What type of information can be submitted to the SEC?
The SEC will pay awards to eligible whistleblowers who voluntarily provide “original information” involving violations of federal securities laws. “Original information” is defined as facts that are not publicly available and derived from independent knowledge. Publicly-available information can, however, be an element of original information provided that it contains independent analysis and is not already known by the SEC.
The SEC seeks timely and credible information involving violations of federal securities laws. The Commission specifically advises that a whistleblower’s tip is more likely to be forwarded to investigators for follow up if it contains detailed and specific information. Examples of specific information include details about the individuals involved in a particular scheme, or non-public evidence that corroborates allegations of violations of securities laws.
In order for information to be considered as having “led to” a successful enforcement action, the whistleblower’s tip must cause the SEC to open a new investigation or re-open a previously closed investigation.
Protections Against Employer Retaliation
The enactment of the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010 provided enhanced protections from employer retaliation for employees who report conduct that they reasonably believe violates federal securities laws. Retaliation encompasses a broad range of conduct but generally includes actions such as suspension, demotion, harassment, termination or any form of discrimination relating to the terms and conditions of employment.
Dodd-Frank empowered the SEC to bring a cause of action against any employer who retaliates against a whistleblowing employee. In addition, Dodd-Frank created a private right of action that allows whistleblowers to file a retaliation complaint in federal court. An employee who proves that his or her employer engaged in prohibited retaliatory conduct, can sue for damages including double back pay (with interest); reinstatement; attorneys’ fees; and reimbursement for certain costs related to the litigation.
Areas of Enforcement and Examination Priorities
While the SEC thorough reviews all information, complaints and referrals it receives, it places special emphasis on the areas it believes present the greatest risks to investors and the integrity of U.S. markets. The whistleblower attorneys at McEldrew Young Purtell Merritt stay abreast of these trends by closely monitoring the SEC’s enforcement actions. Our attorneys have identified the following areas that been the focus of recent enforcement actions.
In recent years, the SEC has emphasized the need for public companies to make cybersecurity a meaningful part of their internal controls and procedures. In 2017, the Cyber Unit of the SEC’s Division of Enforcement was created to target various types of illegal cyber-related activity, including: (i) market manipulation schemes involving false information spread through electronic and social media; (ii) hacking to obtain material nonpublic information; (iii) violations involving distributed ledger technology and initial coin offerings; (iv) misconduct perpetrated using the dark web; (v) intrusions into retail brokerage accounts; and (vi) cyber-related threats to trading platforms and other critical market infrastructure.
Another aspect of the SEC’s enhanced cybersecurity strategy is to encourage public companies to be transparent with investors about material cyber risks and incidents. The Commission issued guidance to companies emphasizing the importance of avoiding misleading disclosures in public filings. As it relates to cybersecurity, “misleading disclosures” can include specific information about known trends, risks and uncertainties due to cyberthreats. It can also mean omissions such as a public company’s failure to disclose a known threat, security breach, or data theft. Any of these scenarios could constitute a violation of one or more federal securities laws.
In its first guidance on cybersecurity published in 2018, the SEC recommended that companies establish policies and procedures to mitigate cybersecurity risks and prevent insider trading. The guidance urged companies to implement policies and procedures to allow senior management to evaluate the existence of data breaches, the impact on company operations, and required disclosure obligations. The SEC also advised that companies maintain internal controls to prevent illegal insider trading prior to public disclosure of a material cybersecurity incident.
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. It isn’t necessary for a government official to be directly related to the award or retention of a government contract for the prohibited conduct to fall within the scope of the FCPA. The language of the FCPA has been broadly interpreted to encompass any business purpose or conduct designed to gain a business advantage. The SEC offers some illustrative examples of conduct that constitutes obtaining or retaining business under the FCPA, including:
- Winning a contract;
- Influencing the procurement process;
- Circumventing the rules for importing goods;
- Gaining access to non-public bid tender information;
- Evading taxes or penalties;
- Influencing the adjudication of lawsuits or enforcement actions;
- Obtaining exceptions to regulations; and
- Avoiding contract termination.
The FCPA also contains accounting provisions applicable to publicly-traded 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 the 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 company assets. Violations of the FCPA can lead to civil and criminal penalties, sanctions, and remedies, including fines, disgorgement, and/or imprisonment.
In recent years, a noticeable trend in enforcement actions suggests that the SEC has adopted a less restrictive view of bribery in cases involving violations of the FCPA’s accounting provisions. In some cases, the nexus to bribery has been so attenuated as to almost render an accounting provision violation as separate, standalone offense. For example, In the Matter of Elbit Imaging Ltd., SEC File No. 3-18397 (March 9, 2018), the SEC charged an Israeli-based company with violations of the FCPA’s books and records and internal controls provisions. Elbit Imaging, and its majority-owned indirect subsidiary, directly and indirectly paid millions of dollars to third-party offshore consultants and sales agents over a five-year period. Although the payments were purportedly made for services related to a real estate project in Romania and the sale of real estate assets in the United States, the company and its subsidiary had no evidence that the consultants and sales agents had actually provided the contracted services when they made the payments.
The SEC charged that the companies failed to properly record the payments in a manner that accurately and fairly reflected the nature of the payments in their books and records. The company was also charged with failing to devise and maintain internal accounting controls sufficient to provide reasonable assurances that company funds would only be used as authorized for legitimate corporate purposes, and that transactions were recorded as necessary to maintain accountability for assets. The SEC imposed a civil monetary penalty of $500,000 for the violations.
The SEC regularly brings enforcement actions against companies for accounting violations such as misstating revenue, expenses or asset valuations for purposes of misleading investors; levelling out earnings instability; or meeting analysts’ estimates. This type of fraud often involves improper accounting adjustments in violation of Generally Accepted Accounting Principles. A company can also be liable for failing to maintain sufficient internal accounting controls to prevent errors in their publicly-filed financial statements.
Another focus of the SEC 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 management within publicly-traded companies, it has also pursued individuals who work “in the trenches,” such as auditors and consultants.
There is no statutory definition of “insider trading;” the rules prohibiting such conduct have been based largely on court interpretations of SEC rules and regulations. Courts have defined insider trading as the purchase or sale of a security by a person while in possession of material, nonpublic information concerning that security. The nonpublic information typically results from a breach of fiduciary duty, or from a duty arising out of a relationship of trust or confidence.
The SEC has not only prosecuted individuals who have traded on inside information, but also those who have passed on material, nonpublic information to others who executed trades based on that information. In Salman v. United States, 580 U.S. ___ , 137 S. Ct. 420 (2016), the Supreme Court addressed the issue of whether a gift of confidential information to a friend or family member alone was sufficient to establish the “personal benefit” element of the offense necessary to support a criminal conviction for insider trading. The Supreme Court answered in the affirmative and upheld the conviction of a man who received trading tips from an extended family member. The Court found that the “personal benefit” requirement of laws prohibiting insider trading may be met by “making a gift of confidential information” to a relative or friend.
Misconduct by Exchanges
The SEC investigates rule violations committed by various trading 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 to do so.
In 2018, the SEC charged the New York Stock Exchange, and two affiliated exchanges, with multiple regulatory violations, including several events that caused a market disruption. It was first time the SEC prosecuted a violation of its Regulation Systems Compliance and Integrity (Reg SCI). Reg SCI is a series of regulations designed to maintain business continuity and recovery from disasters. Among the charges filed by the SEC were the erroneous implementation of a market-wide regulatory halt and negligent misrepresentation of stock prices as “automated,” even though the system experienced extensive problems before two exchanges completely shut down. The SEC also charged the exchanges with applying price collars during unusual market volatility, without a rule in effect to permit such actions, which reportedly resulted in slower resolution of order imbalances. The exchanges agreed to pay a $14 million penalty to settle the charges.
Misrepresentations to Investors
SEC Rule 10b-5 makes it unlawful for any person “[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 an average investor should know before buying or selling a security. Examples of material facts include: (i) costs related the purchase of a security, such as brokerage fees and commissions; (ii) risks associated with a particular investment; and (iii) important financial details such as revenue, liabilities, and condition of assets when the transaction involves a security offering.
Misappropriation of investor funds for personal or business expenses is another area of frequent SEC investigation and enforcement. SEC rules strictly prohibit misrepresentations relating to the intended use of funds from a security 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 has commenced enforcement actions against brokerage firms that failed to implement procedures to prevent the misuse and misappropriation of client funds. In some cases, inadequate internal controls prevented firms from detecting illegal misappropriation of client funds for periods of a year or more.
Brokerage and Private Equity Fees
The SEC has investigated numerous allegations involving inappropriate fees and expenses charged by brokerages and private equity firms. Private equity firms must properly register with the SEC when they charge certain fees to clients. For example, many private equity firms charge portfolio companies with large transaction fees as part of a fund’s acquisitions and sales of securities. However, the negotiation of such transactions, and the resultant fees charged, are usually considered investment banking activities which require registration as a broker-dealer. Despite this restriction, many private equity firms operate as unregistered broker-dealers.
SEC enforcement actions for improperly charged fees can lead to sanctions, fines and, in some cases, rescission of investor purchases. For example, in one enforcement action, the SEC found that bank customers overpaid for Residential Mortgage Backed Securities because brokerage representatives deceived them about the price the firm paid to acquire the securities. The SEC also found that the firm’s salespeople illegally profited from excessive, undisclosed commissions, called “mark-ups.” In some cases, these mark-ups were more than twice the amount that customers should have paid. Many of these deceptive tactics continued unchecked because the brokerage lacked effective internal controls to identify and prevent this type of misconduct.
Trading Price Manipulation
Market manipulation involves unscrupulous individuals who artificially increase the price or volume of a stock in order to attract other investors. These schemes are sometimes utilized as part of microcap stock fraud where false and misleading press releases or statements are issued to artificially inflate the price of the stock. In this type of “pump and dump” scheme, corrupt brokers and investors sell their shares before stock price plummets. The remaining investors are left holding a stock that is worth significantly less than what they paid for it.
One SEC enforcement action involved four individuals engaged in a fraudulent scheme that generated nearly $34 million from unlawful stock sales. The SEC alleged that the four manipulated the market and illegally sold the stock of a microcap issuer. As part of the alleged scheme, the duplicitous traders hid their ownership and sales of shares of the company by using offshore bank accounts, sham legal documents, and anonymizing techniques. They also allegedly orchestrated a wide-reaching promotional campaign and manipulative trading techniques to artificially inflate the share price. The SEC obtained a court order that froze the proceeds from the sales of the stock. After obtaining a default judgment against the group, the Commission 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 traders place bids or offers on a stock with the intent to cancel the bid before execution. These fraudulent practices are designed to deceive other traders as to the true levels of supply or demand in the market thereby falsely manipulating the trading price.