-compliant investment adviser if in fact the adviser’s compliance program is required to suffer the ignominy of a referral to the Enforcement Division. In roughly equal measure they are, penalties and fines, disgorgement of ill-gotten gains, and suspensions or bars that prevent wrongdoers from working in the securities industry. The latter has become a more widely utilized enforcement mechanism as the SEC seeks to reaffirm the personal accountability of professionals for acts of commission and omission which undermine the SEC’s mission.
The Division of Enforcement’s recently released 2017 Annual Report reveals significant insight into the current orientation of the Commission and its unwavering focus upon robust execution of its mission statement.
The Commission is steadfast in its execution of all three mission axes however the protection of investors remains a significant focus year after year regardless of political or budgetary considerations. This reality drives SEC resource allocation in the following investor protection subsets: cyber-related misconduct, non-compliant activities of investment advisers, financial reporting, insider trading, and market abuse. To closely align allocation of resources with two key SEC priorities—protecting retail investors and combatting cyber-related threats—at the end of fiscal year 2017, the Division announced the creation of a Cyber Unit and a Retail Strategy Task Force.
The Cyber Unit combines the Enforcement Division’s substantial cyber-related expertise and its proficiency in digital ledger technology. This component of the Enforcement Division will focus upon the following risk inflection points:
- Market manipulation schemes involving false information spread through electronic and social media;
- Hacking to obtain material nonpublic information and trading on that information;
- Violations involving distributed ledger technology and initial coin offerings (ICOs);
- Misconduct perpetrated using the dark web;
- Intrusions into retail brokerage accounts; and
- Cyber-related threats to trading platforms and other critical market infrastructure.
The Retail Strategy Task Force is a component of the Enforcement Division which focuses upon the protection of investors and relies heavily on the ongoing development and utilization of proprietary technology and data analytics to identify violations of federal securities statutes. The primary focus of the Retail Strategy Task Force will center on the following risk areas:
- Microcap markets;
- Offering frauds (where victims typically are retail investors); and
- The intersection of investment professionals and retail investors.
With respect to the latter area of risk, the Enforcement Division will scrutinize misconduct wherein advisers:
- Steer clients to higher-cost mutual fund share classes;
- Abuse wrap fee account protocol (churning, excessive trading, etc.); and
- Provide investor recommendations to buy and hold highly volatile products like inverse exchange-traded funds and/or provide unsuitable advice to purchase structured products.
Clearly the creation and funding of these Enforcement resources place the non-compliant registered investment adviser in greater reputational and regulatory jeopardy. A long forgotten Chinese philosopher once remarked “a picture is worth a thousand words.” In this same vernacular, one should refer to data provided by the Enforcement Division wherein an interesting “picture” emerges relating to the current and prospective orientation of the Enforcement Division.
Even in the midst of a transition in leadership, 2017 was an impactful year for the Enforcement Division. The Commission brought a diverse mix of 754 enforcement actions, of which:
- 446 were “standalone” (wherein the Commission either sued in civil action or referred to the Department of Justice in criminal action, individual defendants rather than subsets of defendants) actions brought in federal court or as administrative proceedings;
- 196 were “follow-on” proceedings seeking bars based on the outcome of Commission actions or actions by criminal authorities or other regulators; and
- 112 were proceedings to deregister public companies—typically microcap—that were delinquent in their Commission filings.
Consistent with the Division’s focus upon personal accountability, over 73% of the standalone actions entailed prosecution of non-compliant individuals while approximately 20% of these actions involved investment advisers and their personnel. Total monies ordered paid by defendants in fiscal year 2017 was $3.789 billion, comprised of $832 million in penalties and $2.957 billion in disgorgement.
A deeper dive into the numbers reveals a well-known fact … a small number of enforcement actions (generally against larger firms) constitute most of the penalties and disgorgements. Indeed, 5 percent of cases that involve the largest penalties and disgorgement account for most of the financial remedies the Commission obtained in its last fiscal year. However, the remaining 95 percent of cases not only constitute the bulk of the Enforcement Division’s overall activity and resources, but also address the broadest array of conduct. There should be no doubt that the Enforcement Division is intent on protecting all investors regardless of whether they are serviced by the very large investment adviser or the small adviser.
As noted, monetary sanctions and disgorgements are two legs of the enforcement protocol. A third and very effective means of behavioral modification utilized by the Enforcement Division entails removing bad actors from the securities industry altogether, whether as a suspension or a permanent bar. One of the most important things that the Commission can do proactively to protect investors and the market is to remove bad actors from positions where they can engage in future wrongdoing. Bars and suspensions allow the SEC to prevent wrongdoers from serving as officers or directors of public companies, dealing in penny stocks, associating with registered entities such as broker-dealers and investment advisers, or appearing or practicing before the Commission as accountants or attorneys. Enforcement actions resulted in over 625 bars and suspensions of wrongdoers in fiscal year 2017 and over 650 bars and suspensions in fiscal year 2016 pursuant to the SEC’s intent to focus upon personal accountability.
Insight into the Commission’s enforcement activity and underlying rationale provides a very valuable perspective to the adviser registrant intent on attaining and maintaining a culture of compliance. To this end, enforcement actions are closely watched by registrants and their agents. This scrutiny leads to improved compliance risk management and training as non-compliant behavior is modified. In this respect the actions of the Enforcement Division have a multiplier effect insofar as enforcement actions have a meaningful impact on market participants who are not involved in the particular misconduct that has been charged.
Of course, it is understood that registered advisers design their compliance risk management programs to avoid contact with the Division of Enforcement. Perhaps less understood that bears reinforcement with advisory staff is that personal accountability has never been more important.
 Testimony on “Oversight of the U.S. Securities and Exchange Commission” by Chairman Jay Clayton, Washington D.C., Sept. 26, 2017