Saturday, March 7, 2015
There’s been a lot of controversy recently over the SEC’s use – or perhaps I should say, non-use – of the automatic “bad actor” disqualifications for firms that commit securities violations. The disqualification provisions place certain limits on the activities of firms that are found to have committed securities violations. Dodd Frank added a big stick to the list of penalties: It added an automatic disqualification from participating in private placements under Rule 506 of Regulation D. It’s a severe penalty; private placements are extremely lucrative.
But the SEC can waive the automatic disqualification – and frequently does, even for “recidivist” firms that repeatedly rack up securities violations. It imposes fines, perhaps outside monitoring, but it waives disqualifications – especially the Rule 506 disqualification.
The issue has recently hit the public eye because Democratic Commissioners Luis Aguilar and Kara Stein have been objecting to the grant of waivers to recidivist firms. In their view, waivers are an important tool for deterring securities violations, and the SEC has improperly adopted a policy of granting them “reflexively.”
In light of all of this, the SEC has promised to issue guidelines as to how Rule 506 waiver decisions are made; Commissioner Daniel Gallagher thinks the matter may ultimately have to be resolved by Congress.
Until recently, hasn’t been clear just how often these waivers have been granted, and who has received them. But Urska Velikonja just posted a new paper that gathered data on 201 waivers issued between 2003 and 2014. These waivers involved Regulation D disqualification, Regulation A disqualification, and also disqualification from the use of automatic shelf registration statements to raise capital. Velikonja finds that: (1) large financial firms received over 80% of the waivers; smaller firms and nonfinancial firms rarely receive them even though they are much more likely to be the target of an enforcement action; (2) the SEC typically does not offer any real justifications for its decision to grant or withhold a waiver, but the pattern appears to be that the Commission does not grant waivers for firms accused of offering fraud or issuer disclosure violations; usually, they’re granted for firms accused of unrelated misconduct, such as violations of the broker-dealer and investment adviser rules – presumably because the Commission views the latter firms as presenting a lower recidivism risk; and (3) the number of waivers has declined over time, and the SEC has recently begun utilizing partial waivers.
(More under the jump)
As Velikonja points out, the real question in all of this is what are the purposes of disqualification in the first place. If it exists specifically to protect investors from offering fraud by ensuring that bad actors’ offerings are more heavily policed, then the next question is whether unrelated securities violations correlate with future offering fraud – if they are, in other words, warning signals of a fraud waiting to happen. Commissioner Stein clearly thinks so; as she colorfully put it, “If you manipulate Libor, enable offshore tax evasion or launder drug money, should we wait for you to defraud a pension fund before barring you from raising money outside of strict commission oversight?”
On the other hand, if the disqualification provisions exist to prevent future offering frauds, and if unrelated securities violations are weak predictors of offering fraud, then it makes sense to grant waivers. It also makes sense that firms receiving such waivers would be larger, because that’s when it’s more likely that misconduct could be limited to a particular segment of the firm, unrelated to offerings.
Alternatively, we might view disqualification as simply a type of sanction to deter securities violations of all types, in which case, once again, it makes no sense to grant waivers freely, especially to recidivist firms.
Ultimately, that’s what the dispute comes down to – the purpose of the disqualification provisions, how we gauge the likelihood of offering fraud, and perhaps whether the SEC has other weapons in its arsenal that have as great a potential to scare firms straight. And right now, we simply don’t know what the fraud predictors are, which is why Velikonja recommends that the SEC empirically investigate that question.