by T. GormanPosted on Posted in SECActions

The Commission periodically has filed enforcement actions against broker-dealers for failing to file SARs – suspicious activity reports — typically centered on a failure to file reports regarding microcap issuers. Those actions are based on Exchange Act Section 17(a) and Rule 17a-8. SARs on the other hand trace to the Bank Secrecy Act and FinCEN.

The question of broker-dealer compliance with SARs and the Commission’s authority under the Exchange Act Section and Rule typically cited by the agency was raised in an action recently decided by the Second Circuit Court of Appeals. SEC v. Alpine Securities Corporation, No. 19-3272 (Decided Dec. 4, 2020).

The Case

Alpine, a registered broker-dealer, was named as a defendant in an enforcement action by the Commission. The complaint alleged that the firm, which specializes in microcap securities, had failed over a period of time to properly file thousands of SARs either by not filing or by not properly furnishing the required information. The Commission’s complaint alleged violations of Exchange Act Section 17(a) and Rule 17a-8.

Defendant responded by claiming that the Commission did not have the authority to enforce what are Bank Secrecy Act and FinCEN regulations. Specifically, Alpine asserted that the SEC does not have authority to bring an enforcement action based on a failure to file SARs under Section 17(a), that Rule 17a-8 is not valid and that the enactment of the Rule violated the Administrative Procedure Act. The District Court granted summary judgment in favor of the Commission. The Second Circuit affirmed.

The Decision

The Court began with a brief review of the statutory authority for SARs. It traces to the Foreign Transactions Reporting Act of 1970, known as the Bank Secrecy Act, as amended by the PATRIOT Act in 2001. That Act requires broker-dealers to file SARs after Treasury consulted with the SEC, the Board of Governors of the Federal Reserve and the Securities and Exchange Commission. The Treasury delegated authority to the Financial Crimes Enforcement Network within the Treasury or FinCEN. In 2002 FinCEN promulgated regulations that require broker-dealers to file SARs with regard to certain transactions involving at least $5,000.

In 1981 the Commission adopted Rule 17a – 8 under Exchange Act Section 17(a). It incorporated the initial rules applicable to broker-dealers under the Bank Secrecy Act. That Rule was updated in 2011. It incorporates the requirements of the rules regarding SARs enacted by Treasury and FinCEN. Based on this history the Court concluded that the challenges raised by the broker-dealer defendant lacked merit.

First, the Court quickly concluded that the Commission had the authority to initiate this enforcement action. The complaint was based solely on Exchange Act Section 17(a) and Rule 17a-8. Accordingly, the “suit falls within the SEC’s independent authority as the primary federal regulator of broker-dealers to ensure that they comply with reporting and recordkeeping requirements . . .” the Court found.

Second, the fact that Rule 17a-8 requires compliance with the Bank Secrecy requirements does not change this conclusion the Circuit Court stated. This question is governed by the analytical framework of Chevron v. Nat. Res. Def. Council, 467 U.S. 837 (1984). Under that decision if Congress has not specifically addressed the point and the statute is ambiguous, a reviewing court must respect the determination of the agency if it is permissible.

The determination of the agency in this action is tied to an express delegation by Congress of authority to determine “which reports from covered entities, including brokers and dealers are necessary and appropriate to further the goals of the Exchange Act. The Commission’s actions were undertaken in accord with the dictates of the statute. When enacting Rule 17a-8 the SEC concluded that the rule would protect national securities markets and exchanges. SARs, which assist the Treasury in targeting illegal securities transactions, also serve the aims of the Exchange Act by protecting investors and helping guard against market manipulation.

The fact that Congress directed Treasury to regulate record keeping requirements by broker-dealers does not mean that the Commission is precluded from acting in the area as Defendant claims. To the contrary, as the Supreme Court held in FDA v. Brown & Williamson, 529 U.S. (2000) that result obtains only if there is a conflict. Here there is none. When Rule 17a-8 was first enacted the Commission noted in soliciting comments during the rule making progress that Treasury had delegated the responsibility to the Commission. No comments were filed. This is consistent with the fact that Congress did not silo SARs authority with Treasury, implying the SEC also has authority.

Finally, the Rule does not violate the APA as claimed by Defendant. Alpine’s argument is based on the fact that the Rule permits the automatic incorporation in the future of Bank Secrecy Act requirements in violation of the APA notice and comment rule making requirements.

To the contrary, the public was afforded comment opportunities, the Court found. One occurred when the Commission published Rule 17a-8. There the agency expressly stated that it did “not specify the required reports and records so as to allow for any revisions the Treasury may adopt in the future.” When the Rule was formally adopted, the release reiterated this statement. When FinCEN later adopted its SARs rules, they were again subject to notice and comment by the public. There was thus “ample notice and comment opportunities in compliance with the APA,” the Court concluded.

In its most recent amendment to the Rule the Commission made it clear that it was consulting with FinCEN. The agency also made clear the fact that the Rule was consistent with the requirements of the Exchange Act. Based on this point, and the history of the Rule, the Court found that the requirements of the APA had been met.

Comment

Chevron, the Supreme Court’s seminal decision on rule writing, makes it clear that if Congress delegated authority to an agency to write rules, the provisions written must be within the ambit of the authority granted. This means that to the extent Rule 17a-8 comports with the text of the Exchange Act under which it was created, it is likely within the authority granted.

That does not mean that incorporating yet to be written rules written by FinCEN in the future are within the text of the Exchange Act rule writing authority granted to the SEC. Yet that is the question here: Did the Exchange Act grant the SEC authority to write rules directing broker-dealers to comply with whatever SAR rules FinCEN writes in the future? A reading of the plain text of the Exchange Act – the test used by the new conservative Supreme Court – answers the question. No; the text of the statute says nothing on this point

Finally, just how an Exchange Act Rule incorporating “to-be-written-in-the-future” rules authored by FinCEN complies with the APA is unclear. To be sure each version of the Exchange Act Rule was subjected to the notice and comment requirement of the APA. Equally clear is the fact that FinCEN’s rules were subjected to the same APA process. But nothing in the APA says that the notice and comment process used by one agency under one statute – here FinCEN – can be tacked together with a rule written by another agency under another statute in a different time period. Neither the text of the APA nor the text of the Exchange Act specifies that such a procedure can be created by an agency. Equally clear is the fact that APA notice and comment for the public is not possible for yet to be written rules, an issue raised in the case but side stepped by the Court. While the process adopted — essentially a shortcut — may be efficient and might even yield desirable results, it is not in accord with the statues.

This article was updated Dec. 16, 2020 at 5:30 p.m. ET

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by T. GormanPosted on Posted in SECActions

The exit continues at the Commission. This week Director of Enforcement Stephanie Avakian announced her departure from the agency at the end of the year. She has been preceded by the Director of Corporation Finance and the General Counsel. The Chairman previously announced his departure at year end.

Last week Enforcement filed a series of cases. Two were based on false statements tied to financial issues, one against GE and another involving CheeseCake Factory. The agency also brought two offering fraud actions, a case involving digital assets and another tied to share class selection conflicts.

Be safe and healthy this week

SEC

Statistics: The Division of Investment Management filed an expanded suite of data related to private fund statistics and trends on December 10, 2020 (here). The supplement is to the quarterly release of statistics on the funds that has regularly been published since October 2015.

Rules: The Commission approved on December 9, 2020 modifications to the rules regarding the collection of market infrastructure data. That information will now include expanded content of NMS market data, and rules establishing a decentralized consolidation model in which competing consolidators will be responsible for collecting, consolidating and disseminating consolidated market data to the public (here).

SEC Enforcement – Filed and Settled Actions

The Commission filed 3 civil injunctive actions and 6 administrative proceedings last week, excluding 12j, tag-along proceedings and other similar matters.

False statements/financial fraud: In the Matter of General Electric Company, Adm. Proc. File No. 3-2-165 (December 9, 2010). The action is built on two key omissions: First, GE failed to tell investors how its Power division made its numbers. Second, investors were not told about deteriorating trends in the insurance area and potential losses that eventually resulted in pre-tax charges. Initially, GE Power, a significant line of business that manufactures gas turbines, faced challenges in the marketplace. Business in Power was flat, according to internal documents. A large portion of the segment’s earnings and cash came from very profitable agreements that ran for years. A plan was developed to ensure that the division’s financial goals were met. The division had a $5 billion “deferred balance” of unbilled revenue reported in GE’s financial statements. Key, however, was to reduce expenses. If costs and estimated costs for the division were reduced, greater revenue would result and Power would hit its financial goals. In 2016 GE did not tell investors that 25% of Power’s reported profits were generated by reducing estimates of costs to complete the work under the long-term contracts. The next year the same technique was used in the first three quarters to significantly boost profits. Investors were told only that Power generated $1.4 billion in 2016 and $1.1 billion for the first three quarters of 2017. Investors were not told that the revenue increases were generated in part by changing estimates that compromised the cash flow for future years. The company used a similar approach to report increased industrial cash collections for 2016 and 2017. GE decided to sell or factor long term receivables from the Power service multi-year agreements primarily to GE Capital, a subsidiary of the company. This practice – called “deferred monetization” — boosted reported cash flow by over $1.4 billion in 2016 and over $500 million for the first three quarters of 2017. Second, there were issues in the insurance area. Beginning in 2004 the firm explored exiting the line of business. Portions of its insurance portfolio were divested. The long-term care insurance policies remained – a sale would generate huge losses. By 2015 and 2016 costs exceeded revenues. Despite the known trends, GE lowered projected claims costs for the distant future while concluding that it did not have insurance losses. The company did not disclose its rising claim costs and the resulting potential for material insurance losses. In 2017 and 2018 GE made a series of public announcements. They described the actual and disappointing cash and earnings in GE Power absent the changes and a $9.5 billion pre-tax insurance charge. The share price dropped about 75%. The Order alleges violations of Securities Act Section 17(a)(2) & (3) and Exchange Act Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B). In resolving the matter, the Commission acknowledged the remedial actions taken by the firm which included replacing key personnel. The company consented to the entry of a cease-and-desist order based on the Sections cited in the Order and agreed to pay a penalty of $200 million. A fair fund will be created.

Digital assets/unregistered offering: SEC v. Elmaani, Civil Action No. 1:20-cv-10376 (S.D.N.Y. Filed December 9, 2020) is an action which names as a defendant Amir Bruno Elmaani aka Bruno Block. Defendant is the founder of Oyster Protocol, Inc., a firm which issues coins called Pearls. Beginning in the fall of 2017 Defendant, using the name Bruno Block, began offering and selling millions of digital tokens called Pearl, a form of unregistered security. About $1.3 million was raised. The tokens were a “hot” item for a period. In late October 2018 Defendant minted another 4 million Pearl tokens and sold them in the secondary market. He obtained about $570,000. The sales also caused losses for earlier investors when the price dropped by about 65%. The complaint alleges violations of Securities Act Sections 5(a), 5(c) and 17(a) and Exchange Act Section 10(b). The case is pending. See Lit. Rel. No. 24980 (Dec. 9, 2020).

Offering fraud: SEC v. Barbera, Civil Action No. 20-cv-10353 (S.D.N.Y. Filed Dec. 9, 2020) is an action which names as defendants J. Jeremy Barbera, Car Smith and Nanobeak Biotech Inc., respectively, the former CEO of Nanobeak who has been enjoined in a Commission fraud action, a firm that changed its name to the current version in 2019, and a resident of Florida. Over a four year period, beginning in December 2015, Defendant Barbera sold shares of Nanobeak to 37 investors, raising about $3.6 million using false statements. Specifically, potential investors claimed were told that the company was working with scientists at NASA and a nationally recognized research university to develop a sensor to test and detect cancer and drug use. The firm never developed any such technology and approximately 45% of the investor funds were diverted to the personal use of Mr. Barbera. The complaint alleges violations of Securities Act Section 17(a) and Exchange Act Section 10(b). The case is pending. See Lit. Rel. No. 2497i8 (Dec. 9, 2020).

Procedures – pricing: In the Matter of Ice Data Pricing & Reference Data, LLC, Adm. Proc. File No. 3-2164 (Dec. 9, 2020) is an action which names the registered investment adviser as a Respondent. Over the last five years, beginning in 2015, the firm provided global securities pricing, evaluations and other information to advisory clients through subscriptions. For certain categories of fixed-income securities the firm could not provide a valuation. In those instances, it furnished a quote obtained from a single source. While the firm had compliance procedures which addressed what the question of single source quotes, the policies and procedures were not reasonable. The Order alleges violations of Advisers Act Section 206(4). Respondent resolved the matter by consenting to the entry of a cease-and-desist order based on the section cited in the Order and to a censure. In addition, Respondent agreed to pay a penalty of $8 million which was transferred to the U.S. Treasury.

False statements: In the Matter of Covia Holdings Corp., Adm. Proc. File No. 3-20163 (Dec. 8, 2020) is an action which names the firm, a publicly traded company listed on the NYSE, and Fairmount Santrol Holdings, Inc. (now Bison Merger Sub I, LLC), a provider of products used in the fracking process. The two firms have now merged. Over a four year period, beginning in 2014, Fairmount provided products used in oil and gas exploration and production for fracking based on false claims. In an IPO in 2014, and two follow-on offerings in 2016, misrepresentations were made about the products sold by Fairmount, claiming falsely essentially that they facilitated the fracking process. They did not. Yet in the IPO about $400 million was raised while another $438 million was raised in the two follow-on offerings based on the misrepresentations. The Order alleges violations of Securities Act Sections 17(a)(2) and (3) and Exchange Act Section 13(a) and the related rules. To resolve the matter Respondents consented to the entry of a cease-and-desist order based on the sections cited in the Order. In addition, Respondents will pay a penalty of $17 million on a joint and several basis which will be deemed satisfied by a cash payment from Covia in the amount of $1 million under its Chapter 11 confirmation plan.

Trade allocations: In the Matter of Bluecrest Capital Management Ltd., Adm. Proc. File No. 3-20162 (Dec. 8, 2020) is a proceeding which names the a respondent the former registered investment adviser. In 2011 BlueCrest created a leveraged proprietary fund, BSMA, to trade for the personal capital of its personnel. The largest capital allocations were always to Rates and Relative Value strategies. The firm transferred the personnel who had traded Rates and RV strategies to BSMA. Additional traders were retained who could trade for BSMA only. From 2011 through late 2015 the majority of the highest-performing Rates and RV traders were allocated to BSMA. In addition, BlueCrest replaced the capital allocations of the transferred traders by allocating a substantial amount of BlueCrest Capital International capital to the transferred traders, although the amounts generally were below those of Rates and RV. The capital allocations from the trading program to BVI over a three-year period, beginning in 2012, ranged from about 17% to 51% of BCI’s total allocated capital. Respondent failed to properly disclose each of these steps. The Order alleges violations of Securities Act Sections 17(a)(2) and 17(a)(3) and Advisers Act Sections 206(2) and 206(4). Respondent resolved the proceedings by consenting to the entry of a cease-and-desist order based on the Sections cited above and a censure. In addition, Respondent will pay disgorgement of $107,560,200, prejudgment interest of $25,154,306 and a penalty of $37,285,494. A fair fund was created.

Share class selection: In the Matter of Bancwest Investment Services, Inc., Adm. Proc. File No. 3-20161 (Dec. 7, 2020) is a proceeding which names as a respondent the dual registered investment adviser, broker-dealer. Over a two-year period, beginning in 2014, Respondent purchased, recommend or held for advisory clients shares which carried 12b-1 fees without making the proper disclosures. In resolving the matter, the firm undertook remedial efforts. The Order alleges violations of Advisers Act 206(2) and 206(4). To resolve the case the firm consented to the entry of a cease-and-desist order based on the sections cited in the Order and to the entry of a censure. The firm will also pay disgorgement of $286,450, prejudgment interest of $44,982 and a penalty of $75,000. A fair fund was created. The firm will also comply with certain undertakings.

Offering fraud/COVID-19: SEC v. Applied BioSciences Corp., Civil Action No. 24977 (S.D.N.Y.) is a previously filed action against the firm. The complaint alleged that the firm attempted to sell COVID test kits to individuals for home use based on a finger prick test. Contrary to the press release announcing the sale, the tests could only be administered by a medical professional. The press release also did not disclose that the FDA had not approved the tests. To resolve the matter the firm consented to the entry of a judgment, entered by the Court, which enjoined it from future violations of Exchange Act Section 10(b). The order also directed the firm to pay a penalty of $25,000. See Lit. Rel. No. 24977 (Dec. 7, 2020).

False statements: In the Matter of The Cheesecake Factory Incorporated, Adm. Proc. File No. 3-20158 (December 4, 2020). Cheesecake Factory is a well-known national restaurant chain based in Calabasas Hills, California. The firm’s shares are traded on Nasdaq Global Select Market. As the pandemic began to unfold Cheesecake Factory and other restaurant chains effectively had their businesses closed by the initial restrictions imposed which were designed to try and contain the virus. By mid-March 2020 Cheesecake Factory and others faced unprecedented challenges. Over the next month Cheesecake Factory took a series of steps to try and survive. Those included: 1) Efforts to conserve cash such as a March 18, 2020 letter sent to landlords saying that it would not be paying April rent, an event later reported in the media; 2) by March 23 the company was actively seeking additional liquidity through either debt or equity; possible private equity investors were told the company would survive at the current negative cashflow rate for about 16 more weeks – documents reflected a negative cash flow rate of $6 million per week; 3) a March 23 Form 8-K stated that the company was withdrawing prior financial guidance and moving to an “off-premise model” or delivery model was being installed to permit the firm to operate “sustainably;” 4) a March 27, 2020 Form 8-K stated the company was not planning to pay rent in April, that executive officers, board members and certain employees would take a pay cut and 41,000 workers were furloughed but allowed to retain certain benefits; 5) an April 3, 2020 Form 8-K filing attached an April 2 press release disclosing preliminary Q1 2020 sales noting that the restaurants were operating sustainably using the off-premises model; and 6) on April 20, 2020 Cheesecake Factory announced a $200 million subscription agreement for the sale of convertible preferred stock to a private equity investor. The Order alleges that the March 23 and April 3 Forms 8-K were false and misleading. The filings did not disclose that the firm was “excluding expenses attributable to corporate operations” from its discussions of “sustainability;” there was no statement that the negative cash flow was $6 million per week or only 16 weeks of cash remained as was stated to certain potential lenders. The Order alleges violations of Exchange Act Section 13(a). The firm, whose cooperation was considered by the Commission, resolved the matter, consenting to the entry of a cease-and-desist order based on the sections cited in the Order. The firm also agreed to pay a penalty of $125,000 that was transferred to the U.S. Treasury.

Hong Kong

Consultation: The Securities and Futures Commission announced on December 11, 2020 a consultation on proposals to update its entry requirements for license applications and competency standards for individual practitioners. Under the proposals minimum academic qualifications requirements would be raised and a range of qualifications recognized (here).

Data storage: The SFC released additional guidance for market participants on external electronic data storage on December 10, 2020 (here).

Singapore

FinTech: The Monetary Authority of Singapore and the Magyar Nemzeti Bank announced on December 9, 2020 the signing of a cooperation agreement to strengthen cooperation in FinTech innovation between Singapore and Hungary (here).

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