Top 5 SEC Enforcement Developments for April 2023
Top 5 SEC Enforcement Developments for April 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. This month’s installment covers:
On April 4, 2023, the SEC charged Charlie Javice, the founder of the now shuttered student loan assistance start-up, Frank, with violating the antifraud provisions of the Securities Act of 1933 and Securities Exchange Act of 1934 in connection with the $175 million dollar sale of the company to a large bank. The U.S. Attorney’s Office for the Southern District of New York brought parallel criminal charges against Javice charging wire fraud, bank fraud, conspiracy, and securities fraud.
The complaint alleges that Javice made numerous material misrepresentations in order to secure the sale of her company to the bank, most notably that Frank had 4.25 million student customers when the true number of customers was less than 300,000. Javice presented a pitch deck to potential acquirors, including the large bank, touting that there were “4.25mm Frank Students & Growing.” Javice claimed to have access to the first name, last name, email address, and phone number of each Frank student. In reality, Frank only had access to approximately 300,000 students’ data. In an effort to conceal the original misrepresentation, the SEC alleged that Javice paid a data science professor to create fake data appearing to represent 4.25 million customers, and later paid two separate data compilers for additional student data purporting to show the email and phone number of students in college.
The SEC seeks (1) a permanent injunction, (2) disgorgement from all ill-gotten gains and payment of prejudgment interest, (3) civil penalties, and (4) a permanent prohibition against Javice from acting as an officer or director in a public company.
This case underscores that the SEC is focused not only on mature public companies, but also on representations made by start-ups where those representations are tied to securities transactions. As stated by SEC Enforcement Director Gurbir Grewal, “[e]ven non-public, early-stage companies must be truthful in their representations, and when they fall short we will hold them accountable as in this case.”
On April 14, 2023, in a unanimous decision penned by Justice Elena Kagan, the Supreme Court held that federal district courts can hear collateral constitutional challenges to administrative enforcement actions brought by the SEC and FTC before final agency adjudication. The decision consolidates FTC and SEC proceedings, Axon Enterprise, Inc. v. Federal Trade Commission, et al. and Securities and Exchange Commission, et al. v. Michelle Cochran.
Both the FTC and SEC filed administrative proceedings against respondents who, in turn, collaterally challenged those proceedings in federal district courts on constitutional grounds before there was a final agency decision on the merits. Both federal district courts dismissed the respondents’ constitutional challenges for lack of jurisdiction. On appeal, the U.S. Courts of Appeal for the Fifth and Ninth Circuits diverged. Whereas the Ninth Circuit agreed that the constitutional challenges “fell within the FTC Act’s scheme,” and affirmed the dismissal of the FTC respondent Axon’s collateral challenge, the Fifth Circuit disagreed on the equivalent SEC question and ruled that SEC respondent Cochran could bring a pre-merits constitutional challenge to an SEC administrative proceeding in federal district court. The Supreme Court granted certiorari to resolve the circuit split.
In its analysis, the Supreme Court applied the three-factor test created in Thunder Basin Coal Co. v. Reich, to determine if the respondents’ constitutional challenges were the “type [C]ongress intended to be reviewed within the statutory structure [of the FTC Act and the Exchange Act].” The three factors are: (1) whether precluding district court jurisdiction would “foreclose all meaningful judicial review”; (2) if the claim is “wholly collateral” to the statute’s review provisions; [and] (3) whether the claim is “outside the agency’s expertise.” The Court concluded all three factors weighed in favor of allowing federal district courts to review constitutional challenges to agency administrative proceedings before there is an agency adjudication on the merits.
Critically, this decision calls into question the authority of administrative law judges and will likely result in the SEC, among other agencies, continuing to file contested enforcement actions in federal district court rather than in administrative proceedings. As the SEC is authorized to bring some claims only through administrative proceedings and not in federal court—e.g., Rule 102(e) proceedings seeking suspensions against accountants and attorneys and for “causing” certain violations, as opposed to aiding and abetting those violations, which requires proof of a more culpable state of mind—the SEC may find that it has no viable avenue to pursue certain claims absent legislative action to take the Commission out of its current predicament.
For a deeper dive into Axon, as well as the concurrences by Justices Thomas and Gorsuch,please see our April 19 client alert.
On April 17, 2023, the SEC charged Bittrex, the former crypto asset trading company, and its co-founder and CEO William Shihara with operating an unregistered national securities exchange, broker, and clearing agency. The SEC also charged Bittrex’s foreign affiliate, Bittrex Global GmbH, for failing to register as a national securities exchange in connection with the operation of a single order book shared with Bittrex. These charges signal a continuing effort from the SEC to take an aggressive approach to enforcement of participants in all corners of the crypto asset trading market.
According to the SEC’s complaint, between 2014 and 2019, Bittrex operated as a trading platform through which U.S. customers could buy, sell, and trade crypto assets. In the course of its business, Bittrex earned at least $1.3 billion in revenue. The SEC alleges that, like other crypto platforms, Bittrex merged three functions that are typically separated in traditional securities markets: “those of broker-dealers, exchanges, and clearing agencies—despite the fact that Bittrex has never registered with the SEC as a broker-dealer, national securities exchange, or clearing agency.”
The SEC complaint alleges that Bittrex and Bittrex Global should have registered as an exchange because they used a shared book to bring together buyers and sellers and used established and non-discretionary methods to agree to the terms of a trade.
Furthermore, the Complaint alleges that Bittrex should have registered as a clearing agency because it acted as an intermediary when making payments, matching orders, and maintaining customer assets. Lastly, the SEC contends Bittrex should have registered as a broker in connection with its regular business transactions with crypto assets sold as securities.
In addition to the allegations made against Bittrex and Bittrex Global, the SEC complaint also alleges that Shihara helped issuers seeking to make their crypto assets available for trading on Bittrex’s platform delete from its public information any statements of “investment-related terms” that could make crypto assets subject to regulation as a crypto asset security.
The SEC seeks a final judgement (i) ordering defendants to disgorge their ill-gotten gains and pay prejudgment interest; (ii) prohibiting Bittrex and Shihara from continuing to accept and display orders in crypto assets, act as broker or dealer, or perform the functions of a clearing agency without registering with the SEC; and (iii) imposing civil money penalties.
On April 18, 2023, the SEC brought a settled enforcement action against Betterment LLC(“Betterment”), a robo-advisor investment firm, in connection with alleged misstatements and omissions to clients relating to its tax loss harvesting service (TLH). In addition, the SEC alleged that Betterment failed to provide notice of changes to clients’ advisory contracts and failed to maintain certain books and records. Without admitting or denying the charges, Betterment agreed to a censure and a $9 million civil penalty to be distributed to affected clients, among other relief.
The SEC order contends that Betterment changed its TLH scanning frequency on individual accounts but continued to advertise daily scanning; failed to disclose the constraints of the TLH to clients that selected a third-party portfolio strategy; had two computer coding errors that prevented the TLH from operating properly for certain clients; and failed to provide advance notice of material changes to its advisory contract. The TLH issues allegedly caused Betterment’s clients to lose approximately $4 million in potential tax benefits.
In a particularly informative piece of guidance to other robo-advisors, the SEC order noted that Betterment lacked policies and procedures reasonably “designed to ensure necessary communication between its compliance personnel, who review disclosures, and its engineers, who design and update its algorithms,” effectively signaling to companies reliant on algorithm-based advising that they must adequately oversee its implementation. The SEC, generally through investigations conducted by the Enforcement Division’s Asset Management Unit, has brought several enforcement actions against robo-advisors since 2018, when it brought its first cases against two robo-advisers (including one that alleged false statements about a TLH strategy). In 2021, the Division of Examinations issued a Risk Alert: Observations from Examinations of Advisers that Provide Electronic Investment Advice,which was issued to raise awareness of certain compliance issues of robo-advisors observed by SEC examiners.
On April 24, 2023, Coinbase filed a writ of mandamus in the Third Circuit requesting that the court compel the SEC to act on Coinbase’s rulemaking petition to provide clarity for the crypto industry.
In its original rulemaking petition, submitted to the SEC in July 2022, Coinbase asked the Commission to “propose new rules for the offer, sale, registration, and trading of digital asset securities.” In particular, Coinbase requested that the SEC create rules that address which digital assets are considered securities; provide procedures for the registration of issuers, exemptions, and mandatory disclosures; and give guidance for the registration of exchanges.
According to the writ of mandamus filed in April 2023, the SEC is statutorily required, by the Administrative Procedure Act, to respond to requests for rulemaking in a reasonable time; Coinbase describes its nine-month delay as an unreasonable evasion of judicial review given the length, consequences, and alleged “impropriety lurking behind [the] agenc[y’s] lassitude.”
While Coinbase’s filing applies only to its own rulemaking petition, the submission is part of a broader effort to clarify the rules of the road for crypto participants who have expressed frustration at what they describe as the SEC’s “demonstrated determination to forgo rulemaking in favor of achieving de facto regulation through retrospective enforcement.”
The SEC filed a response on May 15, 2023, after being ordered to do so via a text only order from the Court. Briefing was completed on May 22, 2023.
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