August 07, 2019
On July 3, 2019, Chairman Jay Clayton of the Securities and Exchange Commission (SEC) issued a Statement Regarding Offers of Settlement (the “Public Statement”) to announce a significant shift in the SEC’s process of considering requests to waive collateral consequences in connection with settlement offers. Chairman Clayton stated that he recognized “that a segregated process for considering contemporaneous settlement offers and waiver requests may not produce the best outcome for investors in all circumstances,” and thus announced, “that a settling entity can request that the Commission consider an offer of settlement that simultaneously addresses both the underlying enforcement action and any related collateral disqualifications.”
This significant announcement comes nearly a month-to-the-day after Representative Maxine Waters (D-CA), Chair of the U.S. House of Representatives Committee on Financial Services, distributed a discussion draft of a bill entitled, the Bad Actor Disqualification Act of 2019 (the “Draft Bill”). Rather than streamline the waiver process, as Chairman Clayton has now done, the Draft Bill proposes to, create new procedures for the U.S. Securities and Exchange Commission (the “SEC” or “Commission”) to follow in connection with its consideration of waivers to automatic disqualifications under federal securities laws. Indeed, it would create numerous additional hurdles, including a notice and comment process that would potentially take certain waiver decisions outside of the hands of decision-makers at the SEC. Indeed, while only a discussion draft, which faces numerous hurdles before it could become law, the passage of such a bill would impose significant challenges on the ability for companies—and financial institutions in particular—to settle actions with the SEC given the uncertainty it would inject into the waiver process.
For now, in light of Chairman Clayton’s announcement, companies should be pleased that the law’s application appears to be moving in a better direction—toward a more reliable and predictable process. But companies would still do well to pay close attention to Chairwoman Walters’ pronouncements, as momentum on Capitol Hill could quickly swing things in a different direction.
Chairman Clayton’s Public Statement outlined his views regarding the factors affecting settlement negotiations where such negotiations are accompanied by contemporaneous requests for Commission waivers from automatic statutory disqualifications. Chairman Clayton announced that going forward; an offer of settlement that includes a waiver request negotiated with all relevant agency divisions (e.g., Enforcement, Corporation Finance and Investment Management) would be presented to, and considered by, the Commission as a single staff recommendation. In other words, companies will now be able to make offers of settlement in proposed enforcement actions contingent on the Commission’s approval of a waiver application. This is a significant change from prior practice where settlement offers were reviewed and considered separately from waiver requests, meaning that companies were often uncertain whether a waiver would be granted before making a decision on whether to settle an enforcement action. Although Chairman Clayton’s Public Statement indicated that the Commission’s consideration of a waiver will continue to rely on the analysis of the policy divisions (the Staff of the Divisions of Corporation Finance and Investment Management, as the case may be) regarding the appropriateness of a waiver in a particular matter, it remains to be seen whether this change will affect how the SEC considers waiver requests. Nonetheless, from a procedural perspective, this is unquestionably a welcome change, affording a more fair and reliable process for settling defendants without any apparent downside for investors or the markets.
By contrast to the Clayton announcement (which is now the operating procedure for the SEC), the overall impact of the Draft Bill would be to create a process for the consideration of waivers that is separated from decisions in pending enforcement actions, which would mean settling firms would have far less assurance as to the true impact of a settlement offer before making a final decision. Indeed, the proposed procedure is akin to the SEC rulemaking process, with notice, the ability for public comment and an open meeting to consider the merits of a waiver request. The specific changes contemplated in the draft include:
The proposed complexity of the process tracks with the view of Chairwoman Waters and some prior SEC commissioners that the SEC staff and the Commission too freely grant waivers to demonstrable “bad actors.”
While we note that the proposed legislation faces a difficult road in the U.S. House of Representatives, even as currently constituted, and opposition in the Senate, the Draft Bill still presents serious concerns for companies and financial services firms in particular and highlights the current divide between Chairwoman Walters and Chairman Clayton.
Primarily, the legislation would create a chilling effect on the negotiation and resolution of enforcement matters with the Commission and other law enforcement authorities, including the Department of Justice, leading to an increase in cases resolved through litigation, exactly when Chairman Clayton is aiming to do the opposite. Without certainty as to the collateral consequences that would result from a settlement and faced with the possibility of a long, protracted and public waiver process many companies and financial services would necessarily choose to litigate any matter that could result in disqualification.
Further, the Draft Bill advances an erroneous argument that disqualifications are, themselves, an enforcement tool, serving as an additional penalty for certain securities law violations and other specified matters. Various SEC commissioners have appropriately challenged this view over time. For example, in a 2015 speech, then– SEC Chair Mary Jo White stated that “waivers were never intended to be, and we should not use them as, an additional enforcement tool designed to address misconduct or as an unjustified mechanism for deterring misconduct.” Then-Commissioner Daniel M. Gallagher similarly stated in a 2015 speech that “automatic disqualification provisions were never meant to be an additional weapon in the Commission’s enforcement arsenal. Over the years, Congress and the Commission have had a number of opportunities to recast automatic disqualifications as sanctions . . . but have declined to do so.” But the Draft Bill’s contemplated waiver processes would undoubtedly operate as a significant additional sanction.
Even though Chairman Clayton’s recent announcement ushers in a much-needed change to the waiver process at the SEC, as the political process takes shape around the Draft Bill, companies and financial services firms, in particular, will want to pay close attention. Even with an uncertain legislative path forward, draft legislation like this one perpetuates misconceptions of the role of statutory disqualifications in the securities laws and can lay the groundwork for future efforts to change the disqualification waiver process, even if such bills never become law.
Federal securities laws contain a number of direct enforcement tools that the SEC can use to resolve enforcement issues, punish “bad actors” and deter future occurrences of such actions in the future. These remedies include cease-and-desist orders, fines and disgorgement, suspension and disbarment from the securities industry. In addition to agency sanctions, the U.S. Department of Justice can prosecute violations of the federal securities laws in tandem with regulatory enforcement actions.
The resolution of an enforcement matter can activate collateral consequences for a company or its affiliates. Intentionally broad in scope and triggered automatically, these consequences take the form of bad-actor and ineligible-user disqualifications, eliminating a company’s ability to rely on, for example, streamlined public securities offering processes and critical private offering safe harbors, which can preclude affected companies from using some of the most cost-effective and efficient options for raising capital, and these disqualifications can also restrict financial services firms from advising companies in these capital raising activities.
The statutes and regulations that provide for disqualification often also grant regulators exemptive authority, allowing them to waive such collateral consequences pursuant to a defined standard. For the SEC, its exemptive authority generally allows it to grant waivers where (i) the exemption is necessary or appropriate in the public interest and (ii) is consistent with the protection of investors. Historically, the SEC staff was able to review and grant waivers pursuant to delegated authority, without Commission involvement, but, over the last few years, the Commission has increasingly “taken back” the delegation and acted on its own to grant (and reject) waivers.
The Commission principally grants waivers in the following six areas:
Well-Known Seasoned Issuer (WKSI)
Under Securities Act Rule 405, “ineligible issuers,” defined as issuers that have been subject to certain criminal or civil enforcement proceedings, are denied WKSI status and the associated benefits. A WKSI, among other things, is able to file a registration statement with the SEC that can be used to offer and sell securities without review by the SEC. Loss of WKSI status lasts three years from the date of the disqualification. The WKSI disqualification waiver application is negotiated with the Division of Corporation Finance and granted by order of the Commission.
Section 9 of the Investment Company Act of 1940 (the “1940 Act”)
Section 9(a) of the 1940 Act creates a disqualification for persons with certain convictions (including guilty pleas) and injunctions barring said person from certain roles (such as an underwriter, broker, dealer or investment adviser), prohibiting them and any affiliated person from serving as an investment adviser, depositor or principal underwriter of registered investment companies. The SEC may grant a waiver to the disqualification on a showing that applying the sanctions of Section 9(a) would be “unduly or disproportionately severe or that the conduct of such person has been such as not to make it against the public interest or protection of investors to grant such application.” The waiver application is negotiated with the Division of Investment Management and granted by order of the Commission.
PSLRA Safe Harbor for Forward-Looking Statements
Section 27A(c) of the Securities Act and Section 21E(c) of the Exchange Act provide safe harbors for certain forward-looking statements. Such safe harbor provisions are unavailable for any forward-looking statement that is “made with respect to the business or operations of the issuer if the issuer. . . during the three-year period preceding the date on which the statement was first made,” has been the subject of certain criminal or civil enforcement proceeding, including SEC administrative proceedings related to violations of the antifraud provisions of the federal securities laws. The waiver application is negotiated with the Division of Corporation Finance and granted by an order of the Commission.
Regulations A and D
Regulations A and D provide exemptions from registration requirements for certain private offerings, with the exemption under Rule 506 of Regulation D being widely relied upon by public and private companies and funds for raising capital. The disqualification provisions of Rule 262 of Regulation A and Rule 506(d) of Regulation D provide issuer disqualification if it, or a parent or indirect parent of the issuer has, within the past five years, been convicted of securities-related offenses or subject certain orders by a court, the Commission, or certain other federal or state regulators. Waivers may be granted by the Division of Corporation Finance, under its delegated authority.
Disqualification under Rule 506(d) of Regulation D can pose significant challenges to multi-disciplinary firms across a wide array of financial services and offerings. In many cases, such disqualifications preclude affected firms from entire business lines (e.g., engaging in or advising on private placement offerings, registering securities for offer or sale under an automatic shelf registration statement or filing post-effective amendments to register additional or new types of securities).
Regulation E provides an offering exemption for certain small business investment companies and business development companies. The exemption becomes unavailable if the issuer or an affiliate has (among other things) within five years been convicted of certain crimes or subject to certain Commission or court orders. It is also unavailable if a director, officer or a principal security holder of the issuer, or the investment adviser or underwriter of the securities to be offered, has been convicted of a securities-related crime within the past ten years or is subject to an ongoing injunction or SEC order. Regulation E waiver authority has not been delegated to Commission staff and, thus, may only, therefore, be granted by order of the Commission.
Rule 206(4)-3 of the Investment Advisers Act of 1940 (the “Advisers Act”)
Rule 206(4)-3 prohibits an investment adviser that is registered with or required to be registered with the Commission from “directly or indirectly” paying a cash fee to any solicitor that has been the subject of certain convictions or SEC orders, or has been found by the Commission to have engaged “. . . in any of the conduct” detailed in Section 203(e)(1), (5) and (6) of the Advisers Act. The SEC staff has adopted a policy permitting companies to rely on an existing no-action letter issued in 2003, commonly referred to as the Dougherty no-action letter, without having to submit a separate staff no-action request, so long as certain conditions are met.
 Jay Clayton, Chair, Sec. & Exchange Comm’n, Statement Regarding Offers of Settlement, (July 3, 2019).
 View the Discussion Draft.
 The release of the Draft Bill is the most recent of Chairwoman Waters’ efforts to modify the SEC’s waiver process. Representative Waters’ efforts to amend the SEC waiver process date back to 2015, where, as Ranking Member of the Financial Services Committee, she first unveiled draft reform legislation. Subsequent legislative efforts include the identical H.R. 3519, “the Bad Actor Disqualification Act of 2017,” and various letters to the SEC and the Department of Labor with respect to financial institutions with “a history of misconduct.” See Press Release, “Waters Introduces Legislation to Improve SEC Process for Holding Bad Actors Accountable,” July 27, 2017. None of these efforts resulted in a bill that moved out the Financial Services Committee.
 Jay Clayton, Chair, Sec. & Exchange Comm’n, Statement Regarding Offers of Settlement, (July 3, 2019).
 See Luis A. Aguilar and Kara M. Stein, Dissenting Statement in the Matter of Oppenheimer & Co., Inc., U.S. Sec. & Exchange Comm’n, (Feb. 4, 2015).
 Mary Jo White, Chair, Sec. & Exchange Comm’n, Understanding Disqualifications, Exemptions and Waivers Under the Federal Securities Laws, Remarks at the Corporate Counsel Institute, Georgetown University in Washington, D.C., (March 12, 2015).
 See Daniel M. Gallagher, Why is the SEC Wavering on Waivers? Remarks at the 37th Annual Conference on Securities Regulation and Business Law, (Feb. 13, 2015).
 See 15 U.S.C. § 78mm(a)(1).
 See 17 C.F.R. § 230.405 (definition of “ineligible issuer”).
 15 U.S.C. § 80a-9(a).
 15 U.S.C. § 80a-9(c).
 15 U.S.C. § 77z-2(b)(1)(A); Id. § 78u-5(b)(1)(A).
 17 C.F.R. § 230.262(a)(1)-(6); 17 C.F.R. § 230.506(d)(1)(i)-(vi). This time period is extended to 10 years for convictions of certain affiliated natural persons, such as directors, officers and underwriters.
 17 C.F.R. § 230.262(b)(3); 17 C.F.R. § 230.506(d)(2)(iii).
 7 C.F.R. § 230.602(b)(1)-(6).
 17 C.F.R. § 230.602(c)(1)-(3).
 Dougherty & Co. LLC, 2003 WL 22204509 (no-action letter) (SEC Div. of Inv. Mgmt. Mar. 21, 2003) (requiring Dougherty to comply with four conditions including maintaining compliant cash solicitation arrangements, having no bars or suspensions under extant Disqualifying Orders complying with the terms of all Disqualifying Orders, and disclosing the applicable Disqualifying Order to each solicited person in accordance with the terms of the no-action letter); see also EJF Capital, Inc., File. No. 801-65725 (no-action letter) (SEC Div. of Inv. Mgmt. Jan. 16, 2007) (relying upon Dougherty conditions and noting that Friedman is not able to avail himself of said provisions).