By Peter J. Henning
December 8, 2014 12:47 pm
A Bank of America settlement was held up because the S.E.C.’s commissioners could not agree on granting the bank a waiver from rules that could prevent it from selling certain investments.Credit Spencer Platt/Getty Images
The recidivism rate among companies caught violating securities laws can be a bit disheartening. Despite settlements that include corporate proclamations of a commitment to compliance, the same names seem to appear again and again in settlements for new violations.
The Securities and Exchange Commission has recently taken a small step toward making the cost of a violation a bit steeper by refusing to give companies a free pass.
The Securities and Exchange Commission has recently taken a small step toward making the cost of a violation a bit steeper by refusing to give companies a free pass.
In August, Bank of America reached a $16.65 billion settlement with the Justice Department over accusations that it duped investors into buying troubled residential mortgage-backed securities. As part of that settlement, the S.E.C. filed charges of securities fraud. That case was fairly small, requiring the bank to admit it engaged in fraudulent conduct and pay about $225 million for selling a security that resulted in heavy losses to investors.
But getting the settlement approved was held up until late last month because the S.E.C.’s commissioners could not agree on granting the bank a waiver from rules that could prevent it from selling certain investments. That would have had a significant effect on its Merrill Lynch subsidiary by cutting off access to certain types of hedge fund investments, a lucrative segment of the market that would probably cost it clients.
S.E.C. Rule 506 permits sales of an unlimited amount of securities to “accredited investors,” generally defined as those with the financial wherewithal to fend for themselves that do not need the protections provided by the disclosure requirements in the law. This avenue is used annually to sell hundreds of billions of dollars in investments to large investors, like hedge funds and pension plans, and is a significant avenue for raising capital.
In the Dodd-Frank Act, Congress directed the S.E.C. to write a “bad actor” rule. That rule doesn’t allow the exemption if the issuer of the securities or its underwriters was subject to a judicial or administrative order for engaging in fraud or similar types of violations, like failing to maintain adequate books and records. Adopted in 2013 as an amendment to Rule 506, it imposes a five-year ban on participating in securities offerings unless the firm can convince the S.E.C. that there is good cause “that it is not necessary under the circumstances.”
There is another “bad actor” rule important to large companies like Bank of America that routinely access the securities markets to raise capital. Under Rule 405, a “well-known seasoned issuer” does not have to submit its offering documents in advance for review by the S.E.C. before selling securities, allowing it to act quickly when market conditions are favorable. Like Rule 506, this provision cannot be used by a company subject to an order prohibiting violations of the anti-fraud provisions of the securities laws as part of a settlement. But it can be waived for “good cause.”
Those waivers had become routine after a settlement with the S.E.C. Some companies, in fact, received multiple waivers. But last April, Kara M. Stein, one of the five commissioners, dissented from the order granting a waiver to the Royal Bank of Scotland after one of its subsidiaries pleaded guilty to manipulating the London interbank offered rate, or Libor. In a statement, Ms. Stein warned that by routinely granting such waivers, the S.E.C. “may have enshrined a new policy — that some firms are just too big to bar.”
That warning came to haunt Bank of America when it sought a waiver from the bad actor exclusion under Rule 506 after its mortgage-backed security settlement. The bank was a victim of circumstances because Mary Jo White, the chairwoman of the S.E.C., had to recuse herself from the case because of her prior representation of Kenneth D. Lewis, the bank’s former chief executive.
Bloomberg reported that the four remaining commissioners were split 2 to 2 on whether to grant a waiver, with Ms. Stein’s fellow Democratic commissioner, Luis A. Aguilar, joining her in holding up approval of the settlement until the waiver issue could be resolved.
The settlement was finally approved right before Thanksgiving when Bank of America agreed to appoint an outside monitor “not unacceptable” to the S.E.C. to conduct a comprehensive review of its compliance with Rule 506 in exchange for a waiver of the bad actor ban. Importantly, the waiver is only good for 30 months, so Bank of America will have to come back to the S.E.C. to show there is good cause for a waiver of the rest of the five-year prohibition.
The order also does not grant a waiver from the ban in Rule 405 on bad actors using the well-known seasoned issuer exemption. Although it is likely that Bank of America will seek such a waiver in the future, for the moment, it will be a bit more difficult for the bank to quickly access the securities markets.
With settlements looming for big banks over their role in manipulation of foreign exchange rates, the question is whether the treatment of Bank of America will become the norm for obtaining waivers from the bad actor rules or whether the S.E.C. will revert to its earlier pattern of routinely granting those requests. The circumstances requiring Bank of America to work hard for a waiver were unusual because Ms. White’s withdrawal from the case led to the even split between the remaining commissioners. So it could be a one-time situation.
One issue that has divided the commission is whether to view the bad actor rules as another form of punishment for a violation, or as a remedy limited to violations that directly involve a company’s financial reporting. A Republican commissioner, Daniel M. Gallagher, issued a statement in April arguing that “the punishment-focused view” of waivers of the well-known seasoned issuer rule “is even more troubling” because the harm is inflicted on shareholders from the increased costs of issuing securities. “We must have a robust waiver program to appropriately distinguish between cases when disqualification is and is not justified,” he said.
In a speech on Dec. 4, Ms. Stein celebrated the aggressive approach taken with Bank of America, stating that “we should be flexible and nuanced in our approach to these waivers, so that we make the most of this powerful tool.” She described the Bank of America order as “a breakthrough in the commission’s method of handling waivers, and I hope to see more of this and other thoughtful approaches in the future.”
The terms of Bank of America’s waiver that require appointment of a monitor are not particularly onerous. But they are a change from the days when granting such requests was almost a matter of routine. No agency wants to be known as going soft on the companies it regulates, and the bad actor rules had become like sending a child to the time-out chair at home — a mild threat that was easily discarded once the appropriate apology was made.
The S.E.C. is likely to take a tougher stance in agreeing to waivers of the bad actor prohibition, which means defense lawyers will have to consider the waiver issue right from the start rather than assuming the agency will rubber-stamp requests.
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