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The future of SEC enforcement under the Biden administration

Jonathan Barr and partners, Baker Hostetler, Partner, Washington DC, 21 April 2021

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Gary Gensler, who became a Goldman partner at the tender age of 30, left to become assistant secretary of the Treasury for financial markets in 1997 and later helped draft the Sarbanes Oxley Act 2002. He is now chairing the US Securities and Exchange Commission.

On 14 April, the US Senate confirmed the nomination of Gary Gensler as the 33rd Chair of the SEC. This appointment has resulted in a Democratic-Party majority at the SEC which, in turn, suggests that the commission will abandon its current emphasis on capital formation in favour of protecting investors from sharp practice, evolving rules (required by the Dodd-Frank Wall Street Reform and Consumer Protection Act) regarding security-based swaps, compensation, stress tests for asset managers; and inspections, examinations, and enforcement action.

This article predicts the things that we can expect from Mr Gensler’s SEC. These might include a new enforcement policy and greater interest in digital currency, Special Purpose Acquisition Companies or SPACs and new rules to oblige issuers to divulge ESG-related information. ESG refers to environmental, social and governance-related matters.

Jay Clayton’s legacy

During his three-and-a-half years as leader of the SEC, the recently departed chairman Jay Clayton presided over a record number of new rules – more than 65 – and inspired arguably the most comprehensive measure to govern the conduct of broker-dealers when dealing with retail customers, Regulation Best Interest or Reg BI. He also expanded the SEC's definition of the term “accredited investor,” providing retail investors with easily understandable information about the nature of their relationships with their financial hirelings through a new Form CRS, making the SEC’s rules to do with 'whistleblowing' clearer and forcing firms to describe their personnel in a specific way.

The number of "actions" that the regulator took against public companies hit a six-year low for the fiscal year ending in September 2020 - this appears to be associated with a reduction in the total number of "independent actions" on which the SEC has embarked, but it is partly a result of the current pandemic, which has had broad-ranging effects on the SEC’s enforcement activity. However, in 2019, the SEC embarked on a record 95 enforcement-related actions in which it targeted publicly-traded companies – an increase of 30% on the figure from 2018.

Despite the decrease in enforcement activity, the SEC managed to collect a record-breaking $4.68 billion from it, with $3.6 billion coming from the ill-gotten gains that firms had to "disgorge" and $1.1 billion from penalties. On 22 June 2020, the US Supreme Court preserved the SEC’s ability to seek disgorgement in federal courts, but held that such amounts ought to be limited to the net profits that firms make from their wrongdoing. Just six months later, Congress passed the National Defence Authorisation Act for the fiscal year of 2021, which allowed the SEC to seek "disgorgement" for violations of scienter-based securities laws, extending the period for this in the Statute of Limitations from five to ten years.

Many of the measures that Clayton pushed through, however, came about on split commission votes, including Reg BI. These problems are unlikely to become an inherent fixture at the SEC, because the presence of Chairman Gensler has resulted in a 3-2 split in favour of Democrats, who include Acting Chairwoman Allison Herren Lee and Commissioner Caroline Crenshaw. This may very well result in a more active regulatory agenda than before, which may also be shaped by the Financial Stability Oversight Council and by Congress through the Congressional Review Act.

At the first Oversight Council meeting during the Biden Administration (held on 31 March 31), Treasury Secretary Janet Yellen, who chairs the council, asked interagency staff to assess hedge funds and money-market funds, two areas in the commission’s purview, about the risks that open-end funds pose to financial stability, especially on the subject of liquidity. She also wanted to reconvene a Hedge Fund Working Group which last reported to the council in 2016.

The Congressional Review Act has set up a quick process by which Congress can disapprove and thereby nullify regulations promulgated by various federal government agencies. It states that the Government Accountability Office or CEO ought to report all rules to Congress. Upon receiving each GAO report, Congress then has 60 legislative working days to introduce a "special joint resolution of disapproval" of the rule. If Congress were to disapprove previously adopted SEC rules using the Act and the SEC were to issue a new rule, the succeeding rule ought not to be substantially similar unless authorised by Congress in a new law. For example, in 2017 Congress disapproved of the SEC’s resource extraction payments rule and in December last year the SEC adopted, for a third time, a rule to implement this provision mandated by the Dodd-Frank Act.

Gensler’s past points to heavier enforcement

Chairman Gensler previously served from 2009-2014 as the Obama-appointed chairman of the Commodity Futures Trading Commission or CFTC. While there, he advocated extensive reform for the swaps market and was in charge when the agency charged five financial institutions for manipulating the London Interbank Offered Rate, the international benchmark of the average interest rate. He was instrumental in implementing much of Title VII Dodd-Frank Act which Congress passed in response to the financial crisis that erupted in 2008 with the aim of regulating the over-the-counter derivatives market. Before his time at the CFTC, during the Clinton Administration, Gensler served as both the Under Secretary for Domestic Finance and Assistant Secretary for Financial Markets at the Treasury Department and he was also a Senior Advisor to former Senator Paul Sarbanes when he was drafting the Sarbanes-Oxley Act. His post-Treasury career as a regulator has earned him the reputation of being a tough market cop.

Gensler’s track record suggests that he will try to protect investors from sharp practice vigorously, especially because the markets are volatile at the moment and the pandemic still bedevils the economy. He recently stated that “when there are clear rules of the road and a cop on the beat to enforce them, our economy grows and our nation prospers.”

Indeed, the SEC has already started ramping up its efforts to enforce its rules. For example, on 9 February, Acting Chairwoman Herren-Lee announced that the agency would return to authorising senior officers in the Enforcement Division to issue Formal Orders of Investigation. She stated that the delegation of authority would allow the agency to “act more swiftly to detect and stop ongoing frauds, preserve assets, and protect vulnerable investors.”

In an era of heavier enforcement, the SEC will probably expose more corporate officers to personal liability for the transgressions of their firms. The 2019 SEC Division of Enforcement Report touted at least three cases in which CEOs, among other corporate officials, were investigated and/or fined in connection with securities-related crimes that occurred at the firms for which they worked. Last year, the SEC charged individuals in 72% of stand-alone enforcement actions, including corporate officers, accountants, auditors “and other gatekeepers.” This trend will probably continue.

Expected initiatives in crypto-currency regulation

It is also anticipated that crypto-currency will receive significant attention under Chairman Gensler, who taught courses at the MIT Sloan School of Management on blockchain technology and digital currencies. He has noted that, “[c]rypto initiatives have spurred incumbents to update payment solutions and explore new approaches to finance and multi-party database management.”

It is almost certain that the SEC will expand its enforcement prowess in the crypto space. In 2018, in an interview with Bloomberg Markets and Finance, Gensler stated that if the “crypto world is going to be part of the future” a regulator has to regulate it to “guard against illicit activity” and “protect investors.”

He continued: “I think the pure cash crypto-currencies like bitcoin need more protection, and probably more protection than, frankly, even the oil markets.”

Gensler also wrote in an op-ed for CoinDesk in 2019 that  “crypto markets have been rife with scams, fraud, hacks, and manipulation,” but believed that regulation would make consumers more confident about the integrity of the markets.

“I believe financial technology can be a powerful force for good – but only if we can continue to harness the core values of the SEC in service of investors, issuers and the public.”

Coronavirus-related fraud

As the pandemic continues, the SEC is well-poised to continue investigating virus-related fraud and misconduct. A year ago, it set up a Coronavirus Steering Committee to co-ordinate its investigations into various types of misconduct. Between March 2020 and the end of the fiscal year, the Enforcement Division opened more than 150 virus-related inquires and investigations. The SEC received 71% more tips, referrals, and complaints that it did during the same time the previous year. The era of the virus, like other periods of economic crisis, has led to the mass-uncovering of misconduct. The SEC will continue to look for and investigate such misconduct throughout Biden’s presidency.

ESG and the Climate Change Disclosure Regime

The SEC will also have a part to play in the Biden Administration’s plan to deal with changes in the Earth's climate. President Biden has pledged to require public companies to disclose the effects that they are having on the environment, especially in relation to climate-change-related risks and greenhouse gas emissions. Pressure from investors has already forced many companies to disclose such information voluntarily, but the SEC wants to insist on it. During his Senate nomination hearing, Gensler agreed with Senator Elizabeth Warren that companies “should not be able to hide their [climate-related] risks” from their investors.

On 1 February this year, the SEC announced the appointment of Satyam Khanna as the first Senior Policy Advisor for Climate and ESG (environmental, social and governance-related) matters. On 4 March it created a 22-man Climate and ESG Task Force in the Division of Enforcement which will “develop initiatives to proactively identify ESG-related misconduct” and will focus initially on “identify[ing] any material gaps or misstatements in issuers’ disclosure of climate risks under existing rules.” Already, the SEC has found instances in which investment firms might have been making misleading statements about their ESG-related investment processes as well as their adherence to the ESG-related pronouncements of international bodies.

A tough cop

We are likely to see an increase in inspections and examinations [regulatory visits] in the fund industry which will cause the SEC to take more enforcement action there. There will probably be more initiatives regarding various disclosures of information and the protection of investors from harm. Firms ought to equip themselves to handle the increases in scrutiny and enforcement that the Biden administration is going to make.

* Jonathan Barr can be reached on +1.202.861.1534 or at jbarr@bakerlaw.com; John Carney is on +1.212.589.4255 or at jcarney@bakerlaw.com; Jimmy Fokas is on +1.212.589.4272 or at jfokas@bakerlaw.com; Teresa Goody Guillén is on +1.202.861.1630 or at tgoodyguillen@bakerlaw.com

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