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SEC Mass Enforcement Sweep Charges Officers, Directors, Major Shareholders, and Companies with Violating Rules Requiring Prompt Reporting of Transactions and Holdings

September 16, 2014

Highlights SEC's Growing Ability to Employ Automated Big Data Analysis to Detect Certain Misconduct

The Securities and Exchange Commission announced charges against 18 individuals, 10 investment firms and six publicly-traded companies for violations related to filing and reporting obligations of Forms 3, 4, and 5 under Section 16(a) and Schedules 13D and 13G under Section 13(d) or (g) of the Securities Exchange Act of 1934. Those charged agreed to pay financial penalties totaling $2.6 million. In a separately announced case, the SEC charged a biotech company and its former CEO with defrauding investors by failing to report his sales of company stock.

Every officer, director, and person who is the beneficial owner of more than 10 percent of any class of any equity security of a publicly listed company (collectively, "insiders") are required to file initial statements of holdings on Form 3 and keep this information current by reporting transactions on Forms 4 and 5. Beneficial owners of over 5 percent of a company's stock have separate reporting requirements. There is no state of mind requirement for violating these reporting requirements. The failure to timely file a report, even if inadvertent, constitutes a violation.

Several lessons may be distilled from each enforcement action. These lessons illustrate the risk of viewing filing and reporting insider transactions as a mere administrative obligation.

Directors and Officers

Section 16 officers and directors often rely entirely on the company to file their Forms 3, 4, and 5. Several of the officers and directors in this SEC enforcement action were no exception – they represented that their delinquent filings resulted from the failure of the company to make timely filings on their behalf. This did not excuse the officers and directors. The SEC determined that insiders retain legal responsibility for compliance with the filings requirements, including the obligation to assure that the filing is timely and accurately made.

The SEC also did not find persuasive one CEO/Chairman of the Board's explanation that the company properly disclosed in its annual proxy statements the reasons for the late filings, which included "lack of staffing." The SEC found that the CEO/Chairman of the Board took inadequate and ineffective steps to monitor whether timely and accurate filings were made on his behalf.

In the apparently most unintentional case of all, the Chief Accounting Officer of a multinational corporation was not informed that he had Section 16 filing requirements. As a result, he filed neither an initial Form 3 nor subsequent Form 4s or Form 5s. The SEC found that the Chief Accounting Officer's reliance on the company did not excuse his violations because he served in a position specifically designated in the definition of "officer" under Exchange Act Rule 16a-1(f) and an insider retains legal responsibility for compliance with the filing requirements. The company was pursued in a separate enforcement action. The exact method for determining who the Section 16 officers are may vary somewhat from issuer to issuer – often the CEO and board of directors receive input from legal counsel on the topic, and the final determination of who is a Section 16 officer is formalized in a board resolution – but rarely does each individual officer determine for him or herself whether he or she is a Section 16 officer and then commence filing Section 16 forms if he or she decides in the affirmative. Unfortunately for this particular chief accounting officer, "principal accounting officer" is specifically listed in the applicable rule as a Section 16 officer, making this a straightforward situation for the SEC.

Each action accentuates from varying angles the message from Andrew J. Ceresney, Director of the SEC's Division of Enforcement, that "inadvertence is no defense to filing violations."

Public Companies

Issuers that voluntarily accept certain responsibilities (such as filing Section 16 forms for its insiders) and then act negligently in the performance of those tasks may be liable as a cause of Section 16(a) violations by insiders. This pertains to almost every issuer, as virtually every issuer assists officers and directors with their filings. The SEC found companies to be the cause of Section 16(a) violations by their insiders as a result of the companies' negligence in filing the Section 16(a) reports on the insiders' behalf.

In addition, reporting issuers are required to disclose in the proxy statement for the issuer's annual meeting, or in its annual report, any Section 16 reporting delinquencies by its insiders. In preparing the disclosure, issuers are required to review the Section 16 forms filed and identify by name each insider who failed to file on a timely basis and set forth the number of late reports and the number of transactions that were not reported on a timely basis. Most of the issuers subject to these sanctions inaccurately stated that all Section 16 reports were filed on a timely basis during the year. One issuer reported delinquencies, but the SEC did not find its reasons for the delays compelling.

Significant Beneficial Owners

The actions against significant beneficial holders detail various violations of Schedule 13D and Schedule 13G filings, Form 3, 4, and 5 filings, and amendments to those filings. One individual represented that his delinquent filings resulted from the failure of the company's outside counsel and company personnel to correctly advise him of his obligations and to make timely filings on his behalf. However, the SEC found that the beneficial owner did not offer adequate evidence of the scope of the engagements of counsel, the factual circumstances upon which counsels' advice was predicated, or that he and company personnel fully complied with such advice. In addition, the SEC stated "reliance on [company] personnel and consultation with counsel does not excuse his violations because an insider retains responsibility for compliance with the filing requirements."

* * *

This mass enforcement action is consistent with ongoing efforts at the SEC to: (1) improve its big data analysis tools (which it refers to as "force multipliers"), and (2) apply its "broken windows" policy. The "broken windows" policy is the policing theory that no infraction is too small to be uncovered and punished because targeting low-level crimes helps prevent more serious crime. In the context of policing, an example of a "broken window" crime is selling loose, untaxed cigarettes in Staten Island. In the context of securities laws policing, filing a Form 4 late may be considered a lesser "broken window" offense, but the SEC does not view the offense as a harmless or victimless offense. It typically takes the position that every violation is serious – as Michele Wein Layne, Director of the SEC's Los Angeles Regional Office commented on the case of the biotech company and its former CEO, "It's not merely a technical lapse when executives fail to report their transactions in company stock, because investors are consequently denied important and timely information about how an insider is potentially viewing the company's future prospects."

Another interesting aspect of this enforcement action to consider is the relationship between the "broken windows" enforcement approach and the SEC's efforts to encourage people to self-report violations. Where self-reported violations are serious, self-reporting typically doesn't avoid an enforcement action, but may reduce the sanction. What about a violation that isn't serious? Will a company that self-reports to the SEC it inaccurately stated in three proxy statements that all Section 16 reports were filed on a timely basis during the year avoid a proceeding altogether? The SEC may stand firm that every violation is serious and no offense will escape sanctions for self-reporting. Or, we may see it take another approach and spare such self-reporters completely from any proceeding.

One focus of the SEC's "broken windows" policy is corporate insiders. This action and recent insider trading cases highlight the SEC's concerns about insider compliance. Violation of corporate insider filing requirements is a comparatively easy violation to prove, and requires minimal SEC staff resources to enforce. In contrast, there are a myriad of ways to violate these same laws, but conducting enforcement actions on other possible violations necessitate more resources and have a higher risk of defeat – here is one example of a recent civil action on another way to violate Section 16(a): the SEC unsuccessfully argued that an employee's duties qualified him as a de facto officer under Exchange Act Rule 16a-1 and he should have been disclosed as such by the company and filing Section 16 forms. (The employee was not in a straightforward Section 16 officer position like principal accounting officer.)

Companies are accustomed to being vigilant against private actions alleging Section 16(b) short swing profit violations. Only the SEC enforces Section 16(a) reporting requirements, and until now, it has not been nearly as proactive on Section 16(a) as the plaintiffs' bar is pursuing Section 16(b). As part of any Section 16 compliance policies and procedures, issuers should prepare for a future of more active enforcement of Section 16(a) and confirm the integrity of their Section 16(a) filing and reporting processes. Similarly, significant beneficial owners should also review (and if appropriate, enhance) their reporting controls.

As long as the SEC's possesses and improves its data analytics programs and follows a "broken windows" policy, crackdowns on readily provable violations may become regular and frequent occurrences. One day after announcing the charges against the delinquent filers, the SEC moved further in this direction by announcing the creation of the Office of Risk Assessment, which is expected to coordinate efforts to provide data-driven risk assessment tools and models to support a wide range of SEC activities. The office will develop and use predictive analytics to support supervisory, surveillance, and investigative programs involving corporate issuers, broker-dealers, investment advisers, exchanges, and trading platforms. It is another step in the SEC's concerted effort to strengthen its big data tools and expand the SEC's reach to create, in the words of Chair Mary Jo White, "a presence that exceeds our physical footprint and to be felt and feared in more areas than market participants would normally expect that our resources would allow."