Authored by Kristen Hughes
In November 2020, the Securities and Exchange Commission’s (SEC’s) Division of Enforcement (the Division) released its annual report for fiscal year 2020. Undoubtedly, the year will be remembered for the COVID-19 pandemic’s impact on every facet of our lives, including significant impact on financial markets and the economy. The annual report details both enforcement actions in the normal course and those arising as a result of the pandemic.
During the year, the Division brought 715 enforcement actions, and while a decline in actions from 2019, this resulted in a record number of disgorgement and penalties, totaling $4.68 billion, and more than $600 million returned to investors. The key areas driving the majority of standalone cases were securities offerings (approximately 32%), investment advisory and investment company issues (approximately 21%), issuer reporting/accounting and auditing matters (approximately 15%), and broker-dealers (approximately 10%).
Through a year of significant uncertainty and challenge, market volatility and fast-paced change, there was an increased risk of noncompliance. In light of the pandemic, the Division created a Coronavirus Steering Committee to centralize and coordinate investigations relating to potential misconduct. The Division opened more than 150 COVID-19-related inquiries and investigations. The noteworthy COVID-19-related cases outlined in the report presented a common concern: the issuance of false and misleading information.
The following were overall areas of key focus and findings during the year:
- Financial fraud and issuer disclosure – ensuring accuracy and integrity of financial statements, including securities laws violations involving components of financial reporting
The report highlights eight actions where executives were responsible for violations relating to financial statement misstatements, the majority relating to improper revenue recognition through overstatement or fictitious entries. The Division continues to emphasize the importance of clear and complete disclosures in financial reporting. Another priority of the Division was against issuers distorting non-GAAP metrics, key performance indicators and related disclosures. While non-GAAP measures sometimes provide a measure of a company’s financial performance from direct business operations, these may be distorted and misleading or omitted completely by companies where these have a negative effect on GAAP earnings.
- Investment professionals – identifying misconduct between investment professionals and investors
The report stressed the disclosure of material conflicts of interest should be a priority to ensure advisors are meeting their fiduciary obligations. The report specifically identified two keys issues: potential undisclosed conflict relating to an advisors use of a cash-sweep arrangement, and the transparency of fee structures.
In relation to cash sweeps, the Division outlined situations where cash in advisory accounts is automatically swept in to a money market mutual fund or a bank deposit sweep program: in some cases, the advisor may be dually registered or be affiliated with a broker-dealer. In these situations, there is a conflict of interest in recommending one cash investment over another.
A noteworthy case on fee structures found that Morgan Stanley Wealth Management[HC1] distributed misleading information through marketing and client communications in relation to wrap fees (these are fees that cover investment advice and brokerage services, including trade execution), by suggesting that clients were not likely to incur additional transactions costs even though this did occur in some instances with little transparency.
- Preserving market integrity – uncovering violations at major financial institutions, recognizing that this is critical to the integrity of the securities markets
The three key issues addressed were the pre-release of American depositary receipts (ADRs), trade order routing practices and conflicts of interest within the credit rating process. In relation to order routing, this includes violations relating to misrepresentations and omitting material facts about how customer trades are handled, contradictions to the company’s marketing materials or misrepresentations made about compensation received for routing client orders to certain brokerage firms.
- Uncovering and prosecuting abusive trading – detecting and holding accountable those who engaged in insider trading and those who traded using misappropriated information
The Division recognized that there was an increased risk of misuse of nonpublic information due to remote work and market volatility as a result of the pandemic. The report stressed that a strong control environment and compliance policies in relation to the safeguarding of nonpublic material is critical to preventing illegal trading. High-profile cases included a charge against a former finance manager at Amazon and two family members who traded in advance of Amazon earning announcements from 2016 through 2018, and a charge against a former IT administrator at Palo Alto Networks, Inc., for trading after allegedly utilizing IT credentials to obtain confidential information about quarterly earnings.
A copy of the full annual report released by the Division is available here.