SEC Spotlight: Enforcement and Regulatory Developments in the Third Quarter of 2022
The US Securities and Exchange Commission (SEC or Commission) was active in both its enforcement and regulatory efforts during the third quarter of the calendar year, continuing an aggressive approach under Chair Gary Gensler. The SEC’s fiscal year ended on September 30, 2022, and the Commission sprinted to the finish line by bringing numerous enforcement actions, both large and small. Indeed, the SEC issued 26 litigation releases in the week leading up to September 30, which constituted 23 percent of all such releases issued during the entire quarter, and instituted a significant number of administrative proceedings late in the month. When taken as a whole, the agency’s enforcement and regulatory activity during the quarter demonstrates that the Commission is continuing to remain vigorous in its efforts to protect investors.
The biggest splash from the SEC’s Division of Enforcement (Enforcement) came at the tail end of the quarter when 15 broker-dealers and one investment adviser agreed to pay combined penalties of more than $1.1 billion to settle charges involving the failure to preserve text messages on employees’ personal devices. Other notable settled and contested enforcement actions involved audit issues, accounting and financial reporting, cryptocurrency, foreign corrupt practices, data privacy, insider trading, and disclosures relating to environmental, social, and governance (ESG) issues, although Enforcement’s ESG Task Force had a relatively quiet quarter. On the regulatory side, the SEC’s fiscal year-end rulemaking focused on broker-dealer electronic recordkeeping requirements, whistleblowers, shareholder proposals, and proxy voting advice.
This Advisory continues our series of quarterly SEC enforcement and regulatory highlights, with links to additional Arnold & Porter advisories when available. Our analysis is informed by our experience as former leaders and attorneys in the Enforcement Division at the SEC: Dan Hawke as the former Chief of the Market Abuse Unit and Director of the Philadelphia Regional Office, Jane Norberg as the former Chief of the Office of the Whistleblower and a Senior Officer in the Division of Enforcement, and Christian Schultz as former Assistant Chief Litigation Counsel.
Recordkeeping Violations by Broker-Dealers and Investment Advisers. Recent SEC enforcement actions against broker-dealers and investment advisers underscore the importance of establishing and maintaining adequate document preservation policies and procedures and ensuring compliance with the applicable recordkeeping provisions of the federal securities laws.
In September 2022, the SEC announced settled charges against 15 broker-dealers and one affiliated investment adviser in a sweeping action for failures by the firms to preserve electronic communications. The settlements were reached after Enforcement’s investigation uncovered “pervasive off-channel communications” through text messaging applications on employees’ personal devices, and found that their employer firms “did not maintain or preserve the substantial majority of these off-channel communications, in violation of the federal securities laws.” Pursuant to administrative proceedings, the firms agreed to pay combined penalties of more than $1.1 billion, cease and desist from future recordkeeping violations, and retain compliance consultants to conduct comprehensive reviews of their policies and procedures relating to, among other things, the retention of electronic communications found on personal devices.1
The charges against the 16 firms came less than two months after the SEC issued an order instituting settled administrative and cease-and-desist proceedings against a Connecticut private fund investment adviser and its founder and chief investment officer for, among other charges, the adviser’s failure to retain text messages as required by the Investment Advisers Act of 1940 (Advisers Act). The Commission’s order also found that the adviser lacked adequate policies and procedures for record retention.
Notably, the charges and record requirements in these actions arose under different statutes. Specifically, the charges against the broker-dealers arose under Sections 17(a) and 15(b)(4)(E) of the Securities Exchange Act of 1934 (Exchange Act) and Rule 17a-4(b)(4) promulgated thereunder. Rule 17a-4(b)(4) requires that broker-dealers preserve originals of all communications received and copies of all communications sent by the broker-dealer relating to its business for not less than three years, the first two years of which must be in an easily accessible place. In contrast, the charges against the investment advisers involved violations of Sections 204 and 206 of the Advisers Act and certain rules promulgated thereunder. One of these rules is Rule 204-2(a)(7), which requires that registered investment advisers make and keep true, accurate, and current originals of all written communications received and copies of all written communications sent by the investment adviser relating to certain aspects of its business.
The SEC also voted to adopt amendments to the electronic recordkeeping requirements applicable to broker-dealers and other market participants, and these amendments are discussed in the Rulemaking Developments section below. More importantly, the recent enforcement actions show a potential gap in the SEC’s regulatory scheme with respect to recordkeeping by broker-dealers as compared to investment advisers. The provisions under the Advisers Act are broader and speak less specifically to what is a required record than those under the Exchange Act, and there is an argument that the Advisers Act provisions do not contain the same level of preservation requirements as those enumerated in the Exchange Act. This disparity could present logistical challenges to entities that are dually registered as both broker-dealers and investment advisers under the Exchange Act and Advisers Act, respectively—and the language of the laws creates some ambiguity about which types of electronic communications are deemed to be required records. It remains to be seen whether the Commission takes steps to address this.
Auditing. The Commission took an aggressive approach with audit firms this past quarter, including by bringing settled charges against the Chinese affiliate of an US-based accounting firm for failing to comply with US auditing requirements in its component audits of US issuers and audits of foreign companies listed on US exchanges. During the quarter, the SEC also brought numerous other actions against public accounting firms and individual auditors in connection with the audits of public companies, investment funds, and other audit clients. For more information on emerging topics related to auditors’ and accountants’ liability, this Arnold & Porter Advisory has you covered.
Accounting and Financial Reporting. The SEC was active during the quarter in bringing accounting and financial reporting cases. For starters, consistent with statements made during the annual SEC Speaks conference in September 2022, the Commission brought several matters requiring clawbacks of company executives’ incentive-based compensation under Section 304 of the Sarbanes-Oxley Act of 2002 (SOX). Jane Norberg and Christian Schultz recently discussed this development with The National Law Journal, including how Enforcement is sending a clear message that they will continue to look at the leadership of a company when deciding how to proceed with an enforcement investigation.
The following are two accounting and financial reporting cases to highlight from the quarter, both of which resulted in Section 304 clawbacks:
- On August 3, 2022, the SEC charged a medical technology company and two former executives for “pulling forward” revenue by shipping future orders ahead of schedule and without customer approval, thereby violating generally accepted accounting principles (GAAP). According to the Commission, this conduct was done to address projected quarterly revenue shortfalls and achieve projected revenue guidance, and the company would not have met such guidance without pulling forward the revenue. The Commission also found that this conduct was not disclosed to investors, including the known uncertainty that this practice caused for the company’s future revenue streams. The company restated its prior financial statements to correct the premature recognition of revenue. As a result, one of the named executives agreed to return over $200,000 to the company under SOX Section 304, and three unnamed former executives agreed to return more than $360,000 of incentive-based compensation to the company. According to the SEC’s press release, this action arose out of Enforcement’s Earnings Per Share Initiative, which is a data-driven initiative to uncover accounting improprieties and earnings management practices.
- On August 25, 2022, the SEC charged a construction company and its former Senior Vice President (SVP) with fraud for inflating the financial performance of a subdivision managed by the SVP. In 2021, the company restated prior financial statements to correct revenue and profit margin misstatements allegedly caused by the SVP’s misconduct. The company agreed to pay $12 million to settle the charges, and the SEC is litigating the action against the SVP. In addition, in separate administrative proceedings, the company’s former CEO and two former CFOs agreed to cease and desist from violating Section 304 of SOX and to return nearly $2 million in incentive-based compensation to the company. These three former executives agreed to the Section 304 clawbacks and cease-and-desist order even though, in the SEC’s words, the executives were “not charged with misconduct.”
The Commission’s focus on earnings management also was reflected in a settled action brought against a software company on September 12, 2022, in connection with its order backlog management practices. According to the SEC, the company delayed the delivery of license keys on certain software sales until just after quarter-end so that it could recognize revenue from the sales in the following quarter. The SEC found that this shifting of revenue into future quarters built a “buffer” to help ensure that the company would meet its future revenue guidance. Interestingly, the SEC’s order does not find any violations of GAAP, as the company followed the applicable accounting requirements by not recognizing revenue until the software license keys were delivered. Instead, the Commission found that the company’s practices constituted disclosure violations because the company failed to disclose the impact that the practices had on reported revenue and concealed a slowing in revenue growth versus expectations. As part of the settlement, the Commission found that the company violated certain non-scienter based provisions of the federal securities laws and ordered it to pay an $8 million penalty.
ESG Disclosures. Two ESG disclosure cases were brought during the quarter, both of which indicate that the SEC will consider a wide range of matters in ESG-related cases. On July 20, 2022, the Commission brought settled charges against an insurance technology platform and its former CEO for “concealing extensive consumer complaints about short-term and limited health insurance products,” despite making disclosures to investors that the platform “held its insurance distributors to high compliance standards.” On September 23, 2022, the Commission brought settled charges against a mineral producer for misleading investors about the cost effects of a technology upgrade on a mine and for failing to properly assess whether to disclose financial risks created by the company’s discharge of mercury in Brazil. The Commission also found that the mineral producer covered up the improper assessment by submitting inaccurate test reports to Brazilian environmental authorities.
Despite a relatively quiet quarter in terms of ESG cases, the SEC is continuing to focus on this area. As detailed in a previous Advisory, ESG disclosures were a topic of focus at the SEC Speaks conference in September, and representatives from the SEC’s Division of Investment Management provided guidance on the agency’s expectations regarding the contours of funds’ ESG disclosures. As a result, funds and other market participants should expect enhanced ESG enforcement activity on this score over the next several quarters.
Cryptocurrency. The SEC remained active in the cryptocurrency space and brought several enforcement actions. In July 2022, the SEC charged a former cryptocurrency exchange platform manager and two others in an insider trading action involving cryptocurrency assets. In August 2022, the SEC charged 11 individuals for creating and promoting a fraudulent crypto pyramid and Ponzi scheme. In September 2022, the SEC charged a financial technology company, its former CEO, and the CEO of a self-described market making firm for perpetrating an alleged scheme to manipulate the trading volume and price of crypto asset securities. Also in September, the SEC brought settled charges against a company and its CEO for the unregistered offer and sale of crypto asset securities, along with a contested complaint against a “crypto influencer” for failing to disclose compensation he received from the company for publicly promoting its tokens.
This flurry of enforcement is consistent with the SEC’s recent emphasis on crypto enforcement. In May 2022, the agency announced that it nearly doubled the size of Enforcement’s Crypto Assets and Cyber Unit, and the Division of Corporation Finance added an Office of Crypto Assets to its Disclosure Review Program in September 2022. These two organizational announcements are consistent with Chair Gensler’s comments on crypto regulation and the crypto industry during the SEC Speaks conference, which are discussed in this Arnold & Porter Advisory.
Foreign Corrupt Practices Act (FCPA). In September 2022, the Commission announced that an information technology company would pay nearly $23 million to resolve charges for violations of the FCPA when subsidiaries in Turkey, the United Arab Emirates, and India “created and used slush funds to bribe foreign officials in return for business.” Notably, ten years ago, this same company agreed to settled charges by the SEC in connection with the alleged use of “side funds” to make “unauthorized payments to phony vendors” in violation of the FCPA. In addition, in September 2022, Brazil’s second largest domestic airline agreed to pay $70 million to settle FCPA charges in connection with the SEC finding that the airline bribed Brazilian government officials in exchange for favorable payroll tax and aviation fuel tax reductions. The airline agreed to an SEC cease-and-desist order and to enter into a deferred prosecution agreement with the US Department of Justice.
Data Privacy. During the quarter, the SEC focused on data privacy matters involving broker-dealers and investment advisers. In July 2022, the Commission separately charged three broker-dealers (two of which are also registered investment advisers) for deficiencies in their programs to prevent customer identify theft, in violation of the SEC’s identity theft red flags rule, which is called Regulation S-ID. According to the SEC’s orders, the firms’ identity theft prevention programs did not include reasonable policies and procedures to identify relevant red flags of identity theft in connection with customer accounts or to incorporate those red flags into their programs. Later, in September 2022, the SEC charged a dually registered broker-dealer and investment adviser for the firm’s failure to protect personal identifying information (PII) of approximately 15 million customers. The SEC’s order found that, as far back as 2015, the firm failed to properly dispose of devices containing its customers’ PII.
Insider Trading. The SEC is always on the lookout for insider trading, and this quarter was no different. On July 25, 2022, the Commission filed insider trading charges against a former US Congressman from Indiana for twice trading in securities based on non-public information about forthcoming acquisitions and spreading the purchases across several accounts. On September 21, 2022, the Commission brought settled charges against two senior executives of a Chinese mobile internet company for selling the company’s securities pursuant to a purported 10b5-1 trading plan while in possession of material nonpublic information. 10b5-1 trading plans are passive investment programs in which plan participants relinquish direct control over trading and thereby retain an affirmative defense to insider trading actions. In this case, the SEC’s order found that the two senior executives jointly established a purported 10b5-1 trading plan after becoming aware of a substantial drop-off in advertising revenues, thereby violating the antifraud provisions of the federal securities laws.
Whistleblower Awards. The SEC awarded more than $38 million to five whistleblowers during the quarter. The awards granted include:
- Two awards totaling more than $6 million to two whistleblowers, one of whom was solicited to invest in a product that they believed was being misrepresented and subsequently prompted the opening of an investigation, and the other who provided information that prompted the opening of an investigation.
- One award of more than $17 million to a whistleblower who provided information and assistance in a covered and related action, which prompted the SEC staff to open a new investigation.
- Two awards totaling more than $16 million to two whistleblowers, one of whom prompted the opening of the investigation, provided information on difficult-to-detect violations, and identified key witnesses. The second whistleblower submitted important new information during the course of an investigation.
Important Court Decisions
Gag Orders. In July 2022, the US Court of Appeals for the Fifth Circuit rejected a bid by a financial planner and radio show host, who had settled an SEC securities fraud action in 2016, to revise his settlement to eliminate a provision prohibiting him from disputing the SEC’s allegations. This decision was consistent with a 2021 ruling from the US Court of Appeals for the Second Circuit, which found that the SEC’s so-called “gag order” did not violate the appellant’s First Amendment or due process rights, and with the Supreme Court’s refusal to hear a case in which the appellant challenged an SEC settlement that barred him from denying the allegations against him. It should be noted, however, that Judge Edith Jones of the Fifth Circuit criticized the policy behind SEC gag orders and predicted that “it will not be long before the courts are called on to fully consider this policy.” You can view the operative rule, 17 CFR § 202.5(e), here.
Electronic Recordkeeping Requirements. In October 2022, the SEC voted to adopt amendments to the electronic recordkeeping requirements applicable to broker-dealers and other market participants. The amendments add an “audit-trail” alternative to the former electronic recordkeeping rule, which requires firms to preserve electronic records in a non-rewriteable, non-erasable format. The audit-trail alternative permits the recreation of an original record if it is altered, over-written, or erased and is “designed to provide broker-dealers with greater flexibility in configuring their electronic recordkeeping practices while also protecting the authenticity and reliability of original records.”
Incentivizing Whistleblower Tips. In August 2022, the SEC adopted two amendments to rules governing its whistleblower program. The first amendment, to Rule 21F-3, expanded the circumstances in which a whistleblower can receive an award by allowing the Commission to pay whistleblowers for their information and assistance in connection with certain actions brought by entities other than the SEC, including designated federal agencies. The second amendment affirms the Commission’s authority under rule 21F-6 to consider the dollar amount of a potential award for the limited purpose of increasing an award, but not to lower an award. These amendments became effective on September 25, 2022.
Shareholder Proposal Rule. In July 2022, the SEC proposed amendments to the rule that governs the process for including shareholder proposals in a company’s proxy statement. Specifically, the these amendments would revise three bases for excluding shareholder proposals from proxy materials and would permit exclusion if (i) the company has already implemented the “essential elements” of the proposal, (ii) the proposal “substantially duplicates” another proposal previously submitted for the same shareholder meeting if it addresses the same subject matter and seeks the same objective by the same means, and (iii) it substantially duplicates another proposal that was previously submitted for the same company’s prior shareholders meetings. Comments on these amendments were due on September 12, 2022.
Proxy Rules Governing Proxy Voting Advice. In July 2022, the SEC voted to adopt amendments to its rules governing proxy voting advice as proposed in November 2021. According to the SEC, “the final amendments aim to avoid burdens on proxy voting advice businesses that may impair the timeliness and independence of their advice” and “address misperceptions about liability standards applicable to proxy voting advice while also preserving investors’ confidence in the integrity of such advice.” The final amendments rescinded two exemptions from the proxy rules’ information and filing requirements for proxy voting advice businesses—namely, that (i) registrants subject to proxy voting advice have such advice made available to them in a timely manner, and (ii) clients of proxy voting advice businesses are provided with a means of becoming aware of any written responses by registrants to proxy voting advice. The final amendments also deleted 2020 changes to the proxy rules’ liability provision due to risk of confusion regarding its application.
Comment Period Reopened. Shortly after the quarter ended, the SEC reopened the public comment periods for 11 rulemaking releases and one request for comment. The affected releases include:
- Cybersecurity Risk Management, Strategy, Governance, and Incident Disclosure (March 23, 2022), discussed here by Arnold & Porter.
- The Enhancement and Standardization of Climate-Related Disclosures for Investors (April 11, 2022), discussed here and here by Arnold & Porter.
- Special Purpose Acquisition Companies, Shell Companies, and Projections (May 13, 2022), discussed here by Arnold & Porter.
The SEC’s aggressive enforcement efforts continued during the third quarter of calendar year 2022, as evidenced by the number and breadth of the cases that were brought. As the Commission continues on its fast pace of vigorous enforcement, along with its new rulemaking and other actions to increase regulatory oversight, market participants should remain vigilant and ensure that proper controls, policies, and procedures exist and are being followed. Taking proactive steps to mitigate risk, ensure compliance with the federal securities laws, and help prevent potential problems is crucial in today’s securities enforcement and regulatory climate.
We will continue to monitor and report on the key enforcement and regulatory developments at the SEC. In the meantime, please reach out to any author of this Advisory or your regular Arnold & Porter contact with any questions about the issues discussed herein or the state of play at the Commission.
© Arnold & Porter Kaye Scholer LLP 2022 All Rights Reserved. This Advisory is intended to be a general summary of the law and does not constitute legal advice. You should consult with counsel to determine applicable legal requirements in a specific fact situation.
The Commodity Futures Trading Commission (CFTC) also announced separate settled charges against eleven of these firms for related conduct involving CFTC recordkeeping requirements. The CFTC settlements imposed more than $710 million in additional penalties.