Top 5 SEC Enforcement Developments for March 2024

Each month we publish a roundup of the most important SEC enforcement developments for busy in-house lawyers and compliance professionals. This month, we examine:

• The Fifth Circuit’s stay of the SEC’s recent adoption of climate change disclosure rules for public companies; 
• A key adviser liability ruling by the Second Circuit in SEC v. Rashid;
• The SEC’s charges against two investment advisors for “AI washing”;
• A federal court’s opinion permitting SEC v. Coinbase to go forward; and
• A federal court’s order denying the SEC’s summary judgment motion in SEC v. GEL Direct Trust.

1. The Fifth Circuit Stays the SEC’s New Climate Disclosure Rule

On March 6, 2024, the SEC adopted new rules requiring public companies to disclose detailed information on climate-related risks, goals, and greenhouse gas emissions that could significantly impact their business or financial statements, effective 60 days after the publication in the Federal Register. Certain large filers will also need to align these disclosures with previously established frameworks, such as the Task Force on Climate-Related Financial Disclosure and the Greenhouse Gas Protocol.

On March 15, 2024, the U.S. Court of Appeals for the Fifth Circuit issued an administrative stay of the SEC’s final rules on climate-related disclosures. Certain oil field services companies filed the petition for the stay, arguing that it was necessary to provide interim relief while the court reviews legal challenges to the new SEC rules. The basis for the challenges primarily centers on the argument that the SEC exceeded its authority and that the new rules would impose significant compliance costs on companies. The petitioners included claims brought under the Major Questions Doctrine, the Administrative Procedure Act, and the First Amendment. 

This stay introduces uncertainty regarding the future of these disclosure rules, particularly as challenges are also pending in other circuits. These legal hurdles have also forced the SEC to pause its implementation of these requirements. 

As a practical matter, even if the stay does not remain in place, companies will not need to report under the new rules until 2026 at the earliest.

For more information, read our full client alert.

2. Second Circuit Rejects SEC’s Negligence Argument in Investment Advisers Act Dispute

On March 13, 2024, the United States Court of Appeals for the Second Circuit reversed the district court’s decision in SEC v. Rashid. Mohammed Ali Rashid, a former senior partner at Apollo Management L.P., was accused of violating Sections 206(1) and 206(2) of the Investment Advisers Act by fraudulently submitting personal expenses for reimbursement, which were then paid by Apollo-affiliated private equity funds. 

During the relevant time period, Apollo’s Accounts Receivable department improperly charged all expenses relating to monitoring a fund’s portfolio company directly to the fund, even though the fund partnership agreement required Apollo management companies to bear the cost of “administrative expenses.” The district court found that Mr. Rashid was not liable under Section 206(1) of the Investment Advisors Act because he was not aware that the funds, rather than Apollo, would pay for his expenses. But the district court ruled that Mr. Rashid was liable under Section 206(2) of the Act because he was “recklessly indifferent” and, therefore, negligent as to which entity would pay for his falsely submitted expenses. 

The Second Circuit reversed, finding that a reasonable person in Rashid’s shoes would not have known that the funds would pay for his claimed expenses. The Second Circuit explained that the “‘reasonable persons’ against whom Rashid should be compared when evaluating whether he should have known that the funds would pay for his business expenses” were his peers. Here, Rashid’s peers believed that Apollo—not the funds—would pay for reimbursement. Rashid’s “general fiduciary duties [did not include] undertaking the sort of extensive, independent investigation that might have revealed that the funds would pay for his business expenses.” The Second Circuit separately found that the intervening error by the Accounts Receivable department in billing funds directly for such administrative expenses was not reasonably foreseeable to Rashid and, therefore, Rashid also did not proximately cause the funds’ harm. 

In a dissent, Judge Kearse pointed to the fact that Mr. Rashid deliberately sought to defraud someone for paying for his personal expenses and that he made no effort to find out whether his expenses were being billed to the clients he identified. 

This case puts a spotlight on rarely litigated negligence standards in the SEC enforcement context and emphasizes that, as stated by the Second Circuit, Section 206(2) of the Investment Advisement Act, “while broad in its reach, was not intended as a catchall provision to penalize all acts of wrongdoing, untethered to . . . ordinary negligence principles.”

3. The SEC Charges Two Investment Advisers for Misleading AI Claims

On March 18, 2024, the SEC announced settlements of two regulatory actions brought against investment advisers for “AI washing,” a practice defined by the SEC as “making false artificial intelligence-related claims.” Delphia (USA) Inc. was fined $225,000 and Global Predictions Inc. was fined $175,000 for these violations. In both cases, the SEC alleged that the firms misled investors about the use of AI in their investment processes, in violation of negligence-based antifraud provisions of the Investment Advisers Act. 

The SEC’s enforcement in these cases signals its increasing scrutiny of claims by public companies regarding the use of emerging technologies like AI. Companies in the AI space should therefore carefully review any public representations they make in operations and marketing materials and public filings about their use of AI. The SEC’s actions also illustrate the need for AI companies to have robust compliance programs to ensure truthful and accurate disclosures.

For more information, read our full client alert.

4. Federal Court Permits SEC v. Coinbase Case to Go Forward

On March 27, 2024, Judge Katherine Polk Failla of the United Stated District Court for the Southern District of New York ruled that the SEC could proceed with its lawsuit against Coinbase, an American publicly traded company that operates a cryptocurrency exchange platform. The lawsuit alleges that Coinbase operated as an unregistered exchange, broker, and clearing agency in violation of Sections 5, 6, 15(a), and 17A(b) of the Securities Exchange Act of 1934 (the “Exchange Act”), and that it facilitated the trading of cryptocurrency tokens that the SEC claims should have been registered as securities, in violation of Sections 5(a) and 5(c) of the Securities Act of 1933. Coinbase had filed a motion for judgment on the pleadings, arguing that the transactions executed on its platform do not constitute “securities” and therefore fall outside of the SEC’s authority.  

Judge Failla found that the SEC had plausibly alleged that the crypto-asset transactions on the Coinbase platform were “securities” for purposes of SEC v. Howey, explaining that the SEC adequately alleged that “purchasers of certain crypto-assets on the Coinbase Platform . . . invested in a common enterprise and were led to expect profits solely from the efforts of others, thereby satisfying the Howey test for an investment contract.” 

Judge Failla dismissed the SEC’s claim that Coinbase functioned as an unregistered broker through its Wallet application, finding that the allegations were insufficient to support a plausible inference that Coinbase “‘engaged in the business of effecting transactions in securities for the account of others’” within the meaning of Section 15 of the Exchange Act.

The case’s progression may have significant implications for the classification and regulation of digital assets in U.S. financial markets.  

5. Federal Court Denies SEC’s Motion for Summary Judgment Against Allegedly Unregistered Brokers

On March 31, 2024, U.S. District Court Judge Jed S. Rakoff denied the SEC’s motion for summary judgement on claims asserted against GEL Direct Trust, along with its trustee and co‑owners. The SEC alleges that GEL Direct Trust and its associated entities operated as brokers, orchestrating sales of their clients’ penny stocks without proper registration, in violation of Section 15(a) of the Exchange Act. 

To determine whether a person is considered a broker, courts consider a variety of factors, including whether the person: (1) actively solicits investors; (2) receives transaction-based compensation; (3) handles securities or funds of others in connection with securities transactions; (4) processes documents related to the sale of securities; (5) participates in the order-taking or order-routing process; (6) sells, or previously sold, securities of other issuers; (7) is an employee of the issuer; (8) is involved in negotiations between the issuer and the investor; and/or (9) makes valuations as to the merits of the investment or gives advice. Judge Rakoff noted that not all of the broker-indicative factors will be relevant in every case and the SEC does not need to prove each factor to prevail on summary judgment. Here, however, the Court found that Defendants raised genuine disputes of material facts with regards to a “sufficient number” of factors to defeat summary judgment, including (1) transaction-based compensation, (2) solicitation, and (3) order-routing and order-processing.  

This case will proceed to further fact-finding to determine whether the GEL entities should have been registered as, or affiliated with, a broker.

This case emphasizes the rigorous fact-intensive standards and scrutiny involved in determining if an entity operates as a broker under the Exchange Act.