What type of information can be submitted to the SEC?
The SEC posts Notices of Covered Actions on its website for every case in which more than $1 million in sanctions is recovered. We regularly monitor these postings to identify the types of cases that are actively pursued by the SEC. The following summary illustrates the types of misconduct that have been the subject of past enforcement actions. It provides insight into the types of fraud that the SEC might pursue in future enforcement efforts. This summary is not intended to be an exhaustive list; there are many other types of information that can lead to rewards for whistleblowers not listed here.
Companies that manipulate accounting standards and data are a perennial target of SEC enforcement actions. The SEC carefully examines allegations involving misstatements of revenues, expenses or asset valuations that are designed to mislead investors, smooth earnings fluctuations or meet analysts’ estimates. This type of fraud also includes improper accounting adjustments in violation of Generally Accepted Accounting Principles. In addition, a company can be liable for failing to maintain sufficient internal accounting controls to prevent errors in their financial statements.
One of the SEC’s primary areas of focus in accounting misconduct is the fraudulent recognition of revenue. The SEC’s Enforcement Division proactively investigates allegations of financial reporting violations, and will quickly respond when it receives information of potential violations from whistleblowers. The SEC has not only targeted the conduct of high-level financial personnel within a company, it has also focused on individuals who work “in the trenches,” such as public company auditors.
In 2017, the SEC created the Cyber Unit of its Division of Enforcement to target various types of illegal activity in the digital world, including: (1) market manipulation schemes involving false information spread through electronic and social media; (2) hacking to obtain material nonpublic information; (3) violations involving distributed ledger technology and initial coin offerings; (4) misconduct perpetrated using the dark web; (5) intrusions into retail brokerage accounts; and (6) cyber-related threats to trading platforms and other critical market infrastructure.
In early 2018, the SEC published its first guidance on cybersecurity which recommends that companies establish policies and procedures to mitigate cybersecurity risks and prevent insider trading. The guidance emphasizes that companies should implement policies and procedures that enable senior management to evaluate the existence of a data breach, its impact, and the companies’ disclosure obligations. The SEC also advises that companies have adequate policies and procedures to prevent illegal insider trading before public disclosure of a material cybersecurity incident.
The guidance on cybersecurity may be a precursor to a new area of SEC enforcement – failure to maintain reasonable cybersecurity safeguards. Stephanie Avakian, SEC’s Co-Director of the Enforcement Division identified the safeguarding of information and assurance of system integrity as areas of interest for the Cyber Unit. Avakian highlighted specific SEC regulations which require that companies “understand the risks they face and take reasonable steps to address those risks,” such as having “reasonable safeguards in place to address cybersecurity threats.”
The Foreign Corrupt Practices Act
The Foreign Corrupt Practices Act (FCPA) prohibits gifts and improper payments to foreign government officials to obtain or retain business or government contracts. For conduct to fall within the scope of the FCPA, it is not necessary for a government official to be directly related to the award or retention of a government contract. The language of the FCPA has been broadly interpreted to encompass any business purpose or conduct designed to gain a business advantage. The SEC has provided some illustrative examples of conduct that constitutes obtaining or retaining business:
- Winning a contract
- Influencing the procurement process
- Circumventing the rules for importation of products
- Gaining access to non-public bid tender information
- Evading taxes or penalties
- Influencing the adjudication of lawsuits or enforcement actions
- Obtaining exceptions to regulations
- Avoiding contract termination.
The FCPA also contains accounting provisions applicable to public companies. There are two primary components of the accounting provisions. Under the “books and records” provision, a company must keep accurate books, records, and accounts that fairly reflect the company’s transactions and dispositions of its assets. The “internal controls” provision requires that a company maintain a system of internal accounting controls that ensures management control, authority, and responsibility over the company’s assets. Violations of the FCPA can lead to civil and criminal penalties, sanctions, and remedies, including fines, disgorgement, and/or imprisonment.
There is no statutory definition of “insider trading.” The rules prohibiting insider trading have largely been made by the SEC and interpreted by the courts. Insider trading has been characterized in court opinions as the purchase or sale of a security by a person while in possession of material, non-public information concerning that security, where the information is obtained from a breach of fiduciary duty, or from a duty arising from a relationship of trust or confidence.
The SEC has prosecuted individuals trading on inside information, as well as individuals who passed on material, nonpublic information to others who executed trades based on the information. In Salman v. United States, 580 U.S. ___ (2016), the Supreme Court addressed the issue of whether a gift of confidential information to a friend or family member alone is sufficient to establish the “personal benefit” required to impose liability. The Supreme Court affirmed the criminal conviction of a man who received trading tips from an extended family member. The court found that the “personal benefit” requirement of laws that prohibit insider trading may be met by “making a gift of confidential information” to a trading relative or friend.
Misconduct by Exchanges
The SEC also investigates rule violations committed by exchanges. Exchanges have been sanctioned for failing to enforce SEC rules, inadequate investigation of compliance problems, and unauthorized accommodations for member firms. An exchange can also be subject to sanctions when it implements a new business practice, or modifies an existing practice without creating a new rule when required.
In March 2018, the SEC charged the New York Stock Exchange and two affiliated exchanges with regulatory failures in connection with multiple violations, including several events that caused market disruption. It was first time the SEC prosecuted a violation of its Regulation Systems Compliance and Integrity (Reg SCI), a series of broad regulations focused on business continuity and disaster recovery. The charges against the exchanges included erroneously implementing a market-wide regulatory halt and negligently misrepresenting stock prices as “automated” despite extensive system problems before a complete shutdown of two exchanges. The SEC also charged the exchanges with applying price collars during unusual market volatility on August 24, 2015, without a rule in effect to permit such actions. The action reportedly resulted in slower resolution of order imbalances. The exchanges agreed to pay a $14 million penalty in settlement of the charges.
Misrepresentations to Investors
SEC Rule 10b-5 makes it unlawful to “[t]o make any untrue statement of a material fact or to omit to state a material fact . . .” or “engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.” Simply stated, a misrepresentation is a false statement or omission of a material fact relating to an investment. A “material fact” is any information that any average investor should know before buying or selling a security. Examples of material information include brokerage fees, commissions, and other costs related the purchase of a security; risks associated with a particular investment; and a company’s financial condition when the transaction involves the company’s stock.
In the context of a security offering, failure to disclose material information can include important financial details such as company revenues, liabilities, assets and corporate management. The SEC also protects shareholder investments by enforcing rules against manipulation of financial statements through mark-to-market pricing or improper accounting adjustments
Another common area of SEC enforcement is misappropriation of investor funds for personal or business expenses. SEC rules strictly prohibit misrepresentations relating to the intended use of funds from an offering or the manner in which client accounts will be invested. A company must also have appropriate safeguards to protect client funds from unauthorized activity. For example, the SEC brought an enforcement action against a large brokerage firm that failed to adopt policies and procedures designed to prevent financial advisors from misusing and misappropriating funds in client accounts. Because of its inadequate policies and procedures, the firm failed to detect that one of its employees misappropriated funds from client accounts over a period of nearly one year.
The SEC has been especially diligent in cracking down on Ponzi schemes following the fallout from the Bernie Madoff scandal. A Ponzi scheme typically involves a promise of extraordinary or guaranteed returns that pays earlier investors by using funds obtained from later investors. The SEC will pursue other types of fraud against shareholders, including individuals and corporations that sell fictitious securities or bank instruments to unwitting investors.
Brokerage and Private Equity Fees
The SEC has undertaken numerous investigations of alleged violations relating to fees and expenses charged by brokerages and private equity firms. In a 2014 speech, Andrew Bowden, Senior Vice President and General Counsel at Jackson National Life Insurance Company, highlighted the lack of disclosure of the extra fees and expenses charged by some private equity firms above and beyond the normal management fees paid by investors.
The SEC requires that private equity firms properly register with the commission when they charge certain fees. For example, private equity firm managers and operators often charge large transaction fees from portfolio companies as part of the fund’s acquisitions and sales of the securities. However, in most cases the negotiation of such transactions, and the resultant fees charged, are considered an investment banking activity that requires registration with the SEC as a broker-dealer. Despite this restriction, many private equity firms operate as unregistered broker-dealers.
SEC enforcement actions for improperly charging fees can lead to sanctions, fines and, in some cases, rescission of investor purchases. In one enforcement action, the SEC found that traders and salespeople of a large brokerage firm convinced bank customers to overpay for Residential Mortgage Backed Securities (RMBS) by deceiving them about the price the firm paid to acquire the securities. The SEC also found that the firm’s RMBS traders and salespeople illegally profited from excessive, undisclosed commissions, called “mark-ups.” In some cases, these mark-ups were more than twice the amount customers should have paid. The brokerage firm also had inadequate compliance and surveillance procedures to prevent and detect this type of misconduct which increased the firm’s profits on RMBS transactions to the detriment of its customers.
Trading Price Manipulation
Market manipulation is a classic violation of securities laws. Unscrupulous individuals may artificially increase the price or volume of a stock in order to attract other investors. These schemes are sometimes combined with a form of microcap stock fraud where false and misleading press releases or statements are issued to artificially inflate the price of the stock. This “pump and dump” scheme allows unscrupulous brokers and investors to sell their shares before stock price plummets. The remaining investors are left with a stock that is worth significantly less than they paid for it.
In 2018, the SEC charged four individuals involved in a fraudulent scheme that generated nearly $34 million from unlawful stock sales. According to the complaint, the defendants manipulated the market and illegally sold the stock of a microcap issuer. As part of the alleged scheme, the defendants hid their ownership and sales of shares of the microcap company by using offshore bank accounts, sham legal documents, anonymizing techniques, and other deceptive practices. The defendants also allegedly directed a wide-ranging promotional campaign and employed manipulative trading techniques to artificially inflate the share price, which reportedly netted them nearly $34 million. The SEC obtained a court order that froze the proceeds from the sales of the stock. It subsequently obtained a default judgment and established a recovery fund, which returned more than $14 million to defrauded investors.
Market manipulation does not always involve the actual execution of orders. “Spoofing” and “layering” are forms of market manipulation in which a trader places a bid or offer on a stock with the intent to cancel the bid before execution. These fraudulent practices are intended to deceive other traders as to the true levels of supply or demand in the market. In other cases, traders have used limit orders to influence mark-to-market accounting in order to mask investment losses.