The Securities and Exchange Commission’s (“SEC’s”) Division of Enforcement released its Annual Report (the “Report”) last month, which discusses enforcement cases for its fiscal year of 2019.[1] According to the Report, the SEC filed 862 enforcement actions in FY 2019, resulting in disgorgements and monetary penalties of roughly $4.35 billion.[2] Both the number of enforcement actions and total disgorgements/penalties saw an increase for the second year in a row, despite a 35-day furlough in December/January.[3] Enforcement actions also resulted in “nearly 600 bars or suspensions against market participants, and suspended trading in the securities of 271 issuers.”[4]
Of particular note is the dramatic increase in the number of standalone actions filed against investment advisers and investment companies, which nearly doubled its total from FY 2018. The 191 actions filed in FY 2019 represented 36% of the total enforcement actions for the year, compared to 108 actions and 22% in FY 2018. This category saw by far the most movement both in terms of number of actions and percentage change year over year.[5] This increase correlates with the SEC’s stated focus on protecting retail investors from fraud and other corrupt practices.[6] That commitment also is evident in the infractions the SEC targeted this year.
Notable Enforcement Actions of 2019
Certain enforcement actions stood out due to their nature and/or the potential impact that such enforcement actions might have on the financial services industry. The following highlights some of the more notable enforcement matters during this past year.
a. Mutual Fund Share Classes
In February 2018, the SEC announced the Share Class Selection Disclosure Initiative (“SCSD Initiative”).[7] This effort was motivated by several years of the SEC filing numerous actions regarding investment advisers failing to disclose the conflict of interest involving Rule 12b-1 mutual fund share classes when less expensive classes were available to clients.[8] During the four-month amnesty program, 95 investment advisers and investment companies self-reported violations that resulted in $135 million in fees being returned to investors.[9]
Among the litany of enforcement actions the SEC filed in FY 2019 as a result of the SCSD Initiative was against Wedbush Securities, Inc.[10] Over a four-and-a-half-year period, Wedbush “purchased, recommended, or held for advisory clients mutual fund share classes that charged 12b-1 fees” while lower cost share classes were available. Wedbush failed to disclose to its clients the conflict of interest with regard to offering 12b-1 fee share classes. Wedbush was ordered to pay over $1.8 million in disgorgement and pre-judgement interest. By self-reporting the violation through the initiative, Wedbush was able to avoid paying a civil penalty.
b. Revenue Share Arrangement
In SEC v. Commonwealth Financial Network, Commonwealth is charged with failing to disclose to its clients a revenue sharing agreement it had with its clearing broker. According to the SEC’s complaint, Commonwealth received over $100 million in revenue sharing between July 2014 and December 2018 through its arrangement that provided kickbacks to the firm based on clients’ mutual fund share class. The Complaint identifies that share classes with higher expense ratios produced higher revenue share percentages for Commonwealth. Allegedly, Commonwealth’s Form ADV and other communications failed to disclose this conflict of interest. Furthermore, the SEC asserts that after amending their disclosures to include notice that certain funds had higher internal costs, Commonwealth remained deficient and failed to disclose actual conflicts (Commonwealth’s amended language referenced instead potential conflicts associated with tangible incentives to push certain share classes when the firm knew this was an actual conflict). The Complaint seeks disgorgement, prejudgment interest, and a civil penalty under Section 209(e). This matter is ongoing.
c. Conflicts of Interest Involving Financial Benefits Received by an Adviser
In the Matter of BMO Harris Financial Advisors, Inc. and BMO Asset Management Corp. (collectively, “BMO Harris”) 9 for failing to disclose conflicts of interest regarding financial benefits received by BMO Harris associated with their proprietary mutual funds. According to the SEC order, BMO Harris and BMO Asset Management invested approximately half of all client assets in their Managed Asset Allocation Program (“MAAP”) into their own proprietary mutual funds, and selecting higher-cost share classes when other lower-cost share classes were available, thus . reducing the clients’ returns. The two companies were ordered to pay $25 million in disgorgement, nearly $5 million in prejudgment interest, and an $8 million civil penalty for the violations
d. Failure to Supervise
Supervision of employees is paramount to any firm’s internal control system. This was clearly apparent in the case of In the Matter of Nomura Securities International, Inc.[11] From approximately January 2010 to November 2013, three traders of residential mortgage-backed securities deliberately misled and even lied to customers about several material facts, including the price at which the securities transacted, the bids or offers received, who owned the security (when in fact Nomura did) and the amount of compensation Nomura would receive for trades. Collectively, these actions resulted in material trading profits for Nomura, which were not disclosed to the consumer. Had Nomura established stronger internal controls (such as by monitoring trade communications for false or misleading statements), this conduct could have been stopped. Nomura was censured and ordered to make payments exceeding $20 Mil in remediation, representing the gross profits (thereby disgorging $16, 329, 600 and paying prejudgment interest of $3,792,300), and pay a civil penalty of $1 Mil.
Another failure to supervise case, SEC v. Diver, illustrates that even employees that are in C-Level positions must be supervised. In this case, the SEC charges a COO of a Registered Investment Adviser in New York with violations of the Advisers Act’s antifraud provisions. According to the SEC’s complaint, from 2011 to December 2018, Richard T. Diver, the COO of a New York-based investment adviser instructed the company’s payroll service, which he oversaw, to issue checks to him that were significantly higher than his intended salary—in the amount of hundreds of thousands of dollars per year. Beginning in 2017, Diver, was designated to oversee client billing for the company and allegedly instructed his assistant to bill clients at off-cycle times, rather than quarterly as in the past. By abusing his position of authority and control, Diver caused the investment adviser to overbill clients by 25-50%, which in turn generated revenues to fund his inflated salary. When confronted by the CEO, Diver confessed to his actions. The SEC’s complaint seeks permanent injunctive relief, disgorgement, prejudgment interest, and civil monetary penalties. Separately, the United States Attorney’s Office for the Southern District of New York announced criminal charges and filed an indictment against Diver for one count of investment advisor fraud and one count of wire fraud. Both matters are currently ongoing.=
Conclusion
These cases highlight the efforts the SEC has taken to continue strict enforcement of regulations. With new rules and regulations expected to occur in FY 2020 (i.e., Form CRS disclosures, amendments to advertising and solicitor rules, etc.), firms must be diligent in their efforts to remain compliant in order to avoid potential penalties. Thoroughly reviewing the firm’s client disclosures and existing internal controls is a great first step in mitigating potential enforcement risks. It is also recommended that firms test those policies to “self-assess” whether their organization is appropriately positioned to monitor and enforce compliance of their policies and procedures.
Author: Jacko Law Group, PC (“JLG”). Editors: Michelle L. Jacko, Esq., Managing Partner, JLG. JLG works extensively with investment advisers, broker-dealers, investment companies, private equity and hedge funds, banks and corporate clients on securities and corporate counsel matters. For more information, please visit https://www.jackolg.com/.
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[1] The SEC’s Fiscal Year ends on September 30th.
[2] U.S. Securities and Exchange Commission, Division of Enforcement, 2019 Annual Report, p. 14, 16, available at https://www.sec.gov/files/enforcement-annual-report-2019.pdf.
[3] Id. at 1, 14
[4] Id. at 9
[5] Id. at 28
[6] Id. at 10
[7] Available at https://www.sec.gov/enforce/educationhelpguidesfaqs/share-class-selection-disclosure-initiative-faqs.
[8] Available at https://www.sec.gov/enforce/announcement/scsd-initiative.
[9] See Annual Report at p. 11 available at https://www.sec.gov/files/enforcement-annual-report-2019.pdf.
[10] See In the Matter of Wedbush Securities, Inc. (IA Rel. No. 5386) Sep. 30, 2019.
[11] In a separate matter regarding commercial mortgage-backed securities, Nomura was ordered to pay over $1.3 million in disgorgement and prejudgment interest as well as a separate civil penalty of $500,000. (https://www.sec.gov/litigation/admin/2019/34-86373.pdf)