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 November 6, 2017 Issue

SEC Turning Away from ‘Broken Windows’ Enforcement

It looks like the SEC plans to break fewer windows under chairman Jay Clayton than it did under former chair Mary Jo White. What’s more, there may be less emphasis on seeking admissions of wrongdoing when settling cases. The co-director of the agency’s Division of Enforcement reportedly made both these points in a panel discussion at a recent securities conference.

Enforcement Division co-director Steven Peikin "indicated" that the agency would no longer pursue the "broken windows" enforcement strategy that had been pursued under White, and might also make fewer attempts to get companies to admit wrongdoing as part of settlements, said the Wall Street Journal. Peikin spoke at the October 26 Securities Enforcement Forum in Washington, DC.

"It may be the case that we have to be selective and bring a few cases to send a broader message rather than seep the entire field," he said, according to the Journal.

The SEC, when contacted, did not comment on statements made by Peikin during the panel discussion.

Peikin also reportedly noted that the Division of Enforcement might have fewer investigators by next September. Clayton submitted a budget request for the coming fiscal year that called for approximately the same amount of spending as in the current fiscal year.

Separately, on the same day and at the same conference, Division of Enforcement co-director Stephanie Avakian addressed two new Enforcement Division units – the Retail Strategy Task Force and the Cyber Unit – where, she said, additional enforcement scrutiny will be placed in these two areas (see below for more).

Reactions

Willkie Farr partner and former SEC Division of Investment Management director Barry Barbash said he was not surprised by the change in enforcement focus, as "it is a reflection of what seems to be a different enforcement philosophy on the part of the new regime. The new philosophy seems to be a throwback to earlier SEC days; the agency should, generally, not bring an enforcement proceeding when the underlying conduct involves only an alleged technical violation of federal securities laws and their rules. Violations of technical rules should instead be handled by deficiency letters." Enforcement actions, on the other hand, he said, should be commenced "only when the underlying conduct involves major frauds, loss of client or customer monies, and other significant wrongful actions."

"Whether or not it ever had any impact on street crime, I don’t think there is any logic at all for thinking that ‘broken windows’ policing has any validity for securities law violations," said Stern Tannenbaum partner Aegis Frumento. "So, if it’s true that the SEC will abandon it, then I say good riddance to it."

"The SEC has limited resources, and it always will," he said. "There is real securities fraud out there, but it is sophisticated, hard to uncover and hard to prove. Real securities enforcement would see the SEC bringing fewer cases, but more important ones, and against better breeds of crooks. It would require the SEC to do the hard work of ferreting out systemic fraudulent conduct that is well-concealed in trading desk operations, accounting conventions and IT systems, and holding accountable those in power who know of them and condone them."

Faegre Baker Daniels partner David Porteous noted that "the movement away from broken-windows, simultaneously with the Enforcement Division’s announcement of its Retail Strategy Task Force and Cyber Security Units, demonstrates a renewed focus on specific areas, but which have a broad focus or mandate. Rather than being focused on the minutia of every potential rule violation as during the broken-windows /Dodd-Frank era of enforcement, it appears that the Division’s new direction will look at threats to investors and registrants at a higher level."

"The key," he said, "will be whether we observe a change at the examination level and then in what actions either Enforcement chooses to pursue stemming from an examination, or on its own. To the extent Enforcement continues to pursue and recommend proceedings similar to the broken-windows era, it may not seem that different despite the broader focus."

The ‘broken windows’ philosophy

White, the former U.S. Attorney for the Southern District of New York, took a tough enforcement approach as chair of the SEC. The agency would pursue wrongdoing "not unlike the one taken in the nineties by then New York City mayor Rudy Guiliani and police commissioner Bill Bratton," known as "broken windows," she said in an October 9, 2013 speech, also at the Securities Enforcement Forum (ACA Insight, 10/14/13).

Under the broken windows approach, "no infraction was too small to be uncovered and punished,...from street squeegee men to graffiti artists to subway turnstile jumpers to the biggest crimes in the city. The strategy was simple. They wanted to avoid an environment of disorder that would encourage more serious crimes to flourish. They wanted to send a message of law and order."

"The same theory can be applied to our securities markets," she said. "Minor violations that are overlooked or ignored can feed bigger ones, and, perhaps more importantly, can foster a culture where laws are increasingly treated as toothless guidelines....Retail investors, in particular, need to be protected from unscrupulous advisers and brokers, whatever their size and the size of the violation that victimizes the investor."

Among the violations she said the SEC would pursue would be control failures, negligence-based offenses, and even violations of prophylactic rules with no intent requirement.

That enforcement strategy, while praised by some, also became increasingly criticized as it was carried out. Commissioner Michael Piwowar, in a speech before the Securities Enforcement Forum the year after White’s presentation, came down hard on the approach. "If every rule is a priority, then no rule is a priority," he said.

Wrongdoing admissions

White also took a tough approach in a September 26, 2013 speech to the Council of Institutional Investors in Chicago, where she said that the SEC would seek admissions of guilt in certain circumstances (ACA Insight, 9/30/13).

"Much of my thinking on this issue was shaped by the time I spent in the criminal arena, where courts cannot accept a guilty plea without the defendant first admitting to the unlawful conduct," she said at the time.

The cases where such admissions might be sought, she said, were those with any of the following conditions:

  • A large number of investors were harmed or the conduct was egregious.
  • The conduct posed a significant risk to the market or investors.
  • Admissions of guilt would aid investors deciding whether to deal with a particular party in the future.
  • Reciting unambiguous facts would send an important message to the market about a particular case.

Peikin, who, like Clayton was a white collar defense attorney at Sullivan & Cromwell, said in his Forum speech last month that "When I first heard about the admissions policy, it didn’t really knock me down," the Journal reported. He also said that he would nonetheless pursue enforcement when there were intentional crimes that harmed investors.

Retail Strategy Task Force

"This group will look at the many ways that retail investors intersect with the securities markets and look for widespread misconduct," Avakian said. "It will draw from our experience in the retail space and elsewhere to identify strategies that have worked well for us across all kinds of cases, particularly those in which we used data analytics and technology. It will then apply those strategies and investigative techniques more broadly to look for incidents of widespread misconduct targeting retail investors."

Among the specific examples of problems involving retail investors that she said "we are continuing to see" were the following:

  • Investment professionals steering customers to mutual fund share classes with higher fees when lower-fee share classes of the same fund are available;
  • Abuses in wrap-fee accounts, including failing to disclose the additional costs of "trading away" or trading through unaffiliated brokers, and purchasing alternative products that generate additional fees;
  • Investors buying and holding products like inverse exchange-traded funds for long-term investment. "These can be highly volatile products that are generally intended as a hedge against exposure to downward moving markets, and that face a long-term high risk of losing their principal," she said. "Yet, we are increasingly seeing retail investments holding these products long-term, including in retirement accounts;"
  • Problems in the sale of structured products to retail investors, including a failure to fully and clearly disclose fees, mark-ups, and other factors that can negatively impact returns; and
  • Abusive practices like churning and excessive trading that generate large commissions at the expense of the investor.

Cyber Unit

Avakian said that the Division sees its potential enforcement interest in cybersecurity "as falling roughly into three separate types of cases. These are cases:

  • Where cyber-related misconduct is "used to gain some sort of unlawful market advantage." Examples she noted were hacking to access material, nonpublic information in order to trade in advance of some announcement or event; account intrusions in order to conduct manipulative trading using hacked brokerage accounts; and disseminating false information through electronic publications.
  • Involving failures by registered entities to take appropriate steps to safeguard information or ensure system integrity. The SEC has adopted rules, such as Rules S-P, S-ID and SCI, that require registered entities to have reasonable safeguards in place to address cybersecurity threats, Avakian said. "We also coordinate very closely with the Office of Compliance Inspections and Examinations on these issues."
  • Where there may be a cyber-related disclosure failure by a public company. "We have not yet brought a case in this space," she said.

While Avakian said that cybersecurity is an area in which the Enforcement Division has already built up "a substantial amount of expertise, . . . we think it makes sense to aggregate that experience and focus in a single unit" because "the risk that the cyber threat poses is so serious that we think it is critical that we have a group of people specifically focused on dealing with it." Secondly, "how we as a Division approach and deal with the enforcement interest in this space warrants a consistent, well-informed and, oftentimes, measured approach. Having a dedicated unit consider and address these issues will help us achieve that goal."