Paul Hodgson: The SEC should blow its own whistle

Taking a look at the Securities and Exchange Commission and whistleblowing

The SEC’s enforcement agents have been in the news lately, especially its whistleblower activities. First it announced that Health Net Inc. violated securities laws by requiring outgoing employees to waive their ability to receive money from the SEC’s whistleblower program if they wanted to receive severance benefits. Next, a whistleblower who helped expose false accounting at Deutsche Bank has turned down his share of a $16.5m payout — the third largest in the whistleblower programme’s history. Eric Ben-Artzi, a former Deutsche risk officer, has told the SEC he is declining the award in part in protest against the agency’s failure to punish executives at the bank.
With this in mind, it comes as no surprise that, according to the latest Securities Enforcement 2016 Mid-Year Review by Shearman & Sterling, the first half of 2016 saw the highest awards in five years from the whistleblower programme. The programme has already made multiple large whistleblower awards in 2016, including an award for $17 million, the second-highest amount ever, and “its first-ever award to a whistleblower whose tip furthered an investigation, as opposed to leading to an investigation”.
Mark Lanpher, an attorney with Shearman & Sterling, said that the increase “fundamentally comes down to the political pressure put on the agency, including as a result of the Bernie Madoff case and the financial crisis. The pressure has been by Congress first and foremost but also by the press, which has been filtered through all levels of the Commission, to be ever tougher.”
The SEC brought over 400 enforcement actions in the first half of 2016, looks set to surpass its annual record of 807 enforcement actions that was only just set in 2015. As of June 30, the SEC has collected $252.3 million. With the Department of Justice (DOJ) the total rises to $523.2. This far exceeds the $143.1 million both agencies collected last year.

Even the way the SEC is applying enforcement actions is changing. In May this year the NYU Pollack Center for Law & Business and Cornerstone Research issued a report that found that in the first half of 2016 the SEC brought 88 per cent of actions as administrative proceedings (APs). In comparison, in 2010 the SEC only brought 33 per cent as APs. An AP is a “non-judicial determination of fault or wrongdoing and may include, in some cases, penalties of various forms”.
“The increase in the use of administrative proceedings is a fact of history,” noted Lanpher, “since Congress has expanded the SEC’s authority to use APs gradually over time. Situations where the SEC could use APs started out as fairly limited and they had a limited scope of available remedies, but Dodd-Frank wiped away some of the last limitations on when the SEC could use APs and what remedies it could obtain. The SEC has gradually realized that they are another available tool for enforcement.”The report also notes that the SEC is functioning without a full slate of commissioners, but Lanpher did not feel that this made a significant difference to enforcements. “The fact that the Commission is two commissioners down has less of an impact in enforcement, but does have an impact on policy,” he said.
Another growth area of enforcement actions is those against compliance professionals, despite concerns that the actions would have a chilling effect on the profession. “APs against compliance officers have tended to involve alleged personal failures to follow and implement policy, which one could argue is really the responsibility of the firm,” said Lanpher. “Officers are generally acting in good faith, so it is questionable whether this is actually for the good of investors or whether it is having a chilling effect. The SEC has stated that it will only bring actions where there has been a clear dereliction of duty, but there is still a question as to whether this is an accurate representation of the facts. Regardless, COs are increasingly potential targets at the investigation stage and it may be having a chilling effect, and instilling fear on behalf of COs, even if they are not being prosecuted.”
The report admits that it is still difficult to “ascertain a principled pattern for when the SEC will require a settling defendant to admit wrongdoing”. But the SEC did obtain admissions in some cases in the first half of 2016. “There’s no clear pattern for the admission of guilt following an enforcement action,” said Lanpher. “Where there is little in dispute, for example technical violations regarding blue sheet data, where there is clear liability and factual proof, you can expect an admission of fault. The other cases where there has been an admission are primarily those that involve a significant figure in the industry. But there are also many of the same kinds of cases where there is no admission required by the SEC, so it is very difficult to predict.”
Enforcement Director Andrew Ceresney told the attendees at a January 2016 Directors’ Forum that SEC accounting and financial reporting enforcement actions had more than doubled since 2013. He also highlighted that it had charged over 175 individuals in reporting and disclosure matters in the last two years. To go with this rising focus on accounting fraud, the SEC launched a new Corporate Issuer Risk Assessment tool. Asked where this renewed focus on accounting fraud originated, Lanpher said that it was a return to form, not a change of direction. “Enforcement Director Andrew Ceresney made a speech a few years ago where he pointed to the fact that accounting fraud cases were way down and he wondered why, noting that he questioned whether there was actually a reduction in accounting problems. It’s more likely that the financial crisis shifted the Commission’s focus away from these bread and butter cases and it is now refocusing its attention.”

In addition, the SEC’s Division of Corporation Finance also updated its Compliance and Disclosure Interpretations (C&DIs) on May 17, 2016, tightening the rules on using non-GAAP accounting. Shearman expects that, in the future, the SEC will claim that a failure to comply with these C&DIs justifies enforcement actions. The Commission is also using “data mining and other technologies to detect potential financial misconduct before it becomes public”, and announced the formation of the Financial Reporting and Audit Group (FRAud Group) and introduced its Corporate Issuer Risk Assessment program (CIRA) in 2015. These are likely to lead to more enforcement actions rather than less.
Last year, a three-judge panel in the Eleventh Circuit placed a “statute of limitations” on the SEC for cases filed more than five years after the misconduct.Such a ruling would seem to allow every Wall St banker involved in the conduct that led to the crisis to be let off, but this is not the case. “It would be an oversimplification to say that the five-year statute of limitations decision could absolve anyone not currently under investigation for activities that might have led to the financial crisis. For example, under FIRREA [Financial Institutions Reform, Recovery, and Enforcement Act], the Department of Justice has up to 10 years to prosecute in certain cases involving banks and financial institutions, so it can still bring cases. In addition, the SEC could investigate if it thought misconduct was ongoing or where it believes individuals took actions to evade detection into the limitations period. This ruling will make it more difficult to bring prosecutions but it will not close them down.” So there’s hope yet.

Note: Since this article was written the SEC has announced that awards to whistleblowers have surpassed the $100m mark.