Within several months of Securities and Exchange Commission Chair Mary Jo White’s announcement in late 2013 of a commitment to improving the SEC’s trial readiness,1 the Commission suffered a number of losses in federal district court.2 Perhaps not coincidentally, the SEC recently announced that it will be adding two new Administrative Law Judges (ALJs) to its staff—bringing the Commission’s total complement of ALJs to five3—and the Commission’s Director of Enforcement, Andrew Ceresney, has since stated that the Commission will likely begin bringing more enforcement actions before the SEC’s own ALJs, rather than in district court.4
The difference in forum can be significant. The SEC’s ALJs, who are employed by the Commission, are sometimes thought to give the SEC a “home-court edge” that the Commission typically lacks in federal district court before a neutral judge and a jury who are not experts in securities law.5 Thus, the Commission has traditionally reserved its ALJs—whom the Commission touts as having “a sophisticated understanding of the securities laws and markets”—for “cases involving complicated securities issues and technical violations” of the securities laws.6
Although the Commission has increased the number of its ALJs and indicated that administrative proceedings will be used in a wider variety of upcoming enforcement actions,7 the Commission has not signaled the specific types of cases it is likely to pursue. However, given the securities markets expertise8 of the Commission’s ALJs, it would not be surprising to see the Commission bring more cases likely to implicate hot-button technical issues, including valuation and cybersecurity cases.
The SEC has trained its sights on valuation methodologies and practices used by private funds,9 and perhaps for good reason, as investments in private funds, including hedge funds and private equity funds, present a host of valuation-related issues.
Valuation matters, particularly in hedge funds.10 Too high a valuation overcompensates the manager and transfers wealth from new investors to redeeming investors; too low a valuation, on the other hand, transfers wealth from redeeming investors to new investors. Secondly, some hedge funds may employ the use of side pockets, which allow fund managers to exclude certain investments from the calculation of the fund’s net asset value (NAV). The inclusion of unprofitable investments in a side pocket without recognizing the embedded losses would not only present investor liquidity concerns, but also artificially inflate the fund’s NAV.
Given the technical nature of valuation-related issues, administrative proceedings involving valuation may occur with increasing frequency.11
The Commission has also recently shown an interest in cybersecurity, issuing an alert announcing that the SEC’s Office of Compliance Inspections and Examinations would be conducting cybersecurity exams of fifty broker-dealers and investment advisers.12 SEC cybersecurity-related enforcement actions are typically based on Regulation S-P (i.e., the “Safeguards Rule”), which, in general terms, requires broker-dealers, investment advisers, and investment companies to take steps to ensure the safety and confidentiality of customer information by having policies and procedures “that address administrative, technical, and physical safeguards for the protection of customer records and information.”13 Thus, because they are often based on the somewhat technical issue of whether a firm’s policies and procedures were adequate, cybersecurity enforcement actions are likely to be brought as administrative enforcement actions. Indeed, although the SEC has not brought any enforcement actions arising out of its recent cybersecurity sweep, it has brought several cybersecurity-related enforcement actions in recent years, each of which has been handled administratively.14
The Commission’s decision to bring an enforcement action as an administrative proceeding rather than as a civil action in federal district court is not guided by hard-and-fast rules. As the Commission’s Director of Enforcement, Andrew Ceresney, has noted, the Division “evaluate[s] the appropriate forum in each case and make[s] the decision based on the particular facts and circumstances.”15 While the constitutionality of the SEC’s administrative proceedings has given some commentators pause,16 the Commission’s decision to add two more ALJs suggests that it intends to increasingly use administrative proceedings, or the threat of administrative proceedings, to resolve issues that, in the Commission’s view, are too “technical” for federal district court.
1 See Mary Jo White, Chair, SEC, The Importance of Trials to the Law and Public Accountability, 5th Annual Judge Thomas A. Flannery Lecture (Nov. 14, 2013) (transcript available at http://www.sec.gov/News/Speech/Detail/Speech/1370540374908).
2 See, e.g., Bruce Bettigole, Katherine Kelly, and Charlie Kruly, SEC suffers three recent losses despite increased focus on trial readiness, 15 J. OF INVEST. COMPLIANCE 35 (2014); SEC Lit. Release No. 23011 (June 2, 2014), Jury Finds T. Bradley Strickland, Peter Black, and Nelson Obus Not Liable for Insider Trading; U.S. SEC loses insider trading case against ex-sTec CEO, Reuters, June 6, 2014, available at http://www.reuters.com/article/2014/06/06/us-sec-insidertrading-trial-idUSKBN0EH29L20140606.
3 See SEC Announces New Hires in the Office of Administrative Law Judges, June 30, 2014, available at http://www.sec.gov/News/PressRelease/Detail/PressRelease/1370542202073.
4 See U.S. SEC to file some insider-trading cases in its in-house court, Reuters, June 30, 2014, available at http://www.reuters.com/article/2014/06/11/sec-insidertrading-idUSL2N0OS1AT20140611 (quoting Ceresney as saying that “I do think [the Commission] will bring insider-trading cases as administrative proceedings in appropriate cases. . . . We have in the past. It has been pretty rare. I think there will be more going forward.”). Ceresney has made similar statements in the past. See also Gretchen Morgenson, At the S.E.C., a Question of Home-Court Edge, N.Y. TIMES, Oct. 5, 2013 (quoting Ceresney as saying that “Our expectation is that we will be bringing more administrative proceedings given the recent statutory changes” put in place by the Dodd-Frank Act).
5 See, e.g., Morgenson, At the S.E.C., a Question of Home-Court Edge; Russell G. Ryan, The SEC as Prosecutor and Judge, WALL ST. J., Aug. 4, 2014.
6 Morgenson, At the S.E.C., a Question of Home-Court Edge (quoting former Division of Enforcement Co-Director George Canellos).
7 See Highlights from Securities and Exchange Commission (SEC) Speaks 2014, The Nat’l Law Review, Feb. 28, 2014, available at http://www.natlawreview.com/article/highlights-securities-and-exchange-commission-sec-speaks-2014 (SEC Division of Enforcement’s Assistant Chief Counsel, Charlotte Buford, noted the SEC’s intention to use administrative proceedings more frequently and in a wider variety of upcoming enforcement actions.)
8 See Morgenson, supra note 6.
9 See, e.g., In re Oppenheimer Asset Mgmt. Inc., Securities Act Release No. 9390, Investment Advisers Act Release No. 3566 (March 11, 2013) (SEC entered into a settlement with a registered investment adviser to a private fund prior to commencement of administrative and cease-and-desist proceedings, regarding investment adviser’s overstatement of fund performance and investment policies). See also Brockton Retirement Board v. Oppenheimer Global Resource Private Equity Fund I, L.P., 2013 WL 753310, at *1 (D. Mass. Feb. 28,2013) (the partnership interests of the private fund subject to the SEC’s settlement referenced in this footnote were sold through private placements and exempt from registration under section 4(2) of the Securities Act and SEC Regulation D).
10 Valuation also determines manager compensation in hedge funds, and, in certain circumstances, in private equity funds.
11 See, e.g., In re Oppenheimer Asset Management Inc., supra note 9 (settlement with SEC entered into in advance of SEC’s commencement of administrative and cease-and-desist proceedings, where unregistered private equity fund of funds was forced to disgorge management fees based on inflated asset valuation and fund performance).
12 See SEC Office of Compliance Inspections and Examinations, OCIE Cybersecurity Initiative, Apr. 15, 2014, available at http://www.sec.gov/ocie/announcement/Cybersecurity+Risk+Alert++%2526+Appendix+-+4.15.14.pdf.
13 See generally 17 C.F.R. § 280.30
14 See In re Marc A. Ellis, (Apr. 7, 2011) SEC Release 34-64220 (enforcement action against CCO for aiding and abetting Reg. S-P violations where, among other things, an unauthorized individual was able to misappropriate a registered representative’s computer password and remotely monitor the rep’s emails); In re Commonwealth Equity, et al., (Sept. 29, 2009) SEC Release 34-60733 (Reg. S-P enforcement action where an “unauthorized party . . . obtained the login credentials of a . . . registered representative through the use of a computer virus” and was able to access a list of 368 customer accounts from which the intruder was able to make $523,000 in unauthorized purchases); In re LPL Fin. Corp., et al., (Sept. 11, 2008) SEC Release 34-58515 (Reg. S-P enforcement action where firm did not “implement increased security measures and adopt policies and procedures” adequate to protect against an incident in which a hacker was able to gain access to the firm’s computer system and made trades from several customers’ accounts).
15 Morgenson, At the S.E.C., a Question of Home-Court Edge (quoting former Division of Enforcement Co-Director George Canellos).
16 See Ryan, supra note 5.
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