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Insight & Commentary on SEC Enforcement Actions and White Collar Crime

The SEC’s Investment Management Division Has Some Things to Tell You about Cybersecurity

Posted in Cybersecurity

Lots of agencies and organizations want to boss you around about cybersecurity.  In April, the SEC and the Justice Department published more directions on the issue.  We’ll cover the very brief guidance issued by the SEC’s Division of Investment Management first, and then turn to DOJ in a later post.

First, as with everyone else, the IM Division thinks cybersecurity is very, very important for investment companies and investment advisers.

Second, the staff recommended that advisers and funds consider a number of measures to strengthen cybersecurity:

  • Conduct a periodic risk assessment.
  • Create a strategy designed to prevent, detect and respond to cybersecurity threats. Specific pieces of the strategy could include: tiered access to sensitive information and network resources; data encryption; restricted use of removable storage media; and development of an incident response plan.
  • Implement the strategy through written policies and procedures and training that provide guidance to officers and employees. Then monitor compliance.
  • Assess whether protective cybersecurity measures are in place at relevant service providers.

This is a truncated list, and it isn’t magical.  The suggestions could apply to literally any business. You can read the full version here, but FINRA is way ahead of the Investment Management Division in providing usable guidance on how to bolster cybersecurity.

Third, and more interestingly, the guidance suggests that funds and advisers should take their compliance obligations under the federal securities laws into account in assessing their ability to prevent, detect and respond to cyber attacks.  So, maintaining a compliance program that is reasonably designed to prevent violations of the securities laws could also mitigate exposure to cyber threats, the guidance says.  “For example, the compliance program of a fund or an adviser could address cybersecurity risk as it relates to identity theft and data protection, fraud, and business continuity, as well as other disruptions in service that could affect, for instance, a fund’s ability to process shareholder transactions.”  In other words, if a cyber attack prevents you from, say, being able to process shareholder transactions, the staff is going to look back and see how well prepared you were before the assault.  If you weren’t prepared at all, the end result probably won’t be pretty, for the shareholders or you.

The guidance recognizes that it’s impossible to anticipate and prevent every cyber attack.  But it wants you to try.  And appropriate planning could mitigate the impacts of those attacks, as well as help “compl[iance] with the federal securities laws.”  Consider yourself warned.

You Can Settle Your Insider Trading Case with a Negligence-based Charge

Posted in Insider Trading, SEC Litigation

This is almost certainly not true anymore.  But it was true once!  Maybe only once.  Back in October 1991, the SEC sued Shared Medical Systems, a Pennsylvania health care information services company and three of its officers and directors: the company for financial reporting fraud and the individuals for insider trading, among other things.  Here’s what the litigation release said about the insider trading piece:

The Commission’s Complaint alleges that [James] Macaleer, the chairman and chief executive officer of SMS, [James] Kelly, the former executive vice president, treasurer, and secretary of SMS, and [Clyde] Hyde, a former director of SMS, received nonpublic information during 1986 and early 1987 which disclosed a decline in SMS’ historic annual growth rate of 20%. Between October and December 1986, while in possession of this information, they sold a total of more than 157,300 shares of SMS stock. Macaleer is also charged with causing the sale of over 22,000 shares of SMS stock from his children’s trust and Uniform Gift to Minors Act accounts. The defendants sold their stock at prices ranging from $35 to $ 41.875 per share. After public disclosure of this information, the stock price dropped to $27 per share.

As they typically do, the charges include alleged violations of Section 10(b) of the Exchange Act and Section 17(a) of the Securities Act.  As to Section 17(a), the complaint didn’t specify Section 17(a)(1) (which is scienter-based) or Sections 17(a)(2) or (3) (which are negligence-based).  The complaint, filed in the Eastern District of Pennsylvania, was settled as to Hyde.  The other defendants litigated, and filed a motion to dismiss that was denied in August 1992.

It’s hard to know what happened over the next 18 months, but the SEC appears to have slowly tired of the fight.  In February 1994, the Commission dismissed all charges against Kelly, and replaced the complaint against Shared Medical Systems with a cease-and-desist order as to Section 13(a) of the Exchange Act (negligence-based) and related rules.  An amended complaint reinstated the insider trading claims against Macaleer and dropped claims that he had aided and abetted the company’s accounting violations.  Macaleer moved to dismiss again, and lost again in May 1994.

By June, it was all over.  Macaleer settled, in at least two interesting ways.  First, the final litigation release noted he “admitted, that, while in possession of [material, nonpublic] information, Macaleer sold SMS stock and thereby avoided losses he otherwise would have incurred.”  It’s not shocking that the final settlement would include an admission of liability after this extensive litigation, but that was unusual in that pre-Mary Jo White era.  Second, though, the fraud charges were gone.  Macaleer admitted only to violations of Section 17(a)(3), not Section 10(b) or Section 17(a)(1).

I don’t think that has happened in an insider trading case before or since.  It’s really quite remarkable that Macaleer was able to back the SEC down that way.  But his lawyers at Wilmer, Cutler & Pickering were not amateurs: Art Mathews, a giant of the era who died four years later, Andy Weissman, who recently retired, and Kenneth Chernof, now at Arnold & Porter.  I would love to know of other instances where an insider trading case was settled on similar terms.  Lexis tells me there aren’t any, but maybe I’m missing some.

Texas Supreme Court Applies Absolute Privilege to Statements in FCPA Investigations

Posted in FCPA, Investigations

You may remember the 2013 Texas Court of Appeals case involving Shell Oil Company and Robert Writt.  We covered it here, and it left FCPA internal investigations based in Texas in an awkward spot.  To recap very briefly, in 2007 the Justice Department asked Shell to conduct an investigation into potential FCPA violations, and the company did.  The investigation pointed at least one finger at former employee Writt as a bad actor, and Shell reported that finding to DOJ.  Writt was never charged with wrongdoing, and sued Shell for libel.  The key question for the court: were Shell’s statements to DOJ subject to a conditional privilege or an absolute privilege?  Cases involving conditional privilege frequently proceed to discovery, because they depend on factual questions surrounding the good faith basis for the statements at issue.  Cases involving absolute privilege can often be handled at the motion-to-dismiss stage.  If the statements are absolutely privileged, not much is left for discovery.  The Court of Appeals thought Shell’s statements about Writt were only conditionally privileged, and reversed the trial court’s grant of summary judgment to Shell.  On May 15, the Texas Supreme Court reversed again.

Facts Surrounding the Investigation

I tend to think that cases like this one (and maybe all cases) are decided by how the facts are characterized.  Here’s how the Texas Supreme Court described them:  In July 2007, the Justice Department sent Shell a letter explaining that it had become aware that Shell had engaged another company, Panalpina, “to provide freight forwarding and other services . . . and that certain of those services may violate the [FCPA].”  In its letter, the DOJ requested that Shell meet with it to discuss Shell’s engagement of Panalpina. At the meeting Shell agreed to conduct an internal investigation into its dealings with Panalpina and to report its findings to the DOJ, with the understanding that the report would be treated as confidential. The investigation was to be done pursuant to a plan approved by DOJ, and Shell agreed to produce additional documents and information. DOJ subsequently identified several individuals as potential persons of interest regarding its investigation and requested Shell to produce information related to them. One of these was a Shell employee named Robert Writt.

Shell hired outside counsel and investigators to assist in the investigation, and Writt was interviewed several times about his knowledge of possible illegal payments made by Panalpina. In February 2009, Shell provided the investigators’ findings and its report to the DOJ. Among other matters, the report set out that the impetus for it was the meeting between Shell and DOJ representatives regarding allegations of criminal violations. The report also contained information, analyses, and conclusions as to Shell’s relationship with, and Writt’s actions as they related to, Panalpina. The report stated that Writt was aware of “several red flags” concerning Panalpina’s customs clearance process and that he provided inconsistent information about his knowledge of Panalpina’s questionable acts. In addition to providing the report to the DOJ, Shell terminated Writt’s employment. In its termination letter, Shell stated that Writt’s conduct was a “significant, substantial and unacceptable” violation of Shell’s General Business Principles and Code of Conduct.  Writt then sued for defamation and wrongful termination

How the Investigation Was Resolved

While Shell’s motion for summary judgment in the defamation suit was pending, DOJ filed an information charging Shell with conspiracy to violate the FCPA and aiding and abetting the making of false books and records. Shell and the DOJ then executed a Deferred Prosecution Agreement — frequently used in FCPA cases.

In the Agreement, the DOJ acknowledged that Shell had (1) cooperated in the DOJ’s investigation, (2) agreed to cooperate in any ongoing investigation, and (3) agreed to pay a monetary penalty. Shell’s willingness to conduct an internal investigation, admit misconduct, and cooperate with the investigation was an important factor in the DOJ’s decision to offer Shell the opportunity to enter into the Deferred Prosecution Agreement. The terms of the DPA, which are more favorable than the criminal penalties that could have resulted from an FCPA prosecution, required Shell to continue to cooperate with the DOJ and other law enforcement agencies, pay a $30 million criminal fine, and implement an extensive FCPA compliance and reporting program. The DPA provides that if Shell fully complies with its terms, then the criminal charges will be dropped. But if Shell fails to abide by the DPA’s terms, DOJ will resume the prosecution.

Which Kind of Privilege?

But coming back to the defamation case, were Shell’s statements about Writt conditionally or absolutely privileged?  Shell argued that because its statements were made in serious contemplation of a judicial proceeding, and not on the bare possibility that a proceeding might occur, an absolute privilege should apply.  The Supreme Court analogized Shell’s position before the Justice Department in 2007 to that of Brian McNamee in Clemens v. McNamee, 608 F. Supp. 2d 811, 824-25 (S.D. Tex. 2009).  During the course of the investigation described in that case, McNamee was told by the Assistant United States Attorney, FBI agents, and IRS agents conducting the investigation that his status as a witness would be reconsidered if he failed to cooperate with the investigation, which included being interviewed by the Mitchell Commission. Id. at 824. All of McNamee’s interviews with the Mitchell Commission were arranged and attended by Assistant United States Attorneys or other government agents. Id. Although McNamee cooperated with the investigation and offered information voluntarily, he was for all practical purposes compelled to make his statements to the commission. Id. at 825. The court concluded that to classify McNamee’s statements as only conditionally privileged would have caused great harm to the administration of government and the government’s ability to ensure justice was served.  Id. at 825-26.

What It Means

Similarly, in some sense Shell had a choice about making a full report to the Justice Department when it “asked” the company to conduct an internal investigation into the Panalpina matter.  But it didn’t really have a choice.  It could have told DOJ prosecutors to pound sand, and it also could have signed on for an indictment of the company and massive fines.  The court understood this, and also understood the context of how FCPA investigations are resolved these days.  Specifically, “[f]ederal prosecutors and the U.S. Sentencing Guidelines ‘place a high premium on self-reporting, along with cooperation and remedial efforts, in determining the appropriate resolution of FCPA matter.”  Shell didn’t really speak freely when making its statements to the Justice Department.  It was already being ground up in the judicial process, even if that process looks a bit different than many traditional prosecutions do.  So the statements were absolutely privileged.

This case will make investigations that require reports to the government a lot less risky for companies that conduct them.  And tougher for employees who want to sue for defamation.

Vivek Ranadivé and Wisconsin IA Both Big into Cherrypicking, According to Sources

Posted in Investment Advisers

Here’s a thing I think I know about billionaires:  They’ve made piles and piles of money doing something someone somewhere surely advised them not to do because it was a dumb idea.  Then later, actually dumb ideas come along and the billionaires are not dissuaded because they have a billion dollars and who’s going to tell them what to do now?  Which is why I was very excited late last year when Sacramento Kings owner Vivek Ranadivé proposed that his team play only four players on defense, keeping one back to cherrypick easy baskets.  Never mind that it’s hard enough to play defense with five NBA players, or, as Barry Petchesky suggested, “you’d probably have DeMarcus Cousins and Rudy Gay get into a fistfight over who got to hang out under the opponent’s basket.”  I just want to see somebody try it, and it’s too bad that the Kings didn’t actually employ this strategy.  Maybe their experimentation in the D League will bubble up into something I can watch with my own eyes . . . .

In the meantime, do you know who else is big into cherrypicking?  According to the SEC, Wisconsin-based investment adviser Welhouse & Associates.  On Monday the SEC sued the firm and its principal Mark Welhouse for allegedly “improperly allocating to his personal and business accounts certain options trades that appreciated in value during the course of a trading day while allocating to his clients other trades that depreciated in value.”  That is, a different kind of cherrypicking.

The SEC’s order assumes some knowledge about how cherrypicking works.  Here’s what I think is a fair description of what the order alleges:  On any particular day, Welhouse & Associates and Mark Welhouse (together here, “Welhouse”) made proprietary trades for itself and trades for its advisory clients.  Often these were options trades in an S&P 500 exchange-traded fund called SPY that would change in value over the course of the day.  Importantly, these trades did not have to be allocated to a particular account until later in the afternoon, and Welhouse generally allocated them after 2:00 p.m. or 3:00 p.m.

All of this is fine as far as it goes, but the SEC didn’t love how Welhouse allocated these trades when measured against how it said it would allocate the trades.  In several instances, the SEC alleges, Welhouse said it would allocate the SPY trades on a pro rata basis among client accounts and Welhouse proprietary accounts:

  • Mark Welhouse stated, apparently in testimony before the SEC staff, that he allocated all trades pro rata across all accounts for a particular model (including pro rata across Mr. Welhouse’s own accounts and his clients’ accounts that were on the same model);
  • He also said that Welhouse’s January 2012 Form ADV Part 2A’s reference to fair and equitable trade allocation is a reference to Mr. Welhouse’s pro rata allocation across a model.
  • Welhouse’s firm brochures on Form ADV said Welhouse did not trade for its own account at all.
  • Welhouse’s written policies and procedures for trade allocation state: (1) “[a]ll clients are assigned to a model portfolio. . .”; and (2) “[w]hen a trade is put on the trade is purchased by the model portfolio and automatically allocated to the clients account” on a pro rata basis.

In fact, the SEC alleges, Welhouse did not allocate SPY options trades pro rata.  Once the trades went up or down, Welhouse allocated a disproportionate number of profitable SPY options trades to favored accounts (accounts belonging to Mr. Welhouse or another person with the last name Welhouse), while allocating unprofitable SPY options trades to client accounts.  The Commission has accused Welhouse of violating the antifraud provision of the Exchange Act and the Advisers Act, and claims the firm reaped $442,000 in ill-gotten gains from these undisclosed allocations.

Two weird things about this case: First, the testimony Mark Welhouse gave apparently occurred without a court reporter present.  Instead, he “was interviewed by the Commission staff on January 28, 2014. Mr. Welhouse agreed that the interview could be recorded, and the staff recorded the interview.”  Like with a tape recorder?  An iPhone?  It’s not unlawful, but it’s an odd procedure.  The order doesn’t make clear whether this interview was on the phone or in person.  It doesn’t sound like an attorney for Welhouse was present, but it’s hard to tell.  Did the staff just call him on the phone and then ask if they could record the call?  He might have said things he otherwise would not have if the setting had been more formal administrative testimony.

Second, Welhouse & Associates is registered with the State of Wisconsin as investment adviser, not with the SEC.  It’s on the hook for violations of the antifraud provisions no matter where it’s registered, but it seems a little odd that the SEC is handling this case and not the Wisconsin Department of Financial Institutions.

Do Investment Advisers Automatically Have Fiduciary Duties to Their Clients?

Posted in Investment Advisers

I always thought they did.  But on Friday I read this sentence: “An investment advisor-client relationship is not a de jure fiduciary relationship.”  It sort of jumped out at me, because for a long time I’ve assumed that an investment adviser was a fiduciary to its clients.  But I was directed to a case, William L. Thorp Revocable Trust v. Ameritas Inv. Corp., 57 F. Supp. 3d 508, 524 (E.D.N.C. 2014), and there it was in black and white.

Judge Dever, the opinion’s author, is widely regarded as a very careful judge, so I was eager to see where he found authority for this flat statement.  He cited a North Carolina Business Court case, Silverdeer, LLC v. Berton, 2013 NCBC 24 (N.C. Super. Ct. 2013), which struggled a bit with the question.  The Silverdeer plaintiffs, who wanted to demonstrate a fiduciary relationship between themselves and one of the defendants, didn’t cite any cases supporting the notion that there was one.  Instead, they merely cited “N.C. Gen. Stat. § 78C et seq. for the proposition that an investment advisor owes a duty of disclosure to his clients, which they argue in turn creates a de jure fiduciary relationship.”

Of course, if they’d wanted to cite a case in support of such a relationship, they didn’t need to go any farther than the U.S. Supreme Court.  Fifty-two years ago the Court held in SEC v. Capital Gains Research, Inc., 375 U.S. 180, 191-92 (1963), that Section 206 of the Advisers Act imposes fiduciary duties on investment advisers by operation of law.  The relevant provisions of Section 206 read:

“It shall be unlawful for any investment adviser, by use of the mails or any means or instrumentality of interstate commerce, directly or indirectly – (1) to employ any device, scheme, or artifice to defraud any client or prospective client; (2) to engage in any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client.”

As the Court put it:

The broad proscription against “any . . . practice . . . which operates . . . as a fraud or deceit upon any client or prospective client” remained in the bill from beginning to end. And the Committee Reports indicate a desire to preserve “the personalized character of the services of investment advisers,” and to eliminate conflicts of interest between the investment adviser and the clients as safeguards both to “unsophisticated investors” and to “bona fide investment counsel.”  The Investment Advisers Act of 1940 thus reflects a congressional recognition “of the delicate fiduciary nature of an investment advisory relationship,” as well as a congressional intent to eliminate, or at least to expose, all conflicts of interest which might incline an investment adviser – consciously or unconsciously – to render advice which was not disinterested.

Thorp Revocable Trust and Silverdeer allow for the possibility that an investment adviser may have a fiduciary relationship with its client “when one party figuratively holds all the cards — all the financial power or technical information, for example . . . .”  Thorp Revocable Trust, 57 F. Supp. 3d at 524.

Those two cases are focused on North Carolina law, and investment advisers are subject to a dual federal-state regulatory structure in which larger advisers register with the SEC, and the smaller ones with the states (generally).  I suppose it’s possible that federally-registered advisers might bear fiduciary duties to their clients while state-registered ones do not necessarily.  But I have never even considered that possibility and have never read about such a distinction.

Here’s how a leading treatise puts it:

These fiduciary duties apply to all advisers, including both those that provide individualized discretionary management and those that provide impersonal advice through publications or otherwise. The SEC has held that an investment adviser owed a fiduciary duty to its client when the client agreement required the adviser “to act as an investment adviser” even though the client did not in fact expect to receive investment advice from the adviser.

James E. Anderson, Robert G. Bagnall & Marianne K. Smythe, Investment Advisers: Law and Compliance § 9.02[1] (2015).

If you can shed light on this, I’d be happy to hear thoughts.


UPDATE: June 29 — Belmont v. MB Investment Partners, Inc., 708 F.3d 470 (3d Cir. 2013), digs into this issue pretty deeply, including the federal-state distinctions, and notes that states generally defer to federal law in this area.


FIN4 May Have Embarked on a Risky Hacking/Insider Trading Strategy

Posted in Cybersecurity, FINRA, Insider Trading

I haven’t yet turned to a life of crime, so far be it from me to criticize actual criminals’ profit-maximizing strategies.  It’s easy for me to nitpick, but I’m not the one strapping on my mask and trying to earn a (dis)honest dollar every day.  But have a look at this Reuters story from Tuesday.

In it, we learn that the SEC and the Secret Service are investigating a sophisticated computer hacking group known as “FIN4” that allegedly “has tried to hack into email accounts at more than 100 companies, looking for confidential information on mergers and other market-moving events. The targets include more than 60 listed companies in biotechnology and other healthcare-related fields, such as medical instruments, hospital equipment and drugs.”  Apparently their plan is to harvest this information and then trade on it.  Nobody knows where FIN4 is from.  They could be overseas, but supposedly their English is flawless and they have a deep knowledge of how financial markets work, so maybe they’re in the United States.  At one level, a little terrifying!

But this group hasn’t devised a complex, superpowered algorithm to steal information.  Instead, it’s allegedly stealing information the (sort of) old fashioned way: through social engineering.  The Reuters story explains that FIN4 “used fake Microsoft Outlook login pages to trick attorneys, executives and consultants into surrendering their user names and passwords.”  In at least one case, “the hackers used a confidential document, containing significant information that they had already procured, to entice people discussing that matter into giving their email credentials.”

I have two main thoughts.  First, sound information handling practices, and appropriate wariness among professionals using email, still go a long way toward securing confidential data within organizations.  It’s often not the most technologically advanced tactics that yield the worst data breaches.  Second, FIN4 has embarked on a complex money-making plan.  There may be many uses of this information, but one of them seems to be trading securities in the public markets.  That’s not as simple as it seems.  If you’re doing that, you’re on the grid and can’t really hide.  FINRA sees all of those trades and it isn’t that hard for regulators to find out who is making them.  When the Consolidated Audit Trail comes online,* it will be substantially easier and faster. In the meantime, broker-dealers are obligated to identify who their customers are.  If those people have electronic connections to the ones involved in the hacking, those links could be enough for the SEC to get an asset freeze before profits are siphoned overseas.

What FIN4 is allegedly doing is scary, but they haven’t yet built a criminal ATM.


* Speaking of the Consolidated Audit Trail, when is that thing coming online?

Tom Brady Better Off as a Famous Quarterback than a Registered Representative

Posted in FINRA

And this is true for any number of reasons!  There’s the money, the supermodel wife, the buddy trips to the Kentucky Derby . . . .  All pretty obvious.  But there’s another reason, too.  As an NFL quarterback, Brady works under the structure of an organization with occasional governance issues and a loosely drafted collective bargaining agreement.  If he were a registered representative working for a broker-dealer, he’d be under FINRA’s umbrella, and his status with that self-regulatory organization would be in severe jeopardy.

But let’s back up for a minute.  Surely you’re aware of Deflategate.  It is maybe my favorite sports scandal of all time.  In it, Brady allegedly ordered the deflation of footballs in last season’s AFC Championship game against the Colts so he could grip them better and thereby gain an unfair advantage.  The Patriots beat the Colts 45-7 in that game.  Many people have written many things about Deflategate.  The scandal is ludicrous and incredible.  I love it.  Possibly to distract from another scandal, the league promised to investigate thoroughly, and hired the Paul Weiss law firm to do that.

In the resulting 139-page report, we learned that Brady declined to turn over his personal cell phone to investigators.  The lawyers in charge of that investigation don’t come from a world where subpoenas and discovery requests are routinely ignored.  Fortunately for Brady, the league’s collective bargaining agreement only seems to care to the extent that the refusal amounted to “conduct detrimental to the integrity of and public confidence in the National Football League.”  Did it?  Maybe!  People on the radio sure like to talk about whether it did.

Now, if Brady had been a registered representative in Foxboro, Massachusetts and not the NFL wonderboy, in a FINRA investigation he would have been subject to FINRA Rule 8210.  That rule says, in part, that he would be required “to provide information orally, in writing, or electronically . . . and to testify at a location specified by FINRA staff . . . .”  Also, “No member or [associated] person shall fail to provide information or testimony or to permit an inspection and copying of books, records, or accounts pursuant to this Rule.”  In egregious cases FINRA can bar registered representatives permanently for not complying.

If only Tom Brady had a securities license, we might know all the answers to Deflategate and whether the Colts could have overcome that 38 point deficit with properly inflated footballs.  If only . . . .

Why Did BHP Billiton Settle an FCPA Case Including 7+ Year-Old Conduct?

Posted in FCPA

Remember the Water Cube from the 2008 Olympics in Beijing?  BHP Billiton has probably had reason to think about it recently.  On Wednesday it settled an FCPA case with the SEC arising out of the company’s sponsoring the attendance of foreign government officials at the Summer Olympics seven years ago.  Here’s what the SEC says happened:

BHP Billiton failed to devise and maintain sufficient internal controls over its global hospitality program connected to the company’s sponsorship of the 2008 Summer Olympic Games in Beijing.  BHP Billiton invited 176 government officials and employees of state-owned enterprises to attend the Games at the company’s expense, and ultimately paid for 60 such guests as well as some spouses and others who attended along with them.  Sponsored guests were primarily from countries in Africa and Asia, and they enjoyed three- and four-day hospitality packages that included event tickets, luxury hotel accommodations, and sightseeing excursions valued at $12,000 to $16,000 per package. . . .

According to the SEC’s order instituting a settled administrative proceeding, BHP Billiton required business managers to complete a hospitality application form for any individuals they sought to invite to the Olympics, including government officials.  However, the company did not clearly communicate to employees that no one outside the business unit submitting the application would review and approve each invitation.  BHP Billiton failed to provide employees with any specific training on how to complete forms or evaluate bribery risks of the invitations.  Due to these and other failures, a number of the hospitality applications were inaccurate or incomplete, and BHP Billiton extended Olympic invitations to government officials connected to pending contract negotiations or regulatory dealings such as the company’s efforts to obtain access rights.

As a result of this conduct, the SEC says, the company violated the FCPA’s internal controls and books and records provisions.  BHP Billiton will be paying a $25 million civil penalty to resolve the matter. The SEC also says the settlement reflects the company’s remedial efforts and cooperation with the SEC’s investigation.

My question is: why is this case happening now?  Does the statute of limitations mean nothing?  Under 28 U.S.C. § 2462, the SEC has five years to bring cases including “punitive remedies,” which includes civil money penalties such as the one in this case.  In 2013, the Supreme Court held in Gabelli v. SEC that the Commission can’t use the discovery rule to toll the statute of limitations.  If a defendant fraudulently conceals securities violations, that can toll the statute.  But it doesn’t sound like that’s what happened here.  It appears that the SEC first contacted the company about these issues in August 2009.  And based on the cooperation with the investigation acknowledged in the press release, I suspect the company entered into a tolling agreement with the SEC.  So I suppose my next question is, why did it take so long?  The SEC knew about the alleged conduct one year after the Olympics ended.  Why couldn’t it resolve the investigation over the next four?  Or five?  What would the result have been if BHP Billiton had refused to enter a tolling agreement?  Charges under the anti-bribery provisions?   A parallel case brought by the Justice Department?  What was the prize for agreeing to the extension?

I’m full of questions, not answers.  Answers cost money, but feel free to send answers if you have them.

D.C. Circuit Says “Heads I Win, Tails You Lose” Is Maybe Not the Best Set of Rules for Criminal Forfeiture

Posted in Asset Forfeiture

If you’re a federal prosecutor, you have a lot of tools at your disposal.  Crimes waiting to be indicted are abundant.  If you’re having trouble getting a defendant sentenced as a career offender, you can see if he fits as a “de facto career offender” instead.  I mean, it’s not sanctioned by statute, but the Fourth Circuit loves that sort of thing.  But manipulating court proceedings to keep a party from mounting a challenge to criminal forfeiture isn’t really one of those tools.  The D.C. Circuit just told us as much in United States v. Emor, a case issued last week.

SunRise Academy

Here’s what happened.  SunRise Academy was founded in 1999 by Charles Emor as a private, nonprofit school serving special needs children in Washington, D.C.  SunRise had a board of directors that included Emor, his family members, and others.  SunRise grew into a substantial operation, with 150 students each semester and a solid financial endowment.  In 2007, the city issued SunRise a Certificate of Approval to provide educational services to special needs students.  That certificate brought consequences, and in 2009, D.C. Public Schools decided to investigate whether SunRise had fully implemented its policies.  A year later, the school system issued a report and revoked SunRise’s certificate after finding inaccurate daily attendance reports and fabricated student records designed to receive payment from the city for services not actually rendered.

Charles Emor and the Charges against Him

And that was not all.  Between 2006 and 2010, Emor used his authority as a SunRise director and board member to withdraw funds from SunRise’s bank accounts.  He then used those funds to buy a Lexus SUV and other luxury items for himself, provide money to his family members, and pay the rent on his townhouse.

The government eventually caught Emor, arresting him and seizing the Lexus and over $2 million in the account of Core Ventures, a for-profit company that had contracted to build a coffee shop or vocational school on SunRise property.  Federal prosecutors initially charged Emor with 37 counts, including mail and wire fraud and various other federal and D.C. Code violations.  (Prosecutors in D.C. have jurisdiction over city statutes, too.)  The government also provided notice it was seeking forfeiture of Core’s property.

An important question early on was, who had Emor allegedly defrauded?  In some counts, the government alleged that Emor committed mail and wire fraud, through SunRise, in a scheme to defraud the city.  The district court eventually dismissed these counts over the government’s objection.  But prosecutors also described Emor’s scheme as one to defraud SunRise.  These charges included several wire fraud counts involving wire transfers from SunRise to Core.  Emor ultimately reached a plea deal with the government, which agreed to drop all but one count of wire fraud alleging that Emor had devised a scheme to obtain money “from SunRise’s bank accounts.”  Importantly, though, prosecutors “consciously and deliberately” (as the court of appeals said) declined to identify the victim of Emor’s fraud, and the district court deferred a determination of the victim’s identity until the preliminary forfeiture hearing.

The government never charged SunRise with wrongdoing.  Instead, SunRise moved under Federal Rule of Criminal Procedure 41 for the return of its property, claiming that it owned the $2 million and the Lexus.  The district court denied the motion, holding that 21 U.S.C. § 853(k) prohibits third parties from intervening in criminal proceedings, other than a third party proceeding under 21 U.S.C. § 853(n).

How Criminal Forfeiture Works

Under 28 U.S.C. § 2461(c), “criminal forfeiture is available for general . . . wire fraud violations.”  United States v. Day, 524 F.3d 1361, 1376 (D.C. Cir. 2008).  The procedures set forth in 21 U.S.C. § 853 – except for subsection (d) – apply “to all stages of a criminal forfeiture proceeding.”  28 U.S.C. § 2461(c).

At the preliminary order of forfeiture stage, “[i]f the government seeks forfeiture of specific property, the court must determine whether the government has established the requisite nexus between the property and the offense.”  Fed. R. Crim. P. 32.2(b)(1)(A).  The court is required to make its determination “without regard to any third party’s interest in the property.”  Fed. R. Crim. P. 32.2(b)(2)(A).  By statute, in fact, no third party may “intervene” in the criminal forfeiture proceeding.  21 U.S.C. § 853(k)(1).

The sole forum for a third party to address its interest in forfeited property is through a third party ancillary proceeding.  See id. § 853(n).  Any third party, “other than the defendant,” may petition for an ancillary proceeding if it can assert a “legal interest” in the forfeited property.  Id. § 853(n)(2).  The third party must file a petition setting forth the “nature and extent” of its interest in the property, the “time and circumstances” when the petitioner acquired that interest, any supporting facts, and the requested relief.  Id. § 853(n)(3).

After receiving a petition, a court may “dismiss the petition for lack of standing” or for “failure to state a claim.”  Fed. R. Crim. P. 32.2(c)(1)(A).  For purposes of deciding any motion to dismiss, the facts set forth in the petition are assumed to be true.”  Id.

Meanwhile, a third-party petitioner seeking relief from a preliminary order of criminal forfeiture must satisfy one of two conditions.  A petitioner must either show a legal interest in the forfeitable property vested in petitioner rather than the defendant or show its interest was superior to the criminal defendant’s at “the time of the commission of the acts which gave rise to the forfeiture.”  21 U.S.C. § 853(n)(6)(A).  If the petitioner’s interest arose after the crime, the petitioner must show it was a “bona fide purchaser for value” of the property, who was reasonably without cause to believe that the property was subject to forfeiture” at the time of purchase.  Id. § 853(n)(6)(B).

Procedure in the SunRise/Emor Case

By declining to identify a victim of Emor’s fraud as part of his plea agreement, prosecutors prevented SunRise from acting as that victim and seeking restitution under 18 U.S.C. § 3663A(c)(1)(A)(ii).

After that gambit came a threshold question:  Were SunRise and Emor the same legal person?  If so, Rule 32.2(b)(2)(A) and Section 853(k)(1) should have presented no bar to SunRise’s participation in the preliminary forfeiture hearing.  After all, only third parties are to be kept out.  Here, the district court found that SunRise was Emor’s alter ego but still prevented it from participating in the hearing.  If not, a third party ancillary proceeding would be the proper vehicle under Section 853(n).

SunRise filed just such a petition claiming ownership in the forfeited property and requesting a hearing to determine its interest.  In its petition, SunRise alleged an embezzlement theory, claiming the “Forfeited Property at all times remained the property of SunRise Academy,” and that “Mr. Emor’s embezzlement from SunRise occurred at the time of each transfer from SunRise to Core.”  In its opposition to the government’s motion to dismiss, SunRise again referred to Emor’s “embezzle[ment]” of the $2 million dollars and claimed SunRise owned the funds transferred to Core at the time of “the alleged illegal taking by Mr. Emor . . . .”  So if SunRise were able to prove Emor stole or embezzled the funds SunRise sent to Core to build the coffee shop, SunRise could establish possession of legal title or a superior legal interest at “the time of the commission of the acts which gave rise to the forfeiture.”  21 U.S.C. § 853(n)(6)(A).

But SunRise was already stuck.  The government moved to dismiss SunRise’s petition for lack of standing.  The district court found no reason to revisit the alter ego finding from the preliminary forfeiture hearing, and held that SunRise lacked standing.   To recap, SunRise could not participate in the original hearing partly because it was Emor’s alter ego.  And it had no standing to pursue the later third-party claim because it was determined to be Emor’s alter ego at a hearing in which it wasn’t allowed to participate.

Quoting a Friends episode from a decade ago, the court of appeals called this the “Heads, she wins; tails, I lose” approach and reversed.

If you’re in a situation like this, know the rules and procedure and try to prevent this from happening on the front end.  The D.C. Circuit has just put some more arrows in your quiver.

Insider Trading Recklessness and Kevin Love’s Shoulder

Posted in Insider Trading, SEC Litigation

A couple of weeks ago I expressed skepticism about the ultimate impact of Judge Rakoff’s recent opinion in SEC v. Payton.  In it, he held that for purposes of a motion to dismiss, the SEC had adequately alleged insider trading violations in a remote tippee context, even after the Second Circuit’s decision in United States v. Newman.  Briefly, the issue was this: for insider trading liability, the Second Circuit now requires (1) that the personal benefit coming back to a tipper be “of some consequence” and generally something beyond mere friendship; and (2) that each tippee or remote tippee know what that benefit is.

SEC v. Payton

As for the second requirement, I wondered out loud last November if traders wouldn’t adjust to this new world by making sure they didn’t know what the personal benefit was.  I wouldn’t describe myself as a cynic, but I’ve seen people try to construct walls of plausible deniability before.  They can be hard to knock down.  At least for SEC cases, Judge Rakoff thinks they certainly can be knocked down.  He noted in Payton that the intent required to sustain a violation of Section 10(b) in an SEC case is recklessness, which he described as “heedless disregard of the probable consequences.”  That is a sufficient definition in some legal contexts, but I think it understates what the SEC has to show in the Second Circuit.

To prove violations of Section 10(b), the SEC must demonstrate that the defendant acted either with scienter, defined as “a mental state embracing intent to deceive, manipulate, or defraud.”  SEC v. Obus, 693 F.3d 276, 286 (2d Cir. 2012).  The Second Circuit has held that scienter “may be established through a showing of reckless disregard for the truth, that is, conduct which is highly unreasonable and which represents an extreme departure from the standards of ordinary care.”  Id.  Other circuits describe the same concept as “severe recklessness.”  See, e.g., Ziemba v. Cascade Int’l, Inc., 256 F.3d 1194, 1202 (11th Cir. 2001).  The courts’ point is, if a defendant is going that far down the intent spectrum, it really doesn’t matter.  It’s enough for scienter.

Kevin Love’s Shoulder

Kevin Love will tell you.  I don’t know if you saw this play from the last game in the Cavaliers’ sweep of the Celtics in the NBA playoffs’ first round.  In it, you see perennial All-Star Kevin Love and non-All-Star Kelly Olynyk thrashing Love’s shoulder like he’s trying to start a lawnmower.  According to press reports, the move dislocated Love’s shoulder, required surgery, and has taken Love out of action for the next four-to-six months.  Those months include the rest of the 2015 playoffs, which mean a lot to the Cavaliers if not the Celtics.  After the game, Love accused Olynyk of intentionally hurting his shoulder.  Olynyk naturally said of course he would never have intentionally done such a thing.  And lots of knuckleheads on sports radio the next morning yelled about how Kelly Olynyk didn’t have a history of deliberately assaulting other people so how could he have done so here, etc.

As I listened to them I thought, does it matter?  Let’s assume Olynyk didn’t walk onto the court with malice in his heart and his eyes zeroed in on Love’s shoulder.  Having locked arms with Love, though, he did launch into a move that didn’t help get the basketball but easily could have liberated Love’s shoulder from the rest of Love’s body.  If Game 4 had been a civil securities fraud case, I think the Second Circuit would say Olynyk is just as liable either way.

These levels of intent are important, in SEC cases and NBA playoff games.