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Insight & Commentary on SEC Enforcement Actions and Related Issues

Unregistered Brokers: Watch out for Shortcuts

Posted in Broker-Dealers, Non-scienter-based Violations

One of the things I’ve learned since returning to private practice three years ago is that people like to raise money for profitable enterprises when they can.  And why not?  It can be lucrative.  And if the people raising the money have the right connections, maybe even easy!  But these people don’t always love the idea of becoming registered as a broker-dealer.  They will imagine many reasons why they don’t have to do such a thing.  Some of those reasons are legitimate, but others can be shaky.  At times, for example, these people will say, Well, we’re going to affiliate with a registered broker-dealer, so we don’t have to register ourselves.

Watch out for that reason.  Because the SEC went a way toward taking the wind of its sales in May with a case it brought against Rafferty Capital Markets, a registered broker-dealer in New York.  The short version is, Rafferty allowed an unregistered firm to use its license to execute securities trades about 100 times.  Here’s the key part of the press release:

According to the SEC’s order instituting settled administrative proceedings, Rafferty agreed to serve as the broker-dealer of record in name only for approximately 100 trades in asset-backed securities that were actually introduced by the unregistered firm.  While Rafferty held the necessary licenses and processed the trades, it was the unregistered firm that managed the business.  Five of the firm’s employees became registered representatives with Rafferty but they performed their work in the offices of the unregistered firm, which retained sole authority over their trading decisions and determined their compensation.  Rafferty had no involvement in the trading or compensation decisions while the registered representatives executed the trades through Rafferty’s systems on behalf of the unregistered firm.  Based on the agreement, Rafferty kept 15 percent of the compensation generated by these trades and sent the remaining balance to the unregistered firm.

The SEC’s order found that Rafferty (1) willfully violated Section 17(a) of the Exchange Act and Rules 17a-3(a)(1) and 17a-4(b)(4) (record-keeping violations, basically), and (2) willfully aided and abetted and caused the as-yet unnamed unregistered firm’s violation of Section 15(a) of the Exchange Act.

I think the lesson here is fairly simple: if you’re not a registered broker, but you’re acting as one, you can’t escape liability by simply running the transactions through a properly registered firm.  The SEC doesn’t love it and could seek to bring an enforcement action to sanction it.  This unregistered firm may be up next.

Guns and More Guns: SEC Hits Smith & Wesson for FCPA Violations

Posted in FCPA

One thing the SEC likes to do is bring cases with a lot of deterrent value.  That is, cases that it hopes will scare other people and companies into complying with the law.  Often that means cases with large price tags attached.  Companies see those expensive cases and want to stay far away from them if they can help it.  But sometimes deterrence means smaller cases, for the very reason that the threshold for the violations is so low.  The SEC will do this from time to time in the insider trading area.  The idea is, if the SEC is crazy enough to go after something dinky like that, who knows what else it will do?  They might come after me.  This approach fits with Mary Jo White’s “broken windows” strategy (adopted from Rudy Giuliani’s tenure as mayor of New York) in which the Commission tries to “allocate our resources in such a way so that market participants understand we are at least looking and pursuing charges in all directions.”

Anyway, the Commission seems to be taking this angle with a settled administrative case it filed yesterday against Smith & Wesson.  According to the SEC’s order, the Springfield, Mass.-based firearms manufacturer sought to break into new markets overseas starting in 2007.  The company’s international sales staff then allegedly retained a third-party agent in Pakistan in 2008 to help the company obtain a deal to sell firearms to a Pakistani police department.  Smith & Wesson officials authorized the agent to provide more than $11,000 worth of guns to Pakistani police officials as gifts, and then make additional cash payments.  Smith & Wesson ultimately won a contract to sell 548 pistols to the Pakistani police for a profit of $107,852.  In the larger scheme of things, this is a pretty tiny case.  But it might scare the $%^&#! out of smaller companies making its first pushes into international markets.  And indeed, that seems to be exactly the point for FCPA unit chief Kara Brockmeyer, who said in the press release, “This is a wake-up call for small and medium-size businesses that want to enter into high-risk markets and expand their international sales.”

The case also fits with Brockmeyer’s promise from last week that more FCPA matters would be brought as administrative cases, and not in federal courts.  If Judge Rakoff doesn’t like the terms of the SEC’s settlement with Smith & Wesson, aside from writing to his Congressman there’s not a lot he can do about it.

The SEC’s order finds that Smith & Wesson violated the FCPA’s anti-bribery, internal controls and books and records provisions.  The company agreed to pay $107,852 in disgorgement, $21,040 in prejudgment interest, and a $1.9 million penalty.  In arriving at this resolution, the SEC apparently considered Smith & Wesson’s cooperation with the investigation as well as the remedial acts taken after the conduct came to light, though it’s hard to see how the sanctions could have been worse.  Smith & Wesson halted the impending international sales transactions before they went through, and implemented a series of significant measures to improve its internal controls and compliance process.  The company also terminated its entire international sales staff.

Foreign Pink Sheets Companies and the FCPA

Posted in FCPA, Microcap Fraud

Penny stock companies have been much in the news recently.  They can be tough entities for law enforcement to look into given that their officers and directors are often not inclined to cooperate with government investigations.  They can also be full of criminal activity.  At the same time, Foreign Corrupt Practices Act enforcement is often focused on foreign companies, sometimes with tenuous jurisdictional theories.  But what if a foreign penny stock company decided to start paying bribes abroad?  More specifically, let me pose this hypothetical:  Copperco, a copper mining company based in Vancouver trades on the Pink Sheets, known these days as the OTC Markets, and corruptly pays bribes to Mexican government officials to obtain a contract from the Mexican government.  The company’s stockholders are entirely U.S. citizens, but its headquarters and principal place of business remains on the other side of the border in Canada.  Copperco didn’t make use of any U.S. territory in planning or paying the bribes in question.

That is to say, the company has pretty much followed the recipe for FCPA violations.  But I think only pretty much.

FCPA Jurisdiction

The FCPA applies to issuers, domestic concerns, and foreign persons acting in the United States.  What are those?

Roughly, a domestic concern is any business that has its principal place of business in the United States or that is organized under U.S. or state laws.  U.S. citizens and residents also count, as do directors, employees, agents and shareholders of issuers and domestic concerns.  Foreign Persons includes natural and legal persons that are not issuers or domestic concerns.  Officers, directors, employees, agents, and stockholders of foreign persons are also subject to the FCPA if they violate the FCPA while in the United States.

“Issuers” are what I want to discuss.  Section 3(a)(8) of the Exchange Act defines an issuer generally as “any person who issues or proposes to issue any security.”  But for FCPA purposes, an issuer is a company that has issued securities registered in the U.S. or that is subject to the reporting provisions of the Exchange Act.  The bribery provisions apply to any issuer that has a class of securities registered pursuant to Exchange Act Section 12 or is required to file reports under Section 15(d).  This includes companies issuing American Depository Receipts (ADRs) that are traded on a U.S. exchange.

Copperco’s Liability under the FCPA

Is Copperco liable under the FCPA for its illicit payments to the Mexican government officials?  I don’t think so.  Copperco isn’t a domestic concern.  It hasn’t acted within the United States.  Is it an issuer?  Under Section 3(a)(8) of the Exchange Act it is.  It issues securities; it has shareholders.  But the FCPA defines “issuer” more narrowly.  Most penny stock companies have minimal, almost non-existent filing obligations.  They generally don’t trade on a U.S. exchange and do not make periodic filings with the SEC.   This analysis conveniently ignores the Canadian Corruption of Foreign Public Officials Act, but I can’t see a jurisdictional hook for the SEC or Justice Department to bring an FCPA case against Copperco.  Do you?

Three Thoughts about FINRA’s Weird Japanese Insider Trading Case

Posted in FINRA, Insider Trading

One of the things you’re not supposed to do if you’re in the securities business – or any business, really – is buy and sell securities on the basis of material, nonpublic information in breach of a duty not to do so.  The SEC doesn’t like it.  Federal prosecutors don’t like it.  Even state prosecutors don’t like it, and are starting not to like it in imaginative ways.  You know who else doesn’t like it?  FINRA.  FINRA doesn’t bring insider trading cases itself all that much, but it does sometimes.  And on July 2 it settled a weird one with Kenneth Ronald Allen, a registered representative at First New York Securities.


According to FINRA’s Letter of Acceptance, Waiver and Consent, its investigation found that in September 2010, Allen placed orders using a firm proprietary trading account to short sell shares of Tokyo Electric Power Company Inc. (TEPCO), which is listed on the Tokyo Stock Exchange.  Allen created a short position in TEPCO shares while he was in possession of material, non-public information that TEPCO was close to announcing a secondary public offering of its securities.  Allen obtained this information from a consultant whose source was a Tokyo-based employee of Nomura Securities Co. Ltd., a large Japanese broker-dealer, which underwrote the TEPCO offering.

As FINRA says, after receiving this information, Allen traded in TEPCO shares between September 15 and September 28, 2010.  TEPCO publicly announced the secondary offering on September 29, and the market price for its shares declined. Allen covered the short position after the announcement, realizing a profit of approximately $206,000.

Perhaps as a result of this conduct, First New York terminated Allen’s registration on May 29, 2012, and filed an amended Form U5, the Uniform Termination Notice for Securities Industry Registration, on July 3, 2012.  As part of the AWC, Allen consented to a bar from association with any FINRA member firm.  As we’ll discuss below, he didn’t pay a fine or any other monetary sanctions.

My Take

This case is a little odd for several reasons.  First, Allen settled this case on June 25, 2014, but FINRA’s jurisdiction over him was going to expire in nine days.  This doesn’t mean FINRA just had to initiate a disciplinary proceeding against him by July 3; it had to impose sanctions by then.  If on June 25, Allen had said, no, he didn’t really feel like signing the AWC, FINRA would have been jammed up.  It’s not clear to me what it could have done besides pound sand, because it could not have gotten a hearing panel to impose sanctions in that time.  In which case, no sanctions at all.

Second, where was the SEC on this?  Shouldn’t it have filed a case against Allen?  Well, probably not.  In Morrison v. National Australia Bank Ltd., 561 U.S. 247 (2010), the Supreme Court held that Section 10(b) and Rule 10b-5 apply “only in connection with a purchase or sale of a security listed on an American stock exchange, and the purchase or sale of any other security in the United States.”  Under Allen’s facts, the only securities were those of a Japanese issuer trading on a Japanese exchange.  So the SEC was probably out of the game from the start.   This means FINRA might have been the only game in town to bring a case against Allen, under its trusty and expansive Rule 2010.  That rule is the mother of all squish tests, and says, “A member, in the conduct of its business, shall observe high standards of commercial honor and just and equitable principles of trade.”  Almost any sort of conduct can fit under it.

Third, the SEC’s absence means that FINRA would have had to do this investigation entirely on its own, and without piggybacking on the Commission’s work.  This is a long way to go when a bar is the only sanction Allen was ever going to get.  As noted above, Allen consented to that bar, but did not consent to paying a dime of the $206,000, or any penalty or interest, to anyone.  That is because since Fiero v. FINRA, 660 F.3d 569 (2d Cir. 2011), FINRA hasn’t been able to enforce collection of its fines in the courts.  It can bar Allen, but then its ability to collect money from him effectively vanishes.  If he doesn’t want to be associated with a FINRA member, what does he care what FINRA says about a fine?

D.C. Circuit Bolsters Attorney-Client Privilege in Internal Investigations

Posted in Investigations

You may remember that in March, the U.S. District Court in D.C. threw the corporate world into a bit of a tizzy with a ruling that documents related to an internal investigation at Kellogg Brown & Root were not privileged and subject to discovery in a False Claims Act case.  After Judge Gwin, sitting by designation from the Northern District of Ohio, denied a stay of his order compelling disclosure of the documents in question, a great hue and cry erupted.  The D.C. Circuit heard oral argument on KBR’s petition for writ of mandamus on May 7, and an opinion vacating the district court’s order followed on Friday.  Over 30 years ago, the Supreme Court held in Upjohn v. United States, 449 U.S. 383 (1981), that the attorney-client privilege protected confidential employee communications made during a business’s internal investigation led by company lawyers.  For the court of appeals, the situation before it was no different.

The Underlying Facts

Here are the underlying facts: Harry Barko worked for KBR, and in 2005 filed a False Claims Act complaint against KBR and related corporate entities.  Basically, Barko alleged that KBR and its subcontractors had defrauded the U.S. government by inflating costs and accepting kickbacks while administering military contracts in wartime Iraq.  During discovery, Barko sought documents related to KBR’s prior internal investigation into the alleged fraud.  KBR had conducted that internal investigation pursuant to its Code of Business Conduct, which – critically for purposes of the court’s analysis – is overseen by the company’s Law Department.  KBR argued that the internal investigation had been conducted for the purpose of obtaining legal advice and that the internal investigation documents were therefore protected by the attorney-client privilege.  Barko responded that the internal investigation documents were unprivileged business records that he was entitled to discover.

Picking Apart the District Court’s Analysis

The district court reviewed the disputed documents in camera, and determined that the attorney-client privilege did not apply for a number of reasons.  First, the district court distinguished Upjohn by noting that that internal investigation began after in-house counsel conferred with outside counsel, whereas here the investigation was conducted in-house without consultation with outside lawyers.  The court of appeals was not persuaded, and applied the general rule that a lawyer’s status as in-house counsel does not dilute the privilege.

Second, the district court noted that the interviews in Upjohn were conducted by attorneys, whereas many of the interviews in KBR’s investigation were conducted by non-attorneys.  The court of appeals dismissed this as a distinguishing factor as well.  The investigation was conducted at the direction of attorneys in KBR’s Law Department.  Because communications made by and to non-attorneys serving as agents of attorneys in internal investigations are routinely protected by the attorney-client privilege, KBR’s privilege was likewise protected.

Third, the district court pointed out that in Upjohn the interviewed employees were expressly informed that the purpose of the interview was to assist the company in obtaining legal advice, whereas here they were not.  Also, the confidentiality agreements signed by KBR employees did not mention that the purpose of KBR’s investigation was to obtain legal advice.  As the D.C. Circuit noted, though, nothing in Upjohn requires a company to use magic words to its employees to gain the benefit of the privilege for an internal investigation.  In any event, the KBR employees knew the company’s legal department was conducting a sensitive investigation, and that they were not to discuss their interviews without the general counsel’s authorization.

Finally, the district court also distinguished Upjohn on the ground that KBR’s internal investigation was undertaken to comply with regulations that require defense contractors to maintain compliance programs and investigate allegations of potential wrongdoing. Therefore, the purpose of KBR’s internal investigation was to comply with those regulatory requirements rather than to obtain or provide legal advice.  As the court of appeals said, though, so long as obtaining or providing legal advice was one of the significant purposes of the internal investigation, the attorney-client privilege applies, even if the investigation was mandated by regulation and not simply an exercise of company discretion.

The “Primary Purpose” Test

The District Court began its analysis by reciting the “primary purpose” test, which many courts have used to resolve privilege disputes when attorney client communications may have had both legal and business purposes.  But the district court then said that the primary purpose of a communication is to obtain or provide legal advice only if the communication would not have been made “but for” the fact that legal advice was sought.  In other words, if there was any other purpose behind the communication, the attorney-client privilege would not apply.

The court of appeals said this but-for test was not appropriate for attorney-client privilege analysis.  This approach would eliminate the privilege for (1) numerous communications that are made for both legal and business purposes and that heretofore have been regarded as privileged; and (2) internal investigations conducted by the many businesses that are legally required to maintain compliance programs.  The court said that under this construction of the privilege, businesses would be less likely to disclose facts to their attorneys and to seek legal advice, which would “limit the valuable efforts of corporate counsel to ensure their client’s compliance with the law.”

The D.C. Circuit also said the primary purpose test, does not draw a rigid distinction between a legal purpose on the one hand and a business purpose on the other.  Indeed, trying to find a single primary purpose for a communication motivated by two sometimes overlapping purposes (one legal and one business, for example) can be an inherently impossible and infeasible task.  The court of appeals phrased the test this way: Was obtaining or providing legal advice a primary purpose of the communication, meaning one of the significant purposes of the communication?  If obtaining or providing legal advice was one of the significant purposes of the attorney-client communication, the privilege will apply.

What Companies Can Take from This Decision

The district court’s opinion had left companies – especially those in regulated industries where compliance programs are common – in a state of great uncertainty regarding the attorney-client privilege as it applied to their internal investigations.  Companies using Judge Gwin’s opinion as a guide would have been required:

  • to inform employees that interviews are being conducted in order to gather facts that will help company counsel provide legal advice to the company;
  • to ensure that internal investigations are overseen by outside counsel or at a minimum inside lawyers whose functions do not substantially involve managing business operations; and
  • to the extent that non-lawyers conduct witness interviews during internal investigations, to ensure that they do so at the express (and documented) direction of the company’s lawyers.

These are still good practices, and only the beginning of the precautions a company should take in an internal investigation.  But the D.C. Circuit’s decision takes much of the edge off the anxiety created by the district court.  Outside counsel do not have special privilege powers that are unavailable to in-house counsel.  Interviewers do not have to recite magical language to corporate employees to get the benefit of the attorney-client privilege.  Perhaps most importantly, companies with programs that separately require investigation to ensure regulatory compliance can breathe easier.  The court has made clear that as long as obtaining or providing legal advice is one of the significant purposes of the communication, the attorney-client privilege will apply.

The opinion doesn’t apply across the nation.  Other district courts have used the but-for test rejected here.  But I suspect this opinion will quickly become the standard for examining the attorney-client privilege as it applies to internal corporate investigations.  Companies engaged in them should study it and apply it going forward.

Commissioner Aguilar Addresses Boards’ Focus on Cybersecurity

Posted in Cybersecurity

One June 10th SEC Commissioner Luis Aguilar made a speech before the New York Stock Exchange, and he took the opportunity to discuss good corporate governance as it relates to cybersecurity and boards of directors.

It’s an opportune time.  As Commissioner Aguilar noted, one recent survey showed that between 2011 and 2012, U.S. companies experienced a 42% increase in the number of successful cyber-attacks per week.  Recent attacks on Adobe Systems, Target Corp., and Snapchat have affected millions of customers in each instance.  And these attacks are expensive.  Beyond the direct costs associated with notifying and compensating customers for data losses, the secondary reputational harm for corporations involved in severe breaches can drastically affect a company’s bottom line.  Also, cyber-attacks require quick and appropriate action; miscalculated responses can multiply problems caused by the attacks themselves.

For Aguilar, this means that corporate boards should take an active role in considering cyber-attacks and possible responses to them before they happen.  As he notes, the Framework for Improving Critical Infrastructure Cybersecurity, released by the National Institute of Standards and Technology in February 2014, says as much.  But how?  The nature of the risk ensures that it will be technologically difficult to stay ahead of.  Some have recommended mandatory cyber-risk education for directors.  Others have suggested that boards be at least adequately represented by members with a good understanding of information technology issues that pose risks to their companies.  Another way – mandated by the Dodd-Frank Act for large financial institutions but not for public companies generally – is to create a separate enterprise risk committee on the board.

In addition to proactive boards, a company must also have the appropriate personnel to carry out effective cyber-risk management and provide regular reports to the board.  At a minimum, Aguilar thinks, boards should have a clear understanding of who at the company has primary responsibility for cybersecurity risk oversight and for ensuring the adequacy of the company’s cyber-risk management practices.

I don’t think Commissioner Aguilar’s policy prescriptions – such as this one from 2009 about giving the SEC criminal enforcement authority – are always right.  But his thoughts about cybersecurity seem to be pretty close to the mark.  These attacks are here to stay, and public companies and their boards should get ready to respond.  In any event, the speech is heavily footnoted and is a nice guide to the current cybersecurity landscape.

Matt Kelly has good coverage of the speech and issue at Compliance Week.

The SEC v. Congress . . . for the Title

Posted in Insider Trading, Investigations, SEC Litigation

You don’t see this every day.  On Friday, the SEC filed a subpoena enforcement action seeking production of documents from the House Ways and Means Committee and documents and testimony from one of its staff members, Brian Sutter.  This is fascinating to me for so many reasons, among them: (1) the potential Constitutional cluster we’re about to witness; (2) the real test this poses for the recently passed STOCK Act’s effectiveness; and (3) another example of Mary Jo White’s severe distaste for those who defy Commission subpoenas.  The almost certainly unhappy respondents in this case haven’t yet responded in writing, so the factual details below come from the SEC’s supporting brief.  They may not be true.

How we got here

In February 2013 the U.S. Centers for Medicare and Medicaid Services announced an anticipated 2.3% reduction in Medicare Advantage reimbursement rates.  In fact, though, the actual rates released 20 minutes after the close of market trading on April 1, 2013, amounted to a 3.5% increase.  This was very good for some health insurers, whose stock prices increased dramatically, apparently as a result of this news.  The curious part for the SEC was, those stock prices increased in the hour before the news was officially announced.

About 70 minutes before the rate announcement, a lobbyist at Greenberg Traurig emailed an analyst at Height Securities, a broker-dealer, giving notice of the unexpected increase in reimbursement rates.  A half hour after that, the analyst released a “flash report” to dozens of clients, including prominent investment funds.  The report allegedly read:

  1. We now believe that a deal has been hatched to protect Medicare Advantage rates from the -2.3% rate update in the advanced notice mid-February
  2. We believe that the SGR will be assumed in the trends going forward resulting in roughly a 4% increase in cost trends
  3. This is a drastic change in historical policy . . .
  4. We are supportive of MA related stocks (HUM, HNT) under the circumstance

Five minutes after the Height Securities report was released, the prices and trading volumes of the stocks of the affected health insurers apparently increased dramatically.  For example, the price of Humana Inc. stock increased by 7% in the last 15 minutes of trading on April 1.

The SEC staff says it has  learned during its investigation that a colleague of the emailing Greenberg Traurig lobbyist spoke a number of times during March 2013 with Sutter, the staff director of the House Ways and Means Committee’s Health Subcommittee.  The lobbyist himself also spoke with Sutter at about 3:00 p.m. on April 1, ten minutes before the lobbyist’s email to Height.  So . . .

Voluntary Requests and Two Subpoenas

The SEC opened a formal investigation into this matter eight days later, on April 9, 2013.  Though the SEC staff had authority to send subpoenas at that point, it didn’t start that way for its respondents on Capitol Hill.  Instead, beginning in January 2014, the staff tried to get a voluntary production of documents from the Ways and Means Committee and Sutter, and an informal interview with Sutter.  House counsel communicated an unwillingness to produce documents or to make Sutter available for an interview.  After several failed attempts to get information voluntarily (again, this is the SEC’s unrebutted take at this point), the Commission staff issued subpoenas on May 6, 2014.  The scope of the documents sought appears to be fairly narrowly drawn, and is limited to the two months between February 10, 2013, and April 10, 2013.

The Committee and Sutter have objected to the subpoenas on many grounds.  They contend that the subpoenas are overbroad, vague, overly burdensome, and improperly intrude into Mr. Sutter’s privacy.  They also argue that the subpoenas’ demands violate the Constitution’s Speech or Debate Clause and the Committee’s sovereign immunity.

My Take

I may be overly deferential to the SEC here, but the Commission certainly paints a picture of having moved very cautiously in this case.  Even with subpoena authority in place, the staff sought to have documents produced and testimony given voluntarily for many months before sending the subpoenas at issue.  The six document requests at issue do not seem overly broad or vague to me, and they are unquestionably limited to two months from last year.   Separately, the STOCK Act was passed in 2012 to prohibit Members of Congress and Congressional staff members from illicit securities trading on knowledge gained during the legislative process.  If potential violations of that law can’t be investigated and enforced with subpoenas to Congressional staff members, I wonder how the investigations are supposed to happen.  Also, remember that the SEC under Mary Jo White has a fairly itchy trigger finger when it comes to subpoena enforcement actions.  This Commission is not afraid to go to court to get documents and testimony that have been lawfully demanded, and it’s been successful doing so.  I don’t know how the Constitutional questions are going to play out, but they are going to be really interesting.  Pass the popcorn.

SEC Files First Whistleblower Retaliation Case

Posted in Whistleblowers

Well, you can’t say Sean McKessy didn’t warn you.  The chief of the SEC’s whistleblower office has been warning for months at least that his group was looking to bring a stand-alone case enforcing the anti-retaliation provisions of the Dodd-Frank whistleblower rules.

On Monday, the Commission filed a settled administrative action in which Albany, New York-based investment adviser Paradigm Capital Management, Inc. was charged with prohibited principal transactions and then retaliating against the employee who reported the trading activity to the SEC.  As the Second Circuit has recently told us, “Trials are primarily about the truth.  Consent decrees are primarily about pragmatism.”  So the all of the “facts” that follow derive from the SEC’s claims in the settled order, and may or may not actually be true.

The Principal Transactions

Briefly, Paradigm engaged in principal transactions with C.L. King & Associates, Inc. (“C.L. King”), an affiliated broker-dealer, without providing effective disclosure to, or obtaining effective consent from, a hedge fund client (the “Fund”) advised by Paradigm.  As part of a tax reduction strategy from 2009 through 2011, Paradigm owner Candace King Weir directed Paradigm’s traders to sell selected securities at prevailing market prices from the Fund to a proprietary trading account controlled at C.L. King.  Because Weir controlled both Paradigm and C.L. King, the transactions between the two entities were principal transactions that required effective written disclosure to, and consent from, the Fund.  But Paradigm did not provide that disclosure to the Fund and did not get that consent.  Paradigm did establish a review committee to approve the pricing of the trades, but the committee was conflicted.  As a result, the SEC found that Paradigm violated, and Weir caused violations of, Section 206(3) of the Advisers Act.  In addition, Paradigm’s Form ADV omitted to state material facts concerning Paradigm’s process for obtaining consent to the principal transactions.

This part of the case is interesting by itself, and is a relatively sophisticated one for the SEC’s Asset Management Unit to bring.  But for now, I’m more interested in the retaliation piece, and especially what didn’t happen there.

An Insider Blows the Whistle, and Suffers for It

In March 2012, Paradigm’s then-head trader made a whistleblower submission to the SEC that revealed these principal transactions.  On July 16, 2012, the whistleblower notified Weir and C.L. King’s Chief Operating Officer that he had reported potential securities law violations to the Commission.  That day, the whistleblower was questioned about his allegations and then returned to the trading desk.  Paradigm also retained outside counsel to advise the firm.

At the end of the next day, Paradigm informed the whistleblower that he would be removed from the trading desk and temporarily relieved of his trading and supervisory duties.  Paradigm explained that because he executed trades that were reported to the SEC, the firm needed to investigate his actions.  Paradigm further directed the whistleblower to work offsite at a different office building and to prepare a report that would detail all of the facts that supported the potential violations.

On July 17, the whistleblower’s counsel proposed that he be permitted to prepare his report from home rather than come into the office.  Paradigm and the whistleblower’s counsel also discussed the idea of his leaving the firm in exchange for a severance payment.  Between July 18 and July 20, Paradigm denied the whistleblower access to certain Paradigm trading and account systems and his work email while he was at home.  He submitted the requested report on July 20 and told Paradigm he was planning to return to work on Monday, July 23.  On July 21, though, Paradigm told him not to bother coming in.  Three days later, the firm told the whistleblower’s lawyer that the employment relationship had been “irreparably damaged” and that Paradigm wanted him to leave employment with “as little difficulty or acrimony as possible.”

After the two sides could not agree on severance terms, the whistleblower informed the firm that he was prepared to return to work, but only as Paradigm’s head trader.  Paradigm said he could come back on August 13, and that his compensation structure would remain the same.  But he would not return as head trader; Paradigm merely noted that his duties would be “meaningful” to the firm.  His first assignment was to identify any potential wrongdoing by the firm so it could further investigate his allegations.  As part of that assignment, the whistleblower was asked to review more than 1,900 pages of hard-copy trading data.  Paradigm denied his requests for access to electronic reports that might make this review more efficient.  On August 15, Paradigm also directed the whistleblower to consolidate multiple trading procedure manuals into one comprehensive document and propose revisions to that document.

Also, while the whistleblower was working from home, he received Paradigm’s consent to use his personal email address in preparing the report detailing the basis for his claims.  A month later, the whistleblower sent a confidential report from that address to Paradigm’s CCO. This caused Paradigm to believe that the whistleblower previously removed confidential documents using his personal email address.  On August 16, Paradigm accused him of violating Paradigm’s policies and his terms of employment by removing confidential business records from Paradigm’s information network.  The whistleblower resigned the next day.  The SEC found that in forcing the whistleblower to this point, Paradigm violated Section 21F(h) of the Exchange Act, which prohibits an employer from discharging, demoting, suspending, threatening, harassing, directly or indirectly, or in any other manner discriminating against, a whistleblower in the terms and conditions of employment because of any lawful act done by the whistleblower in, among other things, providing information to the Commission.  Paradigm and Weir agreed to pay $2.2 million to settle the charges.

My Take

I think this case is quite important, mostly because of what it doesn’t include.  The whistleblower wasn’t fired.  His salary wasn’t cut.  But he was marginalized and apparently given make-work the SEC thought was designed to encourage his departure.  It’s interesting to me that the SEC decided to make this its first whistleblower retaliation case.  Granted, it’s a settled administrative order, not subject to a federal court’s approval.  But employers subject to the SEC’s jurisdiction should take careful note, and calibrate its reactions to legitimate claims of securities violations to be sure it doesn’t punish a whistleblower for being a whistleblower.  Their counsel will also have to be nimble enough to recognize whether the underlying allegations are valid, and understand how to react.

Criminal Procedure in Game of Thrones

Posted in Uncategorized

Game of Thrones watchers know its quasi-Medieval Westeros as a remarkably harsh, unforgiving world.  There’s just not a lot of room for error.  In fact, if you’re a character and lose your head (figuratively), you just might lose your head (literally).  But one facet of Westeros is soft as butter: its criminal procedure.

The last few episodes have demonstrated as much.  Briefly for non-devotees, the much-hated King Joffrey is killed by poison at his wedding celebration, and his uncle Tyrion happens to be standing nearby as Joffrey chokes and bleeds to death.  Suffice it to say that Joffrey had it coming to him.  But as he fades away, he points his crooked finger at Tyrion.  Playing true to character, Joffrey’s mom, Cersei, freaks out and accuses Tyrion of killing her son.  A trial with three judges soon follows, and it doesn’t go well for Tyrion.  As witness after witness gives false or misleading testimony against him, he eventually decides he doesn’t like the forum so much.  So he demands a trial by combat.  Uh, what?  The trial is almost over, looking bad for the defendant, and he just decides he wants a different kind of trial!

We don’t have trials by combat in the United States.  But defendants can waive their right to a jury trial and opt for a bench trial if they think the latter is a better option.  Rule 23(a) under the Federal Rules of Criminal Procedure establishes four conditions to such a waiver:

  1. the defendant’s written consent to forgo a jury trial;
  2. the voluntary, knowing, intelligent, on-the-record nature of the defendant’s agreement to the waiver;
  3. the prosecution’s consent; and
  4. the district court’s approval.

Though the rules don’t specify when a jury waiver must be made, courts generally say it has to come before the trial starts.  In dicta from United States v. Cena, 451 F.2d 399, 401 n.2 (1st Cir. 1971), the court noted, “A substantial amount of court time and jury time is consumed and wasted in the selection of a jury that is not used.”  The Third Circuit has come out the other way and held that a jury trial waiver can be valid after trial but before the verdict is rendered.  United States v. Lilly, 536 F.3d 190, 194 (3d Cir. 2008).  Tyrion’s trial had almost run its course when he suddenly decided he needed a friendlier forum.  He’d want his trial to be in Philadelphia and not Boston if he were suddenly transported to the United States.

At the beautifully shot trial by combat itself, between Tyrion’s champion, Oberyn Martell, and the crown’s proxy, Gregor “The Mountain” Clegane, the result was certainly final but hardly definitive.  (Don’t watch to the end if you have a weak stomach.)  Oberyn was killed in spectacular fashion, but The Mountain appears to have been mortally wounded and pretty close to death, too.  The lead judge quickly announces the gods’ judgment that Tyrion is to be sentenced to death, but my first thought in watching the two collapsed combatants was, Was that a tie?  It’s unclear what rules apply, but if I were Tyrion’s lawyer I would definitely argue the equivalent of a hung jury and demand a second trial by combat.  We’ll see what happens, but I’m not sure how Tyrion’s going to wriggle out of this one.

Many thanks to Wes Camden, muse, for his thoughts related to this post.

Judge Rakoff Reversed by Second Circuit on SEC-Citi case, Still Sort of Wins

Posted in SEC Litigation, Structured and New Products

You’d be forgiven if you’d forgotten at this point, but way back in Obama’s first term, the SEC once investigated and sued Citigroup for its involvement in a collateralized debt obligation deal.  As the SEC said in its complaint, Citigroup told investors that a CDO fund had been populated with assets selected by an independent investment advisor.  Instead, though, the SEC said, Citi itself selected a substantial amount of negatively projected mortgage-backed assets in which Citigroup had taken a short position.  Basically, Citi made $160 million by taking a short position in pre-selected assets and making misrepresentations to induce investors to take a long position in the same assets.  Or so the SEC said.  Consistent with general federal agency practice, Citi was allowed to neither admit nor deny the allegations.  It was a big hoo-ha.

The case was filed as a proposed settlement on October 19, 2011, and submitted to Judge Jed Rakoff in the Southern District of New York.  Under the deal, Citi would pay $160 million in disgorgement, $30 million in prejudgment interest, and a $95 million civil penalty.  Judge Rakoff had a fit, and a lot of questions.  Among them:

  • Why should the Court impose a judgment in a case in which the SEC alleges a serious securities fraud but the defendant neither admits nor denies wrongdoing?
  • How was the amount of the proposed judgment determined?
  • How does the SEC ensure compliance with the proposed injunctive relief?
  • Why would the penalty be paid by Citi and its shareholders rather than the culpable individuals involved?
  • How could a securities fraud of this nature and magnitude be the result of mere negligence?

He refused to approve the settlement, and set a trial date.  Both sides appealed and sought a stay of Judge Rakoff’s order, first from him directly, and also from the U.S. Court of Appeals for the Second Circuit.  The Second Circuit concluded that the SEC demonstrated a strong likelihood of success on the merits, because Rakoff had not accorded the SEC’s judgment adequate deference, and granted the stay.

And there it was left, for 2½ years.  Lots of other district judges took up Rakoff’s mantle, and refused to approve a number of other settlements between federal agencies and their litigation opponents.  Rakoff wrote a long essay in the New York Review of Books about the financial crisis and prosecutors’ failure to prosecute.  He also submitted to a winding Huffington Post interview in which he minimized the SEC’s resource concerns.  As he said, “The U.S. attorney’s office from the Southern District of New York, which has brought some of the great fraud cases of the last 50 years, has never exceeded 14 human beings in the fraud unit.  That’s the unit I was in. The SEC has hundreds, if not thousands, of people.”  The SEC itself partially changed its policy on admissions in settlements, and started to demand some in appropriate cases.

And yet, it turns out Judge Rakoff was wrong the whole time.  By essentially insisting on admissions to the facts alleged in the SEC’s complaint, Rakoff exceeded his authority as a district judge.  According to the Second Circuit today, here is what a court evaluating a proposed SEC consent decree for fairness and reasonableness should assess: (1) the basic legality of the decree, (2) whether the terms of the decree, including its enforcement mechanism, are clear; (3) whether the consent decree reflects a resolution of the actual claims in the complaint; and (4) whether the consent decree is tainted by improper collusion or corruption of some kind.  Of course, a district court may need to make additional inquiry to ensure the decree is fair and reasonable.  Indeed, it shouldn’t be a “rubber stamp.”  But the primary focus should be on ensuring the decree is procedurally proper and take care not to infringe on the SEC’s discretionary authority to settle on a particular set of terms.

As the court said, it “is an abuse of discretion to require, as the district court did here, that the SEC establish the ‘truth’ of the allegations against a settling party as a condition for approving the consent decrees.”   Judge Rakoff had found an “overriding public interest in knowing the truth.”  The Second Circuit didn’t deny that interest, but put it in context.   It said, “Trials are primarily about the truth.  Consent decrees are primarily about pragmatism.”

The SEC was probably right to give itself some flexibility on its settlement policy.  It can be a hidebound institution when left to its own devices.  And I suspect its leaders are happy tonight knowing that district courts have a bit less flexibility in assessing those settlements going forward.  But make no mistake.  By letting this final opinion sit for as long as it did, the Second Circuit gave the win to Judge Rakoff.  It’s a different world now thanks to his overreaching approach to the Citi case.  It’s funny how things work out.