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The Murky Waters of Wash Trading Digital Assets – DOJ Charges 18 Individuals and Entities

The United States Attorney’s Office for the District of Massachusetts recently unsealed what it described as the “first-ever criminal charges against financial services firms for market manipulation and ‘wash trading’ in the cryptocurrency industry.” The SEC also filed parallel civil charges alleging violations of Securities for the same alleged schemes.

The government has charged eighteen individuals and companies, including four cryptocurrency market makers, with engaging in illegal market manipulation through “wash trading” digital assets. According to the DOJ and SEC filings, although these individuals purported to offer “market making services,” they were actually engaged in offering “market-manipulations-as-a-service” by engaging in artificial trading of digital assets to give the false appearance that there was an active (and heavily traded) market for those tokens.

How this case came to the DOJ’s attention is as novel as the legal theory behind the charging documents. According to DOJ spokespeople, the investigation started with a tip from the SEC about one of the companies at issue. Further investigations into that company—along with the help of cooperating witnesses—led authorities to set up a sham crypto firm, NextFundAI, and create a token associated with the firm. Posing as NextFundAI, the government communicated with the defendants—market makers who allegedly offered to trade and manipulate the price of NextFundAI’s token by wash trading, or trading the token back-and-forth between crypto wallets they controlled.

While there may be rules against wash trading in traditional securities markets (see, e.g., 26 U.S. Code § 1091), the rules are as clear in the digital asset space. Indeed, the regulatory vacuum facing the digital asset industry makes it difficult for those in the industry to avoid eventual regulatory action, and what many have referred to as “regulation by enforcement.” This is particularly true where the technological realities of digital assets do not fit squarely within the existing legal framework. There may be disagreement about the purpose or intent behind a cryptocurrency transaction where one individual is transferring cryptocurrency between wallets that person or entity controls. But there may not be a misrepresentation or fraudulent act inherent in this type of transaction. Indeed, the transaction itself (including the wallet address of the sender and recipient) is likely immediately and accurately recorded on the public blockchain. So, according to the government, the “fraud” is the intent behind the trades – to manipulate the market by artificially generating trade volume to signal interest and activity in the token.

The government’s allegations are also interesting because in addition to the wire fraud charges (18 U.S.C. § 1343), which generally do not require proof that the digital asset at issue is a security, the government has charged the defendants with conspiracy to commit market manipulation (18 U.S.C. § 371), which requires the government to prove that the token at issue is a security. This charge is significant because it will require the DOJ to prove at trial that the tokens at issue are securities.

Although several individuals involved have already pleaded guilty, there are several defendants who appear to be testing the government’s novel theory in court. We anticipate that this will be the first of many similar investigations and enforcement actions in the digital asset space.

End of Summer Pool Party: CFTC Approves Final Rule Amending 4.7 Regulatory Relief for CPOs and CTAs

On 12 September 2024, the Commodity Futures Trading Commission (CFTC) published a Final Rule impacting registered commodity pool operators (CPOs) and commodity trading advisors (CTAs) relying on the regulatory relief provided under CFTC Regulation 4.7. “Registration light,” as Regulation 4.7 is sometimes known, provides reduced disclosure, reporting and recordkeeping obligations for CPOs and CTAs that limit sales activities to “qualified eligible persons” (QEPs).

The Final Rule amends Regulation 4.7 by:

Updating the QEP definition by increasing the financial thresholds in the “Portfolio Requirement” to account for inflation; and
Codifying certain CFTC no-action letters allowing CPOs of Funds of Funds to opt to deliver monthly account statements within 45 days of month-end.

For most asset managers, however, the most significant update is that the CFTC declined to adopt the proposed minimum disclosure requirements. Under existing Regulation 4.7, CPOs and CTAs are exempt from certain disclosure requirements when offering pools solely to QEPs. Without those exemptions, dually-registered managers would be burdened with duplicate or conflicting disclosure requirements under the Securities and Exchange Commission’s (SEC) rules. The Proposed Rule would have rescinded or narrowed certain of these exemptions. Commenters almost unanimously opposed the disclosure-related amendments, and the CFTC ultimately decided to take additional time to consider the concerns and potential alternatives.

The Final Rule doubled the Portfolio Requirement for the Securities Portfolio Test and the Initial Margin and Premium test to US$4,000,000 and US$400,000, respectively. Despite the increased suitability standards for QEPs, the Final Rule will not impact most private funds relying on Rule 506 of Regulation D, as those amounts are still less than the “Qualified Purchaser” threshold under the SEC’s rules.

UK Regulators Publish Final Securitisation Rules

On 30 April 2024, the Financial Conduct Authority (FCA) published a policy statement (PS24/4) setting out its final firm-facing rules relating to securitisations and summarising feedback to its earlier consultation for the UK securitisation markets (CP23/17). The Prudential Regulation Authority (PRA and together with the FCA, the Regulators) also published a policy statement, in parallel with PS24/4, on its final firm-facing rules for those firms over which it has supervisory responsibility (PS7/24). This also follows the PRA’s own parallel consultation (CP15/23).

Background

As part of the UK’s post-Brexit regulatory reforms, the UK government is working to repeal and replace retained EU financial services law with new UK domestic rules. In July 2023, the UK government published a draft statutory instrument (SI) to replace the UK’s onshored version of the Securitisation Regulation (UK SR).

Following the publication of the SI, the PRA launched CP15/23 on its proposed firm-facing requirements on 27 July 2023 and the FCA launched its parallel consultation CP23/17 on 7 August 2023. Both of these consultations are explored in further detail in our previous article (available here). While there is some duplication between the two rulebooks, the Regulators noted that they have coordinated their approach with a view to creating a coherent framework.

The Final Rules

In PS24/4, the FCA has sought, among other things, to incorporate the feedback received on its draft rule proposals set out in its final rules, which are called the ‘Securitisation (Smarter Regulatory Framework and Consequential Amendments) Instrument 2024’.

PS24/4 makes the following key amendments to CP23/17:

Timeline for implementation. The Regulators have confirmed the implementation timeline for the requirements (see the Next Steps section below), which allows for a six-month transition period for pre-implementation securitisations.
Due diligence – public vs private securitisations. The FCA has adjusted the wording of its final rules to accommodate both public and private securitisations. Specifically, they refer to information provided ‘before pricing or original commitment to invest’ (in appropriate places) to reflect that private securitisations do not have “pricings” per se. In addition, the FCA has included guidance to reflect the fact that ‘pricing’ in the Simple, Transparent and Standardised (STS) template is to be understood as also including the ‘original commitment to invest’.
Due diligence – disclosures by ‘manufacturers’. The FCA has adjusted the due diligence requirements for secondary market investors in relation to disclosures made by ‘manufacturers’ (i.e., the term used by the FCA as shorthand for originators, original lenders, sponsors and/or securitisation special purpose entities, each as defined in the UK SR) by:
i) introducing a distinction between primary and secondary market investments, so that secondary market investors are not required to conduct due diligence on documents and information that are no longer relevant (e.g., information provided prior to initial pricing such as at issuance, etc.); and
ii) clarifying that investors are required to conduct due diligence on the most up-to-date information available at the time of the investment, as opposed to documents from the timing of ‘pricing’ or ‘commitment’.
Delegation. The FCA has clarified that it is possible for an institutional investor to delegate its due diligence requirements to an entity that is not an institutional investor, subject to the institutional investor retaining the responsibility for compliance with due diligence requirements. In practice, this means that institutional investors will no longer be able to delegate the responsibility for compliance with the due diligence requirements to AIFMs that are not authorised in the UK, as such AIFMs no longer fall within the definition of an ‘institutional investor’ under the SI.
Risk-retention. The FCA has clarified the scope of the prohibition on hedging of the material net interest required to be retained under the risk retention requirements. Specifically, the FCA has confirmed that hedging in these circumstances is permitted for institutional investors so long as it does not compromise the alignment of interest, in line with the EU’s Risk Retention Technical Standards (Commission Delegated Regulation (EU) 2023/2175). In addition, the FCA confirms that there is no need for risk retention in the context of securitisations of own-issued debt instruments, including covered bonds.
Alignment with the PRA. PS24/4 aligns its drafting with that of the PRA rulebook in areas where the rules are similar – both in the language and ordering of the FCA’s rules. The FCA has stated that in a number of cases, however, it has retained the language on which it consulted where, for example, it considered it provided clarity. In non-shared areas, such as STS provisions, the FCA has retained the language and structure of the rules as proposed in CP23/17.

The FCA’s final rules will be included in the FCA’s securitisation sourcebook (known as SECN) alongside the final FCA securitsation reporting templates, which are in the same form as those currently in effect. Similarly, the PRA’s final rules will be implemented into the PRA rulebook by adding a new Securitisation Part, with consequential amendments to the Liquidity Coverage Ratio (CRR) Part and the Non-Performing Exposures Securitisation (CRR) Part.

Next Steps

The implementation date for the FCA and PRA rules is 1 November 2024, subject to revocation of the UK SR and related technical standards.

The commencement order that will bring into force the revocation of the UK SR and related technical standards has not yet been laid before Parliament. HM Treasury anticipates making this commencement order later this year once the SI comes into force. The FCA has stated that it will consider delaying or revoking the rules if the commencement order is not made.

The Regulators plan to consult on further changes to their securitisation rules in Q4 2024/Q1 2025, although timings are potentially subject to change. In this second consultation, the Regulators plan to review the definition of public and private securitisations and the associated reporting regime, among other areas for policy consideration.

EU Divergence

HM Treasury and the Regulators have generally sought to retain the existing onshored Securitisation Regulation and associated technical standards in the FCA and PRA rulebooks, save for some targeted adjustments. These adjustments will lead to some potentially notable divergence between the UK’s new regime and the regime in the EU, including in relation to the following:

Template requirements. While the EU requires institutional investors to ensure disclosure templates are completed regardless of whether the sponsor, originator or SSPE are located in or outside of the EU, UK institutional investors are only required to ensure that certain prescribed information is provided, regardless of the format. Instead, UK sponsors, originators and SSPEs are under a separate obligation to comply with transparency requirements including the use of disclosure templates.
Originator sole purpose test. SECN references certain factors to be taken into account when assessing whether an originator has been established and is operating for the “sole purpose” of securitising exposures. The EU regime has a similar test, but focuses on whether the securitisation and related risk retention assets are the “sole or predominant source of revenue” of the originator. The UK’s regime does not set the same hurdle for meeting the sole purpose test, instead referring more generally to the retainer’s ability to meet its payment obligations.
Change of risk retainer. Under the EU’s rules the holder of a retained interest may not sell, transfer or otherwise surrender its rights in relation to the retained interest, unless due to its insolvency, “legal reasons beyond its control”, or where there is retention on a consolidated basis. The new UK regime does not include “legal reasons beyond its control” as a reason to disapply the sale restriction.

PS24/4, PS7/24, CP23/17, and CP15/23 can be found here, here, here and here, respectively.

The ‘Effective Spread’ of Order Execution Quality Reporting

On March 6, 2024, by unanimous vote, the Securities and Exchange Commission (SEC) adopted changes to Rule 605 under Regulation NMS, the provision that previously required only entities defined as “market centers” to publish detailed statistics on the quality of execution of “covered orders” in NMS stocks. Amended Rule 605 expands the reporting requirement in many ways:

by reporting party, to (a) broker-dealers with over 100,000 customer accounts (not just “market centers”); (b) Single Dealer Platforms; and (c) Automated Trading Systems (as a stand-alone reporter, separate from any reports by the broker-dealer operator the ATS);
by expanding the scope of “covered orders” to include: (a) non-marketable limit orders received outside market hours and executed during market hours; (b) stop orders; and (c) short sale orders not marked short exempt and not subject to price test restrictions under Reg SHO.
by revising time and size categories to include odd-lot and fractional share orders and measure execution time in microseconds and milliseconds. Timestamps must also contain millisecond granularity.
by expanding execution quality metrics. This expansion is wide-ranging and, among other things, (a) adds effective over quoted spread (“E/Q”) as a reporting metric; (b) requires reporting of average realized spread at multiple periods from 50 milliseconds to five minutes after execution; (c) measures price improvement not only relative to the NBBO, but also relative to the “best available displayed price,” a new baseline that includes available odd-lot liquidity; (d) adds measures of size improvement; and (e) includes fill rate information for non-marketable limit orders.

In the past, Rule 605 reports were practically unreadable for retail investors. They were data-heavy rather than in “plain English” and were reported at the security level, requiring significant data analysis to draw meaningful conclusions. The revised Rule seeks to remedy this deficiency, requiring covered broker-dealers and market centers to provide a Summary Report broken out by S&P 500 and non-S&P 500 securities, by order type (market and marketable limit) and order size, with columns for: average order size (shares and notional), average midpoint, percentage of orders executed at the quote or better, percentage receiving price improvement (both absolute and as a percentage of midpoint); average effective spread; average quoted spread; average effective over quoted spread (or “E/Q” percentage); average realized spread 15 seconds and one minute after execution; and average execution speed, in milliseconds.

While the rule revisions are comprehensive and will require significant programming (or vendor) expense, particularly for broker-dealers newly subject to the rule, many of the changes are welcome. Rule 605 had previously been subject to many increasingly outdated metrics, and firms that route orders will welcome more comprehensive and granular data elements. It remains to be seen whether retail and institutional customers will use the data to demand better execution quality from their broker-dealers or manage order-entry decisions based on the data.

What is meaningful, however, is the timing of this rule revision. These revisions were proposed in December 2022 as part of a package of significant market structure changes, including a proposed Order Competition Rule, a proposed far-reaching SEC best execution requirement known as Regulation Best Execution, and proposals to revise the pricing increments for quoting and trading equity securities and the minimum fees to access that liquidity. These other proposals were very controversial and subject to strong pushback from many parts of the securities industry. Many argued that the SEC should first adopt the proposed amendments to Rule 605 and then use the data from revised Rule 605 reporting to evaluate the other rule proposals. This approach would, of course, delay consideration of the other rule proposals while data were generated under revised Rule 605. The SEC’s adoption of just the Rule 605 revisions does not preclude further consideration of the other rules, but it is a welcome development and a step in the right direction.

The Rule 605 amendments will become effective 60 days after the release is published in the Federal Register. The compliance date is currently set for 18 months after that effective date.

For more news on SEC Regulations, visit the NLR Securities & SEC section.

Third Time’s a Charm? SEC & CFTC Finalize Amendments to Form PF

On February 8, the Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) jointly adopted amendments to Form PF, the confidential reporting form for certain registered investment advisers to private funds. Form PF’s dual purpose is to assist the SEC’s and CFTC’s regulatory oversight of private fund advisers (who may be both SEC-registered investment advisers and also registered with the CFTC as commodity pool operators or commodity trading advisers) and investor protection efforts, as well as help the Financial Stability Oversight Council monitor systemic risk. In addition, the SEC entered into a memorandum of understanding with the CFTC to facilitate data sharing between the two agencies regarding information submitted on Form PF.

Continued Spotlight on Private Funds

The continued focus on private funds and private fund advisers is a recurring theme. The SEC recently adopted controversial and sweeping new rules governing many activities of private funds and private fund advisers. The SEC’s Division of Examinations also continues to highlight private funds in its annual examination priorities. Form PF is similarly no stranger to recent revisions and expansions in its scope. First, in May 2023, the SEC adopted requirements for certain advisers to hedge funds and private equity funds to provide current reporting of key events (within 72 hours). Second, in July 2023, the SEC finalized amendments to Form PF for large liquidity fund advisers to align their reporting requirements with those of money market funds. And last week, this third set of amendments to Form PF, briefly discussed below.

SEC Commissioner Peirce, in dissent:

“Boundless curiosity is wonderful in a small child; it is a less attractive trait in regulatory agencies…. Systemic risk involves the forest — trying to monitor the state of every individual tree at every given moment in time is a distraction and trades off the mistaken belief that we have the capacity to draw meaning from limitless amounts of discrete and often disparate information. Unbridled curiosity seems to be driving this decision rather than demonstrated need.”

Additional Reporting by Large Hedge Fund Advisers on Qualifying Hedge Funds

These amendments will, among other things, expand the reporting requirements for large hedge fund advisers with regard to “qualifying hedge funds” (i.e., hedge funds with a net asset value of at least $500 million). The amendments will require additional disclosures in the following categories:

Investment exposures, borrowing and counterparty exposures, currency exposures, country and industry exposures;
Market factor effects;
Central clearing counterparty reporting;
Risk metrics;
Investment performance by strategy;
Portfolio, financing, and investor liquidity; and
Turnover.

While the final amendments increase the amount of fund-level information the Commission will receive with regard to individual qualifying hedge funds, at the same time, the Commission has eliminated the aggregate reporting requirements in Section 2a of Form PF (noting, in its view, that such aggregate information can be misleading).

Enhanced Reporting by All Hedge Funds

The amendments will require more detailed reporting on Form PF regarding:

Hedge fund investment strategies (while digital assets are now an available strategy to select from, the SEC opted not to adopt its proposed definition of digital assets, instead noting that if a strategy can be classified as both a digital asset strategy and another strategy, the adviser should report the strategy as the non-digital asset strategy);
Counterparty exposures (including borrowing and financing arrangements); and
Trading and clearing mechanisms.

Other Amendments That Apply to All Form PF Filers

General Instructions. Form PF filers will be required to report separately each component fund of a master-feeder arrangement and parallel fund structure (rather than in the aggregate as permitted under the existing Form PF), other than a disregarded feeder fund (e.g., where a feeder fund invests all its assets in a single master fund, US treasury bills, and/or “cash and cash equivalents”). In addition, the amendments revise how filers will report private fund investments in other private funds, “trading vehicles” (a newly defined term), and other funds that are not private funds. For example, Form PF will now require an adviser to include the value of a reporting fund’s investments in other private funds when responding to questions on Form PF, including determining filing obligations and reporting thresholds (unless otherwise directed by the Form).
All Private Funds. Form PF filers reporting information about their private funds will report additional and/or new information regarding, for example: type of private fund; identifying information about master-feeder arrangements, internal and external private funds, and parallel fund structures; withdrawal/redemption rights; reporting of gross and net asset values; inflows/outflows; base currency; borrowings and types of creditors; fair value hierarchy; beneficial ownership; and fund performance.

Final Thoughts

With the recent and significant regulatory spotlight on investment advisers to private funds and private funds themselves, we encourage advisers to consider the interrelationships between new data reporting requirements on Form PF and the myriad of new regulations and disclosure obligations being imposed on investment advisers more generally (including private fund advisers).

The effective date and compliance date for new final amendments to Form PF is 12 months following the date of publication in the Federal Register.

Robert Bourret also contributed to this article.

SEC Enforcement Targets Anti-Whistleblower Practices in Financial Firm’s Settlement Agreements with Retail Clients by Imposing Highest Penalty in Standalone Enforcement Action Under Exchange Act Rule 21 F-17(a)

As the year gets underway, the Securities and Exchange Commission (SEC or Commission) is continuing its ongoing enforcement efforts to target anti-whistleblower practices by pursuing a broader range of entities and substantive agreements, including the terms of agreements between financial institutions and their retail clients. The most recent settlement with a financial firm signifies that the SEC is imposing increasingly steep penalties to settle these matters while focusing on confidentiality provisions that do not affirmatively permit voluntary disclosures to regulators. We discuss below the latest SEC enforcement actions in the name of whistleblower protection and offer some practical tips for what firms and companies may do to proactively mitigate exposure.

On 16 January 2024, the SEC announced a record $18 million civil penalty against a dual registered investment adviser and broker-dealer (the Firm), asserting that the use of release agreements with retail clients impeded the clients from reporting securities law violations to the SEC in violation of Rule 21F-17(a) of the Securities Exchange Act of 1934 (Exchange Act).¹

The SEC found that from March 2020 through July 2023, the Firm regularly required its retail clients to sign confidential release agreements in order to receive a credit or settlement of more than $1,000. Under the terms of these releases, clients were required to keep confidential the existence of the credits or settlements, all related underlying facts, and all information relating to the accounts at issue, or risk legal action for breach of the agreement. The agreements “neither prohibited nor restricted” the clients from responding to any inquiries from the SEC, the Financial Industry Regulatory Authority (FINRA), other regulators or “as required by law.” However, the agreements did not expressly allow the clients to initiate voluntary reporting of potential securities law violations to the regulators. The SEC found that this violated Rule 21F-17(a) “which is intended to ‘encourag[e] individuals to report to the Commission.’”²While the Firm did report a number of the underlying client disputes to FINRA, the SEC found this insufficient to mitigate the lack of language in the release agreements that expressly permitted the clients to report potential securities law violations to the SEC.

The SEC initiated a settled administrative proceeding against the Firm, which neither admitted nor denied the SEC’s findings. In addition to the $18 million civil monetary penalty, the settlement requires that the Firm cease and desist from further violations of Rule 21F-17(a). Notably, the SEC credited certain remedial measures promptly undertaken by the Firm, including revising the at-issue release language and affirmatively alerting affected clients that they are not prohibited from communicating with governmental and regulatory authorities.

This enforcement action is significant for several reasons. First, it signals a broader enforcement focus by the SEC with respect to Rule 21F-17(a) in that this is the first action involving the terms of agreements between a financial institution and its retail clients, which are prevalent throughout the financial services industry. Previously, enforcement had focused squarely on restrictive confidentiality provisions involving employees, such as those found in employment or severance agreements or in connection with internal investigation interviews.

Second, the unprecedented magnitude of the penalty in a standalone Rule 21F-17(a) case underscores the SEC’s emphasis on preventing practices that it views as obstructions of whistleblower rights. SEC Enforcement Director Gurbir Grewal’s statement announcing the settlement reflects this position, “Whether it’s in your employment contracts, settlement agreements or elsewhere, you simply cannot include provisions that prevent individuals from contacting the SEC with evidence of wrongdoing.” Companies (public and private), broker-dealers, investment advisers, and other market participants should expect to see continued enforcement investigations in connection with the SEC’s ongoing attention toward compliance with Rule 21F-17(a), as discussed further below.

The SEC’s Whistleblower Protection Program

Established in 2011 pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, the SEC Whistleblower Program provides monetary awards to individuals who “tip” the SEC with original information that leads to an enforcement action resulting in monetary sanctions that exceed $1 million. Through the end of the SEC’s FY2023, the SEC has awarded almost $2 billion to 385 whistleblowers.³In FY2023 alone, the SEC received over 18,000 whistleblower tips and awarded more than $600 million in whistleblower awards to 68 individuals.⁴

In furtherance of the Whistleblower Program, the SEC also issued Exchange Act Rule 21F-17(a), which provides that “no person may take any action to impede an individual from communicating directly with the Commission staff about a possible securities law violation, including enforcing, or threatening to enforce, a confidentiality agreement . . . with respect to such communications.”⁵

SEC Struck Several Blows in 2023 Against Companies that Failed to Carve out Whistleblower Protections in Their Confidentiality Agreements

The SEC has been aggressively enforcing Rule 21F-17(a) since its first enforcement action in 2015 with respect to that Rule,⁶through several waves of enforcement actions. During 2023, the SEC was especially active with a number of settled enforcement actions asserting violations of Rule 21F-17(a) in which the respondents neither admitted nor denied the SEC’s findings:

In February 2023, the SEC fined a video game development and publishing company $35 million for violating federal securities laws through its inadequate disclosure controls and procedures. The settled action also included a finding that the company had violated Rule 21F-17(a) by executing separation agreements in the ordinary course of its business that required former employees to provide notice to the company if they received a request for information from the SEC’s staff.⁷
In May 2023, the SEC imposed a $2 million fine on an internet streaming company for: (i) retaliating against an employee who reported misconduct to the company’s management prior to and after filing a complaint with the SEC; and, (ii) impeding the reporting of potential securities law violations, by including provisions in employee severance agreements requiring that departing employees waive any potential right to receive a whistleblower award, in violation Rule 21F-17(a).⁸
In September 2023, in another standalone enforcement action for violations of Rule 21F-17(a), the SEC imposed a $10 million civil monetary penalty on a registered investment adviser (RIA) for requiring that its new employees sign employment agreements that prohibited the disclosure of “Confidential Information” to anyone outside of the company, without an exception for voluntary communications with the SEC concerning possible securities laws violations.⁹Further, the RIA required many departing employees to sign a release in exchange for the receipt of certain deferred compensation and other benefits affirming that, among other things, the employee had not filed any complaints with any governmental agency. Although the RIA later revised its policies and issued clarifications to employees that they were not prevented from communicating with the SEC and other regulators, the RIA failed to amend its employment and release agreements to provide the carve out.
Also in September 2023, the SEC charged two additional firms with violations of Rule 21F-17(a). In one case imposing a $375,000 civil penalty, the SEC found that a commercial real estate services and investment firm impeded whistleblowers by requiring its employees, as a condition of receiving separation pay, to represent that they had not filed a complaint against the firm with any federal agency.¹⁰In another case, the SEC imposed a $225,000 civil penalty against a privately-held energy and technology company for requiring certain departing employees to waive their rights to monetary whistleblower awards.¹¹This particular action underscores that Rule 21F-17 applies to all entities, and not only to public companies.

Mr. Grewal, in an October 2023 speech before the New York City Bar Association Compliance Institute, emphasized that potential impediments to the SEC’s Whistleblower Program would be a continued focus of the agency’s enforcement efforts, stating, “we take compliance with Rule 21F-17 very seriously, and so should each of you who work in a compliance function or advise companies. You need to look at these orders and the violative language cited by the Commission and think about how those actions may impact your firms. And if they do, then take the steps necessary to effect compliance.”¹²

Key Take-Aways

The SEC’s recent enforcement actions demonstrate that violations of Rule 21F-17(a) can carry significant fines and reach virtually any confidentiality agreement that does not carve out communications between a firm’s current or former employees or customers and the SEC or other regulators about potential securities violations. Moreover, although many of the enforcement actions relate to language in agreements, Rule 21F-17 is not so limited and can also apply to language in internal policies, procedures, guidance, manuals, or training materials. The message from the SEC is clear: it will continue to enforce Rule 21F-17 with respect to public companies, private companies, broker-dealers, investment advisers, and other financial services entities.

The SEC in its recent orders has provided credit to companies for cooperation as well as for instituting remedial actions.¹³ Being proactive in identifying and correcting potential violations in advance of any investigation by the SEC can result in mitigation of any action or penalties.

Legal and compliance officers may want to consider the following steps in order to evaluate and potentially mitigate any potential exposure to an enforcement action:

Conduct a review of all employee-facing and client-facing documents or contracts with confidentiality provisions and remove or revise any content that may be viewed as impeding (even unintentionally) a person’s ability to report potential securities law violations to the SEC. Depending on the circumstances, this may involve including a reference expressly permitting communications with the SEC and other government or regulatory entities without advance notice or disclosure to the company.
Remove any language from the templates that could be interpreted as hindering an employee’s or client’s ability to communicate with the SEC concerning potential securities law violations, including language threatening disciplinary action against employees for disclosing confidential information in their communications with government agencies when reporting potential violations.
Prepare addenda or updates to current employee- and client-facing agreements that reflect the revised confidentiality clauses.
Include reference in written anti-retaliation policies that employees’ communications and cooperation with the SEC and other government agencies will not result in retaliation from the company.
Conduct trainings for company managers and supervisors regarding appropriate communications to employees regarding their interactions with the government.
Implement policies that prevent any company personnel from taking steps to block or interfere with an employee’s use of company platforms or systems to communicate with the SEC and other government agencies.¹⁴

¹In the Matter of JP Morgan Securities LLC, Admin. Proc. No. 3-21829 (Jan. 16, 2024), https://www.sec.gov/files/litigation/admin/2024/34-99344.pdf.

²Id. (quoting Securities Whistleblower Incentives and Protections Adopting Release, Release No. 34-63434 (June 13, 2011)).

³SEC Office of the Whistleblower Annual Report to Congress for Fiscal Year 2023 (Nov. 14, 2023), https://www.sec.gov/files/2023_ow_ar.pdf; SEC Whistleblower Office Announces Results for FY 2022 (Nov. 15, 2022), https://www.sec.gov/files/2022_ow_ar.pdf; 2021 Annual Report to Congress Whistleblower Program (Nov. 15, 2021), https://www.sec.gov/files/owb-2021-annual-report.pdf; 2020 Annual Report to Congress Whistleblower Program (Nov. 16, 2020), https://www.sec.gov/files/2020_owb_annual_report.pdf.

⁴SEC Office of the Whistleblower Annual Report to Congress for Fiscal Year 2023 (Nov. 14, 2023), https://www.sec.gov/files/2023_ow_ar.pdf.

⁵17 C.F.R. § 240.21F-17.

⁶In the Matter of KBR, Inc., Admin. Proc. No. 3-16466 (Apr. 1 2015), https://www.sec.gov/files/litigation/admin/2015/34-74619.pdf (imposing a US$130,000 fine on a company in a settled enforcement action for requiring that witnesses in certain internal investigations sign confidentiality agreements warning that they could be subject to discipline if they discussed the matters at issue outside the company without prior approval of the company’s legal department).

⁷In the Matter of Activision Blizzard, Inc. Admin. Proc. No. 3-21294 (Feb. 3, 2023), https://www.sec.gov/files/litigation/admin/2023/34-96796.pdf.

⁸In the Matter of Gaia, Inc. et. al., Admin. Proc. No. 3-21438 (May 23, 2023), https://www.sec.gov/files/litigation/admin/2023/33-11196.pdf.

⁹In the Matter of D.E. Shaw & Co., L.P., Admin. Proc. No. 3-21775 (Sep. 29, 2023), https://www.sec.gov/files/litigation/admin/2023/34-98641.pdf.

¹⁰In the Matter of CBRE Inc., Admin. Proc. No. 3-21675 (Sept. 19, 2023), https://www.sec.gov/files/litigation/admin/2023/34-98429.pdf.

¹¹In the Matter of Monolith Res., LLC, Admin. Proc. No. 3-21629 (Sept. 8, 2023), https://www.sec.gov/files/litigation/admin/2023/34-98322.pdf.

¹²Gurbir S. Grewal, Remarks at New York City Bar Association Compliance Institute (Oct. 24, 2023), https://www.sec.gov/news/speech/grewal-remarks-nyc-bar-association-compliance-institute-102423.

¹³See, e.g., In the Matter of CBRE Inc., Admin. Proc. No. 3-21675 (Sept. 19, 2023), https://www.sec.gov/files/litigation/admin/2023/34-98429.pdf (crediting respondent’s remediation program, which included, among other measures, an audit of relevant agreements, updates to policies with respect to Rule 21F-17, and mandatory trainings); In the Matter of Monolith Res., LLC, Admin. Proc. No. 3-21629 (Sept. 8, 2023), https://www.sec.gov/files/litigation/admin/2023/34-98322.pdf (crediting respondent’s prompt remedial acts including revisions to the at-issue release language and affirmatively alerting affected clients that they are not prohibited from communicating with governmental and regulatory authorities.)

¹⁴Cf. In the Matter of David Hansen, Admin Proc. 3-20820 (Apr. 12, 2022), https://www.sec.gov/enforce/34-94703-s (settled SEC enforcement action against former Chief Information Officer of a technology company for violating Rule 21F-17(a) by, among other things, removing an employee’s access to the company’s computer systems after the employee raised concerns regarding misrepresentations contained in the company’s public disclosures).

Upstream and Affiliate Guaranties in NAV Loans

Guaranties are a common feature in fund finance transactions. Particularly in NAV loans, upstream and affiliate (or “sideways”) guaranties are used. Below we discuss some of the context for the use of these types of guaranties, as well as some of the issues that lenders should consider in relying on them.

Upstream Guaranties

It is not uncommon in NAV loan transactions for the borrower to hold the underwritten assets for the financing (i.e., the fund’s portfolio of investments) through one or more controlled subsidiary holding vehicles (each, a “HoldCo”). Lenders may take a pledge of the management and economic interests in the HoldCos (rather than the underlying investments). In order to get as close to the underlying investments as possible (without taking a pledge), lenders may require that a HoldCo issue a guaranty directly to the lenders (or the administrative agent, on behalf of the lenders), guaranteeing the borrower’s obligations under the NAV loan facility. This “upstream” guaranty provides the lenders a direct claim against the HoldCo for amounts due under the loan, mitigating some of the risk of structural subordination to potential creditors (expected or unexpected) at the level of the HoldCo.[1]

Affiliate Guaranties

It is also common in NAV loan facilities for the borrower’s portfolio of investments to be held by multiple subsidiaries and/or affiliates of the borrower. Each such subsidiary or affiliate may be designated as a guarantor for repayment of the loan. As a result, such entities end up guaranteeing the obligations of their affiliates. The purpose of these affiliate guaranties is the same as the upstream guaranties discussed above – namely, to provide the lenders with a more direct enforcement claim in a default scenario.

Use of Such Guaranties

Motivations for the use of such upstream and affiliate guaranties may include:

a lender’s desire to underwrite a broader portfolio of investments, mitigating concentration risk to the portfolio of a single holding entity;
a lender’s desire to ensure that it is not subordinate to creditors that may arise at the level of the entity that directly owns the investment; or
a borrower’s desire to obtain a higher loan-to-value ratio than the lenders would otherwise provide based on the investments alone.
While upstream and affiliate guaranties can help to address these issues, they may raise nuanced legal issues that should be discussed with counsel in light of the relevant facts and circumstances.

Enforceability Considerations

Guaranties constitute the assumption of the liabilities of another entity and are contingent claims against the guarantor. Under certain insolvency laws, guaranties may be subject to challenge, and payments under guaranties may be subject to avoidance. Upstream or affiliate guaranties may be subject to heightened scrutiny and challenge in a bankruptcy or distress scenario. Below are a few potential issues lenders should bear in mind with respect to upstream and affiliate guaranties.

1. Constructively Fraudulent Transfer Avoidance. Under Bankruptcy Code section 548 and certain state laws, (a) transfers of property (including grants of security interests or liens), or (b) obligations assumed (such as incurring a loan or guaranty obligation) may be avoided as constructively fraudulent if BOTH of the following requirements are satisfied:[2]

(i) the transferor/guarantor does not receive reasonably equivalent value; AND
(ii) the transferor/guarantor is insolvent or undercapitalized or rendered insolvent, undercapitalized or unable to pay its debts because of the transfer or the assumed liability.

A guaranty by a parent of the obligations of a wholly owned and solvent subsidiary, a so-called downstream guaranty, is generally regarded as providing the parent with reasonably equivalent value through an enhancement of the value of its equity ownership of the subsidiary.

Upstream and affiliate guaranties require more scrutiny than guaranties by a borrower parent to determine whether any potential enforceability issues are present.

a. Reasonably Equivalent Value. The determination of value is not formulaic or mechanical, but rather generally determined by the substance of the transaction. Value or benefits from a transfer may be direct (e.g., receipt of loan proceeds) or indirect. But if indirect, they must be “fairly concrete.”

In each of the above scenarios, we are assuming that the upstream or affiliate guarantor would not use the proceeds of any loans and, consequently, would not be added to the loan facility as a borrower. However, other indirect but tangible benefits or value to the guarantor should be identified, e.g., favorable loan terms or amendments, use of the NAV facility proceeds that may indirectly but materially benefit the guarantor, maintenance of the entire fund group of entities that benefits the guarantor, etc.

b. Financial Condition of Guarantor. The financial condition of the transferor/guarantor is evaluated at the time of the incurrence of the guaranty. The evaluation is made from the debtor/guarantor – in what condition was the guarantor left after giving effect to the transfer or assumption of the obligation. Diligence regarding a guarantor’s financial condition may demonstrate that such guarantor is sufficiently creditworthy to undertake the guaranty and remain solvent and able to conduct its respective businesses. Representations from the guarantor may be sought to confirm its financial condition.

c. Potential Mitigants. In addition to performing diligence with respect to the above points, lenders and their counsel will often include contractual provisions to mitigate the possibility that a guaranty may be found to constitute a fraudulent transfer. Savings clauses, limited recourse guaranties, and net worth guaranties are all tools that can be used to address the issues noted above. The scope and appropriateness of such provisions is beyond the scope of this article and should be discussed with external deal and restructuring counsel.

2. Preference Challenge. Under Bankruptcy Code section 547, a transfer made by a debtor to a creditor, on account of an antecedent debt, that is made while the debtor was insolvent and within 90 days before the bankruptcy case has been commenced may be subject to avoidance as a preferential transfer. Certain defenses may apply to a potential preferential transfer, including the simultaneous exchange of “new value” by the creditor. However, note that any pre-bankruptcy transfers of value, like payments under a guaranty, may be subject to scrutiny and potential challenge by the guarantor/debtor or a bankruptcy trustee.

Guaranties can be an important element in structuring NAV loan transactions to achieve the terms desired by the parties and to provide necessary protections for the lenders, but consideration needs to be given to the legal issues, such as the ones mentioned here, that their inclusion can present.

[1] Lenders will typically also require the HoldCo to pledge its accounts to which proceeds of the underlying investments are paid, allowing lenders to foreclose on such cash at the HoldCo level, without the need for such cash to first be distributed up to the borrower.

[2] Note that the precise language of certain state fraudulent transfer laws may differ, but conceptually, most state statutes require a showing of (i) insufficient or unreasonably small consideration in exchange for the transfer or liability incurred, and (ii) the transferor/debtor being insolvent at the time of the transfer, or becoming insolvent or subject to financial distress as a result of the transfer.

Regulatory Update and Recent SEC Actions

REGULATORY UPDATES

Recent SEC Leadership Changes

On January 10, 2023, the Securities and Exchange Commission (the “SEC”) announced the appointment of Cristina Martin Firvida as director of the Office of the Investor Advocate, effective January 17, 2023. Ms. Martin Firvida was most recently the vice president of financial security and livable communities for government affairs at the American Association of Retired Persons (“AARP”). As the investor advocate, Ms. Martin Firvida will lead the office that assists retail investors in interactions with the SEC and with self-regulatory organizations (“SROs”), analyzing the impact on investors of proposed rules and regulations, identifying problems that investors have with financial service providers and investment products, and proposing legislative or regulatory changes to promote the interests of investors.

On January 11, 2023, the SEC announced that Paul Munter has been appointed as chief accountant. He has served as acting chief accountant since January 2021. In addition to continuing to lead the Office of the Chief Accountant (“OCA”), he will also assist the SEC in its oversight of the Financial Accounting Standards Board (“FASB”) and the Public Company Accounting Oversight Board (“PCAOB”). Mr. Munter joined the SEC in 2019 as deputy chief accountant in charge of OCA’s international work. Before joining the agency, Mr. Munter was a senior instructor of accounting at the University of Colorado Boulder. He had previously retired from KPMG, where he served as the lead technical partner for the U.S. firm’s international accounting and International Financial Reporting Standards (“IFRS”) activities and served on the firm’s panel responsible for establishing firm positions on the application of IFRS.

On January 13, 2023, the SEC announced that Renee Jones, director of the Division of Corporation Finance, departed the agency and was replaced by Erik Gerding, effective February 2, 2023. Mr. Gerding previously served as the Division’s deputy director. Mr. Gerding joined the SEC in October 2021 and led the Legal and Regulatory Policy in the Division of Corporation Finance. He has taught as professor of law and a Wolf-Nichol Fellow at the University of Colorado Law School, where he has focused in the areas of securities law, corporate law, and financial regulation. Mr. Gerding previously taught at the University of New Mexico School of Law. He also practiced in the New York and Washington, D.C., offices of Cleary Gottlieb Steen & Hamilton LLP, representing clients in the financial services and technology industries in an array of financial transactions and regulatory matters.

Boards File Comment Letters Asking SEC to Withdraw Swing Pricing Rule Proposal

Over thirty (30) fund boards have submitted comment letters to the SEC with respect to the controversial swing pricing rule proposal. Industry participants have noted that this level of direct board participation in the comment process for a rule proposal of this type is unprecedented in recent SEC history. Many of the letters call for a withdrawal of the rule proposal, with some arguing that millions of American investors will not get the best price for their trades. Many letters also stated that requiring swing pricing would burden fund complexes and harm mutual fund investors without solving the liquidity problems that the SEC aimed to resolve. A vast majority of the comment letters indicated that swing pricing is not needed and that current tools for managing liquidity worked well, even during the volatile 2020 markets.

The comment letters also noted that investors who hold fund shares through intermediaries may have to place their orders earlier as a result of the proposed hard close requirement, which would put them at a disadvantage over the investors who buy shares directly from a fund. Several commenters also expressed concern that the hard close could cause intermediaries to drop mutual funds from their offerings in favor of less-regulated investment vehicles, such as collective investment trusts (“CITs”). Some letters pointed out that one of the justifications the SEC raises for the new rule is the market volatility during the early part of the COVID-19 pandemic and its impact on fund liquidity risk management, yet the SEC then goes on to say that it did not have specific data about fund dilution during that period. Letters also alleged that the SEC did not provide an accurate cost benefit analysis, and noted that the SEC states in the rule proposal that it “cannot predict the number of investors that would choose to keep their investments in the mutual fund sector nor the number of investors that would exit mutual funds and instead invest in other fund structures such as ETFs, close-end funds, or CITs.”

SEC Proposes Rule to Prohibit Conflicts of Interest in Certain Securitizations

The SEC issued a proposed rule (the “proposed rule”) to prohibit material conflicts of interest in the sale of asset-backed securities (“ABS”). The proposed rule, Rule 192 under the Securities Act of 1933 (the “Securities Act”), was issued on January 25, 2023, to implement Section 27B of the Securities Act, a provision added by the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”). Specifically, the proposed rule would prohibit securitization participants from engaging in certain transactions that could incentivize a securitization participant to structure an ABS in a way that would put the securitization participant’s interests ahead of those of ABS investors. The SEC originally proposed a rule to implement Section 27B in September 2011. If adopted, the proposed rule would prohibit an underwriter, placement agent, initial purchaser, or sponsor of an ABS, including affiliates or subsidiaries of those entities, from engaging, directly or indirectly, in any transaction that would involve or result in any material conflict of interest between the securitization participant and an investor in such ABS. Under the proposed rule, such transactions would be considered “conflicted transactions” and include, for example, a short sale of the ABS or the purchase of a credit default swap or other credit derivative that entitles the securitization participant to receive payments upon the occurrence of specified credit events in respect of the ABS.

The prohibition on conflicted transactions would commence on the date on which a person has reached, or has taken substantial steps to reach, an agreement that such person will become a securitization participant with respect to an ABS, and it would end one year after the date of the first closing of the sale of the relevant ABS. The proposed rule would provide certain exceptions for risk-mitigating hedging activities, bona fide market-making activities, and certain commitments by a securitization participant to provide liquidity for the relevant ABS. The public comment period will remain open for 60 days following publication of the proposing release on the SEC’s website or 30 days following publication of the proposing release in the Federal Register, whichever period is longer.

Division of Examinations Publishes Risk Alert on Regulation Best Interest

On January 30, 2023, the Division of Examinations published a Risk Alert (the “Risk Alert”) to highlight observations from examinations related to Regulation Best Interest, which had a June 30, 2020, compliance date and to assist broker-dealers in reviewing and enhancing their compliance programs related to Regulation Best Interest. The Risk Alert discusses deficiencies noted during examinations conducted, as well as examples of weak practices that could result in deficiencies. Regulation Best Interest established a new, enhanced standard of conduct under the Securities Exchange Act of 1934 (the “Exchange Act”) for broker-dealers (“broker-dealers” or “firms”) and associated persons that are natural persons (“financial professionals”) of a broker-dealer when making recommendations of securities transactions or investment strategies involving securities (including account recommendations) to retail customers. Regulation Best Interest requires compliance with four component obligations: (1) providing certain prescribed disclosure, before or at the time of the recommendation, about the recommendation and the relationship between the retail customer and the broker-dealer (“Disclosure Obligation”); (2) exercising reasonable diligence, care, and skill in making the recommendation to, among other things, understand the potential risks, rewards, and costs associated with a recommendation, and having a reasonable basis to believe that the recommendation is in the best interest of a retail customer (“Care Obligation”); (3) establishing, maintaining, and enforcing written policies and procedures reasonably designed to identify and address conflicts of interest; and (4) establishing, maintaining, and enforcing written policies and procedures reasonably designed to achieve compliance with Regulation Best Interest. The Risk Alert set out specific examples of practices, policies, and procedures that were deficient in complying with requirements under the Regulation, including:

Policies and Procedures Relating to the Disclosure Obligation. Some broker-dealers did not have written policies and procedures reasonably designed to achieve compliance with the Disclosure Obligation. The SEC noted that examples of policies and procedures that may contain deficiencies or weaknesses include policies and procedures that did not specify when or how disclosures should be created or updated.
Policies and Procedures Relating to the Care Obligation. Examples of policies and procedures that may contain deficiencies or weaknesses include policies and procedures that directed financial professionals to consider reasonably available alternatives without providing any guidance as to how to do so; directed financial professionals to consider costs without providing any guidance as to how to do so; or created systems that allowed financial professionals to evaluate costs or reasonably available alternatives but did not mandate their use or, in some instances, could not determine whether or not financial professionals used the systems.
Conflict of Interest. The SEC observed a number of deficiencies related to the requirement that broker-dealers have written policies and procedures reasonably designed to address conflicts of interest associated with their recommendations to retail customers. For example: some broker-dealers did not have written policies and procedures reasonably designed to specify how conflicts are to be identified or addressed; some broker-dealers limited the identified conflicts to conflicts associated with prohibited activities (e.g., churning) or used high-level, generic language that did not identify the actual conflict (e.g., “we have conflicts related to compensation differences”) and did not reflect all conflicts of interest associated with the recommendations made by the firm or its financial professionals; and some broker-dealers inappropriately relied on disclosure to “mitigate” conflicts that appeared to create an incentive for the financial professional to place its interest ahead of the interest of the retail customer, and did not establish any mitigation measures.

SEC Releases Staff Guidance on Differential Advisory Fee Waivers

The staff of the Division of Investment Management (“Staff”) issued guidance (“Guidance”) on February 2, 2023, to mutual funds, their boards of directors/trustees (“Boards”), and their legal counsel about the implications under the Investment Company Act of 1940, as amended (the “Investment Company Act”), regarding fee waiver and expense reimbursement arrangements that result in different advisory fees being charged to different share classes of the same fund. The Guidance noted that Rule 18f-3 permits fee waivers and expense reimbursements provided that such arrangements do not result in cross-subsidization of fees among classes. The Staff stated that whether a differential advisory fee waiver presents a prohibited means of cross-subsidization between classes is a facts-and-circumstances determination that a mutual fund’s board, in consultation with the investment adviser and legal counsel, should consider making and documenting after considering all relevant factors.

For example, a fund’s Board may be able to conclude that a long-term waiver of an advisory fee for one class of shares, but not other classes of shares, does not provide a means for cross subsidization in contravention of Rule 18f-3 if the Board finds that (1) shareholders in the waived class pay fees to the adviser at the investing fund level in a funds-of-funds structure for advisory services, and (2) that such fees, when added to the advisory fees that are paid by the waived class, after giving effect to the waiver, are at least equal to the amount of advisory fees paid by the other classes, such that the waiver for the waived class is demonstrably not being subsidized by other classes. For a fund that already has such differential advisory fee waivers in place, the Staff said the fund’s board may wish to consider, specifically within the context of Rule 18f-3, whether: (i) such waivers present a means for cross-subsidization, (ii) the steps they are taking to monitor such waivers to guard against cross-subsidization are (and continue to be) effective, and/or (iii) alternative fee arrangements may be appropriate. Relatedly, the Staff suggested that a fund should consider the extent to which the Board’s consideration of these issues under Rule 18f-3 should be disclosed to its shareholders.

SEC Division of Examinations Announces 2023 Priorities

On February 7, 2023, the SEC’s Division of Examinations (the “Division”) announced its 2023 examination priorities. The Division publishes its examination priorities annually to provide insights into its risk-based approach, including the areas it believes present potential risks to investors and the integrity of the U.S. capital markets. The following are a selection of the Division’s 2023 priorities:

New Investment Adviser and Investment Company Rules:The Division will focus on the new Marketing Rule (Rule 206(4)-1 under the Investment Advisers Act of 1940, as amended (the “Advisers Act)) and whether registered investment advisers (“RIAs”) have adopted and implemented written policies and procedures that are reasonably designed to prevent violations by the advisers and their supervised persons of the new Marketing Rule and whether RIAs have complied with the substantive requirements.
The Division will also focus on new rules applicable to investment companies (“funds”), including the Derivatives Rule (Rule 18f-4 under the Investment Company Act) and the Fair Valuation Rule (Investment Company Act Rule 2a-5). If a fund relies on the Derivatives Rule, the Division will, among other things: (1) assess whether registered investment companies, including mutual funds (other than money market funds), exchange-traded funds (“ETFs”) and closed-end funds, as well as business development companies (“BDCs”), have adopted and implemented policies and procedures reasonably designed to manage the funds’ derivatives risks and to prevent violations of the Derivatives Rule pursuant to Investment Company Act Rule 38a-1; and (2) review for compliance with Rule 18f-4, including the adoption and implementation of a derivatives risk management program, board oversight, and whether disclosures concerning the fund’s use of derivatives are incomplete, inaccurate, or potentially misleading.

Under the new Fair Valuation Rule, the Division will, among other things: (1) assess funds’ and fund boards’ compliance with the new requirements for determining fair value, implementing board oversight duties, setting recordkeeping and reporting requirements, and permitting the funds’ board to designate valuation designees to perform fair value determinations; and (2) review whether adjustments have been made to valuation methodologies, compliance policies and procedures, governance practices, service provider oversight, and/or reporting and recordkeeping.
RIAs to Private Funds – Examinations will include a review of issues under the Advisers Act, including an adviser’s fiduciary duty, and will assess risks, focusing on compliance programs, fees and expenses, custody, the new Marketing Rule, conflicts of interest, and the use of alternative data. The Division will also review private fund advisers’ portfolio strategies, risk management, and investment recommendations and allocations, focusing on conflicts and disclosures around these areas. In addition, the Division will focus on RIAs to private funds with specific risk characteristics, including highly leveraged private funds and private funds managed side-by-side with BDCs.
Retail Investors and Working Families – Examinations will focus on how registrants are satisfying their obligations under Regulation Best Interest and the Advisers Act fiduciary standard to act in the best interests of retail investors and not to place their own interests ahead of the interests of retail investors.
Registered Investment Companies ̶ The Division will review compliance programs and governance practices, disclosures to investors, and accuracy of reporting to the SEC of the registered investment companies, including ETFs and mutual funds. The Division will also focus on funds with specific characteristics, such as: (1) turnkey funds, to review their operations and assess effectiveness of their compliance programs; (2) mutual funds that converted to ETFs, to assess governance and disclosures associated with the conversion to an ETF; (3) non-transparent ETFs, to assess compliance with the conditions and other material terms of their exemptive relief; (4) loan-focused funds, such as leveraged loan funds and funds focused on collateralized loan obligations, for liquidity concerns and to review whether the funds have been significantly impacted by, and have adapted to, elevated interest rates; and (5) medium and small fund complexes that have experienced excessive staff attrition, to focus on whether such attrition has affected the funds’ controls and operations. The Division will also monitor the proliferation of volatility-linked and single-stock ETFs, and may review such funds’ disclosures, marketing, conflicts, and compliance with portfolio management disclosures, among other things. In addition, the Division will focus on adviser compensation, practices and processes for assessing and approving advisory and other fund fees, the effectiveness of derivatives risk management and liquidity risk management programs.
Environmental, Social, and Governance (“ESG”) – The Division will focus on ESG-related advisory services and fund offerings, including whether funds are operating in the manner set forth in their disclosures, whether ESG products are appropriately labeled, and whether recommendations of such products for retail investors are made in the investors’ best interests.
Information Security and Operational Resiliency – The Division will review broker-dealers’, RIAs’, and other registrants’ practices to prevent interruptions to mission-critical services and to protect investor information, records, and assets. Reviews of broker-dealers and RIAs will include a focus on the cybersecurity issues associated with the use of third-party vendors, including registrant visibility into the security and integrity of third-party products and services and whether there has been an unauthorized use of third-party providers.
Emerging Technologies and Crypto-Assets – The Division will conduct examinations of broker-dealers and RIAs that are using emerging financial technologies or employing new practices, including technological and on-line solutions to meet the demands of compliance and marketing and to service investor accounts. Examinations of registrants will focus on the offer, sale or recommendation of, or advice regarding trading in, crypto or crypto-related assets and include whether the firm (1) met and followed its standard of care when making recommendations, referrals, or providing investment advice; and (2) routinely reviewed, updated, and enhanced its compliance, disclosure, and risk management practices.

As in recent past years, the Division noted that it prioritizes RIAs and investment companies that have never been examined, including recently registered firms or investment companies, and those that have not been examined for a number of years.

“Our priorities reflect the changing landscape and associated risks in the securities market and are the product of a risk-based approach to examination selection that balances our resources across a diverse registrant base. We will emphasize compliance with new SEC rules applicable to investment advisers and investment companies as well as continue our focus on emerging issues and rules aimed at protecting retail investors,” said Division of Examinations’ Director Richard R. Best. “Our examination program continues moving forward and remains committed to furthering investor protection through high-quality examinations and staying abreast of the latest industry trends and emerging risks to investors and the markets.”

SEC Reopens Comment Period for Proposed Cybersecurity Risk Management Rules and Amendments for Registered Investment Advisers and Funds

The SEC reopened the comment period on proposed rules and amendments related to cybersecurity risk management and cybersecurity-related disclosure for registered investment advisers, registered investment companies, and BDCs that were proposed by the SEC on February 9, 2022. The initial comment period ended on April 11, 2022. Per the SEC’s March 15, 2023, announcement, the reopened comment period will allow interested persons additional time to analyze the issues and prepare comments in light of other regulatory developments, including whether there would be any effects of other SEC proposals related to cybersecurity risk management and disclosure that the SEC should consider. The comment period will remain open until 60 days after the date of publication of the reopening release in the Federal Register.

SEC Finalizes Rules to Reduce Broker-Dealer Settlement Cycle from (T+2) to (T+1)

The SEC adopted rule changes to shorten the standard settlement cycle for most broker-dealer transactions in securities from two business days after the trade date (“T+2”) to one (“T+1”). The SEC indicates that the final rules, adopted on February 15, 2023, are designed to reduce the credit, market, and liquidity risks in securities transactions faced by market participants. The final rules will: (i) require a broker-dealer to either enter into written agreements or establish, maintain, and enforce written policies and procedures reasonably designed to ensure the completion of allocations, confirmations, and affirmations as soon as technologically practicable and no later than the end of the trade date; (ii) require registered investment advisers to make and keep records of the allocations, confirmations, and affirmations for certain securities transactions; (iii) add a new requirement to facilitate straight-through processing, which applies to certain types of clearing agencies that provide central matching services; and (iv) require central matching service providers to establish, implement, maintain, and enforce new policies and procedures reasonably designed to facilitate straight-through processing and require them to submit an annual report to the SEC that describes and quantifies progress with respect to straight-through processing. The final rules will become effective 60 days after publication in the Federal Register. The compliance date for the final rules is May 28, 2024.

SEC Proposes Enhanced Custody Rule for Registered Investment Advisers

The SEC proposed rule changes to enhance protections of customer assets managed by registered investment advisers. If adopted, the changes would amend and redesignate rule 206(4)-2, the SEC’s current custody rule (the “custody rule”), as new rule 223-1 under the Advisers Act (the “proposed rule”) and amend certain related recordkeeping and reporting obligations. According to the SEC’s announcement on February 15, 2023, the SEC exercised its authority under the Dodd-Frank Act in broadening the application of the custody rule. The proposed rule would change the current rule’s scope in two important ways. First, it would expand the types of investments covered by the rule. The proposed rule would extend the rule’s coverage beyond client “funds and securities” to client “assets” so as to include additional investments held in a client’s account, e.g. digital assets, including crypto assets. Second, an adviser would be deemed to have “custody” of client assets whenever the adviser has discretionary authority to trade client assets.

The proposed rule would also require qualified custodians to provide certain standard custodial protections when maintaining an advisory client’s assets and additional protections for certain securities and physical assets that cannot be maintained by a qualified custodian. The proposed rule would also provide exceptions to the surprise examination requirement in instances in which the adviser’s sole reason for having custody is because it has discretionary authority or because the adviser is acting according to a standing letter of authorization. In addition, the proposed rule would expand the scope of who can satisfy the custody rule’s surprise examination requirement through financial statement audits. Finally, the proposed rule would update related recordkeeping requirements for advisers and amend Form ADV to align reporting obligations with the proposed rule and to improve the accuracy of custody-related data available to the SEC, its staff, and the public. The comment period on the proposal will remain open for 60 days following publication of the proposing release in the Federal Register.

“I support this proposal because, in using important authorities Congress granted us after the financial crisis, it would help ensure that advisers don’t inappropriately use, lose, or abuse investors’ assets,” said SEC Chair Gary Gensler. “In particular, Congress gave us authority to expand the advisers’ custody rule to apply to all assets, not just funds or securities. Further, investors would benefit from the proposal’s changes to enhance the protections that qualified custodians provide. Thus, through this expanded custody rule, investors working with advisers would receive the time-tested protections that they deserve for all of their assets, including crypto assets, consistent with what Congress envisioned.”

Republican Leaders Request Information from Gensler on Climate Disclosure Proposal

On February 22, 2023, the chairman of the House Financial Services Committee, Patrick McHenry (R-NC); the ranking member of the Senate Committee on Banking, Housing, and Urban Affairs, Tim Scott (R-SC); and the chairman of the Subcommittee on Oversight and Investigations, Bill Huizenga (R-MI), sent a letter to the SEC Chair Gary Gensler demanding records and other information related to the proposed climate disclosure rule, including responses to previous requests by numerous members of both the House and the Senate that Chair Gensler had failed to provide. The Republican leaders argued that the proposed rule exceeds the SEC’s mission, expertise, and authority and—if finalized in any form—will unnecessarily harm consumers, workers, and the U.S. economy. In addition, the Republican members of the House Appropriations subcommittee pushed to cut the agency’s budget and requested that the SEC expand its enforcement efforts, reduce the pace of its rulemaking, and refrain from regulation. According to the opening statement of Steve Womack (R-Ark.), chair of the Financial Services and General Government subcommittee, who opened the March 29, 2023, hearing, the SEC budget is too big, the agency costs too much to run, and it focuses too much on the implementation and enforcement of new regulations rather than on trying to encourage the flow of investment capital into markets.

“The blistering pace of the SEC rulemaking is a cause for concern,” Womack wrote, “especially when the SEC is wading into areas that are not within their expertise and constitutionally questionable, such as requiring public companies to report on greenhouse gas emissions while claiming private enterprises won’t be impacted.”

SEC Fee Rate Advisories

The SEC announced that, starting on February 27, 2023, the fee rates applicable to most securities transactions would be set at $8.00 per million dollars. Per the January 23, 2023, announcement, the then-current rate of $22.90 per million dollars would remain in effect on charge dates through February 26, 2023. The assessment on security futures transactions remained unchanged at $0.0042 for each round-turn transaction. Subsequently, on March 1, 2023, the SEC announced that a mid-year adjustment to the fee rate for fiscal year 2023 was not required. As a result, the fiscal 2023 fee rate will remain at $8.00 per million dollars until September 30, 2023, or 60 days after the enactment of a regular FY 2024 appropriation, whichever occurs later. Similarly, the SEC confirmed that the Section 31 assessment on round-turn transactions in security futures also would remain at $0.0042 per transaction.

SEC Proposes Changes to Reg S-P to Enhance Protection of Customer Information

The SEC proposed amendments to Regulation S-P (“Reg S-P”) that would, among other things, require broker-dealers, investment companies, registered investment advisers, and transfer agents (collectively, “covered institutions”) to provide notice to individuals affected by certain types of data breaches that may put them at risk of identity theft or other harm. Reg S-P currently requires broker-dealers, investment companies, and registered investment advisers to adopt written policies and procedures for the protection of customer records and information (the “safeguards rule”). Reg S-P also requires the proper disposal of consumer report information (the “disposal rule”). If adopted, the SEC’s proposal, which was announced on March 15, 2023, would (i) update current requirements to address the expanded use of technology and corresponding risks since the SEC originally adopted Reg S-P in 2000; (ii) require covered institutions to adopt written policies and procedures for an incident response program to address unauthorized access to or use of customer information; (iii) require, with certain limited exceptions, covered institutions to provide notice to individuals whose sensitive customer information was or is reasonably likely to have been accessed or used without authorization; (iv) require a covered institution to provide such notice as soon as practicable, but not later than 30 days after the covered institution becomes aware that an incident involving unauthorized access to or use of customer information has occurred or is reasonably likely to have occurred; and (v) make a number of additional changes to Reg S-P, including:

(a) broadening and aligning the scope of the safeguards rule and disposal rule to cover “customer information,” a new defined term which would extend the protections of the safeguards and disposal rules to both nonpublic personal information that a covered institution collects about its own customers and nonpublic personal information that a covered institution receives about customers of other financial institutions;

(b) extending the safeguards rule to transfer agents registered with the SEC or another appropriate regulatory agency, and expanding the existing scope of the disposal rule to include transfer agents registered with another appropriate regulatory agency rather than only those registered with the SEC; and

(c) conforming Reg S-P’s existing provisions regarding the delivery of an annual privacy notice with a statutory exception created by the U.S. Congress in 2015.

The public comment period for the proposed amendments will remain open until 60 days after the date of publication of the proposing release in the Federal Register.

SEC Proposes New Requirements to Address Cybersecurity Risks to the U.S. Securities Markets

The SEC proposed requirements (the “proposal”) for broker-dealers, clearing agencies, major security-based swap participants, the Municipal Securities Rulemaking Board, national securities associations, national securities exchanges, security-based swap data repositories, security-based swap dealers, and transfer agents (collectively, “Market Entities”) to address their cybersecurity risks. In its March 15, 2023, announcement of the proposal, the SEC noted that Market Entities increasingly rely on information systems to perform their functions and provide their services and that the interconnectedness of Market Entities increases the risk that a significant cybersecurity incident can simultaneously impact multiple Market Entities causing systemic harm to the U.S. securities markets.

Proposed new Rule 10 under the Exchange Act would require all Market Entities to (i) establish, maintain, and enforce written policies and procedures that are reasonably designed to address their cybersecurity risks, (ii) review and assess, at least annually, the design and effectiveness of their cybersecurity policies and procedures, including whether they reflect changes in cybersecurity risk over the time period covered by the review, and (iii) provide the SEC with immediate written electronic notice of a significant cybersecurity incident upon having a reasonable basis to conclude that the significant cybersecurity incident has occurred or is occurring. The proposal includes additional requirements for Market Entities other than certain types of small broker-dealers (collectively, “Covered Entities”), including the requirement that Covered Entities utilize a proposed new Form SCIR to (a) report and update information about any significant cybersecurity incident and (b) publicly disclose summary descriptions of their cybersecurity risks and the significant cybersecurity incidents they experienced during the current or previous calendar year. The public comment period for the proposal will remain open until 60 days after the date of publication of the proposing release in the Federal Register.

SEC Proposes to Expand and Update Regulation SCI

The SEC proposed amendments to expand and update Regulation Systems Compliance and Integrity (“Regulation SCI”). Regulation SCI requires certain U.S. securities markets entities (“SCI entities”) to take corrective action with respect to systems disruptions, systems compliance issues, and systems intrusions and to notify the SEC of such events. In the SEC’s March 15, 2023, announcement of the proposed amendments, the SEC explained that trading and technology have evolved since Regulation SCI’s adoption in 2014 and that the growth in electronic trading allows ever-increasing volumes of securities transactions in a broader range of asset classes at increasing speed by competing trading platforms, including those offered by broker-dealers that play multiple roles in the markets. The proposed amendments would expand the scope of SCI entities covered by Regulation SCI to include registered security-based swap data repositories, all clearing agencies that are exempt from registration, and certain large broker-dealers (in particular, those that exceed a total assets threshold or a transaction activity threshold in national market system stocks, exchange-listed options contracts, U.S. Treasury Securities, or Agency Securities).

The proposed amendments would require that an SCI entity’s policies and procedures include the maintenance of a written inventory and classification of all SCI systems and a program for life cycle management; a program to prevent unauthorized access to such systems and information therein; and a program to manage and oversee certain third-party providers, including cloud service providers, of covered systems. The proposed amendments would also expand the types of SCI events experienced by an SCI entity that would trigger immediate notification to the SEC, update the rule’s annual SCI review and business continuity and disaster recovery testing requirements, and update certain of the Regulation’s recordkeeping provisions. The public comment period for the proposed amendments will remain open until 60 days after the date of publication of the proposing release in the Federal Register.

The SEC Issues Frequently Asked Questions for Registration of Municipal Advisors

On March 20, 2023, the SEC updated its Registration of Municipal Advisors Frequently Asked Questions (“FAQs”) page which provides general interpretive staff guidance on various aspects of the SEC’s municipal advisor registration rules. The updated page provides answers to questions across several categories, including the following topics: (i) independent registered municipal advisor exemption; (ii) registered investment adviser exclusion; (iii) issuance of municipal securities/post-issuance advice; (iv) completion of Form MA, Form MA-I, and Form MA-NR; (v) withdrawal from municipal advisor registration; and (vi) investment strategies and proceeds of municipal securities.

SEC Issues Statement Regarding Risk Legend Used by Non-Transparent ETFs

Under the terms of the SEC’s exemptive relief granted to actively managed ETFs that do not provide daily portfolio transparency (“non-transparent ETFs”), each non-transparent ETF is required to include in its prospectus, fund website, and any marketing materials a risk legend highlighting the differences between the non-transparent ETF and fully transparent actively managed ETFs, as well as certain costs and risks unique to non-transparent ETFs. Recognizing that the standardized risk legend required by the exemptive orders may be difficult to place in certain digital advertisements (e.g., banner advertisements) due to space limitations, the SEC issued new disclosure language on March 29, 2023, which may be used in digital advertisements by non-transparent ETFs in place of the standardized risk legend currently provided in the exemptive orders. Requirements relating to placement of the risk legend or new disclosure language in a prominent location remain as prescribed in the exemptive orders.

SEC ENFORCEMENT ACTIONS

SEC Charges Former Investment Adviser Managing Director and Co-Portfolio Manager with Undisclosed Conflict of Interest

The SEC charged a former managing director (the “defendant”) of a New York-based investment adviser (the “Adviser”), with failing to disclose a conflict of interest arising from his relationship with a film distribution company in which the fund he managed for the Adviser invested millions of dollars. The SEC’s order, issued on January 5, 2023, found that, from 2015 to 2019, a closed-end publicly traded fund (the “fund”), invested in Aviron Group, LLC subsidiaries by loaning the subsidiaries, which were in the business of funding advertising budgets of motion pictures, as much as $75 million. The defendant, a co-portfolio manager of the fund, had a significant role in recommending and overseeing the fund’s loans to the Aviron subsidiaries. At the same time, the defendant asked Aviron to help advance his daughter’s acting career. Aviron helped defendant’s daughter obtain a small role in a film produced in 2018. The defendant did not disclose to the fund’s board of trustees or the Adviser’s compliance and legal teams that he asked Aviron to help advance his daughter’s acting career or that Aviron helped his daughter obtain a film role. The defendant consented to the entry of the SEC’s order finding that he violated Section 206(2) of the Advisers Act. Without admitting or denying the SEC’s findings, the defendant agreed to a cease-and-desist order, a censure, and a $250,000 penalty.

SEC Charges Former SPAC CFO for Orchestrating Fraud Scheme

The SEC announced fraud charges against Cooper J. Morgenthau, the former CFO of African Gold Acquisition Corp. (“African Gold”), a special purpose acquisition company (“SPAC”), alleging that he stole more than $5 million from African Gold and from investors in two other SPACs that he incorporated. The SEC’s January 3, 2023, complaint alleged that from June 2021 through July 2022, Morgenthau embezzled money from African Gold and stole funds from another SPAC series to pay for his personal expenses and to trade in crypto assets and other securities; concealed unauthorized withdrawals by falsifying African Gold’s bank account statements; and raised money from the other SPAC’s investors based on misrepresentations. The SEC’s complaint alleged that Morgenthau violated antifraud provisions of the federal securities laws, lied to African Gold’s auditor and accountants in violation of the Exchange Act, knowingly falsified African Gold’s books and records, and filed false certifications with the SEC. Morgenthau consented to a judgment enjoining him from further federal securities laws violations and barring him from serving as an officer or director of a publicly traded company, with monetary remedies to be determined at a later date. In a parallel action, the U.S. Attorney’s Office for the Southern District of New York, on the same day the SEC issued its complaint, announced criminal charges against Morgenthau.

In a related matter, on February 22, 2023, the SEC announced that it settled charges against African Gold for internal controls, reporting, and recordkeeping violations. Per the SEC, it was due to these failures that Morgenthau was able to embezzle money from the company’s operating bank account as discussed in the above complaint. The SEC noted that African Gold made materially false filings with the SEC and maintained inaccurate books and records. According to the SEC’s order, African Gold’s only liquid asset was the money held in its operating bank account, and thus potential fraud by management posed one of the company’s most significant risks of material misstatements in its financial statements. The SEC’s order alleged that, despite this risk, African Gold gave Morgenthau control over nearly all aspects of its operating bank account and financial reporting process with little to no oversight. The SEC’s order found that African Gold violated Exchange Act provisions relating to internal controls, reporting, and recordkeeping. Without admitting or denying the SEC’s findings, African Gold agreed to a cease-and-desist order and to pay a $103,591 civil monetary penalty.

SEC Settles Charges Against Investment Adviser for Alleged Conflicts of Interest Arising Out of Revenue Sharing and Incentive Arrangements

The SEC issued an order instituting and settling administrative and cease-and-desist proceedings against Moors & Cabot, Inc. (“Moors & Cabot”), a registered investment adviser and broker-dealer. Per the January 19, 2023, order, between at least February 2017 and September 2021, Moors & Cabot failed to fully and fairly disclose material facts and conflicts of interest associated with certain revenue-sharing payments and financial incentives that Moors & Cabot received from two unaffiliated clearing brokers. According to the order, Moors & Cabot also failed to implement written compliance policies and procedures reasonably designed to prevent violations of the Advisers Act in connection with the disclosure of revenue sharing, fee markups, financial incentives, and associated conflicts of interest, as well as disciplinary histories. Moors & Cabot is charged with willfully violating Sections 206(2) and 206(4) of the Advisers Act and Rule 206(4)-7 thereunder.

Company to Pay $5 Million for Misleading Disclosures About Its Valuation Methodologies for Fixed Income Securities

The SEC announced settled charges against a privately held financial, software, data and media company headquartered in New York (the “Company”) for misleading disclosures relating to its paid subscription service, which provides daily price valuations for fixed income securities to financial services entities. The SEC’s January 23, 2023, order found that from at least 2016 through October 2022, the Company failed to disclose to its subscription service customers that the valuations for certain fixed income securities could be based on a single data input, such as a broker quote, which did not adhere to methodologies it had previously disclosed. The order found that the Company was aware that its customers, including mutual funds, may utilize subscription service prices to determine fund asset valuations, including for valuing fund investments in government, supranational, agency, and corporate bonds, municipal bonds, and securitized products, and that subscription service prices, therefore, can have an impact on the price at which securities are offered or traded. The SEC’s order found that the Company violated section 17(a)(2) of the Securities Act. Without admitting or denying the findings, the Company agreed to cease and desist from future violations and to pay a $5 million penalty. The SEC’s order noted that the Company voluntarily engaged in remedial efforts to improve its subscription service line of business.

Twenty-five States File Lawsuit to Block DOL’s ESG Rule

Twenty-five states are suing the Biden Administration in an attempt to block the Department of Labor (“DOL”) rule that allows fiduciaries to consider ESG factors when choosing retirement investments (“DOL ESG Rule”). According to the lawsuit filed in Texas federal court on January 26, 2023, the attorneys general claim that the DOL ESG Rule violates Employment Retirement Income Security Act (“ERISA”), which requires that retirement plans invest solely for financial gain, and runs afoul of the Administrative Procedure Act (“APA”) as arbitrary and capricious because the DOL failed to assess either the harm it poses for plan participants and beneficiaries or the advantage of superseding the 2020 DOL rule effectively banning ESG considerations in plan investment selections. Among the twenty-five states are Alabama, Alaska, Arkansas, Florida, Georgia, Indiana, Idaho, and Iowa. In addition to the states, listed plaintiffs include two energy companies, an energy industry trade group, and an individual participant in an unnamed workplace plan.

The claimants argue that the DOL is deviating from prior policy because its 2020 DOL rule still required that financial factors take precedence. It is argued in the complaint that the DOL justified the 2022 rule by noting that it would cure a “chill” or “confusion” allegedly caused by the 2020 rule. Per the claimants, the DOL never identified who was confused, what the source of confusion was, or whether the alleged confusion caused a reduction in the financial returns for plan participants. Claimants further allege that the DOL did not consider alternatives and failed to consider that the solution to the purported concerns caused by the 2020 rules would be to issue clarifying sub-regulatory guidance. The claimants request the court to postpone the DOL ESG Rule’s effective date and to impose a preliminary injunction and declare the DOL ESG Rule in violation of the APA and ERISA.

SEC Charges Options Clearing Corporation with Rule Failures

The SEC announced that The Options Clearing Corporation (“OCC”) will undertake remedial efforts and pay $17 million in penalties to settle charges that it failed to comply with its own SEC-approved stress testing and clearing fund methodology rule during certain times between October 2019 and May 2021. According to the SEC’s February 16, 2023, order, Chicago-based OCC’s failure to implement and comply with its own rule was the result of its failure to properly establish, implement, and enforce written policies and procedures reasonably designed to manage certain operational risks. The SEC’s order further found that OCC failed to modify its comprehensive stress testing system and did not provide timely notification to the SEC of this failure as required by Regulation SCI. The SEC also found that OCC failed to comply with its margin methodology, margin policy, and stress testing and clearing fund methodology relating to specific wrong way risk and holiday margin.

According to the SEC, in addition to the $17 million penalty, OCC has undertaken several remedial measures, including revising its model validation policies and procedures; enhancing its approach to risk data governance; implementing changes to elements of its control environment, including processes, procedures, and controls; and conducting appropriate training on the changes. This is the SEC’s second enforcement action against OCC. In a September 2019 settled action, the SEC charged OCC with failure to establish and enforce policies and procedures involving financial risk management, operational requirements, and information-systems security, and imposed remedial measures and a $15 million penalty.

Republican Attorney-Generals Ask Court to Set Aside SEC Proxy Voting Disclosure Rules

Texas Attorney General Ken Paxton and three other Republican attorneys general filed a petition on February 21, 2023, against the SEC in the federal appeals court opposing the new proxy voting disclosure rules. Among other changes, the new rules amend Form N-PX by expanding the number of voting categories to include information about votes in certain standardized categories, including various ESG-related topics such as environment or climate, and diversity, equity and inclusion. Though the petition does not detail the states’ legal arguments against the proxy voting disclosure rules, Attorney General Paxton claimed in a statement that the rules are politically motivated. According to the office of Utah’s attorney general, the rules “will put shareholders at increased risk of loss, encouraging political activism and raising administrative costs.” The SEC’s two Republican commissioners, Hester Peirce and Mark Uyeda, both voted against adopting the rules, which the SEC’s three Democrats supported.

SEC Charges a Church and Its Investment Management Company for Disclosure Failures and Misstated Filings

The SEC announced charges against an exempt investment adviser (the “Adviser”), a non-profit entity operated by a religious organization (the “Church”) to manage the Church’s investments, for failing to file forms that would have disclosed the Church’s equity investments, and for instead filing forms for shell companies that obscured the Church’s portfolio and misstated the Adviser’s control over the Church’s investment decisions. The SEC also announced charges against the Church for causing these violations. To settle the charges, the Adviser agreed to pay a $4 million penalty and the Church agreed to pay a $1 million penalty. The SEC’s order, issued on February 21, 2023, found that from 1997 through 2019, the Adviser failed to file Forms 13F. According to the SEC’s order, the Church was concerned that disclosure of its portfolio, which by 2018 had grown to approximately $32 billion, would lead to negative consequences and in order to obscure the amount of the Church’s portfolio, and with the Church’s knowledge and approval, the Adviser filed Forms 13F in the names of shell LLCs which it had created rather than in the Adviser’s name.

The order found that the Adviser maintained investment discretion over all relevant securities, that it controlled the shell LLCs, and that it directed nominee “business managers,” most of whom were employed by the Church, to sign the SEC filings. The SEC found that the shell LLCs’ Forms 13F misstated, among other things, that the LLCs had sole investment and voting discretion over the securities, when in reality the Adviser retained control over all investment and voting decisions. The Adviser agreed to settle the SEC’s allegation that it violated Section 13(f) of the Exchange Act and Rule 13f-1 thereunder by failing to file Forms 13F and by misstating information in these forms. The Church also agreed to settle the SEC’s allegation that it caused the Adviser’s violations through its knowledge and approval of the Adviser’s use of the shell LLCs.

SEC Charges Private Fund Auditor and Audit Engagement Partner with Improper Professional Conduct

The SEC announced settled charges against Spicer Jeffries LLP, an audit firm based in Denver, and an audit engagement partner Sean P. Tafaro, for their improper professional conduct in connection with audits of two private funds. According to the SEC’s March 29, 2023, order, during the audit planning stages, Spicer Jeffries and Tafaro assessed that valuation of investments was a significant fraud risk but did not implement the planned audit approach to respond to the risk. The order further finds that Spicer Jeffries and Tafaro failed to obtain sufficient audit evidence about the method of measuring fair value, the valuation models, and whether alternative valuation assumptions were considered. According to the order, due to these failures and others, Spicer Jeffries and Tafaro did not exercise due care, including professional skepticism. The order also found that Spicer Jeffries’ deficient system of quality control led to failures to adhere to professional auditing standards. Without admitting or denying the findings, Spicer Jeffries and Tafaro consented to the SEC’s order finding that they engaged in improper professional conduct. Spicer Jeffries agreed to be censured and to implement undertakings to retain an independent consultant to review and evaluate certain of its audit, review, and quality control policies and procedures. Tafaro agreed to be suspended from appearing and practicing before the SEC as an accountant. The SEC’s order permits Tafaro to apply for reinstatement after one year.

Cyber Fraud and Crypto Asset Enforcement Actions

The SEC brought charges against various individuals and entities relating to cyber fraud and crypto assets, including blockchain and lending programs. For example, these include:

The SEC charged five individuals and three entities for their involvement in a fraudulent investment scheme named CoinDeal that raised more than $45 million from sales of unregistered securities to tens of thousands of investors worldwide. According to the SEC’s complaint filed on January 4, 2023, the five individuals allegedly disseminated false and misleading statements to investors about extravagant returns from investing in a blockchain technology called CoinDeal; the purported value of CoinDeal; the parties involved in the supposed sale of CoinDeal; and the use of investment proceeds. The complaint further alleged that no sale of CoinDeal ever occurred and no distributions were made to CoinDeal investors, and that the defendants collectively misappropriated millions of dollars of investor funds for personal use. In June 2022, the U.S. Department of Justice indicted one of the individuals on three counts of wire fraud and two counts of monetary transaction in unlawful proceeds for his involvement in CoinDeal. The SEC’s complaint charged each party with different violations of the antifraud and registration provisions of the Securities Act and Exchange Act; and aiding and abetting under the antifraud provisions of the Exchange Act; and under the antifraud and registration provisions of the Securities Act and Exchange Act.
The SEC charged a crypto asset-related financial products and services corporation (the “Corporation”), with failing to register the offer and sale of its retail crypto asset lending product. To settle the SEC’s charges, the Corporation agreed to pay a $22.5 million penalty and cease its unregistered offer and sale of its product to U.S. investors. In parallel actions announced the same day, the Corporation agreed to pay an additional $22.5 million in fines to settle similar charges by state regulatory authorities. The SEC’s January 19, 2023, order found that the Corporation marketed its product as a means for investors to earn interest on their crypto assets, and that the Corporation exercised its discretion to use investors’ crypto assets in various ways to generate income for its own business and to fund interest payments to investors. The order also found that the Corporation’s product is a security and that the offer and sale of the Corporation’s product did not qualify for an exemption from SEC registration. Without admitting or denying the SEC’s findings, the Corporation agreed to a cease-and-desist order prohibiting it from violating the registration provisions of the Securities Act.
The SEC charged Avraham Eisenberg with orchestrating an attack on a crypto asset trading platform, Mango Markets, by manipulating the MNGO token, a so-called governance token that was offered and sold as a security. Eisenberg is facing parallel criminal and civil charges in the Southern District of New York brought by the U.S. Department of Justice and the Commodities Futures Trading Commission (“CFTC”). The SEC’s complaint alleged that beginning on October 11, 2022, Eisenberg engaged in a scheme to steal approximately $116 million worth of crypto assets from the Mango Markets platform. The SEC’s complaint, filed in federal district court in Manhattan, charged Eisenberg with violating antifraud and market manipulation provisions of the securities laws and sought permanent injunctive relief, a conduct-based injunction, disgorgement with prejudgment interest, and civil penalties.
The SEC charged Singapore-based Terraform Labs PTE Ltd and Do Hyeong Kwon with orchestrating a multibillion-dollar crypto asset securities fraud involving an algorithmic stablecoin and other crypto asset securities. According to the SEC’s complaint filed on February 16, 2023, from April 2018 until the scheme’s collapse in May 2022, Terraform and Kwon raised billions of dollars from investors by offering and selling an inter-connected suite of crypto asset securities, many in unregistered transactions. The complaint charged the defendants with violating the registration and antifraud provisions of the Securities Act and the Exchange Act.
The SEC announced charges against former NBA player Paul Pierce for touting EMAX tokens, crypto asset securities offered and sold by EthereumMax, on social media without disclosing the payment he received for the promotion and for making false and misleading promotional statements about the same crypto asset. The SEC’s February 17, 2023, order found that Pierce violated the anti-touting and antifraud provisions of the federal securities laws. Without admitting or denying the SEC’s findings, Pierce agreed to settle the charges and pay over $1.4 million in penalties, disgorgement, and interest. Pierce also agreed not to promote any crypto asset securities for three years.
The SEC charged the former co-lead engineer (the “defendant”) of an Antigua- and Barbuda-based company that operated a global crypto asset trading platform (the “Company”), for his role in a multiyear scheme to defraud equity investors. According to the SEC’s complaint, issued on February 28, 2023, the defendant created software code that allowed Company customer funds to be diverted to a quantitative trading firm specializing in crypto assets (a “crypto hedge fund”) owned by co-founders and officers of the Company, despite false assurances to investors that the Company was a safe crypto asset trading platform with sophisticated risk mitigation measures to protect customer assets and that the crypto hedge fund was just another customer with no special privileges. The complaint alleged that the defendant knew or should have known that such statements were false and misleading, and that the defendant actively participated in the scheme to deceive the Company’s investors
The SEC’s complaint charged the defendant with violating the antifraud provisions of the Securities Act and the Exchange Act. The defendant consented to a bifurcated settlement, subject to court approval, which would permanently enjoin him from violating the federal securities laws, a conduct-based injunction, and an officer and director bar. In a parallel action, the U.S. Attorney’s Office for the Southern District of New York and the Commodity Futures Trading Commission (“CFTC”) announced charges against the defendant on the same day the SEC’s complaint was filed.
The SEC charged the crypto asset trading platform beaxy.com (the “Beaxy Platform”) and its executives for failing to register as a national securities exchange, broker, and clearing agency. The SEC also charged the founder of the platform, Artak Hamazaspyan, and a company he controlled, Beaxy Digital, Ltd., with raising $8 million in an unregistered offering of the Beaxy token (“BXY”) and alleged that Hamazaspyan misappropriated at least $900,000 for personal use, including gambling. Finally, the SEC charged market makers operating on the Beaxy Platform as unregistered dealers. Pursuant to the Consents filed on March 29, 2023, the charged market makers have agreed to perform certain undertakings, including ceasing all activities as an unregistered exchange, clearing agency, broker, and dealer; shutting down the Beaxy Platform; providing an accounting of assets and funds for the benefit of customers; transferring all customer assets and funds to each respective customer; and destroying any and all BXY in possession.

Thomas R. Westle and Stacy H. Louizos would like to thank Margaret M. Murphy and Hiba Hassan for their contributions to this update.

For more Financial and Securities legal news, click here to visit the National Law Review

Australia: ASIC Reveals 2023 Enforcement Priorities

The Australian Securities and Investments Commission (ASIC) has revealed its key enforcement priorities for 2023. This year, ASIC has signalled an expanded focus on enforcement activity targeting:

sustainable finance practices and disclosure of climate risks;
financial scams;
cyber and operational resilience; and
investor harms involving crypto-assets.

In its release, ASIC has emphasised that the regulator’s prioritisation of monitoring in these areas intends to “address misconduct, market integrity threats and consumer harms in sectors including financial services, retail and crypto-assets.”

The warning coincides with this month’s release of ASIC’s enforcement and regulatory report that highlights the major uptick in enforcement and regulatory actions taken by ASIC during the last half of 2022, including:

173 criminal charges being laid and $76.3 million in civil penalties imposed;
heightened action against money laundering risks;
the issuance of 22 design and distribution obligations (DDO) stop orders to prevent consumers and investors being targeted by products inappropriate to their objectives, financial situation and needs; and
the regulator’s first action for greenwashing and consequential issuance of infringement notices for misleading sustainability-related statements.

Another priority of ASIC for the coming year is to increase its transparency to industry and streamline its interactions with the entities it regulates. For the first time, ASIC has released a regulatory developments timetable setting out projected timeframes for ASIC regulatory work, such as the publication of draft or final guidance, and the anticipated making of a legislative instrument. ASIC’s release of these key enforcement priorities and regulatory developments timetable gives us a clear indication of ASIC’s intention to continue its heightened level of surveillance and enforcement action into 2023.

Article By Matthew J. Watts and Rebecca Mangos of K&L Gates

For more securities legal news, click here to visit the National Law Review.

Was This The Least Transparent Report In SEC History?

Professor Alexander I. Platt at the University of Kansas School of Law has just released a draft of a forthcoming paper that takes the Securities and Exchange Commission to task for the lack of transparency in its whistleblower program, Going Dark(er): The SEC Whistleblower Program’s FY 2022 Report Is The Least Transparent In Agency History. As Professor Platt notes in a footnote, I have been complaining about the whistleblower’s lack of transparency since at least 2016. See Five Propositions Concerning The SEC Whistleblower Program. Last summer, I observed that “There is certainly no dearth of irony in a federal agency dedicated to full disclosure cloaking in secrecy a billion dollar awards program”.

Professor Platt offers four possible reasons for the SEC’s lack of transparency: (1) resource constraints; (2) lack of respect for public participation and accountability; (3) data problems; and/or (4) an intent to bury something controversial or embarrassing. My concern is, and has been, that whatever the reason(s), the SEC’s lack of transparency creates an ideal substrate for fraud. Unless the SEC drops its cloak of secrecy and exposes its whistleblower program to public scrutiny, it is highly likely that the next article will be about how the whistleblower program was used and abused.

Article By Keith Paul Bishop of Allen Matkins Leck Gamble Mallory & Natsis LLP

For more SEC and securities legal news, click here to visit the National Law Review.

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The SEC’s Whistleblower Protection Program

SEC Struck Several Blows in 2023 Against Companies that Failed to Carve out Whistleblower Protections in Their Confidentiality Agreements

Key Take-Aways

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Upstream Guaranties

Affiliate Guaranties

Use of Such Guaranties

Enforceability Considerations

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Boards File Comment Letters Asking SEC to Withdraw Swing Pricing Rule Proposal

SEC Proposes Rule to Prohibit Conflicts of Interest in Certain Securitizations

Division of Examinations Publishes Risk Alert on Regulation Best Interest

SEC Releases Staff Guidance on Differential Advisory Fee Waivers

SEC Division of Examinations Announces 2023 Priorities

SEC Reopens Comment Period for Proposed Cybersecurity Risk Management Rules and Amendments for Registered Investment Advisers and Funds

SEC Finalizes Rules to Reduce Broker-Dealer Settlement Cycle from (T+2) to (T+1)

SEC Proposes Enhanced Custody Rule for Registered Investment Advisers

Republican Leaders Request Information from Gensler on Climate Disclosure Proposal

SEC Fee Rate Advisories

SEC Proposes Changes to Reg S-P to Enhance Protection of Customer Information

SEC Proposes New Requirements to Address Cybersecurity Risks to the U.S. Securities Markets

SEC Proposes to Expand and Update Regulation SCI

The SEC Issues Frequently Asked Questions for Registration of Municipal Advisors

SEC Issues Statement Regarding Risk Legend Used by Non-Transparent ETFs

SEC ENFORCEMENT ACTIONS

SEC Charges Former Investment Adviser Managing Director and Co-Portfolio Manager with Undisclosed Conflict of Interest

SEC Charges Former SPAC CFO for Orchestrating Fraud Scheme

SEC Settles Charges Against Investment Adviser for Alleged Conflicts of Interest Arising Out of Revenue Sharing and Incentive Arrangements

Company to Pay $5 Million for Misleading Disclosures About Its Valuation Methodologies for Fixed Income Securities

Twenty-five States File Lawsuit to Block DOL’s ESG Rule

SEC Charges Options Clearing Corporation with Rule Failures

Republican Attorney-Generals Ask Court to Set Aside SEC Proxy Voting Disclosure Rules

SEC Charges Private Fund Auditor and Audit Engagement Partner with Improper Professional Conduct

Cyber Fraud and Crypto Asset Enforcement Actions

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