SEC Message to Government Contractors: Don't Limit Whistleblowing

This post was written by Lorraine M. Campos and Nkechi A. Kanu.

On April 1, the Securities and Exchange Commission (“SEC”) settled its first enforcement action against a company for violating whistleblower protections by including restrictive language in confidentiality agreements used in its internal investigations.

The SEC charged a Houston-based government services contractor with violating whistleblower protections codified in section 21F of the Securities Exchange Act. Rule 21F-17 specifically prohibits companies from taking any action to impede whistleblowers from reporting possible securities violations to the SEC.

The contractor’s policy allegedly required its employees in particular internal interviews to sign confidentiality statements that limited their rights to disclose information. The SEC alleged that the language warned of discipline and even termination if employees discussed the matter with outside parties without obtaining approval from the company’s legal department. Although the SEC did not find any specific instances in which the contractor specifically prevented employees from communicating with the SEC about specific securities law violations, the SEC found that imposing pre-notification requirements before contacting the SEC could potentially discourage employees from reporting securities violations.

To settle the allegations, the contractor agreed to pay a penalty, agreed not to violate Rule 21F-17 in the future, and amended its confidentiality statement to clarify that its employees will not have to seek approval from the company before contacting officials, and would not have to fear the consequences of termination or retribution for doing so. The amended confidentiality statement states:

"Nothing in this Confidentiality Statement prohibits me from reporting possible violations of federal law or regulation to any governmental agency or entity, including but not limited to the Department of Justice, the Securities and Exchange Commission, the Congress, and any agency Inspector General, or making other disclosures that are protected under the whistleblower provisions of federal law or regulation. I do not need the prior authorization of the Law Department to make any such reports or disclosures and I am not required to notify the company that I have made such reports or disclosures.”

SEC officials indicated that they will continue to vigorously enforce the prohibitions found in Rule 21F 17. In light of this decision, government contractors should immediately review their policies and amend any existing forms or agreements that may discourage or deter employees from reporting potential legal violations to the SEC or other governmental agencies.

China Auditor Update: SEC and Chinese Audit Firms "Settle" for the Status Quo

This post was written by Jennifer L. Achilles and John Tan.

In an Order of Settlement released February 6, 2015, the SEC agreed to stay the administrative action against the Chinese affiliates of the “Big Four” accounting firms for refusing to turn over their audit work papers relating to several U.S.-listed Chinese companies. As we wrote earlier here, the Chinese affiliates of the audit firms had been facing a six-month bar from appearing before the SEC, which would have disrupted their business and the business of countless U.S.-listed Chinese companies. The Order acknowledges that the requested documents have been provided, and allows the audit firms to continue representing U.S.-listed companies. The Order also requires each firm to pay a $500,000 fine and agree to abide by certain procedures regarding the SEC’s document requests for the next four years. If the audit firms follow the procedures set forth in the Order, the administrative action will be dismissed after a four-year period.

Throughout the administrative proceeding, the Chinese affiliates of the “Big Four” argued that they were caught between a rock and a hard place. If they produced audit work papers directly to the SEC, they could be subject to civil and/or criminal action in China for divulging state secrets. And if they did not produce the requested documents, they could be barred from appearing before the SEC and effectively lose their ability to audit U.S.-listed Chinese companies. The terms of the settlement now require the audit firms to respond to the SEC’s future document requests within 90 days. However, the firms will produce documents to the China Securities Regulatory Commission (CSRC), not the SEC. Both the firms and the CSRC will then be permitted to make redactions to the documents before providing them to the SEC. Additionally, the audit firms may refuse production altogether if they determine, along with the CSRC, that the requested documents should be withheld under China’s state secrets regulations.

This settlement appears to send the SEC right back where it started: unable to review the work papers of Chinese audit firms without the consent of Chinese regulators. The settlement also appears to be a complete win for the audit firms. They are no longer required to produce documents directly to the SEC and risk violating China’s state secrets laws, and they no longer have to fear being barred from appearing before the SEC – at least not for the next four years.

China Auditor Update: SEC To Hear Appeal of Decision Barring Chinese Auditors

This post was written by Jennifer L. Achilles, Terence Healy, and John Tan.

The Securities and Exchange Commission recently indicated that it would review, de novo, the January 2014 decision barring the Chinese affiliates of the “Big Four” accounting firms from appearing before the SEC.  The Commission’s Order, found here, also granted both parties’ motions to submit additional evidence for consideration – most significantly, the auditors’ evidence that they have given the Chinese regulators the audit work papers of the Chinese companies being investigated by the SEC.

As we wrote earlier here and here, the SEC instituted administrative proceedings in December 2012 against the Chinese affiliates of the accounting firms for willfully refusing to provide audit work papers to U.S. regulators as required under Sarbanes-Oxley.  The accounting firms had argued that complying with this requirement would violate China’s state secrets and archives laws, and subject the firms to civil and criminal penalties.  In January 2014, an Administrative Law Judge at the SEC found the accounting firms’ “good faith” arguments irrelevant to the issue of whether the firms willfully refused to comply with the SEC’s requests, and barred the firms from appearing before the SEC for six months.  Following the ALJ’s decision, both the audit firms and the SEC’s Division of Enforcement petitioned the Commission to review the ALJ decision and allow additional evidence to be submitted.

The Commission’s Order reveals that the audit firms have turned over the audit work papers they had been refusing to produce for years.  Although the firms did not produce the requested documents directly to the U.S. regulators, they gave them to the Chinese regulators who can, if they so choose, turn them over to their U.S. counterparts pursuant to the MOU the countries entered into last summer. 

The audit firms are no doubt hoping that their “better late than never” productions will be seen as evidence that they were acting in good faith when they refused to comply with the SEC’s requests for the documents.  But it will be up to the Commission to decide whether the firms’ motives ultimately matter. 

DC Circuit Invalidates Conflict Mineral Reporting Regulations

This post was written by Jeffrey Orenstein.

This week the U.S. Court of Appeals for the D.C. Circuit held that the Security and Exchange Commission’s (“SEC”) final rule concerning “conflict mineral” disclosures is unconstitutional.  Nat’l Assoc. of Mfrs v. SEC, No. 13-5252 (D.C. Cir., decided April 14, 2014).  The SEC rule requires registrants to disclose annually on a Form SD whether their products incorporate conflict minerals (i.e., tin, tungsten, tantalum, and gold, mined in war-torn Central Africa) or whether their products are “DRC Conflict Free.” 

The court ruled that, by requiring companies to report whether their products are free of conflict minerals, the SEC rule improperly compelled commercial speech in violation of the First Amendment.  Accordingly, the court invalidated both the SEC’s final rule and the underlying statutory provision in the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”), but only “to the extent the statute and rule require regulated entities to report to the Commission and to state on their website that any of their products have ‘not been found to be “DRC conflict free.”’”   The court reasoned that “the label ‘conflict free’ is a metaphor that conveys moral responsibility for the Congo war” and, “[b]y compelling an issuer to confess blood on its hands, the statute interferes with that exercise of the freedom of speech under the First Amendment.”

With the June 2, 2014 deadline fast approaching for filing a Form SD, many manufacturers and other parties impacted by the SEC’s final rule are eager to know whether the D.C. Circuit’s decision relieves them of their upcoming filing requirement. Unfortunately, the immediate impact of the decision is not entirely clear.

The court remanded the case to the District Court for a review of whether the SEC’s rulemaking, or language in the Dodd-Frank statute itself, is at the root of the free speech conflict.  In the interim, it is possible that the SEC will provide guidance indicating that issuers should file their Form SD but, per the D.C. Court’s decision, issuers may omit the declaration of whether their products are “DRC conflict free.”  It is also possible that the plaintiffs will move in District Court to stay implementation of the rule, pending the court’s decision on remand.  In the long term, the SEC may appeal the D.C. Circuit’s decision, putting its validity back into play once more, or it may amend its final rule in an effort to satisfy the constitutional standards articulated by the D.C. Circuit this week.

The Lawman Cometh: The SEC Adds Deferred Prosecution Agreements to Its Bag of Remedies

This post was written by Terence Healy.

Last week the Securities and Exchange Commission (“SEC”) announced it had entered into its first deferred prosecution agreement (“DPA”) with an individual.  The announcement is interesting for two reasons.  It reflects the increasing tone of law enforcement the Commission is taking in its enforcement proceedings, and it raises the question (as with so many SEC settlements) as to what the defendant is really gaining by falling on his sword rather than challenging the allegations on the merits.

The case arose from a fraud at the Connecticut hedge fund Heppelwhite Fund, LP (the founder of which, Berton Hochfeld, was criminally convicted earlier this year).  The SEC entered into a DPA with Scott Herckis, the former administrator of the fund and the person who first reported the wrongful conduct to the government.  Herckis, a CPA, had no experience as a fund administrator prior to working with Heppelwhite.  At Hochfeld’s direction, he transferred monies from a capital account to personal accounts under Hochfeld’s control.  Over time, these transfers led to Hochfeld’s capital account having a negative balance.  When Herckis raised this issue, Hochfeld reassured him he would pay the funds back.  Herckis also discovered a discrepancy between the net asset value ("NAV") of the fund between its internal reporting and that of its prime broker.  To resolve this discrepancy, Herckis hired an outside consultant to examine the issue.  Herckis eventually resigned as administrator and then contacted government authorities. In other circles, he might rightfully be called a whistleblower.

By entering into a DPA, the Commission is striking the posture of a law enforcement agency – the tough “cop on the beat” that Mary Jo White promised Congress.  Deferred prosecution agreements are a common tool in criminal law, but generally have not been used in civil proceedings (the SEC’s first DPA with an entity was only entered in 2011).  The fact that these agreements went seemingly undiscovered for nearly 80 years by every former Commission and Enforcement Director suggests they may be out of place in a civil enforcement agency.  (Even the use of the word “prosecution” is somewhat strained in a civil context.)

The DPA is also striking for the nature of the underlying settlement.  Herckis agreed to pay a significant figure of “disgorgement,” even though none of the monies he received as fund administrator could rightly be called ill-gotten.  He also agreed to a five-year bar from the securities industry, and to the significant limitations and reporting requirements of the DPA itself.  In short, even though no penalty was assessed, he consented to relief that was every bit as onerous, if not more so, than if he litigated his case and lost.  He also gave up the chance to defend his conduct, which seemed at most negligent, and claim the mantle of whistleblower. 

As with the SEC’s new penchant for requiring admissions in settlements, we will have to wait and see the extent to which DPAs become a common fixture in the civil enforcement landscape. 

Bold and Unrelenting: Six Months In

This post was written by Terence Healy and Amy J. Greer.

Mary Jo White promised Congress she would pursue a “bold and unrelenting” enforcement program as chairman of the Securities and Exchange Commission (“SEC”). Six months into her tenure, we should take her at her word. In public remarks this week, White reiterated her desire for the Enforcement Division “to be everywhere” and to be “felt and feared” in areas beyond where its resources can reach.

Perhaps the best example of this more-is-better approach to enforcement is the move away from the Commission’s traditional “neither admit nor deny” settlement policy. This practice – born out of a 1972 rulemaking – had been consistently followed by the Commission (and other federal agencies) for decades. But in 2012, responding to criticism from at least one federal judge, the Commission changed this policy as it applied to parties that had admitted or been found guilty in related criminal proceedings. In September, White announced she would seek admissions of wrongdoing in certain cases even where there had been no findings of guilt in related proceedings.

Recent settlements with financial institutions such as Harbinger Capital Partners, in which the parties made limited admission of wrongdoing, demonstrate the Commission means what it says in seeking admissions in certain cases. But the standard for when the Commission may seek such admissions remains unclear. In recent public statements, White indicated she would seek admissions where the conduct was “egregious” or where it posed “significant risk” to investors, or where necessary to send “an important message.” These stated reasons, though sound, hardly provide a clear standard to apply to future matters.

Only time will tell whether this new policy – with all its impractical consequences – can be applied in any but the most rare of cases. Then we will know more about the true meaning of “bold and unrelenting” from the new SEC.

The SEC Brings Charges Against 'Gatekeeper' Accountants

This post was written by James A. Rolfes.

In a “crackdown” on the “gatekeepers” who put investors at risk when they fail to uncover financial statement fraud and misstatements, the Securities and Exchange Commission this week highlighted the work of “Operation Broken Gate” when it announced the filing of several proceedings against certified public accountants and their firms. Just three months ago, the SEC made headlines with the formation of its Financial Reporting and Audit Task Force, a move many categorized as nothing more than a reformatted articulation of Enforcement Division’s various historical initiatives to address financial statement-based securities violations. The filing of these proceedings, however, serves as the initial manifestation of the SEC’s refocused efforts to target accounting matters, and is perhaps a harbinger of the aggressive enforcement proceedings to come.

While no doubt the proceedings announced September 30, 2013, have been the subject of SEC investigations for some time, the SEC’s revelation of “Operation Broken Gate” follows shortly upon the July 2, 2013 SEC announcement of the Financial Reporting and Audit Task Force and the Commission’s intent to dedicate resources to detecting fraudulent or improper financial reporting. According to the SEC, this task force will “concentrate on expanding and strengthening the Division of Enforcement’s efforts to identify securities law violations relating to the preparation of financial statements, issuer reporting and disclosure, and audit failures.” Further, the SEC plans to use technology-based tools, such as the Accounting Quality Model, to identify potential investigatory targets, conduct street sweeps in particular industries and accounting areas, and rely on the increased number of accounting-related whistleblower reports the SEC has received in the past couple of years. All of this suggests increased regulatory scrutiny of accountants and auditors, and inevitably, increased enforcement activity directed at accountants, an objective reiterated by Andrew Ceresney, the co-director of the SEC’s Enforcement Division, in mid-September.

The proceedings filed Monday are in this vein. Three of the matters arose from the work of an SEC task force internally dubbed “Operation Broken Gate” – i.e., matters the SEC stated arose from “the agency’s ongoing efforts to hold gatekeepers accountable for the important roles they play in the securities industry.” This “gatekeeper” reference recognizes that the federal securities laws explicitly require public companies to obtain independent audits conducted in accordance with professional standards, and the public’s reliance on such auditors to assure that public companies disclose accurate financial information.

As alleged by the SEC, the work of Malcolm Pollard, John Kinross-Kennedy and Wilfred Hanson, and the accounting firms through which they conducted their audits, deviated markedly from the professional standards. The SEC claimed that each of these individuals on numerous engagements failed to conduct their audits in accordance with the audit standards set by the Public Company Accounting Oversight Board (PCAOB). The “repeated instances of unreasonable conduct” underlying the charged violations included failures to obtain management representations; maintain adequate work papers; consider and document fraud evidence; or obtain engagement quality reviews, or have the experience necessary to conduct such reviews. The SEC also cited these auditors for not investigating evidence of illegal activity, not reporting that evidence to the appropriate level of management, failing to employ appropriate and timely audit checklists and guides, and lacking recent and relevant audit or accounting experience. Two of these accountants, without either admitting or denying the charges, settled with the SEC and agreed to five-year bans from practicing before the Commission and, in one instance, a $30,000 fine. For the third, the SEC is seeking similar relief in a proceeding before an SEC administrative law judge.

On September 30, 2013, the SEC also announced that it had charged a New Jersey-based accounting firm, and one of its founding members, in connection with the “botched audits of a China-based company that failed to disclose related party transactions.” According to the SEC allegations, the firm of Patrizio & Zhao LLC and John Zhao failed to consider the client’s limited operating history and the lack of employees knowledgeable about U.S. accounting when planning and conducting their audits. The auditor also ignored “red flags” that suggested the client had failed to report related party transactions – i.e., the auditors’ discovery of numerous related parties and related party transactions the client neither identified nor disclosed. The SEC further cited the audit team for placing improper reliance on management representations, failing to obtain competent evidential matter, and failing to prepare adequate audit documentation. Such “repeated instances of unreasonable conduct indicating a lack of competence” justified censure under Commission Rule of Practice 102(e)(1)(ii), as well as a finding that the accounting firm and its founding member caused the client’s primary violation of the securities laws. Both the accounting firm and Zhao agreed to settle with the SEC (without admitting or denying the charges), and received three-year bans from practicing before the Commission. The SEC further assessed the accounting firm with a $30,000 fine.

Granted, the SEC brought these actions based on apparent egregious auditing deficiencies against small accounting firms that lacked personnel with appropriate experience, and thus perhaps have less predictive value as to whether the SEC will bring similar claims against larger accounting firms or the accountants at more established public companies. But the language used to describe the cases, the reference to the dedicate task force and SEC-reiterated intent to target those “gatekeepers” who permit the issuance of misstated financial statements, all suggest that accountants and auditors associated with public companies will face even greater scrutiny in the near future.

U.S. District Court Vacates SEC's Rule Requiring Public Disclosure of Energy Companies' Payments to Foreign Governments

This post was written by Jennifer L. Achilles and Brandon D. Cunningham.

On July 2, 2013, the U.S. District Court for the District of Columbia vacated a rule promulgated by the Securities and Exchange Commission (“SEC”) that would have required energy companies to publicly disclose payments to U.S. and foreign governments in connection with the commercial development of oil, natural gas, or minerals. The American Petroleum Institute (the “API”), the national trade association representing the oil and gas industry, challenged the rule under the First Amendment and the Administrative Procedure Act (“APA”). In a 30-page Memorandum Opinion, found here, Judge John D. Bates decided the issue in favor of the API, holding that the SEC had “misread the statute to mandate public disclosure of the reports.”

The statute in question is the Dodd-Frank Act’s section 13(q), which directs the SEC to promulgate a rule requiring companies listed on a U.S. stock exchange and engaged in commercial resource extraction to “include in an annual report … any payment made … to a foreign government or the [U.S.] Government for the purpose of the commercial development of oil, natural gas, or minerals.” In September 2012, largely ignoring the comments from the companies affected by section 13(q), the SEC promulgated a final rule requiring public disclosure of payments to foreign and U.S. governments, even where the foreign country’s laws prohibit such disclosure. Without reaching the constitutional issue, the court rejected the SEC’s interpretation of the statute, and found fault with the fact that the SEC declined to adopt an exemption for foreign law prohibitions. Clearly siding with the API, the court noted that, “given the proportion of the burdens on competition and investors associated with this single decision, a fuller analysis [is] warranted.”

The ball is now back in the SEC’s court to promulgate a different rule pursuant to section 13(q), and it remains to be seen whether the new rule will be any less onerous for energy companies. The Commission previously acknowledged that public disclosure of payments to government entities would burden competition and harm investors. If the SEC had viewed itself as powerless to address that harm because of its interpretation of Congress’s mandate, this recent decision may clear the way for a new rule requiring only confidential disclosure to the SEC. If, however, the SEC continues to take an aggressive stance, it could re-promulgate an identical rule pursuant to its own discretionary authority and supported by a better explanation for its refusal to allow exemptions. Alternatively, it could decide to redraft the rule to provide exemptions for the foreign countries with conflicting laws.

Déjà Vu All Over Again? SEC Announces More Specialized Initiatives

This post was written by Amy J. Greer and Terence Healy.

After several weeks of anticipation, the SEC's Division of Enforcement announced July 2 three new special initiatives: a Microcap Fraud Task Force, a Financial Reporting and Audit Task Force, and a Center for Risk and Quantitative Analytics. These new groups are in addition to the five Specialized Units announced in 2010, shortly after the last leadership change at the top of the Division. Those units – Market Abuse, Structured and New Products, Asset Management, Municipal Securities, and Foreign Corrupt Practices Act – have been something of a mixed bag, dividing personnel between offices and creating strange reporting lines. The existence of specialty units has also put pressure on the SEC staff to bring a higher volume of cases, and more matters, in those areas (with mixed results).

This time around should be a little easier.

Finding microcap fraud is like shooting fish in a barrel. The question really will be whether the staff will actually start targeting the recidivists who prey on investors in this area. Maybe those "obey-the-law" injunctions will finally get put to some use and we will even see some contempt cases. That would be something really new!

Getting people to work together – between Enforcement, Corp Fin, and the various Chief Accountants' Offices – could very well improve the SEC's monitoring of disclosures and offer Enforcement a look into "the next big thing" in financial reporting, which often happens in the Corp Fin comment process.

Finally, it is not a surprise that the Deputy from Market Intelligence is heading up the Center for Risk and Quantitative Analytics (or CRQA – finally, an unpronounceable acronym – we can look forward to what that becomes). The Market Intelligence and the Market Abuse Unit have been singularly successful at actually using technology, which the agency needs to harness and develop in order to actually identify threats to investors and the markets. The Enforcement Division has been talking about risk-based approaches for years, with varying degrees of commitment. Maybe this time it will stick.

Will the Third Time be the Charm for FINRA's New Supervision Rules?

This post was written by Daniel Z. Herbst.

After two unsuccessful attempts to implement consolidated supervisory rules, the Financial Industry Regulatory Authority, Inc. (FINRA), on June 21, 2013, filed with the Securities and Exchange Commission (SEC) a long-anticipated notice of proposed Rules 3110 (Supervision) and 3120 (Supervisory Control System). The proposed rules would replace and consolidate several pre-existing supervisory rules, and would significantly impact the scope of a supervisor’s duties.

FINRA’s two prior attempts at supervisory rules crashed and burned. In 2008, FINRA first published proposed supervision rules and requested comment. After generally negative comments from the industry, FINRA declined to implement the proposed rules. In 2011, FINRA again proposed consolidated rules that sought to address the comments made in the 2008 filing. Amid a flurry of comments criticizing the proposed expansion of supervisory scope and regulatory authority to include “non-securities activities,” FINRA withdrew the 2011 proposal. FINRA’s third rule proposal attempts to address several of the criticisms levied on the prior two notices, while maintaining the fundamental supervisory structures outlined in the prior notices.

The hot-button scope of the supervision issue remains a moving target in the new proposal. In response to comments from 2011, the proposal removed heavily criticized language about the supervision of “non-securities activities” as well as “all business lines.” On the other hand, the proposal rejected a comment proposing limits to the scope of supervision solely to “securities activities.” Instead, the notice leaves the door open to regulatory interpretation by outlining the scope of supervision by referring to FINRA’s Rule 2010 standard of “just and equitable principles of trade.”

The SEC has yet to open up the rules for comment, but the public likely will soon have an opportunity to weigh in on FINRA’s third supervisory rule proposal.


Research and drafting assistance for this post was provided by Reed Smith Summer Associate Paula A. Salamoun.

The U.S. Has a New MOU with Securities Regulators in China: Real Change or Just Déjà vu?

This post was written by Terence Healy, John Tan, and Jennifer L. Achilles.

The Securities and Exchange Commission’s (“SEC”) power to obtain documents from U.S. companies and their auditors is a key component of its mandate to protect the marketplace from fraud. But what happens when the exercise of that power conflicts with the civil and criminal laws of another country? In the case of the SEC seeking documents of Chinese companies listed on U.S. exchanges, the result has been a long standoff between regulators in the two countries, with foreign accounting firms caught in the middle.

To date, nothing has resolved the standoff. Despite a series of diplomatic agreements between the two nations over the years, and despite the more recent administrative action that the SEC initiated against Chinese accounting firms, U.S. regulators still have no access to accounting workpapers and other information located in China. See earlier article.

Enter the Public Company Accounting Oversight Board (“PCAOB” or “Board”). Recently, the PCAOB and the China Securities Regulatory Commission (“CSRC”) signed a new Memorandum of Understanding (the “2013 MOU”), found here, reviving some optimism that the current standoff can be resolved through diplomatic channels. The 2013 MOU is similar to earlier agreements between the United States and China in that – while providing a mechanism for the exchange of documents – it allows assistance to be denied if a request would violate domestic law. The 2013 MOU is unique, however, in its inclusion of confidentiality provisions setting forth how and under what circumstances the PCAOB can share the information it receives. Specifically, the 2013 MOU requires the PCAOB to obtain prior written consent before sharing non-public information generally, but allows the Board to share information with the SEC simply by giving the CSRC advance notice.

Only time will tell whether the 2013 MOU will result in the release of information from China. While the new MOU has been celebrated in some quarters as a possible breakthrough in the standoff between regulators, the agreement on its face does not address the issue at the root of the impasse: auditors in China cannot surrender their work papers to U.S. authorities without potentially violating Chinese law. Until this fundamental problem is addressed, the stalemate is likely to continue.


Research and drafting assistance for this post was provided by Reed Smith Summer Associate Steven Peretz.

SEC Order Emphasizes Need to Follow Disclosed Valuation Method when Valuing Private Equity Fund

This post was written by James A. Rolfes.

Expressing its concern that “the current difficult fundraising environment … can incentivize private equity managers to artificially inflate valuations,” the Securities and Exchange Commission emphasized the need for private equity firms to “implement policies and procedures to ensure that investors receive performance data derived from the disclosed valuation methodology.” Failing to follow articulated valuation methodology – and having compliance personnel ensure the use of such disclosed valuation policies and procedures – can subject a private equity fund to substantial disgorgement, civil penalties and multi-year oversight of its valuation policies and procedures, as one private equity firm found out this week.

On March 11, 2013, the SEC issued an order that charged a private equity fund manager with violations of the Securities Act of 1933 and the Investment Advisors Act of 1940 because of its failure to follow disclosed valuation policies when preparing marketing materials and quarterly reports disseminated to prospective and existing investors. According to the order the SEC issued, the managers of a private equity fund that itself invested in other private equity funds, had a disclosed policy of valuing assets “based on the underlying managers’ estimated values.” The managers, however, valued their fund’s largest asset using a methodology that differed from that employed by the underlying manager – a switch that led to an internal rate of return mark-up increase from approximately 3.8 percent to 38.3 percent. But “[n]o one told investors and prospective investors that the reported increase in [the private equity fund’s] performance was a result of the Portfolio Manager’s change in valuation method and that, if [the private equity fund] had used [the underlying manager’s] value, as [the private equity fund] had done in the past and as was stated in the quarterly statements and pitch books, the performance numbers would have been materially lower.”

The SEC further criticized the private equity fund managers for failing to have compliance personnel review the portfolio manager’s valuations to ensure such valuations were determined in a manner consistent with written representations. In particular, the SEC found that the managers’ “failure to adopt and implement written policies and procedures” for such a compliance review allowed the dissemination of misrepresentations and omissions that attributed increased value to performance rather than to a changed valuation method, wrongly sourced the valuation write-up to a third-party valuation firm, and falsely disclosed that an independent auditor had audited the underlying funds. As a result, the SEC ordered the private equity fund managers to disgorge $2.27 million to investors, pay penalties of approximately $750,000, and engage an independent consultant to review its valuation policies and procedures; and insure for a period of two years that the private equity fund managers follow adequate valuation policies and procedures.

Down goes Frazier!... The SEC Takes It on the Chin in Supreme Court Fight to Maintain "Discovery Rule" in Enforcement Actions

This post was written by Terence Healy.

The discovery rule is no more. The Supreme Court today issued its decision in Gabelli v. SEC, 568 U. S. ____ (2013), and held the five-year limitations period under 28 U.S.C. § 2462 runs from the date of the underlying violation, and not from when the government reasonably should have discovered the wrongful act. The Securities and Exchange Commission (“SEC”) had long maintained that, in civil enforcement proceedings, the time within which it could initiate actions seeking penalties did not begin to run until the fraud was discovered. After all, the Commission argued, fraud is deceptive by nature, and the law had long recognized a discovery rule as an exception for suits based on fraud.

Gabelli turned on the reading of 28 U.S.C. § 2462, a catch-all limitations statute tracing its roots in the law back to 1799. The statute provides the government must commence any “proceeding for the enforcement of any civil fine, penalty, or forfeiture” within five years from time “when the claims first accrued.” 28 U.S.C. § 2462. In rejecting a reading of a “discovery rule” into § 2462, the Court held that under “the most natural reading of the statute… the five-year clock begins to tick” when the fraud occurs. “In common parlance a right accrues when it comes into existence.” The Court found limiting the government’s ability to bring claims beyond the five-year window also advanced the basic policies of all limitations periods; namely, elimination of stale claims and certainty as to a party’s right to recovery or potential liability.

The Court distinguished cases where a “discovery rule” was used to protect victims of fraud, who often had no reason to know they had been defrauded. The Court noted that the SEC’s very purpose is to root out fraud, and it has been given significant tools to achieve that goal.

Now, with the limitations issue made clear, the SEC’s Division of Enforcement will be under increased pressure to conclude investigations and make charging decisions in a timely manner. If this leads the Commission to better allocate its limited resources – and better exercise its discretion with respect to the individuals and companies it charges – the decision from the Court today may not be such a bad thing…

SEC Better Fasten Those Seat Belts, Looks Like A Bumpy Ride

This post was written by Amy J. Greer.

As the securities enforcement world awaits the U.S. Court of Appeals for the Second Circuit’s decision in the SEC v. Citigroup matter – where Judge Jed Rakoff balked at the Commission’s “neither admit nor deny” policy and refused to approve a settlement for lack of evidentiary support – it now appears the SEC may face increased scrutiny in its litigation practices, regardless of how the Court of Appeals rules. Just last month, another federal judge, this time in Colorado, refused to accept a settlement until the defendant, essentially, admits that the allegations against him are true.

But that might not be the worst of it – the SEC now may have to justify not just a litigation policy but also its own internal practices. In SEC v. Kovzan, the SEC has charged a CFO for his company’s failure to disclose as income certain perks paid to the then-CEO, among them commuting expenses, from the CEO’s home to the corporate headquarters, to the tune of $1.18 million over six years. Kovzan has argued that there was nothing improper about his conduct. And, as support for his position, he sought, and the Magistrate Judge has now ordered produced, the SEC’s own documents and records concerning its practice of reimbursing its officials for travel and lodging when they live in one location but work at an SEC office elsewhere. Ouch. Appropriate or not, you can just hear the gavel at the Congressional hearing as this stuff gets aired.

This is the second time that Mr. Kovzan has sought and been granted the right to receive non-public SEC documents, which he claims are relevant to his defense. Back in October 2012, the District Judge in the case, overruling the Magistrate Judge’s order, granted the defense the right to internal SEC documents relating to the SEC Staff’s decision-making and guidance on Regulation S-K, Item 402, which relates to executive compensation reporting.

So, it appears that even if the Second Circuit hands the SEC a victory, the agency seems to be facing a changed litigation landscape. Defendants are always willing to take shots at the Commission, but these days, the courts seem less willing to block those shots.

The Clock Is Ticking for the SEC... (Or Is It?)

This post was written by Terence Healy.

The Supreme Court heard oral argument this morning in a case addressing the time within which the Securities and Exchange Commission (“SEC”) can initiate an action seeking civil penalties for violations of the federal securities laws. In Gabelli v. SEC, the Court considered whether the “catch all” five-year limitations period under 28 U.S.C. § 2462 runs from the date of the underlying violation or from when the government reasonably should have discovered the wrongful act. The statute – which traces its roots in the law back to 1799 – provides that the government must commence any “proceeding for the enforcement of any civil fine, penalty, or forfeiture” within five years from the time “when the claims first accrued.” 28 U.S.C. § 2462. The SEC argued – and the Second Circuit agreed below – that in cases of fraud, which involve deception by nature, a claim does not accrue until the government reasonably should have discovered the fraudulent conduct. The SEC maintained the law has long recognized the discovery rule as a "historical exception for suits based on fraud." See TRW Inc. v. Andrews, 534 U.S. 19, 37 (2001) (Scalia, J., concurring).

At the argument today, Assistant Solicitor General Jeffrey Wall encountered a hot bench in arguing  that a broad “discovery rule” should be read into a 200-year-old statute. The justices characterized penalties as “quasi-criminal” and distinguished cases finding that a “discovery rule” applied to actions seeking recovery of lost money or property. The government conceded in argument that, for criminal penalties, limitations periods run from the date of violation.

The Court challenged the government to cite any prior cases where a discovery rule was found to apply to an action seeking penalties. On two occasions, Mr. Wall responded that there were not really any cases “on either side of the ledger.” Given the age of the statute at issue, the justices were not satisfied. Justice Kagan asked, “Why is it that you don't have any cases? … This is an old statute.” Justice Breyer pressed the issue, at one point stating, “I will give you 30 seconds to cite me one case. Otherwise, I am going to assume there are none.” Justice Scalia added, “Fraud is nothing new. This has been around for 200 years for Pete’s sake.”

If the Court finds against the SEC and reverses the Second Circuit, the SEC will be under increased pressure to conclude its investigations in a timely manner (something for which the Enforcement Division has not always shown great skill). This is particularly true given that some federal courts have found “penalties” to include such non-monetary relief as professional bars and injunctions against future violations of the law. See SEC v. Johnson, 87 F.3d 484 (D.C. Cir. 1996).

The case is Gabelli v. SEC, Supreme Court Case No. 11-1274. A decision is expected in June.

SEC Regs Amended To Allow Hedge Funds To Advertise: Potential Data Privacy Implications

This post was written by Alexandra Poe, Paul Bond, Keri Bruce, and Frederick Lah.

Last week, the SEC proposed amendments to Rule 506 of Reg D to lift a long-standing ban on advertising for hedge funds and certain other investments. Over the course of the next few weeks, Reed Smith will be releasing a series of blog posts about the various implications this proposed rule may have if it goes into effect. For this post, we consider the potential data privacy implications with the proposed rule.

Hedge funds and other issuers seeking to conduct private offers under Rule 506 of Reg D have long been banned from advertising in public forums like billboards, newspapers, television, or publicly accessible websites. Previously, such issuers could only offer their securities to persons with whom they had a pre-existing substantive relationship based on whether the issuer was able to conclude that the offeree was likely to be an appropriate offeree (i.e., a sophisticated person capable of bearing the financial risk). The ban was designed to prevent issuers that were not subject to full burden of the Securities Act's disclosure and registration requirements from targeting investors whose relative lack of sophistication or bargaining power might prevent them from having all the information necessary to make an informed investment decision. But under the new rules, hedge funds and other issuers would be able comply with Rule 506 and still publicly advertise to anyone, so long as the actual purchasers of the securities are “accredited investors,” as that term is defined in the Rule.

While hedge funds and other Rule 506 companies are now technically permitted to advertise both widespread and publicly, it is dubious that we’ll see hedge funds competing with major consumer brands for prime advertising real estate. A more likely scenario will be that hedge funds will become more aggressive buyers in the information market, and will use that information to tailor their advertising efforts to customers likely to be “accredited investors.” Perhaps this will take the form of email marketing campaigns, direct phone marketing, or possibly even online targeted advertising, for example, on a mutual fund or brokerage firm’s website. Each of these types of advertising comes with its own unique set of privacy considerations. It should also be noted that this new avenue of information-sharing then becomes a compliance consideration for both the hedge fund and the information provider. For example, if a financial institution ends up providing such information to a hedge fund, the financial institution may need to update its privacy policy accordingly to make sure it is complying with regulatory requirements.

The extent to which hedge funds and other issuers seeking to comply with Rule 506 will take advantage of these proposed rules (once and as adopted), if at all, remains to be seen. The resultant data privacy implications will vary depending on the exact advertising measures employed. We will be monitoring this situation for developments.


SEC Warning: Phony Email Hoax

This post was written by Amy J. Greer.

The SEC sent out a warning yesterday that a phony message referencing the Agency's Whistleblower Office is being used in connection with a potential computer hack or dissemination of malicious software. According to the SEC Alert, sent through the Agency's push technology, it has received numerous calls in the past 24 hours concerning an email that reads as follows:

 "Dear customer, Securities and Exchange Commission Whistleblower office has received an anonymous tip on alleged misconduct at your company, including Material misstatement or omission in a company's public filings or financial statements, or a failure to file Municipal securities transactions or public pension plans, involving such financial products as private equity funds. Failure to provide a response to this complaint within a 14 day period will result in Securities and Exchange Commission investigation against your company. You can access the complaint details in U.S. Securities and Exchange Commission Tips, Complaints, and Referrals portal under the following link: "

According to the SEC, the email is a hoax. Since the message appears to be directed at companies, it may be prudent to warn your personnel about this hoax.

Account Intruder Intrigue Obscures Real Market Threat

This post was written by Amy J. Greer.

The latest account intrusion case brought by the SEC had all of the usual hallmarks: a foreign national; hacking into accounts; and trading long distance. But this newest case revealed a potentially more dangerous threat: unfettered and direct access to the markets by those out to commit fraud, whose identifies are hidden through omnibus trading accounts or sponsored market access arrangements. For the first time, the SEC has taken action to try to limit that threat.

Account intrusion cases are not new, unfortunately. The SEC brought the first of these cases when I was still at the agency, back in December 2006. And I was a part of the team that brought the case, against a Belize corporation, located in Estonia, run by a Russian national, which tells you everything you need to know about how difficult it was to effect service - but we did, eventually. In that case, known as Grand Logistic, S.A., which was the name of the company (seemed pretty apt), the SEC also froze some of the assets, since they remained in a US brokerage account, as well as working with foreign regulators to attempt repatriate some of the assets that had been moved out of those accounts. Much about this sounds too familiar to the case brought by the SEC last week against a Latvian national, Igor Nagaicevs, who appears to have gotten away with this conduct for over a year and to have absconded with the cash - $850,000.

For those unfamiliar with the account intrusion scheme, it's really just the latest incarnation of a pump-and-dump: a trader with a knack for hacking will buy or sell short, in his own account (preferably a rather secretive account where the trader's identity will not be obvious to snoopy regulators and SROs), a security that is generally relatively thinly traded; then our hacker will hack into a legitimate brokerage account (like yours or mine) and, using the assets in that account, either cash or cash created by selling holdings, will create movement in the security he already has purchased (the "pump") by buying or selling a lot more. Then, the fraudster dumps his own holdings, making a little killing, all artificially generated by his own actions.

Now, there are at least two other parties to this scheme that do not involve our trader/hacker guy: the trading firm that is giving him market access and the victim brokerage, where the accounts are getting hacked. Up until last week, neither of these had ever been charged by the SEC. In regard to the victim brokerage firms, they have been making their account holders whole, at rather significant cost. For that reason, and presumably because they are also taking whatever steps are humanly possible to prevent such activity, and also because, perhaps appropriately, the SEC rarely takes action against those viewed as victims, the SEC has never acted against these victim brokerage firms. But with this most recent Nagaicevs case, the SEC has decided that it is had enough with these omnibus trading accounts and sponsored market access arrangements that mask the identity of the actual traders, especially when those traders turn out to be committing frauds. Accordingly, the SEC has charged these various unregistered trading firms and their principals, and several of them have settled the charges, including Alchemy, KM, Zanshin, and Mercury, Richard V. Rizzo, and Mercury and Hyatt.  Veiled, unfettered access by traders to the markets is potentially dangerous. The frailty of the markets was well demonstrated in the "flash crash" and many market participants are less than confident that the reasons for that were fully identified (and some think the reasons have yet to be identified at all). "Hidden" traders are also free to trade on material nonpublic information. The degree of potential mischief making is somewhat self-evident. Beginning to close off an avenue for such trouble-making seems like a really necessary first step.


Judge Rakoff Rejects the SEC-Citi Settlement, But Is "Truth" Really the Purpose of Any Settlement and Does the SEC Need the Courts to Settle its Cases?

This post was written by Amy J. Greer.

Once again, Judge Jed Rakoff has proven to be a thorn in the side of the SEC, rejecting the agency’s $285 million settlement with Citigroup Global Markets. While Judge Rakoff’s opinions are always a good read: sharp, well written, and to the point - and this one is posted at the SDNY website and also available here - one can’t help but wonder whether his effort to bring sunshine to the process so as to further his view of the public’s interest in these proceedings won’t have precisely the opposite result.

Using the hook of the injunctive relief incorporated into the settlement as the touchstone for his analysis of whether the public interest is served by the settlement proffered, Judge Rakoff concludes that the settlement “is neither fair, nor reasonable, nor adequate, nor in the public interest. Most fundamentally, this is because it does not provide the Court with a sufficient evidentiary basis to know whether the requested relief is justified under any of these standards.” Opinion at p. 8. This really gets to the meat of Judge Rakoff’s concern: that a party can settle an SEC enforcement action without admitting or denying the underlying allegations. Apparently, in Judge Rakoff’s view, these missing admissions would provide the Court with the facts needed to decide the propriety of the settlement.

While I concede that in certain circumstances this long-standing SEC policy is silly: when I was at the agency, I recall inquiring why the policy applied to convicted felons, for example, who were willing to consent to the entry of SEC judgments after their criminal convictions, a question I still have today. In most circumstances, however, the analysis is no different than in the settlement of any civil matter. Defendants settle cases – including SEC cases – for a multitude of reasons, many of which have nothing to do with whether or not they actually engaged in the conduct alleged. The SEC settles cases for a similar wide range of reasons, including the fact that they simply cannot try every case, and losing cases is decidedly not good policy, makes for bad precedent, and does not serve to deter future conduct.

Just as the settlements of private civil litigation would stall if admissions were required for settlement, significantly fewer SEC enforcement cases would settle if defendants had to admit to any of the alleged conduct. Just like in private civil actions, many defendants do not agree with the SEC’s conclusions, as alleged in the Complaint, and settling parties tend not appreciate the ability of non-parties to seize upon such admissions to further their own causes.

Notwithstanding Judge Rakoff’s suggestion that “knowing the truth” is the overriding public interest to be served by SEC settlements (Opinion at p. 15), in fact, that is the interest served by confidential SEC enforcement investigations, where neither the public nor the Court has any participation. Once that truth is known, the agency then takes the information and undertakes a necessary calculation to serve its true mission, which is to protect investors; sometimes settling cases, sometimes taking defendants to trial. One wonders whether a forced trial can ever be the right outcome, as Judge Rakoff has accomplished here.

But, of course, to achieve its mission of protecting investors, the SEC does not really need Judge Rakoff and I suspect that what we will see is less use of the courts and, so, less public participation in the process. The SEC can just as easily resolve any enforcement matter it chooses to bring in an SEC administrative proceeding, without any of the drama and uncertainty.

Raj Rajaratnam Sentenced: Finally A Small Victory?

This post was written by Amy J. Greer.

After his conviction on 14 counts of securities fraud and conspiracy in what has been described as the biggest insider trading case ever - and, by his defense counsel, John Dowd as a “victory,” since he didn’t get convicted on all counts - today Galleon founder Raj Rajaratnam was sentenced to 132 months, or 11 years in prison, for his massive insider trading scheme.

This sentence represents the longest of the string of sentences handed down this year in connection with this trading ring. Former hedge fund trader Zvi Goffer, another link in the conspiracy’s chain, was sentenced on September 21, 2011 to 10 years, so it was widely expected that Raj would get a longer term.

Prior to sentencing, in an effort to reduce the sentencing guideline range, a complex calculation that takes many factors into consideration - but probably most important here, the amount at issue as a result of the unlawful trading - Raj’s lawyers made pitches to the court in an effort to reduce the ill gotten gains or losses avoided. The prosecution’s numbers were in excess of $70 million; the defense was at under $8 million. There was also much discussion about Rajaratnam’s health issues, also a potential consideration for a sentencing court.

Given that Raj was looking at a sentence in excess of 20 years, perhaps this is where his defense team can finally claim some actual victory. While the crimes for which they were convicted differ, the treatment of white collar criminal defendants in the financial fraud/securities area are often compared and, after all, Dennis Kozlowski is doing 8 to 25 in New York State prison, Jeffrey Skilling, who won at the United States Supreme Court, is doing more than 24 years in a federal penitentiary; more recently, Lee Farkas got 30 years for a mortgage fraud scheme, and then, of course, there’s Madoff’s 150 year sentence.

SEC Rejects Proposal by its Enforcement Staff to Settle Landmark 'Clawback' Suit

This post was written by James A. Rolfes.

Last week, the Washington Post reported the SEC had rejected a proposed settlement of SEC’s landmark case seeking enforcement of the so-called “clawback” of executive compensation under Sarbanes Oxley Section 304. See Hilzenrath, D., Washington Post July 20, 2011, SEC Rejects Proposal. In SEC v. Jenkins, No. 09-cv-01510 (D. Ariz. filed Jul. 22, 2009), the SEC for the first time sought over $4 million in incentive-based compensation from an admittedly non-culpable CEO of a company that had misstated its financial statements due to employee fraud. The SEC further had obtained an early victory in that case, persuading the federal court that SOX 304 did not require a showing that the defendant CEO aided or even knew about the fraud leading to financial statement restatement. SEC v. Jenkins, 718 F. Supp. 2d 1070 (D. Ariz. 2010). Now the Commissioners have rejected the settlement recommendation of the SEC enforcement staff and accepted the risk that trial of the matter could undo this victory -- signaling perhaps the Commission’s intention to aggressively pursue clawbacks.

Behind the scenes, however, the rejection of the settlement provides a less clear message. According to unnamed sources, some Commissioners balked at a settlement that obtained less than half the sought-after compensation, but others rejected the staff’s recommendation claiming the SEC should never have brought the case in the first place. That tension reflects a wider debate now on going as to whether SOX 304 enforcement against “innocent” CEOs and CFOs represents an intended tough Congressional mandate to punish executives who oversee the filing of later-restated financial statements, or a poor policy choice by the SEC. See e.g., Harvard law School Forum on Corporate Governance and Financial Regulation.

That divergence of Commissioner opinion may also play out as the SEC undertakes to establish rules required under Dodd-Frank 954. That legislation mandated expanded restatement-based clawback requirements, and directed the SEC to craft rules requiring public companies to recover incentive-based compensation calculated using erroneous financial data. See Dodd-Frank Leaves Clawback Uncertainty, Compliance Reporter (August 30, 2010) Rolfes, J.  Right now, the SEC has placed that rulemaking responsibility on hold at least until the Fall 2011.

The Raj Guilty Verdict - What Took So Long?

This post was written by Amy J. Greer.

The verdict is in – finally. Guilty on all counts. We’ll have more on that later, as will many people, no doubt.

But for those who wondered what took the Rajaratnam jury so long, I think it’s worth a reminder that, while the evidence in the case might seem somewhat straightforward – at least the juicy tidbits reported in the media, plus all those seemingly useful guilty pleas – insider trading law is definitely not.

Bottom line, there is no US law that says: “thou shalt not trade on material non-public information we all wish we had”; instead, we have Section 10 of the Securities Exchange Act of 1934 and Rule 10b-5 , which proscribe fraud far more broadly.

From these very broad pronouncements have come a patchwork of legal decisions that comprise US insider trading law and which require a fact finder – the Raj jury – to make at least six separate factual findings: that the defendant (1) intentionally (2) purchased or sold a security (3) on the basis of (4) material (5) non-public information (6) in breach of a duty of trust or confidence.

Whew. That’s a lot of work. And it’s worth remembering that most of these elements likely played a role in how the evidence was presented at the trial. Oh yeah - and there’s also that “beyond a reasonable doubt thing” that’s required for a finding of guilt in a criminal trial.

Most of us never have to face the question of whether a jury of our peers will do that hard work. At some level – at every level really – it’s good to know they do. Even in those cases where it seems so straightforward.

Now THAT's "Real Time" Enforcement

This post was written by Amy J. Greer.

At the recent SEC Speaks conference, the recounting of a particular SEC Enforcement action caught my attention and I thought it particularly worthy of note, since most of us who practice in this area believe – with pretty good reason and a whole lot of evidence – that the SEC’s Enforcement Division moves like, well, that tortoise. Usually getting to a finish line, of sorts, but it takes a while. Often a really long while . . . with a lot of meandering.

So, needless to say, Daniel M. Hawke, who heads the Division’s Market Abuse Unit and leads the Philadelphia Regional Office, proudly recounted the much more “hare”-like freezing of $1.1 million in assets of two Spain-based traders, accused of insider trading in connection with PotashCorp’s announcement that it had received and rejected an unsolicited offer from BHP Billiton plc, within 72 hours of that announcement. That’s right: on August 17, 2010, PotashCorp publicly announced the spurned offer, and on August 20, 2010, the SEC’s Enforcement Division obtained a signed order freezing the traders’ assets in the Northern District of Illinois.

And, actually, it’s even better than that. Let’s recount the geography here. The traders are both in Madrid, Spain, trading options through US-based Interactive Brokers, LLC accounts, and all of the trading at issue took place on the Chicago Board of Options Exchange. Potash Corp. is based in Saskatchewan, Canada, and its stock is traded on the New York and Toronto stock exchanges and its options are traded on the CBOE. BHP is based in Melbourne, Australia. SEC staff on the case were located in Chicago, New York, and Philadelphia.

Real time enforcement – that is, taking action shortly after the conduct actually occurred – has been a matter of discussion for a long time at the SEC. Of course, in these types of circumstances, when money is at risk of being moved out of the country and out of the SEC’s ready reach, the timing is even more imperative. But given all of the moving parts here, especially the geographic issues, gathering sufficient evidence to get the freeze order in just 72 hours of the announcement, and within about a week of the trading (all of which occurred between August 12 and 16), just goes to show how quickly the agency can move in the right cases. 

The Tenth Circuit Rejects the Application of the Investment Advisers Act to Brokers of Life Insurance Products

This post was written by James A. Rolfes.

Last week, the Tenth Circuit Court of Appeals, in a matter of first impression, held that a life insurance company sales agent, who referred to himself as a Financial Services Representative (FSR), did not have to fulfill the fiduciary duties imposed on investment advisers under the Investment Advisers Act. Instead, the incidental nature of the investment advice given and the manner in which the sales agent was compensated, qualified the agent for the broker-dealer exemption to the Act’s definition of an investment advisor.

In Thomas v. Metropolitan Life Ins. Co., --- F.3d ---, 2001 WL 310371 (10th Cir. Feb. 2, 2011), the Met Life sales agent analyzed the plaintiffs’ financial situation, gave advice on how to allocate their 401(k) funds, conducted an investment/insurance product “suitability analysis” and recommended the plaintiffs’ purchase of a variable universal life insurance policy. In doing so, alleged the plaintiffs, the agent and, vicariously, his life insurance company employer, failed to disclose the strong incentives the agent had to sell the Met Life proprietary products -- a purported violation of an investment advisor’s statutory duty to give unbiased advice.

The Tenth Circuit, however, rejected the notion that the Act imposed fiduciary obligations on a life insurance agent’s provision of investment advice in the context of the sale of insurance products. The court instead held that the agent’s actions met the two pronged definition of a broker-dealer whose advice the statute explicitly exempts. In particular, the court found that (i) the agent gave advice “solely incidental to” his sale of the life insurance product; and (ii) his compensation (i.e., a $500 brokerage commission) derived from the sale of the insurance policy, and not from his provision of investment advice. In so holding, the court expressed its belief that the plain language of the statute, the legislative history and SEC interpretations all supported the court’s conclusion that the statute’s reference to advice “solely incidental” to the brokerage services meant advice “solely attendant to,” or “given in connection with,” the brokerage service provided, and not to the amount or import of the advice given. Consequently, even though the agent’s advice purportedly served as the “central component” of the sale transaction, he gave such advice in connection with, and thus incidental to, the sale of the insurance product. He therefore did not owe the plaintiffs a fiduciary duty under the Investment Advisers Act.

Ironically, this decision follows on the heels of the SEC’s release of the January 2011 SEC Staff’s Study on Investment Advisers and Broker-Dealers. Pursuant to the Congressional mandate in Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, the SEC Staff evaluated the effectiveness of existing legal and regulatory standards of care for providing personalized investment advice and securities recommendations to retail customers. Contrary to the court’s analysis, the Staff suggests that the amount of advice a broker-dealer provides is relevant in analyzing the applicability of the broker-dealer exemption. But of even greater importance, the Staff strongly recommended consideration of regulatory enacted rules that would do away with the broker-dealer exemption altogether, and instead impose a uniform fiduciary standard on both investment advisers and broker-dealers who provide personalized investment advice about securities to retail customers. In particular, the Staff called for a uniform fiduciary standard that would, among other things, require broker-dealers to disclose conflicts of interest – the issue at the heart of the plaintiffs’ claims in Thomas v. Met Life.

Thus, while the Thomas v. Met Life decision provides comfort to insurance companies and their sales agents, such comfort may be short lived.

Will the Whistles Start Blowing?

This post was written by Sarah R. Wolff.

In January 2010, the Securities and Exchange Commission ("SEC") announced a new cooperation initiative intended to encourage and incentivize individuals and companies to cooperate with and assist the SEC in its investigations and enforcement actions. That initiative, which was characterized as a “potential game-changer” for the SEC’s Enforcement Division by its new director, Robert Khuzami, gave the SEC a new set of tools for its “enforcement toolbox”, including cooperation agreements, deferred prosecution agreements and non-prosecution agreements. These options, while employed by the Department of Justice, were not previously available in SEC enforcement matters. In addition to outlining those tools in a revision to the SEC’s Enforcement Manual, the Commission provided a policy statement detailing the factors the SEC considers when evaluating cooperation by individuals and by companies.

The SEC evidenced its latest expression of interest in obtaining cooperation with its July 23, 2010 announcement that it had awarded a $1 M bounty to two whistleblowers for their substantial assistance in providing information and documents leading to the imposition and collection of civil penalties in the Commission’s May 2010 insider trading actions brought against Pequot Capital Management, Inc. and various individuals. The award was made pursuant to the Commission’s then-existing authority under the Securities Exchange Act of 1934 to award bounties to whistleblowers in insider trading cases. Significantly, in the twenty years since the SEC received its bounty authority, it had only awarded a total of $160,000 to five claimants. All of that appears to have changed with the adoption of the Dodd-Frank Act.

Among the many provisions of Dodd-Frank are specific provisions designed to significantly expand the SEC’s authority to reward whistleblowers for information beyond insider trading cases. The Act provides for the payment of potentially large awards as well as for the protection of employees who provide information to or assist the SEC relating to any violation of the securities laws. To be sure, in order to qualify for a whistleblower award, the information provided to the SEC by the whistleblower must be “original” information; in other words, the information must not previously have been known to the SEC. But if that information provides substantial assistance and leads to a successful enforcement action resulting in over $1,000,000 of monetary sanctions imposed on the wrongdoer, then the SEC has the discretion to award the whistleblower not less than 10 percent and not more than 30 percent of the monetary sanctions collected.

On November 3, the Commission published its proposed rules for implementing the whistleblower provisions of Dodd-Frank. Comments on the rules, which total over 180 pages, are due by December 17, 2010.

Have these developments changed the landscape for clients and their counsel in considering whether, and when, to self-report a potential FCPA or other securities law violation to the SEC or other regulators? Certainly the past five years have seen an uptick in enforcement activity in FCPA investigations and actions, and many of those investigations began with a self-report. The confluence of increased pressure to cooperate early in order to obtain full cooperation “credit” with Dodd-Frank’s whistleblower protections mandates that companies must even more carefully evaluate how they will conduct internal investigations at the first sign of possible wrongdoing. Does an e-mail or an anonymous tip of suggested wrongdoing automatically trigger a full blown investigation? How early companies must share their concerns, preliminary or otherwise, if not their findings, with the SEC and other regulators in order to get cooperation credit, becomes an even more critical decision under the new regulatory regime.

One obvious risk of holding back is that the SEC will receive information from a company employee who in years past might have gone to an in-house compliance officer to voice her concerns. Instead, she went directly to the SEC. Such conduct raises significant issues for companies that have installed significant compliance programs and which now must deal with risk management where the government’s financial incentives may undermine their efforts. In the end, every decision as to whether and when to self-report, and the nature and extent of an internal investigation, are fact-intensive, and there isn’t a one-size fits all prescription. It remains to be seen how the SEC will parse the “race” to disclose and cooperate, in terms of either rewarding an early disclosure or penalizing a company for failing to timely cooperate by, for example, imposing a more significant penalty and other remedies against a company in a subsequent enforcement action.

At a minimum, the dynamics have changed at the SEC and, when combined with Dodd-Frank, present new challenges in navigating the cooperation waters.

No Indemnification for SOX 304 Clawbacks

This post was written by James A. Rolfes.

The Second Circuit Court of Appeals recently ruled that a corporation could not indemnify its CEO or CFO against liability arising under Sarbanes Oxley Act Section 304. The so-called Section 304 “clawback” provision requires a public company’s CEO and CFO to return bonuses, other equity-based incentive compensation and trading profits when “misconduct” leads to material noncompliance with financial reporting requirements (i.e., a financial statement restatement). This statute further gives the SEC the authority to enforce such clawbacks, and, importantly, to exempt CEOs and CFOs from its application. As a result, allowing a corporation to provide a release and indemnification for the clawback would “frustrate the power of a federal agency to pursue the public’s interests in litigation” and “[fly] in the face of Congress’s efforts to make high ranking corporate officers of public companies directly responsible for their actions that have caused material noncompliance with financial reporting requirements.” Cohen v. Viray.

This decision follows closely upon Congress’s call last summer for the SEC to get serious about the return of executive bonuses when a company restates its financial statements. In particular, in the recently enacted Dodd-Frank Wall Street Reform and Consumer Protection Act, Congress expanded upon the SOX Section 304 compensation clawback provision, explicitly instructing the SEC to establish rules requiring exchange-listed public companies to recover the incentive-based compensation paid to corporate executives as a result of using erroneous financial statement data.

The decision also issues during a period in which the SEC has more aggressively used the SOX 304’s clawback provision in enforcement proceedings. Despite being on the books for over eight years, the SEC sparingly invoked the provision in enforcement actions, and then only when a CEO or CFO had direct involvement in causing a financial statement misstatement. Starting in 2007, however, the SEC more regularly has sought SOX 304 disgorgement, and, as the result of a controversial decision that split the Commissioners along party lines, has demanded the return of pay from CEOs and CFOs that unwittingly – as opposed to intentionally – benefitted from the accounting misconduct. (An interpretation recently endorsed by a federal court in SEC v. Jenkins.)

Many questions remain regarding the interpretation of SOX 304 – questions likely to be repeated as the SEC works its way through the rule making process Congress has demanded under Dodd-Frank Section 954. The issues range from what activity will trigger a disgorgement obligation, to whom the obligation will apply, to what payments or incentives will be covered, to what discretion will remain in the SEC’s enforcement of the executive compensation clawback provisions. See Rolfes, Dodd Frank Leaves Clawback Uncertainty, Compliance Reporter (Aug. 30, 2010). What remains clear, however, is that financial statement errors, even if unintentional, will put the earnings of CEOs and CFOs, as well as those of their C-level colleagues, at risk.

Market Abuse and the May 6th "Flash Crash": The SEC Expands its Enforcement Focus

This post was written by Amy Greer.

Recently, I had the opportunity to moderate a panel hosted by the Pennsylvania Bar Institute on which Daniel M. Hawke, the Chief of the SEC’s new Market Abuse Unit and Regional Director of the SEC’s office in Philadelphia, participated. Dan and I worked together for several years, while I was at the SEC, where I served as Chief trial counsel for the Philadelphia Regional Office. It was a pleasure (and really quite a coup) that he, and Elaine Greenberg, who heads the Municipal Securities and Public Pensions Unit and is the Associate Regional Director for Enforcement of the Philadelphia Office and also a former colleague, agreed to come and speak about their new national positions and the current focus of the Agency. Dan and Elaine head two of the five new specialized subject matter units created at the Division of Enforcement, focusing a lot of attention on the SEC’s Philadelphia Office.

The Market Abuse Unit focuses on investigations involving large-scale market abuses such as organized insider trading networks as well as other market manipulation and trading violations. One can expect that future cases brought by the unit may be similar to the SEC v. Galleon insider trading case currently under way. During the discussion, Dan described the Market Abuse Unit as conducting trader-based investigations, instead of reviewing trading on a security-by-security basis. Much of the Unit’s initial detective work depends heavily on computers and the development and deployment of automated trading data analysis. Dan explained that focusing only on securities is too limited to effectively capture improper trading. By focusing on traders, the Market Abuse Unit can look for patterns and relationships across securities to proactively uncover market abuse and trading violations.

However, perhaps even a trader-based analysis is too narrow in light of the “flash crash” that occurred in the stock market on May 6, 2010. The Dow Jones Industrial Average fell nearly 1,000 points causing many companies to trade at unreasonably low levels before the market recovered that same day. While the causes of the “flash crash” still elude regulators, the SEC has taken a strong interest in uncovering the origins of the “flash crash” and preventing future anomalies.

During the discussion, Dan acknowledged that when the market crashed on May 6th, he realized the focus of his Unit was still too narrow. He explained that the Market Abuse Unit must focus on market structure as well. As Dan explained, the Market Abuse Unit will need to specialize on such topics as Regulation National Market System (“Reg NMS”), market fragmentation, un-displayed liquidity and dark pools, high frequency and algorithmic trading, direct market access providers, and related issues. Such specialization will allow the unit to analyze, for instance, a fragmented market with over 50 exchanges to uncover where improper conduct may be occurring.

So how will this new initiative at the SEC’s Market Abuse Unit affect traders and trading practices? At the very least, we can expect this new Unit’s proactive approach and desire to expand its focus will cultivate more knowledgeable and savvy attorneys within the SEC’s Enforcement Division. What’s more, the SEC will now be on the lookout for more advanced and harder to detect market abuse schemes, not just across traders but, between fractured and fragmented markets as well. With all of these changes, one thing is certain, Dan Hawke and his Market Abuse Unit intend to be just as creative and knowledgeable as the traders they investigate.