On November 12, 2013, the Securities and Exchange Commission (SEC) announced it had entered into a Deferred-Prosecution Agreement (DPA) with Scott Herckis, a former hedge fund administrator, for his role in an allegedly fraudulent scheme involving Heppelwhite Fund, LP, a Connecticut-based hedge fund. Under the agreement, the SEC agreed to defer charging Herckis with violations of the federal securities laws and Herckis agreed to disgorge $50,000 in fees he received for services provided to the fund and to be barred from, among other things, providing services to hedge funds for five years. This is the first time since introducing a formal Cooperation Initiative in 2010 that the SEC has entered into a DPA with an individual.

The Facts

Herckis agreed to admit certain factual statements contained in the DPA “in any future Commission enforcement action in the event [Herckis] breaches” the DPA. Those statements included:

1. Herckis is a certified public accountant (CPA) who calculated the performance of the fund’s investment, prepared monthly account statements for fund investors, managed and accounted for contributions to, and withdrawals from, investor accounts, paid fund expenses and corresponded with potential investors;

2. Berton Hochfeld (Hochfeld), through Hochfeld Capital Management, LLC (HCM) managed the fund, which had approximately 25 investors and at least $6 million in assets;

3. Herckis, acting upon Hochfeld’s instructions, effected transfers of more than $1.5 million from the Fund to Hochfeld’s personal accounts;

4. Herckis knew, or was reckless in not knowing, that these transfers were improper;

5. Herckis also was responsible for calculating the fund’s net asset value (NAV) and knew that the NAV he provided to investors was materially less than actual NAV; and

6. In September 2012, Herckis resigned as fund administrator, contacted the government authorities and cooperated with the resulting SEC investigation by producing voluminous documents and explaining the details of Hochfeld’s scheme.

As a result of Herckis’ cooperation, the SEC was able to file an emergency action and freeze more than $6 million in the assets of the fund, HCM and Hochfeld, which, subject to the court’s approval, will be distributed to the fund’s investors. In addition, Hochfeld pleaded guilty in federal court to securities and wire fraud charges. He was sentenced on August 5, 2013 to two years in prison.

Observations

The Cooperation Initiative, now embodied in the SEC’s Enforcement Manual, garnished significant attention when it was announced in 2010. In announcing the program, the staff indicated that the Initiative was expected to “result in invaluable and early assistance in identifying the scope, participants, victims and ill-gotten gains associated with fraudulent schemes.” Since 2010, however, the staff has made limited use of DPAs and Non-Prosecution Agreements (NPA). In fact, the staff has only entered into two DPAs and four NPAs.

According to the DPA, Herckis’ eligibility to enter into the agreement depended in part on the fact that Herckis had never been charged or found guilty of, or liable for, violating the federal securities laws. Herckis also promised to cooperate with the SEC in any related enforcement litigation or proceedings. While the SEC noted Herckis’ cooperation and contribution to its investigation, it did not mention whether the staff was already investigating Hochfeld and HCM before Herckis contacted the authorities. Given the size of the fund and the limited number of investors, it seems likely that the staff was not aware of any wrongdoing prior to Herckis’ report.

In announcing the DPA with Herckis, the staff stressed that it believed the DPA struck the right balance between recognizing significant cooperation and holding Herckis responsible for his misconduct. It is not clear, however, the extent of the benefit Herckis received by self-reporting and cooperating. While the SEC did not “charge” Herckis with violating the federal securities laws, the SEC received substantially all of the relief it would have been entitled to if it had charged Herckis. Under most circumstances, the SEC is entitled to seek disgorgement of ill-gotten gains, prejudgment interest, civil penalties and certain industry bars. Herckis agreed to disgorge the fees he received in connection with the services he provided to the Fund. Herckis also agreed not to provide services to hedge funds or associate with any broker, dealer, investment adviser or registered investment company for five years. The SEC refrained from seeking prejudgment interest on the disgorgement and a civil penalty. Even if the SEC had charged Herckis, however, it could have chosen not to impose prejudgment interest or a civil penalty. It appears the greatest benefit Herckis received from the DPA is that a DPA is likely to have less of an adverse impact on his ability to practice as a CPA (outside the financial industry) than if he had been charged with fraud.

The DPA with Herckis demonstrates the SEC’s evolving policy with respect to its “neither admit nor deny” settlements. Over the last five months, SEC Chairman Mary Jo White and Co-Enforcement Directors Andrew Ceresney and George Canellos have repeatedly said that the staff will require “admissions” in certain cases where “heightened accountability or acceptance of responsibility through the defendant’s admission of misconduct may be appropriate,” and in cases of “egregious misconduct,” involving obstruction of the SEC’s investigation or harm to large numbers of investors.

In prior DPAs, the staff has not required defendants to expressly make admissions. See Amish Helping Fund (Agreement noted that the Fund offered to accept responsibility for its conduct and “not contest or contradict” the factual allegations in the DPA); Tenaris, S.A. (Agreement noted Tenaris offered to accept responsibility for its actions without admitting or denying the factual allegations contained in the DPA). Similarly, corporate defendants who have entered into NPAs have also been permitted to accept responsibility without expressly admitting the factual allegations in such agreements. See Ralph Lauren Corporation (NPA contained “without admitting or denying liability”); Federal Home Loan Mortgage Corporation and Federal National Mortgage Association (NPAs contain “neither admitting nor denying” language); Carter’s Inc. (NPA did not contain any factual allegations).

Based upon the limited information included in the DPA, it does not appear Herckis’ conduct was egregious or otherwise deserving of heightened accountability. The underlying fraud appears to have been limited and by all accounts Herckis’ cooperation allowed the staff to stop the fraud quickly. Herckis, however, was not permitted to accept responsibility without “admitting or denying” the factual allegations. While less onerous than an outright admission, Herckis was required to agree, in the event he breaches the DPA, he would admit certain factual statements contained in the DPA “in any future Commission enforcement action.” The contingent admission would certainly result in the Commission prevailing against Herckis in a future enforcement action, but, at the same time, would likely allow Herckis to defend himself in any related licensing hearings, criminal proceedings or any private actions that may be filed by fund investors.

In sum, the Herckis DPA may illustrate the staff’s willingness to recognize self-reporting and substantial cooperation. It also illustrates, however, that the staff will continue to insist on traditional sanctions including disgorgement and industry bars even when the violator has rendered substantial cooperation. The Herckis DPA also demonstrates that the SEC’s policy regarding admissions in the context of settlements is still evolving and that the staff may be open to using different language regarding admissions to provide some protection with respect to related criminal and private civil actions.