Top 5 SEC Enforcement Developments for February 2023
Top 5 SEC Enforcement Developments for February 2023
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. In a month with multiple dissents from individual Commissioners in settled enforcement actions, this installment covers:
On February 3, 2023, the SEC announced it had agreed to a $35 million settlement order (“Order”) with Activision Blizzard for allegedly failing to maintain disclosure controls and procedures related to complaints of workplace misconduct in violation of Rule 13a‒15a and violating the whistleblower protection Rule 21F-17(a) under Section 21F of the Securities Exchange Act of 1934. The SEC alleged that between 2018 and 2021, the company “lacked controls and procedures among its separate business units to collect and analyze employee complaints of workplace misconduct.” The SEC emphasized that the alleged lack of controls was particularly problematic in light of the company’s previous statements in its public filings, including multiple Forms 10-K that stated: “If we do not continue to attract, retain, and motivate skilled personnel, we will be unable to effectively conduct our business.” The SEC alleged that without proper controls and procedures, the company’s management and disclosure personnel lacked sufficient information to appreciate the volume and substance of employee complaints and the ability to factor those complaints into the company’s public disclosures.
The SEC also alleged that between 2016 and 2021, Activision executed separation agreements that violated SEC whistleblower protection Rule 21F-17(a). Though most of the company’s agreements specifically informed departing employees that they may report complaints to government or regulatory entities (including the SEC), the SEC took issue with language in those agreements that required employees to provide notice to the company if they received a request for information. The SEC noted that the company removed the notification clause in 2022, and similarly improved the way it documented employee complaints and communicated them to management beginning in 2020, but nevertheless imposed a penalty of $35 million for the alleged violations.
Commissioner Hester M. Peirce dissented, stating that the “Commission alleges no fraud, misrepresentations, omissions, or investor harm,” and more generally failed to articulate any securities law violations. Peirce contended that the Commission expanded the disclosure requirements of Rule 13a-15(a) beyond the scope of the rule. According to Peirce, the plain reading of Rule 13a-15(e), which defines “disclosure controls and procedure,” suggests that the required disclosure controls and procedures must capture only “information that is required to be disclosed,” but the settled order expanded this definition to require companies to also include information “relevant to a company’s determination about whether a risk or other issue reached the threshold where it is required to be disclosed.”
Peirce also took issue with the Commission’s interpretation of Rule 21F-17(a)’s prohibition on taking “any action to impede an individual from communication directly with the Commission staff about a possible securities law violation.” Peirce noted that Activision’s separation agreements did not prohibit “disclosures that are truthful representations in connection with a report or complaint to an administrative agency,” and argued that the Commission failed to explain how the company’s notification requirement impedes former employees from communicating with the Commission staff about a possible securities law violation.
On February 7, 2023, the SEC Division of Examinations (“Exams”) announced its 2023 Examination Priorities (“Priorities”). Exams publishes its Priorities annually to provide insights into areas on which it expects to focus in the coming year. As explained in MoFo’s recent client alert, Exams continues to focus on private funds, Regulation Best Interest, ESG, and crypto-related products and services. Exams explained it will also focus on the new Marketing Rule (Advisers Act Rule 206(4)-1), the fiduciary duties of registered investment advisers (RIAs), standards of conduct for broker-dealers and RIAs, information security and operations to protect investor information, and emerging financial technologies, including new practices to meet the demands of compliance, marketing, and servicing investor accounts.
With respect to the new Marketing Rule, Exams will evaluate whether RIAs have adopted and implemented written policies and procedures that are reasonably created to prevent Market Rule violations and whether RIAs are complying with the rule. The New Marketing Rule defines advertisement, general prohibited advertising practices, prohibited testimonials and endorsements (unless the adviser satisfies certain disclosure, oversight, and disqualification provisions), prohibited use of third-party ratings in advertisements (unless certain disclosures are made and criteria are met), and generally prohibited performance information.
Exams will review issues related to violations of RIA fiduciary duties and will assess risks associated with compliance programs, fees, expenses, custody, the New Marketing Rule, conflicts of interest, and use of alternative data. Exams signaled it also will review broker-dealers’, RIAs’, and other registrants’ practices to prevent interruptions to necessary services and protect investor information, records, and assets with a focus on cybersecurity issues with third- party vendors.
Finally, Exams will conduct reviews of emerging financial companies and new practices to ensure broker-dealers and RIAs are meeting and following their respective standards of care when making recommendations, referrals, and providing investment advice. Exams will assess if these entities routinely review, update, and refine their compliance, disclosure, and risk management practices.
On February 9, 2023, the SEC filed a settled federal court action against Payward Ventures, Inc. and Payward Trading Ltd., both commonly known as “Kraken,” for violations of Sections 5(a) and (c) of the Securities Act because Kraken failed to register the offer and sale of its staking services with the SEC. Without admitting or denying the charges, Kraken consented to a final judgment that enjoined it from offering or selling securities to U.S. investors through crypto asset staking services or staking programs, and the SEC ordered it to pay $30 million in civil penalties, disgorgement, and prejudgment interest, among other relief. According to the SEC complaint, Kraken offered and sold its crypto asset staking services to the public in exchange for customers earning an advertised annual investment return of up to 21%. The SEC alleged that Kraken earned, and failed to sufficiently disclose, a fee for its services. SEC Chair Gary Gensler touted the action as a clear signal to the “marketplace that staking-as-service providers must register and provide full, fair, and truthful disclosure and investor protection.”
SEC Commissioner Peirce dissented, questioning whether Kraken could have registered its staking services given the current climate within the SEC for registration of crypto and other digital assets deemed to be securities and the mechanics of such registration, namely whether the staking program as a whole could be registered or whether each token’s staking program would need to be registered. Rather than shutting down Kraken’s staking services, Peirce proposed thinking through staking programs and issuing guidance. According to Peirce, “[u]sing enforcement actions to tell people what the law is in an emerging industry is not an efficient or fair way of regulating. Moreover, staking services are not uniform, so one-off enforcement actions and cookie-cutter analysis does not cut it.”
On February 21, 2023, Ensign Peak Advisers, Inc. (“Ensign Peak”), a non-profit entity operated by The Church of Jesus Christ of Latter-Day Saints (“LDS”) and LDS itself agreed to pay $5 million in combined penalties to settle administrative charges that Ensign Peak, under the control of LDS, violated Section 13(f) of the Exchange Act and Rule 13f-1 thereunder for allegedly failing to file Forms 13F on behalf of LDS, using shell companies (“Clone LLCs”) to file Forms 13F to obscure LDS’s equity portfolio, and misstating information in those forms.
Institutional investment managers are required to timely and accurately file Form 13F if they exercise investment discretion over at least $100 million in securities that are traded on a national securities exchange or on the automated quotation system of a registered securities association. As LDS’s investment manager, Ensign Peak managed approximately $37.8 billion of church assets.
The SEC alleged that LDS knowingly approved Ensign Peak to use Clone LLCs to shield the church’s equity investments portfolio and misstated Ensign Peak’s control over the church’s investment decisions. According to the settlement order (“Order”), Ensign Peak had authority over all Clone LLCs and LDS had indirect control over these LLCs because LDS controlled Ensign Peak. The Clone LLCs entered into investment manager agreements (IMAs), whereby Ensign Peak was designated as the Clone LLCs’ client. The IMAs assigned discretion and authority to the Clone LLCs to manage the securities portfolio. But the Clone LLCs never exercised investment discretion over LDS’s assets. The IMAs stated that the Clone LLCs were not authorized to vote by proxy or otherwise on any of the securities and property held in the securities portfolio assigned to them. Rather, each Clone LLC was required to forward any proxy solicitation materials and consent solicitations it received to Ensign Peak for consideration and action. Each Clone LLC was set up with a “Business Manager” who had responsibility for “preparation and filing of the Company’s governmental reports, returns, notices, and the like.” However, the Order states these Business Managers performed no function other than signing Forms 13F. Many of the Business Managers were employees of LDS, had limited information about the Clone LLCs, and allegedly were selected because they had a common name and a limited presence on social media, making them less likely to be traced to Ensign Peak or LDS. Each Clone LLC allegedly had an address outside Utah (although the Order notes none of them conducted business outside their locations) to give the impression that the Clone LLCs conducted business operations throughout the United States, making it difficult to trace the Clone LLCs back to Ensign Peak or LDS. According to the Order, LDS was concerned about disclosing its massive portfolio because disclosure of its assets “would lead to negative consequences.”
On February 27, 2023, the SEC announced settled charges against registered investment advisers Huntleigh Advisors, Inc. (“Huntleigh”) and its affiliate Datatex Investment Services, Inc. (“Datatex” and, collectively with Hutleigh, “Respondents”), for alleged violations of Sections 206(2) and 206(4) of the Advisers Act and Rule 206(4)-7 thereunder. Section 206(2) makes it unlawful for any investment adviser, directly or indirectly, to “engage in any transaction, practice or course of business which operates as a fraud or deceit upon any client or prospective client.” Section 206(4) and Rule 206(4)-7 “require a registered investment adviser to adopt and implement written compliance policies and procedures reasonably designed to prevent violations of the Advisers Act and the rules thereunder.”
According to the settlement order (“Order”), Respondents failed to disclose (1) compensation Huntleigh received based on client transaction fees; (2) revenue sharing payments an affiliated broker-dealer—Huntleigh Securities Corp. (HSC)—received and shared with Huntleigh from advisory client cash sweep accounts; and (3) the revenue HSC received and shared with Huntleigh based on the rate of margin interest charged to advisory clients. The SEC also noted that Respondents failed to self-report HSC’s receipt of 12b-1 fees to the Commission pursuant to the Division of Enforcement’s Share Class Selection Disclosure Initiative.
The SEC found that Huntleigh and Datatex breached their duties of care, including their “dut[ies] to seek best execution,” regarding the evaluation of the transaction fees charged to their clients and the election of cash sweep account options and mutual fund share classes for clients, and failed to adopt and implement written compliance policies and procedures to reasonably prevent these violations. Respondents agreed to several remedial measures; Huntleigh was censured and agreed to pay a combined $713,502 in disgorgement and pre-judgment interest and $130,000 in civil monetary penalties; and Datatex agreed to pay $50,000 in civil monetary penalties.
Commissioners Peirce and Mark T. Uyeda dissented, asserting that the Order provided no legal authority for finding that a mutual fund share class selection implicates an investment adviser’s duty to seek best execution, or find the most favorable costs or proceeds of a transaction for clients. The Commissioners said that mutual fund share classes should be evaluated under the duty to provide advice in the best interest of the client, rather than under the “duty to seek best execution.” According to the Commissioners, in 2018, when the Commission issued its proposed interpretation regarding the standard of conduct for investment advisers, the Commission specifically discussed mutual fund share class selection in the context of a duty to provide advice in the best interest of the client. And since the final 2019 interpretation deleted the reference to mutual fund share class selection and is silent on which duty this conduct might implicate, Commissioners Peirce and Uyeda argue a duty of care and providing advice in the best interest of the client is more appropriate for selection of mutual fund share classes.