SEC’s Change in Focus: SEC Claims that Negligence is Sufficient to Establish Wrongdoing

The SEC is taking steps to make it easier to pursue investment firms and their executives. According to a September 30, 2011, Wall Street Journal article by Jean Eaglesham, Ken Lench, head of the SEC’s structured and new products enforcement unit, stated that investment firms and their executives may violate their duty of care to investors without intending to defraud them.

The SEC now considers negligence, rather than recklessness or intentional wrongdoing, sufficient to breach the duty of care and, consequently, an allegation of negligence is enough for them to contemplate a civil action.

Although this should not be viewed as big news – Rule 206(4)-8[1] (the anti-fraud rule applicable to pooled investment vehicles) of the Investment Advisers Act of 1940 (“Advisers Act”) was adopted in 2007 and indicated that the standard for enforcement was negligence – the focus appears to be actively shifting toward greater use of the negligence standard, which requires a lower burden-of-proof than recklessness or intentional wrongdoing.

This shift warrants the attention of investment firms, especially following the increase in the arsenal of enforcement weapons bestowed upon the SEC by the Dodd-Frank Act, which enables them to more efficiently gather information, in turn leading to more investigations, subpoenas and enforcement actions, and they can seek settlements or penalties with greater assertiveness.

The number of SEC enforcement actions rose to 735 in 2011 from 677 in 2010. Moreover, the number of actions against investment advisers and investment companies rose to 146 in 2011 from 112 in 2010 (up 30%), with only 76 such actions in 2009 – just under half the number brought in 2011.

The new focus will likely lead to more situations in which allegations of negligence result in a civil case. Accordingly, firms should become more vigilant in implementing and operating robust compliance programs. The trend toward increased personal liability for executives arguably began with the proceeding, alleging failure-to-supervise, that the SEC brought in September 2010 against Theodore Urban[2], the general counsel and head of compliance at broker-dealer Ferris Baker Watts Inc.

The SEC claimed that Mr. Urban ignored or failed to adequately follow up on numerous red flags in connection with the trading of various registered representatives. The administrative law judge found that although Mr. Urban “did not have any of the traditional powers associated with a person supervising brokers,” he nonetheless had supervisory authority because his “opinions on legal and compliance issues were viewed as authoritative and his recommendations were generally followed by people in [his firm’s] business units.”

Importantly, Mr. Urban was found to have acted reasonably under the facts and circumstances. Nonetheless, the matter was significant for its expansion of the SEC’s view on supervisory liability.

A June 2011 civil case alleging negligence against former GSC Capital Corp. executive Edward Steffelin[3] sheds light on the SEC’s focus. Allegedly, Mr. Steffelin led the team responsible for selecting the portfolio for Squared CDO 2007-1, a CDO structured and marketed by J.P. Morgan Securities LLC (which was separately charged by the SEC and agreed to pay $153.6 million to settle, without admitting or denying the allegations[4]). Investors lost most of their invested principal.

The SEC alleges that Mr. Steffelin allowed Magnetar Capital LLC, a hedge fund that purportedly stood to gain if the CDO defaulted, to help assemble the collateral and to have input into the term sheet and pitch book provided to investors. The SEC further alleges that Mr. Steffelin was seeking employment with Magnetar during the relevant period.

Typically, firms have broad discretion when such deals are structured, and disclosures are usually thorough. However, if the allegations are proven and disclosures were not made, then these omissions could arguably give rise to liability. Mr. Steffelin denies wrongdoing and is fighting the charges.

Mr. Lench stated, “Failure to check properly that investors are being provided with fair and accurate information could, under some circumstances, be a breach of that duty [of care], even if there’s no intent to defraud them.”

This, perhaps, is the most important piece of information to take away from the SEC’s statements regarding the change in focus – provided a firm and its personnel are diligent and they disclose their actions and conflicts of interest, there should be little need for concern over this trend. Certainly, they should be mindful that the level of wrongdoing that may lead to a civil action appears to have been lowered. Firms with robust corporate compliance programs should feel comfortable that they are acting responsibly and should not need to worry anew about falling afoul of the SEC’s new focus.

Rightly or wrongly, there is substantial anger among the public and lawmakers alike, and they want to see firms and individuals held accountable for bad actions. Criticism of the SEC is widespread following the Madoff case, and they may increasingly use negligence charges in their efforts toward “getting more bad actors” in what has become a highly politically charged atmosphere. However, is spending time and money pursuing alleged negligence a worthwhile use of the SEC’s increased-but-still-limited resources?

The SEC should pursue cases based on merit. The lower burden-of-proof required for negligence may lead not only to the initiation of additional cases against investment firms, but many such cases may be based upon feeble evidence. Moreover, because the penalties for negligence are less severe than those for recklessness or intentional misconduct, those accused of negligence may be less likely to undertake the time and expense required to fight the allegations, even when they have done nothing wrong. This would do little to protect the public.

How may this impact the industry? Well-managed firms with sound compliance programs should have little reason to fear the SEC’s new focus on negligence. This should apply to many SEC-registered advisers, which have long been required to have written compliance policies and procedures that are already subject to SEC examination.

Allegations of compliance violations, even from negligence, were previously sufficient to result in a deficiency letter or, if the SEC considered the violations significant enough, referral to its enforcement division and the potential for sanctions or other penalties.

“Simply avoiding Ponzi-style outright fraud is not enough to avoid enforcement action,” said Mr. Lench. Most investment firms act as responsible fiduciaries, and did not previously view the appropriate standard of conduct as merely avoiding Ponzi-style fraud.

Nevertheless, investment firms and executives would be wise to pay closer attention to the effectiveness of their compliance programs. What might have been perceived as “good enough” may no longer be sufficient to avoid SEC action. Firms should undertake any necessary steps to bolster their compliance policies and procedures (and compliance personnel if needed). The likelihood of SEC enforcement has increased appreciably.

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About the Author

Todd K. Warren practices in the Regulatory Defense and Compliance Group at Sadis & Goldberg LLP.  Mr. Warren counsels investment professionals in connection with regulatory matters, including compliance and registration issues with the SEC and state regulators as well as preparation of written compliance policies and procedures, and he organizes and structures investment advisers and broker dealers.

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