The SEC’s Costly Crackdown on Firms

In April 2024, SEC Deputy Director Sanjay Wadhwa updated the investor community on the SEC’s record-keeping enforcement initiative against broker-dealers and investment advisors. The efforts focus particularly on firms’ failing to properly record off-channel communications which discuss business activity, such as personal emails, messaging apps, and text messages. The SEC reported that since December 2021, the commission had charged nearly 60 firms with record-keeping violations totalling $1.7 billion in penalties. SEC., Remarks at SEC Speaks (2024). Notable charges include nine firms each sanctioned $125 million for “widespread and longstanding failures by the firm and their employees to maintain and preserve electronic communications.” SEC, SEC Charges 16 Wall Street Firms with Widespread Recordkeeping Failures (2022).

The Impact on Shareholders

Firm mismanagement resulting in significant monetary penalties are not only an issue for the firm but carry externalities for shareholders as well. First, the penalty itself, especially one exceeding $100 million, can decrease the equity value of the firm. Therefore, Shareholders often absorb the cost of sanctions through decreased share value. Sonia A. Steinway, SEC “Monetary Penalties Speak Very Loudly,” But What Do They Say? A Critical Analysis of the SEC’s New Enforcement Approach, 124 Yale.L.J. 209, 222-23 (2014). Second, a firm’s publicized mismanagement may result in reputational harms that directly and indirectly decrease share value. Id. Reputational harm can indirectly decrease share value by hindering a firm’s ability to generate revenue and secure financing as well as creating investor apprehension that directly diminishes share value. Id. Third, a firm can experience lost revenue as executives divert attention away from the business and towards addressing the violations. Id. The externalities flowing from SEC violations create a downstream effect against shareholders by sinking share value.

Shareholders’ Failed Attempt to Seek Redress

Lase Guaranty Trust on Behalf of JPMorgan Chase & Co. v. Bammann (2024)

JP Morgan was one of the nine firms sanctioned $125 million by the SEC for failure to preserve and record widespread use of off-channel communications. As a result of the sanctions, shareholders filed a derivative suit against JP Morgan (JMP) in the Eastern District of New York asserting both federal and Delaware state law actions. Lase Guar. Tr. on behalf of JPMorgan Chase & Co. v. Bammann, No. 22-CV-01331(EK)(JAM), 2024 WL 1117043, at *1–2 (E.D.N.Y. Mar. 14, 2024). Both claims focus on board members’ proxy statements made in 2021 that expressed the robustness of JPM’s compliance environment, governance practices, risk controls, and employee conduct while simultaneously failing to disclose the known, widespread use of non-compliant off-channel communications. Id.

In the federal law claim, shareholders alleged board members’ statements and omissions of record-keeping violations violated Section 14(a) of the Exchange Act. Id. Section 14(a) “prohibits registrants from soliciting proxy statements in a manner that violates SEC regulations–including rule 14a-9, which forbids material misstatements and omissions in proxies.” Id. The court held that the proxy statements were immaterial because JMP’s  upfront disclosures were too general. The court held it is “well-established that general statements about reputation, integrity, and compliance with ethical norms are inactionable” for securities fraud cases. Id at 5 (quoting City of Pontiac Policemen’s & Firemen’s Ret. Sys. v. UBS AG, 752 F.3d 173, 183 (2d Cir. 2014)). The court found the statements were too general for a reasonable investor to detrimentally rely on. Id.  The court also found no liability based on the board members’ omissions of the non-channel communications because there was no duty to further disclose the omitted information. Id. at 6. The court held that a duty to disclose “more” is triggered only when the original disclosures are “sufficiently specific.” Id. Here, because the court found the statements too general, the statements did not trigger a duty for JPM board members to disclose the off-communication misconduct. Therefore, the court dismissed the federal law action because there was no actionable claim under Section 14(a).

The court never addressed the shareholders’ Delaware state claims as the dismissal of the Section 14(a) claim eliminated federal subject matter jurisdiction. The dismissal leaves an unresolved question on whether Delaware state law claims would remedy shareholder damages resulting from a firm’s failure to regulate off-channel communications.

Does Delaware State Law Provide a Pathway for Shareholder Action?

Under Delaware state law, shareholders could potentially assert a Caremark claim against JMP board members in a derivative action. A Caremark claim arises when a company’s directors or officers, acting in bad faith, fail to oversee the company’s key operations. Litigating Caremark Claims in a Shareholder Derivative Action, Practical Law Practice Note w-025-1308. There are two general categories of Caremark claims: (1) the board or officers failed to implement any reporting system or controls, or (2) the board or officers learned of wrongdoing, usually through intentional reporting, and consciously failed to respond. Id. Here, JPM board members admitted to the SEC they knew of the widespread use of non-channel communications, and consciously failed to respond. The SEC found:

“JPMS further admitted that these failures were firm-wide and that practices were not hidden within the firm. Indeed, supervisors, including managing directors and other senior supervisors – the very people responsible for implementing and ensuring compliance with JPMS’s policies and procedures – used their personal devices to communicate about the firm’s securities business.”

JPMorgan Admits to Widespread Recordkeeping Failures and Agrees to Pay $125 Million Penalty to Resolve SEC Charges (2021).

Shareholders must additionally demonstrate board members acted in bad faith in failing to prevent or correct the violations. Id. This could prove a significant barrier against a cause of action. To evidence bad faith, shareholders must demonstrate that JPM board members were not only aware of red flags but that the red flags could amount to an SEC enforcement violation. Id. Here, JPM’s admissions to the SEC likely demonstrate awareness of off-channel communication misconduct, but it is less clear whether board members knew the misconduct amounted to SEC violations. Finally, the shareholders must demonstrate they incurred damages as a result of board members’ bad-faith mismanagement, such as diminished share value caused by lost-revenues or decreased equity value. Id.

Ultimately, the fate of shareholders and firms affected by recent SEC record-keeping violations may rest in future state court actions requiring less stringent pleadings than Federal claims.