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On November 29, the Supreme Court heard oral argument in the SEC’s request to appeal the 5th Circuit’s decision in Securities and Exchange Commission v. Jarkesy. As previously covered by InfoBytes, the 5th Circuit held that the SEC’s in-house adjudication of a petitioners’ case violated their Seventh Amendment right to a jury trial and relied on unconstitutionally delegated legislative power. At oral argument, Justice Kavanaugh stated in his questioning of Principal Deputy Solicitor General Brian Fletcher (representing the SEC) that given the severity of the potential outcome of cases, the SEC’s decision-making process fully being carried out in-house could be “problematic,” and that it “doesn’t seem like a neutral process.” Meanwhile, Fletcher mentioned that the boundaries and “outer edges” of the public rights doctrine can be “fuzzy.” Justices’ questions also centered around Atlas Roofing v. Occupational Safety and Health Review Commission—a Supreme Court case that held that “Congress does not violate the Seventh Amendment when it authorizes an agency to impose civil penalties in administrative proceedings to enforce a federal statute.”
On August 29, the D.C. Circuit overturned the SEC’s denial of a company’s application to convert its bitcoin trust into an exchange-traded fund (ETF). In October 2021, the company applied to convert its bitcoin trust to an ETF pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 (Exchange Act) and Rule 19b-4 thereunder, a proposed rule change to list and trade shares. In June 2022, the SEC denied the company’s application on the basis that the burden under the Exchange Act and the SEC’s Rules of Practice, which requires among other things, that the rules of national securities exchange be “designed to prevent fraudulent and manipulative acts and practices” and “to protect investors and the public interest.”
The company promptly appealed, alleging that the SEC “acted arbitrarily and capriciously by denying the listing of [the company]’s proposed bitcoin ET[F] and approving the listing of materially similar bitcoin futures ET[F]s”. The three-judge panel held that the SEC “failed to provide the necessary “reasonable and coherent explanation” for its inconsistent treatment of similar products” and “in the absence of a coherent explanation, this unlike regulatory treatment of like products is unlawful.”
This decision does not mean that the SEC must approve the company’s application. However, the SEC must review the application again.
SEC files brief in its Supreme Court appeal to reverse 5th Circuit ruling against use of adjudication powers and ALJs
On August 28, the SEC filed a brief in its appeal to the U.S. Supreme Court to reverse the decision of the U.S. Court of Appeals for the Fifth Circuit’s 2022 ruling that the commission’s in-house adjudication is unconstitutional. As previously covered by InfoBytes, the 5th Circuit held that the SEC’s in-house adjudication of a petitioners’ case violated their Seventh Amendment right to a jury trial and relied on unconstitutionally delegated legislative power. The brief argues that securities laws are “distinct from common law because they authorize the government to seek civil penalties even if no private person has yet suffered harm from the defendant’s violation (and therefore no person could obtain damages).” Moreover, the SEC argues that the Court has continually upheld the right of an agency to decide whether to enter an enforcement action through the civil or criminal process. The SEC referenced the 1985 Heckler v. Chaney case, which set the precedent that there is no constitutional difference between the power to decide whether to pursue an enforcement action and where to pursue an enforcement action, as they are both executive powers, supporting the claim that there is “a long and unbroken line of decisions that have relied on the public-rights doctrine in upholding such statutory schemes against Article III and Seventh Amendment challenges.” The SEC also reminded the Court that when it enforces securities laws through an administrative enforcement proceeding with a result that is not in favor of the respondent, the respondent may obtain a judicial review through the court of appeals. Finally, the commission contends that the 5th Circuit erred when it held that statutory removal restrictions for ALJs are unconstitutional, and that Congress has “acted permissibly in requiring agencies to establish cause for their removal of ALJs.”
On July 26, the SEC issued proposed rules under the Securities Exchange Act of 1924 and the Investment Advisors Act of 1940 to address certain conflicts of interest associated with the use of predictive data analytics, including artificial intelligence (AI) and similar technologies, “that optimize for, predict, guide, forecast, or direct investment-related behaviors or outcomes.” The SEC explained that broker-dealers and investment advisors (collectively, “firms”) are increasingly using AI to improve efficiency and returns but cautioned that, due to the scalability of these technologies and the potential for firms to quickly reach a large audience, any resulting conflicts of interest could result in harm to investors that is more pronounced and on a broader scale than previously possible.
Based on existing legal standards, the proposed rules generally would require a firm to identify and eliminate, or neutralize, the effects of conflicts of interest that result in the firm’s (or associated persons) interests being placed ahead of investors’ interests. Firms, however, would be permitted to employ tools that they believe would address such risks and that are specific to the particular technology being used. Firms that use covered technology for investor interactions would also be required to have written policies and procedures in place to ensure compliance with the proposed rules, the SEC said. These policies and procedures must include a process for evaluating the use of covered technology in investor interactions and addressing any conflicts of interest that may arise. Firms must also maintain books and records related to these requirements. Comments on the proposed rules are due 60 days after publication in the Federal Register.
On April 28, the SEC settled with a cryptocurrency ATM operator for allegedly selling unregistered tokens in order to raise money to expand its bitcoin ATM network. Described as a “token sale,” the SEC claimed the respondents in total raised crypto assets during an initial coin offering valued at roughly $3.65 million. According to the SEC, the company offered and sold its token as investment contracts, which qualified it as a security since investors would have reasonably expected to obtain future profits from the token’s rise in value based upon the respondents’ efforts. By offering and selling securities without having on file a registration statement with the SEC or qualifying for an exemption, the respondents violated Sections 5(a) and 5(c) of the Securities Act, the SEC said. Additionally, one of the respondents and its CEO were also accused of violating Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 by making materially false and misleading statements and engaging in other fraudulent conduct connected to the offer and sale of the token. The respondents neither admitted nor denied the SEC’s findings, but agreed to pay a collective $3.92 million civil penalty and said they would cease and desist from committing violations of the Securities Act and the Securities Exchange Act. One of the individual respondents also received a three-year officer and director ban.
District Court orders fintech to pay $2.8 million to settle claims of price manipulation of crypto-assets security
On April 20, the U.S. District Court for the Southern District of New York entered a final judgment in which a fintech company and its former CEO (collectively, “defendants”) have agreed to pay the SEC more than $2.8 million to settle allegations that they manipulated the price of their crypto-assets security. The SEC filed charges against the defendants last September for “perpetrating a scheme to manipulate the trading volume and price” of their digital token, and for effectuating the unregistered offering and sale of such token. The complaint also contended that the defendants hired a third party to create the false appearance of robust market activity for the token and inflated the token’s price in order to generate profits for the defendants. According to the SEC, the defendants allegedly earned more than $2 million as a result. The SEC charged the defendants with violating several provisions of the Securities Act of 1934 and Rule 10b-5, as well as certain sections of the Exchange Act. At the time the charges were filed, the third party’s CEO consented to a judgment (without admitting or denying the allegations), which permanently enjoined him from participating in future securities offerings and required him to pay disgorgement and prejudgment interest.
The defendants, while neither admitting nor denying the allegations, consented to the terms of the April final judgment. The company agreed to pay nearly $2.8 million, including more than $1.5 million in disgorgement of net profits, a civil penalty of more than $1 million, and roughly $240,000 in prejudgment interest. The former CEO agreed to pay more than $260,000, representing disgorgement, prejudgment interest, and a civil penalty. Both defendants are permanently enjoined from engaging in future securities law violations, and are restricted in their ability to engage in any offering of crypto asset securities.
On April 14, the SEC reopened the comment period on proposed amendments to the statutory definition of “exchange” under Exchange Act rule 3b-16, which now includes systems that facilitate the trading of crypto asset securities. (See also SEC fact sheet here.) The comment period was reopened in response to feedback requesting information about how existing rules and the proposed amendments would apply to systems that trade crypto asset securities and meet the proposed definition of an exchange, or to trading systems that use distributed ledger or blockchain technology, including such systems characterized as decentralized finance (DeFi). The SEC also provided supplement information and economic analysis for systems that would now fall under the new, proposed definition of exchange. The reopened comment period allows an opportunity for interested persons to analyze and comment on the proposed amendments in light of the supplemental information. Comments are due 30 days after publication in the Federal Register.
“[G]iven how crypto trading platforms operate, many of them currently are exchanges, regardless of the reopening release we’re considering today,” SEC Chair Gary Gensler said. “These platforms match orders of multiple buyers and sellers of crypto securities using established, non-discretionary methods. That’s the definition of an exchange—and today, most crypto trading platforms meet it. That’s the case regardless of whether they call themselves centralized or decentralized.” He added that crypto-market investors must receive the same protections that the securities laws afford to all other markets. Commissioners Mark T. Uyeda and Hester M. Peirce voted against reopening the comment period. Uyeda cautioned against expanding the definition of an “exchange” in an “ambiguous manner,” saying it could “suppress further beneficial innovation.” Peirce also dissented, arguing that the proposal stretches the statutory definition of an “exchange” beyond a reasonable reading in an attempt to “reach a poorly defined set of activities with no evidence that investors will benefit.”
On March 22, the SEC proposed amendments intended to “modernize” filing procedures through the use of electronic filings on EDGAR using structured data as appropriate. (See also SEC fact sheet here.) Currently, registrants must submit many forms required by the Securities Exchange Act, as well as other materials and submissions, in paper form. The proposed rule would require covered self-regulatory organizations (SROs) to submit these filings electronically, and would apply to national securities exchanges, national securities associations, clearing agencies, broker-dealers, security-based swap dealers, and major security-based swap participants. The proposed rule also would require SROs to make certain submissions in a structured, machine-readable data language, and would amend certain provisions regarding the Financial and Operational Combined Uniform Single Report to harmonize it with other rules, make technical corrections, and provide clarifications. Additionally, the announcement noted that the proposed rule would require, in certain circumstances, withdrawal of notices “filed in connection with an exception to counting certain dealing transactions toward determining whether a person is a security-based swap dealer.” Comments on the proposed rule will be accepted 30 days after publication in the Federal Register or until May 22, whichever is later.
On March 9, the SEC charged a South Carolina-based donor data management software company with allegedly making materially misleading disclosures about a 2020 ransomware attack. According to the SEC’s cease-and-desist order, the company issued statements that the ransomware attack did not affect donor bank account information or social security numbers. It was later revealed that the attacker had accessed and exfiltrated the unencrypted sensitive information. However, the SEC maintained that due to the company’s alleged failure to maintain disclosure controls and procedures, employees did not inform senior management responsible for public disclosures. As a result, the company’s quarterly report filed with the SEC allegedly omitted material information about the scope of the attack and “misleadingly characterized the risk of exfiltration of such sensitive donor information as hypothetical,” the SEC said. The company did not admit or deny the SEC’s findings, but agreed to pay a $3 million civil penalty and said it would cease and desist from committing violations of the Securities Act of 1933 and the Securities Exchange Act of 1934.
On March 6, the SEC announced that an Ireland-based global gaming and sports betting company, as successor-in-interest to a company it acquired in 2020 (the “acquired company”), agreed to pay a $4 million civil money penalty to settle claims that the acquired company violated the books and records and internal accounting controls provisions of the FCPA by using third-party consultants in Russia. According to the SEC’s order, the acquired company operated several gaming brands, including an online poker website. The SEC said that between May 26, 2015 and May 15, 2020, while the acquired company’s shares were registered with the SEC, it paid roughly $8.9 million to consultants in Russia in an effort to legalize poker in the country. During this time period, the SEC explained, the acquired company lacked sufficient internal accounting controls over its Russian operations with respect to third-party consultants, and failed to “consistently make and keep accurate books and records regarding its consultant payments in Russia.” Many of these third-party consultants, the SEC said, were “retained without adequate due diligence or written contracts, and paid without adequate proof of services.” The order indicated that certain payments were inaccurately recorded as lobbying fees, and that some payments went towards reimbursements for gifts given to individuals, including Russian government officials, and to a Russian state agency responsible for administering internet censorship filters. The SEC charged the Ireland company, as successor-in-interest to the acquired company, with violating Sections 13(b)(2)(A) and 13(b)(2)(B) of the Securities Exchange Act of 1934. The resolution requires the Ireland company, which neither admitted nor denied the allegations, to pay a $4 million civil money penalty. The SEC recognized the Ireland company’s cooperation and remedial efforts.