On Monday, May 17, 2021, the U.S. Securities and Exchange Commission (“SEC”) initiated Administrative Proceedings (an enforcement action) against the S & P Dow Jones Indices, LLC (“SPDJI”), in connection with data integrity, for failing to maintain accurate and timely market information used for the S & P 500 VIX Short-Term Futures Index ER (the “Index”). The Index is used (according to the SEC’s May 17, 2021, Press Release) “to calculate values based on real-time prices of certain CBOE Volatility Index (VIX) [the “VIX”] future contracts.” Financial firms license the Index to (according to the Administrative Proceeding) “establish, structure, manage, offer, and sell securities.” One such security was an exchange-traded note (“ETN”) issued by Credit Suisse AG (“CSAG”) called the VelocityShares Daily Inverse VIX Short Term ETN’s, security whose value was linked to the Index.
On February 5, 2018, between 4:00 and 5:08 pm, the VIX experienced a spike of 115%. The Index was supposed “to calculate values based on real-time prices of certain VIX future contracts” at certain intervals during that time. The Index, however, “remained static” during that period. That static was caused by a previously undisclosed Auto Hold feature of the Index, which was triggered when the value of the securities measured by the Index caused it to change (either up or down) in excess of preset thresholds. SPDJI personnel did not release the Auto Hold feature, “resulting in the publication and dissemination” of false Index values.
Perhaps more significantly, accurate VIX values would have breached a key measure of the ETN that would have given CSAG the right to call all the outstanding ETN notes. As a consequence, investors were purchasing or holding a security that had a substantially lower economic value than being reported, and that they did not know was at risk of being called. The following day, when the correct values were reported, CSAG in fact exercised its right to accelerate the ETN notes.
SPDJI was charged in the Administrative Proceeding with violating Section 17(a)(3) of the Securities Act of 1933, as amended (the “1933 Act”), which reads in relevant part:
It shall be unlawful for any person in the offer or sale of any securities…by the use of any means…to engage in any transaction…
Interestingly, SPDJI was not charged for violating Rule 10b-5 adopted under Section 10(b)(5) of the Securities Exchange Act of 1934, as amended. A charge under Rule 10b-5 requires proof that the wrong was intentional, i.e., that the actor acted with scienter. In this case, the SEC recognized that the SPDJI Auto Hold feature and the failure to disclose its existence were not intended to cause the publication of false pricing data, resulted from negligent management of the Index. In any event, SPDJI consented to the entry of a cease-and-desist order and the payment of a $9 million civil penalty.
Commissioner Hester Peirce dissented from the SEC action because in her view (expressed in a May 17, 2021, Public Statement) the conduct of SPDJI “is outside the reach of Section 17(a)(3).” She noted that SPDJI had no direct contact, let alone privity, with any of the investors in the ETN notes. She observed that it was CSAG who had the relationship with the ETN investors, and accordingly had disclosure obligations to them. She fears that the SEC will use this Proceeding as precedent to accomplish “subsequent expansions of the securities laws to reach all manner of actors and conduct with even more tenuous connections to the offer and sale of securities.” She noted that:
[t]his enforcement action may hint at a deeper, unspoken concern that index providers, whose products have become so integral to our securities markets, are not governed by a regulatory framework explicitly tailored to their activities.
She criticized the SEC for “regulating by enforcement,” noting that “an enforcement action…is not a substitute for doing the hard work” to design such a framework. She also noted, however, that she “is open to exploring the need for and propriety for such a framework.”
Commissioner Peirce’s openness to a more nuanced regulatory solution for dealing with index providers and other sources of important data for the capital markets suggests a broad rethinking of the basis for sanctions against them when the work product proves to be deficient. A possible approach under the 1933 Act would be to craft a regulation requiring any provider of data, including indices, used by participants in the capital markets to be both timely and accurate.
If it could be shown that a substantial failure to meet the “timely and accurate” requirement had occurred, the provider would be subject to enforcement action by the SEC. Such a regulation would make clear that no privity or other direct relationship to any purchaser or seller of securities was needed, and no intent to mislead was an element of the violation. In a way, such a regulatory approach would echo part of the “fraud on the market” basis for liability developed by the U.S. Supreme Court in Basic v. Levinson, 485 U.S. 224 (1988), without the need to show “fraud.” This approach would impose an affirmative duty to compile and disseminate accurate data and make clear that a provider that fell short could be subject to sanctions.
More generally, the SEC has focused considerable attention, of late, on data and data integrity. In September 2020, the SEC brought charges against two individuals for “insider trading,” where one of the individuals was a key employee of a company that compiled market indices. He gave advance information about adjustments to an index to his co-conspirator, as discussed in my October 22, 2020, blog post, “Inside Looking Out: Enforcing the Law Against a Market Designer.”
On February 16, 2021, the SEC sued Morningstar for falsifying ratings on collateralized loan obligations to make them more saleable at lower interests, as discussed in my February 25, 2021, blog post, “‘X-Rated’: SEC Sues Morningstar.” And most recently on April 29, 2021, the SEC brought charges against eight public companies for filing late filing requests which contained false and/or materially deficient information, as discussed in my May 6, 2021, blog post, “The Dog Ate My Financials: Dissembling Filers Sanctioned by the SEC,” in which the SEC stresses that it was able to identify the miscreants using data analytics. These cases and the SPDJI enforcement action underscore both the importance of compiling and publishing accurate data AND the consequences for failure, even if unintentional, to do so.
It is abundantly clear that the SEC is concerned about the informational fundament of our capital markets. That concern manifests itself in the need to attend to the disclosures AND the policies and procedures of index and other data providers to insure accuracy and completeness. As is written in the Gospel According to St. John, chapter 8, verse 32 (in the King James version):
…the truth shall make you free.
But as the cases noted above emphasize:
Failure to compile and publish accurate data, and to maintain data integrity, shall make you poorer.