Now that you’ve seen what ACA Insight has to offer, don’t be without it. Subscribe now!

The weekly news source for investment management legal and compliance professionals

Current subscribers - please log in to the website in the upper right-hand corner

News March 2, 2015 Issue

Gallagher: Stop SEC Waiver Practices That Cause Settlement Uncertainty

End the uncertainty in settlement negotiations by having the Commission vote on disqualification waivers and sanctions in one package.

That’s the view of commissioner Daniel Gallagher, who, in a February 13 speech in Dallas before the 37th Annual Conference on Securities Regulation and Business Law, decried the current state of affairs involving disqualifications and enforcement sanctions that sometimes leave advisers, corporations and others hanging after settlement negotiations are concluded.

This happens because the Enforcement Division has recently been refusing to allow respondents to condition settlements on the granting of a waiver from disqualification, said Rogers & Hardin partner Stephen Councill. There is little point in negotiating a settlement if, after it is over, an adviser or other entity finds out it will still be disqualified – an action that may force it to go out of business, he said. "Respondents should have certainty."

"A settlement should involve a meeting of the minds on all aspects of the resolution," Gallagher said. "A settlement should bring finality, and I cannot fulfill my duty as a commissioner to cast a vote in favor of a recommendation without the ability to accurately assess what punishments will be meted out to a respondent as a consequence of my action, and whether those punishments are just given the nature of the violation. … The Commission, as part of the federal government, cannot and should not administer any program, or partake in any activity, that creates uncertainty for market participants in an effort to provide maximum optionality for the agency."

"Until such time as the Commission officially decides whether disqualifications will continue to be treated as sanctions or whether we will revert to the historical process of treating them apart from the enforcement process, I will condition my vote on enforcement recommendation matters on an understanding of the planned disposition of requested waivers," he said.

Another SEC commissioner, Michael Piwowar, provided his own view on waivers as they relate to settlement negotiations in a February 20 speech at the SEC Speaks conference in Washington, DC. "Having established guidelines is particularly important in the context of settlement negotiations to allow a party that is considering a settlement offer to determine whether if it settles it will be able to obtain the necessary waivers to continue to engage in certain business activities," he said. For many waiver requests, he noted, there already are staff guidelines, which commissioners have "recently and with increasing frequency" been ignoring.

"Parties settling with the SEC naturally want finality and certainty with regard to as many issues as they can resolve," said Zaccaro Morgan partner Nicolas Morgan. "Commissioner Gallagher’s comments regarding waivers reflect this reality. Separating out or postponing a discussion of waivers from settlement negotiations simply increases the uncertainty of settling with the SEC, which will increase the number of matters that go to trial and will decrease the number of settlements. Postponing decisions about waivers rather than considering the issue at the time of settlement creates unnecessary uncertainty and delay and would be an inefficient use of the SEC’s limited resources."

The ideal solution and what’s possible

Ideally, Gallagher said, "we would return to the historical practice of having the expert policy division staff dispassionately consider requests for waivers. These dedicated staff members are best suited to assess each waiver request individually, on its merits, considering the facts and the circumstances of each case without background noise from the enforcement case inappropriately influencing that decision."

Unfortunately, though, for waiver requests that require a Commission vote, he said this is no longer possible. Current practice, which Gallagher indicated was brought about to some extent by regulations like Rule 506(d) of Regulation D, the Bad Actor Rule, is to treat disqualifications as enhancements to sanctions. "Some apparently want disqualifications to operate as an additional sanction to impose on respondents who have offered to settle an enforcement matter with the SEC or who are otherwise subject to a disqualifying civil injunction or criminal conviction."

Given these current circumstances, he said, "It is no longer possible to separately consider the merits of the enforcement case without also taking into account the potential impact a disqualification would have on the settling party. We therefore need to amend our practice so waiver requests that come up for a Commission vote are considered together with the enforcement recommendation in a single package, effectively and unfortunately treating the disqualifications as sanctions in those cases."

"What Gallagher is suggesting is a new mechanism for dealing with settlements of SEC cases," said

Stern Tannenbaum partner Aegis Frumento. "First, the enforcement staff would have to begin permitting settlements to be conditioned on waivers of statutory disqualifications; second, respondents would have to file waivers of disqualification simultaneously with the settlements; and third, the staff and the Commission would have to agree to look at both of them together, as Gallagher vows he will now do."

Such a system "would actually be a good thing – more efficient for the Commission and respondents, and fairer too," Frumento said. "It certainly makes sense to me to deal with all the consequences of past conduct in one fell swoop, leaving no lingering uncertainties."

Should the Commission prove "unable to settle on a sensible and fair path forward," Gallagher said, it may be necessary for Congress to resolve this problem and "clearly draw the lines between disqualifications and enforcement sanctions under the federal securities laws." But if that proves not possible, Congress should remove the automatic triggers from disqualification provisions and leave such decisions to the SEC.

Division of Enforcement practice

The uncertainty created by the current system is "exacerbated" by what Gallagher described as an "informal, non-Commission-approved practice recently followed by the Enforcement Division of not allowing respondents to condition settlements on the granting of waivers. This makes no sense to me. If a disqualification is now a sanction, then the waivers must be part of the settlement negotiations."

"This is especially true for financial services firms, which can effectively be sentenced to a corporate death penalty if certain waivers … are not granted. If the Commission wants to put firms out of business, something that always should be on the table in extreme enforcement cases, we should be doing so with our authority over the registration provisions of the securities laws, not [emphasis Gallagher] through automatic disqualifications," he said.

The threat posed by disqualifications can loom much larger for major financial institutions, including large advisory firms, noted

Mayer Brown attorney Adam Kanter. "The more lines of business that a financial institution or large financial services provider engages in, the greater the potential for missteps that would trigger – and the greater the impact of triggering – a disqualification. While a smaller adviser often doesn’t need to worry about an affiliate getting in trouble for activities related to mortgage-backed securities or tax evasion, an affiliate of a large financial institution can have its whole business turned upside down based on the bad acts of an affiliate on the other side of the globe."

Disqualifications, waivers and history

Disqualifications prohibit individuals and/or entities from engaging in business activities or from relying on exemptions. They are typically applied to individuals and entities found to have committed bad acts, although the SEC may decide to waive a disqualification should it feel that circumstances warrant. Factors taken into consideration by the Commission include the types of individuals and entities involved in the misconduct, whether the misconduct was willful, whether it resulted in a violation of the anti-fraud provisions of the securities laws, how long the improper conduct lasted, and any remedial actions taken. Some of the disqualifications are triggered automatically, such as via an administrative proceeding order, while others are discretionary and require SEC action.

Among the laws and regulations with disqualification provisions that affect advisers, Gallagher said, are Section 9(a) of the Investment Company Act, which establishes an automatic disqualification from acting as an adviser to a registered investment company that is triggered by a court-ordered injunction; SEC Rule 405, which prohibits issuers that have violated the anti-fraud provisions of federal securities laws from qualifying as "well-known seasoned issuers," also known as "WKSIs;" and Rule 506(d) of Regulation D, the Bad Actor Rule, which disqualifies felons and other bad actors from continuing to take advantage of the Rule 506 private placement process.

"A common thread runs through the legislative and SEC records underlying each of these disqualification provisions," Gallagher said. "Congress and the SEC may be willing to allow for exemptions from otherwise applicable restrictions or burdens, but only to those persons who are unlikely to abuse that relief through fraudulent or other improper conduct. They recognized that the disqualifications were intentionally over-broad and thus necessitated an exemptive process to be employed when the facts and circumstances warranted a less heavy-handed approach."

Purpose and use

That history is useful in debating the proper role of waivers, he said, which he believes should be to reduce future violations, rather than as a sanctions-enforcement tool. "The former is a forward-looking measure aimed at reducing the likelihood of future fraud; the latter is a backward-looking measure aimed at enhancing the Commission’s ability to punish serious misconduct beyond the statutory and judicial limits otherwise imposed on the Commission’s enforcement remedies."

Yet the Commission already has remedial and punitive sanctions it can impose, Gallagher said. These include the ability is issue injunctions, barring individuals from acting in certain capacities in the markets, requiring that certain consultants be hired, requiring governance and business reforms, ordering disgorgement of ill-gotten gains, and the imposition of financial penalties.

Aside from the intent behind them, automatic disqualifications are not, by their nature, appropriate enforcement measures, Gallagher said. "This is because automatic disqualifications are, in fact, blunt tools that were intended to serve a purpose distinct from enforcement sanctions." They are "the antithesis of ‘flexible’ sanctions that can be ‘tailored’ to the ‘gravity of the situation.’ Instead, they are screening mechanisms that are triggered without any Commission or policy division staff consideration of the facts and circumstances."