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Beware of SEC Requests to Include Non-Monetary Conditions When Settling Enforcement Matters

By Jessica Heim, Laurel S. Fensterstock, and W. Logan Lewis

To settle enforcement matters, the U.S. Securities and Exchange Commission (“SEC”) often seeks to require non-monetary conditions on top of civil monetary penalties from companies that have allegedly violated federal securities laws.

In fact, at the recent Annual Securities Regulation Institute, SEC senior staff reiterated the SEC Enforcement Division’s focus on incorporating non-monetary elements in corporate settlements.  Because these settlement terms, including imposition of an independent auditor or corporate monitor, are ultimately costly and burdensome, companies should be prepared to defend their ability to govern themselves and understand the true costs of such requirements when negotiating with the SEC.

At the 48th Annual Securities Regulation Institute hosted remotely by the Northwestern University Pritzker School of Law, Richard R. Best, Director of the SEC’s New York Regional Office, Division of Enforcement, Erin E. Schneider, Director of the SEC’s San Francisco Regional Office, Division of Enforcement, and Michael A. Conley, Solicitor of the SEC’s Office of the General Counsel, discussed the SEC’s belief that specifically tailored non-monetary remedies are necessary in some cases to more effectively address the behavior that the SEC is seeking to deter through its investigations and enforcement actions.

Ms. Schneider stated, “We have a responsibility to think through what the appropriate remedies are in every case.”  She continued, “Our guiding principles are: How can we protect investors moving forward?  How can we remedy the harm that has occurred?  How can we create a disincentive for other folks who might be inclined to engage in similar conduct?  How do we create a deterrent effect to make that sort of conduct not worth it?”  Mr. Best added, “Carefully designing non-monetary remedies help[s] us to achieve some of the outcomes that [Ms. Schneider] has just mentioned such as just protecting investors and overall deterrence.”

While the SEC may be focused on using its powers of injunction and equitable remedies to achieve its goals of deterrence and remediating harm, this approach is not new.  In October 2018, Steven Peikin, the SEC’s Co-Director of the Division of Enforcement at the time, stated that, “in most of our actions, non-monetary relief can be highly important to achieving the [SEC]’s overall goals as well.”[1]  Mr. Peikin identified detailed undertakings and conduct-based injunctions as “two of the most effective forms of equitable relief” that the SEC may impose to settle enforcement actions.[2]

And the SEC has a long history of taking advantage of its authority to seek equitable remedies, including cease-and-desist orders and injunctions.  We expect this to continue because Congress recently strengthened the SEC’s ability to seek equitable remedies through the 2021 National Defense Authorization Act (“NDAA”).[3]  The NDAA (1) explicitly authorizes the SEC to seek disgorgement for violations of federal securities laws; (2) removes existing restrictions requiring disgorgement awards to be “for the benefit of investors”; (3) extends the statute of limitations from five to ten years for disgorgement awards arising from fraud violations; (4) sets the statute of limitations for equitable remedies, including cease-and-desist orders and injunctions, at ten years; and (5) indefinitely tolls the statute of limitations while defendants remain outside the United States.[4]

Ms. Schneider and Mr. Best identified five cases settled since March 2018 that they claimed are representative of the SEC’s insistence on inflicting non-monetary obligations in addition to monetary penalties to achieve its purported goals of protecting investors and deterring misconduct in the future.  While these cases do include non-monetary relief as conditions of settlement, each also contains a monetary element—sometimes a significant one.

1. Theranos Inc. and CEO Elizabeth Holmes – March 2018

In March 2018, the SEC charged Theranos Inc. and its founder and CEO Elizabeth Holmes for allegedly raising more than $700 million from investors through an elaborate fraudulent scheme.[5]  Theranos and Ms. Holmes agreed to a settlement with the SEC, which included a civil penalty of $500,000.[6] 

In addition to agreeing to pay a civil penalty, Ms. Holmes also agreed, among other things, to relinquish her voting control of Theranos by converting her super-majority Theranos Class B Common shares to Class A Common shares.[7]  This meant that, due to Theranos’ liquidation preference, if Theranos is acquired or otherwise liquidated, Ms. Holmes would not profit from her ownership until over $750 million is returned to defrauded investors and other preferred shareholders.[8]  Ms. Schneider identified these aspects of the settlement as tailored remedies that addressed the SEC’s concerns in light of the SEC’s allegations against Ms. Holmes.

2. Tesla, Inc. and CEO Elon Musk – September 2018

In September 2018, the SEC charged Tesla, Inc.[9] and its CEO and Chairman Elon Musk[10] after Mr. Musk allegedly tweeted that he could take Tesla private at a premium.

According to the complaint against Mr. Musk, he had tweeted on August 7, 2018, that he could take Tesla private for $420 per share, that funding for the transaction had been secured, and that the only remaining uncertainty was a shareholder vote.[11]  The SEC alleged that Mr. Musk knew that the potential transaction was uncertain and subject to numerous contingencies.[12]  The SEC further alleged that (1) Mr. Musk had not discussed specific deal terms, including price, with any potential financing partners, (2) his statements about the possible transaction lacked an adequate basis in fact,[13] and (3) his misleading tweets caused Tesla’s stock price to jump by over six percent on August 7, 2018, leading to significant market disruption.[14]

According to the SEC’s complaint against Tesla, despite notifying the market in 2013 that it intended to use Mr. Musk’s Twitter account as a means of announcing material information about Tesla and encouraging investors to review Mr. Musk’s tweets, Tesla had no disclosure controls or procedures in place to determine whether Mr. Musk’s tweets contained information required to be disclosed in Tesla’s SEC filings pursuant to the federal securities laws.[15]  Nor did it have sufficient processes in place to confirm that Mr. Musk’s tweets were accurate or complete.[16] 

To settle the charges against them, Tesla and Mr. Musk, without admitting or denying the SEC’s allegations, and in addition to each paying a $20 million civil penalty, agreed that:

  • Musk would step down as Tesla’s Chairman, would be replaced by an independent Chairman, and would be ineligible to be re-elected Chairman of Tesla for three years;
  • Tesla would appoint two new independent directors to its board of directors; and
  • Tesla would establish a new committee of independent directors who would put in place additional controls and procedures to oversee Mr. Musk’s communications.[17]

Ms. Schneider, who conducted this investigation, pointed to these internal control and corporate governance changes as examples of tailored remedies that were appropriate under the circumstances to prevent future harm to Tesla’s shareholders.

3. KPMG LLP – June 2019

In June 2019, the SEC brought a settled action against KPMG LLP for: (1) altering past audit work after receiving stolen information about inspections of the firm that would be conducted by the Public Company Accounting Oversight Board and (2) engaging in widespread cheating among audit professionals on internal training exams by improperly sharing answers and manipulating test results.[18] 

KPMG agreed to settle the charges by paying a $50 million penalty and complying with a detailed set of undertakings, including retaining an independent consultant to review and assess the firm’s ethics and integrity controls and its compliance with various undertakings.[19]  Moreover, KPMG agreed to undertake to identify audit professionals who violated ethics and integrity requirements in connection with training examinations within the past three years.[20] 

Mr. Best pointed to the level of specificity of the undertakings in the settlement as critical in assuring the SEC that investors would be adequately protected and that KPMG would comply with applicable laws in the future.

4. Options Clearing Corporation – September 2019

In September 2019, the SEC brought a settled action against the Options Clearing Corporation (“OCC”) for failing to establish and enforce policies and procedures relating to financial risk management, operational requirements, and information systems security.[21]  As the United States’ sole registered clearing agency for exchange-listed option contracts on equities, OCC was designated in 2012 as a “systemically important financial market utility.”[22]  That designation makes OCC subject to enhanced regulation and transparency regarding its risk management systems because disruption to OCC’s operations might be costly not only for itself and its members, but other market participants or the broader financial system.[23]  Without admitting or denying the SEC’s charges, OCC agreed to pay a $15 million monetary penalty to settle the charges.[24]

OCC also agreed to hire an independent compliance auditor to assess its remediation of the alleged violations and subsequent compliance efforts.[25]  OCC agreed that the auditor would report directly to SEC staff and would conduct two reviews, one audit, one assessment, and prepare four reports as detailed by the SEC settlement order.[26] 

Mr. Best identified the appointment of an auditor along with the specific, detailed undertakings set forth in the SEC settlement order as an example of how a multifaceted non-monetary remedy can be tailored to address the SEC’s concerns.

5. VALIC Financial Advisors Inc. – July 2020

In July 2020, the SEC brought a settled action against VALIC Financial Advisors Inc. (“VFA”) after the SEC allegedly found that VFA failed to disclose that its parent company paid a for-profit entity owned by Florida K-12 teachers’ unions to promote VFA’s and its parent company’s services to teachers.[27]  To settle this matter, and without admitting or denying this allegation, VFA consented to a cease-and-desist order, a censure, and a civil penalty of $20 million.[28] 

Additionally, VFA agreed to set advisory fees for all Florida K-12 teachers who participate in its advisory product in Florida’s 403(b) and 457(b) retirement programs, or who currently or may within the next five years own certain other VFA products, at its most favorable rates in the Florida K-12 market.[29]

Ms. Schneider, who supervised this investigation, pointed to this arrangement, whereby VFA ensured that those who had been allegedly harmed by its previous actions would receive its most favorable rates going forward, as a remedy tailored to achieve the SEC’s goals and to protect harmed investors.

What This Means for You

In each case discussed above, the SEC imposed a significant monetary penalty in addition to non-monetary obligations on the settling parties.  The non-monetary aspects of these settlements did not replace monetary penalties.  Instead, by requiring undertakings and other injunctive relief as conditions to settlements, the SEC is in some cases creating even more burdensome obligations for companies that are trying to come to terms with the SEC.  Some non-monetary settlement terms may also prove especially expensive in the long run.  For instance, having a corporate monitor or independent auditor appointed creates the potential for more investigations, and more reporting to the SEC, about issues that may not have been within the scope of the SEC’s initial case — all at the expense of the company.

Bottom line: The SEC’s purported commitment to tailored, creative non-monetary relief can in some cases do companies more harm than good.  To persuade the SEC that such conditions are unnecessary to settle an action, companies should ensure that they have robust compliance programs and sufficient internal controls in place to assure the SEC that they are capable of adequately governing themselves without the need of additional burdensome oversight measures.

[1] Steven Peikin, Co-Director, SEC Div. of Enf’t, Remedies and Relief in SEC Enforcement Actions, at Practising Law Institute’s White Collar Crime 2018: Prosecutors and Regulators Speak Program (Oct. 3, 2018).  The speech is available at https://www.sec.gov/news/speech/speech-peikin-100318.

[2] Id.

[3] William M. (Mac) Thornberry National Defense Authorization Act for Fiscal Year 2021, H.R. 6395, Pub. L. No 116-283 (2021).  The act is available at https://www.congress.gov/bill/116th-congress/house-bill/6395.

[4] Id.

[5] Complaint, SEC v. Holmes, No. 5:18-cv-01602 (N.D. Cal. Mar. 14, 2018), ECF No. 1.  The complaint is available at https://www.sec.gov/litigation/complaints/2018/comp-pr2018-41-theranos-holmes.pdf.

[6] Press Release, U.S. Secs. & Exchange Comm’n, Theranos, CEO Holmes, and Former President Balwani Charged With Massive Fraud, (Mar. 14, 2018), https://www.sec.gov/news/press-release/2018-41.

[7] Id.

[8] Id.

[9] Complaint, SEC v. Tesla, Inc., No. 1:18-cv-8947 (S.D.N.Y. Sept. 29, 2018), https://www.sec.gov/litigation/complaints/2018/comp-pr2018-226.pdf.

[10] Complaint, SEC v. Musk, No. 1:18-cv-8865 (S.D.N.Y. Sept. 27, 2018), https://www.sec.gov/litigation/complaints/2018/comp-pr2018-219.pdf.

[11] Id. at ¶ 2.

[12] Id. at ¶ 3.

[13] Id.

[14] Id. at ¶ 4.

[15] Supra note 9 at ¶¶ 2-3.

[16] Id. at ¶ 3.

[17] Press Release, U.S. Secs. & Exchange Comm’n, Elon Musk Settles SEC Fraud Charges; Tesla Charged With and Resolves Securities Law Charge, (Sept. 29, 2018),https://www.sec.gov/news/press-release/2018-226.

[18] In re KPMG LLP, SEC Release No. 34-86118 (Jun. 17, 2019),https://www.sec.gov/litigation/admin/2019/34-86118.pdf.

[19] Id. at ¶¶ 65-82.

[20] Id. at ¶ 69.

[21] In re Options Clearing Corp., SEC Release No. 34-86871 (Sept. 4, 2019),https://www.sec.gov/litigation/admin/2019/34-86871.pdf.

[22] Id. at ¶ 2.

[23] Id.

[24] Id. at 22.

[25] Id. at ¶ 62.

[26] Id. at ¶ 64.

[27] In re VALIC Financial Advisors, Inc., SEC Release No. 34-89405 (Jul. 28, 2020), https://www.sec.gov/litigation/admin/2020/34-89405.pdf.

[28] Id. at 7.

[29] Id. at ¶ 19.

This information is provided by Vinson & Elkins LLP for educational and informational purposes only and is not intended, nor should it be construed, as legal advice.