May 16, 2018

House Financial Services Committee Capital Markets Subcommittee “Oversight of the SEC’s Division of Enforcement”

Key Topics & Takeaways

  • SEC Enforcement Activities: During the hearing, the Co-Directors of the SEC’s Division of Enforcement defended their Division’s activities, saying that while attention has been paid to top line figures (such as total amount of fines levied or payments disgorged to investors) but that attention should also be given to non-quantifiable goals, such the effectiveness of enforcement at deterring bad actors and if retail investors are adequately protected. They also discussed the Division’s Share Class Disclosure Initiative.
  • Initial Coin Offerings (ICOs): Republican lawmakers used the hearing to discuss their plans to write legislation to codify or differentiate between security tokens, cryptocurrencies, and possibly other crypto products (including non-security tokens). The Enforcement Co-Directors defended the SEC’s actions in the cryptocurrency space thus far, arguing that they are appropriately focused on the substance of crypto-based products and ensuring that securities, including non-traditional tokens, are registered when necessary.
  • Kokesh Decision: Throughout the hearing, there was substantial discussion about the recent Supreme Court decision in Kokesh v SEC that found that a five-year statute of limitations applies to SEC disgorgement actions. The witnesses argued that the ruling in the case would impact the ability of the SEC to recover funds that are part of “long-running frauds” and that the decision would force the Division to reconsider important parts of its enforcement program. 

Witness

  • Stephanie Avakian, Co-Director, Division of Enforcement, U.S. Securities and Exchange Commission
  • Steven Peikin, Co-Director, Division of Enforcement, U.S. Securities and Exchange Commission

Opening Statements

Subcommittee Chairman Bill Huizenga (R-Mich.)

In his opening statement, Huizenga outlined the SEC’s Division of Enforcement’s powers and responsibilities and discussed the Division’s enforcement actions over the last year. Huizenga said he believes that the size of monetary penalties gives an incomplete measure of success, as that measure fails to measure deterred activity. Huizenga also expressed agreement with SEC Commissioner Peirce’s recent remarks on the “broken windows” theory of enforcement and argued that it was a “misguided approach” to enforcement that boosted statistics without materially improving the landscape for investors.

Subcommittee Ranking Member Carolyn Maloney (D-N.Y.)

In her opening statement, Maloney discussed the steep challenge faced by the Division of Enforcement given the size of the markets that the Division must monitor and stressed its importance to investors as the lead unit punishing bad actors in the marketplace. Maloney then discussed the importance of the private right of action available to investors to file lawsuits against companies that violate securities laws as a necessary supplement to the Division of Enforcement’s activities. 

Testimony

Stephanie Avakian and Steven Peikin, Co-Directors, Division of Enforcement, U.S. Securities and Exchange Commission

In their joint testimony, Avakian outlined the Division of Enforcement’s five key principles guiding their actions: 1) focus on the interests of individual investors; 2) focus on individual accountability; 3) keep pace with technological change; 4) impose sanctions that meet enforcement goals; and 5) constantly assess the allocation of resources. Avakian also outlined some of the Division’s recent efforts and noted that under their tenure, 80 percent of enforcement cases have a named individual target. Peikin discussed the Division’s efforts to stop long-running frauds and to return funds to investors. 

Question and Answer

SEC Enforcement Activities

Huizenga noted recent media attention paid to a decline in the total amount of monetary penalties levied by the Division of Enforcement and asked the witnesses if the SEC has “gotten soft” on financial crimes. Avakian said that top line figures, such as total dollars collected in fines or disgorged are helpful but do not capture the whole enforcement picture. Avakian said that consideration should also be paid to the effectiveness of enforcement at deterring bad actors and if retail investors are protected, and that these goals are not easily measured with quantitative metrics.

Huizenga later asked how the SEC weighs pursuing an admission of guilt from the entities subjected to enforcement actions. Peikin said that admission can be very costly and difficult to pursue, and the SEC must do a cost-benefit analysis of pursuing an admission of guilt when the target of an enforcement action agrees to the SEC’s other enforcement terms (such as disgorgement).

Huizenga also asked how the witnesses viewed individual versus corporate-wide penalties for misbehavior. Peikin said that it is the view of SEC Chair Clayton that individuals drive misbehavior more than corporations, and so the Division of Enforcement has begun bringing more cases with named individual defendants. Peikin agreed that there is a place for corporate liabilities and penalties and other places for individual liability.

Initial Coin Offerings (ICOs) and Cryptocurrencies

Initial Coin Offerings (ICOs) and cryptocurrencies were frequent topics at the hearing. Maloney led off by asking if it is possible for tokens to begin life as a security before evolving into something that is not a security. Avakian said that determining what is and is not a security requires a facts and circumstances test, and that if those change over the course a token’s existence, the SEC’s classification of it will similarly have to change. Repeatedly throughout the hearing the witnesses argued that the SEC focuses (properly) on the substance of a crypto transaction, not its nomenclature.

Rep. Tom Emmer (D-Minn.) defended ICOs during the hearing and stated that ICOs create real opportunities for investors, and that the federal government should not prevent the token industry from developing as it could yield real benefits. Emmer asked the witnesses to describe their engagement on tokens thus far. Avakian said the Division of Enforcement has engaged with players throughout token markets, including crypto exchanges, and are trying to keep a dialogue going with industry to better understand these new markets. Emmer said that “clear lines” between cryptocurrencies and tokens are needed so innovation can continue without fear of regulatory interference. Avakian said that the Division of Enforcement works with the Division of Corporation Finance (and other groups within the SEC) on crypto matters and said that they analyze the substance of the underlying product and whether it has the characteristics of securities before requiring registration. Emmer said he appreciated the SEC’s “light touch” policies thus far.

Rep. Warren Davidson (R-Ohio) said he was working on legislation to help regulators draw lines between cryptocurrencies, tokens, and related products. He asked the witnesses how the regulators are sharing oversight of this new industry, and Peikin said that the SEC has focused on tokens while the Commodity Futures Trading Commission (CFTC) is focused on cryptocurrencies.

Rep. David Scott (D-Ga.) asked the witnesses to describe the types of violations of securities laws they have seen. Peikin said that some tokens are “out and out frauds” while others are simply failing to register what would otherwise be legal securities.  Scott closed by noting that regulatory warnings do not appear to be slowing down the market for ICOs.

Kokesh Decision

Throughout the hearing, there was substantial discussion about the recent Supreme Court decision in Kokesh v SEC that found that a five-year statute of limitations applies to SEC disgorgement actions. The witnesses argued that the ruling in the case would impact the ability of the SEC to recover funds that are part of “long-running frauds” and that the decision would force the Division to reconsider important parts of its enforcement program. Huizenga asked the witnesses how the decision would affect the Division of Enforcement. Peikin said the decision has had a “meaningful impact on [the SEC’s] ability to return funds to investors.” Maloney asked if there were steps Congress needed to take post-Kokesh to protect investors. Peikin declined to ask for legislation but the witnesses said that the SEC was interested in working with the Financial Services Committee on the issue moving forward. Peikin also noted that many financial crimes have a statute of limitations longer than five years. Rep. Randy Hultgren (R-Ill.) also asked about Kokesh’s impact on the Division of Enforcement and if the witnesses had specific proposals for post-Kokesh enforcement. The witnesses again declined to provide the specifics or possible legislative fixes but reiterated their willingness to work with the committee on this problem.

Administrative Law Judges (ALJs)

Rep. Ann Wagner (R-Mo.) used her questions to press the witnesses on the use of and dependability of Administrative Law Judges (ALJs) to adjudicate SEC enforcement litigation (Wagner also sharply criticized the Former SEC Chair Mary Jo White for relying heavily on ALJs). Avakian conceded that they differ in important ways from federal courts, but her and Peikin defended ALJs as necessary and legitimate tools. Wagner argued that ALJ cases could create biases or conflicts of interest in SEC proceedings, when compared to federal courts, but Avakian rejoined that some enforcement actions or charges require the use of an ALJ. Avakian also noted that after appealing from an ALJ to the full Commission, losers in cases can then appeal to federal courts. Wagner closed by saying she was concerned by the “overreach of authority” of ALJs and said she was concerned that entities subject to enforcement actions did not receive a choice of venue. Davidson also expressed concerns about the SEC’s success rate before ALJ’s as opposed to their success rate before federal judges. Peikin responded that under Chair Clayton, the SEC has bee more restrained in the use of ALJs and said that during the last year the SEC’s success rate in both venues are roughly comparable. Peikin also said that the SEC has modernized and improved ALJ proceedings recently and noted that ALJs impose more requirements on the SEC than federal courts (specifically, that ALJs require the SEC to turn over far more documents).

Cybersecurity

Hultgren asked the witnesses to discuss their expectations regarding public company disclosure of cyberattacks. Peikin said that enforcement actions regarding cyber disclosure will be carefully considered, saying that the SEC did not want to “second-guess good faith disclosure decisions” but noting that in some cases, such as the Yahoo! breach, the failure of a company to disclose a cyber event was so “egregious” that enforcement was necessary.

Share Class Disclosure Initiative

Rep. Bruce Poliquin (R-Maine) asked the witnesses to explain how the SEC’s new Share Class Disclosure Initiative would help investors. The witnesses said that this program would address a problem they have seen across mutual funds of all sizes, involving investment advisors recommending higher fee mutual fund share classes that earn the advisor compensation, instead of recommending lower or no-fee share classes from the same fund. Avakian defended the program as necessary to tackle the problem on a large scale, as individual share class disclosure investigations are time and resource-intensive. Avakian also said that self-reporting in the allotted time period would lead to a standard settlement term that would require disgorgement to investors in exchange for no financial penalties.

For more information on this hearing, please click here.