Top 5 SEC Enforcement Developments for August 2022
Top 5 SEC Enforcement Developments for August 2022
In order to provide an overview for busy in-house counsel and compliance professionals, we summarize below some of the most important SEC enforcement developments from the past month, with links to primary resources. This month we examine:
August saw the SEC continue to focus on crypto assets—in particular, companies’ compliance with the SEC’s registration requirements—as the SEC filed charges against two more companies for conducting unregistered offerings of their crypto assets.
Bloom Protocol, LLC
On August 9, 2022, the SEC filed a settled action against Bloom Protocol, LLC (“Bloom”), a technology startup in the credit risk space that claimed to move identity attestation and credit scoring to a blockchain, for the illegal offer and sale of unregistered crypto assets. Between November 2017 and January 2018, Bloom raised approximately $30.9 million through an initial coin offering of Bloom Tokens (“BLT”) to over 7,000 investors. The SEC deemed BLT to be investment contracts, and therefore securities, under the Supreme Court’s Howey test. Accordingly, the SEC found in a settled order that Bloom violated Sections 5(a) and 5(c) of the Securities Act by failing to register the offering of BLT, and the offering did not qualify for any exemption.
In concluding that BLT are securities, the SEC continued to emphasize substance over form, making clear that companies cannot navigate around the elements of the Howey test simply by stating the tokens are not “investments” when other facts suggest otherwise. The SEC explained:
Although the terms of the token sale agreements that certain purchasers entered into with Bloom, Ltd. required purchasers to agree that they were buying BLT for their “utility” and not as an investment, the structure of the platform and the marketing demonstrate that the BLT purchasers had a reasonable expectation of profit through Bloom’s efforts to develop the token’s uses and increase its value.
The SEC also pointed to BLT investors’ after-the-fact comments about the tokens as further confirmation of their status as securities, noting “[m]any comments on social media platforms by investors that purchased in the ‘public sale’ also demonstrate that they purchased the BLT as an investment.”
In Bloom’s accepted Offer of Settlement, Bloom agreed to undertakings including registering BLT with the SEC and initiating a claims process to compensate investors, and to pay a civil money penalty of $300,000. Bloom also agreed to an additional springing penalty, up to the total amount raised of over $30.9 million if Bloom fails to comply with the SEC order. The SEC credited Bloom’s voluntary and prompt remedial actions to prepare for registration, including retaining an auditor, commencing an audit process, and hiring employees to support the audit and registration process.
On August 16, 2022, the SEC filed a complaint in the Western District of Washington, charging Dragonchain, Inc., a blockchain platform; its founder Joseph J. Roets; and the two other entities controlled by Roets, Dragonchain Foundation (the “Foundation”), and The Dragon Company (“TDC”), with the unlawful offer and sale of securities for selling unregistered tokens called “Dragon” (“DRGN”). Defendants are charged with violations of Sections 5(a) and 5(c) of the Securities Act. The SEC seeks permanent injunctions against the defendants, including prohibiting Roets and the three entities he controls from participating in any crypto asset securities offerings, disgorgement of all ill-gotten gains, and civil money penalties.
The SEC alleges that from 2017 through the date of the SEC’s complaint, Dragonchain conducted a $16.5 million unregistered offering and sale of DRGN, including open market sales through social media platforms and other methods, with no available registration exemptions. The SEC further alleges that Dragonchain used DRGN to fund its operations by transferring additional DRGN to certain contractors and service providers who, in turn, sold DRGNs in the open market in unregistered transactions.
Before the SEC filed its complaint, Dragonchain submitted a “Response to SEC Letter,” which included the familiar criticism that the SEC is conducting “regulation by enforcement” in the crypto space and walked through an element-by-element discussion of how Dragonchain believed the Howey test should be applied to DRGN. Dragonchain argued, among other things, that purchasers of DRGN were not making an investment—only “a direct purchase of a utility token software micro-license which would be expected to be used as a utility”; purchasers could not expect to share in any profits (and therefore there was no common enterprise); and the powers retained by the purchasers indicated that profits were not expected based on the efforts of others. Dragonchain’s letter relied heavily on the description of DRGN in its own promotional materials, however, and the SEC’s complaint suggests that, as with Bloom, the SEC was unwilling to place too much emphasis on how the company described its own product.
Considered in tandem with the Bloom settlement, the Dragonchain action makes clear the SEC is continuing to take action against unregistered sales of crypto assets even where they do not allege fraud or other misconduct, and is wary of promotional materials that describe “investment contracts” in ways the SEC might perceive as trying to navigate around the Howey test. Indeed, in a statement that could be read as an announcement for why the SEC chose to pursue this (and similar) cases, the SEC explained in its complaint that since Dragonchain never filed a registration statement for the offer and sale of DRGN, “it never provided investors with the material information that other issuers include in such statements when soliciting public investment. Instead, Dragonchain created an information vacuum such that it could sell DRGNS into a market that possessed only the information Dragonchain chose to share about DRGNs.” Among a sea of SEC pronouncements and settled actions, this may give another federal court an opportunity to weigh in on when tokens should be treated as investment contracts.
#CryptoRegulations #Crypto=Securities? #RegistrationRequirementCrypto
On August 3, 2022, the SEC charged Surgalign Holdings, Inc. (“Surgalign”), formerly RTI Surgical Holdings, Inc. (“RTI”), and former executives Brian Hutchison and Robert Jordheim with misleading investors by fraudulently “pulling forward” revenues. As alleged by the SEC, from 2015 through 2019, RTI shipped orders weeks or months before the requested delivery date in an effort to address projected revenue shortfalls. In many instances, RTI allegedly shipped orders early and recognized revenue for the sales without customer approval, and during several quarters relied upon the use of pull-forwards in order to meet its revenue guidance without disclosing this reliance to investors. In 2020, RTI restated its public financial statements to correct errors caused by this practice.
Surgalign and its former CFO Jordheim settled with the SEC for charges of negligence, but former CEO Hutchison is litigating. The SEC’s complaint against Hutchison details his alleged fraud, including that he used the “euphemism ‘order book management’” to refer to the practice of pull-forwards and pressured employees to further the company’s fraudulent practices. The SEC charges him with scienter-based fraud under Section 10(b)(5) of the Exchange Act, among other violations.
In contrast to the allegations against Hutchison, the SEC’s settled order with Surgalign and its former CFO finds that they violated the negligence subsections of Section 17 of the Securities Act, among other regulations. Surgalign and Jordheim agreed to cease and desist future violations and to pay civil monetary penalties—$2 million for Surgalign, and $75,000 for Jordheim.
Jordheim also agreed to be suspended from appearing and practicing before the SEC as an accountant, with a right to apply for reinstatement after five years, and to return $206,831 to Surgalign pursuant to SOX Section 304. Three other former RTI executives separately returned over $361,000 of incentive-based compensation to Surgalign, and the SEC is pursuing such a clawback from Hutchison as well. This continues a trend of the SEC invoking Section 304 to clawback such profits in recent actions, as noted in our June “Top 5” Alert.
In another signal that meaningful cooperation may impact the terms of a settlement, the SEC pointed to Surgalign’s “substantial cooperation” in determining to accept an offer of settlement for what it described in its Hutchison complaint as a rather egregious fraud. That cooperation included “disclosing information about conduct that the staff had not yet uncovered through its own investigation, conducting an internal investigation regarding this conduct, and providing the staff regular and detailed updates on the internal investigation and key documents identified through that investigation” in a way that substantially advanced the quality and efficiency of the staff’s investigation and conserved Commission resources.
On August 16, 2022, the SEC filed settled actions against Eagle Bancorp, Inc. (“Eagle”) and its former CEO and Chairman of the Board, Ronald D. Paul, charging them with negligently making false and misleading statements in the company’s annual reports and proxy statements by failing to disclose various related party transactions in violation of SEC rules and U.S. Generally Accepted Accounting Principles (“GAAP”). In particular, according to the administrative order (for Eagle) and federal complaint (for Paul) filed in the Southern District of New York, from March 2015 through April 2018, Eagle failed to disclose nearly $90 million in related party loans extended by Eagle’s principal subsidiary, EagleBank, to family trusts affiliated with Paul. The SEC order also alleged that Eagle failed to disclose related party loans to its directors and their family members totaling tens of millions of dollars.
Eagle’s loans received public attention in December 2017, when a short-seller report accused Eagle of failing to properly disclose related party loans. Eagle responded to the short-seller report by falsely claiming that the loans in the short-seller report were not related party loans in statements to the investing public.
The SEC charged Eagle with violating anti-fraud, proxy, reporting, books and records, and internal accounting controls provisions of the federal securities law, and Paul with violating anti-fraud and proxy provisions of the federal securities law and making false certifications. Eagle agreed to cease and desist from future violations and to pay disgorgement of $2.6 million, prejudgment interest of $750,493, and a civil penalty of $10 million, and Paul agreed to a permanent injunction, a two-year officer and director bar, and to pay disgorgement of $109,000, prejudgment interest of $22,216, and a penalty of $300,000. In a parallel action, on August 16, 2022, the Federal Reserve Board announced settled enforcement actions against EagleBank and Paul.
Eagle was not the first, and certainly will not be the last, company that faced investor scrutiny following a short-seller report questioning the company’s disclosures. The case should serve as a reminder to companies to have an effective process in place to respond to questions—legitimate and otherwise—to avoid compounding potential errors by standing by false or misleading statements in prior disclosures. The SEC’s description of the company’s actions when confronted with the short-seller’s allegations likely provide insight into how the parties arrived at a $10 million company penalty in a negligence-based action. The SEC explained:
After the release of the short seller report, numerous Eagle investors inquired of Eagle and Paul about the nature and amount of these loans to Paul’s family trusts, and whether they were or should be disclosed as related party loans. Despite being aware of these inquiries, and instead of undertaking a thorough and independent investigation of the short report’s allegations, Eagle relied on Paul’s false assertions about the facts necessary for an accurate analysis of whether the loans to Paul’s family trusts were related party transactions that should have been disclosed.
On August 25, 2022, the SEC charged Granite Construction, Inc. (“Granite”) and its former Senior Vice President (“SVP”), alleging fraud for overstating the financial performance of Granite’s major subdivision managed by the SVP. The SEC alleged that the SVP manipulated Granite’s financials both by deferring recording increases to the total expected costs on several significant projects and by inflating profit margins. As a result, said the SEC, Granite allegedly materially misstated its revenues from 2017 through 2019. According to the SEC, the SVP’s alleged scheme came to light around mid-2019 when several significant construction projects were completed and Granite could no longer defer recognition of the cost increases. The SEC charged Granite and the SVP with violating—and in the SVP’s case, aiding and abetting violations of—the antifraud provisions of the federal securities laws, including Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act.
Granite agreed to pay $12 million to settle SEC charges, a number that may have been influenced by Granite’s cooperation with the SEC and remediation efforts. According to the SEC’s complaint against Granite, Granite self-reported potential revenue recognition issues to the SEC and initiated an internal investigation “[w]ithin weeks” of receiving internal complaints concerning the accuracy of certain project forecasts, and subsequently restated its financial statements from 2017 through 2019 and disclosed the overstatement of its revenues in 2017 and 2018. The complaint further described Granite’s remediation efforts, which the SEC noted in its litigation release along with Granite’s self-reporting, explaining it “credits [Granite] with self-reporting to the Commission and undertaking remediation by, among other things, redesigning its internal accounting controls and policies and procedures to increase the transparency and accuracy of expected costs for construction projects.”
In separate administrative proceedings, the former CEO and CFOs of Granite, who were not charged by the SEC with misconduct, agreed to return bonuses and compensation to Granite pursuant to SOX Section 304, which “requires executives to reimburse certain compensation when an issuer is required to restate its financials as a result of misconduct.”
On August 25, 2022, the SEC finalized Item 402(v) of Regulation S-K, adopting the pay versus performance disclosure requirements that the agency was directed to promulgate by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. Item 402(v) requires disclosure of executive compensation paid versus financial performance (the “PvP Disclosure”) for reporting companies in any proxy and information statement that is required to include Item 402 executive compensation disclosure for fiscal years ending on or after December 16, 2022. Calendar year-end companies will need to include the PvP Disclosure in proxy statements filed during the 2023 proxy season.
Item 402(v) will require that companies provide a new table disclosing specified executive compensation and financial performance measures for the company’s five most recently completed fiscal years. This table will include, for the principal executive officer (“PEO”), and, as an average, for the other named executive officers (“NEOs”), the Summary Compensation Table measure of total compensation and a measure reflecting “executive compensation actually paid,” as specified by the rule.
The financial performance measures to be included in the table are: (i) cumulative total shareholder return (“TSR”) and TSR of the company’s peer group, (ii) net income, and (iii) a company-selected measure specific to that particular company, in each case, over the company’s five most recently completed fiscal years. Furthermore, the company shall include a separate list of its top three to seven financial performance measures used to link executive compensation actually paid to the company’s NEOs during the most recently completed fiscal year to company performance.
In addition, Item 402(v) requires a clear description of the relationships between each of the financial performance measures included in the table and the executive compensation actually paid to its PEO and, on average, to its other NEOs. Companies will be required to also include a description of the relationship between the company’s TSR and its peer group TSR.
Further details regarding the PvP Disclosure requirements are available here.
Olivia Stitz, an associate in our New York office, and Chenjia Zhu, a law clerk in our New York office, contributed to the writing of this alert.
 The Howey Test is a four-prong test created by the Supreme Court for determining whether certain transactions should be treated as investment contracts, which are listed as securities under the Securities Act of 1933 and Securities Exchange Act of 1934. Under the Howey test, a transaction is an investment contract if (i) it is an investment of money; (ii) the investment is in a common enterprise; (iii) there is an expectation of profits from such investment; and (iv) any profit comes from the efforts of a promoter or third party.