One year ago this month, Jay Clayton took charge as chairman of the Securities and Exchange Commission. We’ve since learned lot about his overall philosophy in guiding the Commission, notably his desire to improve the vehicles of capital formation and, metaphorically, defibrillate the flatlining marketplace for initial public offerings.

Armed with a full slate of commissioners—at least, that is, until Commissioner Michael Piwowar departs this summer—we are learning more about his, and the Commission’s, views on enforcement.

Stephanie Avakian and Steven Peikin, co-directors of the Enforcement Division, elaborated on some of those views during their testimony Wednesday before a sub-committee of the House Financial Services Committee.

A major takeaway: Say goodbye to the “broken windows” philosophy that guided actions during the chairmanship of Mary Jo White.

White first dropped the phrase “broken windows” on the compliance world during a speech in October 2013. Just as police officers deter serious crime by tackling small quality-of-life issues—from graffiti to turnstile jumpers to, yes, breaking windows—White’s idea was to do the same with SEC rules and requirements. “It is important to pursue even the smallest infractions,” she said, suggesting that this dedication would both increase the Commission’s number of enforcement actions and send a strong message to those who would do greater harm.

Critics of the plan have argued ever since that White’s plan is flawed and creates an undue burden on compliance officers who must now worry about minutiae along with bigger risks.

Under Clayton, the days of chasing after small infractions are apparently over.

That is good news for Rep. Bill Huizenga (R-Mich.), who said that enforcement statistics may give “only a partial picture of a successful program.”

“I am pleased to see that the enforcement division under Chairman Clayton has diverted its attention away from the broken windows enforcement philosophy.”

“In my mind, this misguided approach to enforcement appears to have only been successful at boosting statistics, rather than meaningfully improving investor protections,” he added. “I’m pleased to see that the Commission is shifting away from minor violations in securities laws and instead taking a more selective approach to enforcement. After all, we should not evaluate the true effectiveness of a regulatory agency or its enforcement program solely based on how many headlines it can generate.”

Recent research shows that, as predicted, the number of those “headlines” is indeed diminishing.

A report released this week by New York University’s Pollack Center and Cornerstone Research finds that SEC enforcement actions against public companies and their subsidiaries “continued their downward trend through the first half of the 2018 fiscal year.”

“SEC enforcement activity is on pace to reach the lowest level since 2013,” the report says.

In the first half of fiscal year 2018 (ending March 31), the SEC filed just 15 new enforcement actions against public companies and their subsidiaries—a 67 percent decrease from the 45 filed in the first half of FY2017, the researchers say. Monetary settlements are also on pace for decreases.

The report predicts that recent collections are also in decline. In FY2017, the Enforcement Division’s efforts enabled the Commission to return a record $1.07 billion to harmed investors.

“We don't judge our effectiveness based on simplistic metrics, such as the raw number of enforcement actions filed or total fines and disgorgement,” Peikin testified at the hearing. “Those numbers are an easy way to compare activity in one period to another, but I think they ultimately measure the wrong kinds of outputs and drive the wrong kinds of incentives—encouraging us to divert resources away from challenging, high-impact cases and to seek penalties without regard for investors’ best interests. In my view, neither of those things makes sense.”

“Even as we enhance our focus on protecting retail investors, we will continue to actively pursue cases against large corporations, financial institutions, and other market participants who violate our federal securities laws. We do not face a binary choice between protecting Main Street and policing Wall Street.”
Steve Peikin, Co-Director, Enforcement Division, SEC

Another supportive view of the Commission’s evolving enforcement posture comes from Commissioner Hester Peirce, a Republican and one of the SEC’s newest members.

During a May 11 speech at the 50th Annual Rocky Mountain Securities Conference in Denver, she also chastised the “more is better” enforcement approach, one that may prize quantity over quality.

Peirce said she shares Chairman Clayton’s view that rejects “enforcement statistics as the measure of the agency’s success.”

“I share his commitment to strong enforcement of our securities laws without making raw numbers the measure of our success,” she said, stressing “the danger of playing to the numbers.”

“In the past, we sometimes have taken a less resource-conscious approach—a more-is-always-better approach,” Peirce said. “The ‘broken windows’ philosophy of enforcement was well-intentioned … punishing every small violation, however, means casting discretion aside in favor of making the SEC look tough. Violations are not all equally serious. I agree with Commissioner Michael Piwowar, who notes that, ‘If every rule is a priority, then no rule is a priority.’”

“By holding up raw numbers as the measure of success, the broken-windows-era SEC felt pressure to exceed its previous year’s enforcement actions,” Peirce added. “It was an arms race as our lawyers rushed to settle a case or sprint to the courthouse—or the administrative law judge—to file the next action, especially as the SEC’s fiscal year-end neared, our own version of earnings management. While following the ‘broken windows’ approach, perhaps the SEC should have changed its name to the Sanctions and Exchange Commission, because it acted like a branch of the U.S. Attorney’s Office for the Southern District of New York. An enforcement philosophy that pursues minor violations with the same vigor as it does major violations causes major problems.” 

Among the problems, in her view: “an enforcement-first approach sends the message to regulated entities and others that picking up the telephone to ask the SEC a question about how to comply is risky.”

“Why draw attention to yourself by asking a compliance question of an agency that thinks every foot fault is enforcement-worthy?” Peirce asked.

Another hazard, she said, is that it “encourages compliance personnel to measure themselves by the number of enforcement referrals they make.”

A focus on individual culpability

A continuing change for the Commission comes from efforts to hold individuals culpable, for their misdeeds. It is a concept many argue that corporate settlements can dissuade, especially as regulators focus on expensive fines that come at a cost borne by shareholders.

At the hearing, Avakian stressed that “a core pillar of a strong and effective enforcement program is individual accountability.” 

“it is critical to hold individuals responsible in appropriate cases and to pursue wrongdoing at the highest corporate levels supported by the evidence,” she said. 

Since May 2017, a number of the Commission’s enforcement actions have also involved charges against one or more individuals, Peikin added. “These actions have involved charges against the senior-most executives of large companies and firms, including CEOs, CFOs, presidents, and senior partners, he said. “The Commission also has charged individuals in several cyber-related matters.”

Among those cases were actions against six accountants charged with using leaked confidential Public Company Accounting Oversight Board data, charging Theranos CEO Elizabeth Holmes and former President Ramesh Balwani with “massive fraud;” and charging former top executives at the global mining group Rio Tinto with fraud.

“To be sure, our focus on individual accountability consumes more of our limited resources; with much to lose, individuals may be more likely to litigate with the Commission,” Peikin said. “But that price is worth paying.  We will continue to hold individuals accountable where warranted by the facts and the law.”

In her earlier speech, Peirce added to that topic by warning that the Commission must “take great care in imposing liability on chief compliance officers.”

“CCOs advocate for compliance at registered entities,” she said. “They implement and update compliance programs. They monitor for violations. We need to empower them, not dissuade them from taking the jobs in the first place. It is all too easy for a firm that has not taken compliance seriously to attempt to lay blame at the feet of a CCO who was trying her best to get the firm to pay attention to compliance.”

“I am willing to hold CCOs who are bad actors accountable. The mere fact that a fraudster wears a CCO badge does not get them off the hook,” she added. “However, it is not the job of the SEC to second-guess the good-faith decisions of CCOs.”

A Supreme Court setback

The enforcement co-directors also addressed questions regarding a recent Supreme Court ruling in the matter of Kokesh v. SEC.

The Court held that Commission claims for disgorgement are subject to a five-year statute of limitations.

“The Kokesh decision has already had a significant impact across many parts of the Division,” Avakian testified. “Many securities frauds are complex and can take significant time to uncover and investigate.  Some egregious fraud schemes are well concealed and are not discovered until investors have been victimized over many years. In certain cases, Kokesh threatens to severely limit the recovery available to harmed investors.”

“Wrongdoers should not benefit because they succeeded in concealing their misconduct,” Peikin added. “While we appreciate the need for clear statutes of limitations, we are concerned with an outcome where some investors must shoulder additional losses—and the fraudulent actor is able to keep those ill-gotten gains—because those investors were tricked early in a scheme rather than later.”

“No matter how quickly we work, it is likely that Kokesh will have a significant impact on our ability to enforce the federal securities laws and obtain recovery for harmed investors in long-running frauds,” he added.

A focus on retail investors

Clayton has stressed, as has his enforcement directors, a focus on strategies and techniques to identify, punish, and deter misconduct that most affects everyday investors. These harms include accounting fraud, charging inappropriate or excessive fees, “pump-and-dump” frauds, and Ponzi schemes.

“We recently announced an initiative to encourage self-reporting and remediation by investment advisers who have received compensation for recommending or selecting more-expensive mutual fund share classes for their clients when identical and less-expensive share classes were available, without disclosing this conflict of interest,” Peikin said.

“Even as we enhance our focus on protecting retail investors, we will continue to actively pursue cases against large corporations, financial institutions, and other market participants who violate our federal securities laws,” he added.  “We do not face a binary choice between protecting Main Street and policing Wall Street.”

‘Combatting cyber-related threats’

To address the continuing threats that fall under the umbrella of cyber-risk, the SEC is also stepping up its efforts.

This prioritizing led to the creation of the Cyber Unit in FY2017, the first new unit that the Division has created since specialized units were first formed in 2010.

The Cyber Unit focuses its efforts on the following key areas: market manipulation schemes involving false information spread through electronic and social media; hacking to obtain material, non-public information and trading on that information; violations involving distributed ledger technology and initial coin offerings; misconduct perpetrated using the dark Web; intrusions into online retail brokerage accounts; and cyber-related threats to trading platforms and other critical market infrastructure.

“It demonstrates the priority that we place on combatting cyber-related threats to investors and our markets,” Avakian said of the unit.

Topics